Stress test

The low interest rate environment continues to weigh heavily on small and medium-sized credit institutions in Germany.¹ This was established by the latest survey on the profitability and resilience of German credit institutions in a low interest rate environment, which was undertaken by BaFin and the Deutsche Bundesbank at the beginning of April 2017.²

The survey focused on the around 1,500 small and medium-sized German credit institutions that are directly supervised by BaFin. These account for almost 90 percent of all credit institutions in Germany, corresponding to over 40 percent of total assets.

Profitability

The survey first collected institution-specific target and forecast data. In addition, the credit institutions simulated their earnings for the period 2017 to 2021 in five interest rate scenarios predefined by BaFin, assuming different balance sheet adjustments.

Table 7 Methodological rules and interest rate scenarios (2017 to 2021)

Methodological rules and interest rate scenarios (2017 to 2021)

* bp = basis points BaFin

On the basis of their own target and forecast data, the surveyed credit institutions reported that their profit for the financial year before tax would fall by 9 percent over the next five years. Since the institutions simultaneously anticipated balance sheet growth, this corresponds to a 16 percent decline in their total return on capital. In the 2015 survey, banks and saving banks had anticipated a decrease of 25 percent, spread across the following five years.

Majority well capitalised

The majority of German institutions are well capitalised. "The good level of capitalisation demonstrated by most institutions is useful in softening the effects stemming from the low interest rate environment", said Raimund Röseler, BaFin's Chief Executive Director of Banking Supervision, at the presentation of the survey results at the end of August 2017. In addition, most institutions were planning to increasingly focus on alternative sources of income to make up for the dwindling margins in the interest rate business.

The five simulated scenarios point to ever diminishing profitability on the part of German banks and savings banks if the current low interest rate environment persists or intensifies. Banks’ total return on capital would contract by around 40 percent if interest rates remain stable up until 2021, or even shrink by much more than 50 percent if interest rates fall. Assuming a dynamic balance sheet, portfolio adjustments can cushion this impact accordingly, largely on account of contracting margins in borrowing and deposit business. If interest rates were to be raised, the institutions would initially experience a slump in profits owing to impairments. In the medium to long term, profits would, however, bounce back above their 2016 level on the back of widening margins.

Resilience

Overall, the institutions concerned intend to increase their Common Equity Tier 1 (CET1) ratio from a level of 15.9 percent to 16.5 percent by 2021. However, one-third of them expect to see a drop in their CET1 ratio over the next five years, mainly as a consequence of the substantial increase in risk-weighted assets that, aside from an upturn in the volume of business, may have been generated by a greater willingness on their part to engage in risky investments.

The institutions continue to expect fierce competition from other banks and fintech companies. Close to every tenth institution indicated that it was currently in the process of implementing a merger or planning to do so in the future.

Stress test

In order to gauge the impact of a deterioration in economic conditions on institutions' capital adequacy, the survey again incorporated a stress test, used to measure the resilience of credit institutions in the current situation in a variety of stress scenarios covering interest rate risk, credit risk and market price risk. The aim was to establish how effective the credit institutions’ capital adequacy was in coping with these stress factors.

Generally resilient

The test found that most small and medium-sized institutions exhibit a good level of resilience. The Common Equity Tier 1 ratio after stress stands at 13.3 percent across all participating banks. Valuation effects arising from an abrupt interest rate hike have the greatest impact on the stress test. As regards market price risk, the stress effects can be attributed in more or less equal measure to interest-bearing and non-interest-bearing items. However, non-interest-bearing items make up only about one-fifth of the banks’ portfolios and are therefore play a disproportionately strong role with respect to stress effects. Turning to the findings of the credit risk stress test, the banks showed themselves to be well equipped to deal with a sudden surge in credit risk. In this connection, the positive macroeconomic developments in particular helped to relieve the situation.

The findings of the stress tests will be fed into the target equity ratio, as described above. This is intended to ensure that the institutions are well capitalised to withstand stress scenarios.

Financing of residential real estate purchases

The risks of housing loans have increased slightly, but for the most part, lending standards and conditions have not been loosened. A specific stress test relating to the institutions’ activities in the area of residential real estate showed that the majority of institutions would be able to cope with an assumed decrease of 20 or 30 percent in house prices over a period of three years. The banks' Common Equity Tier 1 ratios would decline by 0.5 or 0.9 percentage points, respectively.

Bausparkassen

While the survey was underway, a parallel survey of German Bausparkassen was conducted, tailored to their business model. The prevailing low interest rate environment may impinge on the profitability of Bausparkassen but the scenario calculations show that their profits should stabilise over time so long as interest rates remain low or incline upwards. If, however, market interest rate levels continue to fall, profits would remain subject to pressure.

The 2017 survey, the third after 2013 and 2015, allows the German supervisors to gain a comprehensive insight into the profit outlook of German credit institutions, identify potential risks at an early stage and heed the findings of the survey in the course of their supervisory activities.

Pension obligations

One of BaFin's supervisory priorities in 2017 was an investigation of the risks associated with pension obligations. Accordingly, the 1,500 small and medium-sized German credit institutions directly under national supervision were asked about their direct and indirect pension obligations as part of the 2017 survey on the low interest rate environment. They were also requested to indicate how they dealt with pension obligations in their risk management as at 31 December 2016.

The evaluation of the survey provided BaFin with information on the extent of the direct and indirect pension obligations, and on the allocation of the indirect pension obligations to external pension providers. It also enabled the materiality of pension obligations for the institutions to be estimated and general statements to be made about their riskiness. BaFin will make use of the findings in supervisory interviews with individual institutions about the economic valuation of pension obligations and in analyses of the institutions' internal capital adequacy.

The results show that for the majority of institutions, their direct pension obligations do not represent a material (balance sheet) item. For some institutions, however, the extent of the obligations exceeded 20 percent of reported equity, with the result that in these cases pension risks could have a significant impact on equity or the risk coverage potential.

Further burden on results of operations

The treatment of indirect pension obligations in the financial statements is likely to represent a further burden on institutions' results of operations which are already under pressure, as a result of the additions to pension provisions that will be required. The HGB³ technical accounting rate of interest, which is smoothed over a period of 10 years, will approach the low level of interest rates in stages, so that the consequences of the low interest rate environment will be manifest in rising expenses for pension provisions.

With respect to the allocation of indirect pension obligations to external pension providers, the survey clearly showed that the savings bank sector uses supplementary benefit funds (Zusatzversorgungskassen) almost exclusively, while other groups of institutions have not settled on a single type of pension provider.

BaFin's assessment of the risks arising from indirect pension obligations in the event that the retirement commitments given are not fulfilled, or fulfilled only in part, by the pension provider, had not been completed at the time of going to press since the survey did not provide sufficient information for this purpose. However, the overall risk of an institution facing significant funding costs due to unexpected increases in contributions as a consequence of indirect pension commitments entered into, can be assessed as low. Funding gaps for the retirement benefits granted are generally reflected in staged increases in contributions by the pension providers or supplementary payments by the institutions – recognised in the income statement over a period of time.

BaFin will give further consideration to how long-term funding costs arising from indirect pension obligations should be reflected as hidden liabilities in an analysis of internal capital adequacy.

Some institutions have established separate risk control and management processes for risks arising from direct and indirect pension obligations. The reason the majority of institutions have not done so is likely to be because they do not classify the pension risks as material. The reasons for this will be reviewed in individual cases in supervisory discussions with the particular institution.

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