By Christian van Beek, Director, Financial Institutions Ratings

At sector level, German banks’ performance in 2021 was the best it had been in a decade. The banks benefited not only from exogenous factors such as the bonus rate under the ECB's TLTRO III programme and a better-than-expected economic environment through the pandemic but above all from good growth in interest and commission income in the groups’ core businesses.

While it is too early to draw sector-wide conclusions, signals to-date from the first quarter of the year look promising. Deutsche Bank reported profit growth in all segments in Q1 2022: +54% at the private bank, +25% at the corporate bank, +12% in asset management and +1% at the investment bank. Commerzbank, on the basis of its preliminary numbers, reported a 12% increase in revenues; supported, the bank noted, by strong customer business in all operating areas. UniCredit in Germany posted at 14% y-on-y increase in total revenues in Q1 2022; fee income rising 16% and net interest revenues up 12%.

From a broad business perspective, the most adverse scenarios forecast during the pandemic failed to materialise, leading to less negative economic consequences hence low cost of risk for the banks. NPL ratios across the sector have fallen to well below the levels of end-2020. At the same time, the sector was able to preserve the risk reserves it built mostly through post-model adjustments.

Cost reductions have also contributed to the improvement in earnings, as the restructuring efforts of recent years are increasingly paying off. The elevated cost structures of the German retail banking groups have continued to improve. This effect was significantly lower for the German wholesale banks. In Q1 2022, Deutsche Bank reported a 4% decline in non-interest expenses. Adjusted costs (ex-transformation charges and bank levies) were down 3%. UniCredit Germany’s operating costs fell 7.4%.

The positive dynamic is likely to weaken considerably in 2022, however. Inflation will increase the pressure on the cost side, while cost of risk will likely rise, as spillovers from the war in Ukraine weigh on the growth outlook.

German banks have relatively low pre-provision profitability compared to European peers, which limits their ability to absorb increases in cost of risk in more extreme scenarios. This is driven by low net interest margins and cost/income ratios that are still far from international standards. We believe this gap could continue to narrow over the long term, albeit very slowly. The additional reserves overlays built during the Covid pandemic represent an additional buffer against future asset-quality deterioration.

Overall, we believe that even a continuing deterioration in the economic environment will remain manageable for banks in Germany.