The potential for significant corrections on the international financial markets remains great. For a long time, investments had come to a standstill as a result of the extremely low interest rates. A great deal of liquidity was in circulation, and the (re-)financing conditions were correspondingly favourable. These framework conditions have radically changed in a short space of time. In 2023, there were no significant or sustained corrections on financial markets, with expectations regarding the further development of interest rates playing an important role in this context. Markets expect that the interest rate increases have reached their peak and that first interest rate reductions will be made in the foreseeable future. With geopolitical risks also at a high level, the risk premiums on markets appear to be still low. A sudden change in market expectations in response to adverse shocks could bring about abrupt corrections on markets.

Interest rate increases, quantitative tightening and geopolitical uncertainty

International financial markets remain in a fragile state. The increasingly tense geopolitical situation¹ and the subdued forecasts for economic development in certain key countries and regions engendered great uncertainty in 2023. To tackle the high inflation, the European Central Bank (ECB), the US Federal Reserve and the Bank of England, among others, initiated a round of interest rate increases in 2022.² Furthermore, they started to sell the bond holdings that they had accumulated in recent years in the process known as quantitative tightening. The central banks have thus withdrawn liquidity from the markets. The restrictive monetary measures are resulting in higher financing costs for companies of the real economy. This could lead to rating downgrades and increased default rates on international bond and securitisation markets, especially among highly indebted companies of the real economy.³

The supervised insurers have considerable exposures to corporate, bank and government bonds. Bonds with a BBB rating, the poorest investment grade rating, account for around ten percent of total investments by market value of primary insurers supervised under Solvency II (as at 30 September 2023).

The Russian war of aggression against Ukraine, the terror attack on Israel and the escalation of the conflict in the Middle East alongside uncertain developments in other regions harbour further risks for financial markets. In the past, the central banks and sovereign states shored up markets in stress situations especially with additional liquidity. In the present environment, such measures would not be in keeping with the current monetary policies of central banks.

Different repercussions for certain asset classes

Rising interest rates, a weakening economy and an increasing level of risk aversion have not given rise to growing default rates on international bond markets so far. However, the market values of bonds fell strongly from mid-2021 until the third quarter of 2023 (see Figure 1).

Figure 1: Development of market values of fixed-interest securities

Source: LSEG Datastream, as at October 2023

The higher risk premiums seen in 2023 in the form of higher yield expectations indicate that markets’ trust in the debt sustainability of a number of countries is falling. This particularly concerns countries with budgets that will come under pressure in the years ahead as it becomes more expensive to refinance maturing bonds.

The situation underlying equity markets in 2023 was mixed: after falling strongly as a result of the war in Ukraine and the great uncertainty accompanying this in 2022, markets recovered over the course of 2023. Given the macroeconomic situation, significant corrections cannot be ruled out.

Such corrections would have a direct but not significant impact on insurers’ solvency and earnings because the share of listed stocks in the overall portfolios of insurers amounted to approximately five percent in sector average terms as at 30 September 2023. German banks would also be affected if prices on equity markets were to fall sharply. However, the institutions’ share of stocks in their own securities accounts (Depot A) is very low at an average 0.3 percent in terms of their total assets (as at 30 September 2023).

What is more, corrections on financial markets could trigger higher margin requirements in the derivatives business – i.e. the amount of funds that have to be furnished as collateral. Collateral that has already been furnished might no longer suffice if sizeable corrections were to occur. Market players would then have to provide additional liquidity at short notice.

Risks arising for financial stability from non-bank financial intermediation

In recent years, the significance of non-bank financial intermediation (NBFI) in relation to financial intermediation has risen noticeably throughout the banking sector. According to data of the Financial Stability Board (FSB), the global volume of NBFI assets more than doubled between the years 2008 and 2022. Stability risks can arise due to inadequate transparency and regulatory gaps, with the risks arising from the excessive use of leverage and liquidity outflows particularly significant in this context.

If alternative investment funds (AIFs), in particular, or other vehicles with a low deployment of equity capital and possibly complex financial instruments take high risks and turn out to be less liquid in situations of stress or crisis, contagion effects can be triggered elsewhere in the financial sector in the form of panic selling. System-wide stress could be engendered as a result of this. This is especially the case if banks of systemic importance are involved in such transactions. A scenario of this kind creates additional concentration risks and poses risks for financial stability.

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Risks in BaFin's Focus 2024
Foreword by the President

Main Risks in BaFin’s Focus

1. Risks arising from significant increases in interest rates
2. Risks arising from corrections on the real estate markets
4. Risks arising from defaults on loans to German companies
5. Risks arising from cyberattacks with serious consequences
6. Risks arising from inadequate money laundering prevention
7. Risks arising from market concentration due to the outsourcing of IT services

Trends

1. Digitalisation
2. Sustainability
3. Geopolitical turmoil

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