German Chancellor Olaf Scholz inspects a gas turbine intended for the Nord Stream 1 gas pipeline in Russia. Source: Andreas Rentz/Getty Images News via Getty Images Europe

Germany's largest banks are likely to avoid a direct hit from a potential Russian gas shut-off thanks to their well-diversified loan books, which will shield them from serious asset quality deterioration, bank executives and market observers said.

Overall strong capitalization, low levels of bad loans and government support for companies in vulnerable sectors will also help, analysts said.

"We don't see outsized exposure to a particularly vulnerable sector," Sonja Förster, a vice-president at DBRS Morningstar's global financial institutions group, said in an interview. Banks have carefully managed loan book risk and diversified well, and much of the German corporate sector entered the COVID-19 pandemic with solid fundamentals, meaning widespread defaults in any single industry are unlikely, Förster said.

Germany is particularly susceptible to cuts in Russian gas imports, which accounted for 55% of the country's total gas consumption in 2021, figures from energy industry association BDEW show. Worries that Russia could cease all gas deliveries to Europe amid tensions related to the war in Ukraine have escalated since June, fueled by a maintenance shutdown of the Nord Stream 1 pipeline in July. Russia's biggest gas pipeline to Europe currently runs at a limited capacity of 20%.

While energy security issues increase risks for banks, the sector's "solid" loss absorption buffers will help cushion the expected rise in problem loans from the current "benign levels," Moody's analysts said in an Aug. 12 note.

German banks kept problem loan levels "very low" while adding reserves and slightly improving already-strong capital during the pandemic, Bernhard Held, vice-president, senior credit officer at Moody’s, said in an emailed comment. "This gives them a solid starting position to digest problem loan increases," Held said.

Alert but confident

Deutsche Bank's corporate loan book is well diversified, with no concentration risk and a high degree of investment-grade corporates, CEO Christian Sewing said during a recent earnings call. Meanwhile, Commerzbank's strong capital and provisioning, along with improved profitability, makes it confident it can manage any recessionary trends, CEO Manfred Knof said.

Both banks expect their cost of risk to rise by about 20 basis points of average loans in the event of a gas shut-off, although neither considers that to be a base case scenario. Second-quarter cost of risk at Deutsche was 19 basis points, or €233 million. At Commerzbank it was 42 basis points, reflecting a risk result of €106 million and a separate management overlay of €564 million.

The German government may step in if the situation becomes dire. State support schemes and aid programs via development bank KfW proved "very efficient" during the pandemic and the same could be expected if Russian gas deliveries were halted, Commerzbank CFO Bettina Orlopp said during an earnings call.

Thomas Groß, CEO of federal state lender Landesbank Hessen-Thüringen, or Helaba, said in an earnings statement that the bank's "highly diversified business model" positions it well to cope with the impact of energy shortages and high inflation in the rest of 2022. A spokesperson declined to comment specifically on gas supply scenarios.

Diversified books

In a sample of Germany's biggest banks, Bayerische Landesbank, or BayernLB, has the highest exposure to vulnerable sectors. Its exposure to the energy sector accounted for 41% of total gross credit volume in the corporate book at the end of 2021.

However, more than 60% of the exposure consists of renewable energy or energy transition-focused projects, and the energy portfolio as a whole is "well diversified, spread across the whole value chain and 85% of it is investment grade rated," a BayernLB spokesperson said via email. The bank believes companies in the portfolio "will be able to manage and survive the current crisis," the spokesperson said, adding that the bank is in close contact with clients.

BayernLB's energy exposure is an example "suggesting that high-level corporate industry exposures may not tell the full story about gas supply dependence," Moody's Held said.

Helaba, BayernLB and the country's other federal state banks "have strengthened their risk management and are not particularly exposed to possible gas supply rationing," according to Held.

Federal state banks ran into trouble during the 2008 global financial crisis but have since restructured. Because there has been so much balance sheet cleanup in the past, the banks show good diversification of exposures overall, according to Förster.

Norddeutsche Landesbank, or NordLB, was not available for comment. A spokesperson for Landesbank Baden-Württemberg, or LBBW, said the group cannot comment before its Aug. 24 earnings release.

There is also some regional diversification in the banks' portfolios. The federal state banks, or landesbanken, are more exposed to Germany-based companies, with BayernLB's domestic corporate portfolio, for example, accounting for 74.4% of its total corporate book in 2021. Deutsche Bank's domestic share accounted for roughly 44% of total corporate exposure and Commerzbank's for roughly 41%, according to company filings.

High gas consumption

Industrial consumers and utilities account for more than half of gas consumption in Germany, while households account for 30%, BDEW data analyzed by Scope Ratings shows.

The chemical sector needs the most gas among industrial consumers, followed by the metals and mining, and food processing, industries, the data shows.

These industrial consumers would likely bear the brunt of any supply cuts because the need of households would be prioritized, Yesenn El-Radhi, vice-president of global sovereign ratings at DBRS Morningstar, said in an interview. This may necessitate state support for companies, which would weigh on public finances, said El-Radhi.

Low concentration risk

The impact on banks is expected to come from a general economic deterioration and souring consumer sentiment, rather than their direct exposure to gas-dependent industries, Förster said. Sector-specific risk may be manageable.

German chemicals group BASF SE, for example, is highly dependent on gas in its manufacturing process, but also has an oil and gas subsidiary that benefits from high gas prices. This can, to some extent, offset lower revenues, Förster said.

Companies that run into trouble will likely get aid from the federal government, as in the case of Uniper SE, Förster noted. Germany's largest gas importer said July 22 that the state will buy a 30% stake in the company for €267 million as part of a €15 billion support package.

A recessionary environment will lead to some corporate defaults and probably some asset quality erosion at banks. But higher net interest income, driven by rising central bank rates, will mitigate this, Förster said.

German banks are likely to see a higher industry risk benefit from rising rates than many European peers due to their relatively high reliance on net interest income, S&P Global Ratings analysts said in a July 19 report.

Probability of default grows

Corporate defaults across the DACH region — comprising Germany, Austria and Switzerland — as a whole are expected to rise, according to S&P Global Ratings. The agency expects default rates among DACH-based speculative-grade corporate issuers to rise above the projected European average of 3% by March 2023. In 2020 and 2021, the region's high-yield sector shrugged off the stresses of COVID-19 and outperformed the global average, with default rates of 1% to 2%, the agency noted.

Construction materials, internet retail and leisure products were the industries that booked the largest year-over-year increases in median market signal 1-year probability of default rates in the first half of 2022, S&P Global Market Intelligence data shows. The rate of increase among industrial conglomerates and metals and mining companies was roughly five times higher than a year ago, the data shows.

Consumer discretionary, materials and industrials were the sectors with the highest median probability of default rates recorded in the first half of this year, according to the data.

Corporate loans account for less than half of total loans at large DACH-based banks with total assets above €50 billion, Market Intelligence estimates show.