German Banks - Tough Times

By Scott B. MacDonald

German banks are an important part of the international financial system. They are critical to the European economy and have been a relatively sound investment in the past. The relative safety of investing in German banks, however, is over. The sector is grappling with difficult structural problems, ratings are under pressure and spreads are generally wider. We expect things to get worse before they get better. HVB Group, Dresdner Bank, and Commerzbank will remain challenged into 2003. Deutsche Bank is in comparatively better shape, but even Germany’s largest private sector bank faces a difficult business environment, especially as the global securities industry has yet to recover. Although we do not expect any of the country’s major banks to fail, we have concerns the sector will end up muddling through the next few years, badly in need of structural reform and growing less competitive with other European and international institutions.

In late October 2002, chairman of the supervisory board of Deutsche Bank and president of the German banking association, Rolf E. Breuer, denied his country’s banks were in a crisis. He stated “’Banking crises’ is a very risky expression, because usually people think of 1929. We’re not talking about a liquidity problem. We’re not talking about a credit crunch. What we are talking about is a lack of profitability.” While Mr. Breuer is correct that profitability is a major problem facing German banks, the crisis aspect of the matter can be debated. The situation facing German banks is challenging. The German economy remains troubled, corporate bankruptcies are on the rise, and investors are clearly worried. HVB Group, one of the country’s major banks, recently sought to issue bonds in the U.S. market, but finally balked at the pricing – equal to where many high yield bonds trade. In addition, the equity shares of another of the country’s largest banks, Commerzbank, plunged in October to their lowest level since 1996 in October. At the same time, the rating agencies, Moody’s and Standard & Poor’s have downgraded the credit ratings of most major German banks. If not a crisis, it certainly feels like one.

The worrisome thing is that banking conditions in Germany are set to deteriorate further before they get better. On October 22, regional head of corporate clients at Commerzbank, Berkhard Leffers, stated: “We haven’t seen the worst yet; insolvencies and risk provisions are likely to keep rising in 2003.” To this he added that the outlook for an economic recovery in the world’s third largest economy is “very pessimistic.” Indeed, German banks have suffered as a loss of investor confidence due to the increasing risk of deflation, low capital levels, weak core earnings and concerns over the impact of declining equity markets. Real GDP growth is now expected to be around 0.4% for 2002 and a little over 1% in 2003. This is hardly the robust momentum needed to pull the German corporate sector from its doldrums.

The root of the problem for German banking is structural – the vast majority of banks are not in business so much to make a profit, but as to provide credit. The country has over 500 Sparkassen (savings banks), which are largely owned by municipalities and the 12 Landesbanken, regional banks owned by state governments and savings banks associations. Together these institutions, along with a number of other smaller lending institutions, account for 39% of domestic retail and corporate deposits and 35% of bank lending. In contrast, the country’s Big Four – Deutsche Bank, HVB Group, Dresdner Bank and Commerzbank – account for only 14% of deposits and 15% of loans. While the public sector banks benefit from state guarantees, which helps them to contain borrowing costs and lending rates, the Big Four have no such support and consequently see their profitability squeezed.

In addition to the public sector vs. private sector mismatch, German banks are not the most cost-efficient, leaving them with bloated operating costs. There are also too many of them. Germany possesses some 2,700 lending institutions. It also has 42,350 branches -- more than any other major industrialized country except Belgium.

Germany’s private bankers increasingly see the need for change. Commerzbank’s CEO Klaus-Peter Mueller said during a conference in London in early December that he would welcome domestic bank consolidation. The statement fueled investor speculation that the troubled bank may partner up sooner rather than later. The bank is currently in the process of eliminating more than 6,000 jobs to cut costs and boost returns. Commerzbank reported a 3Q02 loss of €129 million.

Pressure is also coming from the European Union and the Basel Committee, a body of major economies that functions as a guide to international bank regulation. Although Germany’s public sector banks are being pushed to reform and are phasing out a number of the state supports, including the guarantees, this is a multi-year process. There is no quick leveling of the playing field.

The danger going forward is that what is required to turn German banking around is likely to take several years and is greatly complicated by domestic politics. Change means consolidation, introducing greater cost-efficiency and trimming personnel. It means charging off a growing pool of bad loans. Consolidation also means vertical integration between the Sparkassen and Landesbanken. Politicians from various regions do not wish to surrender their banks, many of which make critical loans to struggling corporations. With unemployment at 10%, pulling critical credit lines can lead to greater joblessness. This is something that does not win elections for those already in office. Moreover, the closing of bank branches would only add to the ranks of the unemployed.

Is Germany becoming Japan, where many banks are close to or are already insolvent and kept alive by injections of public money and the forbearance of bank regulators? Although deflation is emerging as a major concern and there is a closer relationship between the private and public sector than with Anglo-American economies, Germany is not yet Japan. But, the preconditions are there, including a slowness to act, political resistance from elements of the ruling elite, eroding loan portfolios and steep declines in the value of stockholdings. All this points to the risk of a self-fulfilling prophecy, in which the fears of a crisis grow with the slowness of response and bank counterparties begin the add costs to doing business with what they regard as troubled institutions. This, in turn, raises obstacles to accessing international capital markets, which may need to be tapped to top off capital adequacy ratios.

We return to Mr. Breuer’s denial of a crisis. It is fair to state that German banking is not in a crisis – along the lines of 1929. Support from the German government should prevent that, while pressure from the European Union helps push reform. However, until local political support for the public banks is curtailed and reforms are pushed in a more meaningful fashion, there is a risk that German banks will head into a crisis. If the banking system of the world’s third largest economy slips into a crisis, it would be only one more force pulling the global economy toward a potentially lengthy recession. In contrast, a German banking system on the mend would have much to offer in helping drive the European economy and reducing the current heavy dependence on the U.S. economy as the sole engine for global .