Moody's has downgraded its outlook for German banks to "negative" from "stable" as profitability and overall creditworthiness weaken in a low interest rate environment.
In a report published Thursday, the ratings giant said the already weak profitability of German banks will decline further over the next 12 to 18 months as net interest income falls.
"Traditional commercial banks and in particular deposit-funded institutions will struggle to out-earn their costs in the continuing low interest rate environment, even though loan-loss provisions are unsustainably low," said Bernhard Held, Moody's vice-president and senior credit officer.
The bleak prognosis comes just a day after the European Central Bank (ECB) warned that falling bank profitability posed one of the biggest threats to economic growth in the euro zone.
The German Bundesbank signaled similar concerns Thursday. "We see that credit risk is underestimated, so given the 10 good years we had in the German economy, if there's backward looking expectations, you may underestimate the risk going forward, so that is one of the vulnerabilities," Claudia Buch, vice-president of the Bundesbank told CNBC Thursday.
Moody's highlighted that smaller deposit-funded banks in Germany will take the hardest hit, with maturing loans and securities repricing at lower rates, while interest rates paid on retail deposits are "in practice at or close to 0%."
Banks in Europe's largest economy have struggled to improve their high cost to income ratio, which reached 80% in 2018, and the report projected that this is unlikely to improve in the short-term against persistent revenue headwinds.
Deutsche Bank has lost 600 billion euros of its assets and is down more than 60 percent in terms of market capitalization since 2007. Commerzbank on the other hand has gained around 100 billion pounds or so in its total assets but lost half of its market cap.
In terms of share price, Deutsche Bank stock is down more than 80 percent over a ten-year period, while Commerzbank shares have lost nearly all its value over that period, with shares down nearly 90 percent.
Speaking at the Handelsblatt Banking Summit in Frankfurt in September, Deutsche Bank CEO Christian Sewing and Commerzbank CEO Martin Zielke both cautioned over the serious side effects of low interest rates from central banks.
Rising rates are good for banks since it allows them to lend out money to investors at a profitable rate of interest. Lower interest rates restrict a bank's ability to make profits, thus adding pressure on margins.
Negative interest rates, such as in Europe, penalize the banks for holding cash deposits at central banks. The current ECB deposit rate is -0.5%, the lowest on record.
In a bid to ease the pressure on bank balance sheets from its latest package of measures, the ECB introduced a "two-tier" system which exempts a portion of the bank's deposits, currently set at six times their mandatory reserves, from the levy.
However, data from Pictet Wealth management show that the exemption would only result in an annual saving of 3.1 billion euros ($3.4 billion) for the entire euro zone banking system.
Thursday's report said that increased customer deposits are proving costly for German banks, while a lack of fixed income return alternatives and investors' general reluctance to move towards equity investments have boosted banks' deposits.
Faced with persistent low or negative rates, Moody's suggested that German retail banks are increasingly considering charging negative rates themselves to large retail depositors.
However, the agency suggested that borrowers' repayment capacity will remain high on the back of low rates, a robust labor market and buoyant domestic demand.
Moody's forecast German GDP (gross domestic product) growth at 0.6% for 2019 and 1% in 2020 on account of slowing global trade, which has also facilitated negative outlooks for the automotive, chemicals and manufacturing sectors.