Will German Banks Earn Their Cost of Capital?

Abstract

Research QuestionThis paper analyses the effect of a sustained period of low interest rates on the outlook for the German banking sector. Low interest rates provide a particular challenge for German banks, which are highly dependent on interest income and exhibit relatively high cost-income ratios.It is thus an open question whether German banks will manage to earn their cost of capital in this environment. ContributionWe analyse the interest earnings from loans and the interest expenses for deposits, i.e. the core business interest margin of a bank. We consider different future interest rate scenarios and analyse the extent to which they cause a further narrowing of the core business interest margin. Finally, we test whether a special feature of German accounting standards could serve as a buffer in sustaining profitability for some time. ResultsOur results indicate that a sustained period of low interest rates will increase the pressure on the core business interest margin earned by German banks. Even if interest rates stayed constant at current levels, the core business interest margin of German banks would be reduced by 16% over the next four years. Moreover, this projected decline in the core business interest margin will result in only 20% of German banks earning a cost of capital of 8% by the end of this decade. However, by applying a special feature of German accounting standards and using hidden and open reserves, German banks may alleviate this decline to a certain extent. Nichttechnische Zusammenfassung Fragestellung AbstractIn recent years, the German banking sector has overcome major challenges such as the global financial crisis and the European debt crisis. This paper analyses a recent development as a particular determinant of the future outlook for the German banking sector. Interest rates are at historically low levels and may remain at these levels for a considerable period of time. Such levels pose a specific challenge to banks which are heavily dependent on interest income, as is the case for most German banks. We consider different interest rate scenarios and analyse the extent to which they cause a further narrowing of the interest rate margin. Our results indicate that a projected decline in this margin will result in no more than 20% of German banks earning a cost of capital of 8% by the end of this decade. This decline is somewhat alleviated by the fact that German banks can apply a special feature of German accounting standards by using hidden and open reserves.

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