Step one in the Bundesbank’s approach to banking supervision: ignore a problem and it will just go away. Like an indulgent father unwilling to accept his son’s failings, the central bank is doing its best to pare down the travails of Germany’s private banks to a temporary blip in a history of otherwise strong earnings growth and sound profitability. “We’ve had some discussions about the stability of the banking system and I must underline that there are no concerns of a systemic nature,” says Edgar Meister, board member of the Bundesbank and chairman of the banking supervision committee of the European system of central banks. “I think the big banks are well managed. They have hidden reserves and the kind of provisioning done in the past helps them overcome this lag in profitability. So I am optimistic that the big commercial banks have a really good chance of competing with other international banks.”
How reassuring – but it’s far from the whole story. The banking system of the world’s third-largest economy is on its knees and the prospect of any German bank, with the possible exception of Deutsche Bank, being able to compete with British, Spanish or French banks is laughable. Between them the four major players – Deutsche, Dresdner Bank, Commerzbank and Hypovereinsbank – have a domestic market share of about 19%. In the UK, the top tier has around 29% of the market, in France it’s 43% and in Spain 52%.
Things are not getting any better. Over the past 10 years, the market capitalization of the German banks has been steadily deteriorating relative to European peers. At the end of 1994, Deutsche Bank was the second-largest European bank by market cap, Dresdner was ninth and Commerz sixteenth. Today Dresdner is no more, Deutsche is eleventh and Commerz twenty-ninth. “In a European context, German banks are clearly middling,” says Andreas Dombret, head of the German financial institutions group at JPMorgan.
After years of dismal returns on equity, diminishing profits and burgeoning loan-loss provisions, Germany’s Grossbanken now have nowhere left to hide. During the internet bubble of 1999 and 2000, they were able to conceal the fact that huge parts of their businesses, particularly retail, were not making money and keep shareholders sweet by reporting hefty fee income from investment banking and asset management. Since the stock markets fell back down to earth, however, and inflows to mutual funds dried up – falling to just e4.8 billion ($4.1 billion) in January to August 2001, down 92% on the same period the previous year – German banks have been stripped of any semblance of progress.
Exacerbating their problems is the stagnant German economy and the concurrent decline in asset quality among the nation’s corporates. “We are forecasting that 2002 is going to be worse and 2003 even worse still. Corporate loans will anticipate the trend in retail loans,” says Edgar Betteridge, an analyst at investment bank Fox-Pitt, Kelton. Though large potential bankruptcies such as KirchGruppe attract the most publicity, the bulk of the casualties are likely to be among the lower-profile small and medium-size companies to which most German banks are heavily exposed.
It would be easy to put the blame for all this on the esoteric and complex structure of Germany’s banking system. The retail market is dominated by cooperative and savings banks (Sparkassen) that are not bound by the demands of shareholder value. Their role has been rather to serve the local community and provide the region’s businesses with generous hand-outs and generally be nice to people.
Institutions such as British bank Lloyds TSB, which owes its high return on equity to the substantial fees it charges to retail clients, couldn’t exist in Germany where the customer, not profit, is king and there’s a bank on every corner. Around a third of all European bank branches are in Germany. Consumers have a huge choice of banks and are extremely price sensitive. So unsurprisingly not-for-profit institutions have soaked up virtually all customer deposits, leaving Deutsche with a meagre 6% of the retail market, Hypovereinsbank 5%, Dresdner 4% and Commerzbank 3%. Only a miracle could turn such lowly market shares into viable businesses.
The only number rising is costs
The banks may be struggling with a difficult market but external factors are not entirely to blame for their predicament. The German banking sector is notoriously bad at cost control. In retail banking for example, the cost per client in Germany is an annual e400, compared with e250 in the rest of Europe. “The whole strategy the German banks have been pursuing is now in question,” says Volker von Kruchten, an analyst at BHF Bank. “They wanted higher earnings through commission in order to become more competitive and increase their attractiveness, but now their costs are too high.”
As a result, German banks tends to have low price-to-book valuations and high P/E ratios compared with those elsewhere. Despite the fact that these are huge banks – Deutsche has almost e1 trillion in assets and Commerzbank e500 billion – their market capitalization is relatively small. This makes them vulnerable to takeovers, even from smaller banks. The fact that, in 2000, Unicredito initiated merger talks with Commerzbank is the ultimate indictment of the German bank. Italian financial institutions long had a reputation for being the least efficient and worst managed in Europe but, besides this, Unicredito has a market cap of around e200 billion. That’s two and a half times smaller than Commerzbank.
All four big banks urgently need to reduce their frighteningly high cost-to-income ratios. Even Deutsche, now arguably more a US than a German bank, is not immune. “The retail banking side is not working because of weak management by [chairman Rolf] Breuer,” says one banker. “He has not been able to get a grip on the business, particularly on the cost side which has really exploded, particularly in the past few years.”
The big banks might be making all the right noises and for the first time meaningful job cuts – but their past record gives little cause for optimism. Successive management teams have pledged cost-reduction measures with little to show for it a year or two down the line. A favourite trick, according to analysts, is to say that the savings have been reinvested in the business, thus bypassing requests for quantitative results. “There are positive things to say about the German banks but the question is why we should believe that they are going to do anything about it now,” says Betteridge at Fox-Pitt, Kelton.
It isn’t as if lack of profitability is a new phenomenon in Germany. The savings and cooperative institutions have always undercut everyone else so it’s hard to see why private-sector banks haven’t tackled the problem earlier. “All of them have failed to control rising expenses from staff, IT and investment banking spending and low risk adjusted margins,” says Stefan Best, a director in the financial institutions group at Standard&Poor’s.
A major part of the problem is that the big German banks, apart from Deutsche, went into investment banking too late and spent too much on building up teams and capabilities. Rather than viewing it as a long-term project, they saw it as an opportunity to make money fast. Much of HVB’s business, for example, came from the companies in which it had equity stakes, which proved to be willing guinea pigs for its fledgling equity capital markets division. Commerzbank installed a convertibles team in 1999 that so far has done just one deal.
“Banks took the approach that investors wanted them to build out in investment banking and asset management,” says David Williams, an analyst at Morgan Stanley. “This was a double-edged sword because it provided a dividend but proved to be more expensive and difficult than was initially thought.” Lack of a long-term perspective meant that they failed to spot the downturn coming. Early last year, for example, Klaus Peter Müller, CEO of Commerzbank, was still upbeat about the business and pledged a budget increase of 15%. By mid-year he was eating his words.
The deep-rooted feelings of benevolence among bank chiefs towards the Mittelstand – small and medium-size German companies – has also helped cap returns on equity. Historically, this part of the economy leans heavily on the banking sector for capital and it seems they don’t have to ask twice. “It’s a special privilege for us to work with the Mittelstand and give them not only advice but also loans,” says Albrecht Schmidt, CEO of HVB.
The Mittelstand is seen as the backbone of Germany’s industry and any threat to it arouses strong feelings. Hence the appeal by the German delegation to the Basle committee that risk weightings be tailored to the size of a firm. William McDonough, chairman of the Basle committee on banking supervision, said in a speech in Frankfurt recently that he wondered why Germany was alone in drawing attention to the implications of Basle for SMEs. The answer is simple – this is a highly sensitive political issue in Germany.
Schmidtbank’s warning signal
According to a Frankfurt-based banker, the generosity of the private banks, along with recent over-investment in infrastructure and investment banking, has irreparably damaged the credit profile of German banks. “The balance sheets of most of them are completely bombed out,” he says. “Hidden reserves are fewer and fewer, most of them have now been liquidated.” Well-publicized cases, such as the collapse of Schmidtbank and the difficulties at Bankgesellschaft Berlin, which is having to be bailed out by the region’s government, provide just a glimpse of what’s going on behind the scenes, this banker says.
Arguably, the private banks should not be using their balance sheets to bail out institutions that lack the ability to manage their own finances – as they did at the end of last year for the Bavarian Schmidtbank. German news magazine Der Spiegel reported that CEOs of Germany’s big banks met the finance minister of Bavaria and were given a deadline by Jochen Sanio, president of the supervisory authority, to agree on a rescue package or the bank would be closed. That they did so reflects a concern for the stability of the financial system and the risk of a contagion effect if Schmidtbank were allowed to fail.
Commerzbank has shown in the past that it is far too free and easy with its balance sheet and some of its exposures suggest a wayward attitude to credit risk management. In 2000, for example, Commerz increased its stake in BRE Bank of Poland from 48% to 50%. Unfortunately BRE has a large credit line to Elektrim, a Polish industrial holding company that is currently going bust.
A stake in a Polish bank at least makes sense strategically. Yet Commerzbank also inexplicably owns 33% of Korea Exchange Bank, a stake it began to accumulate in 1988 and then increased in 1999 and December 2000. KEB seems to have got the better deal. It is one of the largest creditors to chip manufacturer Hynix, also on the verge of collapse. “These are not show-stoppers but Commerzbank’s capital is close to the 6% tier-one boundary.
If they continue to slip there is a danger it might fall below the regulatory guidelines,” says Betteridge at Fox-Pitt, Kelton.
It’s little surprise, though, given the catalogue of recent errors, that Commerzbank has such a slack grip on its credit exposure. In 1992, for example, it set up a unit called Commerzbank Financial Products (CFP) under Antoine Paille, who had been responsible for taking Société Générale into the derivatives business. The unit was entirely French-speaking yet based in Frankfurt. “I remember visiting their offices in Frankfurt and having to translate from German to French for the benefit of the people working there,” says a banker. Needless to say, the division didn’t survive for long.
Müller could go some way towards erasing the blots on Commerzbank’s copybook by proving to the market that he now has a strategy and the wherewithal to execute it. He’s renowned as a great communicator but that alone won’t make the share price rise. What Commerz needs more than anything is focus. Time is running out for it to decide its own fate, whether as a bank for the Mittelstand, a distribution platform, or a player in asset management or in investment banking. Bankers admit to being flummoxed as to Müller’s next move. “Arguably Commerzbank shouldn’t exist. Where is its competitive edge? What is it in the business of doing?” asks one banker in Frankfurt. “All they have is a collection of second- and third-class businesses,” says another. “And what is second class today becomes third class tomorrow if no investments are made.”
Now is not the time to sell parts of the business but there’s nothing stopping Müller from sharpening his focus and directing resources away from, say, investment banking and asset management towards areas where Commerz has a chance of being competitive. The best strategy would be for it to forget about the high-profile, glory-winning business and concentrate on becoming a good, cost-efficient secondary trading operation so that if, say, Fidelity decided that it wanted to enter the German market, Commerz would be an obvious vehicle.
Unless Müller manages to get his house in order soon, the future looks bleak. Abysmal results and a gloomy financial outlook – the bank looks unlikely to turn a profit this year and probably next – are keeping possible buyers away. “I’ve spent a lot of time talking to potential partners for Commerzbank and I honestly don’t think that there’s anyone left out there who’s interested,” says a despairing investment banker.
That’s little wonder after the experience of Alessandro Profumo, boss of Unicredito. Last October, news broke that Commerzbank was in talks with the Italian bank. “Profumo said this institution can’t be all crap, there must be some value there somewhere and we have to look for it,” says a banker close to the discussions. Unicredito’s shareholders disagreed. Its stock plummeted 20% as investors panicked about potential earnings dilution. Profumo could not ignore such a strong signal of disapproval and rapidly called off negotiations.
Who wants cheap banks?
Today Commerzbank shares are trading 40% lower than during the merger talks. And while its relationship bankers are keen to market it as a bargain, it is more of a pariah. “It’s a perfect opportunity to get a foothold in Germany relatively cheaply,” says a banker close to Commerz. “It is impossible to take over Deutsche, Dresdner is out of the picture and HVB is too close to Munich Re.” Moreover, any purchaser would need to be large enough to take a huge hit up front for such a takeover. For the moment, Commerzbank’s weakness is its insurance against this.
HVB is relying on majority shareholder Munich Re to provide the same sort of protection. Observers suggest that had it not been for Munich Re’s 25% stake in the Bavarian bank, it would have been bought long ago. CEO Schmidt’s problem is not lack of strategy, as is the case at Commerz, but failure to implement that strategy convincingly.
HVB does at least have focus – it bought Bank Austria in 2000 and is concentrating on building market share in southern Germany, Austria, Poland and the Czech Republic. However, Schmidt has not been particularly rigorous, say critics, at deriving value from these acquisitions. Until recently there were separate risk-monitoring operations for Bavaria and Austria, for example, and easy synergies such as the integration of back-office operations have not been exploited.
HVB is also heavily exposed to the German real estate and mortgage market. For a while, the market forgot that and three or four years ago HVB traded at a multiple of 17 or 18 times earnings as opposed to 13 times for the rest of the sector. But as long as Sparkassen and Landesbanken can operate at margins below its cost of financing, it has a problem. A lot of HVB’s bad debts are an overhang from the merger. It was created from the combination of two banks, one of which, Bayerische Hypotheken- und Wechsel-Bank, had an enormous property loans portfolio, the full extent of which came as a shock to Schmidt after the deal had been completed.
He is now trying to reduce that exposure, and corporate loans made since, via a securitization programme. “Our loan portfolio is 1.5 times higher than that of Deutsche – that is too large,” he says. “It’s a result of the acquisitions and merger activities in recent years. But we now have volumes that we need to reduce with capital market transactions.”
There’s been much speculation in Munich as to whether Munich Re will increase the size of its holding in HVB. When it swapped its interests in Dresdner and Allianz Leben, Germany’s largest life insurer, for an additional 17.4% in HVB last year, some bankers were convinced that a takeover bid would soon follow. That now looks unlikely. For one thing, Schmidt would certainly resist such a move. “We are absolutely convinced that we can create more value for the shareholders of Munich Re and HVB this way than with a merger,” he says. In addition, though, Munich Re has little reason to be pleased with its investment. When the trade was done six months ago, HVB’s share price was double what it is now and HVB’s 5% return on equity is less than Munich Re’s cost of capital at 7% to 8%.
A merger wouldn’t make sense for Munich Re either. The insurer is getting what it wants – HVB’s distribution network and asset management products – without having to go through the disruption and potential further value destruction of a merger. Moreover, Munich Re’s board is dominated by people with a background in reinsurance who may well not have the skills needed to oversee an acquisition.
One option might be for HVB to sell its money-management operation, Activest, to Munich Re. Analysts say that this unit is not as profitable as it should be but Schmidt argues that he needs this kept in-house to give tone to HVB’s private-banking operations. As only 60% of the products that Activest sells are its own, and the other 40% is open architecture, that proposition is debatable. If Activest continues to underperform, Schmidt may not have the luxury of this choice for much longer.
In the meantime, Munich Re has also snapped up an additional 5% stake in Commerzbank, taking its share to 10%. The move raised temperatures on the stock markets and sent Commerzbank’s share price up 9% but investors probably shouldn’t get too excited. The reinsurer is simply hedging its bets in the same way as Allianz, which also has a stake in HVB, is doing. Müller’s bank is cheap and will be involved in consolidation at some time in the future, however distant. As an insurance company, Munich Re has a long time horizon and can sit on the investment for up to 10 years if it has to. In the meantime, it is behaving like a dog in the manger by preventing another insurer entering the German market through one of its beleaguered banks.
Those banks are now fearfully eyeing the progress of the Dresdner-Allianz marriage, which came after a farcical round of merger talks last year in which multiple combinations of Deutsche, Dresdner, Commerzbank and HVB were mooted. In the end, Allianz had no choice but to get hitched to oft-jilted Dresdner which, by that stage, had lost too many talented people to survive for long alone.
But Dresdner is paying a heavy price. It will be trimmed down to become little more than a franchise business for Allianz. It’s doing a fantastic job at cleaning up its problems, but that’s because it can afford to. Laying off staff is extremely costly in Germany, which explains the slow progress being made by other banks. Dresdner doesn’t have to worry about hefty restructuring costs or being cash negative in the next nine months despite all the cash that is being used to make redundancies, as it has Allianz in the background ready to make up the extra.
At least Dresdner now has a credible management team in charge. Allianz CEO Henning Schulte-Noelle, and CFO, Paul Achleitner, command respect in both Munich and Frankfurt. Achleitner was formerly a M&A banker at Goldman Sachs and is regarded as one of the best deal makers in Germany. As for the Dresdner executives, Leonhard Fischer, head of investment banking, is tipped to be in the running for Achleitner’s role in time. He is of Achleitner’s generation and is said to share many of his views. Chairman Bernd Fahrholz meanwhile, is thought unlikely to make the transition from banking to insurance.
Both Commerzbank and HVB have recently recruited troubleshooters – a clear acknowledgement of the fact that investors no longer have faith in management to sort things out. Müller hired Martin Blessing from McKinsey at the board level and Eric Strutz from Boston Consulting Group. At Hypovereinsbank, Stefan Jentzsch, also an ex-Goldman banker, has been appointed to the board in the newly created role of chief risk officer. He is viewed by his old colleagues in Frankfurt as a master investment banker. Asked if he had Jentzsch in mind when he created this role Schmidt doesn’t hesitate in replying in the affirmative. Was the new title Jentszch’s idea? Absolutely.
Four may become two
But there are limits to what appointees can do. Although they can help create the impression that the banks are serious about cleaning up, they can’t guarantee their future independence. While an economic recovery has not materialized, and the longer it takes, the more likely it is that the German banks will have to enter mergers. “In the worst-case scenario that they are not able to raise levels of profitability, two huge powerhouses could emerge – Allianz including Dresdner and Deutsche on one side and Munich Re, Commerzbank and Hypovereinsbank on the other,” says von Kruchten at BHF Bank. But nothing like that will happen before 2003.
It’s unlikely that any of the big four will go bankrupt though. And there are one or two bright spots. One is the implementation of Basle II, which will help the private banks. “Regulatory capital is geared more closely to the real risk banks are facing so the returns for borrowers that are not that creditworthy becomes higher so that will improve margins,” says Tobias Winkler of the Bundesverband deutscher Banken (BDB), Germany’s private banks association. “Moreover Basle has promised that overall capital requirements will not increase, for banks using the IRB approach there will be a slight decrease in capital requirements so this is also going to decrease capital costs and improve ROE.”
The abolition of state guarantees for the Landesbanken should also help bring about a step-up in interest margins because these banks will no longer have access to funding at the same cost as the government. As a result they will be obliged to lend at higher rates.
One option to increase profitability might be closer cooperation between private-sector and public-sector banks. “You have not only three banking groups in Germany but very high walls between these groups,” explains Karl Knappe, director at the BDB. “Until now there has been some consolidation within the sectors, which is obviously sub-optimal. Today we are at a point where is it difficult to go further unless some stones start to come out of the walls.” But progress is limited. Savings banks and their parent organizations the Landesbanken are still effectively owned by politicians and that looks unlikely to change in the very near future. One or two of the savings banks such as Frankfurter Sparkasse have reportedly contemplated doing IPOs, but it is difficult to tell whether these are serious strategic discussions or simply the result of disagreements between the politicians of a particular region and the CEO of that region’s savings bank.
Even if the legal status changed to allow closer cooperation, it’s not certain that it would happen. The savings banks will not sit there and wait for the private banks to buy them. They are powerhouses covering an enormous customer base in wealthy regions and any bank wanting to get its hands on such assets will have to pay for the privilege. “I invited the savings banks to talk and my invitation is still there. I’d be very happy if the big savings banks came to me and wanted to cooperate. It would be a great advantage for both of us if we could share the costs and achieve economies of scale,” says Schmidt at HVB.
But, according to Jürgen Sengera, CEO of WestLB, the largest of the Landesbanken, he shouldn’t hold his breath. “I think the private sector regard us as competitors, we see them as competitors and up to now I didn’t receive any signs of a desire to cooperate and as we don’t have a desire to cooperate with them I don’t think there will be any,” he says. “We have seen many invitations to savings banks but these invitations were on the private banks’ terms.”
What the private banks need is for the capital markets to recover quickly. This would have a positive leverage on income from fee-based businesses, cost-cutting and eventually interest income. More buoyant capital markets would also make it easier for banks to divest the stakes they still hold in various corporates. Deutsche Bank’s exposure to DaimlerChrysler, which is too large to be hedged, resulted in a write-down of e6 billion in the third quarter of 2001.
Disposing of these shareholdings is a good plan given that Basle will double the capital needed to cover equity exposures as opposed to loans. It is a pity for the banks to have to use loan reserves to cover a reduction in profits but they might have to do this in order to protect ratings. “It will be interesting to see what happens following the abolition of the capital gains tax this year. We would be concerned if they used their hidden reserves exclusively for special dividends or acquisitions, we would prefer to see them realizing gains and retaining a sufficient part of the profits to maintain adequate capital strengths,” says Best at S&P.
But the capital markets reviving, in the short term, seems remote. Until then it is a question of survival of the most cost efficient. Meister at the Bundesbank says: “Our biggest bank is very far advanced. Commerzbank is getting better and Hypovereinsbank is getting better too – it is also very close to an insurance company.”
When asked for clarification, Meister replies that he can’t talk about everything he knows about the bank but it will manage through the downturn. Now what was that about a problem in the banking sector?
Citi and SEB show how it’s done
Complaints from the big German banks that it’s impossible to make money in retail banking are starting to wear a little thin. After all, some foreign banks operating in Germany manage it. Citibank, for example, has been present with a retail banking business since 1973, when it acquired KKB Kundenkreditbank. Today it has 300 branches throughout the country and reported preliminary earnings before risk adjustment and taxation of e800 million ($610 million) in 2001, up almost 20% on the previous year.
CEO of the bank’s German operations Christine Licci attributes this success to the fact that, whereas other banks have tried to be all things to all people, Citi has a relatively narrow business focus. “Most retail banks mix servicing retail customers and enterprises. We only look at private individuals and that has allowed us to become successful,” she says. As a result, Citibank has built up a 4.5% share of the credit card market as one of the five major players in this area, an 8.6% share of the loans market and 1.5% in investment products, which it began to offer two years ago. Overall, its market share is 1.1%.
Licci admits that attracting new customers is an uphill struggle: “It’s extremely difficult. Everyone has his or her home bank and will only try somewhere new if there is an appealing service or product on offer,” she says. “We try to launch new products regularly and every time we do we have an influx of new customers.” German consumers are notoriously price-sensitive, however, and tend to compare costs and spread their business over several banks. So even if Citi captures new clients, there’s no guarantee that they will become permanent customers.
Citi’s game plan, continues Licci, is to try to entice such casual users into a committed relationship by offering a premium-style bank account, pre-empting customer needs and developing innovative products. She claims it was the first to introduce 24-hour access to its services via the internet and telephone banking.
It’s also essential to standardize services as much as possible in order to survive in the German market. “In the last few years we have been taking administration out of the branches and centralizing mail and phone services,” says Licci. Over 70% of Citibank’s money transfers are now done automatically, compared with around 40% at most German banks. The bank also has an extremely refined credit scoring system that means customers can be given loan approval in less than half an hour, rather than the customary two or three days. This perhaps explains why 58.6% of Citibank Germany’s revenue comes from its loans business.
Crucially, these developments help to keep the operation’s costs down, something that Citi, as a US bank, is arguably better equipped to do than competing German institutions, which until recently have not had to think too seriously about this. “Doing business in a cost-conscious way is the way we do business at Citigroup,” says Licci.
Hoping for a rerun of Citi’s success is Lars Lundquist, CEO of SEB Bank Germany. In 1999 Swedish bank SEB took over BfG, at the time the fifth-largest private commercial bank in Germany, for e1.6 billion. “The potential is here to run a retail bank profitably if you have your costs in order,” he says.
The acquisition was essentially opportunistic. SEB wanted to expand and saw limited opportunity to do so in its domestic market. It already had operations in the Baltic states and Poland but wanted to set up in a western European country too. “It really came down to here’s an opportunity, here’s where we can get in,” says Lundquist. “Initially we, like other banks, said that BFG was not the bank we want but we found it fitted the criteria we were interested in and was at a price where we thought we could create value.”
Lundquist’s priority since arriving in Germany from Sweden, where he was board member in charge of asset management, has been to cut costs. “What we have done is to introduce more successful, that is harsher, cost reductions,” he says. He has also been focusing on reducing the bank’s credit-risk exposure. “German banks have large credit losses compared with what we are used to. BFG wasn’t an exception but it was a level we weren’t uncomfortable with,” he says. This process involves identifying which companies SEB wanted to work with in the future, and which relationships it wants to get out of.
So far, Lundquist says, things are going well. He has been busy breaking the bad news to the companies SEB will no longer lend money to and managed to reduce costs by around 20% mainly through 800 redundancies. But the real test is yet to come. Up until now, SEB has been able to use the excuse that it was in the midst of restructuring to explain the fact that it hasn’t increased its customer numbers. That can’t go on for ever. Unless Lundquist succeeds here too, his cost-saving efforts will be to little avail.
