(Editor's note: This article is part of a series of commentaries on retail banking sectors, illustrating how technology disruption forms part of S&P Global Ratings' analysis of banks.)
S&P Global Ratings thinks German banks have to accelerate their digitization efforts to catch up with other banking systems, in light of the mounting competitive threat from fintechs and Big Techs.
Applying our four-factor analysis of a banking system's technology, regulation, industry, and preferences (TRIP), we think the current structure of Germany's competitive and overbanked industry is a key tech disruption risk (see chart 1). We believe conservative client preferences and an aging population help explain the digital gap with banking sectors in other countries.
So far, these factors have protected incumbent banks' market shares from new entrants to the retail banking market. Although we believe German banks are in a position to offer state-of-the-art banking products, we see no urgent demand from the client base. We acknowledge that regulators in Germany, as well in Europe, are trying to create a level playing field for players in the financial industry, including fintechs. So far, we see regulation as a neutral factor to the digital agenda of banks, but we expect more rules in the future.
Industry: Disruption Risk | Very High
Fintechs are preying on the banking system's weak spots, while the big techs lie in wait
Germany's banking system has three main pillars consisting of private banks, savings banks, and the cooperative banking sector (see chart 2). We believe this tripartite system impedes performance and efficiency, given the unabated dominance of public-sector savings and mutually owned cooperative banks, which are under less pressure than commercial banks to create shareholder value. We think this also explains why Sweden and China, for example, have progressed better so far on the digital journey.
The heavy structure of the German banking system leads to high costs and slower innovation. Most German banks are struggling with their existing core IT systems, and the savings and cooperative banks are saddled with a huge and costly branch network. Plus, the country's two largest universal banks in the country are distracted by ongoing restructuring programs. A high cost base, combined with significant pressure on revenues as a result of the low-yield environment in the eurozone, results in an elevated cost-to-income ratio that we estimate at about 75% for Germany's banking system in 2018. Among other things, this means lower available budgets for investments into a transformation of the operating model. The country's overbanked system, featuring tough competition, is also dampening net interest income, which at year-end 2018 was a roughly 70% dominant share of operating income. The banking sector's elevated competitive dynamics are demonstrated by a low Herfindahl–Hirschman Index (HHI; low value = high competition, high value = low competition), a measure of banking market concentration. Germany has the lowest HHI among the seven wealthiest EU member states and ranks last in the EU (chart 3).
New players are using the weakness and inertia of the German banking industry as an opportunity to enter the market. Fintechs and, to a larger extent, pure online banks have gained market shares in retail banking over the past few years. The product portfolio for these entrants mainly consists of personal loans, small and midsize (SME) lending, savings, as well as investment services. We think Germany is an attractive market for fintechs in light of its sheer size and high wealth level. That said, the size of the country's fintech industry remains smaller than in other large economies. Based on a number of sources, we estimate that roughly 1.7% of global venture capital is invested in German fintech companies. Faced with funding problems and the struggle to find a successful business model, the country's fintech industry in our view will undergo consolidation, either via mergers with other start-ups, acquisitions by larger banks, or strategic partnerships across the industry. For instance, N26--one of Germany's prominent start-up banks--has several cross-segment partnerships with other fintechs to offer products in the payment, savings, and insurance segment.
Big Techs have entered predominantly via payment services, as they have done in other countries via partnerships with banks and nonbanks. For the time being, Big Techs are shying away from entering the banking market due to regulatory barriers to entry. They have not yet offered core banking products like loans and deposits accounts to their online client base, but we could envisage this happening in the future. That said, we understand that Amazon is offering working capital loans to merchants on their e-commerce marketplace in Germany. Amazon's existing client relationship and historical transactions with merchants give the company a clear data benefit that it can use as a commodity for cross-selling opportunities.
Apart from the underperformance of the banking system and the threat from more agile fintech players and cash-rich Big Techs, we think another digital decelerator is difficulty attracting IT talent. First, there is much distrust about the banking system since the financial crisis, and labor is moving into other sectors of the economy. Second, IT talent tends to prefer smaller players (like fintechs) where they believe they can have greater influence. In our view, banks have to acknowledge this situation and adapt to sustain their digitalization efforts.
Technology: Disruption Risk | Moderate
Tech is ready, but clients are not
According to the World Economic Forum's Global Competitiveness Report 2018, Germany is the world's most innovative economy, followed by the U.S. and Switzerland. This is based on the speed at which countries can adopt new ideas, methods, and products; and most of them in Germany are in the automotive sector where the focus is on digitally networked mobility, driverless vehicles, and electric mobility. We do not see technology as a constraint for German banks in digitizing their business models. But because they can't switch out their mostly outdated core IT systems overnight, they are at a disadvantage versus fintechs, which don't have legacy systems to maintain before adopting the latest technology.
The current network infrastructure of Germany's conventional banks is more than sufficient for plain-vanilla banking, and we see no threat to that from the introduction of 5G mobile networks in the country, which is in any case is lagging. While advanced product solutions and services for end-clients are scarce at the country's banks, we believe there is potential for innovation to reduce the cost structure. This might come from smart technologies in risk management departments (for example, machine learning applications as anti-money laundering and "know-your-customer" compliance tools) or blockchain-based solutions (for example, to shorten clearing and settlement times, and reduce fees in payments and post-trade services). We have not seen a lot of cases so far of German banks using these technologies in their retail business lines.
A feature of the future of retail banking, in our view, will be the ever-increasing importance of open banking--an ecosystem where incumbent banks open their gates to third-party providers through Application Programming Interfaces (APIs) so they can offer digital banking services to clients. We think this will foster innovative banking solutions simply because of access to customer data, which market participants can analyze to maximize value to the client. With the introduction of the Payments Services Directive 2 (PSD2) in the EU, and the mandatory transition into German law, banks must allow third-party providers access to customer data for the provision of certain payment services from September 2019, once the clients explicitly agree to the data exchange.
We understand from German banks that cloud computing is an important prerequisite for the future of digital banking, and more of them are aiming to move from traditional servers to cloud solutions. We think cloud computing will strengthen banks' ability to store and process vast amounts of information that can be better utilized to generate new products for example. That said, the dependence of banks on cloud providers, and likely tighter regulation over outsourcing key IT systems to vendors, is a risk factor that we will monitor.
Preferences: Disruption Risk | Moderate
Client conservatism and security concerns give German banks some extra time to adapt
German clients prefer brick-and-mortar banking over digital banking. Data-supporting evidence comes from the payment behavior of the German population. Respondents to a representative survey by the German central bank revealed that almost 50% of their total purchases at point of sale (for example, retail outlets, online or mail-order purchases, or travel bookings) were still in cash in 2017 (see chart 4). That's one of the highest rates worldwide. More recent data from the central bank show that 78% of payments at retail outlets (for example, when buying food) were still with cash. Online banking penetration in Germany is weak in a European context (see chart 5). Household surveys also indicate that Germans are attached to their bank branches and cash. At the same time, preferences are changing. While the share of cash transactions between 2008 and 2014 declined by only 4.5 percentage points, between 2014 and 2017 it dropped by almost 6 points.
We tend to think that digital conservatism in Germany arises from the relatively high value the population places on security concerns. What's more, we believe the lack of demand for digital banking is also a result of the geographic spread of the population. Historically, people were evenly distributed among the regions in Germany. Urbanization has been less pronounced than in other countries because, for instance, Germany's strong Mittelstand (SME sector) offers attractive employment opportunities in more rural areas. This also explains the expansive branch network of cooperative and savings banks, in our view, because these historically aimed to be closer to their clients than private banks (as show by the first pillar in chart 2). The sheer availability of branches could go a long way to explaining the lack of demand for digital banking.
Another factor behind digital conservatism is German demographics. Germany's population is relatively older than in many other European countries, and age correlates positively with lower digital literacy and conservatism. And we expect the ratio of seniors (over 65 years old) will increase to 32% of the total population in 2050 from 23% in 2020, based on our last aging report (see table 1 from "Global Aging 2016: German Reforms Start To Tackle The Cost Of Aging published on July 8, 2016). This trend could somewhat protect digitally underdeveloped banks.
Table 1 | Download Table
|Aging Population Expectation Until 2050: Germany|
|Working-age population (% of total)||66.1||64||61.9||59||56.7||56.2||56||55.5|
|Elderly population (aged over 65; % of total)||21||23.2||25.2||28.1||30.6||31.2||31.5||31.8|
|Old-age dependency ratio (%)||31.8||36.2||40.7||47.6||53.9||55.6||56.2||57.4|
|From: "Global Aging 2016: German Reforms Start To Tackle The Cost Of Aging," published on July 8, 2016|
However, we think that client preferences for digital banking in Germany could change at a faster pace, given that they have been more dynamic in the past few years, and with the natural increase in the digitally native population, which will grow up with smartphones and see mobile banking as the norm--something that fintechs and Big Techs will reinforce. Despite the currently conservative stance of the population about banking, we think German banks will have to monitor client habits and be able to respond to changes to keep their market shares.
Regulation: Disruption Risk | Moderate
More requirements are coming to strengthen cybersecurity
We regard regulation and policymaking as a neutral digital disruption risk for German banks. Apart from a significant regulatory burden and related costs in the past few years, banks haven't been distracted by this factor, at least regarding digitalization. Regulation and policymaking in the financial industry has been tilted toward microprudential and macroprudential policies since the financial crisis, such as revisions to Basel standards and the switch from bail-out to bail-in regimes in Europe.
German regulators in our view do not have a digital agenda that would, for example, prompt banks to accelerate their digital efforts. For example, retail mortgages, a bread-and-butter business for many German banks, still legally require numerous paper documents and physical signatures that prevent the move to, for instance, blockchain transactions. And there are no regulatory sandboxes for authorized fintechs to test financial products and services in a controlled environment, such in Singapore or U.K. since 2016. There are also no tax incentives in Germany for investing in start-ups like fintechs. This contrasts negatively to the U.K., for example, where significant tax incentives exist via the so-called Seed Enterprise Investment Scheme since 2011.
Instead of leading, German policymakers are for the most part following what banks are doing and reacting when they have concerns. That said, some agencies appear to have increased their efforts to strengthen the digital resilience of banks because of concerns about data security threats. The German Financial Supervisory Authority (BaFin) has introduced cybersecurity regulatory requirements, "Bankaufsichtliche Anforderungen an die IT" in November 2017, while the European Central Bank launched its nonmandatory Threat Intelligence-Based Ethical Red Teaming (TIBER-EU) initiative in May 2018. TIBER-EU aims to mimic cyberattacks of real-world attackers and test them on banks, which can use lessons learned to minimize cyberrisks.
Data privacy concerns also culminated in the EU's General Data Protection Regulation (GDPR) in May 2018, with stricter rules about data confidentiality and data access, imposing harsh fines for noncompliance. In addition, the introduction of PSD2 indicates that regulators aim to establish a more level playing field for all providers. We think PSD2 will push German banks to increase their efforts to deliver better digital solutions to keep clients and invest in their IT infrastructure.
The new regulations since 2017 indicate greater oversight by policymakers in this area. We think that German banks, but also other banks in Europe, need to prepare for more rules in the future, not least because digitalization goes hand in hand with cyberthreats and data security risks. Outdated and fragmented IT systems make data-rich institutions an attractive target for penetrators.
German Bank Ratings Remain High, But Digital Delay Could Begin To Weigh On Profitability
The credit ratings of German banks remain strong in global comparison, supported by the country's economic strength. We do not see an adverse impact from the country's lagging digital transformation on bank ratings in the near term, even though the banking industry ranks behind other countries in this area. That's because most clients still prefer offline banking. A threat to their business models is not showing up in our assessment of business stability and market share indicators. However, it is fair to say that costly IT systems, investments in IT upgrades, and expenses for branch networks contribute to the system's high cost base, with a negative impact on profitability. We think that over time, German banks will need to adapt their business models. Demand for online products have significantly increased in the e-commerce world, and we think this will spread to retail banking. In our view, digitization shields banks from the threat of new entrants and protects their market share while fostering a solid bottom-line performance.