The state-owned Banque et Caisse d'Epargne de l'Etat may be performing well, but Luxembourg operations of Fortis and Dexia have encountered problems as the knock-on effect of the recession in powerful neighbouring economies takes its toll on one of the world's smallest countries. Writer Nick Kochan

There is a cruel irony about Luxembourg banking. However well it does, in the hardest of economic conditions, it is not large enough to create a private sector bank capable of competing with the largest European banks. The country has no less than 154 banks, but the great majority are subsidiaries of other European banks. The country's financial institutions are highly vulnerable to the machinations that take place in Paris, Brussels, Amsterdam and Frankfurt.

The small may be virtuous, even rich, but they will never be powerful. That is the lesson of recent events in Paris, where European giant BNP Paribas is on the verge of snapping up Fortis Luxembourg, the subsidiary of Fortis Belgium, of which the Belgian government owns 100%. Fortis Luxembourg, which is now owned 49% by the Luxembourg government following the bail-out, has understandably sought to distance itself from the failure of its parent by reverting to its former name Banque General de Luxembourg (BGL).

Subject to the outcome of a Fortis shareholder meeting in late April, BNP will acquire 75% of the newly acquired Fortis Belgium, with the Belgium government retaining 25%. The government of Luxembourg will retain a 33% 'blocking' stake in the BGL operation, with the remainder held by BNP Paribas through the Belgian bank. The new structures will be formally implemented in late April.

Staying strong

Luxembourg's other major private banking player, Dexia, has escaped the humiliation of a state bailout. The Luxembourg operation, which accounts for between 20% and 30% of the turnover of the total group, required a government guarantee in October 2008, but the bank's more cautious management has seen it through the turbulence, says Dexia Luxembourg spokesman Tom Anen.

"The situation for Dexia is totally different to that of Fortis. The only help we have had from the Luxembourg government is that it is willing to guarantee our investment. It has said, 'OK, you people need a guarantee so I, the state of Luxembourg, give you my signature, so the funds are guaranteed by us.' The problem did not come from the Luxembourg part but we are a group and we have to have a group solution. This group answers to three governments - the Belgian, the French and the Luxembourg governments. So it was clear that the Luxembourg government had to participate as well. The whole deal was more about politics than business," says Mr Anen.

In addition to giving a guarantee, the Luxembourg government spent €400m on acquiring preference shares in Dexia Luxembourg. Mr Anen says that government may convert these into ordinary shares in two or three years.

Safe haven

In the meantime, Luxembourg's state-owned bank, Banque et Caisse d'Epargne de l'Etat (BCEE), is performing well. One local banker says: "Fortis and Dexia have each lost some of their local customers to BCEE, [which is] regarded as a safe haven in a storm." A spokesperson for Landesbank Baden Wurtemberg, a substantial player in Luxembourg with a presence in asset management, says: "There are still some clients moving away from Fortis and going to other banks, but what's the alternative? The only alternative is the BCEE, which is owned by the state. Fortis and Dexia are solid banks - they got into trouble but now they are solid." BCEE has a strong retail base, with 75 branches and a reputation for customer loyalty. It is the only bank in Luxembourg with AA+/AA1 ratings.

Local banking authorities accept that confidence in Luxembourg banking, the Duchy's largest contributor to revenues, has taken a major hit. Jean-Jacques Rommes, director of the Association des Banques de Luxembourg (ABBL), says: "It has been a shock for our national pride and confidence to see the state intervening in two big banks. Both are of systemic importance to the Luxembourg economy, so there was absolutely no choice whether the state wanted to intervene or not; it was absolutely clear that the state had no choice."

Luxembourg banks have thrived on asset management and private banking. But the Duchy's bankers say that these have been regarded as useful cashcows by parents in larger economies where banks have a retail presence. Mr Rommes says: "The Luxembourg subsidiaries were quite liquid and solid. But the problem is that their overnight money was with the parent banks, and the parents had tremendous problems with illiquid investments. The crisis has not had an impact on the whole of the financial centre. Banks such as HSBC or Deutsche Bank in Luxembourg have little sentiment about what happens to Fortis, even if it is in this same little country."

Strategy over tactics

BNP's move into the highest echelons of Belgian and Luxembourg banking is a textbook study in the virtue of strategy over tactics, and patience over haste. BNP waited a long time to find the moment to strike at Fortis. It made its move when it saw that Fortis had been fatally wounded by its role in the disastrous takeover by Royal Bank of Scotland of ABN AMRO. The bank was in no position to resist its advances and succumbed with minimal complaint.

Desired target

A senior banking source who did not wish to be named, says: "They had been eyeing Fortis for quite some time, well before 2008. There had been discussions long before 2008. They had the vision of expanding in Europe but felt that banks were still too expensive. BNP had bought Banco del Lavoro in Italy. Fortis was the next opportunity. It represented more than 2.5 million clients. It is number one in Belgium, it is in the Luxembourg market with its subsidiary. It has a retail network in Turkey. It fitted into the BNP strategy."

The Belgian and Luxembourg governments preferred the solution presented by BNP to a rival made by ING, say observers. Robert Scharfe, a member of the management board of BGL, says: "The BNP solution is extremely attractive because it changes the scope of what we are doing. BNP Paribas is strong in Luxembourg in private banking and extremely strong in the fund industry. The combined entity will make it by far the largest bank in all customer segments. This would create enormous opportunities for our clients."

Retail base

The acquisition should "add a significant base of retail clients, in two countries where we don't have a retail base," says Eric Martin, managing director of BNP Luxembourg. "BNP will become the largest bank in Europe in terms of deposits, with more than €540bn. In terms of asset management and private banking, we become a very large player, in the top five of European asset managers. We become the number one private bank in the eurozone, with more than €600bn assets under management."

While BNP considers the opportunities that lie ahead as it absorbs and integrates the Luxembourg operations of Fortis, relations between the Belgian financial community and those of Luxembourg are at a low ebb. The Luxembourgers point to vacillation by Belgian shareholders who initially accepted the Belgium government's decision to sell Fortis to BNP last October as the sole way out of the crisis. But they subsequently changed their mind and launched a legal action to seek to stop the sale. This has postponed the bank's merger with BNP. A source at the ABBL says: "The Belgian state has not shown itself to be very effective in all this. Belgium has been very chaotic. If you look at the history of Fortis in the past six months, Belgium managed it quite chaotically."

He adds: "The Belgium state took over the bank, then the Belgium state decided to sell the bank to BNP Paribas, but the court ruled that the Belgium state should have asked a general meeting of shareholders before it sold the stake to BNP Paribas. It was then forced to hold that meeting. The shareholders of Fortis said that they did not want to sell it to BNP Paribas."

Rescue effort

The political point is taken up by Fernand Grulms, the chief executive of Luxembourg for Finance. "The Belgium government wants to take the credit for the rescue of Fortis in Belgium and Luxembourg. The contrary is the case. If the Luxembourg government had not intervened, it would never have had the opportunity to save Fortis in Belgium. The financial subsidy actually went from Luxembourg to Belgium and not from Belgium to Luxembourg as it tends to present it," he says.

The Luxembourg subsidiary took the brunt of problems elsewhere in the Fortis group, says Mr Grulms. "There was not really a need to do something in Luxembourg, because this was a very safe bank. The ­problems were with the parent bank, not the subsidiary."

The treatment of depositors in the failed Kaupthing bank in Belgium and in its Luxembourg subsidiary has exacerbated tensions between the two countries and was the subject of a row between the two countries' prime ministers. Mr Rommes says that Belgium sought to capitalise on the countries' different limits in its bank deposit guarantee schemes. "The Belgian government increased the limit from €20,000 to €100,000 retrospectively. It could do this without any problem because it knew that there was no likelihood of further banks going insolvent. The Belgians' response was something to the effect of: 'If you had put your money in the Belgian bank, you would have got €100,000; but as it was a Luxembourg bank, you only get €20,000."

Political strains have been sharpened by the worsening economic picture in Luxembourg. Its banks face a decline in assets under management, which represents about one-third of the country's portfolio. Private banking and fund administration each account for a further third of the total banking market. Luxembourg's assets under management have fallen by 25% during the past year, from €2000bn to €1600bn, says Mr Rommes.

The impact will be felt by shareholders and investors, he adds. "If the fund industry shrinks in importance, it shrinks also in its capacity to produce revenues. Obviously, you cannot make the same absolute amount of commissions on less capital. And if you have less revenue you have difficulties in paying the same profits to your shareholders or your partners."

Consolidation expected

The fund management industry is expected to respond to the downturn with consolidation, according to Mr Grulms. "We expect the restructuring of the fund landscape in the months to come and more competition in the industry. Consolidation would be a normal market reaction. It would be naïve to think the fund landscape will remain exactly as it is," he says.

The private banking sector has also shrunk as a result of falling asset values. The €300bn sector has been hit hard by falling asset values, says Mr Grulms. "Banks who serve private banking clients cannot be happy with their performance. This side of the business has not been helped by some very controversial discussions on so-called 'tax havens'. From our point of view, this argument has lost every rationale. We hear very funny things, such as that Luxembourg is untransparent, unregulated, and it is because of these black holes in the financial industry that the crisis has blown up," he says.

These arguments are perhaps the last thing that Luxembourg needs as it seeks to climb off its knees and regain the composure for which it is famous among its discreet and diminishingly wealthy clientele.


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