OREANDA-NEWS. Retail banks still generate the bulk of profits in Germany's banking sector, says Fitch Ratings. Competition is fierce and wholesale margins are under pressure but retail business lines can produce stable and solid returns if market share is sufficiently large or if business models focus on high-margin assets and costs are well controlled.

This was the case in 2014 when retail banks achieved a pre-tax return on assets of 0.9%, a solid performance given today's low interest rates, and well ahead of the weak returns reported by the country's universal and wholesale banks, including the Landesbanks.

Retail-focused banks contributed 75% of the sector's 2014 pre-tax profits, dominated by the large groups of cooperative (36%) and savings (33%) banks, which have long served German consumers and small SMEs, providing a comprehensive range of banking products and services. The two groups of cooperative and savings banks, with market shares of between 15% and 20% and 25% and 30% respectively, are Germany's most profitable large banking groups. Their profitability is only surpassed by those of smaller consumer finance specialists.

The cooperative and savings banks' large networks benefit from economies of scale and pricing power from leading, if not dominant, local market positions, notably outside the large urban areas where competitive pressure from large universal banks is highest. The consumer finance specialists, still small but rapidly growing, benefit from tight cost management, moderate competition from the large groups, market discipline ensuring solid margins and very low shares of non-client related assets.

Independent commercial real estate (CRE) lenders are shrinking their balance sheets and restructuring following heavy losses suffered during the financial crisis. The performance ratios achieved by most of these banks are weak (0.3% pre-tax return on assets) but the break-up of troubled Hypo Real Estate group is positive as it should allow the viable side of the business to grow. Among CRE lenders, only Aareal required neither restructuring nor bailout to maintain a business model that is adapted to the post-crisis environment.

The three large universal banks represent 38% of sector assets but generated only 18% of the banking sector's pre-tax profits in 2014 and 0.2% pre-tax return on assets. Deutsche Bank, Commerzbank and HVB are addressing their modest retail performance, incorporating different strategies ranging from large reductions in branch networks to strong growth in mortgage lending. The Landesbank sector's performance is weak as the sector is structurally exposed to high competition, particularly in corporate finance, and includes banks that are still restructuring.

The ECB's comprehensive assessment conducted in 4Q14 highlighted no major shortcomings at German banks. Recommended adjustments required for some shipping and CRE assets were manageable. Germany's retail banks are well capitalised and capital ratios at the universal and wholesale banks have improved strongly in recent years following balance sheet deleveraging and capital raising from their owners and the market.

We do not expect a fundamental change in the banking sector's performance in 2015, unless markets are disrupted. Our Outlook for the sector is Stable. In the medium to longer term, we envisage a gradual shift in profitability, away from the cooperative and savings banks and towards the universal lenders. Profitability at the cooperative and savings banks is highly dependent on net interest margins and this is likely to be impacted by sustained low interest rates. Universal banks should, on the other hand, benefit from more client-centric asset bases after years of shrinkage as they emerge from restructuring and adapt their structures to the new regulatory environment.