The low-interest-rate environment continues to weigh heavily on small and medium-sized credit institutions in Germany. This was established by the latest survey on the profitability and resilience of German financial institutions in a low-interest-rate environment, which was undertaken by the Deutsche Bundesbank and the Federal Financial Supervisory Authority (BaFin) and focused on the around 1,500 small and medium-sized credit institutions that are directly overseen by national supervisors. These account for around 88% of all credit institutions in Germany, corresponding to around 41% of total assets.

Profitability

The survey first collected institution-specific target and forecast data. Second, for the period between 2017 and 2021, the credit institutions simulated their earnings in five interest rate scenarios predefined by the supervisors, assuming different balance sheet adjustments. 

	Scenario	Yield curve	Balance sheet assumption
1	Target scenario	Institution-specific assumptions	Dynamic
2	Constant	+/-0 bp as at 31.12.2016	Static
3	Positive interest rate shock	+200 bp as at 31.12.2016	Static
4	Negative interest rate shock	-100 bp as at 31.12.2016	Static
5	Negative interest rate shock	-100 bp as at 31.12.2016	Dynamic
6	Inverse turn	+200 bp to -60 bp as at 31.12.2016	Static
Table 1: Methodological rules and interest rate scenarios applied in the low-interest-ratesurvey (2016 - 2021)

Based on their own target and forecast data, in the summer of 2017 the surveyed credit institutions reported that their profit for the financial year before tax would fall by 9% over the next five years. Since the institutions simultaneously anticipated balance sheet growth, this corresponds to a 16% decline in their total return on capital. In the 2015 survey, banks and savings banks had anticipated a 25% decrease, spread across the following five years, total return on capital being defined as profit for the financial year before tax relative to their total assets.

"While these institutions are planning ahead somewhat more positively than two years ago, it should be noted that this finding solely indicates that their profitability – which started low – is deteriorating at a slower pace than before," said Andreas Dombret, the Bundesbank Executive Board member in charge of banking supervision, going on to emphasise that, "The phase of stagnation caused by low interest rates is far from over." That being said, the majority of German institutions are well capitalised. As Raimund Röseler, BaFin's Executive Director for Banking Supervision pointed out, "The good level of capitalisation demonstrated by most institutions is useful in softening the effects stemming from the low interest rate environment." In addition, most institutions are planning to increasingly focus on alternative sources of income to make up for the dwindling margins to be had in the rates business. Mr Dombret welcomes the fact that banks are not resting on their laurels in terms of how they source capital and instead taking active countermeasures, commenting that "Given the narrowing margins to be had in the rates business, banks and savings banks are increasingly focusing on alternative sources of income. In particular, commission business will play a stronger role in stabilising their future earnings." 

The five simulated scenarios point to ever diminishing profitability on the part of German banks and savings banks if the current low interest rate environment persists or intensifies. Banks' total return on capital would contract by around 40% if interest rates remain stable up until 2021, or even shrink by much more than 50% if interest rates fall. Assuming a dynamic balance sheet, portfolio adjustments can cushion this impact accordingly, largely on account of contracting margins in borrowing and deposit business, such as in the area of savings and transferable deposits. If interest rates were to be raised, the institutions would initially experience a slump in profits owing to impairments. In the medium to long term, profits would, however, bounce back above their 2016 level on the back of widening margins.

Resilience

Overall, the institutions concerned intend to increase their Common Equity Tier 1 (CET1) ratio from a level of 15.9% to 16.5% by 2021. However, one-third of them expect to see a drop in their CET1 ratio over the next five years, mainly as a consequence of the substantial increase in risk-weighted assets that, aside from an upturn in the volume of business, may have been generated by a greater willingness on their part to engage in risky investments.

Competition in the German banking market

As part of the survey, the institutions were also asked to comment on competiveness in the German banking market. In response, they stated that they continue to expect fierce competition from other banks operating in their field, as well as from FinTechs. "More than 70% of the surveyed institutions feel exposed to stronger competitive pressure than ten years ago," said Mr Dombret. Against this background, close to every tenth institution remarked that it was currently in the process of implementing a merger or planning to do so in the future. "The institutions primarily want to reduce costs in their retail business, for example by closing branches. But mergers and acquisitions are becoming more and more attractive and are now viewed less critically than in the past," he added.

Stress test to determine the prudential target equity ratio

In order to gauge the impact of a deterioration in economic conditions on institutions' capital adequacy, the survey again incorporated a stress test, used to measure the resilience of credit institutions in the current situation in a variety of stress scenarios covering IRR, credit risk and market price risk. The aim was to establish how effective the credit institutions' capital adequacy was in coping with these stress factors. The test found that most small and medium-sized institutions in Germany exhibit a good level of resilience. "The institutions proved to be well capitalised in each of the stress scenarios and more than satisfied the prudential capital requirements," Mr Röseler explained. The CET1 ratio after stress stands at 13.3% across all participating banks. "But around 4.5% of participating banks failed to meet the capital requirements laid out in pillars I and II in conjunction with the capital conservation buffer when subjected to stress, despite taking into account hidden reserves," Mr Röseler said. Valuation effects arising from an abrupt interest rate hike have the greatest impact on the stress test. Any such hike also weighs on banks' short-term net interest income. As regards market price risk, the stress effects can be attributed in more or less equal measure to interest-bearing and non-interest-bearing items. However, non-interest-bearing items make up only about one-fifth of the banks' portfolios and are therefore play a disproportionately strong role with respect to stress effects. Turning to the findings of the credit risk stress test, the banks showed themselves to be well equipped to deal with a sudden surge in credit risk. In this connection, the positive macroeconomic developments in particular helped to relieve the situation.   

The risks identified in the course of the stress test will be used to measure the prudential target equity ratio. This serves as a valuable early warning signal for supervisors and helps to reinforce the stability of the German banking market. Particularly vulnerable institutions are subjected to even stricter oversight.    

Financing of residential real estate purchases

The institutions were also asked to provide information on the standards and conditions applying to the granting of housing loans. A slight degree of increased risk is evident in this area but, for the most part, lending standards and conditions have not been loosened.

In addition, based on the data collected by the survey, a stress test was performed relating to the institutions' activities in the area of residential real estate, the aim being to ascertain how a 20% or 30% decline in property prices over a period of three years would affect those credit institutions' capital adequacy. According to the model analyses, the majority of institutions are equipped to cope with any such revisions of house prices by up to 30%. The CET1 ratio applied to banks would decrease by 0.5 and 0.9 percentage points respectively.

Building and loan associations

While the survey among small and medium-sized banks was underway, a parallel survey of German building and loan associations was conducted, tailored to their business model. The interest rates attached to old-style loans under savings and loan contracts are, on the whole, less attractive to today's customers than the conditions now applying to residential real estate financing. At the same time, the interest on savings under a building loan contract that used to accumulate in the past is now comparatively high. This is why fewer savers are entering into loans under savings and loan contracts at present. That said, despite the lower level of interest to be earned, the demand for such contracts has not waned. The prevailing low interest rate environment may impinge on the profitability of building and loan associations but the scenario calculations show that their profits should stabilise over time so long as interest rates remain low or incline upwards. If, however, market interest rate levels continue to fall, profits would remain subject to pressure.             

Following two previous surveys in 2013 and 2015, this year's third survey allowed the German supervisors to gain a comprehensive insight into the profit outlook of German credit institutions and to identify potential risks at an early stage. BaFin and the Bundesbank shall heed the findings of the survey in the course of their supervisory activities.