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Western EuropeFebruary 1 2010

What really happened at Hypo Group Alpe Adria

The nationalisation of Austria's Hypo Alpe Adria had more to do with regulation and ownership models than exposure to emerging Europe. Writer Philip Alexander
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What really happened at Hypo Group Alpe Adria

When the Austrian government nationalised Hypo Group Alpe Adria (HGAA) for the token sum of €3 in December 2009, the bank was widely perceived as the country's latest victim of the economic downturn in the nine emerging European economies - mostly in the Balkans - in which it operates. Most notoriously, US economist Paul Krugman warned in April 2009 that Austria could follow Iceland down the slippery slope to a system-wide banking crisis, driven by Austrian banks' exposure to central and eastern Europe (CEE).

In reality, however, the three largest Austrian banks operating in emerging Europe, namely UniCredit-owned Bank Austria, Raiffeisen International, and Erste Bank, all recorded profits in the first three-quarters of 2009, despite the inclement economic conditions. In most CEE countries, non-performing loans appear to be at or near a peak, so recovery could begin this year. In which case, HGAA could yet be the only victim.

"With this bank, losses are above average compared with their peers, and we explain that by their historically weak risk management," says Dominique Nutolo, financial institutions analyst at credit ratings agency Moody's.

When it released its results for the first half of 2009 in August, HGAA management maintained that its capitalisation should be adequate to cover potential losses, which reached €161m for those six months. Of its four largest CEE business units (Slovenia, Croatia, Bosnia-Herzegovina and Serbia), only Bosnia-Herzegovina reported a loss, of just €832,000.

But by November, the Austrian Financial Markets Authority (FMA) warned that the bank was likely to need a further capital injection. Weeks later, the existing shareholders were in urgent negotiations with the Austrian authorities. On December 14, it was announced that the national government would acquire the bank. The previous shareholders - including Germany's Bayerische Landesbank (BayernLB) with 67% and the province of Carinthia with 12.4% - agreed to provide €1.05bn in fresh capital. The Austrian government is set to put in at least another €450m.

Hidden losses

What had changed in the weeks between the first-half results and the FMA's warning? Kurt Pribil, executive director of the FMA, says: "The managements of HGAA and of the FMA agreed in July 2009 on HGAA commissioning an independent auditing firm to perform exhaustive asset screening throughout the entire company group. The executive board of the bank commissioned the auditing firm of PricewaterhouseCoopers [PwC] Austria with the task. Within four months, 60 employees had analysed about 30% of the group's consolidated assets."

The analysis remains unfinished, but according to HGAA spokeswoman Martina Uster, PwC "is expected to conclude that there is a requirement for further risk provisions and value adjustments in the fourth quarter of this year".

Ms Uster adds: "The volume of risk provisions to be processed for the 2009 financial year will amount to a sum significantly over €1bn. With this, all the bank's risks are judged to have been captured and recognised on a conservative basis."

Consequently, Harald Waiglein, a spokesman for the Austrian finance ministry who was present during the negotiations with HGAA, emphasises that the bank's situation is unique, rather than reflecting the wider impact of the CEE slowdown. "This is not a typical case of banks making the wrong financial decisions. This is a case which could have criminal significance," he says. A special police unit has been created to investigate why the bank acquired such a large volume of at-risk assets - thought to be as high as €2bn on a total asset base of €41.7bn.

These assets were geographically diverse, but Mr Waiglein says they are concentrated in its leasing segment - especially yacht leasing - and in tourism projects. The yacht leasing portfolio had apparently reached about 400 vessels. "Some of these now appear to be missing, others have been repossessed for sale," he says.

Political risk

This is a costly failure of due diligence for two banks - HGAA itself, and its previous majority owner BayernLB. The public prosecutor in Munich is already investigating how BayernLB, which is now 94% owned by the Lander (province) of Bavaria, came to pay €1.625bn in May 2007 for a bank that it had to sell for €1 after injecting another €1.1bn in capital, and then a final €825m at the point of nationalisation.

BayernLB CEO Michael Kemmer, who was CFO in May 2007, resigned in the wake of the HGAA nationalisation. The common thread in both investigations is the part-ownership of both banks by provincial administrations, which is sure to raise further questions over a model that has been blighted by more than its fair share of losses even before the global financial crisis.

In theory, says Gottwald Kranebitter, the head of financial advisory services at KPMG in Austria, provincial government ownerships should discourage excessive risk taking. "The main difference is that they do not have the same need as listed banks to produce growth and dividends. The province has a budget with a set dividend from its hypo, but that is it, nobody is necessarily telling the bank to produce the best possible return on equity," says Mr Kranebitter, who advised HGAA management during the pre-nationalisation negotiations.

But HGAA appeared to be pursuing a much more aggressive expansion strategy, and one Austrian financial analyst notes that there is always the possibility that such a bank's financial decision-making will become clouded by political considerations. "There are no systemic differences in corporate governance between the Austrian hypo or German landesbanken and the private banks that could explain the problems. But in individual cases, local lending decisions may become driven by the political need to help the growth of local companies. What is more serious is if the local politicians also want the bank to expand internationally for reasons of political status - the bank may not have the knowledge to manage this," he says.

In the case of HGAA, ratings agency Moody's has been flagging up concerns about weak risk management and corporate governance since at least August 2006. "This bank grew rather rapidly in the past four years. For any entity, it is a challenge to keep up risk management when you have such rapid growth," says Mr Nutolo.

A source close to the police investigation in Austria says it is likely to examine if any of the major lending decisions now causing HGAA so much trouble involved the previous Carinthia provincial administration of Jörg Haider, who died in October 2008.

There was at least one clear political decision that led to the nationalisation of HGAA. Ms Uster confirms that the previous shareholders chose not to retain ownership of the bank, even after having injected so much capital into it since 2007 and finally having more concrete knowledge of how large the losses were likely to be.

Rolf Petermann, head of financial institutions group coverage (Germany and Austria) at Société Générale Corporate and Investment Banking (SGCIB), says the decision by BayernLB should be seen in the context of greater influence exerted in the landesbanken sector by the European Commission (EC). As part of its competition approval for a capital injection and asset risk shield provided by the Bavarian Freistaat (provincial) government, the EC has stipulated that BayernLB concentrates on its core competencies and regions. Such downsizing would most likely have included the divestiture of BayernLB's majority stake in HGAA at a later date.

Regulatory lessons

Inevitably, there will be questions over how regulators overlooked the growing problems at HGAA until recently. Finance minister Josef Pröll announced last month that he intended to increase government ownership of the Austrian National Bank to 100% from 70%, to ensure its independence from the commercial banking sector. This will bring the Austrian central bank into line with most others in the EU.

Mr Pribil says the authorities adapted quickly to regulating Austrian banking groups that perform the bulk of their business in the CEE region. "Austrian banks were pioneers in the CEE markets, and thus the FMA regards itself as a pioneer in the area of cross-border supervision. Even before supervisory colleges were established at EU level, the FMA had been inviting all of the supervisors of individual bank groups to regular co-ordination meetings for the purpose of information exchange," he says.

The FMA introduced onsite inspections of cross-border banks by regulators in more than one country - ironically, HGAA was the first bank to be inspected in this way. Today, the Austrian authorities are strong supporters of plans for a single EU supervisory body for cross-border banking groups. "This authority ought to rely on the network of national supervisory authorities for fact-finding, while decisions should be taken by the central authority and be binding for all," says Mr Pribil.

Given the location of risks on HGAA's balance sheet, it is possible that the regulatory shortfall lies in the leasing segment, rather than in cross-border supervision. While HGAA's own leasing business was regulated in Austria as part of a larger financial institution, Mr Kranebitter says that independent leasing businesses in Austria and several CEE countries are not subject to supervision by the financial services authorities in those countries.

In this context of lighter regulation for leasing, one analyst says fraud is more common in leasing businesses than in mainstream banking. He believes some of the assets booked on HGAA's leasing segment did not strictly fit the definition of the business. By its nature, large equipment leasing also potentially leads to greater loan concentration than, for example, the mainly retail banking operations of Erste Bank.

Mr Waiglein says that the finance ministry is not planning any major legislative changes on bank regulation as yet, but it does have an eye on the role of provincial governments in the private sector. "We are considering the possibility of putting a limit on the contingent liabilities that provincial governments can assume, for instance by their support of a bank," says Mr Waiglein.

Hypo Alpe Adria: Balance sheet by business segments

Hypo Alpe Adria: Balance sheet by business segments

Future prospects

If CEE exposure was not of itself central to HGAA's undoing, it seems likely that it will play a key role in the restructuring and recovery strategy for the bank, due to be announced next month. Major EU banks operating in emerging Europe signed up to a deal with multilateral agencies - appropriately enough in Vienna - in March 2009 to maintain capital levels in their CEE subsidiaries, to avoid a sudden halt in lending.

Although Mr Waiglein says this Vienna Initiative was intended to be systemic rather than setting exact capital levels for individual banks, he adds: "It was precisely to keep Austrian commitments under the agreement that we nationalised Hypo Alpe Adria, to avoid damage to the banking systems in south-eastern Europe."

This does not preclude HGAA selling some of its CEE units to another bank, either to earn the Austrian government a quick return, or to meet EC concerns about the competition implications of nationalisation. Stefan Maxian, head of CEE equity research for Raiffeisen, says that while the bank's average market share in the countries where it operates was about 6.5% at end-2008, it has a significant presence in Bosnia-Herzegovina (21% share) and Croatia (10%).

"These markets are still very interesting, especially as the bank reached substantial size there. The question is at what cost they achieved that size, in terms of risks in their credit portfolio, and that may make other banks quite reluctant to acquire assets from Hypo Alpe Adria," says Mr Maxian.

Either way, the CEE region remains attractive because it is underbanked, especially compared to Austria, which is one of the world's most competitive banking markets. "We generally think that eastern Europe has good markets in the medium term, although they are troubled at the moment. A bank with a good presence there should be able to profit in the future," says Mr Nutolo, but he adds that Hypo Alpe Adria will first need to strengthen its risk management.

By contrast, the future of the hypo model appears rather more doubtful. There are only two significant Austrian banks with provincial government ownership, Hypo Landesbank Vorarlberg and Hypo Tirol, neither of which has pursued HGAA's aggressive international expansion strategy.

Mr Pribil says: "The former business model of the provincial mortgage banks has become obsolete since the EU has toppled the guarantee model, which was similar to that of Germany's landesbanken. Governments may not take over any new guarantees, and existing ones will melt away like icebergs. Most of the provincial mortgage banks are no longer under the majority influence of an Austrian province, and this trend will continue."

And Mr Petermann of SGCIB believes that the lander governments, under pressure from the German federal government and EC, are finally close to accepting the need for further consolidation among the seven remaining landesbanken. "One could see a scenario in three to five years time where there are just two or three landesbanken - though bringing it down to one looks difficult for practical and political reasons," he says.

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