Andreas Dombret: What's the state of play in Germany's banking
sector?
Statement by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the press conference to unveil the Deutsche Bundesbank's Financial Stability
Review, Frankfurt am Main, 15 November 2016.
* * *
1. Between more Europe, and less
Ladies and gentlemen
Before I delve into the risk situation in Germany's banking sector, let's look back at the past
12 months - a period which, in a nutshell, saw the sector oscillate between more Europe, and
less.
It was the second year in which the Single Supervisory Mechanism (SSM) was in operation. Over
the past 24 months, the ECB has been directly responsible for overseeing the euro area's largest
banking groups, which now number 129, of which 21 are German institutions. By adding "more
Europe" to the realm of banking supervision, the SSM is clearly paying ever greater dividends,
and I am confident that we can iron out any issues that remain.
We took a step of a different sort towards "more Europe" at the beginning of the year, which saw
the establishment of the second pillar of the European banking union - the Single Resolution
Mechanism (SRM).
And judging by the European Commission's agenda, there are to be further steps in this
direction. I'm talking about the plans to establish the third pillar of the banking union: the European
Deposit Protection Scheme (EDIS). But this is an initiative that should be viewed with a degree of
caution, because the conditions for creating a single deposit guarantee scheme still haven't been
fulfilled. Just take the areas of fiscal and economic policy in Europe, which are still firmly in the
national realm and have a major bearing on the health of each country's banking system. As long
as we haven't created a common set of European rules for these policy areas, establishing the
EDIS would result in the fallout of misguided national policymaking being passed on to savers
across the entire euro area.
And there is also the fact that banks continue to carry huge amounts of sovereign bonds issued
by their home countries on their balance sheets. And yet again, these are exposures that are not
backed by capital. If a single deposit protection scheme were put in place, the community might
end up shouldering the risks associated with general government debt. Furthermore, the
problems surrounding non-performing loans are still unresolved in a number of countries, which
means the risk situation differs strongly from one national banking system to the next. I will return
to this particular point later in my statement today.
While a recently published draft report by Esther de Lange at the European Parliament does
already address some of the criticism levelled at the Commission proposal, that paper indicates
that the proposed initial re-insurance phase starting in 2019 will still take place without any
riskreduction measures whatsoever. That would be inacceptable in my view.
My conclusion from this is that we should stick to the current system - harmonising the national
deposit insurance schemes - as long as many outstanding issues remain unresolved.
For all the progress that has been made towards deeper integration, European unity suffered
something of a setback on 23 June this year. That was the day on which the UK electorate voted
against the country's continued membership of the European Union. That brings us to the topic
of "less Europe". I won't wade into the political debate today, but focus instead on what Brexit
means for financial markets.
Five months on from the UK referendum, we can say that the European financial system has
done a pretty good job overall of absorbing the outcome of the vote. Apart from a bout of
heightened financial market volatility, notable share price losses, particularly among bank stocks,
and the sharp depreciation of sterling, the Brexit vote did not unleash any turmoil in financial
markets, nor, might I add, was there ever any risk of a financial crisis. There are two reasons for
this. First, the good level of resilience that has now been achieved in the European financial
system. Second, and no less important, the response shown particularly by the Bank of England.
Nonetheless, the long-run repercussions of the Brexit vote will only really come into view when
we get a better idea of the outcome of the forthcoming exit negotiations.
The signals which the UK government is currently sending out would appear to suggest that a
"hard Brexit" might be in store - that is, the UK would leave not just the EU but also the European
Economic Area. That would spell the end of the current EU passporting regime - an
arrangement which presently enables financial institutions domiciled in the UK to offer their
products and services across the entire European Economic Area. It also permits continental
European institutions to do business in the UK.
If the UK were to leave the European Economic Area, the question facing some business areas
in the financial sector will be whether the UK's future supervisory regime will be equivalent to the
one on the continent. Assuming we do see a hard Brexit, I expect the UK wouldn't want to unravel
the accomplishments of EU regulation and that its future regulatory measures would be geared
to global and European standards.
Come what may, what matters for us in the EU is that we continue to press ahead with our
flagship financial market projects - first and foremost the capital markets union - even after
the UK leaves the EU, and that we reinforce the EU's financial system. In doing so, we must
make sure that the door is open for close cooperation with the UK authorities. This is the context
in which I see the scheduled merger between Deutsche Börse and the London Stock Exchange,
for, once merged, the enterprise could serve as a bridge between the UK and EU financial
markets and ensure continuity, such as in the clearing of euro-denominated financial
instruments.
Let me now turn to the current risk situation in the German banking sector.
2. 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.
3. ... 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
higheryielding 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.
4. Conclusion
In summary, there are three points I would like to highlight.
First, the supervisory environment for banks has become even more European since our
last Financial Stability Review, and for good reason. The establishment of the Single
Resolution Mechanism at the beginning of this year marks another major milestone.
However, before we take any further steps towards deeper integration, we should now
gauge whether all the groundwork has been laid, and as far as the European Deposit
Insurance Scheme is concerned, we shouldn't take the second step before the first.
Second, German banks have boosted their stability still further - equity capital ratios are up
again, leverage is down again. That's good news.
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. My advice to them is this: there's no blueprint
for guaranteed success. But what I can say is that besides regularly reviewing their
business models, credit institutions should also consider further mergers, a more
streamlined branch network and other cost-cutting measures.
Thank you very much.