The profitability of small and medium-sized banks and savings banks (less significant institutions, LSIs) in Germany is low. The prospect of a prolonged period of historically low interest rates makes it very likely that profitability will decrease further. This was shown by the recent survey carried out by the Deutsche Bundesbank and the Federal Financial Supervisory Authority (BaFin) on the earnings situation and the resilience of German credit institutions in the low interest rate environment.

"The 2019 LSI stress test confirmed our assessment that this period of low interest rates represents a considerable challenge for the banks,” said Raimund Röseler, BaFin’s Chief Executive Director of Banking Supervision during the presentation of the stress test results in Frankfurt. The stress scenario led to the Common Equity Tier 1 capital worsening by 3.5 percentage points. “On average, the German institutions nevertheless have a sound capital backing even under stress”, emphasised Röseler.

In principle, banks recognise the challenges posed by the low interest rate environment and are taking measures to improve their profitability. “Banks increasingly consider the possibility of passing on negative interest rates to customers in their forecasts, although so far they habe primarily done so with corporate customers and wealthy private clients,” said Prof. Joachim Wuermeling, the member of the Deutsche Bundesbank’s executive board responsible for banking supervision. Furthermore, banks and savings banks are prepared to take more risks in order to improve their results. “The institutions must only take greater risks if and to the extent that they are able to bear such risks and price them at a level appropriate to the level of risk they entail,” said Wuermeling.

Approximately 1,400 small and medium-sized German credit institutions took part in the survey carried out by the Deutsche Bundesbank and BaFin. They are all under direct national supervision, and constitute approximately 89% of all credit institutions in Germany, covering around 38% of total assets. This survey also led to the banks and savings banks considering various stress scenarios in their planning. The results of the stress test will feed back into the Bundesbank’s and BaFin’s supervisory activities.

Earnings situation

In the survey, the Bundesbank and BaFin obtained the institutions’ own planning and forecast data. The credit institutions also carried out results simulations for the period between 2019 and 2023 for five interest rate scenarios defined by the supervisors. The institutions worked on the basis of a static balance sheet for this, which meant that they were not able to adjust their portfolios.

Table 1: Methodological requirements and interest rate scenarios in the survey (2019 - 2023); bps stands for basis points

On the basis of the credit institutions’ own planning and forecast data, the institutions stated in the second quarter of 2019 that they anticipated a 23% increase in pre-tax net profit for the year in five years. This corresponds to a 10% increase in the return on assets (2017: -16%). The return on assets is defined as the ratio between net profit for the year before tax and the total assets. The reason for this very positive forecast is that around half of the institutions performed their calculations on the basis of rising interest rates. The banks and savings banks that planned for a constant interest rate trend, meanwhile, anticipate a 2% fall in the return on assets. This negative trend may worsen in light of the further fall in interest rates that has occurred since the survey was carried out. 

The simulations of the five predefined interest rate scenarios show that the earnings power of banks and savings banks in Germany would worsen considerably if the low interest rate environment continued in the long term or became more acute. The primary reason for the fall in the return on assets was that the institutions would transfer the falling market interest rates to interest on deposits only to a limited extent. A rise in interest rates would initially be likely to result in a fall in profit, in particular because of a drop in the prices of securities. In the medium to long term, however, profits would recover as a result of increased margins.

Resilience

On average, the institutions anticipate an increase in the Common Equity Tier 1 capital from 16.5% to 16.8% by 2023. However, a third of the institutions expect Common Equity Tier 1 capital to fall. This is based primarily on the significant increase in risk-weighted assets, which is due to growing business volume and higher risk exposure. The longer the low interest rate environment continues, the more difficult it is for the institutions to build up capital. In spite of this, the institutions are still able to continue to build up surplus capital, just to a lesser extent.

Stress test to determine the Pillar II Guidance

In order to gauge the potential effects of a decline in economic conditions on the institutions’ capital resources, the supervisory authorities defined several stress scenarios for the institutions to use. The institutions simulated their earnings situation and resilience for the period between 2019 and 2021, in each case using a baseline scenario and a stress scenario. The stress scenario anticipated a severe slowdown in the economy, during which interest rate risks, credit risks and market risks arose, among other things. New to the 2019 stress test was the modelling of the banks’ statements of profit or loss, based on a crisis scenario defined by the supervisors. While institutions were able to generate income over the three-year stress horizon primarily from interest-based and commission-based business, they also had to cope with considerable slumps in profit contributions in the stress scenario. The calculations were subjected to comprehensive quality checks by the supervisors. The supervisors’ goal was to determine whether the credit institutions’ capital resources were sufficient over a three-year period. After a fall in capital of 3.5 percentage points over the three-year stress horizon, small and medium-sized institutions in Germany would still, on average, have a Common Equity Tier 1 capital ratio of 13%, which is still a sound capital base.

The stress test shows the vulnerabilities of each individual institution. The risks discovered in the stress test are used to determine thePillar II Guidance. If an institution drops below this ratio, this acts as a valuable early warning threshold for supervisors. Particularly vulnerable institutions are placed under more intensive supervision at an early stage. This helps to strengthen the stability of the German banking market.

Residential and commercial real estate mortgage lending

The institutions also provided data on their volumes, standards and conditions with regard to residential and commercial real estate. While the interest rate terms barely changed during the period under review, the expansion of lending in these two areas indicates an increase in risk volume. The credit standards for residential property have become successively less conservative over the past three years. This can be seen in particular from the increase in the loan-to-value ratios (LTVs). The degree to which these standards have been relaxed is not currently of concern, however, as long as they are not relaxed further. For commercial real estate mortgage lending, there is no clear indication of credit standards falling.

The survey highlighted the need for standardised data collection on real estate financing. A legal basis should therefore be developed for this in a timely manner.

Credit underwriting standards for corporate finance

Over 100 banks and savings banks were surveyed regarding their credit underwriting standards in the area of corporate finance, excluding commercial real estate mortgage lending. The majority of the participants saw an increase in domestic competition in this sector for the time period considered in the survey (2015 to 2018). There were also indications that credit underwriting standards were being relaxed. For instance, the proportion of unsecured loans as well as bullet loans increased considerably, in particular with small commercial customers. On the other hand, average loan durations shortened and the proportion of borrowers with a good credit rating increased. The German supervisors will conduct in-depth analyses of future developments.