Real economy and banking industry

Conditions in the German economy brightened in spring 2023. Supply chain disruptions are waning and energy prices are at a slightly more affordable level, which is stimulating economic growth. Against this backdrop, the economic research institutions that contribute to the Joint Economic Forecast have significantly raised their forecast for the change in Germany’s GDP in 2023. Having predicted in autumn 2022 that GDP would contract by 0.4 percent year on year, they forecast a small increase of 0.3 percent in their recent spring report.

One of the main reasons for this improved forecast is that the economic slowdown that had been predicted for winter 2022/2023 last autumn was less pronounced than anticipated. According to the latest data from the Statistisches Bundesamt [German Federal Statistical Office], GDP in the fourth quarter of 2022 was down by 0.5 percent on the previous quarter on an inflation-adjusted, calendar-adjusted, and seasonally adjusted basis, falling by a further 0.3 percent in the first quarter of 2023. The economic research institutions believe that the manufacturing industry will help to prop up the economy in the coming quarters as it will benefit directly from the dissipation of supply-side disruptions. By contrast, construction activity will remain weak, partly because of the rise in finance costs.

The economic research institutions predict that, at 6.0 percent in 2023, consumer price inflation will be only slightly lower than in 2022 (6.9 percent). The rate of inflation is not expected to come down significantly until 2024 (2.4 percent) when energy prices will be lower.

In the labor market, the economic research institutions predict that employment will continue to increase. The average number of people in work in Germany in 2023 will probably rise by 330,000 to 45.9 million, while the unemployment rate is expected to edge down by 0.1 percentage point to 5.4 percent.

The start of 2023 has seen western central banks continue to tighten monetary policy because inflation rates remain high. By May 10, 2023, the ECB had raised its key interest rates by a further 125 basis points in three stages. The rate on the deposit facility thus stands at 3.25 percent, compared with 2.0 percent at the end of 2022. The interest rate for main refinancing operations has climbed from 2.5 percent to 3.75 percent. The US Federal Reserve (Fed) has also made three rate hikes in 2023 and also in three stages, increasing its key rate by a further 75 basis points to a range of 5.00 percent to 5.25 percent. The two central banks have indicated that they have now completed the bulk of the cycle of interest-rate rises and intend to stop them completely this year. Interest rates should then remain at that final level for a while. As the Fed began raising interest rates earlier than the ECB, it is also likely to reach the final level sooner.

Many of the predicted effects on the overall economy also have an impact on the outlook for the banking sector. In 2023, earnings expectations will be particularly affected by the changes in the interest-rate environment. Interest rates have continued to rise in 2023 but growth has slowed down markedly. Although we anticipate growth, it will be at a low level, in particular because inflation is not yet at the targeted level and lowering it is the main aim of these interest-rate rises. Given the prevailing interest-rate situation, we see better earnings potential for the banking industry in 2023 than was the case in 2022. This is clear, for example, from the increase in lending rates that has already taken place and that will help to stabilize net interest income. This prediction applies even though the volume of new business is likely to stagnate or even decline slightly. After all, rising interest rates also increase the obstacles for prospective buyers intending to take out a mortgage. In addition, lower real incomes resulting from persistently high inflation mean reduced demand for real estate and thus increased competition for the remaining customers. However, the widening of margins should more than offset this effect. There will be a negative effect on the liabilities side as the rising interest rates will result in customers wanting to fix the interest rates on their assets at the now higher market rates for longer periods again. The related interest expense will therefore rise dramatically, especially as virtually no interest was available on savings for a long while. We anticipate that the overall effect on net interest income will be positive as the expected growth of interest income is likely to outweigh interest expense, primarily because the usually more sluggish liabilities side and the interest-rate agreements that will be needed to be extended by the banks at higher rates will help to mitigate the slowdown in real estate finance. Substantial negative valuation effects on the banks’ own-account investments are not predicted. A negative scenario like that seen in 2022 is extremely unlikely. Risk costs in the lending business are expected to rise only slightly as most fixed lending rates remain extremely low and therefore have barely any adverse impact on debt service capacity. Interest rates tend to be locked in for lengthy periods in Germany, and this model is proving its worth by helping to ensure financial stability. Another risk could arise in connection with corporate customers’ financial strength. However, we are anticipating a relatively small impact on credit risk that should remain manageable. We believe that the fallout from geopolitical events will continue to weigh particularly heavily on the cost of living. Although price rises (inflation) are flattening out, price levels are still much higher than they were a year ago. This means, for example, that a significantly larger proportion of household income has to be spent on energy and food. Households whose debt service capacity has only a small buffer may struggle and therefore need to be monitored closely by the institutions. The effects of this scenario may potentially be alleviated for consumers by the compensatory wage settlements that are starting to be reached in some industries. However, these higher wages could take their toll on companies, which may then suffer financial difficulties and find themselves forced to raise prices.

Volksbanken Raiffeisenbanken Cooperative Financial Network

From an operational perspective, the Cooperative Financial Network made a positive start to 2023 following the challenges of 2022. The aforementioned risks posed by macroeconomic conditions and competition based on rates on the liabilities side will have a significant impact on financial performance over the course of the year. Based on current assessments, net interest income will increase in 2023. We anticipate a rise in interest income owing to the shift in interest rates on the assets side, although this will of course also depend on the volume of new business. Interest expense will go up sharply during the year due to the adjustment in rates on liability-side products. In 2023, net fee and commission income will remain at the high level achieved in 2022 and therefore continue to make a significant contribution to earnings. Payments processing will remain a major source of fees and commissions in 2023. Gains and losses on investments will bounce back strongly this year, resulting in a net gain. The previous year was affected by interest-rate-related valuation adjustments, the effects of which will be partly offset in 2023 if interest rates remain unchanged. We still do not anticipate any material credit-quality-related risks in connection with investments. Expenses for loss allowances will climb significantly in 2023 to reflect the likely deterioration in macroeconomic conditions, with high inflation and the knock-on effects from the energy price crisis contributing to an increase in defaults.

Net income from insurance business is predicted to rise sharply in 2023. In respect of the Insurance operating segment, this forecast is rooted not only in expectation of an encouraging level of insurance operating business but also, in particular, in the predicted normalization of gains and losses on investments held by insurance companies and, to a lesser extent, in the expected effects of the transition to the new accounting standards for insurance companies.

Administrative expenses are expected to be considerably higher in 2023 than in 2022 owing to wage increases and general inflation.

As 2022 was a weaker year due to valuation effects, we anticipate a significantly higher profit before taxes for the Cooperative Financial Network in 2023.

Despite the reduced level of profit retention in 2022, the regulatory capital ratios will hold steady this year because the expected slowdown in the growth of new business will probably mean a lower level of risk-weighted assets at the end of 2023.