While 2024 saw some volatile periods, the international financial markets proved stable overall. Various developments, especially if they arise in combination, could lead to corrections on the financial markets in 2025: rising geopolitical tensions and political uncertainties, the high sovereign debt ratios of many industrialised nations and the development of inflation and economic growth.

In view of falling inflation rates, the monetary policy of major central banks has been less restrictive since the second half of 2024. The European Central Bank (ECB) initiated its interest rate turnaround in the middle of the year, while the US Federal Reserve cut interest rates in September 2024. Market participants had expected the interest rate cuts; further interest rate adjustments have already been priced in. Depending on accounting methods, interest rate reductions will lead to valuation gains or to a reduction in hidden liabilities.

Slumps due to the unwinding of carry trades

At the beginning of August 2024, temporary slumps were observed on the global financial markets. This was triggered by a slight increase in key interest rates by the Bank of Japan in combination with labour market data from the US that was perceived as poor. These slumps were largely caused by the unwinding of carry trades.

In the low interest rate environment, yen borrowing at interest rates close to zero was attractive for international investors and foreign governments looking to invest in higher-yielding assets. As interest rates rose, investors increasingly liquidated their yen-denominated loans, causing the Japanese currency to appreciate. This led to sharp price drops in the asset classes in which investors had invested by means of carry trades.

Losses from these market movements were largely recouped within a short period of time. Nevertheless, this incident shows that the market is highly volatile, especially when high volumes are held and a herd instinct (even if irrational) sets in among investors. Although the available data is limited, the severity of the market turbulence that resulted from the unwinding of carry trades also suggests that some of the investments based on this investment structure are highly leveraged. This further increases volatility.

Risks due to high global sovereign debt

The high level of sovereign debt in many countries also harbours risks for the global financial system. Interest rate hikes in recent years have increased financing costs. For highly indebted countries in particular, this resulted in an increased default risk and reduced credit ratings. This was reflected on the markets in the rising risk premiums on government bonds from these countries. This also affected individual eurozone countries in 2024. In future, US government bonds could also come under pressure if doubts arise about their debt sustainability.

In a worst-case scenario, the high national debt of some countries could lead to considerable distortions on the bond and stock markets. The German financial system and the real economy could then potentially be affected by contagion effects, particularly due to the international interconnectedness of German banks and insurers.

Bond risks

The fair values of bonds stabilised at a low level in 2024 (see Figure 5). As a result of interest rate cuts and investors’ expectations of lower inflation, the prices of long-term bonds recovered slightly from the third quarter of 2024.

Figure 5: Development of market values of fixed-interest securities

Source: BaFin diagram using data from Refinitiv Datastream, as at 9 December 2024

Nevertheless, there are still price risks. Banks and Sparkassen hold significant bond positions. The 2024 stress test conducted by BaFin and the Deutsche Bundesbank at less significant institutions (LSIs) showed that losses in the market value of bonds would lead to capital depletion of almost 2.5 percentage points – based on a Common Equity Tier 1 capital ratio of 18.2% in 2023.

Insurers also have material exposures to corporate, bank and government bonds. For example, the proportion of bank bonds and bank deposits of German insurers that fall under Solvency II was around 16% in mid-2024. BBB-rated bonds accounted for around 8% of the total investments held by these insurers.

A slump on the stock markets can also directly affect banks and insurers

Stock market share prices rose across the board in the first half of 2024. In the third quarter, this movement levelled off to a sideways trend. In the fourth quarter, a positive development was recorded and the prevailing positive trend of 2024 continued. The German DAX benchmark index exceeded the 20,000-point mark for the first time, while in the US the S&P500 and Nasdaq 100 reached new all-time highs.

Significant corrections on the stock markets can pose a risk for insurers and banks. However, shares account for a relatively small portion of insurers’ investment portfolios. The industry average as at 30 June 2024 was around 4%.

In relation to their total assets, shares likewise account for a very small proportion of assets held by German banks in their own portfolios (Depot A). According to the 2024 LSI stress test, the volume of bonds held by German LSIs is almost 30 times higher than the volume of shares held. This can also be seen from the fact that, in the stress test, price slumps on the stock markets only had a minor impact on banks’ capitalisation.

Importance of non-bank financial intermediaries increasing further

Non-bank financial intermediaries (NBFIs), such as asset managers and investment companies, in addition to insurers and Pensionskassen, are becoming increasingly important compared to the banking sector. According to the Bundesbank’s Financial Stability Review 2024, NBFIs provide around 40% of financing for the real economy in the eurozone. They hold around half of the financial assets in the eurozone – this share has increased by 18 percentage points since the global financial crisis. In Germany, NBFIs hold around 40% of financial assets in the financial system, an increase of 15 percentage points since 2009.

At the same time, the risks associated with the NBFI sector remain relevant, particularly the risks arising from excessive debt and abrupt liquidity outflows, which can lead to fire sales. The level of debt in the NBFI sector is often opaque. Open-ended investment funds are particularly vulnerable, since the assets have significantly longer maturities than the liabilities. These maturity mismatches make fire sales more likely. There are holding and redemption periods for German open-ended property funds that mitigate this risk. Nonetheless, the redemption of fund units may be suspended, for example in the event of insufficient liquidity in the fund.

The strong interconnectedness between banks and the NBFI sector also brings the risk of mutual contagion effects. Moreover, the accelerated speed at which information is disseminated alongside the use of algorithms and artificial intelligence in trading increase the risk of unidirectional effects being amplified.

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Risks in BaFin's Focus 2025
Foreword by the President

Main Risks in BaFin’s Focus

1. Risks arising from corrections on the real estate markets
3. Risks arising from corporate loan defaults
4. Risks arising from cyber incidents with serious consequences
5. Risks arising from inadequate money laundering prevention
6. Risks arising from market concentration due to the outsourcing of IT services

Trends

1. Digitalisation
2. Sustainability
3. Geopolitical turmoil