Profitability at Germany’s small and medium-sized banks and savings banks (less significant institutions, or LSIs) improved significantly in 2023. Institutions achieved stronger earnings during the period of higher interest rates; they have further expanded their capital resources and appear to be prepared even for serious adverse scenarios. These were among the findings of the sixth LSI stress test and accompanying survey, which were conducted this year by the Federal Financial Supervisory Authority (BaFin) and the Deutsche Bundesbank.

“Most institutions are strongly capitalized handling the very demanding challenges posed in this year’s stress test,” said Raimund Röseler, BaFin’s Chief Executive Director of Banking Supervision, while presenting the stress test results in Frankfurt. The scenario assumed in this year’s test was far more challenging than in the last exercise two years ago. In total, the shock caused the common equity tier 1 (CET1) ratio to decrease by 3.7 percentage points to 14.5%. The stress effect was mainly driven by credit and market risks.

In the scenario presented in the stress test, the number of institutions that experience difficulties lies in the medium double digits. These institutions would not meet the supervisory capital requirements in the event of a major economic downturn. The number of impacted institutions is twice as high as in the 2022 LSI stress test – mainly due to the tougher scenario specifications.

Institutions should continue to strengthen their capitalization and not erode their solid capital base unless absolutely necessary. The economic situation remains uncertain. We will closely monitor the outlier institutions. If necessary, we will take supervisory countermeasures at an early stage, Röseler declared.

Results of the survey on the current and future earnings and risk situation show that institutions are anticipating an increase in loss allowances. Banks and savings banks are still willing to take on additional risks on their books and increase their lending. However, their plans foresee a greater increase in CET1 capital than in risk-weighted assets, which leads to a moderate rise in the CET1 ratio and takes more than sufficient account of the additional risks they plan to assume.

Our analysis shows that the majority of banks and savings banksare less optimistic with regard to commercial real estate. Supervisors will continue to closely monitor this segment, said Michael Theurer, the Deutsche Bundesbank Executive Board member responsible for banking supervision. The outlook is more positive for residential properties, but lower market values are expected for buildings in need of renovation to meet energy efficiency standards. The banks and savings banks consider the greatest challenges to be recruitment, increased competition for deposits and the slowdown in economic activity. In particular, challenges arising from demographic change will have a long-term impact on the banking sector. Institutions need to begin adapting to this development early and take a forward-looking approach, Theurer advised.

1,200 small and medium-sized German credit institutions took part in the stress test conducted by the Deutsche Bundesbank and BaFin. The participating institutions represent approximately 91% of all credit institutions in Germany and approximately 40% of aggregate total assets. The results of the stress test are incorporated into the supervisory activities of the Deutsche Bundesbank and BaFin.

Annex

Earnings

BaFin and the Deutsche Bundesbank collected the institutions’ own planned and forecast figures in the survey. The institutions were also asked to simulate their earnings for the period from 2024 to 2028 in five interest rate scenarios predefined by the supervisors. Institutions performed these calculations assuming a static balance sheet, meaning they were not able to adjust their portfolios.

On the basis of their own planned and forecast figures, the surveyed credit institutions reported in the second quarter of 2024 that they expect their return on assets to increase by 45% over the next five years (2022: + 18%). Return on assets is defined as the profit for the year before tax in relation to total assets. However, this highly positive projection is based on the optimistic assumption that interest rates will remain steady or even increase slightly in the medium to long term.

Resilience

On average, the surveyed institutions expect to increase their CET1 ratio from 18.2% to 19.4% by 2028. They plan to do so despite the larger rise in risk-weighted assets, which can be traced to an upturn in the volume of business and increased risk-taking.

Stress test used for determining Pillar 2 guidance

Stress testing examines the resilience of institutions under adverse economic conditions and estimates the consequences for their capital resources. To this end, the banks and savings banks simulated their earnings and resilience for the years 2024 to 2026 under baseline and stress scenarios predefined by the supervisors. The stress scenario for this year’s test entails a dramatic economic downturn resulting in interest rate risks, credit risks and market risks, among others. Other components of the banks’ profit and loss accounts were extrapolated based on historical data, partially with discounts.

The supervisory authorities aimed to determine whether the capital resources of the credit institutions were still adequate over a three-year period in a stress scenario. After capital depletion of 3.7 percentage points (the largest decrease in the CET1 ratio over the three-year scenario horizon), the small and medium-sized institutions in Germany still had a CET1 ratio of 14.5% on aggregate, which represents a sound capital basis.

The stress test identifies the vulnerabilities of each individual institution. The risks revealed in the stress test also factor into the calculation of Pillar 2 guidance. An institution’s failure to comply with this recommendation acts as an important early warning threshold for supervisors. Institutions that are particularly vulnerable can be subjected to even closer supervision at an early stage. This helps further strengthen the stability of the German banking market.

Translation provided by the BaFin.