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Western EuropeDecember 23 2010

German banks feeling the strain

Rescue packages and a rebounding economy have stabilised the German banking system. But it remains vulnerable to weak profitability, low-quality capital and exposure to cyclical industries abroad. Moreover, some doubt that even the crisis has failed to force structural change. Writer Geraldine Lambe, Research Geraldine Lambe and Guillaume Hingel
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German banks feeling the strain

The German Bundesbank's annual financial stability report in November was a lot more positive than its predecessor. Numerous federal and regional government support packages have worked to stabilise the system, bad banks have cleaned out huge swathes of bad assets from two of the banks worst affected by the crisis, and asset guarantees and liquidity measures have taken the pressure off others. A healthily rebounding German economy and sound domestic asset quality have done some of the rest of the work.

Yet the system remains vulnerable. Half of the top 12 German banks continued to be loss-making in the first half of 2010 and some of the more resilient banks have weak return profiles. German banks are still more leveraged than their European counterparts, their capital is of lower quality, and many have large exposures to cyclical industries and volatile markets abroad.

The German banking system as a whole remains more opaque than many would like. Several of the banks receiving government or state support have not published up-to-date financial stability reports (detailing how they are dealing with restructuring and risk); the Bundesbank says these are "optional". During the Committee of European Banking Supervisors (CEBS) stress test in July, several large German banks would not disclose their sovereign exposure. Officials from Germany's BaFin regulatory authority said the banks were not obliged to fully disclose their exposure under German law.

Of the six landesbanken approached for this feature, only BayernLB agreed to an interview. Commerzbank declined a meeting, and Deutsche Bank did not respond to a request, nor did the Association of German Banks and the Association of Savings Banks.

And the system is stubbornly resistant to structural change. While most agree that the country has too many landesbanken, almost half of which are still receiving government support, consolidation remains elusive. "At the beginning of 2009, the Bundesbank, the finance minister and others said the country had to solve the issue of too many landesbanken; but, nearly two years later, there is an extra landesbank, since SaarLB deconsolidated from BayernLB," says Michael Dawson-Kropf, senior director for financial institutions at ratings agency Fitch in Frankfurt.

According to Moody's recent banking system outlook (BSO), most of the strengths of the German banking system originate from outside the banking sector, and the future is "one of grindingly slow recovery and balance sheet repair, [with] uncertainties never greater".

Exposure to structured products

The system as a whole still holds a lot of structured products. According to the Bundesbank report in November, the relative composition of risk positions has hardly changed since the end of 2009, with roughly €82bn of retail mortgage-backed securities, about €22bn of commercial mortgage-backed securities, about €62bn of collateralised debt obligations, and just under €34bn of securitised student loans. These figures do not include the assets hived off into bad banks from Hypo Real Estate (currently about €191bn) or WestLB (just over €68bn).

The combination of persistent poor profitability and low interest rates has raised concerns that German banks will start taking risks in the search for yield - the strategy that landed them in trouble previously. The central bank report notes that some banks active in the market are "again displaying similar response patterns in proprietary trading". In its survey of 11 banks' commercial real-estate lending, the overall lending volume in the first quarter of 2010 totalled about €25bn, which is roughly 3¼ times these banks' Tier 1 capital. At the time of writing, the Bundesbank had not responded to requests for more detailed information on individual banks, or which banks were included in the commercial real-estate survey.

While the Bundesbank says the revival of market activity appears to be limited to relatively highly rated assets, Moody's suggests that carrying large volumes of assets with a low risk weighting can still be risky in periods when expected losses and recorded losses differ widely - as they did during the crisis - and leaves banks highly leveraged.

"Banks such as HSH Nordbank and NordLB have large shipping portfolios, and many German banks also have large commercial real-estate lending books. Since this type of asset-based financing is collateralised, the regulatory capital requirement is quite low. However, these are highly cyclical industries and we therefore consider that their financing actually requires substantial capital," says Katharina Barten, senior credit officer for financial institutions at Moody's in Frankfurt.

According to Moody's, the German system's absolute capitalisation has risen from 2.5% in 2007 to 3% now, which is still the lowest among Europe's banking systems and leaves it more vulnerable to possible economic shocks than other countries.

System leverage: total equity as percentrage of total assets

Sovereign exposure

There is some uncertainty about Germany's exposure and resilience to other credit risks, including sovereigns. While German banks have historically been perhaps the biggest lenders to other European economies, particularly in southern Europe, the Bundesbank says total exposure to the economies of Greece, Ireland, Italy, Portugal and Spain amounts to only 15.5% of their international exposure.

But, according to Bank for International Settlement figures, Germany has the largest amount of foreign claims on Ireland. German banks' total exposure to Ireland was $138.6bn at the end of June 2010, larger even than that of the UK banks ($131.6bn). It is relatively easy to account for most of the UK exposure by aggregating the Irish loan books of RBS and Lloyds; one cannot do the same for German banks. The figures on Irish exposure could be overstated; CreditSights, an independent research house, thinks so. "It is possible that some, or even much, of the exposure is not Irish risk, but instead represents lending to entities based in Ireland with foreign parents, or to financing vehicles based in Ireland," it said in a recent report.

So far, no German banks have admitted to having substantial Irish exposure; the Bundesbank says German banks' exposure is €25bn.

Seven of the nine German landesbanken participated in the CEBS test alongside Commerzbank and Deutsche Bank; they all passed, although many observers have expressed reservations about the lack of stress in the test. However, six of the 14 German banks tested did not disclose their exposure to sovereign debt, one of the key benchmarks in the exercise. The banks that did not reveal their sovereign debt quotient were Deutsche Bank, Postbank, Landesbank Berlin, Hypo Real Estate (which failed the test) and mutual groups DZ and WGZ. But of the figures that were revealed, the exposure of LBBW and WestLB to peripheral eurozone economies represented more than 90% of their Tier 1 capital. According to a December report from Nomura, entitled 'Performance Drivers: pan-European banks', Commerzbank's exposure to peripherals represents about 225% of its tangible equity.

p78 table 1

Funding dependence
Depending on who one speaks to, funding German banks' asset base (which, after shrinking by 7.2%, to €7400bn, in 2009, grew by 2.9% in the first half of 2010) is considered a point of vulnerability. Savings and co-operative banks together control more than half of all deposits, leaving many banks dependent on wholesale funding.

Although many argue that debt markets are fully open to German banks, their need to refinance about €250bn to €300bn of maturing market funds per year could prove challenging over the coming years. This is particularly true given debt market volatility and Berlin's view that bondholders should be made to share the pain of bank and sovereign rescues in future. German banks have already increased their reliance on short-term funding rather than decreasing it. According to the Bundesbank, the percentage of German institutions' outstanding bank debt securities with a time to maturity of less than a year has risen from a long-term average of 22% to about 30% at the last count.

In its BSO, Moody's states that the recent volatility surrounding peripheral eurozone countries has "added to the woes" of Germany's main public sector finance banks - Deutsche Pfandbriefbank (ex-HRE) and Eurohypo (owned by Commerzbank). "Even before the pressures on some countries' debt arose in the first half of 2010, these two banks during the past two years had limited access to senior unsecured funding and required either government or parental support," says the report.

And even if savings banks and co-operatives were to recycle all their excess liquidity through the landesbanken, it would still not be enough to offer a significant funding boost. Data from the Association of German Savings Banks shows that, in 2009, retail primary deposits held by German savings banks totalled €752bn. The combined balance sheet of WestLB and BayernLB is more than €600bn.

German banks third graph part 2

Capital requirements
Capital also remains a key issue for German banks. In September 2010 the country's banking association said that the country's 10 biggest banks might need €105bn of additional capital under the new Basel regulatory regime; the Bundesbank has since revised that figure down to €50bn. Much of the capital they do have is in the form of hybrids, which the crisis proved to be far less loss-absorbing than Tier 1 should be. For the large international banks and many landesbanken, the percentage of hybrids in their Tier 1 ranges from about 30% to 73%. This is partly a result of historically weak profitability - as hybrid instruments have helped banks to report more adequate returns on equity - but the capital injected during the crisis at both federal and regional level has only further increased German banks' reliance on such instruments.

Furthermore, support from asset-protection schemes - so-called risk shields - has also reduced banks' economic capitalisation; while these gave banks regulatory capital relief, much of the economic risk remains with the banks, based on their first loss tranches, including HSH Nordbank (with a risk shield on €10bn of assets), LBBW (risk shield of €12.7bn) and BayernLB (risk shield of €4.8bn).

While German banks have been given until the end of 2018 to replace hybrid capital, some question the ability of certain banks to do so. It is hoped that much of it could come from retained earnings, but with more write-downs expected on some portfolios, and many billions of euros of future earnings earmarked for payouts to support-providers, retaining sufficient earnings could be difficult.

For many, access to the equity capital markets is limited. Until a law passing through parliament is finalised, for example, Commerzbank is not allowed to issue more equity. With a low-return environment, further write-downs expected from securitised portfolios and other assets, amid what is already a difficult market for bank stocks, many bankers believe that for Germany's most troubled banks, equity market appetite will remain muted.

One-quarter to one-third of German banks' capital reserves come in the hybrid form of 'silent participation': non-voting capital that does not absorb losses as long as a bank is still in business. Most of banks' silent participations are state funds, provided as part of ownership agreements for publicly owned banks, or as bailouts during the crisis.

According to analysts, some landesbanken have suggested that these silent participations could be converted into common equity, which would require a change in ownership structures. Berlin has also indicated to the Basel Committee that it is willing in principle to accept changes to the design of silent participation - such as allowing it to be impacted by losses in the same way as core equity, or cancelling coupons in the case of loss instead of postponing them, as happens currently.

To keep the proposed Basel III regulations on track, the committee has agreed to an extended transition period to replace silent participation - by the end of 2018 instead of 2012. Not all German bankers believe this will be long enough. Karl-Heinz Boos, executive managing director of the Association of German Public Sector Banks, for example, is on record as saying that this would take until 2040.

Shrink or sell
The other option is to shrink balance sheets to comply with Basel III. Munich's BayernLB has gone some way towards downsizing. Management moved the asset-backed security portfolio and non-core business such as ship financing into an on-balance-sheet risk unit to be wound down, and made immediate plans to reduce risk-weighted assets of €170bn by €90bn; chief financial officer Stefan Ermisch says it has already achieved 70% of that target.

"The bank was too big; the non-core business diluted the balance sheet and the business model," says Mr Ermisch, who joined BayernLB at the height of the crisis.

Other banks are being forced to shrink to comply with European Commission (EC) state aid rules. Under their restructuring plans, HSH, LBBW and WestLB need to reduce total assets by up to 50%. WestLB has transferred €77bn of high-risk and non-strategic assets to a run-off institution, Erste Abwicklungsanstalt (EAA), but still needs to shrink further. According to data from investment bank Execution Noble, Commerzbank's portfolio restructuring unit has a structured credit portfolio of €23.7bn, more than three times its tangible book value. Add in HRE's €191bn bad bank, and LBBW's €17.3bn Sealink portfolio (covered by first- and second-loss guarantees from the Free State of Saxony and the State of Baden-Württemberg) and there is a huge amount of troubled securities and non-core assets to be disposed of. According to the latest data available, the EAA has only been able to unwind about €6bn of WestLB's original €77bn portfolio. The Bundesbank says that the system-wide reduction has so far largely been achieved through maturities, amortisations and redemptions. The question remains: how far and how quickly can more significant downsizing be achieved?

"Shrinking assets by letting higher-risk, long-term lending portfolios run off, or waiting for asset values to improve, can be a long and painful process. Historically, it has often taken eight to 10 years to fully clean up balance sheets from non-performing real-estate portfolios after particularly harsh downturns," says Moody's Ms Barten. This is supported by FMS, the wind-down vehicle for HRE, which has a 10-year plan.

In terms of the assets identified by banks as 'non-strategic' and that they would like to sell, in common with other banking systems, it is a question of who will buy them. Commerzbank, for example, must get rid of Eurohypo before the end of 2014 - but, in the near term, who will buy a business that is still making losses, has a significant portfolio of non-performing international real-estate, and against which Commerzbank has suggested it will take an impairment charge of about €1bn in coming months?

Moreover, traditional buyers of distressed assets, such as private equity firms, seem less enthusiastic about Germany's financial sector than they used to. According to reports in the Financial Times and Reuters, Lone Star is looking for an early exit from IKB, the troubled lender it bought from German development bank KfW in the early stages of the crisis. Since IKB has not been returned to full health, many have been surprised by the suggestion of Lone Star's early exit. Meanwhile, nine trusts advised by JC Flowers have steadily reduced their holdings in HSH over the past year.

Changes in ownership

Ownership change?
However successfully German banks shrink assets or increase quality capital, the long-term health of the German wholesale banking sector depends on consolidation. Nobody believes that the German corporate sector - no matter how vibrant its mittelstand (small and medium-sized enterprises) - can sustain so many landesbanken, and without a change in German law to allow landesbanken to own savings banks or co-operatives, this is the main area of business most of them are left with.

But consolidation remains stymied by either a lack of suitable buyers and partners, or a lack of political will. Berlin may want the number of landesbanken reduced, but some regional state owners remain stubbornly welded to them as a tool of regional development policy. Landesbank Hessen-Thuringen, for example, has strong support from the State of Hessen, and a rescue package was put together very quickly for LBBW by most of its owners.

But not all landesbanken now benefit from such cosy relationships; in the wake of the huge bailout costs to regional owners and some savings banks, more owners than ever before are inclined to be rid of their local landesbanken. As politicians in less prosperous regions look to cut spending on services and infrastructure, they have come under increasing pressure from voters over continued support for landesbanken. Similarly, some savings banks - none of which required help during the crisis - have baulked at the support they have been forced to give.

The Bavarian Savings Bank Association, as well as the savings banks associations of Schleswig-Holstein, Rhineland-Palatinate, Westphalia-Lippe and the Rhineland, have reduced their stakes in their local landesbanken; some by simply not subscribing to recapitalisations. In November 2009, the prime minister of Schleswig-Holstein announced that no more support would be available from that state for HSH, and that the state intended to privatise the bank. And when WestLB had to raise new capital from the government bailout entity SoFFin in December 2009, many regarded it as a sign that no more help was forthcoming from its owners.

So the question remains about what to do with the landesbanken? Horizontal consolidation is not a panacea. Mergers of banks with 'winning' models (such as those which are closer to their savings banks, for instance Helaba) are more likely to succeed than those between banks that suffered badly in the crisis (such as WestLB and HSH Nordbank). While few believed the proposed merger between WestLB and BayernLB would ever happen, at the same time nobody thought that it would end the problems of a combined bank. Despite BayernLB's ownership of retail-focused DKB, many argue that a tie-up with WestLB would simply have created a much bigger bank with more troubled assets, which still had funding constraints and an unsustainable business model. BayernLB's Mr Ermisch says the board will assess all opportunities. "We will do anything that makes economic sense; we will do nothing that does not make economic sense," he says.

The impending restructuring law and insolvency legislation could help to force change - for banks as well as bondholders. For one thing, they offer legal rights to intervene and break up banks. "Until now, the German authorities have not been allowed to close down a landesbank, no matter what condition it was in," says Achim Dübel, the founder of Finpolconsult, a Berlin-based independent advisor on the German finance and real-estate sector.

Others hope the EC will be able to exert the pressure that Berlin does not seem able to. To comply with European rules, WestLB must change its ownership structure (be sold or merged with another bank) or be wound down, while Commerzbank must sell Eurohypo. The rescue packages of BayernLB, HSH and WestLB have still to be approved by the EC. "WestLB could turn out to be a 'sample' case and lead to further action," says Mr Dübel.

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