Real economy and banking industry

Economic conditions are currently gloomy in Germany. Although the lifting of COVID-19 restrictions is favorable to economic growth, substantial problems are arising due to the war in Ukraine, the related energy price rises, and supply bottlenecks, which have recently worsened again. Against this backdrop, Deutsche Bundesbank has significantly lowered its 2022 growth outlook for Germany. In December 2021, the Bundesbank’s economists had projected a rise in GDP of 4.1 percent. However, in their latest assessment from June 2022, they predict GDP growth of just 1.9 percent in the baseline scenario.

The underlying assumption for this updated scenario is that the war in Ukraine and its fallout will not escalate. In addition to this baseline scenario, the experts at the Bundesbank have also produced an alternative risk scenario in which the supply of energy from Russia is cut off. They anticipate that economic activity would contract mark-edly if this scenario were to materialize. In this scenario, they forecast an increase in GDP of only 0.5 percent in 2022, probably followed by a substantial 3.2 percent drop in economic output in 2023.

With regard to consumer prices in Germany, the Bundesbank’s baseline scenario for 2022 envisages the inflation rate – as measured by the Harmonized Index of Consumer Prices (HICP) – rising to 7.1 percent. They believe that upward pressure on prices has built up significantly, the effects of which will continue to be felt even if – as is expected – commodity prices go back down a little and supply bottlenecks gradually ease in the second half of the year. The economic researchers anticipate that the labor market will remain robust. The number of people in work is likely to rise by 1.3 percent this year, while the unemployment rate is expected to fall to 5.0 percent.

Fueled by the war in Ukraine, inflation shot up not only in Germany but also in the rest of the eurozone and other European countries in spring 2022. Although initially driven by energy and commodity prices due to Europe’s dependency on imports from Russia, inflation has become more broad-based over the course of the year. In May 2022, consumer prices in Germany (measured by the HICP) were up by 8.7 percent compared with May 2021 (eurozone: up by 8.1 percent). The core inflation rate, i.e. excluding energy and food prices, was 4.8 percent (eurozone: 3.8 percent). US inflation has also jumped to an unprecedented high (8.8 percent in April).

Central banks around the world have responded by raising interest rates, in some cases significantly. The US Federal Reserve (Fed) increased its key interest rate by 25 basis points for the first time in March 2022, followed by a hike of 50 basis points in May and then of 75 basis points in June to a range of 1.5 percent to 1.75 percent. The Fed also began to scale back the assets on its balance sheet that it had built up during the pandemic by buying bonds. It has raised the prospect of further interest-rate rises over the course of the year. On June 9, 2022, the ECB announced that it would raise its three main interest rates by 25 basis points in July. It also intends to discon-tinue net bond purchases under APP with effect from July 1, having ended PEPP in the second quarter. However, the paper held on the ECB’s balance sheet is to be fully reinvested for the time being. Further moves on interest rates by the ECB will depend on medium-term inflation levels and on the situation in the eurozone’s bond markets.

The expected influences on the overall economy also have an impact on the banking sector and its outlook for 2022. The risks resulting from the recent jump in interest rates lie in valuation effects on own-account investments and resulting from standard 3 issued by IDW’s banking committee. Opportunities will arise in the customer busi-ness. Higher interest rates should mean higher margins in the assets-side business. The expectation that interest rates will continue to rise is generating increased demand for loans based on current terms and conditions. This phenomenon will also lead to higher interest income. Rising interest rates have an impact on the equity and liabili-ties side too, and we anticipate that customers will soon no longer have to worry about negative interest rates. However, a marked increase in interest rates for liabilities to above zero will be heavily dependent on the perfor-mance of alternative investments and is therefore only likely to materialize with a certain time lag. Given the sub-stantial economic and geopolitical uncertainty, loss allowances for corporates and private households are ex-pected to go up.

The banking sector still faces considerable pressure in terms of both adjustment and costs caused by the need for structural change in order to adapt to the competitive environment and comply with regulatory reforms. A large number of competitors, frequently with approaches based on the use of technology, are presenting the banking sector with the challenge of scrutinizing its existing business models, adapting them as required, and substantially improving its efficiency by digitalizing business processes, including sales channels. The corresponding capital in-vestment is likely to continue to push up costs in the industry before the anticipated profitability gains can be real-ized.

In response to the regulatory requirements, the financial industry has reduced its leverage over the last few years and substantially bolstered its risk-bearing capacity by improving liquidity and capital adequacy. The current imple-mentation of the final Basel III framework and the corresponding requirements imposed by EU banking regulators in Brussels should be seen in this context. In addition, BaFin will address the specific risks in Germany by imposing a countercyclical buffer and a sectoral systemic risk buffer for the residential real estate sector from 2023. The potential ramifications of these changes for lending and for the loan terms and conditions will need to be studied.

Volksbanken Raiffeisenbanken Cooperative Financial Network

The Cooperative Financial Network started 2022 with a tailwind from the very good results that it achieved in 2021. However, future earnings may be affected by the aforementioned risks resulting from the general economic climate, and this would weigh heavily on the financial position and financial performance of the Cooperative Financial Network.

Based on current assessments, net interest income will hold more or less steady in 2022 because interest rates are rising and TLTRO III open market operations are being reduced. Net interest income is expected to be stabilized by the forecast growth in the interest-bearing business, although this will be heavily dependent on the level of new business going forward.

Net fee and commission income is projected to be down slightly in 2022 compared with the exceptionally high level achieved in 2021. However, it will still make a hefty contribution to earnings thanks, in particular, to an increase in assets under management and the income that these will generate.

Profit before taxes will be adversely affected by the greatly elevated valuation effects for securities investments resulting from the much higher level of interest rates. This will particularly affect gains and losses on investments, which are therefore expected to deteriorate significantly in 2022. However, we do not anticipate lasting material declines attributable to credit ratings.

Expenses for loss allowances are likely to rise sharply in 2022 compared with their relatively low level in 2021. However, the exact change in loss allowances is subject to significant uncertainty, primarily because corporate and retail customers are not yet experiencing the full impact of the surge in energy and commodity prices and because many supply chains are now facing renewed delays and disruptions. Overall, there is a risk of an increasing number of insolvencies, which will then affect the banks’ loan books.

Net income from insurance business is predicted to decline sharply in 2022. This forecast is largely based on the anticipated deterioration in gains and losses on investments held by insurance companies, which is expected to be greater than the forecast growth in premiums earned from the insurance business in the various divisions of the “Insurance” operating segment.

Administrative expenses are likely to increase slightly in 2022 compared with 2021 because of growth-related capital investment combined with unchanged or slightly higher staff expenses and rigorous management of costs. The cost/income ratio is predicted to climb sharply in 2022 as a result of the expected marked fall in income compared with 2021 and a small increase in expenses.

The regulatory capital ratios will decline in 2022 owing to interest-rate-related valuation effects and regulatory changes (e.g. elimination of members’ commitments). Moreover, RWAs are predicted to continue growing, albeit at a slightly slower rate.

Following a very healthy 2021 and taking account of all the factors than can currently be assessed, we anticipate that profit before taxes will fall sharply in 2022.