To get a sense of the turmoil facing Germany’s banking sector, just look at a few of the major shake-ups announced in the last few months.
Deutsche Bank, Germany’s largest bank, is in the middle of a massive institutional makeover and could shed a big chunk of its retail banking operations. Commerzbank, the country’s second-largest bank, is gutting an entire layer of management, downsizing its London office and mulling more branch closures. Hypovereinsbank, the third-largest, in August said it planned to close nearly 50 percent of its branches around Germany.
And that’s just the big three. Below this top tier there are nearly 2,000 regional and local banks, each struggling to make a living in Europe’s most competitive market. Most face high operating costs, low profitability, ultra-low interest rates, an overbearing financial regulator, and increased competition from banks abroad.
Only six percent have managed to earn back the cost of their investments in three years.
These underlying problems have been masked for years by a European debt crisis that has soaked up the energies of financial markets and policymakers across the continent, directing the spotlight from Germany towards the economic crisis in southern Europe.
But the gradual easing of difficulties in the southern portion of the continent is beginning to shed light again on Germany’s weak banking sector and the longer-term challenges it faces. The picture isn’t bright.
“In the short term, we see a modest improvement in the German banking system … but overall the structural challenges are definitely there,” Michael Dawson-Kropf, the chief banking analyst at rating agency Fitch, told Handelsblatt Global Edition. “Despite the modestly positive outlook for 2015, I think the pressure is mounting.”
The move towards a common banking market for Europe and desire for digital banking poses a threat to Germany’s storied financial institutions, many of which have thrived on close-knit relationships with their customers.
In some cases, the prospect of waning state support could tip them over the edge.
“The kind of slow progress we are seeing in addressing these challenges I think would probably be one of our biggest concerns,” Mr. Dawson-Kropf said. “German banks have traditionally only moved fast when there was immediate pain, or external factors forced changes.”
“I think in 10 to 20 years, maybe only about half of the regional banks in Germany will survive.”
A major downsizing seems unavoidable.
The number of German banking institutions could be cut in half by mergers or closures in the next decade. Bain & Company, a consulting firm, estimates that about a third of all bank branches will be closed in the coming years, putting one in five jobs in jeopardy.
To be sure, Germany’s banks are not facing imminent collapse.
The largest are still far more secure than many of their European peers – all 21 of the largest banks in Germany were declared safe last October in a “stress test” by the European Central Bank. The fact that Germany’s banking system is relatively healthy has allowed them to fly under the radar during Europe’s financial crisis.
Each bank is also working to find its path through the wilderness.
The top two banks are making opposite bets: Deutsche Bank is doubling down on its strength in investment banking. Commerzbank, which is still 18-percent owned by the German government, thinks it has found a path in Germany’s ultra-competitive retail banking sector.
Both banks need solutions – profitability is well below other major banks (see graphic).
But aside from the two domestic leaders, Mr. Dawson-Kropf said it is the danger posed to Germany’s local banking sector – its network of hundreds of savings banks and cooperative banks – that has been underestimated the most by bond and equity traders.
While they may be among the most profitable banks today, these local state-supported institutions face tremendous challenges in coming years from the shift to digital banking.
Where for the past few years the banking world has been mostly about survival, the next few years will turn around long-term profitability and operating costs. It is a reality that most banks in Germany are only just beginning to confront, and many are hungry for new ideas, according to Wilhelm Schmundt, a partner at Bain & Company in Munich.
“The topic of cost reduction is now very, very high on the agenda of all financial houses,” Mr. Schmundt said in an interview. Bain & Company, in a widely-circulated report on the sector’s long-term challenges, estimated banks need to cut 30 percent off their costs to remain viable.
Bain has met with more than 50 banks, regulators and associations since the report’s release in October.
“German banks have traditionally only moved fast when there was immediate pain, or external factors forced changes.”
These challenges aren’t new in Germany. The country’s banking sector has long been less profitable and more competitive than other major economies, notably the United Kingdom. The number of banks in Germany has already shrunk by a factor of eight since 1970.
What has changed – and what has put Germany’s banking model under threat – is the ease of doing business across borders in Europe. The creation of common banking rules and a common supervisor in the European Central Bank has many predicting a wave of consolidation in European banking.
Some banks headquartered outside Germany are looking for a way into Europe’s largest economy.
“I think in 10 to 20 years maybe only about half of the regional banks in Germany will survive,” Christoph Pape, a banking consultant in Frankfurt, said in an interview.
Merge or die. That could be the new motto in Germany.
It’s not just a question of cost, but more an existential dilemma about how banks – especially regional and local banks – can operate in an increasingly digital, globalized Europe. Mr. Pape says many have yet to fully grasp the dangers.
“The business model still hasn’t yet properly come into focus,” he said. “At the moment, after regulation, it is costs that are stronger in focus. We should really first be looking at the whole operation before looking at costs.”
Just six percent of the nearly 2,000 banks in Germany earned a positive return on their equity in the last three years, according to Bain. That means the vast majority have been unable to earn money for their investors.
Even Deutsche Bank had a return on equity of just 2.7% in 2014.
But sorting winners from losers won’t necessarily happen quickly. The German banking market is heavily influenced by the state.
Many banks are backed by local communities and state governments. It is the main reason that Germany’s network of state-owned banks, known as Landesbanken, are alive today despite a series of bad bets in the 2008 financial crisis.
In short, Germany has been unwilling to let its banks fail.
“From an economic point of view, you can’t explain it,” said Mr. Dawson-Kropf of Fitch Ratings, which has a negative outlook on Germany’s banking sector this year. “The decision-making process is not always driven by economic thought, but by regional, personal, or political interests.”
The number of banks in Germany has fallen just 1 percent per year since 2008. Britain has seen its banking sector shrink 2 percent per year, and Spain, 6 percent.
The pace could pick up if state governments in Germany decide they can no longer support their local champions, or if the European Commission gets tough and begins to rule state aid as a form of illegal subsidy, or if small banks decide they no longer can handle the burdensome costs of increased financial oversight on their own.
Whether they like it or not, Mr. Dawson-Kropf says the prospect of a prolonged period of record low interest rates across Europe could propel mergers of German savings and cooperative banks.
This is not necessarily a good thing.
Germany has long prided itself on the fact that its banking sector is ultra-competitive, a product of a more federal economic model compared to France or Britain, where the capital cities dominate the economies.
Germany has an estimated 23 credit institutions for every one million inhabitants – about four times as many as in the United Kingdom. Competition is good for customers, but bad for banks.
“There are two hearts beating in my chest,” Mr. Pape said. “The retail and business customers are profiting from this. The question is how long the profitability of every individual bank will hold up.”
Christopher Cermak has covered financial markets, economics and politics from Washington D.C., Frankfurt and Berlin. He is an editor with Handelsblatt Global Edition in Berlin. To contact the author: email@example.com