14 March 2017

Bundesbank's Dombret: The challenges currently facing the German banking sector

Andreas Dombret said low interest rates and a change in regulatory requirements are presenting German banks and savings banks with a major challenge. The same is true of advancing digitalisation.

2. Low interest rates mean additional provisioning

[...]Shrinking earnings from interest business are a fundamental problem for banks and savings banks. In prolonged periods of low interest rates, maturing loans with high rates of interest are replaced with new, lower-yielding loans. To counteract a decline in interest income, banks tend to increase the average maturity of the loans they issue. But this only goes so far to remedy the malaise in the current environment because longer-term interest rates are very low, too. So to continue earning money from interest business, banks need to cut back on their interest expenditure. Until now, however, the de facto deposit rate floor for retail investors has been 0 %. This is making classic deposit business increasingly unattractive for many banks and savings banks, and for many of them it would be cheaper to raise funding in the money and capital markets. [...]

What happens if interest rates climb sharply within a short space of time? Persistently low interest rates have driven up what is known as maturity transformation business at German banks and savings banks. The narrow spread between short and long-term interest rates means that institutions are now seeing stronger inflows of short-term deposits. If, at the same time, they originate more long-term, fixed-interest loans, they increase their exposure to the liquidity and rate interest risk accordingly.

Persistent low rates are a particular challenge for institutions whose business models are driven primarily by deposit and lending business - and there's quite simply a particularly high number of them in Germany. In 2014, German banks and savings banks derived almost three-quarters of their operating income from net interest income. Smaller institutions face an extra hurdle in that they can only hedge against unexpected changes in interest rates to a very limited extent in the capital market. Thus, we have seen a clear increase in interest rate risk at savings banks and cooperative banks, in particular, since 2011.

Those of you who watched the presentation of our annual financial statements for 2016 will know that the DeutscheBundesbank, too, is readying itself to face the risk of an interest rate reversal. This was the reason why we significant increased our general risk provisions last year. Central banks use different accounting standards than banks and savings banks, of course, but they, too, need to act today and equip themselves to deal with the risks stemming from a turnaround in interest rates.

Having a sound capital base is one good way of achieving this. It is gratifying to note that German institutions have substantially increased their tier 1 capital over the last few years. We have seen the tier 1 capital ratio rise from 9.1 % in 2008 - the year that marked the start of the global financial crisis - to as much as 15.8 % in September last year. But in the face of mounting risks, banks would do well to strengthen their capital base further, by setting aside reserves from taxed profits, for instance.

It is vital for banking supervisors to keep a close eye on institutions' profitability, which is why we will again be conducting a survey on low-interest-rate and stress scenarios this year.

3. New regulation - a challenge for banks and banking supervisors alike

[...] The banking lobby never tires of saying that additional regulatory requirements put considerable pressure on their institutions. I'd like to say two things here.

First, the reforms are not an end in themselves - and they are certainly not the result of blindly taking action for the sake of it. Quite the opposite: they are necessary and consistent. Necessary because the global financial crisis cast serious doubt on the functional viability of our financial system. "Carrying on" as we were is simply not an option. And the reforms are consistent in that they specifically address the aspects that were exposed as being particular vulnerabilities by the crisis. This is why we cannot and will not water down fundamental regulatory principles and requirements.

But on the other hand, the following point is equally important in my eyes. Supervisors are keeping a very close eye on the effects that changes in regulatory requirements are having on banks and savings banks. And, indeed, we are seeing a considerable need for adjustment for many institutions, particularly in terms of their IT infrastructure. This poses a challenge for smaller institutions, in particular, as they cannot exploit economies of scale to the same extent as their larger competitors. At the same time, the staff involved in implementing regulatory tasks are being asked to meet ever higher qualitative and quantitative requirements. [...]

This is quite simply why regulatory reform is not just a challenge for the banking industry, but also for supervisors. And we supervisors should examine, where it is possible and prudent to do so, whether we can implement targeted relief measures for small banks. Regulatory proportionality is the name of the game here. It's something we already apply today in some respects, such as in the distinction between standard and model approaches. Nevertheless, we should urgently put more thought into how we can embed the principle of proportionality even more firmly in future. The development of a dedicated regulatory regime for smaller banks and savings banks is another conceivable option. And even if this is still far off, no topics should be off-limits to us at this stage.

4. Digitalisation - a challenge and an opportunity

[...] In contrast to the other challenges I've mentioned today, digitalisation is, from the perspective of credit institutions, also an opportunity, as it provides a wealth of potential for driving down costs and tapping into new sources of income. Banks and savings banks must, nevertheless, always keep an eye on the risks presented by this brave new world. [...]

What about the income side, meanwhile? Here, too, digitalisation opens up new possibilities. Virtualisation, which I have already touched upon, provides more than just cost benefits. It also allows banking services to be adapted to suit the changed expectations of customers. Customers nowadays are accustomed to banking whenever and wherever they want and expect their bank to be highly flexible. And German institutions have already responded to this. With banking apps on their smartphones, the younger generation, especially, are effectively carrying a bank branch around with them in their pockets. In other areas, too, such as wholesale banking, digitalisation has already opened up new possibilities. And it's safe to say that a lot more will change in the foreseeable future.

Nor, when it comes to developing new services, should banks shy away per se from cooperating with external service providers. Enterprises specialised in IT-based financial services, known as fintechs, are no longer seen by established institutions solely as rivals, which was their original concern. On the contrary, I think there is still considerable potential for reaping efficiency gains here. It is now a question of bringing together digital know-how and innovative power, on the one hand, and established brands and mature customer bases, on the other.

But let's not forget the risks presented by digitalisation. What happens, say, when IT systems are down for a time? If this disrupts automated processes, the losses can be substantial; for example, if payment systems come to a standstill because individual payments cannot be executed. But also because news of such incidents now travels around the world in a matter of minutes, leading to a considerable reputational risk. The same is true in the case of cybercrime, where criminals target vulnerabilities in IT infrastructure for personal gain or to inflict damage. As you can see, in the area of digitalisation, too, adequate risk provisioning is absolutely essential.

5. Tackle reforms decisively

Ladies and gentlemen, the challenges facing German banks and savings banks are not minor in nature. The persistent low-interest-rate environment is squeezing earnings, while the incomplete regulatory reforms are causing uncertainty and entail considerable costs for many institutions. Moreover, the advance of digitalisation, while promising fresh opportunities, also harbours risks. Making strategic decisions under these conditions can feel like having to lay the tracks for a train journey without knowing where the destination is.

And this is precisely where the difficulty lies, because one thing is certain: it will not be enough for German banks and savings banks to rely solely on precautionary measures. Take the low interest rates, for example. Building up additional capital buffers is necessary for cushioning short and medium-term losses, and institutions would be wise to significantly shore up these defences. But those who think that they can simply wait out the storm are mistaken. Banks and savings banks must additionally initiate fundamental reforms and pursue these decisively. This is the only way that the banking industry can overcome today's problems and also prepare for tomorrow's challenges.

The German banking industry has already taken decisive action in some areas. Many institutions carried out a thorough review of their business models after the crisis and have thus learned from their own mistakes. Banks and savings banks are also facing up to the structural challenges of a changed market environment. For example, there has been a steady reduction in branches over a period of many years now. In the case of savings banks and cooperative banks, there have also been numerous mergers. At the beginning of 2016 there were roughly 30 fewer credit institutions in Bremen, Lower Saxony and Saxony-Anhalt than ten years earlier. This is a decline of 12 %. So you see, the banking industry has risen to the challenge, whether in terms of realigning business models, embracing consolidation or through other effective instruments.

Full speech

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