Real danger lies in Mitteleuropa’s financial sector

8/3/2015

By Wolfgang Münchau

Much of what could go wrong in the eurozone did. Among the few things that did not has been the unreformed financial sector in Mitteleuropa. That may now be about to change.

The apparent stability of the sector is on some level surprising: Germany, the Netherlands and, to a lesser degree, Austria have been running persistently large savings surpluses — money they invested abroad. In Austria, one conduit for such outbound flows was Hypo Alpe Adria, a bank that was nationalised in 2007 after suffering heavy losses in central Europe. Last week the bad bank into which Hypo’s non-performing assets were folded declared a moratorium on its €11bn of debt.

Germany, too, has its share of dodgy banks. But the real risk there lies elsewhere: in the life insurance sector. Moody’s, a rating agency, already warned in late 2013 that an environment of low interest rates would be very dangerous for the German life insurers. At that time, the yield on 10-year German government bonds was still a respectable 2 per cent. They were at 0.34 per cent last Friday. For five-year paper, the rate is even negative.

Today’s scheduled start of quantitative easing by the European Central Bank could lead to a further fall in market interest rates for as long as the programme goes on — at least until September 2016.

To see the impact of low rates on the life insurance sector, one needs to understand their business model. These companies sell insurance products and annuities with guaranteed returns. They invest the money they receive from their policyholders in government and corporate bonds. For this to work, the average return on the bonds they hold in their portfolio has to be higher than the guaranteed rate they pay out.

To make matter worse, this is all happening at a time when the insurance industry itself is subject to tightening domestic and European regulation. Since 2011, German insurance companies have to hold a reserve to protect themselves against falling bond yields. And a new European regulatory regime will impose stricter capital requirements and solvency rules from 2016.

At zero interest rates, it is very difficult for the industry as a whole to remain solvent. In anticipation of the difficulties ahead, German insurers have begun to diversify into other assets, such as property or private equity, taking on more risk in the process. But all this is small-scale stuff.

One of the best analyses on this subject is from two authors at the Bundesbank. They simulated three scenarios — baseline, small stress, and big stress. In the severe scenario, the average return is between 1 and 2 per cent, which is more than the return on German government bonds you can buy today.

Of course, average returns of insurers’ portfolios are higher. This is because the insurers are holding bonds they bought many years ago during times of higher interest rates. But as time goes on, the weight of low-yielding bonds in their portfolio will rise. For them the biggest danger is the length of time interest rates stay low.

The result of the simulation is shocking. In the milder of the two stress scenarios, 12 of the 85 German insurance companies under investigation would be insolvent by 2023. In the harsher version, that number would rise to 32 companies with a total market share of 43 per cent. And this is only the life insurance industry. Many German companies have underfunded pension schemes, which may also be in trouble.

When you hear German central bankers complain about the financial stability risks of low interest rates, this is what they are referring to. Low interest rates are, of course, not the cause of this slow-moving train wreck. The cause is, of course, the train.

If there is anything in Europe that requires urgent reform, it is not the Greek product market, but the German and Austrian financial sector. This sounds utterly implausible to the casual observer. But if Germany continues with its policy of forcing a deflationary adjustment in the eurozone and running large savings surpluses with an unreformed financial sector at home, we should prepare for the next big financial crisis.

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