Why many small banks are currently less profitable than large institutions

Frankfurt The abrupt turnaround in interest rates by the European Central Bank divides the German banking industry into two camps. On the one hand, institutes like Commerzbank and Deutsche Bank, which have earned as much as they did 15 years ago. On the other hand, institutes such as Sparkasse Zwickau, which ended the past year with a loss.

“Many banks achieved record results in 2022, with smaller institutions such as savings banks and cooperative banks being the exception,” says Clemens Koch, Head of Financial Services at PwC Germany. The financial regulator Bafin recently came to a similar conclusion: It said that the overall profitability of small institutions was slightly negative between January and September 2022, while large institutions were able to increase their profitability somewhat.

At first glance, this seems surprising: the rising interest rates of the central bank mean that banks can earn more money again with deposits and loans – and small institutions such as savings banks and Volksbanks are particularly dependent on the interest surplus that results from the interest rate differential of low deposit rates and higher lending rates.

The important net interest income is rising again

The net interest income has increased at pretty much all banks: by almost seven percent at the Westphalian savings banks and by eight percent at the east German banks. In both cases, it was the first move higher in seven years. In the case of large financial institutions, however, there was a lot more in it: at Commerzbank, for example, an increase of 33 percent, at Deutsche Bank 22 percent and at ING Germany 14 percent.

In addition to other factors, the credit program of the European Central Bank (ECB), known by the abbreviation TLTRO, could also have contributed to this, under which banks were able to borrow money at extremely favorable conditions under certain conditions. “Our evaluations show that private banks benefited more from interest income from TLTRO loans than Volksbanks or savings banks in 2022,” says Sven Hauke, Head of Banks and Capital Markets at PwC Germany.

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But another factor is more important. Savings banks and Volksbanks have invested extensively in bonds and other securities. Depending on how they account for these securities, they often need to book their investments at current market value. “These securities portfolios have often posted price losses due to the sharp rise in interest rates,” says PwC expert Koch. Bonds fall in price when interest rates rise because they offer less interest than new bonds.

Savings banks and Volksbanks protect themselves less often from changes in interest rates

In principle, banks can protect themselves against the consequences of such interest rate risks. But not every institute does that. “Larger banks hedge against interest rate risks more broadly than is the case with smaller institutions,” explains Sven Hauke ​​PwC Banking Capital Markets Leader Germany. “That’s why we tend to see the negative valuation effects more strongly in smaller institutions.”

In addition, savings banks and Volksbanks rely more on securities than others in relation to their size, as shown by an analysis by PwC based on Bundesbank data. In the case of savings banks and Volksbanks, the volume of such securities investments is twice as high as the institute’s equity. With private banks, the commitment is only one and a half times as extensive.

This has consequences: The Westphalian Savings Banks Association reported on Tuesday about value adjustments in the securities business to almost 670 million euros. For comparison: during the financial crisis in 2008 it was just over 520 million euros.

The East German savings banks in Brandenburg, Saxony-Anhalt, Saxony and Mecklenburg-Western Pomerania were hit even harder. With them, depreciation on securities amounting to 1.42 billion euros hailed the result. Before this assessment, the 43 members of the East German Savings Banks Association (OSV) reported an operating profit of EUR 1.32 billion. The valuation expenses in the securities accounts caused by the rise in interest rates exceeded the operating result by EUR 100 million.

According to Peter Barkow, the managing director of the analysis company Barkow Consulting, the fact that securities investments are so important for the regional institutes is due to the fact that these institutes have “comparatively high deposits and many also have a surplus of deposits”. The financial institutions have more deposits available than opportunities to grant loans with them.

This is also confirmed by Jürgen Wannhoff, Vice President of the Westphalian savings banks. “We took in more deposits than we could issue in the lending business,” he said. The excess of deposits is traditionally highest in eastern Germany.

Book losses are likely to be temporary

Another factor: According to the observations of data analyst Barkow, many of the small financial institutions have decided to “invest the excess deposits mostly in longer-dated securities and not in the interbank market or with the central bank”. Without an interest rate hedge, sharply rising central bank interest rates have a particularly negative effect in such cases.

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Book losses like this don’t have to be a problem – as long as the banks don’t sell them at a loss or the bond issuers go bust. “This valuation effect hit the institutes primarily in 2022, some will still hit it in 2023 with a view to the further development of interest rates, but then the topic should be digested,” says PwC expert Koch.

The Westphalian Savings Banks Association expects the recent write-downs to be offset by write-ups over the next three years, and the East German Savings Banks also expect “the corrections will not represent permanent losses”. Typically, thrifts would hold their fixed-income paper to maturity, at which point 100 percent would be repaid. The association assumes that 500 million euros will flow back in the next four years alone.

However, the East German savings banks remain vigilant. According to the association, there are still no savings banks that have had problems because of these value adjustments. However, according to OSV Association Managing Director Wolfgang Zender, the association’s internal traffic light system, which is used to monitor the risk situation of the institutes, “numerous savings banks are on red”, so they are carefully monitored.

More: Bafin President warns of interest rate risks: “The first line of defense has fallen away”

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