German banks feeling the pressure in the face of low interest rates
A prolonged phase of low interest rates would further squeeze German banks' core business interest margin. As a result, the share of credit institutions facing difficulties in earning their cost of capital could rise. This was the conclusion reached by a team of authors from the Bundesbank and the European School of Management and Technology Berlin in a new discussion paper, whose co-authors include Bundesbank Executive Board member Andreas Dombret.
Narrowing of margins would not be without consequences
A further fall in interest rates would exacerbate the problem. However, even if interest rates were to remain constant, this would still pose a problem for German banks: "Even if interest rates stayed constant at current levels, the core business interest margin of German banks would be reduced by 16 % over the next four years." The projected narrowing of margins would result in only 20% of German banks remaining in a position to earn a cost of capital of 8% by the end of the decade. This was the average return on equity generated by global banks in 2014, according to calculations by the International Monetary Fund. However, the cost of capital demanded by shareholders and external investors depends on a given bank's risk situation.
In the study, the authors analysed interest earnings from loans and interest expenses for deposits, ie a bank's core business interest margin. In this context, they considered a variety of future interest rate scenarios and examined the extent to which they caused a further narrowing of the core business interest margin. In the first scenario, interest rates stay constant for the next four years, while, in the second scenario, they decrease by 1% per annum over the first two years and then stay constant for the next two years. The third scenario assumes that interest rates stay constant for the first two years and rise by 1% per annum over the last two years.
The authors believe that the prevailing low-interest-rate environment poses a challenge for German banks, in particular - first, as they are heavily dependent on interest income and, second, as their cost-income ratios are comparatively high. This means that, relative to their income, their costs are high. In actual fact, other studies have also shown that German banks are, on average, less profitable than foreign credit institutions. One reason for this could be that, in a highly competitive market, German banks' lending margins are not enough to offset the meagre returns on deposits they are currently earning.
Cushioning the blow - use of hidden and open reserves
The authors made reference to possible counterstrategies open to credit institutions: "However, by applying a special feature of German accounting standards and using hidden and open reserves, German banks may alleviate this decline to a certain extent," they report. Pursuant to the German Commercial Code (Handelsgesetzbuch), German banks may form what are known as contingency reserves that can be utilised in more difficult times.
In addition, banks should take advantage of the opportunities presented by digitalisation in order to cut their operational costs. According to the paper, this approach shows more promise than the potential for cost savings that exists in the traditional banking model.