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WorldDecember 2 2013

German banks smarten their appearance ahead of ECB review

German banks will want to look as good as possible for the European Central Bank’s asset quality review, especially in light of the country’s hard line during various sovereign debt and banking crises in the wider eurozone. 
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German banks smarten their appearance ahead of ECB review

As the European Central Bank (ECB) gets started with its asset quality review of eurozone banks, German banks are assessing what year-end tidying they need to do for the December 31 balance sheet date, which will be the basis for the ECB examination.

The ECB is aiming to complete its asset quality review in the fourth quarter of 2014 in time to begin its single supervisory mechanism role in November. But individual banks and their national regulators do not have to wait until they are handed the results of the comprehensive assessment, and already have one eye on the upcoming review. Of Germany’s 128 banks, 24 will be directly supervised by the ECB, more than in any other country, which is understandable given the size of its economy and banking system.

Looking good

Germany’s bank regulators, Deutsche Bundesbank and BaFin, will want to avoid being called up by the ECB for failing to deal adequately with problems at their banks in light of the hard line taken by the German government during the course of the various eurozone sovereign debt and banking crises.

It is notable that BaFin took more interest in shipping loan provisions during 2012, at a time when the EU was publicly discussing plans for a single supervisory mechanism for eurozone banks. The Bundesbank has highlighted the so-called €100bn problem of ship exposure, mostly concentrated at three banks: HSH Nordbank, Nord/LB and Commerzbank, which all significantly increased loan loss provisions for 2012 and have continued with heavy provisioning in 2013.

“Looking at ECB supervision in a purely German context, the German regulators would like their banks to look as good as possible when the ECB takes over,” says Holger Schmieding, chief economist at Berenberg Bank in London. “That may of course also be the case in other countries, but for Germany it would be embarrassing if the ECB detects any significant problems with its bank balance sheets.

“The ECB may not be the perfect regulator, since ideally central banking and bank supervision functions would be separate, but the institution already exists so it is a good way to get a new European regulator set up quickly. And clearly one big advantage is that the ECB is an institution with a lot of credibility.

“The banks themselves are trying their best to clean up their balance sheets and there is a foreshadowing effect related to the ECB review, which is not necessarily good news for the economy because there is still a credit crunch in parts of the eurozone and a need to stimulate growth.” 

When presenting details of the ECB's comprehensive assessment in Frankfurt in October, Ignazio Angeloni, director-general of financial stability at the ECB, noted that the ECB was keenly aware of the dangers of exacerbating a credit crunch in some parts of the eurozone. "We are aware that the banks are preparing and we welcome the fact... but we certainly don't want to see deleveraging taking the wrong form by just shrinking assets," says Mr Angeloni.

Championing the mittelstand

Fortunately for Germany, a credit crunch is not high on a list of worries. Mittelstand companies – the country’s small and medium enterprises – have performed well through the economic crisis and, because German banks now have less of an international focus, mittelstand lending is a favoured segment.

But Germany remains overbanked and margins are thin. Progress has been slowing on running off legacy loan books in troubled segments such as commercial real estate and shipping. "The pace of landesbanken deleveraging has slowed down in the past 12 to 18 months, but it is always the case that there are low-hanging fruits that can get the process moving and then it becomes more difficult," says Christian van Beek, director of financial institutions at Fitch Ratings in Frankfurt.

"The deleveraging story at the moment is more one of maturing loans rather than selling assets. As many banks have non-core assets in portfolios that are being run down, they are experiencing a reduction in their interest income as older loans mature. Banks are keen to increase business in higher margin areas such as mittelstand lending, though this is a very competitive market at the moment,” he adds.

Year of transition

Commerzbank has a much more domestic focus since it had to be rescued during the financial crisis and has exited ship lending and commercial real estate lending. In the boom years up to the financial crisis, it built up a huge shipping loan book and has been taking heavy provisions during 2013, totalling €248m for the first half versus €284m for the first half of 2012. Commerzbank views 2013 as a year of transition, during which the implementation of the strategic agenda is weighing on its results with one-off restructuring expenses and higher loan loss provisions.

Rival bankers in Germany continually speculate over a possible takeover of Commerzbank. In the absence of any likely domestic buyers, the focus is usually on foreign banks, although there is an assumption that the German regulators will be very choosy about potential suitors. The government currently owns a 17% stake via SoFFin, the financial market stabilisation fund.

As with many other banks, Commerzbank has a strategy to keep its figure for risk-weighted assets down by selling down loan participations and tapping into growing interest from institutional investors. In June, Commerzbank and French insurance company AXA signed a partnership whereby Commerzbank will originate loans to medium-sized corporates in Germany, Switzerland and Austria while giving AXA access to these syndicated loans, club deals, bilateral loans and schuldscheine (German law-tradable loans). Commerzbank is also a very active lender to the many smaller companies in the mittelstand, devoting more resources and making use of its network of 1200 branches across Germany.

Extra rapid growth

Another traditional mittelstand lender is HypoVereinsbank, part of Italy’s UniCredit Group, which has been targeted for extra rapid growth in this segment. Mittelstand companies are served by its Unternehmer Bank unit, alongside business and real estate clients. With 780 branches across Germany, HypoVereinsbank has a strong position in classical retail, private banking and lending to mittelstand companies. The Unternehmer Bank and Private Clients Bank are each divided into six regions, and the heads of these regions adopt an entrepreneurial approach to advance the development of their region.

At HSH Nordbank, the deleveraging process continues. It had to be rescued by state aid in the wake of the 2008 crash and has since halved its balance sheet size and exited some business lines, notably aircraft lending where it was a major global player. It has repositioned itself as a bank for entrepreneurs, focused on owner-managed companies in the upper-medium-sized German corporate segment. This includes ship owners, real estate owners, and energy and infrastructure developers.

Since 2009, HSH Nordbank has made significant provisions on its shipping portfolio, notably in the container segment. “Back in autumn 2012 we reviewed our long-term loan loss provision planning going forward in a very conservative way, and with a view to the future," says Wolfgang Topp, head of the restructuring unit at HSH Nordbank. “We expected our loan loss provisioning requirements to rise again this year before starting to decline perceptibly next year. This forecast remains valid. Furthermore, we have [in 2013] successfully forged ahead with the wind-down of our portfolio.”

The one German universal bank with global reach is Deutsche Bank, which with total assets of €1800bn is about three times the size of Commerzbank in second place, according to bank balance sheets for September 30, 2013. That number is set to come down, given Deutsche’s strategy of shrinking its balance sheet. But in spite of reducing their assets, German banks remain quite highly leveraged by eurozone standards and want to boost their capital ratios.

Deutsche Bank has set out balance sheet reduction and cost-cutting targets under its Strategy 2015+ plan. Its third-quarter 2013 earnings were hit by a €1.2bn provision for litigation risk, while there was also a sizeable drop in earnings in its corporate banking and securities unit, to €345m. One analyst comments that the disappointing performance highlights the importance of Deutsche achieving its planned operating cost reduction to improve efficiency. Nonetheless, Deutsche remains a global heavyweight and under its Strategy 2015+ programme has stated its intention to emerge as one of a handful of strong global universal banks.

In September, Moody's investors service changed its outlook for the German banking sector to stable from negative, which it had been for five years. The improved outlook takes into account the prospects of a stable operating environment due to an improving economy and more benign credit environment and the continuing strengthening of banks' capital buffers, due in part to more stringent capital requirements.

Hurdles to come

Challenges remain, however. A highly competitive lending environment is leading to generally weak profitability and the deleveraging process still has some way to go at many banks.

"Three of the top 10 largest German banks are in the private sector and have good access to equity markets," says Katharina Barten, vice-president at Moody's in Frankfurt. "But for the savings banks, co-operative banks and landesbanken, the best way for them to improve their capital position is to reduce the size of their balance sheets." Retained earnings are helping boost capital, but profits are being squeezed by the high level of competition.

"Many banks are seeking to increase market share and others seek to replace maturing (mostly international) non-core investments with domestic loans and thereby reposition franchises that were hit in recent years," says Ms Barten. "There is, however, limited corporate loan demand, an issue that heightens competition and puts pressure on banks to loosen underwriting standards."

The ECB comprehensive assessment is made up of three pillars. A supervisory risk assessment will address key risks in bank balance sheets, including liquidity, leverage and funding. The asset quality review will examine real assets on bank balance sheets and take a detailed look at samples of loan portfolios. The stress-test will take a forward-looking view of the shock absorption capacity of banks.

Analysts expect that capital shortfalls will mostly be met by private means, such as raising equity, cutting dividends, selling assets and liability management exercises. Public backstops, where needed, would mostly be provided on a national level, although the EU has made it clear that, to inspire confidence, EU-level capital injections will be available.

The ECB is determined that over the 12 months of the comprehensive assessment, no information will leak out and the results will be communicated at the end of the process. And it has to be clear to the markets that if it uncovers capital deficiencies, funding will be available to fix bank problems.

Clearly German taxpayers remain worried about unlimited public backstops for banks in peripheral EU countries. However, in spite of deleveraging across the German banking sector, leverage remains relatively high by eurozone standards, suggesting that the ECB stress-test may be an area in which German banks themselves come up short. And as the ECB team begins its work to take samples of loan portfolios and drill down to evaluate asset quality across the eurozone banking sector, there may yet be moves by German banks to boost their loan loss provisions to ensure that they look good as they emerge from the asset quality review.

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