For many years the Landesbanken - the state-owned banks of Germany - have been accused by their private-sector competitors of having poor business models and contributing to the overbanked status of the domestic market.
Until 2005, explicit guarantees allowed the Landesbanken to issue AAA rated bonds and use the proceeds to refinance transactions that undercut the competition. Those guarantees ended in 2005, but the last round of AAA bond offerings created liquidity that was used in a whole host of problem areas, ranging from collateralised debt obligations (CDOs) investments to commercial real estate and shipping.
The European Commission is now pressing for big changes. At the time of writing, the results of its reviews of BayernLB and HSH Nordbank were imminent.
As always where the Landesbanken are concerned, state-level politicians may want to block or delay reforms, though some politicians in the state of Bayern have publicly called for the sale of BayernLB.
In the past, state politics has prevented some cross-state mergers that might have resulted in bigger and stronger banks. The nuclear option of simply letting a bank fail was one that politicians wanted to avoid. It was an option they steered clear of when WestLB ran into trouble in 2008.
Circumstances have moved on, though, and now the pressure is on. "Since federal money from Berlin was required at WestLB, this has changed the rules of the game, while the Financial Markets Stabilisation Fund [SoFFIN] is generally being used by Berlin as an instrument for change across the Landesbank sector," says one senior executive at a Landesbank.
SoFFIN has been widely used by banks for risk protection via guarantees. State governments have recapitalised some Landesbanken, and in the case of WestLB it became the first to receive a direct capital injection from the federal government, via €3bn worth of hybrid capital from SoFFIN.
WestLB - still majority owned by the North Rhine Westphalia government, together with a group of NRW savings banks - was downgraded to A3 by Moody's in May of this year. It is now in the midst of a restructuring that will see the current owners divest the majority of their shareholding by the end of 2011 - a requirement of the EU following its approval of state aid.
Many bankers wonder where a bidder will emerge from during the next 18 months. Indeed, Moody's stated in its 'rating action' report that it does not rule out the bank being split up and unwound if efforts to divest it prove unsuccessful.
WestLB is the furthest down the road of reform, having been hit earliest by the financial crisis, including ill-advised investing in structured finance products such as CDOs. Thus it finds itself shaping up as a test case for possible further Landesbank sales.
Under review
Landesbank Baden Wuerrtemburg (LBBW) has also been reviewed by the European Commission, and has been forced to shrink its balance sheet, though there are no requirements for the owners to divest themselves of it. At the time of going to press, the markets were waiting for European Commission reviews of BayernLB and HSH Nordbank.
"As a compensation measure for having received state aid, both WestLB and LBBW have been required to reduce the size of their balance sheets by between 40% and 50% over a period of several years," says Stefan Best, a bank analyst at ratings agency Standard & Poor's in Frankfurt.
"The current shareholders of WestLB also have to reduce their ownership to less than 50% by the end of 2011," he adds. "We may see a similar requirement for HSH Nordbank and BayernLB to reduce their balance sheets, and possibly for state ownership to be reduced below 50%, but the European Commission reviews of these two banks activities are still pending."
HSH Nordbank (also downgraded to A3 by Moody's in May) is already in the process of radically reducing the size of its balance sheet and winding down non-core areas of the bank, as is BayernLB.
Berlin might like to see mergers among the slimmed-down Landesbanken, but bankers remains sceptical about such a solution, given the strength of the federal political system in Germany and the power of each regional government. Thus it is possible that the various banks will simply be slimmed down, unless they are directly ordered by the EU to be sold off.
"They may end up like big savings banks - that may be a more realistic scenario than mergers," says Mr Best. This would be a single state solution, and so would not run into the various difficulties of getting two state parliaments to agree. And it would be less controversial than an outright privatisation, and certainly a wind down.
Commercial exasperation
Among executives at commercial banks in Germany, exasperation at the Landesbank model has been evident for many years. A few decades ago, at a time when banks globally were seeing slippage in their historically high ratings, the Landesbanken found themselves with a competitive advantage via the explicit state guarantees that gave them access to AAA funding.
This went into everything from corporate lending to structured finance and global project finance, but bankers complained that it was cheap funding in search of lending opportunities rather than being based on any sound strategy. 'No business model' is still a commonly heard complaint. Another is more harsh. "Germany has the best auto industry, but the worst banking sector," is the verdict of one German banker.
Market distortion
The transport finance segment, including asset-based aircraft financing, is a good example of what commercial bankers view as the problems caused by the Landesbanken. Back in the 1990s, the Landesbanken were often referred to by aviation bankers as 'the new Japanese', since they were using their guarantees to raise AAA funding and depress loan margins right across the sector - which the Japanese had done in aircraft finance in the 1980s before the asset bubble burst back in the country.
At the top of the market in 2006 or 2007, Landesbanken such as WestLB were arranging Japanese operating leases and providing the debt to carriers around the world. BayernLB was also a major player in aircraft finance, arranging loans in China, but it has since shut down its aircraft finance division. WestLB has now pulled back from being a major aviation player, and LBBW has also scaled down.
At the annual general meeting of DVB Bank in mid-June, Wolfgang Driese, the bank's chairman, was forthright in identifying the Landesbanken as the worst performers during the financial crisis. He noted the irony in the calls from politicians for more regulatory oversight, when the Landesbanken were those most in trouble.
"In the same way that politics is made up of different approaches and trends, the banking sector comprises service providers that operate very different business models," Mr Dreise told shareholders in Frankfurt.
"There is no doubt that some of them operated weak business models, or developed and sold dubious products. Allow me to make a minor point here - most of these banks in Germany had been under state control for decades."
A case in point: the turbulent scenes at HSH Nordbank have been repeated at Landesbanken around Germany
HSH example
The recent upheaval at HSH Nordbank illustrates the turmoil within the Landesbank sector. Back in 2003, Landesbank Schleswig Holstein (usually known as LB Kiel) merged with Hamburgische Landesbank to form HSH, which is the main banker to the governments of its home states and the central bank to the savings banks in the region. It is highly integrated into the regional economic affairs.
At the end of 2006, WestLB sold a minority stake to a group of seven trusts, advised by US private equity firm JC Flowers. This made it the first Landesbank to have a private minority shareholder.
Today, the two federal states (the city of Hamburg has state status) own 85.5% of the shares, and have committed to retain a majority stake until at least the end of 2013. The Savings Banks Association of Schleswig Holstein owns 5.3%. The JC Flowers trusts own 9.2%.
However, HSH was hit hard by the financial crisis in 2008. In November 2008 it signed an agreement with SoFFIN for access to government guarantees of up to €30bn. And in early 2009, the Hamburg and Schleswig Holstein parliaments approved a capital increase of €3bn, as well as a guarantee amounting to €10bn. SoFFIN had the power to review the future business model, and approve it in early 2009.
Sweeping management changes at the top followed in 2009. This was accompanied by some public slanging between old and new management, and even the start of legal actions against former executives.
Hilmar Kopper, chairman of the supervisory board at HSH Nordbank, better known as former chairman of Deutsche Bank in the 1990s, even weighed in with an official statement setting out his "concern and dismay" at public attacks on bank management.
HSH posted losses of €2.8bn for 2008, and €679m for 2009. In December of last year an internal restructuring unit was set up, which will wind down and divest business segments that are not compatible with the new bank strategy. Total assets fell by €33bn in 2009 to €175bn, and further reductions are to come. Its Tier 1 capital ratio stood at 10.5% at the end of 2009.
Rival bankers were already saying many months ago that the HSH Nordbank balance sheet would have to be radically slimmed down. "It might end up with a €100bn balance sheet - so not a very big bank," says one rival.
The kind of events at HSH Nordbank have been repeated at a number of other Landesbanken. BayernLB fell victim to its catastrophic acquisition of Hypo Group Alpe Adria in Austria, which has since been nationalised.
Hard-pressed Bayern taxpayers, already facing an era of public spending cuts and austerity, found themselves on the hook for a €10bn recapitalisation.
In nearby Baden Wuerrtemberg, LBBW was given a €5bn capital injection from the state government in 2009, plus guarantees on some parts of its portfolio. It too has faced a European Commission review, and is in the process of reducing its balance sheet by about 40% compared with 2008 year-end figures. The balance sheet stood at €448bn as of June 2009. Improved corporate governance is also a priority. These measures have satisfied the European Commission that they will offset distortions of competition brought about by bailout money.
Takeover options
So who will buy the banks if they are indeed put up for sale? Hannover-based Nord/LB and Frankfurt-based Landesbank Hessen-Thuringen (Helaba) have come out of the crisis in better shape than many other banks. However, they seem to have little appetite to get involved in taking over their rivals or digesting them at a time when they are busy monitoring their own loan books and capital ratios.
Therefore questions remain over whether there will be any buyers for WestLB. Certainly each solution has its difficulties. One observer crosses off the possibilities. Consolidation via mergers? This runs into the same political interests, and in any case would not create a new business model. Vertical integration with the savings banks? Good idea, but, the savings banks are not interested. Sale to a European commercial bank? Not very attractive given that Germany is overbanked in areas from commercial real estate to corporate and small and medium enterprise lending. An initial public offering? "No way," he says.
Of course, market conditions may improve. The sale of WestLB by the end of 2011 does appear to be a high-pressure deadline, but other EU-ordered divestitures would have several years to complete.
"It is difficult to see buyers coming forward under the current market environment, so we will see if conditions have improved by the end of 2011, by which time a stake in WestLB is supposed to be sold," says Michael Dawson-Kropf, an analyst at Fitch Ratings in Frankfurt.
He notes that the European Commission reviews of BayernLB and HSH Nordbank are close to completion, which could include a requirement for a sell-off by the current owners.
"Financial markets might look very different in three or four years' time, so much will depend on how long the current owners have to reduce the size of these banks and then complete a sale or perhaps an amalgamation with another Landesbank," says Mr Dawson-Kropf.
