Abstract
In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.
IX. Challenges for the Banking Sector and the ECB Comprehensive Assessment1
1. Progress under way. The German banking system has strengthened further in 2013. Last year’s earnings were supported by historically low loan loss provisioning, due to a favorable macro-economic environment in Germany, and an improving European outlook. Profitability, however, varied, as did one-off charges. Nonetheless, the improvement in capital adequacy continued, and virtually all German banks are expected to be ready to implement stricter regulatory requirements in a timely manner. Many banks are also restructuring their balance sheets, and making progress in addressing legacy and non-performing assets, cutting costs, and accelerating impairment charges in the income statement.
2. The ECB is conducting a comprehensive assessment (CA) the outcome of which will be a milestone for European banks in general and German banks in particular. This exercise is taking place before the transfer of supervisory power to the ECB in November of this year in the context of the Single Supervisory Mechanism (SSM - see Chapter VIII). The CA has been and is likely to remain the most prominent theme of 2014 for the German banking sector. The process started in November 2013 and results are expected to be available by October 2014. The assessment comprises three phases: (i) a risk assessment, which covered all significant bank risks; (ii) an asset quality review (AQR), which is ongoing at the time of writing and focuses on the quality of the main assets and their valuation, and (iii) and forward-looking stress-tests coordinated with the European Banking Authority (EBA), which will examine banks’ resilience under adverse economic conditions. Germany has the highest number of banks involved in the exercise. Together, these banks hold about 65 percent (€5 trillion) of German banking sector assets. The SSM national supervisory authorities and the ECB are expected to closely cooperate on the implementation of the CA and are supported by independent consultants and auditors. The CA may uncover provisioning shortfalls and, in a few relatively weaker banks, capital shortfalls.
3. Against that background, the core of our analysis focuses on the 23 largest German banking groups subject to the EBA stress tests.2 German averages shown in our Figures are based on this sample while European averages are based on the full EBA sample of 124 European banking groups. In the text and charts, we also discuss recent developments in the narrower group made of the largest 10 German banking groups with an international focus3
Profitability reflects low provisions, rather than strong operating revenues
4. Low operating income. Aggregate net earnings in our sample of 23 banks remained flat in 2013 at €4.8 billion. They stood at €4 billion in the smaller group of 10 banks, a small decline relative to 2012 (Figure 1). Profitability remained subdued, as top line revenues were adversely affected by a reduction in net interest income, which accounted for over half of operating income. Net interest margins (NIMs) are structurally low in Germany and are below European peers’, mainly due to intense domestic competition, sometimes described as “overcapacity.”4 The low interest rate environment is adding further pressure on NIMs. Universal banks with a diversified revenue mix are less exposed to this challenge, but some were affected last year by the significant slowdown in investment banking revenues, primarily in fixed income. Furthermore the largest German bank booked litigation expenses of 2.5 bn euros last year as a result of several legal and regulatory challenges that are still ongoing and may be a drag on its profitability this year again. German banks’ return on equity (RoE) and return on assets (RoA) compared favorably to European peers on average, but single digit RoEs may not be sufficient to cover the cost of capital over time Sustained cost-cutting measures over the last few years have helped bring down German banks’ cost-to-income ratio more in line with their peers in the rest of Europe.
Mixed Picture on Profitability
Citation: IMF Staff Country Reports 2014, 217; 10.5089/9781498328524.002.A009
Source: SNL Financial.5. Low provisions helped earnings. Net earnings were supported by historically low loan loss provisioning due to a favorable macroeconomic environment in Germany, and the recovery across Europe. With cross-border claims lower, German banks are less exposed to a deterioration of the outlook outside Germany. Provisioning may have bottomed out, and it is likely to increase again, particularly in the face of a deterioration of economic prospects in some parts of the world, including emerging markets. Tensions between Ukraine and Russia might also have an impact on asset quality should there be an escalation of sanctions.
Capital positions have improved, but leverage ratios are still too weak in selected banks
6. Good progress towards Basel III implementation. According to the FSB5, the results of the Basel III quantitative impact study showed that, the 42 German banks participating in the exercise complied on average with a fully loaded Basel III common equity tier one capital requirement of 7 percent as of year-end 2012. The sum of individual capital shortfalls for the seven largest and most internationally active banks declined to €14 billion at year-end 2012, and decreased further in 2013. This overall improvement is attributable to increases in regulatory capital as well as a reduction in risk-weighted assets.
7. Risk-based capital ratios are at historical highs. The average Tier 1 ratio for the sample of 23 German banks improved from 14.9 percent in 2012 to 16.4 percent in 2013, above the European average of 14.8percent (Figure 2). Capital positions have improved, as banks have divested non-core assets, and dealt with some expensive legacy assets. Ongoing restructuring and de-risking efforts have led to a reduction that is more pronounced in risk-weighted assets (RWAs) than in total assets. Some banks also issued equity in 2013, which helped rebuilding capital, but organic capital generation may be slowed down by subdued profitability going forward. These higher capital ratios are justified in light of forthcoming stricter regulatory requirements, and to provide a buffer available to cushion possible capital needs identified by the ECB comprehensive assessment.
Robust Risk-Based Capital Ratios, But Weaker Leverage Ratios
Citation: IMF Staff Country Reports 2014, 217; 10.5089/9781498328524.002.A009
Source: SNL Financial.8. Leverage ratios, however, continue to lag behind. At end-2013, some large German banks fell short of the 3 percent minimum threshold fixed by Basel III, while the majority of smaller banks are expected to comply easily with the forthcoming minimum requirement. The leverage ratio is likely to have a significant impact on global diversified German banks, particularly in comparison to European and even more in comparison to American peers that are already taking steps to comply with stricter domestic requirements. It is worth noting that the leverage ratio definition is not fully settled yet, that reporting will not be required until 2015 and that implementation of the ratio is scheduled for 20186. Issuing additional Tier 1 (AT1) instruments would help timely convergence towards the expected minimum leverage ratio requirement and gradually build buffers more commensurate with levels observed with global peers. Of the ten banks in our core sample, the two with the lowest leverage ratio were in the middle of capital raising exercises at the time of writing.
9. Reliance on state aid has diminished. Capital injected by the federal government came down from a peak of €29.4 billion and accounted for €17.1 billion at end-2013 while Public guarantees provided by the federal government have been fully phased out from their €168 billion peak. Several Landesbanken still benefit from risk-shields provided by their public owners. The repayment of state aid as required by the European Commission may be a drag on the capital of select banks and may offset any improvement in regulatory capital for some time. In addition, full exit conditions are not mapped out yet. The outcome of the asset quality review (AQR) and stress tests may also result in further needs for public assistance in vulnerable banks.
Funding has improved overall, but a few banks need to make further progress
10. Liquidity is robust, but a few banks’ funding is still relatively weaker. German banks built strong liquidity buffers ahead of the implementation of the Basel III liquidity coverage ratio (LCR). According to the 2013 Bundesbank FSR, the 12 largest banks’ liquid assets exceeded short-term liabilities by 22 percent in mid-2013. The average loan-to-deposit ratio in the sample of
23 banks (132 percent) is about 10 percentage points above the European average, but with a wide dispersion, as some Landesbanken remain very dependent on wholesale sources (Figure 3). Wholesale funding on average represents a bigger share of funding in Germany, even if this is partially offset by the low reliance on borrowing from the Eurosystem.
Mixed Picture on Funding
Citation: IMF Staff Country Reports 2014, 217; 10.5089/9781498328524.002.A009
Source: Haver Analytics, SNL Financial, and IMF staff calculations.Asset quality remains robust overall, with pockets of vulnerabilities
11. German banks’ assets are of higher quality than European peers’. Non-performing loans (NPLs) are low, reflecting robust economic performance in Germany. At end-2013, NPLs averaged 5.8 percent for the largest 23 banks, or less than half the European average (11.9 percent)7. Coverage of NPLs appears to be in line with European standards (Figure 4).
Relatively Strong Asset Quality Overall
Citation: IMF Staff Country Reports 2014, 217; 10.5089/9781498328524.002.A009
Source: SNL Financial.12. Credit risk appears to be concentrated in specific sectors which will be a focus of the AQR in Germany. Shipping loans, loans for foreign commercial real estate (CRE) and legacy assets, including securitizations and exposures to selected European countries remain particularly vulnerable to default risk. Exposures to the GIIPS8 amounted to €338 billion, or 9.4 percent of GDP at end-2013. For the twelve major banks with an international focus, the aggregate exposures to the shipping industry and securitizations at end-2013 represented 42 percent and 46 percent of Core Tier 1 respectively, while exposure to foreign CRE represented 68 percent of core capital at end-2013:Q1.
13. Asset quality, NPL coverage, and exposures to troubled sectors are very heterogeneous across banks. For the largest banks, shipping and CRE exposures are modest relative to their total loan portfolio but the combined exposure to shipping and CRE reaches multiples of Core Tier 1 for some of the other banks. In particular, shipping exposures account for up to 20 percent of assets in some Landesbanken. Thus, while NPL ratios are low on average their dispersion is notable as they range from 1 percent to 20 percent. The coverage of NPLs shows a similar dispersion, with one Landesbank enjoying the strongest coverage (115 percent), and two Landesbanken showing the lowest, at 27 percent and 36 percent respectively. The AQR will pay particular attention to the consistent treatment of the classification of loans in forbearance across countries and across financial institutions, and some reclassification may be needed as a result in a few cases.
14. The CA may uncover additional capital needs in vulnerable banks. At an aggregate level, improved capital ratios should provide an adequate buffer against stressed conditions. Still, significant disparities among banks are likely to be identified. While in the aggregate exposures to troubled assets seem manageable and many banks appear to have excess capital at the moment or the ability to access markets, these exposures tend to be concentrated in a few vulnerable banks already under restructuring and further provisioning needs cannot be ruled out. The CA may therefore force a reexamination of some current restructuring plans.
15. Several avenues to address possible capital shortfalls identified by the CA could be considered. Some German banks could reduce the nominal of their silent participations should they report a full-year loss according to German GAAP. They could raise also raise capital (as done by two of the largest banks at the time of writing), convert debt into equity, and/or reduce risk-weighted assets. Should private sources of equity not be available or sufficient and public sources be needed, the European Commission state aid rules would be applicable (e.g. on holders of subordinated debt). Creditor bail-ins for systemically important banks, if deemed necessary, would be expected to be applied with due consideration given to financial stability concerns.
Prepared by V. Le Leslé (SPR) and J. Vandenbussche (EUR), with research assistance from M. Maneely (EUR).
23 out 124 banks are German in the EBA sample, while 24 out of 128 banks are German in the ECB sample. SEB AG is a subsidiary of Sweden-based SEB Group. Because Sweden is part of the European Union but not part of the Single Supervisory Mechanism, SEB AG is included only in the ECB sample.
All the information in this chapter comes from publicly-available sources, primarily SNL, Bloomberg and individual bank reports.
Bundesbank, Financial Stability Review (FSR) 2013, page 49.
March 2014 Peer Review of Germany, annex 1.
The leverage ratio shown in Figure 2 is constructed as tangible common equity divided by total tangible assets.
Only 5 banks had reported NPLs and coverage ratios as of mid-2013. At end-2012, NPLs averaged 5.6 percent, and coverage ratio 46.1 percent. Both metrics have improved in 2013.
Greece, Ireland, Italy, Portugal and Spain.
