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German banks' extreme vulnerability to low rates could force big change

Record low interest rates, high costs and fierce competition are putting extreme stress on Germany's banks, with some senior banking figures suggesting the traditional three-pillar model may begin to fracture.

German banks are particularly sensitive to ultra-low rates, as they are highly reliant on earning interest on loans made from deposits, and bring in relatively little alternative income from fees and commissions. Following years of historically low rates, the ECB cut the deposit rate by another 10 basis points to negative 0.5% on Sept. 12, suggesting banks face a "lower for longer" rate environment. Its main refinancing operations remain at zero percent.

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Meanwhile, the German banking model itself — divided into commercial, public and cooperative bank "pillars" — causes overcapacity and strong competition, as well as barriers to consolidation, all of which pushes up costs. German banks have the highest cost-to-income ratios in the EU, with an average of 83.2% as of June 30, compared to 64.1% across the wider bloc.

The model slows down badly needed consolidation, as the ownership structure of the different banks prevents cross-pillar mergers. Germany has had the largest number of banks in Europe for decades; as of September there were 1,571 credit institutions, accounting for roughly a third of all such entities in the eurozone, according to ECB data.

It also creates fierce competition, with savings and cooperative banks jousting with commercial banks in consumer lending and the lucrative SME lending segment.

At the same time, foreign-owned banks have picked up market share, especially in corporate banking. ING-DiBa AG, owned by Netherlands-based ING Groep NV, France's BNP Paribas SA and TARGOBANK AG, owned by France-based Crédit Mutuel Group, have been "growing like hell" in the German market, according to Uwe Stegemann, a Cologne-based senior partner at management consultancy McKinsey.

These firms are less burdened by cost and the limitations of ownership structures. German savings banks, for example, cannot raise capital easily as this would sometimes require approval by a regional government.

"That is a significant limitation in this world where capital requirements are increasing," Stegemann said.

Time for change

Historically, many German banks mitigated the negative effects of low rates thanks to very low loan loss provisions. But given the recent slowdown in the German economy, they can no longer count on that. Germany lowered its 2020 forecast for GDP growth to 1.0% from 1.5% earlier in October.

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Germany's financial regulator and central bank surveyed 1,412 smaller banks and found that an unchanged ultra-low rate environment over the next five years would impact returns. Moody's said these banks' profits would fall by more than 50% under this scenario. Furthermore, to cut costs in order to protect their credit profiles, fundamental change to the banking system is needed, the rating agency said.

A change in their traditional business model is long overdue, according to McKinsey's Stegemann. The traditional balance-sheet-oriented banking model is not viable in the medium term, he warned in a recent study.

A growing number of critics have started to question the usefulness and validity of the three-pillar model, and some have even suggested reform, Stegemann said in an interview.

Such change has also been suggested by Commerzbank AG CEO Martin Zielke, who said Sept. 27 that ECB policy has created a "perfect storm" for the financial sector. Two or three years ago he would have ruled out a reform of the three-pillar model, but now he would not, he told analysts on a call to discuss Commerzbank's new restructuring plan.

"I see some signs that we will see some changes. And if that comes, we want to be prepared," Zielke said.

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Separately, Hamburg Commercial Bank AG CEO Stefan Ermisch said his organization was proof that cross-pillar mergers could be possible. Previously known as HSH Nordbank, Hamburg Commercial Bank was the first ever landesbank to be privatized, although its sale was a condition for state aid imposed by the European Commission, and thus a special case.

Since that privatization, the Federal Savings Banks Association DSGV has been pushing for a mega-merger between all remaining landesbanken to increase efficiency and protect the integrity of the public banks pillar. The latest move towards such a deal was the DSGV decision to initiate potential merger talks between Landesbank Hessen-Thüringen Girozentrale and DekaBank Deutsche Girozentrale.

Cooperation rather than consolidation

Legal barriers for significant changes remain high, Stegemann said.

For example, savings banks are protected by the Savings Bank Act which governs everything from their formation to their ownership and sale. To allow lenders outside the public banks pillar to acquire them, Germany needs to change that law.

Therefore the talks in the German banking system are more about cooperation than outright consolidation and mergers, Stegemann said.

Recently, Taunus Sparkasse, a savings bank, and Frankfurter Volksbank eG, a cooperative lender, agreed to launch joint branches.

There is also the so-called XPay project, which aims to create a joint payment services platform for banks across all the pillars.

"Such initiatives are how some banks are trying to overcome the high legal hurdles [to consolidation]," Stegemann said.