The weakness of the European banking sector appears to be centering on Germany at the moment. Last week, two of our banks stood in the focus of market happenings. What must happen for the situation in the European banking sector to stabilize and improvement to become possible in the medium term?
Huge upheavals were sparked off at Deutsche Bank when the US Ministry of Justice announced that the bank could face a 14 billion dollar fine. Commerzbank has announced yet another restructuring in order to strengthen its profitability. But the burdens on European banks are not merely confined to Germany. All EU countries are affected by this.
Three factors are essentially responsible for the burdens facing European banks – low interest rates, regulatory requirements and the new rivals, known as the FinTechs. In Germany, the burdens are compounded by the existence of too many banks. This can be attributed to the structure of the German banking system. The tripartite structure of the German banking sector (savings banks, cooperative banks and private banks) has resulted in an especially high number of banks. This is being exacerbated by the many foreign banks keen to gain a foothold in Germany due to the perceived attractiveness of the lending business here and the accompanying desire to have a slice of the profit cake.
These three negative factors expose the frailty of the business models, and the deficits are revealed in the earnings weakness of banks. Yet the consequences that these deficits are having for banks differ entirely. The main effect of the low interest rates and returns is that they lower banks‘ margins, while the regulatory costs impact in the same way as permanently rising fixed costs. For Germany alone, we estimate extra costs in connection with the regulatory requirements in the region of EUR 10 billion.
The FinTechs, on the other hand, are broadening the competition for potential and existing clients. Traditional banks can only attune themselves slowly to these companies. FinTechs have less complex business models and are therefore partially subject to less complex regulatory requirements. What’s more, the companies are very flexible both in terms of their IT structure as well as their business structure, and are therefore able to swiftly adapt to changing competitive and demand profiles. At the moment, these companies pose a major challenge for the traditional banks. In general, however, FinTechs form a part of the normal business cycle and, from an industrial policy viewpoint, these companies should ultimately have a favourable impact on the efficiency of the banking sector.
While FinTechs can be viewed as a normal part of the business cycle, the same cannot be said of the low interest rates and regulatory costs. The consequence of these exceptional burdens for banks is that their business models are being stressed at enormous speed. Compounding this is the fact that European banks are particularly susceptible to this type of burden. This is because the interactions of European banks are shown on their balance sheets. Their US counterparts, by contrast, do not recognize loans on their own balance sheets but instead pass them on via the capital market. Both models have their own justification and have evolved historically. However, in Europe the present system has proved its worth over a long period of time and cannot simply be changed because the entire economic structure has been based on this. For example, the current small and medium-sized corporate sector would not exist today if it were not for the banking system in its current form.
At the same time, though, this structure makes European banks especially vulnerable to tighter regulation. For the tighter rules essentially focus on the size of banks‘ balance sheets and the capitalization requirements associated with this. This is particularly evident in the new regulations in connection with Basel IV. In the current form, the burdens of European banks will turn out palpably higher than those of American banks.
Where will things go from here?
There are first signs that the banking regulator as well as the central bank (in both cases the ECB) are recognizing how important banks are for economic recovery in the eurozone. The banks are the pivotal point between monetary policy and the real economy. The ECB would destroy its own attempts to stimulate growth if the banks were to be excessively weakened and their functional effectiveness reduced. This insight should find reflection in future interest rate policy as well as in the way in which the regulatory requirements are interpreted and applied. While there will not be any major change, the potential repercussions for the real economy should play a greater role.
Over a longer term horizon, however, it would be advisable to generally reconsider the regulatory rules. In my opinion, it would be more efficient for banks to have a limit imposed on their Tier 1 capital; if this limit were reached, the regulatory requirements would significantly decline. As things stand today, this limit could lie at around 20 percent. Banks would then have a strong incentive to exceed this limit but would not be under any pressure to do so. The costs for the additional equity capital would be considerable, but the regulatory costs would also fall noticeably.
For quite some time, European banks have been endeavoring to adapt to these new conditions. However, the speed of change differs very greatly. Banks that waited too long are now paying a high price today. But the right direction is generally being taken, as can be seen in the successful development of banks in Europe or Germany.
Even if the two major German banks have experienced great difficulties of late, signs suggest that the situation in the European banking sector should stabilize and improvements be achieved in the medium term. The banks know their strengths, the European market and their clients, and this advantage should be used to greater effect. But this will not be possible without a significant degree of flexibility.