Profits at small and medium-sized German banks will continue to come under pressure from the low interest rate environment, albeit at a slower pace than in previous years, according to a survey by German bank regulators.

A total of 1,500 banks and savings institutions, accounting for 88% of the German banking market and 41% of total assets, predicted their profits before tax would decline by an average of 9% between them over the next five years. This corresponds to a 16% fall in their total return on capital, compared to a forecast of a 25% decrease in return on capital in a similar survey conducted in 2015 by the Bundesbank and financial market watchdog BaFin.

"While these institutions are planning ahead somewhat more positively than two years ago, it should be noted that this finding solely indicates that their profitability — which started low — is deteriorating at a slower pace than before," Andreas Dombret, the Bundesbank Executive Board member in charge of banking supervision, said in a statement Aug. 30. "The phase of stagnation caused by low interest rates is far from over."

Dombret said lenders were looking for alternative sources of income to offset margins pressurized by the low interest rate environment, and he predicted that commissions would take on a greater importance in stabilizing future earnings.

Total return on capital will decline by 40% if interest rates remain stable until 2021, but will fall by more than 50% should interest rates fall further. If rates should rise, bank profits will continue to fall in the short term due to impairments, but will rise again in the medium to long term as margins widen.

'Vulnerable institutions'

The watchdogs applied a stress test to the institutions to gauge their capital strength, simulating credit and market price risks and a hike in interest rates. Around 4.5% of the surveyed institutions failed to meet regulatory capital requirements.

The tests will help serve "as a valuable early warning signal" and will strengthen the banking sector's stability, BaFin said in a statement. Vulnerable institutions will be more strictly supervised, it said.

The majority of institutions surveyed estimate their common equity tier one ratio — a key measure of a bank's capital strength – would increase to 16.5% by 2021 from 15.9%. One-third, however, expect the ratio to fall due to an increase in risk-weighted assets on greater businesses volumes and a greater willingness to engage in risky investments.

The German banking market is one of the most fragmented within the EU, and stiff competition for market share has put pressure on margins, which has only been exacerbated by the low interest rate environment.

In a separate statement following the survey's publication, the German Banking Industry Committee, which represents banking associations, called for a scaling back of the European Central Bank's low interest rate policy, designed to stimulate growth.

"Once the situation has returned to normal, the squeeze on the earnings of the German banking industry will be eased and it will be able to counter potential risks more effectively," it said.