Landesbanken look to a new life

“The Landesbank issue is a bit like the undead,” the analyst sighs. “It seems to stay with us for ever.” In July 2001, the European Commission ended years of complaints and evasions by ordering Germany to remove public guarantees from state banks. Created to do public finance business for their local governments, the states of the German federation, the Landesbanken have antagonized Europe’s privately owned banks by using their funding advantage to move into commercial lines such as asset management, investment banking and derivatives, undercutting rivals to get market share. Now their funding advantage has to disappear within three years. And no-one is sure how the Landesbanken will compete without it.

All over bar the detail

The issue is still unsettled. Germany is in talks with the EC to settle important details. In a typical European bureaucratic tangle, the text, when translated into German, is unclear on whether the grandfathering arrangement that will continue to guarantee bonds issued by the Landesbanken before the ruling will also ensure timeliness of repayment. It’s a real problem as far as rating agencies are concerned.

Nobody seriously expects major changes at this stage but the squabbling continues anyway, delaying still more the point when the banks will finally need to face up to change. The Landesbanken have three years to get ready for real competition. They need to overcome their chronic unprofitability and consolidate. But business will be tough, and mergers fraught with political difficulties.

The problem is twofold. Although the efforts of the Landesbanken to move into commercial business were what prompted the ruling, they have been historically unprofitable, specializing in low-yielding public-sector loans. They have only been able to lend this cheaply because of their funding advantage. And because these loans are zero risk-weighted, the banks have needed only tiny capital reserves.

Ian Centis, banking analyst at BNP Paribas, explains that the banks will have to start funding at more expensive levels when their ratings fall. This will mean moving away from reliance on public-sector lending towards higher-yielding assets. But, he points out: “This will mean that their assets are no longer mostly zero risk weighted. So they will either have to shrink their balance sheets or find a lot more capital quickly. Their state owners could inject more capital but it is unclear whether Brussels would demand that this yield a market return. The EU kicked up a fuss five years ago about Banco di Napoli in Italy – it is likely to insist that any additional capital now carry market remuneration. Also, it is open to question whether all states would be able to afford a recapitalization.”

Brussels might allow a capital injection. But the amounts involved would be too large for some state budgets. Many state authorities, such as financially troubled Berlin, are as heavily indebted as their banks. The Landesbanken will have to raise substantial amounts of new capital. Indeed, observers at other German banks say they are likely to end up effectively privatized. One Landesbank, LB Kiel, recently surprised the market by getting an A3 Moody’s rating for a tier-one issue – at the top end of the range most analysts expected. This is a hopeful sign but is no guarantee of favourable treatment in the long term.

So fast action is needed. Guido Versondert, European financial credit analyst at Barclays Capital, says: “My impression is that the rating agencies are taking a fairly relaxed view of the sector for the moment. But the challenge remains the same – the Landesbanken and savings banks start from a fairly comfortable position, and lots of things speak in their favour. But that will involve overcoming local and regional political forces, and there are numerous management teams and local representatives who will not want to give up their status and power, so that there is a real danger the market could remain fragmented.” If this happens, if the banks bury their heads in the sand, he adds, they will eventually find their franchises being eroded by privately owned rivals.

One way forward could be horizontal consolidation. Already the Landesbanken have intricate alliances and cross-shareholdings – at the start of 2002, for example, Bayerische LB increased its stake in the smaller Saar LB from 25.1% to 75.1%, and is strengthening its cooperation with LB Hessen-Thüringen. But Gerry Rawcliffe, head of investment-grade credit research at Dresdner Kleinwort Wasserstein, says this consolidation is easier to talk about than to achieve: “It would be politically sensitive. None of them would want to lose its regional identity but on the other hand it is hard to see a rationale for an owner to maintain five distinct Landesbank subsidiaries. In the UK, we often fail to appreciate the strength of regional allegiances in Germany – it is a genuinely decentralized federal state. The Landesbanken and the politicians who support them want to keep it that way. There have been grand schemes before to unite all of them into some kind of super-Landesbank, and all of them have failed because of political resistance.”

Landesbanken have traditionally been there to serve their states; changing to a wider role would be traumatic. Even deciding where to put a merged bank’s headquarters could cause bitter arguments. In any case, not everyone is convinced that merging several large, unprofitable banks will create anything except an even bigger unprofitable bank.

Another possible solution would be vertical integration with the Sparkassen – the network of local savings banks that Landesbanken service and in many cases own stakes in. Analysts cite the example of LB Baden-Württemburg, which embarked on its own restructuring at the end of 1998, merging with a local Sparkasse and with the old L-Bank and hiving off the latter’s development business into a new, guaranteed L-Bank. Rawcliffe at DrKW says: “LBW has already consolidated by merging with Landesgirokasse, the very strong regional savings bank. Rather than a pure wholesale bank, you get a more diversified business, which in the current rather difficult environment is a major ratings stabilizer. It’s almost the only Landesbank with a sizeable retail franchise, and is the strongest financially.”

But there are problems with this model too. Rawcliffe continues: “Again, each local savings bank wants to keep its own identity, so we run into similar political problems to those at the national level. This makes it very hard for meaningful consolidation to take place. So you get compromise solutions that are unlikely to make much difference.”

And, to make a difference, consolidation would have to take place on an unprecedented scale.

“You’ll need some very major agreements indeed,” says a German banker from the private sector. “I can’t see it happening any time soon.” LBW has still only merged with one of more than 50 savings banks in its state. The Landesbanken too are sceptical. Jürgen Sengera, WestLB’s CEO, says: “Looked at from the outside, that would be the natural solution but experience has shown that is impossible due to German structures, and that’s why WestLB will not touch that issue. It’s not resignation; we’re paying tribute to the facts.”

Versondert at Barclays Capital agrees: “All this would need to result in real consolidation, not just the multiplication of headquarters. It will be no good if they stop with a patchwork of Landesbanken and savings banks scattered across several states; they would need to improve their market shares much more significantly.”

Officials at the Landesbanken that have announced strategies are, unsurprisingly, bullish. Sengera says: “WestLB is big enough; we will have the least problems in the future markets. I don’t feel under pressure at all.”

Dietrich Rümker, chairman of LB Kiel, agrees: “Contrary to what some competitors might have expected, we will not surrender our market share. We are forced to change our business models, and we are doing so. But Germany is an interesting market, and competition will continue to be intense.”

Few independent observers are anywhere near as sanguine about Landesbank prospects. “Having to do without subsidized funding might sharpen their focus a bit,” says one analyst, “but it is far-fetched to think they will suddenly become super-efficient market players. I think many Landesbanks will struggle – there is just no need for Germany to have so many wholesale banks trying to do the same things.” He adds that of 13 Landesbanken, fewer than half are likely to survive in their present form. Says one German banker: “They need to look very carefully at their business and see where they can provide added value, and not just complain endlessly about losing their guarantee.”

This means merging, specializing and focusing on profitability. “They can probably compete in certain niches,” says Centis. “Their market position may be somewhat weaker than that of commercial banks; they will be at a disadvantage in areas such as asset management and private banking, and there is a whole host of ancillary services which can obviate low margins on lending, such as payroll services, that the Landesbanken probably cannot offer. But, for example, LB Hamburg has built up a strong position in shipping finance, and it will probably be able to retain that.”

Likewise, several Landesbanken are trying to move into investment banking activities such as off-balance-sheet credit derivatives, rather than undertaking major re-engineering of their asset bases. The German regulator has so far taken a flexible view of this strategy, and these instruments get favourable treatment in terms of capital reserve requirements. WestLB, the bank that moved most aggressively into investment banking, is again at the forefront here, but others, including Bayerische LB and Helaba (Landesbank Hessen-Thüringen Girozentrale), are also investigating the possibility. The Enron scandal suggests that this kind of thing can carry unsuspected risks, and credit rating agencies may be suspicious.

If all were to go well, though, these markets are so young and undeveloped that competition with commercial banks would be on a far more level playing field than in other areas.

It may seem unfair to criticize the banks for not making detailed restructuring plans before the final ruling has been announced. Nevertheless some market participants are not prepared to be charitable. “I think a lot of them have no clear idea of what to do,” says a banker, who likens the Landesbanken to rabbits paralyzed in front of a snake.

Versondert at Barclays Capital is more optimistic. He argues that access to retail deposits, not legal guarantee mechanisms, has always been the real driver of profitability. “The challenge is to convince the local savings banks of the advantages of integrating with the Landesbanks, and this will take time,” he says. “But if they succeed, the smaller number of resulting banks will have a large retail client base, profitable retail funding and strong distribution capacity and could pose a real threat to the commercial banks.”

Deutsche, Dresdner, Commerzbank and others have campaigned hard to get to this stage, hoping to eliminate competitors. So far their tactics have worked, and the Landesbanken have to respond. But the privately owned banks could end up wishing they hadn’t bothered. Or the Landesbanken could fail to move in time and fall prey to nimbler rivals. Either way, ignoring harsh commercial realities is no longer an option.

Bayerische LB: a new style of public ownership

Bayerische Landesbank has proposed a new ownership model to appease Brussels. It plans to create a holding company, Landesbank Finanzholding, jointly owned by the Association of Bavarian Savings Banks and the state of Bavaria. Local officials and management hope that this will preserve the bank’s public-sector character – the owners will be able to sell some of their stakes in the holding company but must each keep at least 25.01%, guaranteeing the public sector perpetual control. CEO Werner Schmidt says: “It’s important to note that neither of the two can sell their shares without the consent of the other. This is because it will help us to perform our mandate of helping the economy and the private sector.” That is, this bank has no intention of abandoning its development mission entirely.

Because the effort of restructuring will be less than that at other banks, this relatively simple solution should enable Bayerische LB to concentrate on business strategy. Schmidt says: “It’s good that we are not preoccupied with having to divide the company as WestLB is doing. Because we are not influenced by the external aspects, we can concentrate on responding to the market’s needs, and can take up the challenge of the future better than if we had to split or merge.” Schmidt does not rule out consolidation outright but says that any partner would have to fit with the structure and strategy of Bayerische LB and its owners.

Schmidt is hopeful that even on its own his bank can differentiate itself from its peers and that its core businesses will escape the loss of guarantees relatively unscathed. He says: “We believe Bayerische LB will secure a different rating from the others. We believe we will be a solid A. This might only marginally impact our funding cost. We believe we will be able to pass on the bulk of the funding costs to the market.”

WestLB: leader takes a waiting brief

WestLB is often singled out as the bank that did most to provoke action from the European Commission on Landesbank guarantees. In 1993, before the wider debate, the two clashed over a capital increase from the state, which Brussels viewed as an illegal subsidy. Its push into investment banking territory was by far the most aggressive of its peers, and it gained market share quickly in a number of areas. Not everyone takes the mutterings about the bank too seriously , says an analyst: “It was more blatant than the others but I think they were all at it, really.” But it has certainly stirred up ill will in large sections of the German market.

The bank wants to split its operations into two – a development bank that will retain the public mission and a commercial bank to carry on all private-sector activities. It had hoped the former would keep its state guarantee and so could guarantee the commercial bank in turn. This hope has not been gratified but WestLB is pressing ahead with the structure anyway, probably in the hope that it will eventually be able to attract private shareholders for the new commercial entity.

Some analysts doubt that this will be enough in itself. They think many of the bank’s commercial and capital markets activities will simply be unviable without cheap funding. “WestLB’s solution doesn’t really change much,” says one. “It will just do what Brussels is going to make them do anyway. It’s the only Landesbank that is truly internationally active as an investment bank, and it will now be more difficult for them to make money. They are clearly going to struggle in an environment in which all the top houses are struggling too. There is a huge difference between inventing a legal structure that will satisfy Brussels and coming up with a genuine strategy that will let them compete against the likes of Deutsche Bank.”

Jürgen Sengera, WestLB’s CEO, denies that the strategy of splitting the bank is even connected to the removal of its state guarantees, attributing it instead to the 1993 wrangle with the EU. He says the bank has set itself ambitious targets, including a competitive rating and an 18% return on equity by 2005. It will move further into credit derivatives and asset-backed finance, concentrating on high-margin areas where the bank can compete with bigger firms while maintaining core businesses such as fixed income and project finance. “It will stick to its defined market segments and in those segments it has been very successful,” he argues.

Although acknowledging that the EC decision will take between e100 million and e200 million ($175 million) from the bank’s bottom line – 20% to 25% of present earnings before taxes – Sengera says WestLB will make this up by cutting costs. It has already announced that it will lay off 1,500 staff. By the time all the Landesbanken have announced their own strategies, he hopes WestLB will be have a much stronger cost base. The bank will seek e1.2 billion in new equity from its owners, alongside a e2 billion hybrid capital increase. Sengera plans to target growth areas and stick to the bank’s most profitable businesses. WestLB will demand from its clients the opportunity to bid for more than just loans and will gradually reduce its lending activities in favour of capital market instruments.

Some may be sceptical about whether many of the other business segments will be profitable. But Sengera seems relaxed about the immediate future. Although WestLB is seen as a potential first mover in consolidation, he is in no hurry to rush into anything. He says: “Whenever you discussed the Landesbanken in the past you usually ended nowhere, because the owners still thought they could make it on their own. Various efforts by my predecessor to try to establish closer cooperation were not very successful. The pressure might have been too low. From that experience I draw the conclusion that now we should wait for the others.”

LB Kiel: active consolidator

LB Kiel is one of the smaller Landesbanken but it has set out one of the clearer strategies so far. It accepts that it will have to make big changes to its business plan and culture to adapt to the new funding circumstances. In fact, it foresees eventual public listing. Dietrich Rümker, the bank’s chairman, says it intends to build on its key strengths, such as shipping finance, real estate and infrastructure.

The bank is already trying to become more market-oriented. “In the past, our main focus was not on profitability,” Rümker says. “Today, profitability is a key issue and our strategy has already changed our culture. For example, we have implemented Raroc [risk-adjusted return on capital] targets and this has made our lending activities more disciplined. This has allowed us to stabilize margins, even though markets have been pricing in negative effects from the state aid debate since 1999, increasing our funding costs. Regarding our public-sector business, there is no cheap finance any more. Growth in public-sector lending is not very dynamic. However, we will stay in the market for infrastructure finance, substituting innovation and know-how for cheap funding through guarantees.”

Unsurprisingly, like officials at other Landesbanken he professes optimism about life after state guarantees and thinks customers will be better off: “It will not be possible to economize on quality,” he says. “There is no way to increase profitability except by increasing efficiency. By doing this we will prosper and our customers will benefit. The final destination is clear – LB Kiel will be transformed into a publicly listed company.”

Rümker is uncertain how the sector will look in a few years’ time. “We expect a trend towards concentration, as in other German and European banking groups,” he says. “However, I do not see the main focus to be on adding balance volumes. Raising efficiency will be the main point. Whether this is to be done by joint ventures in special areas or by mergers is not yet clear. I think we will see both. And I am convinced that the tie between Landesbanken and savings banks will hold. The savings banks link the Landesbanken to the retail market, while benefiting from their expertise. Due to our 49.5% stake in Hamburgische Landesbank, LB Kiel is an active player in the consolidation game – there can be no northern solution without our permission. But we do not want just to give our permission – we want to be a driving force, a first mover in the consolidation process.”