Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
Western EuropeApril 1 2007

Chipping away at the three-pillar structure

While the sale of Landesbank Berlin is raising hopes that Germany’s tripartite banking system will start crumbling, those more capitalist-inclined bank boardrooms with an eye on overseas expansion shouldn’t hold their breath. Geraldine Lambe reports.
Share the article
twitter-iconcopy-link-iconprint-icon
share-icon

The word idiosyncratic could have been coined to describe the German banking sector. And this three-pillar system – in which a handful of privately owned banks compete against less profit-oriented publicly owned regional and savings banks and a vast array of co-operative banks – has proved remarkably resistant to change, despite the abolition of state guarantees for public sector-owned banks.

While there has been small-scale consolidation, business remains split between more than 2000 banks, ensuring market share per institution is tiny when compared with other banking markets. Combined with high wage costs, strict labour laws and powerful worker representation, the result has been chronically low margins and a lack of pricing power.

Although great strides have been made to cut costs and improve profitability, growth is hard in such a competitive market, and return on equity (ROE) therefore remains low. The average ROE in German banks is 13% (much lower if you factor in savings banks and co-operatives, where the average is 6% and a little less than 5%, respectively) compared with an average of 21% in other European countries and 29% in the US. The big five, at least, now have a more respectable average of 20%.

Private banks have demanded change for more than two decades, chiefly regarding a level playing field. In terms of cost of capital this was achieved with the removal of state guarantees following EU intervention but, while public banks can, in theory, expand by merger or acquisition in the public or private sector (if they had enough money), there are still legal barriers preventing private banks from buying any of the hundreds of savings banks, even if owners want to sell them. This means that more than 50% of the German banking system is not for sale, by law.

To date, dramatic change only happens on the heels of a crisis. Private equity house and distressed asset specialist Lone Star, for example, acquired Allgemeine Hypothekenbank Rheinboden (AHBR) from the German Trade Union Federation in December, 2005 only when it was on the brink of liquidation in the wake of huge losses on interest rate derivatives and bad debts on east German property loans, causing turmoil in the pfandbrief (mortgage bond) market in which AHBR was a major issuer.

The latest development to trigger hope of major structural change is the sale of Landesbank Berlin (LBB), previously known as Bankgesellschaft Berlin, which nearly collapsed in 2001 when a revaluation of its property-related liabilities erased its entire capital base. The European Commission approved a €23bn bail out of the bank by the City of Berlin on condition that the city sold its stake by this year. One half of Berliner Bank was sold to Deutsche Bank last year for €680.5m in an auction that reportedly attracted 22 bidders.

The rest of LBB’s business is currently under auction, with 14 bidders left in the ring. These include Deutscher Sparkassen- und Giroverband, the savings bank lobby group, which already owns 10%, and other strategic buyers such as BayernLB, Landesbank Baden-Württemberg, WestLB and HSH Norbank. Financial bidders are said to include Lone Star, though the company declines to confirm this.

So will the sale of LBB be the bridgehead that opens up the public sector-owned banks? No-one is holding their breath.

Some argue that it could show owners what they could gain financially by selling rather than shoring up a business or merging with another small player. With high levels of debt in some länder (states), this argument sounds persuasive.

Regional variations

According to Standard & Poor’s, although the uptick in the economy and tax rate increases have stabilised the financial situation for Germany’s local and regional governments, and have led to sound tax revenues for most of them, the economic strength of German states differs widely. Gross domestic product (GDP) per capita in the city-state of Hamburg is nearly 70% above the German average while that of Mecklenburg-Western Pomerania (MWP) is more than 30% below the average, for example.

By the end of 2006, German states’ debt had reached €492.3bn (up from €482.4bn at the end of 2005, and after an increase of 19% between the end of 2002 and 2005). Standard & Poor’s believes that without additional structural measures (and increased efforts to rein in expenditure, including pension costs), debt levels will continue to rise in many states.

The publicly owned sector yields much less than it should for tax payers. “The price Germans pay for the system is pretty high,” says Michael Heise, chief economist for Allianz, owner of Dresdner Bank. “Publicly owned banks give a very low yield on equity [analysts suggest an average of less than 1% versus Commerzbank’s dividend yield of about 2.5%]. If you consider that these banks constitute about 50% of the banking market, that comes to billions of euros lost. I don’t think that some of the local authorities realise the value of their assets and how they could be used to pay off debt.”

Nonetheless, many see little mood for change. “Even with the most optimistic outcome of this sale – LBB is sold for a good price to a privately owned German bank and acts as an example of horizontal consolidation – there is little chance that the sale will lead to wholesale change in German banking. There is simply no incentive for local politicians to give up the influence that the current system offers,” says Michael Drill, CEO of boutique investment bank Lincoln International.

“They are not driven by profitability. Their role is to support regional development. They ensure that local mittelstand [small and medium-sized enterprise] companies get funding on far more favourable terms than they could possibly secure from private banks.”

He cites the case of heavily indebted MWP in eastern Germany. About two years ago, the mayor of Rostock mooted the idea of selling or merging the local bank, but the local government stepped in and changed the law in order to prevent it. “This demonstrates the political resistance to any change. It was a small bank that would have represented only symbolic consolidation, but nobody wants to set a precedent.”

Mr Drill further argues that if structural change could not be achieved in the banking sector when the German economy was struggling, “then now that the economy is recovering, the urge to sell such assets will disappear, at least for the next two or three years”.

But does it matter if the three-pillar system continues? Local mittelstand and retail markets are well served and regional economies are supported. The only people really hurt by the continued survival of the three-pillar system are the big five private banks that struggle to erode the market share of savings banks and co-operative banks in the retail and mittelstand markets. Defenders of the public sector argue that the three-pillar system guarantees competition, market-oriented prices and modern financial services to all clients.

Size matters

Klaus-Peter Müller, chairman of Commerzbank and president of the Association of German Banks, thinks otherwise. A passionate advocate for change, Mr Müller argues that size matters and maintains that by inhibiting the growth of the large commercial and universal banks, Germany is robbed of a national champion and loses influence in European financial circles.

“If you look at the top 10 banks in Europe by market capitalisation, where are the German banks? This is more than symbolic. The country is in danger of falling behind in its influence on financial markets, and lack of size can hinder innovation. Domestically, it determines the amount of business banks can do; lending limits, for example, depend on a bank’s level of equity.”

Analysts at WestLB say that such constraints leave players such as Commerzbank vulnerable to takeover. The landesbank’s recent report argues that, despite Commerzbank’s acquisition of Eurohypo, in terms of market capitalisation, Commerzbank is losing more and more ground to other

European players. “The bank now finds itself in a situation in which it will have to buy if it does not want to be bought,” says the report.

Mr Müller denies that Commerzbank is vulnerable, but his feelings are clear – if someone launched a hostile bid, how would the bank, with a market capitalisation of about €21bn, defend itself against a Grupo Santander, for example, with a market capitalisation in excess of €70bn?

Mr Müller cites the difference between the growing European force that is UniCredit, and Commerzbank. The former has doubled or tripled its size through acquisition, while Commerzbank, following its acquisition of Eurohypo – the only real choice available to it in Germany if the publicly owned banks are off-limits – must grow by the more difficult organic route.

The inability to grow significantly and increase profitability in the home market has ramifications abroad, too. Should Commerzbank want to acquire a bank in a foreign market, say, for €8bn, it would be a massive investment, akin to almost 39% of the bank’s market capitalisation. For Grupo Santander, for example, it would represent about one-eighth of its market capitalisation and for a bank like Citigroup, it would be a drop in the ocean.

Slow change

LBB may not herald the end of the three-pillar era, but it is a sign that change is happening, albeit slowly. There has been consolidation – co-operative banks have reduced from 2039 in 1995 to about 1257 today, while the number of savings banks has shrunk from 578 to 457 – but when that occurs between tiny co-operative banks, sometimes with only a few thousand customers, it makes little impact on the system overall.

In addition to intra-pillar consolidation, such as the sale of Sparkasse Frankfurt to Dekabank (the central financial services provider for the savings banks group), there has been limited consolidation across financial pillars, such as Berliner Bank to Deutsche Bank and the more shocking sale of WestLB’s stake in HSH Nordbank to private equity firm JC Flowers. The ongoing turnaround of AHBR is a demonstration of restructuring in action (see below).

Although change is slow, Karsten von Köller, chairman of Lone Star Germany, believes that there is a new spirit emerging in Germany, a more capitalist approach and a growing internationalism that is becoming apparent in the boardrooms of banks and companies and which is coinciding with a generational shift. It is these dynamics that will help drive change in the German banking sector, he says.

“A meaningful number of board members in landesbanks have moved over from the private bank sector and are bringing that mindset with them,” he says, citing Thomas Fischer, CEO of WestLB, and Siegfried Jaschinski, chairman of the board of managing directors at Landesbank Baden-Württemberg. “And more and more managers have spent a large part of their working lives outside of Germany, adding a more international approach,” he adds.

It is no coincidence, then, that Mr Fischer, who oversaw the sale of WestLB’s stake in HSH Nordbank to JC Flowers, came from Deutsche Bank, or that the chairman of the board of Dekabank, Franz Waas, was the board member of HSH Nordbank responsible for its capital markets activities and private equity operations. Mr Jaschinski oversaw the acquisition of Baden-Württembergische Bank and the increase of net income of 21.3% last year, while ROE was raised to 16.1%.

Bank rejuvenation

In the private banking sector, expanding market share remains difficult and there is further competition from foreign banks that have successfully targeted niche areas that generate attractive returns, such as consumer finance (for example, Citi and Santander in consumer credit cards) and mortgage lending (mainly via internet-based banks such as ING-DiBa), leaving German banks to defend existing share or compete for the lower margin segments.

That said, prospects are far more positive than they were a few years ago. Banks have been diligent in dealing with non-performing loans (NPLs) and cost structures have been realigned. The result is an obvious upturn in profitability.

At Commerzbank, 2006 figures showed operating profit was up by 47% on 2005. Trading income had shot up by 81% and net commission income was up by 13%. At the same time, costs have been kept under control, with only a 3% rise.

Commerzbank continues to benefit from the upswing in the German economy and from real estate banking, where the acquisition of Eurohypo is reaping dividends. If it lagged some competitors (including Postbank, Dresdner Bank and foreign players such as Citi) in offering free current accounts as a way of gaining new retail customers, it finally joined the fray at the end of last year.

According to analysts, its retail business model is well positioned, with a focus on investments for retail customers. For example, it is the market leader in Germany in equity derivatives with a 25.8% market share of the German Euwax, as well as being number three in France and number two in Portugal.

Commerzbank’s Mr Müller says there are demonstrable signs that the bank is achieving its stated aim to be the best retail bank covering the country, as well as the best partner for German mid-cap companies.

“We are the only bank selling mutual funds under an open architecture, and a consumer organisation, the Stiftung Warentest, has just named Commerzbank the best consumer adviser,” says Mr Müller. “At the same time, the German Association of Entrepreneurs has just published a survey in which Commerzbank has the highest ranking of all German banks.”

Mr Müller also believes that its strategy with the mittelstand, which currently accounts for about 25% of the group’s income, is well placed to address the sector’s changing requirements. “Companies are changing and increasingly need ratings advice, so we now offer a ratings questionnaire via our secure internet site, which will provide a rating free of charge.

Growth areas

Mezzanine loans – flexible financing instruments between balance sheet equity and debt capital – are seen as one of the most promising areas of growth in German corporate banking. Over the past two years, nearly 400 mittelstand companies have taken up more than €2.6bn in mezzanine capital in continental Europe. Mr Müller says that Commerzbank is offering it to clients as a means of dealing with the succession issues of the mittelstand sector. “It means that equity is not automatically an issue when the head of a family firm wishes to retire and succession is undecided,” he says.

If it is difficult to build market share in the German retail and corporate sector, Commerzbank has a leading position in German trade finance. “We have about 16% market share in the clearing of German trade payments,” says Mr Müller.

Dresdner Bank, too, seems to be undergoing something of a renaissance. Last year’s figures revealed that earnings had more than doubled, income was up by 13%, costs were down by 2% and return on risk-adjusted capital had risen to 15.6%.

The bank has reorganised itself into two divisions, putting private and (smaller) corporate clients into one, and the bigger corporate clients into the investment bank. The bank says this will more clearly define client groups according to their needs and ensure that all the staff serving corporate and investment banking clients have the same incentives.

Pro-forma figures, adjusted to reflect the two divisions, show that income in the private and corporate sector is up by €169m, and up by €491m in the investment bank.

On the retail side, the bankcassurance model finally seems to be gaining a little traction. In 2006, Dresdner acquired 330,000 new customers through Allianz, and altogether it has acquired 750,000 customers via its parent insurer. This year, the bank aims to welcome the one-millionth customer acquired in this way, which will mean a 5% gain of Allianz’s customers.

There is also a pilot project of 100 banking insurance agencies that have a full-time member of bank staff and that offer a banking presence. If the model works well, spokespeople say the aim is to open about 1000 banking agencies in Germany.

AHBR’S TURNAROUND: RESTRUCTURING IN ACTION

Was this article helpful?

Thank you for your feedback!