Potential deleveraging in the German banking system and effects on financial stability

The stability of the German banking system, in its capacity as an integral component of the country's financial system, has come under particular scrutiny, not least since the onset of the COVID-19 pandemic. Financial stability hinges on whether banks are sufficiently resilient to stress effects, which can arise if the economy suffers an unexpected downturn, for example. This might coincide with system-wide deleveraging if banks are insufficiently resilient. Systemwide deleveraging, in turn, could pose a risk to financial stability and have adverse repercussions for the real economy. The monitoring tool presented in this paper can be used to determine the potential deleveraging based on a sequence of six analytical steps that take multiple first-round scenarios into account. The sequence comprises (i) the loss-absorbing capacity of banks in the current (starting) situation, (ii) the banking system's key stress channels, (iii) deleveraging as a bank response to a reduction in their loss-absorbing capacity, (iv) second-round effects in the interbank market, and (v) the resulting effects on lending capacity to non-financial corporations, allowing for substitution effects. To illustrate the role played by macroprudential buffers, the scenarios initially assume that banks use their buffers. That is to say, banks tolerate undershooting the macroprudential buffer requirements and attempt to maintain their supply of credit. As a next step, a comparison is then made with the results if banks do not use their buffers. This comparison allows us, last of all, (vi) to estimate the macroeconomic effect of buffer use on the real economy. The results produced by the monitoring tool indicate that buffer use involves a macroeconomic trade-off. Given a (slightly) higher probability of default and spells of lower resilience, banks have to restrict their lending to a lesser extent, which allows an additional downturn in real GDP to be avoided.