German banks are expected to remain among Europe's least profitable over the next two to three years, and if this continues over the long term, they may be less able to attract new business, according to industry observers.

The fragmentation of the German banking system has created a vicious circle of low profits and high costs. In recent years, these issues have been compounded by negative interest rates in Europe, to which German banks are particularly exposed because of their high reliance on net interest income.

With central banks ramping up monetary stimulus to the economy amid the coronavirus pandemic, interest rates are set to remain low for even longer, while credit losses and nonperforming loans surge and bank revenues decline.

Mid-term outlook

Return on equity in the German banking system has been among the six lowest in the EU and European Economic Area since 2015, according to the European Banking Authority. At the end of 2019, Germany was the only country with a negative average banking sector ROE, at negative 0.2%, and the worst performer in the EU and EEA.

The situation is unlikely to change in the medium term, with German banks expected to post 2022 ROE lower not only than that of counterparts in France, the U.K., Sweden and the Netherlands, but also that of lenders in Italy, Spain, Portugal and Greece, which are seen as being among the most vulnerable to the effects of the COVID-19 pandemic, according to global management consultancy Oliver Wyman.

READ MORE: Sign up for our weekly coronavirus newsletter here, and read our latest coverage on the crisis here.

Due to capital erosion and higher nonperforming loans in the next few years, German banks' profitability will be below pre-coronavirus levels at the end of 2022, Moody's projected in a July 15 report. At €8.24 billion, the aggregate net profit of the German banking sector in 2019 was the weakest among the top five European economies, according to S&P Global Market Intelligence data. It was more than three times lower than France's €29.48 billion and the U.K.'s €25.62 billion, more than two times lower than Spain's €17.43 billion and even below Italy's €11.29 billion.

German banks' return on average tangible equity has been the lowest among lenders in the top five European economies since 2017, the data shows.

German consultancy Roland Berger expects German banks' pretax earnings to stay negative until 2023 in its most likely scenario, or until 2025 if the coronavirus-related disruption lasts longer, it said.

Long-term risks

There are long-term risks for German banks if they remain on their current path. They will continue to lose attractiveness and relevance with clients, be less able to capture strategic opportunities and may be restricted to mere infrastructure providers in the future, Thomas Schnarr, partner and head of Oliver Wyman's financial services practice in Germany, Austria and Luxembourg, said in an interview.

German banks need a step change and this will require a lot of effort and a radically different view of what their business model should look like, Schnarr said.

"Running a universal banking model with profitability above the range of 8% to 10% ROE looks very challenging in Germany," he said.

A key headwind is the sheer number of institutions still operating in the market, Schnarr said.

"With so much competition, it is hard [...] to maintain profitable prices," he said. Both the retail banking and wholesale banking revenue pools in Germany have been broadly flat over the last few years and, compared to elsewhere in Europe, many banking products in Germany are cheaper, he said.

With 1,528 credit institutions as of July 30, Germany accounted for roughly 28% of the EU's total 5,524 banks, ECB data shows.

Silver linings

Low profitability is clearly the biggest weakness of German banks as it limits their ability to absorb future losses, Sonja Forster, a vice president in the European financial institutions team at DBRS Morningstar, said in an interview. On the other hand, a big plus for them is that the state budget and the corporate sector entered the crisis in relatively good health, she said.

"The German government also handled the crisis comparatively well, and as a result, we believe the impact on the economy has been reduced compared to other countries," Forster said. In its summer economic forecast, the European Commission projected a GDP contraction of 6.3% for Germany in 2020, compared to a 9.7% drop in the U.K., 10.6% in France, 10.9% in Spain, 11.2% in Italy and an EU average drop of 8.3%.

The small share of unsecured consumer lending and credit card business they hold also works in German banks' favor, Forster said. Given the sound asset quality of the sector at the onset of COVID-19, nonperforming loans will increase but to a manageable level, she said. The NPL ratio of German banks was 1.2% as of March 31, versus an EU average of 3%, EBA data shows.

German banks will also benefit from the ample fiscal support provided by the German government and are unlikely to see a spike in default rates, at least in 2020, Schnarr said. The German government's economic support package, which amounts to over €1 trillion, including state guarantees, is the largest the country has ever provided.

NIM drag

However, default rates may grow in 2021 as government backing fades away, Schnarr cautioned. This could coincide with an expected weakening in net interest margins. Many German banks have used their vast cash deposit holdings to buy highly rated corporate and sovereign bonds, the yield from which has boosted their net interest income, but many are now maturing and this means margins will decline, Schnarr said.

German banks' NIM has hovered above 1.3% for the past five years but has been trending downward, according to S&P Global Market Intelligence