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Western EuropeMay 2 2004

Less ambition, more success

Jan Wagner finds that the global banks aiming to expand into Germany should opt for niche markets.
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To global banks hungry for expansion, Germany’s commercial banks appear tempting again. Earlier this year, Citigroup expressed an interest in taking over Deutsche Bank, Germany’s largest bank. But the US bank failed to get to the next step after Deutsche’s board said the bank preferred independence.

Since Deutsche is not for sale, two other big commercial banks are now the subject of takeover speculation in German financial circles: Second-ranked HypoVereinsbank (HVB) and fourth-ranked Commerzbank. Following a dramatic improvement in their fortunes recently, the banks’ chief executives have signalled that a merger would help them better compete in Europe. And unlike Deutsche, both can be had for a bargain price, as their market capitalisation is still below book value.

However, the truth is that expansionist-minded global banks have no apparent appetite for Commerzbank or HVB. Why? They are wary of getting the same indigestion which has befallen Dutch banking giant ING since it bought Germany’s BHF in 1999.

With e59bn in assets, BHF is much smaller than HVB or Commerzbank, which each have upwards of e500bn. But what the merchant bank has in common with its larger competitors is that it is a major lender to Germany’s Mittelstand, the small and mid-sized companies which dominate the corporate sector. Although a huge business in Germany, this exposure made all three banks vulnerable to any weakness in the economy.

As a result, during the German economic slump of 2001 to 2003 that caused a record number of Mittelstand insolvencies, BHF went from being ING’s great hope to a severe liability. Indeed, the bank’s latest business report makes for particularly grim reading. It shows that in 2003, BHF had an operating loss of e127m on the back of e265m in risk provisions. These risk provisions were used to mostly cover bad corporate loans. It was already apparent that all was not right at the bank from the bank’s 2002 results, which reflected an operating loss of e9m and as much as e294m in risk provisions.

Beyond the losses resulting from an explosive loan book, analysts say BHF’s other problems are more endemic. Unlike Commerzbank and HVB, its presence in the German market is simply too minor for it to compete effectively, and hence enable ING to make serious money there, they say.

BHF offers other banking services apart from lending, including financial markets, mortgage banking, asset management and private banking. Yet the 2003 results show that it is making small amounts of money in the former three areas and near to break-even in the latter.

“BHF finds itself in a difficult position, as the decision in the early 1970s to get out of retail banking and become a merchant bank is taking a huge toll. Other European banks have been able to weather the storm in corporate finance far better by having some sort of retail presence,” observed Konrad Becker, analyst at the Munich private bank Merck Finck & Co.

BHF’s woes have prompted persistent speculation in Frankfurt that ING wants to sell the bank nearly five years after taking it over. But ING firmly denies any such intention.

In prepared remarks for The Banker, the bank said: “At this point, we are concentrating on improving the performance of ING BHF-Bank. Some further measures will have to be taken, but ING is confident in management’s ability to return to profitability by 2005.”

Looking back

In hindsight, it is easy to say that a successful international player like ING should have known what it was getting into when it bought BHF. Yet at the time of the takeover, the world was very different. The European economy was in considerably better shape, and equity markets, driven by the technology boom, leapt from one record high to the next. Such euphoria caused a wave of consolidation within the European banking industry, and ING was anxious to participate in a big way.

ING took control of BHF in September 1999 in a deal worth e3.5bn. To former ING chief executive Godfried van der Lugt, the profitable and well-capitalised bank seemed the ideal vehicle with which to enter Europe’s largest economy.

Though small in size, its ample capitalisation made it a leading financier for larger members of the Mittelstand. Other banking activities such as investment banking and structured finance were also cleverly structured around the corporate finance business. Partial proof that this business model worked came from BHF’s experience with the Neuer Markt, the now defunct technology stock segment of Frankfurt’s stock exchange. The bank raked in enormous profits by bringing numerous Mittelstand clients to the Neuer Markt.

Mr van der Lugt was equally charmed by the prestige of this traditional Frankfurt bank. BHF held the distinction of having never posted a loss since its beginnings in 1854. It also served as an important training ground for several top German bank executives. “ING was so convinced of BHF’s promise that it didn’t even bother doing proper due diligence,” remarks a source familiar with the 1999 takeover.

Trouble brewing

Trouble began to brew at BHF in 2001 when the bursting of the technology bubble combined with accounting scandals among several Neuer Markt companies led to the demise of the segment. This robbed BHF of an important source of profit. A year later, BHF’s loan book – long considered its greatest asset – started to disintegrate amid the wave of corporate insolvencies in the second year of Germany’s economic slump.

Preoccupied with a new strategy of expanding its retail and insurance activities abroad, ING’s board was slow to react to the warning signs from Frankfurt. According to a source, the board was also hindered by the belief that since it lacked German expertise, BHF should be allowed a great deal of independence.

Change of attitude

The board’s attitude changed after Peter Gloystein, a former Commerzbank executive who had taken over in late 1999, suggested the bold idea of increasing BHF’s lending to the Mittelstand in spite of the economic slowdown. Mr Gloystein argued that since this business line was the bank’s greatest strength, investing in it was the only way to fight the downturn and ensure BHF’s profitability.

ING’s board, now headed by CEO Ewald Kist, saw things entirely differently, and a frustrated Mr Gloystein resigned in August 2002. Mr Kist then replaced him with one of his own: Syste Andringa, who had built a reputation at ING as a trouble-shooter.

While Mr Andringa could not prevent BHF from falling seriously into the red, the 62-year-old Dutchman has been rationalising with a vengeance. Since taking the reigns, he has reduced BHF’s headcount to around 2500, resulting in cost savings of e100m from this year. To repair BHF’s battered balance sheet, Mr Andringa has removed non-performing loans and put them into a special workout vehicle called the “institutional restructuring unit”.

Mr Andringa, himself in charge of corporate finance, has also instructed staff to approve loans only when margins are high and default risks are low. The measure has markedly improved BHF’s risk exposure.

Mr Andringa was not available for an interview with The Banker at time for publication, but a good synopsis of his turn-around strategy appeared in BHF’s 2003 business report: “The dominance of our corporate finance business has, as a result of restructuring, certainly declined, but it remains too high. The relation between the loan capital extended to the amount of interest returned remains unsatisfactory,” he stresses.

As a result, “we will make corporate banking more dependent on commissions and concentrate more on selective products. We will also further integrate our financial markets business with corporate banking to provide expertise to the leading members of the Mittelstand,” the CEO adds. According to BHF, the strategy, along with the costs savings, should return the bank to the black on the operating level this year. For next year, a net profit is forecast.

Bottom line

If, however, Mr Andringa fails to meet these targets, BHF has no future with the Dutch bank. This was made very clear in ING’s prepared remarks: “We continuously monitor all of our businesses to ensure that they deliver sufficient returns, have a sustainable market share and advance ING’s strategy. We have always said businesses that structurally underperform ING’s hurdles and destroy shareholder value will be sold or closed.”

One London investment banker thinks that BHF’s fate is sealed whether Mr Andringa succeeds or not. “Sooner or later, BHF will be sold, as ING is not willing to tolerate the low margins in Germany’s corporate finance business. Mr Andringa’s role is to restore BHF’s health so ING can get a better price for it,” the banker says.

Missed opportunities

Critics also charge that the defensive strategy in corporate finance is undermining BHF’s chances of competing at all. It is feared that if the corporate finance business – the heart of BHF – is removed, the other organs may be all right but they no longer have any function and the bank will die anyway.

It is thought that ING missed an opportunity to bolster BHF’s competitiveness in corporate finance when times were better. Prior to the downturn, ING could have merged BHF with IKB, another specialist in German corporate finance, to create a true Mittelstand bank. IKB is now 33% owned by KfW, Germany’s government-owned development bank.

On the other hand, Mr Becker, who covered BHF prior to its takeover, argues that this view is far too charitable to the bank. According to him, BHF was never as promising as it appeared for two main reasons: first, it had been struggling with bad corporate loans ever since Germany’s last recession in the early 1990s. And again, the bank never offered the kind of critical mass necessary to compete in Germany, especially when times got tough.

The sources familiar with the 1999 takeover say: “ING desperately wanted to enter the German market as part of its foreign expansion. It bought BHF because it was the only bank available at the time.”

ING’s experience with BHF is a telling example of why global banks have been reluctant to attempt a big German expansion, even during good times. Even if BHF, like HVB and Commerzbank before it, makes great progress in cleaning up its loan book, this will not change the inherent unattractiveness of Germany’s corporate finance business.

Margins in the business are thin due to the overcapacity caused by commercial banks, publicly owned Sparkassen and Landesbanken as well as co-operative banks. Soon-to-be-removed state guarantees enjoyed by Sparkassen and Landesbanken have made the business even tougher, since these banks can undersell the competition thanks to top credit ratings derived from the guarantees.

Mindful of these hurdles, some global banks have adopted a far less ambitious approach to Germany, concentrating on winning retail market share by unveiling innovative products. The models for this approach are those foreign investment banks and asset managers in Germany that have all done well by remaining niche players.

Niche success

The results have been impressive. To begin with, Citigroup and Royal Bank of Scotland have captured significant shares of Germany’s retail market by offering no-hassle personal loans, flexible credit cards and low-cost insurance. Citigroup has even doubled the number of its retail branches in Germany to 300 from when it first entered the market in 1989.

Even ING itself has profited immensely from such an approach. Its online bank Diba, which it bought for a pittance compared with BHF’s price, now has more than 3.7 million customers, making it Germany’s fourth-leading retail bank. Diba also had one of its best years in 2003, raising pre-tax profits by 68% to e37m. The bank’s recipe for success has been simple: along with online flexibility, the bank offers higher interest rates on cash accounts than its German competitors.

Since all of these successes were achieved with relatively low investment, Mr Becker feels that they demonstrate the way forward in Germany for foreign banks. “This is certainly something that ING has come to appreciate, so when a buyer for BHF materialises, the Dutch bank will sell it and hopefully recoup its original investment,” he says.

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