BaFin President Felix Hufeld on low interest rates, digitalisation and regulation

2016 was dominated by three issues at BaFin, and they will continue to feature high on its agenda in 2017: continuing digitalisation, de-facto zero interest rates and the question of the right level of regulation. These issues have often enough been carried forward from one year to the next. Together, they pose a threefold challenge for the supervised undertakings – especially for banks.

Digitalisation and big data as an opportunity

Whether you tend to regard the increasing digitalisation of the financial sector as a destructive force or as an opportunity is a question of perspective, because digitalisation has a bit of both: it has its destructive elements, but – to quote loosely from Schumpeter – it's a creative destruction, one that can also offer opportunities and give rise to new things. That by no means suggests that the old, i.e. the established world of finance, is necessarily doomed to failure.
Yet digitalisation and big data are having an influence on the entire value chain of financial services. They may even break up this chain and reassemble it anew. There may also be links in the chain that will become obsolete in a few years' time. The question is what this creative destruction does to the business models of banks and insurers. Take insurers, for example: given the amount, range and quality of the data modern technology allows them to gather and analyse, they will in future be able to tailor their tariffs to individual customers with increasing precision. From a regulatory perspective, this is both sensible and desirable. Ultimately, however, big data could put the concept of the community of the insured to the test.

Old against new?

The catalysts of digitalisation are innovative fintech companies competing with the established companies in the financial sector. They use ultra-modern, flexible IT technology and put established providers under pressure in terms of offering and pricing. At the very least, this puts a question mark over existing business models. But even in the age of digitalisation, the banking and insurance business is based on trust, and fintech companies will first have to earn that trust. Meanwhile, established companies will require a degree of agility, and to demonstrate intelligence when making business decisions. As Ludwig Börne taught us, in a rolling ship, he falls who stands still, not he who moves.

Data giants

This applies all the more in an environment of increasing competition: there are large firms outside the financial sector that hold huge amounts of customer data. In the future, these data giants could decide – as a sideline, effectively – to add financial services to their portfolio. Who and what offerings will prevail in the market in the coming decades will be decided by the market itself, i.e. the customer.

Supervision doesn't take sides

Supervision is impartial. It is without fear or favour. It applies its rules and standards appropriately to fintech companies, too, based on the old principle of "same business, same risks, same rules". What BaFin has made clear right from the start therefore continues to apply: its role is to supervise, not to boost the economy. Both functions are important and meaningful, but they should not be mixed. Fintech companies and the issue of digitalisation in general also pose challenges for BaFin. It has to get to the core of these issues and must not allow its knowledge to become outdated, because it is rightly expected to provide adequate answers to the regulatory and supervisory questions of digitalisation. Here, the watchword is “shape administrative procedures around target groups”.

Cyber risk

This also, and in particular, applies to cyber risk, the dark side of digitalisation, where destruction is not coupled with creative benefits – not mentioning the illegal advantages cyber attackers seek to gain. Digitalisation creates a huge target. The business and value chain processes in the financial sector are heavily IT-dependent. For this reason, confidence in financial services providers today means above all confidence in IT security and the protection of personal data. To consider IT security purely from a cost perspective is therefore not only risky for operations, but also strategically short-sighted. True, to ensure sustained IT security is not an easy task – neither for established providers nor for fintech companies, incidentally. What's more, by its very nature, IT security is short-lived. What is considered secure today may become a gateway for cyber attacks tomorrow. But BaFin insists on sustained IT security and demands that undertakings also insist on such security from their IT service providers and suppliers. Both supervisors and the supervised undertakings must realise: there is no end to learning.

Low interest rates pose added challenge

In addition to the various challenges arising from digitalisation, there is another issue facing the sector: persistently low interest rates. Their effect is increasingly being felt – especially among those traditionally affected by them, such as life insurers in Germany. Most undertakings have prepared themselves well for continuing hard times on the interest rates front, for example by strengthening their capital base, cutting back discretionary bonuses and offering new products with new forms of guarantees. But the pressure, especially on weaker life insurers, is visibly mounting. They will have to make great efforts if they want to reliably keep paying the benefits they once promised in better times. Some owners may also have to get used to the fact that they will have to strengthen the capital of their undertakings. For BaFin, this means that it continues to operate – and increasingly so – in intensified supervision mode.

Pensionskassen and Bausparkassen in the low interest rate environment

This applies even more so to Pensionskassen, which are also struggling to cope with the low interest rates. They, too, started to take mitigating steps at an early stage in order to boost their risk-bearing capacity. Almost all Pensionskassen have recognised additional provisions. However, if the low interest rates persist, some of them may no longer be able to provide the promised benefits in full.¹

It comes as no surprise that the low interest rates are also weighing on the earnings of the Bausparkassen. One of the reasons is that interest expenses for Bauspar deposits dating back to periods of higher interest rates are not offset by similar interest income from Bauspar loans. The Bausparkassen are trying to deal with the consequences of this discrepancy. They are introducing new lower-interest tariffs, creating leaner processes and reducing their costs. The fact that they are also visibly working to reduce the proportion of high-interest-bearing Bauspar contracts in their portfolios has repeatedly caused a stir in the media. A recent court ruling has created greater clarity in this regard.²

Banks also increasingly affected

The longer the historically low interest rates continue, the more deeply felt their impact will be on the banks' books. In terms of capitalisation, German institutions are still in relatively good shape. But for how much longer? In times such as these, operating profitably becomes increasingly difficult, especially for banks that are primarily involved in the deposit-taking and lending business. The institutions are making the usual adjustments: cutting costs, introducing adequate prices, looking for new sources of income and revising their business models. A tour de force, especially in a banking sector that is as fiercely competitive as the one in Germany. But as I said earlier: those who don't move will fall. The trick is to make the right moves.

Interest rate risk

The longer interest rates remain low, the greater interest rate risk becomes for banks and insurers. All the more so, because in times of low interest rates banks are inclined to accept long-term loans and insurers favour extremely long-term investments. At the same time, the supervisory system requires that assets and liabilities are balanced appropriately. BaFin keeps an eye on these risks and intervenes where necessary.³ In general, the regulatory community faces the issue of the unintended procyclical effect of financial regulation – in combination with international accounting standards as well.

Is regulation a burden?

Competition from fintechs and sluggish earnings because of low interest rates – banks in particular have for some time been complaining about another burden they'd love to eliminate: regulation. Let's take a quick look back: it's true that regulation has been tightened, and significantly so, since the outbreak of the financial crisis in 2007/2008. But it was with good reason, because large-scale deregulation had taken place in the years leading up to the crisis, and that had to be corrected.

There is no rule that says that regulation should be fun for the regulated. But there are rules in both German and European law that specify that it must be appropriate and must not be an excessive burden. In terms of proportionality, European bank regulation is not yet where it should be. As part of the reforms of the CRD IV and CRR⁴ , BaFin is therefore looking for ways to lessen the burden on smaller institutions. That this needs to be done is beyond doubt for BaFin, although it is far from clear to what extent it will be able to prevail in the European legislative process.

Navigating challenges

The process of reducing the burden on smaller institutions involves some challenges that have to be navigated carefully; for instance, banks can only fulfil their important economic role if they are sufficiently solvent and have adequate liquidity, and the banking system as a whole is stable and resilient. The capital and liquidity requirements, which were tightened following the crisis, must not be relaxed again – not even for smaller banks. The equation that "small equals low-risk" is in many cases a fallacy, and there have to be firm minimum standards for all banks. Consequently, concessions for smaller institutions should above all focus on areas where administrative effort can be minimised without reducing risk-bearing capacity.

Regulatory concessions that are a threat to financial stability must be off the agenda. This also and above all means that the particularly stringent requirements for large and systemically important banks must not be relaxed. Proportionality works both ways and must not be confused with laxity. In general, the reasonable and important objective to put greater emphasis on the principle of proportionality must not be confused with general deregulation. If there is one thing we have to prevent from happening, it is a relapse into the destructive “pork cycle” of deregulation-crisis-regulation-deregulation-new crisis. From a global perspective, such a relapse can by no means be ruled out at present. It is all the more important, therefore, to keep referring back to the lessons the financial crisis has taught us.

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