Is Germany overbanked? - Market structure and competition

Table of Contents

List of Figures

List of Tables

List of Abbreviations

1 Introduction
1.1 Problem Definition and Objectives
1.2 Course of Analysis

2 International Profitability Comparison
2.1 Profitability of the Banking Sector
2.2 Income Generation of the Banking Sector
2.3 Costs of the Banking Sector

3 German Banking System
3.1 Overview
3.2 Commercial Banks
3.3 Savings Banks
3.4 Cooperative Banks

4 Market Environment
4.1 Bank Density
4.2 Branch Density
4.3 Competition
4.4 Calls for Further Consolidation

5 Evaluation of the System
5.1 Customer Needs
5.2 Stability of the German Banking System
5.3 Lessons Learned From Other Countries

6 Concluding Remarks

Appendix

References

List of Figures

Figure 1: Number of Banks per million Residents in 2004

Figure 2: Number of Branches per 10,000 Residents in 2004

Figure 3: Number of Credit Institutions 1997-2004 [Delta in %]

Figure 4: Classification of German Banks

List of Tables

Table 1: Number of Banks per Sector

Table 2: Total Assets per Sector

Table 3: Total Assets and Number of Commercial Banks

Table 4: Total Assets and Number of Saving Banks

Table 5: Total Assets and Number of Cooperative Banks

List of Abbreviations

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1 Introduction

1.1 Problem Definition and Objectives

“Germany is overbanked. There is no country in the world with more banks than Germany. Not only the number of credit institutions is remarkable, but also the branch density.”^[1] That position by Georg Wübke, head of financial activities at Simon-Kucher & Partners Strategy & Marketing Consultants, is shared by many in the financial industry. Christopher Pleister, president of the German association of cooperative banks (BVR) opposes this view and asserts that “Germany is not overbanked in the retail banking industry”.^[2]

These two contrary positions give rise to heated disputes about the features of the German banking system. The banking landscape has changed tremendously in the past decades, yet it has not gone far enough for some critics, collectively represented by the Bundesverband deutscher Banken (BdB). Persistently low profitability of major German private banks has sparked a dispute about structural reforms by way of continued and intensified consolidations with the aim of reducing costs and benefiting from economies of scale and scope. Mergers and acquisitions of banks within the traditional three groups cooperative banks, Sparkassen (savings banks) and private commercial banks are no new phenomenon and have been going on for decades. However, the advent of Basel II with its minimum capital requirements and the recent abolition of the guarantee and maintenance obligation (Gewährträgerhaftung and Anstaltslast) for public banks have been seen as the catalyst for more fundamental change in the German system.

These calls for more fundamental change, such as the privatization of Sparkassen, base their claim on the notion that Germany is still overbanked. The high number of banks, the high number of branches and the structural peculiarities are portrayed as the culprits of the weak profitability. Oftentimes, this is accepted as a fact without reflecting critically on this proposition. Moreover, it is argued that private banks need to recuperate their profitability to prevent hostile takeovers by other international banking giants and to ensure stability in the German banking system.

Consequently, the objective of this paper is to analyze and evaluate the merits of the claims that Germany is overbanked and overbranched by examining empirical data from other countries and contrasting them with the German situation. The effects of the market structure on the profitability are the main theme; yet, customer needs and systemic stability as well as experiences made in other countries are to be taken into account when appraising the situation.

1.2 Course of Analysis

To elaborate on this issue, first, key performance indicators of the German retail banking industry will be compared to those of other key international markets to give a better understanding of the profitability of German banks and identify the main driver of the situation. Second, the German banking system is to be described and its unique features are to be pointed out and compared to other nations’ systems. Having shed light on the profitability and the peculiarities of the system, as a third point, the market environment is to be analyzed in a comparison to other countries. This part deals more directly with the overlying question if Germany is overbanked and overbranched, and it also discusses the competitive environment. In the last section, the preceding three chapters, the profitability, the peculiarities of the system and the market environment, are to be evaluated in light of customer needs, stability and experiences from other nations. Lastly, a conclusion will be drawn in which a weighted appraisal of the German banking structure is presented.

2 International Profitability Comparison

The profitability of the German banking sector is the main focus of the debate that Germany is overbanked. Pressure by certain institutions and the advent of Basel II have put pressure on banks to improve their earnings.^[3] Thus, it is important to understand the components of profitability, costs and income, and other key performance indicators of German banks. This chapter will compare them with other banking systems in order to find the culprits of the weak earnings in Germany.

2.1 Profitability of the Banking Sector

The indicator to start off with is the pretax profit over total assets ratio. It measures the profitability of a bank relative to the total assets a bank has under management. One generally takes pretax values when comparing performances between countries because different tax rates would otherwise distort the results. This ratio is the lowest in Germany out of all old fifteen European Union Member States (EU-15) and declined from 0.35% in 1999 to 0.03% in 2003. Only very recently has this ratio improved from 0.14% in 2004 to 0.44% in 2005. The EU-15 average ranges between 0.60% and 0.70%. In addition to the low earnings before interest, tax, depreciation and amortization (EBITDA) over total assets ratio,^[4] it is further exacerbated by the high value adjustments in view of the real estate crisis and general sluggish economic growth which has led to high loan losses.^[5]

The pretax profit over total assets ratio showed that German banks do not perform well relative to their size. More important is the question how they perform for their equity holders which is measured in pretax return on equity. This is the ratio analysts turn to when evaluating if economic value is created or destroyed by a certain enterprise. In Germany, this ratio has been declining from 1993 to 2003 (only 1998 was an exception) and approached zero in 2003. Post-tax returns even turned negative in 2003.^[6] Only quite recently, in 2004, the profitability has risen again to 4.21%, a value that is still significantly below other industrialized countries and also less than the cost of equity.^[7] Hackethal and Schmidt estimate an average post-tax cost of equity of around 10% so that the German banking industry has destroyed an enormous amount of economic value since 1990.^[8] Other countries have performed considerably better in similarly difficult times. Structural reforms in France and Italy at the beginning of the 90s have been fruitful and led to gradually increasing returns on equity which currently stand at 8.6% (2003) and 12.78% (2004) respectively.^[9]

As mentioned above, high value adjustments and loan loss provisions have led to a deterioration of profitability. This means that German banks have not been pricing risk as adequately as their peers in other countries. An analysis by the Organization for Economic Cooperation and Development (OECD)^[10] has shown that Germany’s loan loss provisions as a share of gross income has remained constant at around 15% from 1985 to 2001, whereas other countries were able to improve their risk management and consequently reduce their provisions – most significantly the UK from 18% in 1985 to 7% in 2001. However, a full analysis of these numbers must also factor in different economic growth rates and high numbers of corporate and consumer insolvency. The very low real growth of gross domestic product (GDP), in Germany only 0.7% p.a. since 2001, low consumer spending and weak corporate net investments have certainly also negatively affected bank profitability and contributed to the high value adjustments and loan loss provisions. Therefore, in this respect, the general disadvantageous macroeconomic conditions also have to bear some responsibility for the weak performances of German banks.^[11]

However, besides these extraordinary effects, the question remains why the general operating performance of German banks trails behind their peers in other countries. Therefore, in the next step, the general administrative costs versus income generation from core banking activities are to be examined. An important ratio to evaluate this relationship is the cost-income ratio. It relates administrative expenses to net interest and provision income. According to OECD data,^[12] most cost-income ratios of universal banks in developed countries oscillate between 60% and 65%. Germany has long been within the normal range and in line with the United Kingdom (UK) and the United States (US). Only quite recently, starting in 1999, Germany’s cost-income ratio has risen to above 70% and therefore about 10 percentage points higher than the US’s and the UK’s.^[13]

2.2 Income Generation of the Banking Sector

So what has led to the hike in the cost-income ratio for German banks? Have the costs gone up, signaling inefficient operations, or has income decreased, signaling low margins, bad product offerings? In order to answer this question the development of costs as well as income has to be examined. On a general basis, income can be split up in interest income and non-interest income (mainly fees). A good indicator for the interest income is the interest margin. One definition describes it as the respective difference between the share of the interest income of total assets and the share of interest expenditure of total liabilities. The development of interest margins for OECD countries from 1986 to 2001 shows that margins have been deteriorating worldwide. Only the US has been able to keep its margin above 3%, whereas Germany’s and Japan’s interest margin ranged around 1.3% in 2001.^[14] Only France underperformed this value with a margin just below 1% in 2001. The main reason for margins to drop significantly across the board is the squeeze in savings deposit margins.^[15] In line with declining treasury bill rates across Europe, European savings deposit margins have also shrunk from 1980 to 2000. In France, e.g., the savings deposit margin amounted to 5.3% in 1980 and plummeted to 0.92% in 2000. This effect has increased the price for the retail banks’ source of funds and its ripples are also felt in the retail intermediation margin^[16] which has decreased significantly in all EU Member States.^[17]

When looking at the interest margin defined as net interest income over total assets, a similar picture can be drawn. All across the EU interest margins have declined from 1999 to 2004 and now range between 1% and 3%, with Germany, Austria and Belgium displaying the lowest figures around 1% in 2004.^[18]

Generally low interest margins have forced banks to focus on non-interest related income generation. Consequently, for most industrialized nations the share of non-interest income with respect to total income has been rising steadily from 1986 to 2001. Unsurprisingly, UK and US banks are at the forefront in terms of non-interest income generation as it constituted more than 40% of total income in 2001.^[19] The capital market based system has certainly helped their banks to generate fee income from businesses such as asset management, underwriting, advisory services and trading. German banks, on the other hand, have been less successful in finding ways to compensate for the sharp drop in interest income and generated only about 36% of their total income from provisions and other fee-based services.^[20] It is also important to bear in mind that the increase in the share of non-interest income is also a result of the fall in interest income. Examining the ratio non-interest income over total assets gives a more valid view of the progress made towards generating more fee-based income. For Germany, this ratio has actually declined significantly from 2000 to 2004 from 0.42% to 0.35%, whereas the EU-15 average bank generates about 0.64% of total assets in provisions.^[21]

2.3 Costs of the Banking Sector

The second component of the cost-income ratio is operating expenses. OECD analysis has shown that the ratio total operating expenses over total assets in Germany has actually and surprisingly declined from 1.8% in 1985 to 1.4% in 2001.^[22] Interestingly, it was lower than the respective values for France (1.6%), UK (1.8%), Netherlands (1.9%), Spain (1.9%), Italy (2.0%) and the US (3.6%) in 2001.^[23] This finding clearly purports that Germany does not have a cost problem but that the low cost-income ratio is solely a factor of insufficient income generation. This is an astonishing result in light of the fact that Germany is regarded to be overbanked and overbranched as that implies high costs and inefficient operations.

Bikker and Bos have made another remarkable observation. Their study of all old fifteen EU Member States (EU-15) and Switzerland based on data from 1990 to 1997 ranked the German banking system number one for its X-efficiency, i.e. German banks performed best in terms of cost efficiency relative to their peers across Europe. This finding supports the claim that German banks are well managed and generally keep their costs under control.^[24] Further analysis by the Deutsche Bundesbank seconds this claim. Their model based on the Stochastic Frontier Analysis, which measures costs per output factor, shows that the efficiency of the German banking system currently (2004) stands at 76.1% which is the highest level since the beginning of their analysis in 1993. German banks have particularly well recovered from the high inefficiency at the turn of the millennium,^[25] which were a result of high expenditures in Information Technology, and investment banking activities and did not pay off instantly.^[26]

Moreover, calculations by the International Monetary Fund (IMF) also contrasted German cost efficiency in the banking sector with the efficiency in France, UK and Italy. The result mirrors the findings of the analyses quoted above, as Germany currently shows a higher efficiency figure than the other three countries and the spread to the other two has consistently and significantly increased since 2002.^[27]

One can conclude by describing the German banking system compared to systems of other developed nations as very efficient yet lacking means to generate sufficient income. Low interest margins prevail and cannot be offset by a sufficient increase in non-interest related income. Consequently, the next chapter continues with an analysis of the German banking system in order to find indicators and reasons for the income problem of German banks. A detailed understanding of the system is also important to formulate an informed opinion about the question whether Germany is overbanked.

[...]

^[1] Wübke, G. (2006), p. 3.

^[2] Pleister, C. (2005), p. 1.

^[3] See International Monetary Fund (2006), p. 100.

^[4] See Bundesverband deutscher Banken (2005), p. 6/9 which shows that Germany is the second worst performer in EBITDA over total assets ratio after Belgium with 0.55% in 2003.

^[5] See Ibid., p. 8/9; Deutsche Bundesbank (2006b), p. 35.

^[6] See Bundesverband deutscher Banken (2006), p. 46.

^[7] See Bundesverband deutscher Banken (2005), p. 9/9.

^[8] See Hackethal, A. /Schmidt, R. (2005), p. 3.

^[9] See KfW-Research (2005), p. 4.

^[10] See OECD (2003), quoted according to: Hackethal, A. /Schmidt, R. (2005), p. 4.

^[11] See Bundesverband deutscher Banken (2006), pp. 46-49.

^[12] See OECD (2003), quoted according to: Koetter, M., et al. (2004), p. 36.

^[13] See Koetter, M., et al. (2004), p. 36.

^[14] See Ibid., p. 38.

^[15] Savings deposit margin is defined as treasury bill rate – rate paid on savings deposits.

^[16] Retail intermediation margin is defined as rate charged on consumer loans – rate paid on savings deposits.

^[17] See Dermine, J. (2003), pp. 46-47.

^[18] See Bundesverband deutscher Banken (2005), p. 2/9.

^[19] See OECD (2003), quoted according to: Koetter, M., et al. (2004), p. 36.

^[20] See Hackethal, A. /Schmidt, R. (2005), p. 2.

^[21] See Bundesverband deutscher Banken (2005), p. 3/9.

^[22] See OECD (2003), quoted according to: Koetter, M., et al. (2004), p. 36.

^[23] See Hackethal, A. /Schmidt, R. (2005), p. 3.

^[24] See Bikker, J./Bos, J. (2004), pp. 38-40.

^[25] See Deutsche Bundesbank (2005), p. 69.

^[26] See KfW-Research (2005), p. 3.

^[27] See International Monetary Fund (2006), p. 93.