Dr Andreas Dombret Member of the Executive Board of the Deutsche Bundesbank spoke on What’s the state of play in Germany’s banking sector? He makes the point that current profitability of banks is low and links it to low interest rates.
Included in the speech was a fascinating passage on rate mismatch, which is a rising environment could have a strong negative impact. Worth reflecting more widely on this phenomenon.
German banks have expanded their maturity transformation in recent years. In order to stabilise profits in times of very low interest rates, they have increasingly extended the lives and the interest rate lock-in periods of their loans. For instance, the percentage share of longer-term loans and advances – that is to say claims with a maturity of more than five years – at German banks has risen from 60% in 2007 to just under 70%. The ratio among institutions in the savings bank and cooperative bank sector is especially high. At 83%, it is significantly higher than the 47% ratio for commercial banks.
Thus, we are in a situation in which banks and savings banks are holding many long-term, low-yielding investments in their books. Moreover, valuations for many investments are extremely high. By contrast, risk provisioning in the German banking system is very low, at 0.6% of total assets. This makes banks vulnerable to unexpected macroeconomic developments, such as an abrupt hike in interest rates or an unforeseen deterioration in economic activity.At the same time, they have shortened the maturities of their liabilities. The ratio of overnight deposits to total liabilities towards non-banks has risen within ten years from 36% to around 60%. An important aspect in this context is that customers are parking their funds in deposits because interest rates on investments are so low. It is difficult to predict how these funds will be shifted as soon as more attractive investments become available. Historical experience gives us a rough idea, but in view of the extreme situation of the current low-interest-rate environment it is of only limited use as a guide for the future.
The bottom line here is that we see an increased vulnerability of banks to changing interest rates. This is why we have been keeping a very close eye on the topic of interest rate risk.
Our low-interest-rate survey 2017 focused on this very issue, simulating the implications of possible shocks for small and medium-sized banks and savings banks. One scenario entailing an abrupt rise in the yield curve by 200 basis points highlights banks’ short-term vulnerability. In such a scenario, profits would initially plummet by around 55% before staging a recovery in the medium term. This means that the speed at which interest rates are raised is crucial.
The stress test carried out as part of our low-interest-rate survey combined several risks at once. Besides an abrupt rise in the yield curve of 200 basis points, it simulated a simultaneous increase in credit and market risk. On aggregate, in such a case the tier 1 capital ratio would drop from around 16% to around 13%, which is to say by some three percentage points. Yet a more detailed look reveals the positive impact of substantially improved capital levels. Small and medium-sized institutions prove largely resilient to a simultaneous rise in the three types of risk.
Thus the stress test scenario presents a mixed picture overall. On the whole, German banks and savings banks are robust and in good shape. But this should not blind us to the major challenges and the associated need for adjustments that banks face. Elevated interest rate risk and the low level of risk provisioning increase vulnerability to shocks. I would therefore call on banks to focus their risk management operations primarily on the issues of maturity transformation and interest rate risk.
