financial sector

Shrinking Down to Size

Stormy times for banks. Source: imago/Reuters
Stormy times for banks.
  • Why it matters

    Why it matters

    The banking sector faces cost savings, job cuts and consolidation to meet the demands of regulators that they make their operations more stable.

  • Facts

    Facts

    • Report estimates cost reduction potential of German banks at 30 percent, or €25 billion.
    • Only six percent of banks are generating profits that exceed their capital costs.
    • Bonuses account for about one third of balance sheet totals of German banking sector.
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    Audio

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Germany’s banking sector, the most competitive in the developed world, faces an era of deep cutbacks and painful job cuts if the many thousands of individual banks based in Europe’s largest economy hope to survive and become profitable again.

That is the conclusion of a new study by Bain, a U.S. management consultancy that predicts as many as 125,000 jobs in the German banking sector may have to go in the coming years. Consolidation in the financial sector, which has more banks per inhabitant than any other developed country, looks likely in the next decade.

According to Bain, which is based in Boston, Massachusetts, German banks will remain fundamentally unprofitable unless they change their ways. That’s because, in the majority of cases, banks’ returns on capital are well below their equity costs, falling far short of the yield requirements of potential investors.

Record low interest rates, high labor costs, too many bank branches and new competition from financial technology companies have all contributed to make it a difficult time for the financial sector in Germany, where more some 3,000 banks compete for a limited amount of market share.

For 2014, Bain estimated banks’ balances to have had a 2.1 percent return on equity on average, compared to capital costs of 7.7 percent. The result is a shortfall of €25 billion, or $27 billion.

“These are indicators of an industry that's in a real mess.”

Walter Sinn, banking consultant, Bain

Almost all financial institutions in Germany, ranging from giants like Deutsche Bank and Commerzbank to the hundreds of smaller savings banks and cooperative banks that dot the landscape, face the same fundamental problem.  It’s also a problem facing many banks across Europe.

Only six percent of German banks generated profits that exceed their capital costs in 2014.

Bain’s calculations are more pessimistic than some. Germany’s Bundesbank, for example, calculated an average return on equity after tax at 3.95 percent. However, the central bank also includes bank reserves in the total in addition to the institutions’ after tax profits.

But regardless of the numbers, the consultants’ conclusions chime with calls from regulators across Europe, who have criticized the German industry for its low profitability. The head of banking supervision of the European Central Bank, Danièle Nouy, and Bundesbank board member Andreas Dombret have both recently criticized banks’ low profitability.

Furthermore, according to the Federal Association of German Banks, the BdB, a lobby group, the future earning potential for the industry is also limited.

“The next few years are going to be a joyless cost squeeze,” the association’s chief executive Michael Kremmer told attendees at a Handelsblatt conference in Frankfurt last week.

It’s a view shared by consultancy firm Bain. “In essence, the banks need to tackle their structural costs,” said Walter Sinn, one of the authors of the Bain study. According to his estimates, banks need to reduce their costs by 30 percent, or around €25 billion before tax. According to the study, that reduction would mean shedding about 125,000 jobs.

Given the age structure of the banking sector work-force, this could be achieved by 2025 through natural attrition, retirement and early retirement schemes. According to Bain, banks could potentially cut a further 115,000 full-time jobs by using contractors and service companies instead.

Even if banks manage to take these radical measures and reduce costs, Bain’s forecast is grim. The moves would help to address the capital shortfall in the next decade but the gap will not close. Bain’s forecast for 2025 is for a capital shortfall of €13 billion ($14 billion), despite a rising return on equity and a sinking cost of capital.

“These are indicators of an industry that’s in a real mess,” Mr. Sinn said.

In order to achieve these job cuts, banks would need to make massive investments in IT and to restructure their operations, the cost of which will become clear in the next few years.

Beyond that, Mr. Sinn predicted predatory competition and industry consolidation are ahead for the sector. Financial technology start-ups, or “fintechs” that are offering more ways to take banking activities online, are also likely to complicate matters for traditional banks that have been slow to adapt to the changing times.

“The final nail for financial Germany’s coffin could well be FinTech. German institutions have long ignored the challenge of digitalization,” Peter Barkow of Barkow Consulting said in a recent report, arguing that German banks are only in the early stages of a major disruption in the way they do business.

But not everyone is convinced. Some have questioned Bain’s calculations, for example, while the concept of return on investment is controversial.

Bain determined the rate of return from the risk-free rate on ten-year German government bonds, which currently stands at just under one percent, and also includes the capital market yields investors expect.

“I see the whole concept of capital costs as misleading, and so don’t think much of these kinds of statements,” says Mark Roach, a trade union secretary for Verdi, Germany’s largest labor organization which covers bank employees. Mr. Roach argued that the calculations of the cost of capital are always influenced by the expectation of a return on the capital market.

“Returns on equity for investors, to a large extent, come from share price gains and not necessarily from dividends,” Mr. Roach said. These capital gains are not paid by the banking institutions, but by other shareholders.

While Germany’s banks look at ways to cut jobs and reduce operating costs, they are still big spenders when it comes to bonuses. According to a recent study, 3,400 German bankers are drawing the maximum bonus allowed under the limits set by the European Banking Authority, the continent’s regulator. Only Britain has a higher number of bankers drawing the maximum.

The new bonus-cap laws were passed in Brussels in early 2014 to prevent bankers being paid massive rewards for ultra-risky transactions. The bonuses are supposed to be tied to bottom-line success and cannot exceed the equivalent of a banker’s usual salary. Only in cases when the majority of shareholders approve can the bonus be doubled.

According to EBA figures, a total of 31 German banking institutions – including the German branches of American banks – gave the green light for the maximum bonuses to be paid out. That accounts for about one third of the balance sheet totals for all German banks.

 

Yasmin Osman covers banking and supervision for Handelsblatt in Frankfurt. Christopher Cermak of Handelsblatt Global Edition in Berlin and Katharina Slodczyk of Handelsblatt in London contributed to this story. To contact the author: osman@handelsblatt.com

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