The state of the financial markets: Black Monday in August 2024

At the beginning of August, there was a sell-off on the stock markets, which was also referred to in the media as Black Monday 2024. Was this a blip or are the financial markets now entering troubled waters again after a long period of growth? 

Michael Koetter: The setback in August actually went beyond normal market fluctuations. After a long phase of growth, which has continued with only a few interruptions since the Covid crisis in 2020, this slump is a sign of growing uncertainty. On the one hand, there are concerns about the decoupling of the financial markets from the real economy, while geopolitical risks, such as the ongoing war in Ukraine or tensions in Asia, also play a role. We also see structural weaknesses in Germany: economic growth is stagnating, the shortage of skilled labour is obvious, bureaucratic burdens are increasing, the innovative strength of German firms is limited and the last state elections point to further political turbulence in the medium term until the next federal elections. All of this is contributing to uncertainty on the markets, and we may have to expect more setbacks again after this recovery phase.

In your research, you also examine the development of the property markets in Europe. In Germany, we have seen sharply rising prices in the property sector in recent years. Does your data point to a bubble that could soon burst?

Michael Koetter: The property market in Germany is indeed under pressure, but I wouldn't call it a nationwide bubble at the moment. The price increases in recent years have been strong, particularly in urban centres, but the driving factors - low interest rates, high demand and limited supply - have gradually weakened. The interest rate increases of recent months are having a dampening effect and we are already seeing prices stabilise or, in some cases, fall slightly. However, high property prices in combination with increased financing costs are a problem for many households, particularly in metropolitan regions, especially for new tenants. In rural areas, on the other hand, we are seeing that property markets are increasingly losing liquidity: It is simply taking longer and longer to sell a property in rural areas. Overall, a stronger correction on the markets remains possible, but we are currently observing a normalisation rather than an abrupt bursting of a bubble.

The setback at the beginning of August brought back memories of the global financial crisis of 2007/2008 for many. One of the main demands at the time was stronger banking supervision. How crisis-proof are the banks in Germany today?

Michael Koetter: The reforms that were implemented after the financial crisis have undoubtedly made the banking landscape more stable. Capital requirements have been tightened and banks now have to hold higher buffers in order to better absorb shocks. In addition, supervision by institutions such as the European Central Bank and the German Federal Financial Supervisory Authority (BaFin) has become much stricter. Nevertheless, weaknesses remain. The interest rate turnaround is a challenge for many banks, as they have benefited from low interest rates for years. Our current research indicates that the activation of new macroprudential instruments to curb overheated property prices is, for example, leading to banks primarily collateralising loans that were granted in less liquid, i.e. riskier, regional property markets. Some smaller institutions are therefore still vulnerable, especially if they are heavily involved in property loans that were granted in increasingly illiquid property markets. Overall, we have a more robust system today, but the risks should not be underestimated.

During the setback at the beginning of August, some politicians expressed concerns about retirement provision with shares and warned of the risks. What do you think of these assessments in the context of the discussion about a so-called 'equity pension'?

Michael Koetter: The concerns are not unfounded, but I think a blanket rejection of securities investments in retirement provision is exaggerated. In the long term, shares offer the opportunity to build up assets and provide protection against inflation, provided that the investments are broadly diversified and held over a longer period of time. In this context, the planned "equity pension" or "generation capital" of the traffic light coalition makes perfect sense in order to stabilise pension systems, because long-term and well-diversified investments in equities are historically significantly more profitable than money market investments or fixed-interest products, for example. However, it is important that the framework conditions are right: At an individual level, factors such as the time of entry and diversification must be taken into account. At a structural level, strong banking and financial market supervision is needed to ensure that the providers of such products operate transparently and fairly. There is still a need for action here, particularly in the supervision of banks by BaFin, but also and above all in the rapidly growing shadow banking segment, such as hedge funds.

BaFin has recently been criticised more frequently. In your opinion, has the banking supervisory authority implemented enough reforms to minimise such risks?

Michael Koetter: BaFin has introduced some reforms following the Wirecard scandal, but there is still room for improvement. In particular, the early detection of undesirable developments in the financial markets and in the aforementioned shadow banking system remains a challenge. BaFin must not only pay more attention to the stability of banks, but also take more rigorous action against providers of financial products. Particularly in the area of pension products, it is crucial that consumers are protected from excessive costs or non-transparent structures. Insofar as less strongly regulated and much less transparent players from the shadow banking system are increasingly competing with traditional financial institutions, I still see a need to catch up here. It is essential that BaFin is equipped with the necessary personnel and technology to meet the complex requirements of a globalised financial system.

How useful is a national BaFin in times of global trade and investment?

Michael Koetter: A national supervisory authority such as BaFin remains important even in times of global trade and investment, as it has specific knowledge of the local financial system and the national banking landscape. Nevertheless, national supervisory authorities are reaching their limits in an increasingly globalised financial system. Financial flows and risks do not stop at national borders, which is why international cooperation and close links with European and global supervisory bodies are crucial. BaFin works closely with the ECB and international bodies such as the Financial Stability Board (FSB), but more coordination is needed to efficiently address global risks. In the long term, we should think about greater Europeanisation of banking supervision in order to better manage cross-border risks.

What role can financial market research play here in providing support?

Michael Koetter: Financial market research plays a key role in analysing developments in the banking sector and the financial system in a well-founded manner and identifying risks at an early stage. Research institutions such as the IWH contribute to this by collecting data, analysing market mechanisms and quantifying the consequences of financial policy measures, which serve as a basis for decision-making for both supervisory authorities and politicians. Particularly in times of globalised financial markets, it is important that economic research institutes systematically investigate international interdependencies and new risks, such as those arising from financial technology or geopolitical tensions. Research can also provide impetus as to how supervisory structures can be improved and made more effective, for example by evaluating existing regulations and proposing reforms.

In the context of the setback in August 2024, the role of the banking union in the EU is also being discussed more intensively again. How do you assess the current status of the banking union?

Michael Koetter: The banking union is a key building block for stabilising the European banking sector. The introduction of the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM) was a major step towards standardised supervision and resolution of banks within the eurozone. However, the banking union remains incomplete as the third pillar, a European deposit guarantee scheme, is still missing. This means that in the event of a banking crisis, national guarantee schemes still apply, which increases fragmentation. Until this problem is solved, the banking union will remain vulnerable, especially in times of heightened market turbulence such as in August.

What challenges do you see for European banking supervision in view of the current developments on the financial markets?

Michael Koetter: One of the biggest challenges for European banking supervision is the increasing complexity and interconnectedness of the financial markets. Banks no longer only face traditional risks such as loan defaults, but also new dangers such as cyber attacks, geopolitical tensions or the consequences of climate change. The European Central Bank and national supervisory authorities must therefore be able to recognise and assess these diverse risks at an early stage. In addition, smaller banks are often overwhelmed by the new regulations, which reduces their resilience in crises. The supervisory authorities must strike a balance here between too much and too little regulation. In addition to the coordinated monitoring of banks and the aforementioned shadow banks, I also see the increasing non-financial reporting obligations as a major challenge. In this respect, the ECB is increasingly moving into uncharted territory. One example is the penalties imposed for the first time in May this year when some banks failed to quantify climate risks on time. It remains unclear to me whether and to what extent it is possible for banking supervision to assess these types of risks correctly and more precisely than banks. The role of climate and other non-financial risks in banking supervision thus remains poorly defined. Such doubts regarding the mandate and competence may lead to a fundamental loss of credibility of supervision, which would undoubtedly be detrimental to the stability of the financial system.

How strong is the cooperation between national banking supervisory authorities within the EU, and is there still room for improvement?

Michael Koetter: Cooperation between national supervisory authorities in the EU has improved in recent years, primarily thanks to the Single Supervisory Mechanism, which has been led by the ECB since 2014. The European Banking Authority (EBA) develops the guidelines for carrying out microprudential supervision, the ECB coordinates the supervision of the largest systemically important banks, while the national supervisory authorities continue to monitor smaller institutions. However, there are still national differences in the way supervision is practised, which can lead to inconsistencies. Cooperation could be further optimised, particularly in the area of bank resolution, where national interests often dominate. Greater harmonisation and a more comprehensive European deposit guarantee scheme would be important next steps here in order to ensure the stability of the entire banking system in times of crisis.