Banks should be setting aside recent bumper profits to provision for clients defaulting on loans as the impact of higher interest rates feeds into the economy, according to the president of the country’s regulator.

The banking industry enjoyed a windfall in 2023 as lenders reaped the benefits of central banks’ interest rate hikes while keeping deposit rates low.

Central banks around the world tightened monetary policy aggressively over the last two years in a bid to tame soaring inflation, but focus has now turned to when the likes of the U.S. Federal Reserve, the European Central Bank and the Bank of England will start cutting policy rates again.

Though economies have been surprisingly resilient in the face of rising borrowing rates, many policymakers have warned that the impact on households and businesses has yet to be fully felt.

The head of the German regulator (the Federal Financial Supervisory Authority which is better known as BaFin) told CNBC Tuesday that while the shock from rate increases has been “digested in the banking books,” there could be further troubles ahead.

“The difficulties that come from this rate environment for the clients of the banking sector — whether that’s in the real estate sector or in the real economy — we haven’t seen that flow through yet,” he told CNBC’s Annette Weisbach, adding that it “won’t be easy” to repeat the profitability expected in 2023 and 2024 as rates remain historically high.

“So firms have to be very wary about provisioning requirements about not only letting the shareholders profit from this good year that they’ve had, but put as much aside to deal with the costs that are coming because they will come.”

Deutsche Bank, Germany’s largest lender, beat third-quarter expectations with a 1.031 billion euro ($1.12 billion) net profit, and promptly said it would increase and accelerate shareholder payouts.

Insolvencies ‘pre-programmed’ to rise

The euro zone economy is widely expected to be in recession and Germany in particular is projected to face a prolonged slump, having contracted by 0.3% year-on-year in 2023, as high inflation and interest rates bit into growth.

However, many banks have yet to meaningfully increase their loan loss provisions. Branson said the market should expect them to start this year, and some may have already begun setting aside more money for bad loans in the final quarter of 2023.

“We’ve seen things happen in the commercial real estate market, which we’ve maybe predicted for a long time but now are crystallizing, so as I said 2024 and the years thereafter, they’re not going to be as easy as 2023,” Branson said.

He added that lenders should “keep the powder dry for the more difficult times,” including investing in operational security and stability, such as protection against cyberattacks.

Company insolvencies have yet to meaningfully pick up in the way that would be expected during a rapid incline in interest rates. However, Branson noted that the figures have thus far been “artificially low” due to a prolonged prior period of extremely low interest rates and the massive fiscal stimulus from governments to tackle the Covid-19 pandemic and energy crisis in recent years.

“So I think it’s almost pre-programmed that insolvencies will begin to rise again and that’s in a way normal for banks that they’ll also have have to deal with some credit losses in their books,” he said.

“That’s why we’re a bit skeptical the profitability will continue to rise after such a good 2023, and that’s why the banks have to look carefully now about what they need to provision.”