Yet more ingredients for rapid growth in German capital markets activity have been put in place: a levelling of the playing field in the banking sector; tax changes easing corporate restructuring; and reform of the pension system. Sceptics might argue that such hopes have proven misplaced in the past. But this time the potential rewards may be too big to ignore.
Make no mistake about it. The agreement reached in July this year between the Competition Commission of the European Union and the German banking and financial authorities on the removal of state support for the Landesbanks has major implications not just for the German market, but for the securities industry throughout Europe. "Monumental", was how the development was described in an update published by Fitch on July 20, in part because it appeared to be one of those very rare instances in which all parties came out with something to celebrate.
"At a political level," read the Fitch report, "the EC has managed to reach a compromise with the German authorities ensuring conformity with European competition law. The private sector banks should welcome the eventual levelling of their playing field, while Landesbanks and savings banks can be pleased that they have been given a four year transition period to 'get their act together' and establish themselves as viable commercial banks."
The constituency not mentioned in this check list, however, was the investment banking community training its sights on the potential for increased activity and which - on the surface - had every bit as much reason for uncorking the champagne in July as Germany's private banks did.
This is because like a boulder dropped from a great height into a calm lake, the abolition of Gewährträgerhaftung and Anstaltslast in the Landesbank sector created waves that spread in every imaginable direction. The extent of those waves were described thoroughly at the beginning of September, when Goldman Sachs unveiled a comprehensive report analysing the long term repercussions of the July agreement between the EU and the German banking authorities.
Most obviously, the agreement will dramatically change the Landesbank sector itself, given that by July 2005 the twin support mechanisms will have been dismantled, leaving the Landesbanks to borrow, like their competitors elsewhere in Europe, on commercial terms dictated by their own financial strength. In turn, that means that the same waves spread into the corporate bond market, because - conventional wisdom believes - the Landesbanks will no longer be able to lend to the corporate sector at uneconomic levels, possibly forcing a number of companies to step into the capital markets. Given that Landesbanks are heavyweight lenders outside as well as within Germany, that has repercussions for the broader European corporate market.
The ripples also spread to the Pfandbrief market and the securitisation and asset backed sectors in Germany. On the one hand, a decline in Landesbank ratings will provide issuers of public sector Pfandbriefe with fewer sources of collateral, hence probably reducing supply in the jumbo market. On the other, with Landesbanks forced to restructure their balance sheets in pursuit of improved RoEs, the potential for issuance in the asset backed market will proliferate. If the Landesbanks were to securitise 20% of their collective loan portfolios, according to Goldman Sachs, they would generate issuance of about Eu130bn, which is equal to the growth of the entire euro zone securitisation market in 2000.
Finally, the ripples emerging from the July agreement spread to the equity market, because the abolition of the state support mechanisms raise the possibility of privatisation among the Landesbanks. According to the Goldman Sachs calculations, Eu10bn of privatisation activity is possible over the medium term as a result of the loss of the Landesbanks' guarantees. To put this figure into perspective, Goldman points out that over the last five years, total receipts generated by banking privatisation in the euro zone amounted to Eu21bn.
In sum, as Goldman Sachs European banking credit analyst Charles Mount explained when unveiling the bank's analysis of July's agreement: "We expect the capital markets to be filled with activity over the medium term as the public sector is replaced with an increasingly private orientation. We believe investors should anticipate significant equity and hybrid debt issuance to build capital ratios and support investment needs; to privatisations; to higher levels of loan securitisations designed to free capital; derivatives activities to support more portfolio management; and more consolidation."
That is quite an inventory, and one that suggests Germany's capital markets stand on the cusp of far-reaching change. Throw in the added effects of German tax reform, corporate restructuring and initiatives supporting the growth of the private pension sector, and it is small wonder that so many investment bankers see the expansion of their German franchises as key to the success of their European operations.
The danger, however, is that the potential for activity in the German capital market is being horribly over-exaggerated by bankers, investors and the media alike. Germany, after all, is not renowned for moving particularly fast when it comes to the development of its financial services sector or capital markets. The leitmotif that runs through this year's EuroWeek report is therefore that the German market is not one that will leap instantly forward by five steps as a result of Landesbank, tax or pension reform. Rather, it is one that will move forward by three steps and backward by one or two in a process of evolution rather than revolution.
Of course, the horror of September 11 will hardly have helped. An immediate by-product of the attacks in the US was the postponement of a planned bond issue for Lufthansa. That, of course, was a special situation, although bankers believe that September's outrage will inevitably have decelerated the broadening of the German capital market.
"Before September 11, I would have said that the most exciting potential development for the German capital market was the extension of the corporate bond market into the triple-B and even the double-B area," says Walter Henniges, managing director of debt capital markets at Deutsche Bank in Frankfurt. "But the events of September 11 inevitably sparked a flight to quality and led to a widening of spreads between triple-A and triple-B names. For the time being, that will make it more difficult to bring triple-B credits to the market, although over the longer term I am optimistic that there will be continuing interest from the investor side in diversifying away from the telecoms and autos sectors, which should open up more opportunities further down the credit curve."
That may well be. But the truth is that long before September 11 the global macro-economic environment was becoming less conducive to corporate issuance in Germany as in most other markets. The point was made in a research bulletin published by Dresdner Kleinwort Wasserstein (DrKW), significantly, on the day of the New York and Washington atrocities. This warned that "our analysis suggests that net corporate issuance in 2002 will fall around 50% from 2001". The same report attributed this expected decline to a continued slowdown in the global M&A market and to a more general reduction in investment in response to the depressed economic outlook.
Thankfully, for those pinning their hopes on activity in the German corporate market, the DrKW report adds that it expects that in euro issuance, the "overall decline [is] likely to be smaller given the counter-effect of an ongoing structural shift from bank financing to debt market financing".
In spite of this postscript, some observers found the DrKW prognosis too downbeat as far as the German market is concerned. At HSBC in Düsseldorf, for example, head of debt capital markets origination Christian Kolb says he was "puzzled" by the DrKW analysis. "To me the report was too negative," he says. "In Germany we have a number of special circumstances, such as the tax changes that are coming into force next year, as well as continued corporate restructuring. Family owned companies looking to expand their businesses are fully aware of the implications of the Basle II guidelines and recognise that the financing opportunities provided by the banking sector are diminishing."
Bankers agree that Basle II will have especially important repercussions in the German market, although several also point out that corporate restructuring in the months ahead might have as much to do with companies encountering financial distress as with those seeking to refocus on their core activities in pursuit of shareholder value. After all, to date Germany has emerged relatively unscathed from the savage collapse in asset prices at the blue chip level that has hit some European companies. So far there have been no German equivalents of Railtrack or Swissair, although there have been scores of smaller scale technology casualties in the Neuer Markt.
At Lehman Brothers in London, director of debt capital markets Richard Zirps believes a prominent theme for the coming 12 months in Germany will be corporate restructuring and credit profile preservation. "Asset and liability management instruments can help corporates not just to manage risks but also to realise hidden value through asset monetisation," he says. "In the past, awarding bond mandates was closely linked to lending and more recently to M&A advisory. Over the foreseeable future balance sheet restructuring will be a central driver."
From the perspective of the German corporate sector, of course, funding raised via the capital markets need not be specifically earmarked for an acquisition or some other form of investment. Beyond the most obvious industrial sectors - principally telecoms and autos - German corporate balance sheets remain relatively undergeared, and for these companies replacing relatively expensive equity with debt might be an effective way to return value to shareholders and bolster RoE. "A lot of German corporates are underleveraged and see the value in diversifying away from the bank market," says Jörg Sautter, vice president of corporate debt capital markets at Schroder Salomon Smith Barney in Frankfurt.
"So although we may see a decline in M&A activity, I think we will see some of the German corporates will use the current interest rate environment to finance their investment programmes and build up efficiently financed war chests."
JC Perrig, director of debt capital markets at Credit Suisse First Boston (CSFB), agrees that there are plenty more reasons for German issuers to use the capital market than simply to raise M&A finance - so much so that he says he prefers to use the expression 'capital market user' than 'issuer'. "Users of the capital market in Germany are coming to realise that the market is not just there as a source of financing," he says. "It is also a good way for companies to resolve their balance sheet and capital structure shortcomings. Questions companies are asking themselves are: is my equity/debt mix the right one? Is the structure of my debt portfolio appropriate? Should I be trimming down my balance sheet by taking assets off the balance sheet and securitising? And should I be looking at using derivatives to change the hedging strategy of my portfolio? There is a host of products out there that go well beyond financing that companies are now starting to look at, which is one reason why I'm very bullish about the prospects for Germany."
Again, that may well be the case. But Germany's track record in capital market issuance over recent years suggests that more often than not its potential has flattered to deceive. Take the German equity-linked market, which was supposed to have been one of the most reliable barometers of the commitment among Germany's Vorstands to corporate restructuring galvanised by tax reform. Between 1998 and 2000 it certainly appeared that a number of German issuers were accessing the market in general - and the exchangeables area of the market in particular - with gusto, with issuers in the financial services sector (principally Deutsche Bank, Allianz and Munich Re) leading the charge as an efficient means of spinning off cross-holdings.
The process also extended to the corporate sector, most notably with the launch by Siemens of its Eu2.5bn exchangeable into Infineon in July 2000.
Since then, however, activity on the equity-linked front has gone eerily quiet. "We had expected an acceleration in issuance in the exchangeables market once the tax changes were announced," says James Eves, head of European equity-linked origination at UBS Warburg in London, "because exchangeables were the only tried and tested public means of bridging the tax change by raising money today on a sale that becomes effective in 2002. But although we have seen a few deals over the last 12 months from issuers like Allianz, Lufthansa, EnBW and Ergo, on balance it has been a pretty quiet year. A possible explanation is that a number of companies that have held stakes in others for many decades believe that they should not feel compelled to offload them this year via the exchangeables market unless they have a specific financing requirement."
Another explanation, however unpalatable it might appear to non-German analysts, is that German companies are much less obsessed with corporate restructuring than conventional wisdom would have outsiders believe, and that many continue to retain cross-holdings for political or relationship reasons irrespective of the impact this may have on shareholder value.
As disappointing as equity-linked activity has been, much the same is true for straight corporate bond issuance, the overall figures for which are also broadly misleading. While well received landmark deals for borrowers such as RWE and Aventis have helped to dilute the dominant share of Deutsche Telekom and DaimlerChrysler, internationally targeted, strategic and bookbuilt corporate issuance out of Germany has failed to reach the levels promised two or three years ago.
That has serious implications for many of the banks that have spent several years building up a German franchise and trawling around the country for clients in the Mittelstand. For many, the investment has been considerable. For example, at Merrill Lynch in Frankfurt, head of corporate origination Volker Blume points out that over the last two years his team has expanded from two people to six, focusing exclusively on origination among German corporates in the German speaking region.
Merrill's competitors are the first to agree that the bank has enjoyed considerable success in building bridges with Mittelstand borrowers, but they also question how profitable the exercise has been. As one banker says, "the fees that have been collected in straight corporate bond underwriting have been meagre".
Nevertheless, none of this leaves those international banks focusing on Germany any less enthusiastic about the potential for their franchises over the coming years - and it is hard to find any among the serious bulge or nearly-bulge bracket players that are not working hard at expanding their German operations. Perrig at CSFB says: "We see Germany as an absolutely essential piece of the puzzle in Europe."
Unsurprisingly, those banks that can leverage off a chunky balance sheet as well as a proven debt capital market track record argue that they are especially well equipped to win large scale business across the board in Germany. "I am optimistic about the potential for the whole range of Barclays Capital's product line," says Rainer Stephan, chief executive of the UK institution's Frankfurt office. "There will be plenty of opportunities for us on the ECP and the MTN side as well as on the bond side."
The so-called "pure" investment banks that might not be able to make such active use of their balance sheets are also upbeat. "The changes that are coming about in the Landesbank sector are good for our franchise in a number of ways," says Carsten Kengeter, head of German fixed income at Goldman Sachs in Frankfurt.
"We will be looking to assist them on how to position themselves within a more competitive environment as well as on optimising their capital structure and on their overall financing strategies. And in a more abstract way, if the Landesbanks go down the route of focusing more on profit maximisation, as we believe they will, it will open up more opportunities in the corporate bond market." *