Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank discussed the state of play in Germany’s banking sector as they unveiled the Deutsche Bundesbank’s Financial Stability Review.
He said that first, the supervisory environment for banks has become even more European since the last Financial Stability Review. Second, German banks have boosted their stability still further – equity capital ratios are up again, leverage is down again. Third, persistently weak earnings are taking their toll on German banks. The low-interest-rate environment will particularly make itself felt at small and medium-sized institutions over a medium to long-term horizon. Institutions will need to tackle these challenges head on if they are to safeguard their stability and profitability.
The latest financial stability review identified some key risks:
- In the current macroeconomic setting, there is a danger of risks being underestimated. Low interest rates, low risk premiums and high valuation levels are affecting all sectors of the economy – firms, households and general government. The incentive is there to amass more debt. This increases vulnerability to future changes in prices or interest rates.
- The current macroeconomic setting can favour a credit-financed real-estate boom. Prices are rising in the German real-estate sector, and lending is on the rise. However, there are no acute signs of an easing of credit standards. Preventive measures can mitigate future risks, though.
- Risks are accumulating in financial institutions’ balance sheets. The amount of low-interest long-term loans is rising, while the share of low-yielding assets has increased. This is leading to increased liquidity and interest rate risks. Persistently low interest rates would hit precisely those financial institutions whose business models depend heavily on interest rates.
German banking sector still stable …
I’ll start with the good news: German institutions have substantially increased their capital levels – and thus their resilience as well – since 2010.
The tier 1 capital ratio of the German banking system as a whole rose by just a slim 0.16 percentage point between June 2015 and June 2016, leaving it broadly unchanged at its year-end 2015 level of 15.7%. But this underlines the long-term trend improvement in capital adequacy, which is the key determinant of any banking sector’s resilience. In early 2008 – the year of the global financial crisis – the tier 1 capital ratio averaged no more than roughly 9.1%.
A major effect that impacted positively on the tier 1 capital ratio in Germany came from the decline in risk-weighted assets since 2008. That is to say, banks have stepped up their investment in assets with lower capital requirements.
The results of this year’s EBA stress test confirm that the German institutions which took part in that exercise are more robust to macroeconomic shocks today than they were just a few years ago. To sum up – there can be no doubts as to the solvency and liquidity of the German banking sector.
… but profitability is too feeble by international standards
Yet having a stable capital base alone isn’t enough to ensure sustained resilience. Banks need to generate sufficient profits as well.
Let’s start by looking at Germany’s major banking multinationals. Compared with their total assets, these institutions have slightly improved their operating income, which is up from 1.31% in 2009 to 1.51% in 2015.
However, the major banks saw their return on total assets dip again for the first time last year. While it is true that the provisions made by one major institution had a negative impact on the return on total assets in Germany, if we exclude that particular institution, the remaining group of banks saw an increase in return on total assets, at 0.35%. All in all, that figure is still low by international standards, however. German banks as a whole are likewise lagging behind the international field – their aggregate return on equity, for example, languishes at just under 6%.
What’s causing these problems? The diagnosis is relatively simple. Profitability is exceedingly weak among German credit institutions, and the persistent low-interest-rate environment is only making matters worse. Credit institutions whose business models are heavily geared to net interest income, in particular, might encounter serious medium to long-term problems if the phase of rock-bottom interest rates persists. The longer rates remain low, the more the pressure on net interest income in Germany will intensify.
But for now, we can cautiously sound the all-clear, particularly for small and medium-sized German institutions, because although the low rates are leaving a dent in their profits, most banks and savings banks are still bearing up. Net income from traditional interest business for German banks as a whole was down by €0.9 billion at €78.1 billion, but that decline was offset by an increase in net fee and commission income, which was up by €1.2 billion at €30.5 billion. Credit cooperatives and savings banks – institutions that are heavily reliant on interest business, relatively speaking – also managed more or less to maintain the previous year’s net figure.
But the low-interest-rate environment is also posing a threat to the financial system. As higher-yielding legacy loans mature, they are being replaced by ones generating lower returns, some of which have longer tenors.
Moreover, the narrow spreads between short-term and long-term interest rates are squeezing the margins that banks can generate from maturity transformation. Together, these effects are crimping net interest income. Furthermore, banks are recording stronger flows of short-term deposits, which increases their exposure to interest rate risk. Ever since 2011, we have been seeing an almost steady rise in the Basel interest rate coefficient, which is a measure of interest rate risk. What this means for German credit institutions is that they should actively manage and hedge their higher interest rate risk – having an adequate capital base helps as well.
A major risk associated with a low-interest-rate environment materialises when that spell comes to an end. In this scenario, pre-tax net income would probably suffer a short-term slump, especially if interest rates were to climb abruptly following a long period of low rates. This would not only generate present-value losses in the short run, but might also cause interest expenses to outpace interest income in the medium term. Moreover, German institutions are now carrying more risky assets in their books than they were just five years ago. Not just that: they are also extending the average residual maturity in their proprietary business, which is exposing them to more credit default and market risk.
But from a long-term vantage point, an interest rate hike would help the banking sector recover and regain stability. And that’s precisely why it’s so important for the banking system to be adequately capitalised, since that would help it cushion shocks over a short to medium-term horizon.
Supervisors are closely monitoring German institutions in this setting. Following on from our exercises in 2013 and 2015, we at the Bundesbank are planning to conduct another survey on the low-interest-rate environment next year among the institutions we supervise directly – this time with added interest rate, credit and market risk stress tests. We hope this survey will give us an insight, early on, into any critical and risky developments in the banking sector and assist supervisors in their dialogue with institutions.
Past survey results tell us that credit institutions are responding to the new setting and pushing up their earnings from commission business – which includes, amongst others, account management and payment fees – and also increasingly passing on negative interest rates to major customers. We have also been seeing a steady flow of consolidation and mergers in the savings bank and cooperative sectors.
For all the progress we have made, there’s still one topic that continues to worry me. Roughly eight years on from the onset of the financial crisis, a number of European banks are still saddled by disturbing amounts of non-performing loans (NPLs). Therefore, scaling back these legacy exposures is one of the foremost aims of banking supervisors in the euro area, and rightly so.
There are two main reasons why we’re interested in NPLs. One, they make banking systems more vulnerable because they drive up both capital requirements and funding costs. Two, they make it harder for the banks in question to supply credit; this, in turn, puts the brakes on growth in the euro area. As a consequence, NPLs don’t just weigh on credit institutions’ earnings; they also intensify solvency risk and obstruct economic activity in Europe.
In this context, I would like to highlight the public consultation on the draft guidance to banks on NPLs which was initiated by the ECB and ran until yesterday. Equipped with this guidance, banking supervisors will be in a position to uniformly assess banks’ internal handling of NPLs as part of their regular supervisory dialogue.
But as far as financial stability in Germany is concerned, I see no immediate cause for alarm. NPLs are far less of a problem in the German banking system than they are in some of the other euro-area countries. At roughly 2%, the NPL rate in Germany last year was well down on the euro-area average. That figure also includes non-performing shipping exposures, and they certainly do worry me because there are still no signs that the economic situation in the shipping industry is about to recover. It goes without saying, then, that we shall continue to keep a close eye on banks with substantial exposures to shipping loans.
As for the institutions saddled by NPLs, we expect them to take measures that are conducive to promptly reducing legacy exposures and bolstering their resilience. These measures include not just thoroughly cleansing their balance sheets of both existing and anticipated losses but above all conducting appropriate credit risk management and holding an adequate level of capital.
