German banks' profit struggle set to continue as 3-pillar model holds back deals (2024)

German bank profits will likely continue to lag European peers over the next three to five years as a fragmented and highly competitive domestic system leaves them limited room to grow.

The country's three-pillar banking system, comprising state-owned savings banks, member-owned cooperative banks and privately held lenders, is both lauded and bemoaned, reflecting the very nature of the German economy but also serving to seriously constrain profits and restrict what many consider an overdue consolidation. Then-German Finance Minister Wolfgang Schäuble in late 2017 exemplified the duality of the argument, telling the Handelsblatt newspaper that greater diversification reduces systemic risk and serves as a bulwark against financial crisis, but also acknowledging that it is a drag on short-term profitability.

German banks recorded an average return on equity of just 1.1% as of December 2016, according to European Banking Authority data. That ranked 24th among the 28 EU countries plus Norway, and was well below the 3.3% average in the EU as a whole.

"The banking industry's division into three main segments impedes its performance and efficiency," S&P Global Ratings said in its 2017 annual risk assessment study of the German banking industry. "[M]easures to improve pretax profitability are hampered by the decentralized structure, and unabated dominance, of public sector savings and mutually owned cooperative banks, which are under less pressure than commercial banks to create shareholder value."

Low interest rates have played a major part in restricting earnings, but German banks are also lumbered with a higher expense burden than their peers. The sectorwide cost-to-income ratio was just over 80%, according to the EBA, the highest among the 29 countries sampled and well above the 65.7% average.

Small banks to serve small business

Europe's largest economy is driven by small and medium-sized businesses, most of which are unlisted and depend on bank financing. Classic bank credits were the top financing choice for 94% of SMEs surveyed by German landesbank LBBW in early April.

Germany had 1,625 active credit institutions as of February 2018, according to ECB data, more than a third of the 4,734 in the eurozone and nearly three times as many as second-placed Austria, which had 570. The bulk of these are in the state- and member-owned categories, typically having a narrow regional focus and serving primarily local clients.

The German banking system mirrors that structure, comprising mostly small and medium-sized lenders, noted Hans-Peter Burghof, a professor and head of the economics and financial services department of Hohenheim University in Stuttgart. That is a boon for the mittelstand, as Germany's often family-owned SMEs are known, but it creates fierce competition between banks and depresses profit relative to the rest of Europe, Burghof added in an interview.

That they do not target profit generation as a primary objective creates a particular competitive challenge for larger privately held commercial banks like Deutsche Bank and Commerzbank, noted Dirk Holländer, head of the strategic finance practice of the Zeb consultancy.

"Savings [banks] and credit unions are very relevant competitors to privately owned banks in Germany with regards to certain business segments," he said in an interview. "Together, they are capturing over 50% of the retail lending market and over 60% of the corporate lending market in Germany.

"In Germany, we are currently facing a 'war for assets' resulting in cut-throat competition for loans and mortgages. There has never been a time when loans were so cheap and margins for banks were so tight," Holländer added.

Consolidation

In this ultracompetitive environment, a drastic cull of the population of banks is increasingly seen as necessary. Global management consultancy Oliver Wyman recently estimated that as many as 1,000 German lenders could close by 2030 amid competition from foreign players and disruptive financial technology, and the Bundesbank, Germany's central bank, found in a recent survey that half of all lenders would contemplate a merger in the next five years.

Holländer likewise predicted that the population of German banks will continue to shrink over the next half-decade, especially in the savings and cooperative bank pillars. But the fact that inter-pillar mergers are largely out of the question is a major obstacle to systemic consolidation, according to George Yiannakis, vice president of global FIG at rating agency DBRS.

"The German system is bound to remain overbanked in the medium to short term and will be lagging in terms of profitability and efficiency," he said in an interview.

And even a wave of consolidation among smaller, domestically oriented lenders is not predestined to be a boom for their larger rivals, said Holländer.

"In Germany, we have a situation that on a political level there is this understanding that the big investment banks created the mess that the taxpayer had to pay for. The smaller, regional banks which only provide services [based on] the clients' needs are considered stable and a backbone of the financial industry," he said.

In that respect, at a time when Germany's top two lenders, Deutsche Bank AG and Commerzbank AG, are counting on their domestic market to boost earnings and complete their multiyear restructuring programs, the functioning of the local system adds to, rather than relieves, the pressure on them.

S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.