Profitability at small and medium-sized banks and savings banks in Germany (less significant institutions, or LSIs) remains low, and an economic downturn will add to the pressure on their earnings position. The interest rate reversal may, however, provide some relief in the medium term. These are the findings of the fifth edition of the LSI stress test and parallel survey conducted this year by the Deutsche Bundesbank and the Federal Financial Supervisory Authority (BaFin).

“The 2022 LSI stress test has shown that the past and current crisis situations are a challenge for banks, but manageable as things currently stand,” Raimund Röseler, BaFin’s Chief Executive Director of Banking Supervision, explained at the presentation of the stress test results in Frankfurt. Noting the deterioration of 3.2 percentage points in the Common Equity Tier 1 (CET1) capital ratio to 14.5% under the assumed stress scenario, he said: “German institutions are well-capitalised for the most part,” emphasising that “a low double-digit number of them will struggle if the economy experiences a significant downturn.”

The banks and savings banks are mostly cautious in their plans. Many of them had not yet factored in a reversal in interest rates, which means that the contributions from net interest income over the medium term are likely to be on the positive side as interest rates increase. A short-term burden on banks as a result of the rising interest rates will be generally manageable for the banking sector. At the same time, banks expect that their risk-weighted assets will increase at a faster rate than their total assets. “If banks take on more risks, they will naturally also have to modify their risk management to ensure that those risks remain sustainable,” said Professor Joachim Wuermeling, the Bundesbank Executive Board member responsible for banking supervision.

An analysis of other key topics shows that the bulk of banks and savings banks see climate risks as being of low to moderate importance for their business model. A majority of them stated, furthermore, that they were planning on increasing their spending to protect against IT risks in the next few years. “The institutions regard digitalisation as a major topic, and they need to keep their eye on IT risks,” Wuermeling added.

The joint Bundesbank-BaFin survey saw around 1,300 small and medium-sized German credit institutions take part, while a similar survey was run in parallel for the building and loan associations. They are all subject to direct national supervision, comprise around 91% of all credit institutions in Germany, and account for roughly 45% of the aggregate total assets. The stress test results feed into the supervisory activities of the Bundesbank and BaFin.

Annex

Profitability

The survey saw BaFin and the Bundesbank collect the institutions’ own planning and forecasting data. In addition, institutions conducted earnings simulations in five interest rate scenarios defined by supervisors for the 2022-26 period based on a static balance sheet assumption, which means they were unable to adjust their portfolios.

Based on their own planning and forecasting data, the surveyed credit institutions stated in the second quarter of 2022 that they were expecting their pre-tax profit for the financial year to be 32% higher in five years. That corresponds to an increase of 18% in their return on assets (2019: +10%). Return on assets is defined as pre-tax profit for the financial year over total assets. This very positive forecast will notably materialise over the medium term, while a slight decline is forecast in the first year.

The simulations in the five defined interest rate scenarios show that the likely initial impact of increases in interest rates would be a decline in profits, notably on account of price losses on securities and shrinking net interest income. Over the medium to long term, however, profits would recover on the back of widening margins and help boost profitability.

Resilience

On average, institutions are expecting the CET1 capital ratio to decline from 17.7% to 16.9% by 2026. This is mainly due to the stronger increase in risk-weighted assets on account of growing business volumes and greater risk-taking.

Stress test to calibrate the Pillar 2 guidance (P2G)

The stress test examines institutions’ resilience under adverse economic conditions and the impact on their capital adequacy. In this particular exercise, the banks and savings banks simulated their profitability and resilience for the years 2022, 2023 and 2024 in a baseline and a stress scenario defined by supervisors. The stress scenario simulates a significant deterioration in the economy during which interest rate, credit and market risks, amongst other things, materialise. Other items in the credit institutions’ profit and loss accounts were extrapolated based on historical values, some with markdowns. A new feature of the 2022 stress test was the possibility for institutions to be exempted from some of the calculations provided their risk volumes were below certain thresholds. Calculations were subjected to comprehensive prudential quality assurance. Supervisors were looking to determine whether credit institutions’ capital adequacy over a three-year period would also be sufficient in a stress scenario. On aggregate, following capital depletion of 3.2 percentage points over the three-year stress horizon, small and medium-sized institutions in Germany still have a CET1 capital ratio of 14.5%, which represents a solid capital base.

The stress test shows the vulnerabilities of each individual institution. The risks identified in the stress test are used to calibrate the Pillar 2 guidance, which is a valuable early warning threshold for supervisors if it is undershot. Particularly vulnerable institutions are subjected to even more intensive supervision early on. This helps to further strengthen the stability of the German banking market.

Building and loan associations

A separate stress test was carried out in parallel at building and loan associations, with the features being tailored to their particular business model. These institutions saw their CET1 capital ratio decline by a significant 6.9 percentage points in the adverse scenario but would still have a sound capital base of 15.6%.