Low interest rates and lacklustre profitability could spark consolidation in the German banking sector. Despite these challenges, the system remains well capitalised with low NPLs and the prospect of benefiting from Brexit, as Kit Gillet reports.

Deutsche Bank

The German banking sector is considered to be a stable, if conservative, system that generates regular, if unspectacular, profit margins. Even so, in recent years strong forces have been at play that point to both its enviable fundamentals as well as the more challenging banking environment that exists.

German banks are seeing strong lending growth at a time when they are struggling to maintain their profits, with low interest rates, weak non-interest income and still-high cost structures putting a strain on profit margins. Overall, however, confidence in the German banking sector remains high, linked to the liquidity strengths of the banks as well as their strong asset risk and funding structures.

“German banks have strengthened their capital position in recent years. Non-performing loan [NPL] ratios remain extremely low, though – by European and international standards – profitability continues to be poor,” says Andreas Krautscheid, chief executive of the Association of German Banks. However, he adds that German banks are “under strain from trends affecting all banks worldwide: the need to adapt to new regulation, the challenges of digitalisation and globalisation, and persistently low interest rates. In Germany, the situation is compounded by intense competition.”

Expanding economy

According to Germany’s central bank, the Bundesbank, the country’s economy is experiencing the longest period of expansion since reunification. However, this has been coupled with low interest rates, high asset prices and low volatility in the financial markets. “If interest rates were to spike suddenly, this might mean losses, in particular for small and medium-sized banks,” it says.

Germany’s banking sector is highly fragmented, with more than 1000 banks, divided into three traditional pillars: the sparkassen (savings banks), their associated landesbanken (co-operative banks), and the private sector commercial banks, chief among them Deutsche Bank, which occupies a unique place in the German banking sector as the country’s only truly global player.

Among the three, the co-operative banking sector is considered to be in the healthiest position. According to the National Association of German Co-operative Banks (BVR), which represents about 1000 local co-operative banks and related banks and financial institutions, in 2017 their network generated a consolidated net profit after taxes of €6.1bn, up 3% year on year, with equity exceeding €100bn for the first time. Meanwhile, total assets grew by €27.5bn to €1240bn.

The savings banks are also thought to be in good health, while on the lending side there has been above-average growth among the savings banks and the co-operative banks, with the private banks lagging slightly behind. According to Jan Schildbach, director and head of the banking, financial markets and regulation team at Deutsche Bank Research in Frankfurt, lending growth in Germany in 2018 is the highest since the dot-com bubble. “We’ve seen 5% corporate loan growth, a bit less on the retail side, but still very solid,” he says. 

However, a key challenge facing the entire banking sector is the ongoing low-interest-rate environment. “This very long period of very low interest rates isn’t favourable for the banks. Basically everything on the balance sheet has repriced at a much lower spread than before. That applies to the liquidity portfolios, the lending portfolios,” says Carola Schuler, managing director of banking in Europe, the Middle East and Africa at Moody’s Investors Service in Frankfurt.

This has had the effect of lower yields being locked into the banks’ balance sheets, and with the German banking system relying heavily on long-term assets such as mortgages, even if the interest rate cycle turns it would take a relatively long time before the banks would benefit from an upward trend in net interest income. 

In its latest Financial Stability Review, released in November 2018, the Bundesbank raised concerns about the German financial sector’s preparedness to weather potential bad times. It said a fall in the current valuations of real estate, for example, could hit the financial system hard, with mortgages accounting for more than half of all loans to domestic households and enterprises, and with the share of new loans for house purchases with an interest rate lock-in period of more than 10 years having risen from 26% in 2010 to 45% today.

The hunt for profits

The low-interest-rate environment in the banking sector has had a strong impact on one of the main metrics of success: profitability. “The main topic in Germany is profitability,” says Patrick Rioual, senior director of financial institutions at Fitch Ratings. “In terms of capitalisation, funding and risk profile, the picture is pretty good. The NPL ratio is one of the lowest in Europe, and it is still declining.” However, he says, profitability is still modest – and that has been the case for many years. “When we say modest we are talking about annual pre-tax income for the entire sector of about €25bn to €28bn,” says Mr Rioual, with the public sector savings banks and the co-operative banks accounting for about 65% to 70% of the sector’s pre-tax income.

Banks have been trying to counter the loss of interest-related income through reduced spending by engaging in cost-cutting exercises as well as the greater use of digital technology. Even so, according to Moody’s, in 2017 the German banking sector’s cost-to-income ratio was 76%, not helped by banks’ large branch networks. These offer the equivalent of one bank employee per 134 citizens, against the EU average of one employee per 187. 

While efforts have been made to reduce this, the existing infrastructure and the necessity to invest in new technologies make it difficult for banks to significantly reduce overall costs. German banks also lag behind their international peers when it comes to fee- and commission-based income, relying instead on interest-based earnings. According to the BVR, net fee and commission income of its members increased by 8.9% to nearly €6.5bn in 2017, though this was still just one-third of overall net interest income (€18.6bn).

“Banks have tried to be more successful with fee-based income, and fee and commission income is indeed trending upwards, though I would say relatively slowly. Overall, the benefits have been smaller than expected,” says Deutsche Bank’s Mr Schildbach. “There is some growth, but fee and commission income is only one-third of net interest income, where we’ve seen a 10% decline, so it hasn’t made up for that.”

Areas of potential growth, such as the auto lending and leasing market, are also proving difficult to expand into, with auto lending dominated by the finance subsidiaries of automotive manufacturers. German consumers also largely avoid credit card debt, blocking another source of potential revenue for the banks.

Meanwhile, competition is proving extremely tough, especially in wholesale asset classes such as corporate lending and commercial real estate, and at some point the risk might increase that competition will spread into banks’ underwriting standards, which were tightened in the aftermath of the financial crisis and have not loosened significantly. 

Digital expansion and fintechs

German banks remain conservative in their approach, but in recent years many have been working to improve their digital and fintech offerings, both as a way of reducing operating costs but also to increase their competitiveness. In August 2018, the BVR announced that the majority of its co-operative bank members were shortly rolling out smartphone wallet services. Meanwhile, the Association of German Banks now has more than 20 fintech companies among its members. 

Still, “it is probably fair to say that the German banking sector as a whole has underestimated the potential for competition as well as the benefits of a technological transformation”, says Moody’s Ms Schuler. “They have taken longer than other banking sectors to realise that there is something that needs to be done,” and while they’ve realised the new reality “they are perhaps a few years behind other banking systems”.

“The good thing is that they have the capacity to invest,” adds Ms Schuler. “Now they need the vision and execution to be able to get to the level of technological sophistication and leadership that is needed in order to protect their core businesses in the long term.”

Deutsche Bank woes

Among Germany's private banks, Deutsche Bank remains a source of concern, with years of losses, ongoing legal concerns and ambitious restructuring plans under way. Those involved in the bank were hoping that 2018 would be a turning point; in announcing third-quarter earnings, Deutsche Bank CEO Christian Sewing said the bank’s profit before tax of €506m was another milestone on its way to becoming a sustainably profitable bank. “We have our costs under control and sufficient capital to grow. We are on track to be profitable in 2018, for the first time since 2014,” he added. 

However, police raids on the bank’s Frankfurt headquarters in late November, related to criminal investigation into suspected money-laundering activities in its wealth management division, could impact on efforts to implement much-needed changes. Following the raids, the bank’s share price dropped to an all-time low. The bank also scored badly in the latest round of European stress tests, with a core capital ratio of 8.1% for 2020, placing it among the 10 worst banks.

“We downgraded Deutsche Bank in September 2017 when we saw it was going to face headwinds in terms of profitability, and then there was the change in management earlier in 2018 and announcements of further restructuring, which made us revise the bank’s outlook to 'negative' in June to reflect substantial execution risk,” says Christian Scarafia, who co-heads western European banks at Fitch Ratings. 

Deutsche Bank has been targeting a post-tax return on average tangible equity of more than 4% in 2019, while reducing full-time staff to below 90,000 by the end of the year. Looking further ahead, the bank is aiming for a post-tax return on average tangible equity of about 10% in a normalised environment, with a common equity Tier 1 capital ratio above 13%.

Mr Scarafia believes that while Deutsche Bank has been engaged in cost-cutting exercises and has exited some businesses – especially on the investment banking side, which has helped its capital ratio – there is still a long way to go. “Looking at its own targets, which include a return on tangible equity of 4% in 2019, which isn’t very strong at all, this highlights the challenges that the bank faces and the weak profitability that it is currently able to generate,” he says. “Deutsche spent 2018 engaged in a lot of work, but any effects of that on performance will likely take some time to be seen.”

Domestic focus

While foreign loans and securities represent one-quarter of German banks' total assets, according to Moody’s latest Banking System Outlook, partly mirroring the involvement of German companies in international trade, the country’s banks have a much stronger domestic focus compared with the years leading up to the financial crisis. This makes sense, with many banks having had their fingers burnt, especially those that expanded into areas such as Spanish real estate and global shipping. 

“Deutsche Bank excepted, the rest of the market has retreated into the domestic market and curtailed their exposure to foreign assets – they still have foreign exposure in terms of liquidity, security investment, but no longer significant [exposure] in terms of credit,” says Fitch’s Mr Rioual. He adds that this leaves banks increasingly exposed to the German market, “which is good news at the moment, but when the economic cycle inevitably turns that means there will be a high correlation with the state of the German economy”.

Some analysts believe that Germany may have already reached the peak of its economic cycle. The country is expected to see a real gross domestic product growth rate of about 2.2% in 2018, down from 2.5% in 2017, with this expected to drop further to 1.7% in 2019.

Even so, German banks remain in an enviable position when it comes to areas such as common equity and NPLs, which represented just 2.5% of gross loans in Germany at the end of 2017, according to Moody’s. “The recently published results of the 2018 EU-wide European Banking Authority stress test affirm an improvement in the resilience of German banks,” says Joachim Wuermeling, an executive board member at the Bundesbank. He adds that core equity ratios have risen from 10% in 2008 to 15.4% in 2017, saying: “This improvement in capital resources was mainly driven by an increase in core equity by about 60% as well as – although to a lesser extent – by a decrease in risk-weighted assets by about 14%.”

Mr Wuermeling also highlights that the majority of local savings and co-operative banks remained profitable and stable even during the financial and sovereign debt crisis, aided by strong customer relationships, a deposit-gathering ability and by avoiding aggressive and high-risk activities. “As a result, regional German banks have shown themselves to be quite resilient against adverse economic conditions despite their strong focus on domestic lenders,” he says.

Potential for mergers

The fragmented nature of the German banking sector has led to regular small-scale consolidation in recent years. Even so, major consolidation, in the form of large-scale mergers, has not been noticeable in recent years: the last major acquisition was Commerzbank’s purchase of Dresdner Bank in 2008. However, this may change in the near future. 

In November, European Central Bank supervisor Sabine Lautenschlaeger, speaking at a conference, raised the issue of consolidation in the German banking sector. “We have many banks in Germany and discussions about consolidation in Germany are a very positive idea,” she said.

Discussions have taken place in recent months regarding a potential merger between savings banks Helaba and NordLB, along with DekaBank, LBBW and potentially real estate lender Berlin Hypthat, which would, if it happened, create the second largest bank in Germany, with assets of nearly €700bn. It has also been reported that executives at Deutsche Bank and Commerzbank are increasingly open to the idea of a merger. The German government – which owns a 15% stake in Commerzbank, making it the lender’s largest shareholder – is thought to strongly support the deal.

However, those involved in the sector are cautious about the potential for a major deal in the short term. “I would be relatively sceptical about the likelihood that we will see large-scale mergers in the near future, just because we have the three-pillar structure solidly in place,” says Deutsche Bank’s Mr Schildbach. “We’ve seen a decline in the number of savings banks and the number of co-operative banks, but this is more organic consolidation, not on the big scale. The overall environment is not conducive to that.” 

Opportunities from Brexit 

Brexit remains a source of concern, but despite the uncertainty it’s causing, German financial centres could ultimately benefit, with banks relocating some operations from the UK. According to lobbying group Frankfurt Main Finance, a transfer of €750bn to €800bn in assets from London to Frankfurt is likely to take place, linked to Brexit, with the majority of this expected to happen in the first quarter of 2019.

“I expect Frankfurt to be one of the beneficiaries of Brexit, especially in the longer term, with more and more wholesale banking taking place,” says Deutsche Bank’s Mr Schildbach. However, he adds: “Brexit overall is a lose-lose for the banking sector. It’s a huge cost trigger, as banks have to build that infrastructure in other locations, hire more people, do all the IT work. It’s a cost driver.”

According to Oliver Wagner, managing director of the Association of Foreign Banks in Germany, there are currently about 25 international banks relocating businesses to Germany, and many are doing this by scaling up their existing operations in Frankfurt. “This relocation goes along with an increase in personnel and infrastructure for IT, law and risk management – just to mention a few areas,” he adds. This is expected to involve thousands of new jobs. 

Meanwhile, in November 2018 it was reported that the German government was moving ahead with plans to make it easier for banks to fire high-earning senior staff, so-called risk takers earning at least €234,000 annually. The move, which will be limited to banks with more than €15bn in assets, is part of efforts to make the country more appealing to foreign banks as Germany’s tight employment protection laws are considered a notable disadvantage for German financial centres as they compete with the likes of Paris and Dublin. “The planned legal changes regarding the labour law are an important signal to the international finance community that Germany is able to adapt to international standards regarding highly paid senior bankers,” says Mr Wagner.

Meanwhile, others see the need to reduce the regulatory burden on other areas of the financial sector. “It is important to us that economic and financial policy-makers show a stronger commitment to Germany as a financial centre,” says BVR president Marija Kolak, who says her association is calling for more nuanced regulations of the financial markets that take into account the business model, size and lower risk of regional banks. “Relieving regional banks of bureaucracy and excessive reporting requirements is the right and proper approach. But this now needs to be put into practice,” she adds. 

Future pressures

German banks remain in an enviable position, being well equipped to withstand any potential downturn in the national economy. In fact, their resilience has only increased in recent years. Even so, pressures are growing and raising questions about banks’ ability to increase profits and adapt. 

“For many banks, the big challenge remains to demonstrate that they can generate significant volumes of new business and price it decently,” says Fitch’s Mr Rioual. “We are also probably reaching the peak of the economic cycle, and that means that we haven’t seen any sizeable loan loss provisions in many years in Germany. That will return at some point, so they will face a new challenge.”


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