Germany's banks were faced yet again with a difficult year in 2014. The main features of the year were low interest rates and tighter regulatory requirements combined with the efforts of many financial institutions to realign their business models.

Improved earnings, rising costs

Parallel to the first increase in accumulated total assets of German credit institutions since 2011, the earnings situation has also slightly improved in 2014, but remains tight. Growth in net interest income to some € 90 billion was recorded as financial institutions continued to profit from maturity transformations on the back of favorable refinancing costs, although these now appear to have marked a preliminary low. At the same time, net commission income climbed by four percent to some € 30 billion, profiting both from higher fees as well as from valuation effects in the securities business.

However, surprisingly little has happened on the cost front. While the long-term trend towards consolidation continued in 2014 – the number of banks declined by 57 institutions, 1,100 branches were closed and 5,000 employees made redundant – this movement was unable to halt the upward spiral of administrative expenses at German credit institutions, despite all the restructuring efforts. The key drivers here were the costs for fulfilling the regulatory requirements which for the entire sector amounted to more than two billion euros per year. This is proving a serious challenge above all for the small and medium-sized financial institutions since the high cost burdens are having to be borne by lower business volume. All in all, the cost/income ratio (CIR) of 70 percent for the overall market remained at its long-term average.

Earnings gap of € 25 billion

A look at the sector's profitability more than highlights the challenging conditions still underlying German banks. Only around six percent of the credit institutions are still managing to earn their cost of equity that has fallen slightly due to the drop in the risk-free interest rate. The after-tax return on equity averaged out at 2.1 percent. Thus, compared with the cost of equity of an average 7.7 percent, this translates into an after-tax earnings gap of a total € 25 billion for 2014. The regulatory increase in the equity ratio from an average 5.4 percent in 2013 to 5.9 percent in 2014 also played a role here.

At the same time, there are signs of movement on the market – the gap between the most and the least profitable banks has widened further in the last five years and is today quite substantial. In the past this could be attributed primarily to the difference in net interest income but over time the advantageousness of the cost position has grown in significance. The same applies to the comparison between and within the institution groups where the leading financial institutions can be seen setting themselves apart more and more. A selection process is clearly underway on the market.

No alternative to radical structural cost reductions

Bain has analyzed how the earnings gap will develop on the German market in the next ten years. The conclusion we reach is that, given the limited potentials on the earnings front in the face of persistently low interest rates, high competitive pressure, ever tighter demands on capitalization and an anticipated slight rise in risk costs, the task of improving the cost position will become a key lever for credit institutions.

According to Bain's estimation, Germany's banks have the means to lower their current cost base by a good 30 percent, i.e. around € 25 billion. This would necessitate measures such as a reduction of 11,000 branches and 125,000 jobs. Bain estimates that a further some 115,000 jobs could be outsourced to service providers such as service companies. Slashing costs in this magnitude poses an enormous challenge. Banks need to rethink their own business models and reposition themselves structurally.

Seven steps towards saving 30 percent of the cost base

In the Bain analysis, the cost structure of the credit institutions was screened along the value-added chain in the blocks distribution bank, production bank and management bank to expose both the savings potentials and the possible contrary effects. Besides the need to create a consistent efficiency culture and establish a suitable governance for securing the cost potentials over the long term, Bain has also identified seven directions of impact which will enable the present day cost base of EUR 84 billion to be lowered by 30 percent:

1. Realign the business portfolio
2. Implement automation and digitalization
3. Reduce the organizational complexity
4. Lower the real net output ratio through greater outsourcing
5. Transform the IT infrastructure
6. Lower the material costs
7. Participate in the consolidation process
8. Return of five percent possible

In all likelihood, however, even maximum cost savings over the next ten years will be insufficient to enable the institutions to generate their future cost of equity in average terms. But according to the Bain scenario, which works on the assumption that the European Central Bank will make a slight increase in interest rates in the medium term, the earnings gap can at least be halved by 2025 to EUR 13 billion. Despite the assumed additional capitalization requirements, the average return on equity after tax would more than double to 4.9 percent – but would still remain below the expected cost of equity of 6.6 percent. The wheat is increasingly being separated from the chaff in the competition. Banks that now reconcile themselves to the new conditions as well as to the inevitable consolidation will emerge from the adjustment process as the clear winners.