FRANKFURT (Reuters) - If interest rates do not rise in coming years, German banks, already among the least profitable in Europe, will suffer a major margin contraction, the Bundesbank said on Wednesday in a paper co-authored by board member Andreas Dombret.

Banks' interest rate margin will drop by 16 percent, roughly a sixth, if rates stay steady for the next four years.

By then, only a fifth of the banks would earn a cost of capital of 8 percent, the average long-term benchmark cost of equity, the paper said.

Operating with the highest cost in the euro zone, Germany's 21 biggest banks earned a 2.13 percent return on equity in the third quarter, less than a third of what French or Spanish banks made, European Central Bank data shows.


"The German banking sector has not been able to significantly reduce operating costs in the recent and not so recent history," the Bundesbank paper said.

"Even if interest rates stayed constant at current levels, the core business interest margin of German banks would be reduced by 16 percent over the next four years," the paper added.

Holding interest rates in negative territory, the European Central Bank has promised low rates for years to come, even keeping the door open to further rate cuts.

Germany's saturated bank sector has hundreds too many lenders, primarily smaller savings banks and cooperatives, requiring a major wave of consolidation to restore profitability, banking supervisors have said.

The paper also warned that rising interest rates would also be a challenge initially.

"When an interest rate hike takes place, long-term assets such as housing loans that were initiated while rates were approaching the zero lower bound will provide only minimal income, while compensation for new incoming short term liabilities may rise quickly," it added.

To study the impact of low interest rates on smaller banks not supervised by the ECB, the Bundesbank and the financial regulator BaFin will conduct a stress test later in 2017.

(Reporting by Balazs Koranyi Editing by Jeremy Gaunt)

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