A EUROMONEY SURVEY – MARCH 1996
“If you look at German newspapers,” says Tim von Halle, managing director of fixed-income sales and trading at West Merchant Bank (the investment banking arm of Westdeutsche Landesbank), “it is clear that at least 60% of Germans don’t believe European economic and monetary union (EMU) will happen by 1999.”
Analysts and investors increasingly appear to agree, galvanized by German finance minister Theo Waigel’s recent admission that even Germany is behind schedule in meeting the Maastricht currency-convergence criteria. The admission prompted one German banker to remark – only half in jest – that aside from Luxembourg, the economies best equipped to meet the criteria by 1999 are Argentina and New Zealand.
Several banks are beginning to discount a delay in currency convergence. For example, Banque Paribas Capital Markets reported in January “we believe that some degree of flexibility is desirable in applying the Maastricht criteria but it currently looks as though a good deal more than mere flexibility is needed to get EMU off the ground by the target date of 1999. Our view is therefore that EMU is most likely to be delayed because 1999 is simply unrealistic as a starting date, unless the financial underpinnings of EMU are to be discarded or a political deal between France and Germany overrides the Maastricht criteria.”
Neither of these eventualities seems probable: flexibility is unlikely to appeal to a Bundesbank already sceptical of the long-term soundness of the proposed new currency, the Euro, while a behind-closed-doors “deal” between France and Germany on, perhaps, a mini-Euro, is unlikely to endear either country to those EU governments which have battled to implement austere and domestically unpopular convergence plans.
Whether players in the German bond market were already factoring in the possibility of EMU delay last year is open to debate. Through the year, the steepening of Germany’s yield curve, in which the spread between two-year and 10-year Bunds climbed from 112 basis points (bp) to around 270bp by the end of December, was attributed to worries about the long-term security of the Euro. “What we saw last year,” says Mary Bloem, European bond analyst at Banque Paribas in London, “was a substantial flow of German assets into short-dated German paper and into Switzerland because of [investor] concerns that if they were long-term holders of German Bunds they would be paid in Euros.”
Bloem points to several other factors militating last year against concentration at the longer end of the curve – above all, the short-term prospects for further Bundesbank easing of interest rates and the scope for continued Deutschmark strength.
At Merrill Lynch in Frankfurt, vice-president Manfred Ludwig believes, however, that investors are already dismissing the possibility of convergence by 1999. “The story last year was a risk premium at the long end of the curve and demand concentrated in maturities up to five years,” he says. “Now that seems to be receding. A lot of investors were of short duration and now we’re seeing many of them move along the yield curve.”
The proof, according to many Frankfurt syndicate managers, was in the demand – local and international – for Deutschmark issues stretching along the curve. Although this has been dampened somewhat by the recent fall-off. While sovereigns such as Sweden and Finland issued at five and seven years respectively, Austria opted for a 10-year maturity – an important breakthrough, given that it was the first good-sized 10-year Deutschmark issue since July.
Demand for the issue (especially from east Asian accounts), encouraged the deal’s lead manager, Dresdner Bank, to increase it to Dm2 billion from Dm1.5 billion. Austria, which reportedly was keen to test an even longer maturity of 12 years, was then followed into the 10-year sector by a cluster of other borrowers, including domestics such as L-Bank (a Dm1 billion global issue) and Landesbank Hessen-Thüringen (Helaba). However, the recent market downturn has restrained issuance since late February.
Underlying demand for longer-dated paper is not just a reflection of diminishing concerns about the Euro, or of over-supply of five-year paper. At DG Bank in Frankfurt, fixed-income director Willi Ufer suggests that many domestic investors, shell-shocked after 1994’s upheavals, missed out on much of last year’s rally and are now becoming increasingly edgy about their performance records. “The long end of the curve is falling as domestic investors become worried about their performance requirements,” he says. “They are beginning to realize that every day they stay in the money markets they’re losing money.” Much the same argument could be made for emerging-market Deutschmark issues, which have flooded the market in early 1996. Frankfurt-based bankers point out that strong demand for Latin American issues, in particular, has been driven by yield-hungry German and Swiss retail accounts rather than by domestic insurance companies.
Booming investor demand for an expanding range of maturities and credit risks is one reason why bond market professionals in Frankfurt are in euphoric mood. They appear almost uniform in their belief that all fundamental indicators point towards an extension of the bull market in German bonds (once the market rebounds), through at least the first half of 1996. With German unemployment pushing past the four-million mark, and with Deutsche Bank, for one, putting the chances of a German recession in 1996 at 30%, analysts appear to agree that concerns about inflation (for once) are taking a back seat to fears about joblessness. This leaves the way open for further interest-rate easing [as yet initiated] by the Bundesbank.
As recent research published by Deutsche Morgan Grenfell notes: “Economic growth has recently come to a standstill, so that the Bundesbank’s latest rate cut (in mid-December) now looks more than justified. With the discount rate at 3%, there is for the moment plenty of room to let money-market rates fall further. Should the economy worsen sharply, however, we would expect the discount rate to be cut to the historical low of 2.5%.” For those contemplating the short-term outlook for German bonds, the Deutsche report adds: “We do not expect a definitive turnaround in monetary policy – an increase in interest rates – until the first quarter of 1997 at the earliest.”
Indicators aside, there are plenty of other reasons for the positive outlook. Above all, market players point to a surge in the globalization of the Deutschmark sector in 1995. “The trend towards internationalization is sweeping,” says von Halle at West Merchant Bank. “One of the driving forces behind the market’s growth last year was a fundamental reallocation of assets by Asian investors, especially central banks, and their acceptance of the Deutschmark as a reserve currency.”
Roman Schmidt, first vice-president of debt capital markets syndication at Deutsche Bank in Frankfurt, agrees. “One thing that has become clear over the last 12 to 18 months is that most of the world’s major institutional investors are seeing the global capital markets being split up into dollars, yen and Deutschmarks,” he says. “Whereas two or three years ago they tended to buy the convergence story, which meant guilder or French franc bonds, they are now concentrating on the Deutschmark because it will form the major base for any Euro-currency we see in the future.”
Frankfurt-based syndicate managers say it is not just the currency which is making the Deutschmark the medium of choice for a growing range of issuers and investors. The product line, too, is increasingly being tailored towards international institutional investors. Two examples of this last year were the World Bank’s Dm3 billion seven-year issue and a Dm1.5 billion issue by the European Investment Bank (EIB). The EIB broke with tradition by opting for a negotiated price mechanism rather than a competitive bidding structure, which was interpreted as testimony to the expanding maturity of the Deutschmark market.
The breakthrough towards genuine internationalization of the Deutschmark market came in 1995 and early 1996 in the form of the new jumbo Pfandbrief issues. These are defined as bonds of Dm500 million or more which are issued through a syndicate whose members undertake to maintain a secondary market on a bid/offer spread of five or 10 pfennigs. Finally, a traditionally illiquid domestic instrument gained some semblance of international flavour, with foreign banks – led initially by UBS – stepping in for the first time as lead managers of Pfandbrief issues.
Further internationalization of the Pfandbrief market came in January this year through the launch of Bayerische Vereinsbank’s 10-year $1.5 billion issue. The deal was groundbreaking for a number of reasons. First, it was led by a quartet of German and international banks, with Bayerische itself joining forces with Commerzbank, Merrill Lynch and UBS to place the issue. Second, as Merrill’s Ludwig notes, “it was really the first of the jumbo issues to have been explicitly targeted at foreign investors and to have been structured around Asian demand. We announced the launch to coincide with the market’s opening in Asia and priced it on a spread basis as we would with Euros.” As a result, thinks Ludwig, about 40% of the issue was placed outside Germany.
The Vereinsbank issue was followed quickly by the first-ever “global” Pfandbrief, a Dm2 billion issue for Depfa led by Commerzbank, Morgan Stanley and UBS. Again, this issue took the structure of the market a few steps further. First, it was preceded by the issuer securing a triple-A rating from Moody’s, without which the issue would have found few takers in the US. Second, the fees were set at Euromarket levels, rather than being based on the traditional five- or 10-pfenning bid/offer spread.
To Peter Schwicht, managing director at JP Morgan in Frankfurt, these recent developments herald an ultimate convergence between the Pfandbrief and the Eurodeutschmark sectors. Indeed, the placement of the Depfa global issue – 35% in the US, 30% in Europe and 25% in Asia – coupled with its spread-based pricing, Euromarket fees and international bookrunning consortium suggests that the distinction between the two products is already so fine as to be irrelevant.
There are a number of other pointers towards the growing internationalization of the Deutschmark capital market. It is not just the Pfandbrief issuers, for example, who are turning to the international market in search of fresh funding. Leonhard Fischer, head of treasury and trading at Dresdner Bank in Frankfurt, notes that “we are tapping international markets like never before. We launched the first $1 billion yankee issue and our first medium term note (MTN) issue. It is concrete internationalization and it is happening throughout the German borrowing sector. But to capitalize on the goal of internationalization, it is essential to develop the Finanzplatz Frankfurt; not just in the interest of the banks but for others as well.”
Above all, internationalization of the Deutschmark capital market is evident in the expanding influence, involvement and acceptance of foreign banks as German borrowers increasingly seek to gain access to international funding, be it via listings on the New York Stock Exchange, yankee issues or syndicated loans. Witness last year’s unprecedented decision by Siemens to appoint JP Morgan as the sole arranger of its $2 billion facility.
Yet international banks do not need to have been in Frankfurt long term to win an increasing chunk of Deutschmark-denominated business. European banks such as BZW and ABN Amro have been winning substantial mandates unimaginable five years ago. As Yann Gindre, head of origination at BZW in London, says: “To be an originator in a non-German bank used to be a very tough job, both because borrowers weren’t issuing that much and because the market was so well-controlled by the German banks. Now, non-Germans can win business.”
Frankfurt’s market players believe that one central theme in 1996 will be the increasing international exposure of the Pfandbrief. Many also expect that there will be further diversification in the Deutschmark fixed-income product range. Asset-backed finance is one potential growth area. After a lull following last year’s Rheinhyp Dm380 million GEMs (German mortgage securities) issue the sector has begun to come to life. In January this year, Deutsche Bank announced the launch of Germany’s first public asset-backed financing in a Dm500 million issue for Volkswagen. Additionally, one US banker in Frankfurt reports that his institution is putting the finishing touches to a similar securitization on behalf of a German corporate client.
Another area which is ripe for development, say Frankfurt bankers, is the broader range of structured deals. “Because of the low interest-rate outlook we’re seeing very strong demand now for yield enhancement,” says DG Bank’s Ufer. “In the first wave of structured deals we saw a lot of naive products. The second wave is going to be much more sophisticated and driven in part by a big merger phase on the asset-management side.”
Despite the progress of the past year, concerns remain about the long-term competitiveness of the Deutschmark product range and, by association, about Frankfurt’s future as a financial centre. “Clearly there are still deficiencies at the long and short ends of the curve,” says Voigt, “and if you focus on the future and on the eventual introduction of the single currency, then these are deficiencies which will not favour the development of Frankfurt as a financial centre.” Tentative attempts have been made to extend the yield curve, both by the central authorities and by private borrowers, but the government’s 1994 introduction of a 30-year bond suffered, say bankers, from woeful timing. Meanwhile, Germany’s commercial paper (CP) market is brutally condemned by one US banker in Frankfurt as a “joke”.
“Investors, particularly money-market funds, are crying out for three- to six-month paper,” says another Frankfurt banker, “but the Bundesbank still prevents 98% of non-German borrowers from issuing Deutschmarks with a maturity of less than two years.” Nor, since the axing of the Bulis market (Bundesbank issuance) for three-, six- and nine-month government paper in September 1994, have there been any government benchmark issues at the short end of the curve. “The whole market was fuelled by the Treuhand [the German privatization agency],” says the same banker, “and when that ceased to exist the government refused to step in by offering short-term government or quasi-government paper. Another key problem with the CP market was the disaster at Metallgesellschaft, which was a very active CP issuer. So we had two major setbacks from which the market never really recovered.”
Another familiar gripe about Frankfurt and its future competitiveness is the Bundesbank’s dogged maintenance of minimum reserve requirements, which have stunted the development of a repo market and encouraged the main German banks to establish repo desks in London. Some Frankfurt bankers draw a measure of consolation from the Bundesbank’s cuts in reserve requirements in 1993, 1994 and 1995, although as Salomon Brothers pointed out shortly after the latest cut, it would be premature to see these as a precursor to the abandonment reserve requirements.
The extent to which the deficiencies in the structure of the German capital market will jeopardize Frankfurt’s potential as a financial centre in the new Europe is unclear. Equally unclear, say Frankfurt-based bankers, is where genuine responsibility for Frankfurt’s long-term development lies. It is easy to blame the Bundesbank for an ultra-conservative stance induced by paranoia over inflation for failing to support the evolution of the capital market. But Dresdner’s treasury and trading chief Fischer, who was formerly in charge of capital markets at JP Morgan in Frankfurt, cautions against misjudging the fundamental mandate of the Bundesbank: “We need to make it absolutely clear that it is not the job of the ministry of finance, the Bundesbank or even the banks to think about the Finanzplatz as the main priority. The Bundesbank’s priority is to secure the stability of the Deutschmark. The finance ministry’s priority is to ensure that it can borrow as competitively as possible and the banks’ priority is to ensure that they make a return on equity for their shareholders.”
Against this background, things are changing, says Fischer. A few years ago, he suggests, observers outside Germany could justifiably have accused the local mortgage-bank fraternity of complacency, given the ease with which the banks could sell their bonds in the domestic market. The enthusiasm with which they are now promoting their issues overseas represents a sea-change in the mortgage banks’ mentality, and Fischer believes it is little more than a matter of time before Germany’s biggest issuer – the government – follows suit.
“Germany has to ensure that in 10 years’ time it will still be able to issue debt as easily as it has in the past regardless of what happens with EMU,” he says. “We’re already seeing important changes and that’s why I believe Germany is going to be a fascinating capital market over the next decade. And if that helps the Finanzplatz, fine.”
A historical shift or just a hangover?
The rise and fall of the Eurodeutschmark bond sector threatens to upset the system. Too much of this year’s new-issue volume could be leftover. It may mean a bad headache – or just temporary indigestion, as Rupert Gordon-Walker reports
Is the Deutschmark bond market heading for a hangover? Between Janaury and mid-February the market was asked to absorb one-third of the total registered in the whole of 1995. Eurodeutschmark offerings in January reached Dm26 billion (compared to a monthly average in 1995 of Dm7.14 billion) – almost 34% of total new Eurobond deals, compared with 27% for Eurodollar issues. But for years dollar-denominated bonds have taken a market share of between 30% and 40%. Unless this is a historical shift, the Deutschmark sector is on the verge of over-indulging, as the late February fall-off demonstrates.
“It is not sustainable,” says Roman Schmidt, director of syndications at Deutsche Morgan Grenfell in Frankfurt. “Investors are full and many are offside, several deals are probably unsold and even retail investors have realized that some of the new issues were not cheap.”
Issuers have been taking advantage of two yield-curve features. First, strong performance in the underlying government market (the recent fall-off aside) has encouraged domestic borrowers to lock into 10-year funding at under 6%. When the Bund futures contract reached the 100.5-101 range, syndicate chiefs contacted bank and corporate treasurers – another offering then hit the screens. In January more than Dm5.5 billion was raised below this resistance level.
The second factor is a technical anomaly at the five-year part of the curve which means that the interest-rate-swap window has been open since the beginning of 1995. There are two theories for the cause of this opportunity, although they seem to be two aspects of the same phenomenon, viewed from different perspectives. According to Amr Mounib, senior vice-president and head of Eurobond trading at ABN-Amro in Amsterdam, strong demand for five-year Bobls has made them expensive compared to the futures contract. All the deliverable bonds, numbers 106, 110 and the benchmark 116, are “special” in the repo market. Uncertainty as to whether economic and monetary union will be achieved in Europe on target, has in turn led to “safe-haven” status for the Deutschmark, and has prompted massive central bank buying of five-year Bobls. This has depressed yields at a key point on an otherwise steep yield curve.
But as Deutsche Morgan Grenfell’s Schmidt points out, there is no real five-year Bobl. The benchmark 116, against which new Eurobonds are priced, matures in August 2000, so “five-year deals are being measured against a four-and-a-half-year Bobl”. An outstanding 8.5% Bund with a redemption date in February 2001 might be a better reference bond, but market convention dictates that the benchmark is the latest Bobl. This is convenient for issuers because the high-coupon Bund yields about 35 basis points [bp] (0.35%) more than number 116. Nor is the distortion about to end. The latest offering from the ministry of finance, number 117, will have an October 2000 redemption date.
Smart investors now seem aware of the anomaly and will be more selective, says a syndicate head at a US bank. However, to suggest that investors have recognized the illusion for what it is, seems disingenuous. Institutions do know that yield spreads quoted on offerings by enthusiastic salesmen are not quite what they seem. The swap window has opened for issuers but lenders have been content to buy Deutschmarks, usually unhedged. German retail buyers want yield and have gotten it – valuing spread differentials is always an art rather than a science. A rising market meant that it was impossible for long-term holders to lose, and a constant supply of different credits has given investors switching alternatives. Others are likely to follow the flow, once the fall-off has eased. A fund manager at a leading uk institution says: “We were happy to buy becasue we knew there was strong retail demand throughout continental Europe.”
Low interest rates have also been inducing even more European retail bond buying than usual. And the background of a weaker yen and low domestic yields has also sent Japanese investors overseas into 10-year Eurodeutschmarks and emerging Latin sovereigns (offering exotic rates) which have been able to raise funds 60bp-70bp cheaper than in US dollars. Asian central banks have filled their vaults with five-year paper, hoping for short-term trading profits. Value measured by yield differentials against the government curve has been less important than the returns gained from falling interest rates and Deutschmark appreciation.
But in February the market staggered. “The Dm2.5 billion 10-year deal for KFW [Kreditanstalt fur Wiederaufbau] at the end of January was too big and led to a falling market and widening spreads,” says Mounib. This continued into late February, with the market contracting sharply.
According to Schmidt at Deutsche Morgan Grenfell around half of this year’s new issues are still on lead-managers’ books, although the percentage varies according to sector. About 30%-40% of recent triple-A sovereign paper probably is in firm hands, high-yielding Latin American issues for first-tier names such as Mexico and Argentina have also been placed, but bank and corporate financing vehicles are struggling to find homes for more than 40%-50% of their issues.
The top three German banks, Deutsche, Commerzbank and Dresdner continued to dominate primary issuance, leading between them one-third of deals last year. Morgan Stanley and CS First Boston led the overseas challenge, and ABN-Amro Hoare Govett, with 15 deals worth almost Dm4 billion, made an impact.
But Eurobond issuers also face competition from the growing Pfandbriefe borrowing programme, which has raised more than $18 billion to date. The public-sector secured bonds (Offentliche) are rated triple-A by Moody’s and the mortgage bonds (Hypotheken) issued by Depfa, the public-sector lending institution, are rated one notch lower. Increasingly, issues are being targeted at international investors.
Yet a saturated market incites innovation. On February 1 1996, Volkswagen raised Dm500m million secured by car lease receivables in only the second asset-backed deal in Germany. Assets are placed in a special purpose vehicle (SPV) which takes loans off the company’s balance sheet and frees capital. The SPV gives sufficient cover for the bond’s interest payments to ensure a triple-A rating from credit agencies.
The enhanced international profile of the Eurodeutschmark sector is also encouraging the introduction of products that are already well-established in the dollar markets. So further asset-backed deals are likely this year, as well as more issues that are callable in the event of withholding tax imposition. Further high-volatility zero coupon bonds, which also simplify forex transactions for overseas investors, are expected.
However, two first-quarter deals illustrate the developing trend in issuance from emerging and niche market issuers. Argentina, after tapping the market in smaller size last autumn, launched a Dm500 million seven-year issue at 473bp over the curve through CSFB, which immediately raised it to Dm1 billion in response to overwhelming demand from retail and emerging-market funds. This deal was quickly followed by Mexico, which also issued seven-year paper, at 484bp, and again its reception prompted lead-manager Deutsche Morgan Grenfell to increase the issue by 50% to Dm1.5 billion.
Isabelle Terrillon, associate director of emerging markets at Nomura International in London, sees more emerging sovereigns looking to the Deutschmark sector this year. “The Deutschmark will be like the yen was last year for attracting exotic borrowers, particularly from the transitional central European economies.”
One candidate, the National Bank of Hungary, will have to wait unless it is prepared to pay more than its usual 250bp. Turkey is asking for bids on a five-year deal after the success of its three-year issue in January and is likely to issue at around 300bp. Other high-yielding issuers are likely to be the Province of Buenos Aires, Brazilian development bank BNDES and Sao Paulo’s electricity utility CESP, which is waiting for central bank approval before going ahead with a Dm500 million five-year issue.
In addition, as long as the swap window stays open, top-quality sovereign names will also continue to tap the market. Arbitrage opportunities for borrowers in the dollar sector are scarce and European retail preference for European sovereigns should resume once the backlog of issues has gone. Slow economic growth in Germany, which will justify low domestic interest rates, is a prerequisite for sustaining demand. Italy, Sweden and Portugal will be regular issuers – six deals for the Kingdom of Sweden last year worth Dm4.5 billion were specifically targeted at retail buyers.
With a wide selection of AAA names and bank and corporate financing vehicles – mixed with high-yielding sovereigns – to come, investors should wait for the indigestion to subside. The open swap window might look quite refreshing once again.
Leading non-German Dm Eurobond issuers* |
||
|
Dm mn |
Issues |
European Investment Bank |
5,500.0 |
4 |
Kingdom of Sweden |
4,500.0 |
6 |
Republic of Austria |
4,000.0 |
3 |
Republic of Argentina |
3,000.0 |
5 |
General Electric Co |
2,875.0 |
12 |
United Mexican States |
2,500.0 |
2 |
Hellenic Republic |
1,850.0 |
3 |
Export-Import Bank of Japan |
1,450.0 |
2 |
Bank Nederlandse Gemeenten |
1,350.0 |
4 |
Bank Francaise du Commerce Exterieur |
1,100.0 |
2 |
Source: Euromoney Bondware. *January 1 1995 to January 31 1996 |
||
All German banks want to increase their shareholder value and have come up with one or two surprising innovations to prove it. But can they resist the ever-growing demands of international investors? Laura Covill investigates
Daimler-Benz’s surprise decision to ditch Fokker, the loss-making aircraft manufacturer, made history as the first time that a major German corporation has thrown one of its core businesses overboard without warning. The ruthlessness of the move, which gave Daimler a Dm2.3 billion ($1.6 billion) write-off but may destroy 6,000 jobs and push Fokker into bankruptcy, surprised many who still believed in the paternalism of German big business – at least towards their own subsidiaries.
But it has not escaped the notice of other German corporations that the markets rewarded the mettle of Daimler chief executive Jüergen Schrempp with a boost in the share price. Rightly so, says Richard Davidson, an investment strategist at Morgan Stanley in London. “[Daimler] is now focusing on achieving a decent return rather than becoming the biggest company in the world, which is what it seemed to be aiming for before. That’s what Daimler’s business should be about.”
Belatedly, German banks are also recognizing that they must act in the interests of shareholders to attract and keep international investors who act professionally and make decisions for the long term. In short they must offer shareholder value.
Things were different just a handful of years ago. “Our capital increases went brilliantly well,” says a rueful Albrecht Schmidt, chairman of the board of managing directors at Bayerische Vereinsbank. “Then, as now, we had a good reputation in the market. And no one ever asked us about shareholder value.”
Now, all the major private-sector German banks – Deutsche Bank, Dresdner Bank, Commerzbank, Vereinsbank and Bayerische Hypotheken-und Wechsel-Bank (Hypo-Bank), plus the new conglomerate Bankgesellschaft Berlin – acknowledge that they have to vie not only with each other and other companies in the Dax 30-share index, but also with foreign banks for the attention of international investors. At the same time, as Schmidt points out, domestic German investors are developing an interest in international equities and securities.
“The debate on the single currency has made the German banks aware that they have to compete for investors’ favour with institutions from other European countries,” says Jüergen Ackermann, head of investor relations at Commerzbank. “Investor portfolios are becoming geared towards sectors, rather than countries.”
This creates a double danger for German equities. Not only can German stocks be substituted for same-sector stocks from other European markets but they also remain stubbornly expensive because of the high Deutschmark and their substantial capital and cost bases. “If you invested on a pure valuation basis you’d probably never buy Germany at the moment,” comments Susie Roberts, a German fund manager at Robert Fleming in London.
This dilemma has turned shareholder value in Germany from a jaded cliché used to describe unwelcome foreign practices into a fresh and new approach to the international capital market.
Since German investor relations began in earnest at the start of the decade – Deutsche became the first German bank to set up such a department in 1990 – close encounters with foreign fund managers, strategists and treasurers have been a genuine revelation. German corporate financiers and bankers have had to overcome a natural reluctance to deal with investors who care little for the consensus element in the German social market economy, who demand dividends today, not lower provisions tomorrow, and who prefer transparent accounts to an opaque, but steady profit trend over decades.
For Deutsche Bank, which is attempting to change its entire management culture, the shareholder-value movement has come as an opportunity. “One way to get more discipline into a company is to create more public criticism,” says Jüergen Krumnow, the board member in charge of accounting and controlling. In a bold move announced late last year Krumnow anticipated the disclosure demands of most investors by pledging to publish the bank’s 1995 balance sheet under international accounting standards (IAS).
If this happens, without exemptions and loopholes, Krumnow will disclose far more than a German bank has ever revealed about its true financial position. For where German accounting standards allow companies to paint a general picture of earnings and offer unrivalled scope for adjustments in the guise of hidden reserves, provisioning and extraordinary profit and loss, international accounting standards are relatively rigid. Krumnow promises that Deutsche Bank’s IAS accounts will contain full details of provisions, goodwill, pension obligations, market and book values of participations and – most spectacularly – hidden reserves.
Once Deutsche Bank’s reserves are known, Krumnow will have little scope to indulge in “profit-smoothing”, the traditional German practice of borrowing from hidden reserves to boost earnings in a poor year, and vice-versa in a good year, so that that an even profit trend is discernible over a number of years.
In turn, the choppier earnings pattern will have to be reflected in the dividend, so that another traditional practice, that of “dividend-smoothing” (shareholders are paid a lower percentage of eanings in good years to bolster reserves for the lean years), is out too. The German tradition is to offer a steady upward trend in dividends over a number of years, but now, says Krumnow, Deutsche’s dividend will fluctuate in line with the earnings figures.
Significantly though, Krumnow himself appears not wholly converted to the idea of shareholder value as it is understood internationally. One moment, Deutsche Bank’s finance director opines that “shareholder value is about optimizing earnings in each division [of the bank].” The next moment, he backs the traditional German theory that divisions should cover each other’s losses if one division has had a difficult year or large investment needs.
“I know shareholders don’t want to hear this but we have a kind of social responsibility,” Krumnow says, referring to the bank’s equity stake in a medium-sized German company. “In Germany ownership carries a social obligation and you can’t neglect the interests of the proprietors and the workforce.”
No wonder, then, that finance directors at other German banks and blue chips were shocked and dismayed by Krumnow’s plan. For Deutsche Bank is not only improving disclosure, it is dismantling an entire equity culture. Inevitably, other listed banks will eventually be obliged to follow.
But investors welcome the opportunity to learn more about Deutsche Bank’s business structure and earnings. Ian McEwan, a Merrill Lynch banking analyst who recently produced a study of Deutsche Bank, says that the IAS accounts “will increase transparency by giving a full picture of provision movements and securities gains, and in particular, should give a much better picture of the state of balance-sheet provisions.” This does not alter McEwan’s fundamental belief that the bank’s return on equity and earnings per share are declining; indeed, greater disclosure will allow analysts to examine the accounts in more detail and to make more precise criticisms than previously possible.
Once it is easier to compare German banks’ stock with British or Spanish institutions, finance directors will not be able to escape pressure to produce a more impressive balance sheet.
Unwittingly, Deutsche Bank may have opened the floodgates to a much more critical investor culture. Krumnow has raised international investor expectations not just of Deutsche Bank, but of other German banks’ stock as well.
In particular, it is return on equity which has finance directors cringing. Hypo-Bank wants to increase its post-tax return on equity to 15% within five to 10 years, while Vereinsbank is aiming for 18% “within 10 years, maybe less”, according to Schmidt. At Commerzbank, the goal is 10% within three years. That compares with 20% to 25% usually achieved by other European institutions.
This will not be achieved easily at German banks. Krumnow points out that Deutsche Bank’s return on equity will actually fall as a result of IAS accounting because about Dm4 billion of provisions no longer will be recorded as profit. McEwan points out that the key to capital growth is the amount of retained profit after the dividend has been paid. In other words, the more generous the dividend as a percentage of net profits, the more difficult it will be to create new capital.
Indeed, the only real means of improving capital ratios is to desist from further capital increases. German banks have gained an unwelcome reputation for their eagerness to ask investors for fresh money but they are now promising to exercise more self-discipline.
Hypo-Bank planned to increase its capital this year but has now dropped the idea. “Investors tend to take a negative view of capital increases,” says Werner Müenstermann, the board member in charge of accounting and treasury management. “They wrinkle their brows at every attempt [to raise money] and you feel they’re asking why we aren’t capable of expanding on the strength of our own resources.”
Under IAS, Deutsche Bank will report the book value of its industrial holdings, so that the difference between book and market values will be transparent. That will simply heighten demands for Deutsche Bank and other banks to sell those holdings and release hidden assets on the balance sheet. Although Commerzbank recently sold a number of its holdings, and Deutsche Bank last year sold 3% of its considerable stake in Daimler-Benz, the tax consequences of doing so were so punitive that large-scale selling probably remains out of the question, no matter how much shareholders plead with the banks to realize their wealth.
Likewise, dividend payments from German companies are likely to remain at modest levels as long as they are taxed at source: it’s much more cost-effective for banks to add net earnings to reserves or loan/loss provisions instead.
In the first nine months of 1995, all six main bank stocks (except Commerzbank) showed a decrease in interest and commission income. Prognoses for 1996 are no better. Indeed, some Deutsche Bank competitors suggest that it is introducing IAS accounts now so as to divert attention from its poor operational performance.
McEwan recently reduced his 1996 earnings forecasts for several German banks on the basis that growth in loans will be poor with falling margins, own-account trading will expand only marginally, cost growth should remain above inflation and increased provisions may be needed as the property market turns down and the high Deutschmark takes its toll on smaller German companies.
Each bank has its own particular recipe for improved earnings and strategic success in the long term, and this always centres on its position as “house bank” for a broad raft of corporate clients and its penetration of the retail market, plus other factors. At Hypo-Bank, that factor is its “focused strategy in investment management”, while Deutsche Bank’s ambitions to become a global investment bank are well known.
But none of the main banks is contemplating a radical departure from its traditional cost and earnings base. To take one example: Vereinsbank is planning to set up a direct bank and market rumours say the bank is considering closing dozens of branches in its Bavarian network. But according to board chairman Albrecht Schmidt, Vereinsbank will reduce the range of services available at each branch, although there will be no drastic closure policy.
Improving profitability will be more a matter of style. “We want to make our products so attractive that the prices we set will be accepted, and we also want to optimize the time and expense involved,” Schmidt said. Simply put, there will be a gradual improvement in products and services, accompanied by cost-cutting from inside existing structures. This seems to indicate the limits of German banks’ dedication to shareholder value.
Fundamentally, the notion is still deeply troublesome to German companies, which believe that they owe an equal duty to creditors and to customers. German business law and accounting standards are based on the principle that creditor protection takes priority over the interests of shareholder or management. “The banks are faced with an internal conflict between providing transparency for investors and giving assurances to their customers,” explains Ackermann of Commerzbank.
That social market contract is at the heart of German banking; which is, at best, long-term and patient with businesses in temporary difficulties and at worst over-indulgent and uncritical with trusted customers who conceal desperate problems (Deutsche Bank’s blindness to the frauds and concealment perpetrated at the Schneider property group being one notorious example).
And under a strict interpretation of shareholder value, Metallgesellschaft would never have been saved from its debacle in the oil market because the (December 1993) rescue package awarded fresh money to an unrestructured company which had already lost billions and could offer no immediate prospect of repayment.
Bankers brought up in the German system have deep-seated belief in the virtues of the country’s traditional financial system. For example, Schmidt of Vereinsbank says that “untaxed reserves” (his way of describing equity participations) are necessary instruments to cope with cyclical fluctuations without endangering the balance sheet.
Despite their intentions to improve shareholder value (and it is more than lip service) German companies stilll do not operate in the kind of environment where “the company’s intrinsic value is reflected in share price and in dividend”, as Schmidt says. Moreover, they have little inclination to change to a system which they associate with shareholder tyranny, short-termism, and loss of authority by the bank’s management. German bankers will resist those trends as long as possible, no matter what the consequences for shareholder value.
Banks’ net return on equity |
||
|
Return on equity 1994 |
Goal |
Bankgesellschaft Berlin |
5.3% |
10.5% (medium term) |
Bayerische Vereinsbank |
6.6% |
18% (within 10 years) |
Commerzbank |
11.8% |
10% (3-5 years) |
Deutsche Bank |
6.8% |
25% (pre-tax) |
Dresdner Bank |
7.7% |
not disclosed |
Hypo-Bank |
6.2% |
15% (5-10 years) |
Source: banks, Goldman Sachs |
||
Deutschmark-denominated assets are much in demand and nowhere more so than in Japan. Lesser-known German borrowers are seizing the opportunity – suddenly going international and east, as Philip Moore reports
For a growing number of German borrowers, including mortgage banks, savings banks and municipalities the booming Eurodeutschmark sector provides an excellent opportunity to go international. Diversification of their investor bases – to satisfy growing demand for local lending – is the main reason. But besides focusing on strong demand from European investors for Deutschmark-denominated assets, these borrowers are expected to capitalize on an upsurge in interest from east Asia, especially Japan.
“A lot of German issuers have gone to great lengths to launch investor-relations programmes in the Far East,” says Tim von Halle, managing director of fixed-income sales and trading at West Merchant. Merrill Lynch syndicate manager Manfred Ludwig thinks that there are probably about 20 German bank issuers, including the Landesbanks, which could easily raise competitive funding in east Asia – a far cry from five years ago when the number probably could have been counted on one hand.
These German issuers are offering the Japanese irresistable pick-ups of up to 400-500 basis points (bp) over locally available assets. They also offer ratings-conscious investors a level of quality which is increasingly difficult to match. Yann Gindre, managing director of debt capital markets and head of origination at BZW in London, points out that “when you talk to Japanese investors and ask what they want, they will tell you AA or AAA borrowers. Now how many of those are left in the European financial sector? All the French have gone. The Swiss don’t need the money. That leaves the German banks, whose ratings have held up very well.” Hence the transformation of a borrower such as Sudwestdeutsche Landesbank, which has moved from being essentially reliant on its domestic markets to become a familiar name with Japanese retail investors.
After the government, probably the best-known German borrower internationally is Frankfurt-based development bank Kreditanstalt für Wiederaufbau (KFW), a prolific issuer which raised Dm22 billion in 1995. According to treasurer and senior vice-president Gerhard Lewark, since January 26 1996, the bank has been recognized officially as enjoying a risk profile on a par with the government. This was the result of a reduction by Germany’s Federal Banking Supervisory Office of KFW’s Bank for International Settlements’ risk weighting to zero from 20%. Lewark expects that for the time being this reduction will have a beneficial impact more on the bank’s domestic fundraising than on its international borrowing, but he remains optimistic that the ever-expanding internationalization of the Deutschmark bond market will play into KFW’s hands.
“I’m a great supporter of the internationalization of the Pfandbrief market,” says Lewark. “I don’t see Pfandbriefe issues as competition to KFW, but if a growing number of issuers can contribute to making international investors more aware of the Deutschmark spread products, it can only benefit us all.”
Despite KFW’s strong reputation overseas, Lewark insists that the bank – which will raise some Dm20 billion this year (probably in line with last year’s distribution of 51% in the domestic market and 49% internationally) – can ill afford to become complacent. “Of course we are well known within the international underwriting community,” he says, “but our view is that a portfolio manager in Edinburgh or a French insurance company ought to be holding KFW paper. We have no substantial assets in sterling or French francs but we are aiming to issue in those currencies in order to become better known in Europe. It’s our way of preparing for EMU.” Most of the bank’s non-Deutschmark funding, he says, is swapped into dollars, although its last French franc issue was swapped into Deutschmark.
The reduced risk weighting for KFW raised a number of eyebrows among those German issuing competitors which remain on a 20% rating. Many bankers insist that a handful of German special-purpose banks enjoy an identical risk profile and credit quality to KFW. Nevertheless, this did not stop L-Bank, or its new director of funding, Stephan Tribull, from launching a 10-year Dm1 billion global bond in January which was well received in spite of a flurry of other international issues from German borrowers.
“I think it was a true global issue in that it was the first time that none of the managers complained about any of the paper coming back,”says Tribull. Priced at 24bp over the 2006 Bund – or two points over the previous week’s 10-year Austrian issue – the bonds were dispersed among Asian, US, and European investors. The issue owed at least part of its success, say Frankfurt bankers, to the issuer’s insistence that the size would not be increased, regardless of demand. Tribull believes that this year L-Bank will issue roughly the same volume as in 1995 – about Dm17 billion – of which 50% will be raised domestically and the remainder internationally.
Among institutions keen to rub shoulders with the likes of KFW, L-Bank, DSL and Helaba (both of which launched Japanese-targeted issues in January), is Landwirtschaftliche Rentenbank. This 100%-government-owned, AAA-rated bank has been serving Germany’s agricultural, forestry and food processing sectors since 1949 and tapping its domestic market since 1952. A spokesman says that while the Frankfurt-based bank has made a conscious decision not to abandon a domestic funding source which has served it well for over 40 years, it chose to start tapping international markets through the establishment of a Euro-MTN programme in 1994.
“We started with a Dm2 billion programme, which has now been lifted to Dm5 billion. It will be lifted again, probably in March,” the spokesman for the bank explains. Issues launched by Rentenbank in 1995 included a debut Dm500 million Euro-Deutschmark benchmark deal led in April by Banque Paribas (Deutschland), and a Dm300 million bond arranged by Nikko Bank in October following extensive international roadshows and a series of one-to-one meetings with Japanese institutional investors. “We will continue to opportunistically issue off our MTN programme as long as we can secure funding within a very tight target range of Deutschmark Libor less 15bp or 20bp,” says the spokesman.
For now, Rentenbank’s funding requirements are exclusively in Deutschmarks, meaning that this target funding range includes the swap costs. In 1996, according to the spokesman, Rentenbank will be aiming to raise a further Dm10 billion, of which around 30% will be generated internationally.
Another new name in the Eurodeutschmark market is the AAA-rated Deutsche Ausgleichsbank (DAB), wholly-owned by the government and formed in 1950. The bank satisifed all its funding requirements through the domestic market before 1995, when it established a $2 billion Euro-MTN programme. It launched its first Dm500 million issue off the programme via Deutsche Morgan Grenfell and Lehman Brothers in October 1995, some 40% of the paper being placed internationally. “DAB was a good name to sell outside Germany,” explains one Frankfurt syndicate manager. “It’s a new name with international investors but its legal structure is exactly the same as KFW’s.”
According to DAB funding director Robert Fassbender, the Bonn-based bank’s requirement for 1996, swollen again by the costs of German reunification, is expected to be between Dm5 billion and Dm7 billion, of which some 50% will be raised overseas. Unlike KFW, which is a natural dollar taker, all DAB’s international funding is swapped back into Deutschmarks.
Another new class of German borrower tapping the international capital market is the Sparkasse (savings banks). The first of these to secure a Moody’s rating, in September 1995, was Landesgirokasse Stuttgart (LG-Bank), which was assigned a AAA/Prime-1 deposit rating and a B financial-strength rating in reflection of its “consistently high interest margins and core profitability, low overheads and a relatively low risk profile”. LG-Bank, which has total assets of Dm35 billion, was followed into the international ratings arena three weeks later by Stadtsparkasse Köln (SK), Germany’s third-largest savings bank, which secured the same ratings as its Stuttgart-based counterpart. Moody’s noted that SK, which at the end of 1994 had total assets of Dm24 billion, has “attained a critical mass that allows it to operate in most product and service areas independently of its respective Landesbank”.
SK’s first issue following its rating was a Dm250 million deal described by its co-lead manager, ABN-Amro, as an “internationally targeted domestic issue”. Thomas Hegel, syndicate manager at ABN-Amro’s Frankfurt office, says: “Because SK had secured a long-term debt rating, it recognized that it had the opportunity to look beyond the domestic market where investors attach less importance to ratings. SK wanted to diversify its investor base and we saw demand from domestic as well as Benelux-based institutions.” As a result, says Hegel, the size of the SK deal could have been raised “easily” to Dm400 million from Dm250 million.
As of late February, LG-Bank was understood to be ready to follow SK with a larger, internationally-targeted issue launched off its recently established Euro-MTN programme. However, bankers and analysts caution against expectations of a flow of new issues from Germany’s savings banks. As Jürgen Berblinger, managing director of Moody’s Deutschland, notes, there are in Germany more than 600 Sparkasse, of which only 10 or 15 at most, have sufficient “critical mass” to launch what he describes as “borderline” issues opportunistically tapping domestic and international demand.
Even these larger institutions, say Frankfurt banks, have very restricted demand for international funding, given that their traditional financing route is through domestic bond issues distributed through their savings branches.
Top 10 German Dm Eurobond issuers 1995-96* |
||
|
Dm mn |
Issues |
Sudwestdeutsche Landesbank Girozentrale |
5,400 |
13 |
Deutsche Pfandbrief und Hypothekenbank |
5,000 |
6 |
Deutsche Siedlungs und Landesrentenbank |
4,700 |
12 |
Kreditanstalt fur Wiederaufbau |
4,450 |
5 |
Deutsche Bank |
3,400 |
8 |
Commerzbank |
2,350 |
6 |
Landesbank Rheinland-Pfalz Girozentrale |
2,000 |
4 |
Landesbank Hessen-Thuringen Girozentrale |
2,000 |
2 |
Landwirtschaftliche Rentenbank |
1,600 |
7 |
Dresdner Bank |
1,500 |
2 |
Source: Euromoney Bondware. *January 1 1995 to January 31 1996 |
||
If Daimler-Benz is in such a mess, why reward shareholders with a payout?
Laura Covill explains
Few novice finance directors have had such a challenging first year as Manfred Gentz of Daimler-Benz, Germany’s largest and – in terms of earnings – least successful company. Eight months after taking up his position, Gentz recently had to announce the biggest loss in German corporate history. Several divisions of the Daimler conglomerate apparently had failed at the same time, resulting in a shortfall of approximately Dm6 billion ($4.1 billion) in 1995.
It came as a surprise, therefore, that shareholders accepted Gentz’s news so calmly. Bizarrely, the bombshell scarcely moved the company’s share price. Analysts simply reassessed the Daimler share as a “high-risk” stock and traded in hopes of a dividend this year for the prospect of short-term and medium-term price gains following a restructuring.
The unspoken assertion from Gentz and Jüergen Schrempp, Daimler’s new chief executive, that others were to blame for Daimler’s colossal drop in earnings power, seems to have been accepted. They were praised for the ruthless decision to abandon loss-making businesses.
Much of this good work was undone, however, when Gentz made the surprise announcement that the company might pay a dividend after all – an unusual move for a company which is losing money in several different ways.
Daimler’s Dm6 billion loss for 1995 includes Dm2 billion operating losses at aerospace company Dasa, Dm2.3 billion in write-offs from the abandonment of Fokker, the loss-making aircraft manufacturer, and Dm1.5 billion in charges from the closure of several divisions at electricals and electronics company AEG. Under US accounting rules the group’s loss is likely to be even larger, because a greater amount of goodwill will have to be written off.
In German eyes, however, losses are not a sufficient reason to scrap a dividend. Indeed paying a dividend through thick and thin is the German tradition – shareholders even received Dm8 per share in 1993, when the company made a loss of Dm1.8 billion on the US-GAAP balance sheet.
Although Gentz says that Daimler is “fully committed” to shareholder value, he is also quick to stifle the notion that the company’s financial policy has changed dramatically. “This isn’t a major break with the past. Because of the situation with the US dollar we brought forward our review of the group portfolio and tried to identify the long-term loss-makers.”
Even the hint of a dividend suggests that Daimler’s board of management is unwilling to depart from the long-standing German practice of “smoothing” dividends: shareholders are paid a lower percentage of earnings in good years so that the reserves can be bolstered and used in years when operating results are too meagre to pay a dividend. Daimler sources say that the board is divided on whether to continue this policy. Gentz favours it. “You can practise smoothing in dividend policy,” he says. “You just have to explain your thinking clearly to shareholders.”
Gentz argues that it is legitimate to pay a dividend out of current operating earnings, even if the previous year was a financial disaster. By April, when the dividend is announced, the board will be able to assess Daimler’s earnings in the current year and may then decide to make a payment. The company’s willingness to even contemplate a dividend indicates that Daimler’s earnings position may not be as dire as it looks.
Schrempp and his colleagues had long suspected that Fokker and AEG would never be profit centres, but when they finally decided to cut their losses on those erstwhile investments, their instinct was to deal with all the problems in one financial year.
“We had to take the worst-case scenario,” says Gentz. At Fokker, for instance, Daimler has formed reserves of Dm2.3 billion, partly on the assumption that the aircraft manufacturer will cease trading. “A leasing portfolio suffers when the manufacturer is no longer operating, since the book value of the planes can no longer be realized,” reasons Gentz. At AEG the costs of restructuring, sale and closure will be spread over this year and next, but the write-off of Dm1.5 billion will be made in full in 1995. “All possible depressing factors will be taken into account on the 1995 balance sheet,” says Gentz.
The company will form substantial new provisions this year, releasing reserves next year once the problems have been eliminated. The advantage of using US accounting methods – and Gentz hopes that by the end of 1996 the Daimler-Benz Group will be exempted from having to draw up German accounts at all – is that reserves cannot be kept in limbo but must be freed immediately once they are no longer justified.
The strategy appears to have worked to great success. Gentz should heed his own warning, however. “The German accounting system is basically sound. But a side-effect is that you can smooth out earnings over a number of years and then you stop noticing exactly what is happening on the operating side in any given year.”
The trading culture may be changing, but Frankfurt’s dream of replacing London as Europe’s financial centre remains a long way from reality. Laura Covill on a tale of two cities
The Landeszentralbank Hesse, Frankfurt’s local branch of the Bundesbank, recently issued an appraisal of the prospects for foreign banks in Frankfurt. It made gloomy reading. The LZB’s most optimistic remark predicted that Frankfurt’s European Monetary Institute (EMI) – regarded as the forerunner to a European central bank – will eventually attract more foreign banks to the city. Scant comfort in that, it might seem, for the capital markets.
The LZB also noted that various foreign banks had decided to make Frankfurt the focus of their Deutschmark business, but that London recently had increased its lead over the German city in forex trading, Bund trading and Deutschmark interest-rate derivatives trading.
The LZB’s disappointment is typical of the soul-baring that has occurred since last year, when Deutsche Bank made London the hub of its capital-markets operations. That announcement came as a particular shock in Frankfurt because it unashamedly acknowledged that the city had still not become a competitive financial centre.
Even before this announcement, Germany’s main financial institutions had begun the process of transformation in their trading cultures, but now this process is being accelerated. Deutsche Bank’s non-Deutschmark operations have been consolidated with Morgan Grenfell. Dresdner Bank is learning the ropes from new investment banking subsidiary Kleinwort Benson. Other German banks are following suit.
The greatest challenge for Frankfurt is to halt the decline by creating an environment that will attract the best traders and salespeople with international experience. Local bankers have learned from Frankfurt’s poor record that it is almost obligatory to gain career experience in other international centres before returning to a senior position in the city. In the past, talented locals, impatient to make more rapid progress than that permitted by the formal hierarchies at big German banks, went to US investment houses to build their careers. Indeed, the Frankfurt offshoots of Salomon Brothers, Goldman Sachs, Morgan Stanley and their peers have evolved since the late 1980s by recruiting talented personnel from Germany’s big banks.
Yet over the past two years, the tables have turned. The bulge-bracket firms have begun to consolidate and even to shed staff in Germany. Consequently, a number of young, experienced Germans have returned to senior positions at traditional German houses.
One prominent example is Leonhard Fischer, who left JP Morgan in Frankfurt last year to become co-head of trading and treasury at Dresdner Bank. Fischer, 32, has gained acceptance at highly traditional Dresdner by acknowledging corporate culture while simultaneously increasing trading profits. It’s a similar story with Alfred Möckl, who was head of equities at Morgan Stanley in Frankfurt before being appointed as one of the managing partners of respected German merchant bank BHF-Bank. And Morgan Stanley’s London operation was the training ground for two more of Frankfurt’s chief traders: Erich Pohl, co-head of treasury and trading at Dresdner Bank and Jürgen Karcher, head of trading at Commerzbank.
The change in culture perhaps has been most striking at Dresdner. Its traders now are permitted to take a much more imaginative approach on positioning because management recognizes that spreads in regular trading have become too tight to yield substantial earnings.
This is possible only because the level of capital-markets expertise in Frankfurt has increased enormously. “Germany used to be like the Third World in finance,” says a US-born trader at a major German bank. “A lot of us felt like the new sheriff in town because we had practical experience in products. But there are now a lot more experienced people, even in junior positions. Everyone is of a higher calibre than a few years back.”
The pace of change in the Frankfurt market appeals to some traders. “What took 25 years in the US has happened in five years here because of the DTB (Deutsche Terminbörse, Frankfurt’s electronic derivatives exchange),” says Alan Rogen, an equity-derivatives trader at ABN-Amro in Frankfurt. “The market has become far more efficient; there’s better turnover but smaller margins.”
William Klein, American head of capital markets and securities at Landesbank Sachsen, says: “In the past, German financial institutions suffered from a lack of service and customer orientation. Up to now, German corporate culture showed that it couldn’t be as flexible or as innovative as in London.” He says he hopes that his bank, established three years ago and employing 60 staff in capital markets, will break that mould.
Klein earlier worked in Frankfurt as head of derivatives trading at Schröder Münchmeyer Hengst. It is from usual to see non-Germans arrive direct from London, New York or Chicago and find management positions at German institutions.
However international their clientele, the big banks (regarded traditionally as Deutsche, Dresdner and Commerzbank) are still formal hierarchies and they almost invariably recruit Germans for senior positions. This means non-Germans are unlikely to find management positions – and even if they do – salaries are usually not comparable with London. Despite some improvement in the past couple of years, Frankfurt traders and salespeople still earn significantly less than their London equivalents.
Historically this was not an issue. Until the early 1990s, few German traders complained about pay because insider trading was widely regarded as a form of supplementary income. But now every trading room in Germany has a compliance department and traders are acutely aware that the first conviction has recently been made under a new law against insider dealing.
Traders and salespeople also are being more easily persuaded to move from one institution to another as the jobs market becomes more transparent and pay levels begin to rise. As a result, trading houses are beginning to realize that if they expect staff to be honest and to remain loyal, they will have to pay more.
Here, differences are opening up between German houses. Deutsche Morgan Grenfell (DMG), in particular, has begun to increase both salaries and bonuses and to demand more in return. Although traders and salespeople know that they still do not earn as much as their colleagues in London, management is trying to quash or avoid such comparisons. “You’re fired if you discuss money with each other,” says one DMG trader.
Traditionally, the Frankfurt trading fraternity acknowledged that Deutsche Bank paid lower salaries than houses with lesser names because it was seen as an honour to work there, so the theory went. According to DMG traders in Frankfurt, that philosophy persists. They believe that experience at DMG gives them particularly good job prospects, at least in the German market, so less pay is accepted as part of the package.
At Commerzbank, until two years ago, a trader’s bonus was practically a fixed sum paid regardless of performance. While basic salary has remained the same, now traders and salespeople who do well can earn a substantially larger bonus. The same is true of Bayerische Vereinsbank, though some other German banks stick to the traditional system of small, fixed bonuses.
According to Klein of Landesbank Sachsen, salaries for traders have been rising since the beginning of the 1990s, but the increases have been particularly steep in the past two years. The implications for his institution are profound. Even though Landesbank Sachsen is based in Leipzig, where the cost of living is significantly lower than Frankfurt, management feels obliged to pay Frankfurt salaries to persuade qualified capital-markets staff to work in the eastern German city.
Nevertheless, traders realize that good jobs in Frankfurt have become scarce. Most complain that there are too many traders chasing too few clients. This has somewhat dampened pay expectations. However, for the top positions, financial rewards in Frankfurt are as good as anywhere. Germany’s leading banks have shown that they are willing to pay large salaries to secure the likes of Fischer and Karcher.
According to traders, the highest rank-and-file salaries in Frankfurt are paid by the German offshoots of US investment banks. In return, those institutions are more ruthless than the native German institutions about dismissing traders who fail to attain their targets. “We don’t get paid huge bonuses, but then again, we don’t get fired unless we do something really bad, really devious,” says a trader at Commerzbank.
While the working pace at Commerzbank or DMG in Germany remains more relaxed than at their London or New York operations, US houses insist on the same working habits in all their offices. Staff are expected to keep the same hours and achieve the same targets as colleagues in New York and London.
“I’ve done everything I can to avoid adapting to Frankfurt and to retain my working habits from London; after all, I know I’ll be going back some day,” says Friedrich von Nathusius, head of fixed income at Morgan Stanley’s German operation. “I don’t start at eight-thirty (seven-thirty in London) just because I’m in Frankfurt. Lunch is for wimps.” According to Nathusius, his bank’s Frankfurt operation works the same hours as London, staying an hour later in the evening to conform to London times.
For those who’ve once worked in London, it can be a tough decision to return to Frankfurt. Nathusius spent seven years in London and bemoans the fact that his compatriots often have to take a pay cut to return home. Although the international houses such as Morgan Stanley pay approximately the same pre-tax salaries in the two cities, Germany’s punitive income tax means that employees end up with substantially less in their pockets.
Nathusius urges Frankfurt’s city development agency to lobby the German government to allow offshore-type contracts. That arrangement would allow financial specialists who come to Frankfurt for just a few years to retain their foreign tax status or to enjoy special tax breaks. As yet, however, neither the city nor the German government has taken this suggestion on board.
But the choice between Frankfurt and London is also one of lifestyle, which weighs very heavily with traders. On the one hand, London is still perceived to offer more career opportunities and more rapid progression than Frankfurt. It is often pointed out that London has 600,000 people working in financial services while the same number represents Frankfurt’s entire population. London enthusiasts are also scornful about the absence in Frankfurt of a service culture, the restricted German shopping hours and the limited range of cultural and leisure pursuits in the area. It is telling that several board members of major Frankfurt banks, including Deutsche, Dresdner and Helaba, have chosen to reside in London or in the nearby Surrey countryside and to commute weekly to work in Frankfurt.
However, life in Frankfurt offers far shorter commuting times from pleasant semi-rural villages outside the city. Safety and a better family life are also considerations for many salespeople and traders, who tend on average to be older than those in London.
Bankers with a family to support are also attracted to the spirit of paternalism which German banks still retain. Vereinsbank’s Frankfurt staff who declined to move to Bavaria when the bank relocated most trading to Munich last year were not simply ordered to resign but were given generous redundancy pay.
Given German labour laws, however, it could be that Vereinsbank had little choice. Indeed, German traders and salespeople who otherwise live by the rules of the market usually take full advantage of Germany’s generous employment legislation if their employer threatens dismissal. It means large severance payments – and sometimes even forced reinstatement. Most Frankfurt traders would be shocked to see a dismissed colleague being handed a black bag and given five minutes to clear their workspace before being escorted off the premises.
Even in sales positions, it is not unusual for those who resign to be kept on for weeks or even months, since under a German employment contract, it usually takes around nine months for an employee to break free of their old job.
In the past, Commerzbank traders who handed in their resignation used to be retained for between six and nine months, until the end of their notice period. Nowadays, they leave within a week or two. But management is still remarkably unconcerned about the possibility that the departing trader might act irresponsibly or deliberately lose money for his former employer.
Given this level of paternalism, loyalty to employers in Frankfurt is much greater than in London.
Outside Frankfurt, traders often do not have the option to switch employers for a significantly higher salary. The major German houses are scattered all over the country – in Berlin (Bankgesellschaft Berlin), Munich (Vereinsbank, Hypo-Bank), Dusseldorf (WestLB, Trinkaus & Burkhardt) and even, in the case of L-Bank, in the provincial town of Karlsruhe. In those centres, discontented traders and sales people have few other career options.
It remains to be seen whether Vereinsbank’s relatively isolated trading centre on the outskirts of Munich can sustain the same efficiency as a Frankfurt trading room. However, in the absence of similar alternative trading employment in the Munich region, Vereinsbank is unlikely to experience the degreee of staff turnover than it might have done in Frankfurt. “Those who don’t want to leave Munich would certainly have trouble finding other jobs,” says Philip Waldstein, head of primary-market syndications. Indeed, greater staff loyalty is said to have been one of the crucial factors when Vereinsbank decided to relocate almost all its trading to Munich.
“Location is completely irrelevant,” says Waldstein. “We are just as professional as those in other centres. And when traders in London want to communicate, they do just the same as us: they reach for the phone or watch the screen.”
But by arguing that the Bavarian countryside is just as good as Frankfurt or London, Vereinsbank is undermining Frankfurt’s central argument that the German capital markets must consolidate their expertise to compete with other centres. Most bankers agree that the multiplicity of financial centres in Germany has hindered Frankfurt’s chances of becoming stronger. Many hope that the demise of the seven regional stock exchanges will advance the cause of unity.
Yet Frankfurt’s ambitions remain modest, as summed up by Nathusius of Morgan Stanley: “When Germany’s stock-market trading is finally consolidated in one centre, then Frankfurt will be able to play second fiddle to London.”
The DTB was quick off the mark to form a network of terminals outside home base to allow easy access to German derivative instruments. It wants to challenge Liffe for supremacy in Europe. Rupert Gordon-Walker examines how the battle lines are drawn
Frankfurt’s response to the European Union Investment Services Directive gives the clearest indication yet of its strategy in the run-up to monetary union. The directive, effective from January 1996, allows EU members free access to each others’ financial markets.
The Deutsche Terminbörse (DTB), which was integrated into the Frankfurt Stock Exchange (Deutsche Börse) last year, has been first off the mark by forming a network of terminals throughout the continent, linked to its electronic Integrated Exchange, Trading and Information System (IBIS). Traders and investors in German derivative instruments will have easy access to the central DTB, which will make it harder for rival exchanges, such as the UK’s Liffe, to attract a share of its business.
At issue are the relative merits of electronic screen-based trading, practised by the DTB, and the open-outcry method practised by Liffe, the Matif and the Chicago exchanges.
To counteract the threat from Liffe the DTB was created in 1990 when Frankfurt realized it needed a futures and options exchange if it was going to be a serious contender for the position of Europe’s financial centre. Since then start-up activity has grown tenfold, with more than 300,000 contracts traded daily on its electronic screens last year.
In contrast to Liffe, the DTB has no booths to rent out, so transaction fees make up the bulk of the exchange’s income. It charges a Dm2 commission for each equity index trade and 50 pfennings for an interest rate deal – slightly more than the fees on US exchanges. The electronic trading system forms the DTB’s roots – and they are growing.
Five London-based companies have already established links to the DTB: Spear Leeds & Kellog, Saratoga, FCT Europe and subsidiaries of the German banks Landesbank Hessen-Thüringen (Helaba) and Commerzbank. Stefan Lutz, a vice-president of the Deutsche Börse expects three more to follow. Link-ups have also been formed in Switzerland, but the greatest investment has been in Paris, where 15 screens are now operating.
Negotiations between the DTB and the Matif (the French financial futures exchange) for closer cooperation and integration have not been smooth and agreement remains uncertain. In December 1993, the two exchanges made an arrangement for electronic trading of two of each other’s products. In September 1994, DTB offered the Bund (Bundesanleihen) and Bobl (Bundesobligationen) contracts, but pressure from locals on the French exchange – who feared that ending the open-outcry system would destroy their livelihoods – meant that the Matif failed to reciprocate.
Discussions were stalled until last spring, when a broader understanding was reached between the Paris bourse and the Frankfurt stock exchange, which had by then absorbed the DTB. If the agreement goes ahead this month, Frankfurt will supply the technology for electronic trading in both derivative markets and Paris will supply the systems for equity trading in each centre. Lutz says there are a couple of alternative systems if things go wrong. Nevertheless, the intention is clear: to expand the number of users of DTB products and integrate the trading of those products within the DTB.
The DTB’s primary focus has been equity products. Dealings in the option contract on the Dax index of 30 blue-chip companies is now one of the most active worldwide. In January, 2.8 million contracts were traded – 140,000 each trading day. In addition, futures and futures options on the index are available, but more broadly-based indices, CDAX (all stocks) and Faz (top 100), have been disappointing because of poor turnover in the underlying shares. Trading in Dax products accounts for 60% of the DTB’s annual turnover.
At the end of last year, the Deutsche Börse made its first penetration into the US market. The American Stock Exchange agreed to trade warrants on the Dax index in a pilot project which, if successful, should lead to trading in more liquid German instruments using DTB technology.
Liffe has a distinctly different strategy. “Its aim is to strengthen its position as the leading international futures and options exchange in Europe,” says Ralf Herkoltz, the German managing director for business development at Liffe. Last year the exchange made an agreement with the Tokyo International Financial Futures Exchange (Tiffe) to trade the three-month Euroyen contract after Tokyo closes for the day, forged a link with Singapore’s Simex and made a reciprocal arrangement with the Chicago Board of Trade (CBOT) for Liffe to trade US treasury instruments before Chicago opens and for the CBOT to trade UK gilt derivatives after London closes. Liffe also has plans to offer commodity futures and is currently in negotiation with the London Commodity Exchange (LCE).
Although Liffe poses no serious threat to DTB’s domination of Dax contracts – and the creation of an electronic network is designed to pre-empt a challenge – there is competition for control of trading in German interest-rate instruments.
Liffe fired the first shot in this skirmish when it began trading the 10-year Bund futures contract in 1988, two years earlier than the DTB, and thus established a “first-mover advantage” (first in the market), according to Herkoltz. Last year, volume traded on the floor reached 32.23 million contracts, 72% of the instrument’s worldwide turnover. Liffe regularly has taken a 70% share for the past four years. Lutz hopes that the expansion of terminal points will send more of this business to DTB.
To counter Liffe’s advantage, and expand the range of domestic instruments to cover the length of the German yield curve, the DTB introduced two new contracts in March 1994. One was a short-term interest-rate futures contract: three-month Fibor (Frankfurt interbank offer rate), to rival the Eurodeutschmark contract traded on Liffe. Fibor has since gained credibility as a hedging tool and has driven demand for interest-rate swaps and forward-rate agreements. It has proved more successful than the DTB’s long-term interest-rate innovation, the Buxl, which was suspended because of poor liquidity caused, say dealers, by a limited supply of underlying 15-30 year government bonds.
First-mover advantage for the five-year Bobl contract was achieved by the DTB, however. The contract belatedly was introduced by Liffe in 1992 but during the following year managed only one million contracts and was delisted in September 1994.
In contrast to the five-year French Btan futures contract, which failed to take off and was suspended by the Matif in 1993, the Bobl shows signs of growth. In January, volume on the DTB leapt to more than 100,000 a day, fuelled by Dm26 billion of Eurodeutschmark issuance, part of which needed to be hedged. But as Amr Mounib, head of Eurobond trading at ABN-Amro in Amsterdam, points out, traders often prefer to use the more liquid 10-year futures contract for hedges on five-year cash deals, duration weighting the purchase or sale to reduce the mismatch.
But according to many in the market the fight between the DTB and Liffe is physical. Put simply, bond traders prefer open-outcry. Mounib, for instance, complains that the Bobl contract on the DTB’s screens is often illiquid. “It is fine if I want to deal in the 200-to-300 range but I lose five ticks if I try to complete 1,000 contracts and 10 or more if my order is 2,000 to 3,000.”
A government bond dealer at a German bank says it is almost impossible to deal during volatile conditions. “After news that is particularly market-sensitive, everyone pulls their bids and offers, so I have no chance to fill my stop order. After the dust has settled the market can open half a point away either side from where it was trading.” Leaving an order with a local or a bank’s floor trader is often more efficient and flexible because if the trader is good he will know the clearing level for other dealers’ orders.
On the other hand, investors prefer screen-based trading, according Lutz at the Deutsche Börse. In a volatile market they have problems placing orders with brokers and even greater difficulties transacting business on open-outcry exchanges. Advertising a bid or offer on-screen at least has the advantage of transparency, which increases the chances of filling an order.
These largely idological battles will affect the success of the DTB’s plans. This sucess will rest largely on its ability to convince traders that they can achieve comparable or superior liquidity by using its screens. Otherwise, international exchanges, especially its European rival, Liffe, will attract greater volume in existing contracts and might even introduce contracts on German equity products.
The Deutsche Börse has been encouraged by the support given to its DTB operation by the three biggest German banks – Deutsche Bank, Dresdner Bank and Commerzbank. Dresdner Bank, in particular, has pushed hard for Frankfurt, concentrating its futures trading on the exchange and marketing the DTB to investors throughout Europe. The strategy may be working. On some days, volumes traded on the DTB by leading US investment houses such as Goldman Sachs and Saloman Brothers surpass the activity of German banks.
But the battle is far from over. If the DTB is going to achieve a niche – and really challenge Liffe – the expansion and sustainability of that trend is essential.
