Ten years ago, when Stefan Ermisch moved to Hamburg to become chief financial officer of HSH Nordbank, the banking champion of Germany’s largest port was in deep crisis. It looked like it could only get worse.
Previously the world’s biggest lender in ship finance, by 2012 HSH faced a renewed slump in shipping that was weighing heavily on efforts to restructure its bloated balance sheet. Meanwhile, its public-sector owners – represented by the then mayor of Hamburg and now federal chancellor Olaf Scholz – had just forced out their second chief executive in less than two years.
Shortlisted
- BNP Paribas
- DBS
When Ermisch became CEO three years later, the European Union offered HSH a lifeline in the shape of a new state-aid agreement, but only in exchange for a commitment to privatization within two years. Yet the bank’s future was by no means assured. Many still feared HSH would go the same way as WestLB, another federal, state-owned wholesale bank or Landesbank, which was liquidated in 2012.
Today, HSH has been transformed almost beyond recognition.
Jump to
The bank is not called HSH anymore but Hamburg Commercial Bank (HCOB), following its 2018 privatization and subsequent rebranding. By early 2022, it could boast some of the best financial metrics in banking in Germany – if not Europe – including a common equity tier-1 (CET1) ratio of 28.9% and a 50% cost-to-income ratio in a country where 70% is normal. It also hopes to become one of the first banks in Germany to migrate to the cloud.
Its transfer to Germany’s private-sector banks deposit insurance scheme on January 1 this year, following a ratings upgrade by Moody’s in November, was a vital stamp of approval in the turnaround.
“The changeover by a former public-sector bank to the deposit protection fund has been a convincing success,” proclaimed Christian Sewing, president of Germany’s private banks’ association, the BdB, and chief executive of Deutsche Bank, at the time.
The BdB was far from ready to allow HCOB into the scheme in February 2018, when US private equity companies led by Cerberus Capital Management and JC Flowers & Co bought the 95% of the bank previously owned by Hamburg and the neighbouring state of Schleswig-Holstein for €1 billion.
Even after three years of building up its financial strength and satisfying the BdB of its solidity, the former HSH Nordbank still has its doubters. Ratings agencies fear that refocusing on commercial real estate and shipping, as well as renewable energy and some corporate lending, has brought HCOB more efficiency than diversification. It is based in a German market that – not least because of the survival of other Landesbanken – remains notoriously fragmented and therefore unprofitable.
But there is no denying the importance of what has happened in Hamburg.
Radical restructuring of its balance sheet and costs, as well as state support, has seen this institution become the first fully privatized Landesbank.
“It has been a phenomenal demonstration of how you can run a profitable bank in Germany and move from the public sector into the private sector,” comments a senior investment banker in London.
For Cerberus, which now owns 42.4% of HCOB, the investment has been one of a series of plays in German banking in recent years, including the 2017 purchases of 5% and 3% stakes in Commerzbank and Deutsche, respectively.
Like HCOB, these investments in Germany’s biggest private-sector banks reflect a view that operational management is often more to blame for underperformance in German banking than the country’s competitive landscape and labour laws.
Commerz and Deutsche have also stepped up their restructuring efforts over the past five years, although when Cerberus cut its stakes in those two early this year, both banks’ share prices were still trading below their 2017 levels.
JC Flowers’ Hamburg story goes back even further. Flowers made an initial bet on HSH Nordbank in 2006, leading a consortium against other bidders, rumoured to include Cerberus, to buy 24% of the bank for €1.25 billion from WestLB. This was with a view to doing an IPO, but it was a hollow victory. Although the firm participated in a capital raising in early 2008, putting in €300 million to maintain the stake, subsequent bailouts diluted it to 5%.
But Flowers, which now owns 35% of HCOB, maintained a right of first refusal on any sale, as well as intimate knowledge of the bank from having been a shareholder and having had representation on the board.
Reluctance to consolidate
By 2018, according to Flowers founder Chris Flowers, it was the same bank but not the same opportunity. This time, the states had to get out entirely. Moreover, during the previous 10 years, HSH’s staff headcount had dropped from 5,000 to 2,000 and its balance sheet had fallen from €208 billion to €70 billion.
Since then, the bank’s staff and balance sheet have shrunk even further under private ownership. By the end of 2021, it had 919 employees and €30 billion in assets.
“We’ve been very, very pleased with how this has developed,” says Flowers. “It has been a tremendous success. You can measure that in different ways but certainly by the numbers – including profitability, capital ratios, balance sheet strength and the cost-to-income ratio – and in terms of clarity of strategic direction.”
German banking is a very stubborn industry
Stefan Ermisch, Hamburg Commercial Bank
Despite such enthusiasm, according to Ermisch, many in the German banking establishment were less than eager for the privatization and attendant restructuring to succeed. This was mainly for fear that it would put pressure on them to do something similar because it has been such a high-profile story in Germany.
“Almost everyone thought it was impossible and that nobody would buy HSH,” Ermisch admits. “The more they articulated that, the more I was convinced that we would succeed.”
Ermisch draws attention to what he says is the Landesbanken’s wider reluctance to consolidate after EU state aid rules diminished their relevance. He also notes the private-sector banks’ failure to create a bigger national champion.
“German banking is a very stubborn industry,” he points out.
During the privatization, Hannover-based Landesbank NordLB was rumoured to have looked at HSH, alongside China’s HNA and Anbang. But other bids for HSH effectively narrowed down to Apollo, another US private equity company. Talk later in 2018 of the creation of a mega-Landesbank based on a merger of NordLB and Frankfurt’s Helaba, and perhaps then Stuttgart-based LBBW, similarly came to nothing.
Commerz and Deutsche also steered well clear of the chance to take advantage of the state’s need to sell HSH. Around the same time, they also pulled out of a mooted merger between themselves: this despite rumoured support for a merger from Cerberus and Scholz, who was then in charge of the federal finance ministry, Commerz’s largest shareholder.
Pressure for change
Now that the old HSH has proven its doubters wrong – and succeeded not just in finding a buyer but in posting stellar financial results – does it put more pressure for change on the rest of the German banking sector? Ermisch thinks so.
“I believe the success of the transformation here is super important as it shows that, even in Germany, this return profile is possible; it is not wishful thinking,” he says.
“Nobody can shut their eyes on this performance. A company with no future is suddenly one of the best-performing banks in Germany, measured by capital, efficiency, return on equity. This surely shows that transformation does make sense; it is possible, but it is the result of hard work and of making something dysfunctional functional.”
It is not the only time in his interview with Euromoney that Ermisch uses the word ‘dysfunctional’ to describe the bank he joined in 2012. Ermisch has worked at banks across Germany, as well as in Vienna and Milan. Yet his arrival in Hamburg was clearly something of a shock, to the extent that he was tempted to quit.
HSH, Ermisch recalls, had built up an order book of €40 billion in shipping loans in the three years before the 2008 crisis, largely based on unrealistic hopes of ever-rising shipping values. By the time he arrived, most of that book was turning sour.
Ermisch says that fantasies about the bank’s capabilities were such that there was an atmosphere of internal peace and harmony, even as large swathes of loans defaulted. He sums up the old approach as “good food at lunchtime, but outcomes that aren’t measured very well.”
There were too many people, too many products and way too much reliance on shipping.
Instability at the top of the bank hardly helped. Post-2008 chief executive Dirk Jens Nonnenmacher exited in early 2011 after Hamburg and Schleswig-Holstein lost confidence in his leadership due to questions around his role in a 2007 structured credit investment (a Hamburg court later issued him a €1.5 million fine for the transaction).
The states then forced out former Citi investment banker Paul Lerbinger in late 2012 – again going over the head of then chairman Hilmar Kopper, previously Deutsche’s longstanding chief executive.
But the restructuring had already started and Ermisch says it accelerated after he joined as CFO in October 2012, when Constantin Von Oesterreich took over from Lerbinger.
HSH’s state owners recapitalized the bank to the tune of €3 billion in early 2009, issuing €10 billion of asset guarantees after it posted a €2.8 billion annual loss for 2008 – the guarantees later turned out to be entirely necessary. At the time of the bailout the bank promised to halve its loan book to €100 billion, entailing a big round of job cuts from 2009 onwards.
A state-aid settlement with the EU in late 2011 then demanded the core bank shrink further to €82 billion in assets – entailing further job cuts and an exit from aviation finance – but not privatization.
However, the problems remained. There was no sign of recovery in shipping values, which were suffering from huge excess of supply thanks largely to the rush by HSH and others to fund ships before 2008.
HSH was also struggling to meet fees that the 2011 EU settlement required it to pay its state owners in compensation for the asset-guarantee scheme.
By the time Ermisch arrived, the situation was unsustainable. After a second consecutive annual loss in 2012, HSH was forced to ask for the states and Brussels to increase the guarantees back to €10 billion, having just cut the scheme to €7 billion to lower the fees. In early 2014, HSH posted its biggest annual loss since 2008, €882 million, thanks to the shipping slump, the guarantee fees and provisions related to potential tax liabilities in its old proprietary trading unit.
We believe that managing large portfolios of non-performing loans is typically not among the core competencies of banks… We have spent decades building that capability
David Teitelbaum, Cerberus
In 2011, after almost three more years of negotiations over the guarantees, HSH finally reached a new agreement with the EU, allowing the bank to sell bad debt to the states. HSH would be split in two: a state-owned holding company for legacy assets and liable for the fees for the guarantees, and a unit for the core business. The states would then have to sell the bank by 2018 with the European Commission’s approval or face a wind down.
The agreement was a pivotal moment.
“I saw that we could manage it at that point,” says Ermisch. “The requirement from the European Commission to privatize the bank opened the door to crystallize the guarantees and of get rid of the legacy book.”
In the end, Cerberus took the legacy unit’s €6 billion of non-performing exposures (NPEs) as part of the 2018 privatization deal. HSH then ended up with an NPE ratio below 2% and a balance sheet allocation to shipping that had fallen to 8%.
These investments were made in parallel, though Cerberus would have done the equity investment without the NPEs, according to David Teitelbaum, Cerberus’ global head of financial institutions advisory. But, he says, the NPE component was vital in allowing the bank to focus on its business and in convincing Brussels and supervisors at the European Central Bank that it could be viable in the longer term.
Unlike JC Flowers, Cerberus’ origins are in distressed investing.
“We believe that managing large portfolios of non-performing loans is typically not among the core competencies of banks,” says Teitelbaum. “We have spent decades building that capability.”
Restructuring progress
However, even before privatization, there was progress on restructuring. The balance sheet shrank by a quarter between 2016 and 2018. Staff numbers fell below 2,000 just before the private equity companies took over.
“Without the work on restructuring the bank prior to privatization, the privatization and the success we have today would not have been possible,” says Ermisch.
It was easier after the 2016 EU agreement reinforced the threat of a wind-down. Ermisch could then more convincingly argue to the bank’s stakeholders that they had only one of two choices: stringent cuts, which might at least allow the bank to survive as an entity, or liquidation.
We need proactively managed consolidation in Germany, but this is not in the DNA of politicians regarding banking
Stefan Ermisch, Hamburg Commercial Bank
That need for an ultimatum is why Ermisch thinks little will change in the rest of the German banking sector – especially the Landesbanken’s operating models – until the next crisis.
“We need proactively managed consolidation in Germany,” he says, “but this is not in the DNA of politicians regarding banking. The management boards of the Landesbanken are too weak to put enough pressure on the owners. They are good people, but they don’t have the power to convince the owners to force changes. When the next crisis comes, I think exit strategies will get more articulated by public owners.”
State interests
Ermisch began his career at Frankfurt private bank Merck Finck, before working as a bank equity analyst in Dusseldorf at Trinkaus & Burkhardt (part of HSBC) and then WestLB. Having tipped off the market about what he correctly saw as a potential merger of Bayerische Vereinsbank and Bayerische Hypobank, he then became head of M&A and corporate development at HypoVereinsbank (HVB) after that deal became a reality.
Ermisch found HVB a fun place to work in the early 2000s as it grew in central and eastern Europe through the acquisition of Bank Austria Creditanstalt. The fun stopped when UniCredit bought HVB in 2006. Two years later, the Bavarian government lured him to BayernLB with the prospect of a listing.
“I naively thought it would be cool to do an IPO of a Landesbank,” says Ermisch. “I started full of hope and energy, and then six weeks later Lehman Brothers collapsed and I was stuck in the public banking sector.”
I naively thought it would be cool to do an IPO of a Landesbank… I started full of hope and energy and then six weeks later Lehman Brothers collapsed
Stefan Ermisch, Hamburg Commercial Bank
German banking, in Ermisch’s view, is still in desperate need of consolidation and an end to the widespread state interests in the sector. State-owned banks remain dominant not just in wholesale banking through the Landesbanken but also through the hundreds of local government-owned savings banks, or Sparkassen, which typically co-own the Landesbanken alongside the states.
“In Hamburg, we could execute a Landesbank privatization from A to Z, and that makes me very happy,” Ermisch says. “There is now a clear view that this is possible, when a lot of people thought it was not.”
Although German borrowers clearly benefit from the highly competitive nature of German banking, Ermisch struggles to find much advantage in the current setup of the sector beyond a relatively decentralized supply of highly paid city jobs.
“Germany’s federal structure leads to a huge bureaucracy, also visible in parts of the Landesbanken sector,” he says. “The banking industry is understood as a utility to serve a need but not always to produce returns.”
The problem, as he sees it, is that state ownership often stands in the way of necessary restructuring. Ermisch says that the prevalence of shareholders not orientated towards returns adds to the overbanked nature of the German market, both through the reluctance to do mergers and through a lack of business focus and specialization at the banks.
“Germany is a highly industrialized country and the Landesbanken are the dominant financier of the larger mid-caps,” he says. “They have a 20% market share in corporate and commercial banking in Germany. This makes sense if you have one Landesbank. We have five.”
Costly cop-out
It is now 20 years since the EU put an end to automatic guarantees for the Landesbanken’s funding.
According to Ermisch, the HSH case has amply demonstrated how complicated it is to recapitalize state-owned banks under Brussels state-aid rules. Rather than injecting adequate capital into HSH at the outset, he sees the states’ half-hearted 2008 decision to offer €10 billion in guarantees as a cop-out that became extremely costly for HSH because of the fees it had to pay. Years of complex negotiations with Brussels followed.
What does all this mean for HCOB today?
The wider German corporate banking market is still highly fragmented, and the dogged determination of foreign banks to take a portion of it makes it ever more competitive. Meanwhile, HCOB’s remaining activities – commercial real estate, shipping and project finance – still partly mirror its activities when it was a state-owned Landesbank.
Yet according to Ermisch, greater specialization has meant exiting businesses in Germany in which HCOB has relatively little expertise and therefore less of a competitive advantage. It has also allowed it to shrink the home-market business, which it deems insufficiently attractive from a risk-return perspective.
Transformation often comes down to business and product simplification. It is about asking the questions: ‘What are we good at and what are we not good at?’
David Teitelbaum, Cerberus
Since privatization, HCOB has moved further from classic German corporate banking because the margins are so low. After he became chief executive, Ermisch explains, he shifted the emphasis away from businesses traditionally associated with Landesbanken, such as unsecured machinery financing for Mittelstand car suppliers – the sort of thing he sees almost every other bank in the country offering.
The bank has also exited wealth management, another business in which it had few differentiating factors and which is amply provided by other banks, especially in Hamburg. It has also scaled back capital markets products such as foreign exchange and derivatives for similar reasons.
Although this has left it more reliant on net interest income – with fee-generating capacity largely restricted to carrying out payments for shipping and commercial real estate clients – Ermisch says that has by no means come at the cost of profitability, despite low rates.
Cerberus’ Teitelbaum explains that simplifying the bank along core business lines has generated greater efficiencies in back-office functions and IT. Alongside a move to more standardized IT systems, he says it has made it easier to transition to a cloud-based technology platform through an agreement with German software provider SAP.
“Transformation often comes down to business and product simplification,” says Teitelbaum. “It is about asking the questions: ‘What are we good at and what are we not good at?’ to get to the core of the business. In doing that, IT system requirements and back-office processes can simplified.”
Higher loan margins are naturally another key ingredient of why HCOB’s underlying return on equity is now much higher, despite its lack of capital-light fee income. Dan Roth, HCOB’s head of strategy and transformation, says the bank’s net interest margin will soon be above 200 basis points, compared with 145bp in 2021 and just 75bp in 2019.
Doesn’t this just mean more risk?
Diversification and resilience
Commercial real estate is now the biggest part of HCOB’s business, with segment assets of around €8 billion, compared with about €3.7 billion each in shipping, project finance and corporate banking. Commercial real estate is also its second-highest yielding segment, with a return on equity of 20% compared to 25% in shipping. A much higher interest-rate environment will clearly weigh on property prices, even if they’re stable for now.
“Our portfolio structure in terms of provisioning levels and origination standards is much better than it was in the years before privatization,” Ermisch insists.
A downturn in the ship finance market presents another potential risk of a downgrade, according to Moody’s. However, the supply and demand dynamic is relatively benign for now, largely because German and other European banks have avoided the sector over the past decade after being burnt so badly in the early 2010s.
Overall, the view from Moody’s is that, although HCOB’s high capital ratio is a comfort, it is concentrated in cyclical businesses and its track record of good profitability under its new owners is relatively short. Standard & Poor’s also warns that, given its historic lack of international expertise beyond shipping, HCOB’s move more towards higher-margin corporate business outside Germany is a potential concern.
“The job was done quite well on the cost side after privatization, but there is a question about the business model,” agrees Michael Teig, who covers HCOB as a credit analyst at UniCredit.
Teig reminds Euromoney how, before 2008, HSH had a reputation for doing deals that other banks would shy away from.
“When other banks were more cautious, they were still underwriting,” he says. “That has changed, but it is difficult to assess these things from the outside.”
However, greater attention to returns should improve HCOB’s resilience, as S&P itself points out, because profitability (through internal capital generation) is a first line of defence.
This is also Roth’s message. HCOB’s diversification of its loan book outside Germany – commercial real estate in the Netherlands and the UK, for example – is the result of a closer analysis of customer profitability than before, not a desperate rush to higher yields.
“You can get a similar level of corporate risk at better prices in different markets,” he says.
German corporate banking sounds safe, Roth admits, but some areas come with higher credit costs, such as leveraged buyouts of smaller mid-caps.
“There are definitely pieces of the German corporate market where you don’t get paid for the risk, at least partially because we are competing with banks that have a lower cost-of-capital requirement,” he says. “In lower-risk areas, there are strong and stable German corporates, but they have significant pricing power. You might not take any losses, but without tremendous scale, you won’t cover your cost of capital.”
[…]
Private equity looks to realize its gains
With both the German private banks association and international ratings agencies hailing the success of Hamburg Commercial Bank’s (HCOB) privatization and turnaround in 2021, its private equity owners are now turning their attention to an exit. Can they achieve it?
Due to the potential for synergies, a merger would be preferable, although an IPO is also possible when markets are strong enough. Morgan Stanley is rumoured to be helping assess the possibilities for HCOB, including M&A.
At HCOB, the first step will be to try to extract dividends, something it agreed with the private banks’ association, the BdB, not to do during its transition period to the BdB’s deposit insurance scheme.
Aside from allowing the owners to realize some gains, reducing capital through dividends will now serve to boost its returns and therefore valuation on a price-to-book basis. The bank’s fundamental target is to achieve a return above its cost of capital, which it estimates at about 9%. In the medium term, it assumes it can earn a return on equity of between 10% and 11%. Last year, it earned 18%. However, this is all based on a hypothetical 13% common equity tier-1 (CET1) ratio.
HCOB is now targeting a medium-term CET1 ratio of below 20% and, for the longer term, chief executive Stefan Ermisch moots a ratio close to a 13% industry average and HCOB’s regulatory requirement of 12.7%. But proving itself to the ratings agencies is a hurdle, as the bank is still largely dependent on wholesale funding, with a loan-to-deposit ratio of 180% at the end of 2021.
One strategic option is to make an acquisition of its own, taking advantage of its capital strength. But in terms of finding an acquirer for HCOB, it could end up as victim of its own success, reckons a senior financial institutions banker. This is because its efficiency and profit margins are such that the M&A maths might not work for a deal with most German banks, whose basic profitability and therefore price-to-book values tend to be much lower.
That might make a deal with a foreign bank more likely.
“If I would put myself in the shoes of a foreign bank, I would say this is an interesting moment in time to step into Germany,” says Ermisch. “Strong houses – companies with a strategic view – will observe that if the cycle of the next 10 years is higher rates, margins will go up, and today valuations are very low.”
According to Chris Flowers, whose company JC Flowers owns 35% of the bank, the fact that HCOB is even able to consider an exit, perhaps via a merger, shows how far it has come. “Until now, it wouldn’t have been the time to think about M&A,” he says. “We had a lot of work to do to get the bank to where it is today. Profitability, capital, balance sheet, costs, IT – all that’s been transformed.”
[…]
Cerberus’ European bank playbook
Cerberus’ joint takeover of Hamburg Commercial Bank (HCOB) in early 2018 happened only a few months after it had made large minority investments in Commerzbank and Deutsche Bank. But the private equity company’s involvement in HCOB is closer in approach to its 2007 purchase of a majority stake in Bawag, Austria’s fourth-largest bank.
Whereas HCOB is a corporate bank, Bawag is primarily active in retail. But the structure of the Austrian banking market is close to that of Germany due to the presence of savings banks and cooperative banks, as well as an array of unlisted regional wholesale banks, or Landesbanken.
Under Cerberus’ ownership Bawag’s international strategy turned from eastern Europe to Germany, including the acquisition of Stuttgart-based Sudwestbank in 2017. Bawag then bought 2.5% of HCOB as part of the latter’s 2018 privatization.
Cerberus exited Bawag in 2019 after a 2017 IPO. But insiders say Bawag gave Cerberus knowledge and confidence about what it could achieve at HCOB, as well as more trust from supervisory authorities.
Cerberus has taken an active role not just in appointing its people to the board but also by helping HCOB to source staff to run the bank. Two of the four people on HCOB’s management board are US citizens and former Cerberus insiders: chief financial officer Ian Banwell and chief investment officer Christopher Brody, who held a similar position at Bawag between 2008 and 2011.
Dan Roth is HCOB’s head of strategy and transformation, another US former Cerberus insider and a veteran of Bawag, where he led the Sudwestbank integration. He says HCOB could use Cerberus’ experience to put together a sort of playbook to get HCOB to at least a 10% return on equity, the industry rule of thumb for what is sufficient reward for investors in banks.
Cost efficiency, both in staffing and IT, was one obvious lever. Another is the balance sheet: getting out of businesses in which the bank has less expertise or that offer returns below its assumed cost of capital. In HCOB’s case, that involved shrinking in some traditional areas of German corporate banking, exiting private banking and slashing much of its capital markets activities.
One other notable similarity with Bawag is HCOB’s 2020 sale and leaseback of its central Hamburg headquarters, pending a move to newer offices. The buyer was the same Austrian real estate company, Signa, that bought Bawag’s historic headquarters in Vienna in 2013.
But Roth says there’s no magic formula: it is just about focusing on what the bank can do best.
“Most banks establish a floor to their cost base that is higher than it needs to be,” he says. “Shrinking is not always the right strategy, but there is nothing about being bigger that guarantees higher returns.”
