Banks’ weaknesse scruelly exposed

  • 13 Nov 2007
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There is no doubt that the decline and probable fall of WestLB and IKB, likely to be swallowed by domestic rivals over the next few months, has been an embarrassment to the German financial services sector. But, ironically, their demise might be just what the sector needs — at least, from shareholders’ point of view. For years, commentators have urged German banks to merge and consolidate so that the country has a banking sector to match its economic might. Philip Moore reports.

It is probably safe to say that Düsseldorf’s financial services sector has had happier summers. The first bombshell came in April, when WestLB announced that it had fired two individuals on its proprietary equity trading desk allegedly for taking a series of unauthorised short positions in Volkswagen and BMW shares.

Those rogue trades would contribute to losses incurred by WestLB’s prop desk of more than Eu600m in the first half of 2007, which the bank said had masked a "successful" period in other areas of its business.

By then, however, Thomas Fischer, who was WestLB’s flamboyant chief executive at the time the losses were incurred, and the bank’s chief risk officer, Dr Matthijs van den Adel, had both been ousted.

General consensus suggested that that did not just bring to an end the time that Fischer had spent at the helm of WestLB since his appointment, amid much hope for the future, in October 2003.

It also seems probable that it brought the curtain down on the career of the banker who celebrated his 60th birthday last month, and who — hopefully — will be remembered more for the contribution he made to German banking than for his failure to transform WestLB into an architect of the industry’s consolidation.

After all, it was Fischer in his capacity as chairman of the managing board of the Stuttgart-based savings bank, Landesgirokasse, who began to tear down the walls of Germany’s three-pillar banking system by pushing through the deal that accelerated restructuring of the banking sector in Baden-Württemberg.

The three-way merger that brought together Landesgirokasse, SüdwestLB and the commercial banking operations of L-Bank was revolutionary at the time, and in forming the modern LBBW was responsible for creating what is generally viewed today as one of Germany’s most successful banks.

By the time of Fischer’s demise, Finanzplatz Düsseldorf had suffered another body-blow, with IKB Deutsche Industriekreditbank announcing in July that it had become the first high profile European casualty of the US subprime mortgage crisis.

Although KfW led a bailout of IKB in August, the beleaguered Düsseldorf-based bank announced in September that it expected to post a whopping Eu700m loss for the year. That in turn led to the threat of a series of actions from disgruntled shareholders allegedly claiming that they were not kept sufficiently informed about IKB’s exposure to the US subprime mortgage market.

The near-collapse of IKB claimed another casualty for Düsseldorf’s financial services sector with the resignation of Stefan Ortseifen, an IKB man since 1984, who had adopted responsibility for structured finance in 1994 and became CEO in 2004. Following Ortseifen’s speedy departure, a crack team from KfW was parachuted in, led by Günther Bräunig and Dieter Glüder — who is well known to capital market practitioners as the brains behind KfW’s Promise and Provide securitisation platforms.

It was not long before another German bank was also suffering the ignominy of being bailed out by a stronger and more dependable local player. When SachsenLB buckled under the pressure of its exposure to conduits, LBBW stepped in, agreeing to acquire the struggling Leipzig-based bank at the start of 2008.

Ill-equipped and unqualified
Each of the disasters that befell the German banking sector over the course of this summer was slightly different, but many capital markets specialists believe that each also had the same related root cause.

This, they argue, is that Germany remains catastrophically overbanked, with too many of the country’s state-owned banks unclear whether they should be serving political purposes — and masters — or commercial ones.

The extreme competitiveness of the German banking market is great for customers, giving them many sources of cheap credit to choose from. And for many in Germany, there is no more to be said — the industry is fulfilling its function. What more could a country want from its banking system?

But such conditions are not as comfortable for ambitious banking executives, or shareholders. When you have to compete with dozens of savings banks, cooperative banks and Landesbanks to lend to individuals or small companies, it is hard to make the kind of returns expected by the stockmarket.

Many believe it was this bind that pushed banks like IKB and WestLB, both of which hover between the state and private sectors, to seek profit with poorly managed excursions into structured finance or other capital markets activities.

IKB’s website may still be advising that its clients need a "competent, reliable financial partner" at their side, and "a bank that... masters the intricacies of modern finance".

But although IKB may indeed have been a competent, reliable and even masterful lender to small and medium sized companies, none of those terms are accurate ways of describing the bank’s fateful foray into the ABS market, where it put far too many of its eggs into CDOs.

Fortunately, apart from SachsenLB and IKB, few other banks had such concentrated exposure to the problem asset class.

According to Standard & Poor’s in September: "The size of liquidity facilities granted by rated German banks is much smaller in the context of the banks than the IKB or SachsenLB exposures. Furthermore, German banks’ reliance on securitisation as a funding tool is very limited.

"Overall, we do not expect widespread rating changes as we consider that German banks’ earnings and balance sheet capacities are sufficiently strong to absorb the subprime challenges and related implications on the valuation of assets, as well as the draws on liquidity facilities."

S&P found that rated Landesbanks’ exposure to ABCP conduits amounted to some Eu75bn, less than 5% of their total assets. "When taking the size of SIVs into account," the agency adds, "the potential exposure increases to about Eu100bn, or less than 6% of assets."

SachsenLB was a clear outlier, with its exposure of Eu25bn amounting to a staggering 37.2% of total adjusted assets. At the next most vulnerable bank — WestLB — exposure equated to 11.8% of its assets, while at LBBW, which is generally recognised as the strongest of the Landesbanks, it was a mere 1.6%. "Overall," concluded S&P, "we consider the exposures as a manageable yet temporary strain on Landesbanks."

A necessary evil?
The kind of industry commentator who has been longing for change in the German banking sector may come to look back on the fiascos of 2007 as the best thing that has happened to German banking since the Landesbanks’ state guarantees were removed in 2005.

The demise of those guarantees was widely expected to spark consolidation among the Landesbanks. All the Landesbanks needed to develop new, viable, standalone business models to plug the gap previously filled by the arbitrage opportunities that arose from the cheap funding levels they enjoyed in the days of Anstaltslast and Gewährträgerhaftung, the state support mechanisms.

Given the feeble standalone ratings of some of the Landesbanks, it was inevitable that many would be too weak to maintain their independence in the post-guarantee world.

Most private sector bankers — who want, above all, the industry to be profitable — believe that consolidation is desperately needed in Germany.

"The fundamental problem is that Germany remains overbanked," says Stefan Dreesbach, managing director of the frequent borrower group at RBS in London.

"At the last count there were still more than 2,000 banks in Germany. If you exclude Deutsche Bank, none of those plays a significant role globally, while at a domestic level none controls more than 5% of the retail market. That makes it very difficult for the banks to make decent money in the local market, which is quite different from a market like the UK, where retail banking is concentrated in the hands of five or six profitable players."

Whether UK retail customers feel well served by this oligopoly is another matter.
Klaus-Peter Müller, president of the Association of German Banks and chairman of the board of managing directors of Commerzbank, has been outspoken on this subject.

Addressing the association in January, he argued that structural deficiencies in the German banking system were a major reason why the country’s banks were "still languishing at the bottom of the European league for profitability".

Others agree that congestion in the German banking market would not be so bad if so many of the banks weren’t politically managed entities, prepared to give their services away virtually free. "The principal problem is that about 75% of the German banking industry is run by non-profit-making organisations," says one Frankfurt banker. "That makes it very hard for the 25% of the industry that has to compete with other players on an international basis."

Bankers believe this has made it almost impossible for foreign banks to gain a hold in Germany, either through organic or inorganic growth.

Of the German banks, only Deutsche has made an unqualified success of spreading its wings internationally. For the others, chasing returns in fiercely competitive or risky areas such as international investment banking, private equity or structured finance has all too often ended in tears.

Much consolidation has already taken place, although the most recent merger, the acquisition of Depfa by Hypo Real Estate Group, has less to do with addressing inefficiencies in the German banking system and more with creating a global real estate powerhouse.

The combined group will have assets of Eu385bn, a market capitalisation of more than Eu10bn and some 2,000 employees, making it one of Germany’s largest banks, although Germany itself will only account for 34% of the group’s total financing portfolio.

The speed of consolidation in the public sector of the German banking industry, however, remains a disappointment to analysts and private sector bankers who have long argued that even three Landesbanks is a crowd.

That is why the travails at banks like SachsenLB have been welcomed by some commentators. Trade unions have started to rattle their sabres about LBBW’s acquisition of SachsenLB, warning that the Stuttgart-based bank plans to make swingeing job cuts in Leipzig.

But otherwise, you would be hard pressed to find anybody outside the Saxony region with the slightest shred of sympathy for SachsenLB, which many plainly regard as one of the stupidest things to have come out of German reunification.

Certainly the demise of SachsenLB was of little interest to the man in the street. "On the day after SachsenLB had collapsed, the headline in the business pages of one of the popular papers was about food price inflation rather than the banking crisis," says one economist in Frankfurt.

Missed opportunity
Private sector bankers, however, are scathing in their condemnation of SachsenLB, which was set up in January 1992 in order — in some bankers’ estimation — to give the new East German Bundesländer what amounted almost to a token Landesbank of their own.

"We missed a huge opportunity at reunification to create a more unified banking industry," says one banker in Frankurt. "Instead, the political chieftains insisted on establishing a new Landesbank in Lower Saxony. Was there any need for SachsenLB? Absolutely not. It was a useless, artificial entity."

The positive side-effect of the subprime meltdown, say bankers, is that it has forced an acceleration in consolidation by washing out players like SachsenLB.

Although SachsenLB is one of the smaller Landesbanks, its acquisition by LBBW marks an important step towards the publicly-declared goal of LBBW’s CEO, Siegfried Jaschinski, of building the national champion that German banking so desperately needs.

"This is the fourth largest economy in the world, but we have to ask the question: how can a country so large and influential, and one that relies so heavily on exports, continue to function efficiently with a financial industry that is so ill-equipped to compete on a global basis?" asks one banker in Frankfurt.

Banking leaders are convinced that without accelerated consolidation in its public sector, Germany’s banking industry will lag behind its international competitors.

Granted, well before the subprime crisis, consolidation in the Landesbank sector had taken a tentative step forward with the acquisition of an 81% stake in Landesbank Berlin by the Association of German Savings Banks (DSGV) for Eu5.35bn, outbidding Commerzbank and LBBW in the process.

But opinion about that transaction and its implications for German banking is decidedly mixed. Some bankers express disappointment at what they describe as the politically motivated high price that the DSGV was prepared to pay for keeping Landesbank Berlin in the public sector family.

More specifically, they say that the association would have been prepared to pay more or less any price to have ensured that the bank did not fall into private ownership, which would have occurred had Commerzbank’s bid been successful.

Those who were disappointed by the outcome of the Landesbank Berlin sale say that in transferring a major Landesbank from one pocket of state ownership to another it has done nothing to diminish political meddling in the day-to-day management of German banking.

Others are prepared to take a more constructive view of the sale. Dominion Bond Rating Service, for example, commented that the new ownership structure at LBB "might increase the dynamic" of the consolidation process in Germany.

"Overall," says DBRS, "we believe that LBB’s acquisition by DSGV has the potential to increase the pressure on Landesbanken further to improve their efficiency and service quality as well as their business models. Landesbanken that fail to do so might also contemplate the alternative to achieve these goals through a closer co-operation or merger (mother-daughter model) with another Landesbank."

However, easily the most significant development in the consolidation process, which bankers believe is imminent, will be the acquisition (dressed up, for political reasons, as a merger of equals) of WestLB by one of the more powerful Landesbanks.

Recent press coverage has suggested that there is something of an auction process for WestLB going on behind the scenes, with several private equity bidders reportedly in the frame.

Thought to be among the frontrunners is JC Flowers, which in 2006 led the consortium of institutional investors that bought WestLB’s shareholding in HSH Nordbank.

Keeping it in the (German) family
Bankers in Germany, however, believe it is highly unlikely that WestLB will be acquired by a foreign player.

"People who point to the precedent of HSH Nordbank overlook the fact that HSH is largely an international wholesale bank with relatively small central bank operations responsible for 17 savings banks in Schleswig-Holstein," says Michael Bonacker, co-head of European financial institutions at Lehman Brothers in Frankfurt.

"By contrast, anybody acquiring WestLB is buying into 25% of Germany’s savings banks, which is why I can’t see any buyer other than another German Landesbank winning control of WestLB."

Most bankers in Germany agree, saying that the list of potential buyers probably contains no more than two names.

Bayerische Landesbank is one frequently named candidate, since it is one of the few surviving Landesbanks with a healthy balance sheet and clear expansionary ambitions.

But the most recent manifestation of those ambitions suggests that Balaba’s main focus at the moment is on the potential of central and eastern Europe.

BayernLB’s Eu1.625bn acquisition of a majority holding in Austria’s Hypo Alpe-Adria-Bank (HAAB) has given Balaba a foothold in markets such as Croatia, Slovenia, Serbia and Montenegro. Balaba’s Austrian acquisition — twinned with the continued fortification of closer links with Bavaria’s savings banks — is likely to be the main focus of management attention in the foreseeable future.

That would leave Siegfried Jaschinski’s LBBW as the favourite to acquire WestLB, creating Germany’s second largest bank behind Deutsche.

LBBW has made little secret of the perceived benefits a union with WestLB would bring, and while it also has its eyes on expanding into eastern Europe, analysts say it will do so largely from the small and manageable platform of SachsenLB in Leipzig.

While Jaschinksi himself is known to relish the opportunities that an acquisition of WestLB (at the right price) would bring, some of WestLB’s shareholders have also declared themselves in favour of a so-called "merger" with LBBW.

The government of North-Rhine Westphalia is hesitant about a sale, with politicians in the Land apparently at loggerheads with each other about the implications for job losses or for the relocation of jobs to Stuttgart.

But the Rhineland Savings Banks and the Savings Banks Association of Westphalia-Lippe (each of which owns just over a quarter of WestLB) have openly expressed support for a deal with Stuttgart.

Wanted: profitable business model
Whether WestLB will turn out to be a valuable prize or an albatross around the neck of its ultimate saviour is the subject of animated debate.

In the short term, WestLB can hardly be described as looking like an oil painting to the suitors that may be eyeing it up.

Leaving aside the shenanigans that led to the dismissal of its CEO — and previous misadventures in areas like private equity that were so injurious to its reputation — WestLB has long been regarded as a bank in desperate search of a sustainable and profitable business model.

It is also burdened by shockingly high costs, even in the context of the Landesbank sector, with a cost-to-income ratio in 2006 of 94%, which dipped to a still-vertiginous 85% in the first quarter of this year.

As Fitch unflatteringly observed at the end of June: "The group’s main challenge remains sustainable revenue generation. Measures to improve underlying revenues have not yet borne fruit and operating costs remain high. There is little tangible evidence of success in efforts to enhance domestic revenues."

The report added that Fitch "believes that core operating profit is not likely to recover for at least some time to a level that will enable WestLB to cover high costs and report sustainable profitability in line with its domestic and international peers."

Counterbalancing these worries, however, WestLB has been forging closer relations in recent years with the savings banks in its region. These have more than 11m clients and if those relationships are efficiently harnessed, could be a mine of attractive business.

"WestLB would very much be an asset to whichever bank buys it," says Bonacker at Lehman Brothers. "Everybody knows that it took a bad loss in the first half of this year, and that there are a couple of strategic and operational issues that will need to be addressed over the longer term. But for a buyer that is able to capitalise on WestLB’s access to the savings banks it will be a very attractive asset."

Desirable IKB
If it seems unlikely that WestLB will be allowed to fall into foreign hands, much the same is true of IKB, which has attracted a number of covetous eyes since its ill-fated adventure with the US subprime market effectively put it on the block.

"IKB is certainly a desirable franchise, because of its leadership in the market for German SME business, which is why its share price has stayed so high in spite of what happened during the summer," says Alexander Plenk, banking analyst at Unicredit in Munich.

Speculation over a likely buyer of IKB has intensified since the announcement in early October that KfW had appointed Merrill Lynch and Clifford Chance to advise on the possible sale of its 37.8% stake in the small and medium sized business specialist.

Several banks have already thrown their hat into the ring as potential buyers of IKB, leading Plenk to say that he believes the most likely buyer will be one of the leading German players — with Commerzbank, DZ Bank and HSBC Trinkaus all among the frontrunners.

However, a foreign buyer is not out of the question, he adds. "IKB’s franchise might also be interesting to foreign banks," says Plenk. "A bank like ING, or some of the French players which have tried but failed to penetrate the German market in the past, may see IKB as an attractive opportunity. There would be much more significant cost synergies for a German bank acquiring IKB, although there would also be some double coverage of Mittelstand customers, so the value added might be limited."

How much immediate effect the turbulence within the banking sector has on Germany’s capital market and broader financial services industry remains to be seen. One school of thought suggests that the upheavals can only be helpful if they force banks to reappraise their lending strategies.

"I would be surprised if there are no implications for bank lending arising from this summer’s crisis," says Rainer Guntermann, economic analyst at Dresdner Kleinwort in Frankfurt. "On balance I expect banks to become more risk-averse in lending to the private sector. Risk will need to find a new price, which means households may find it more expensive to finance new homes and SMEs may have to pay more of a premium for their bank debt."

That may well be. But as the trouble has come at a time when the German corporate sector is in robust financial health, the effects may be limited.

"You could make the case that once the banks have taken their conduits and SIVs on to their balance sheets they will look to pass their higher refinancing costs on to the corporate sector," says Dirk Schumacher, chief economist for Germany at Goldman Sachs in Frankfurt. "But as corporate balance sheets and profitability are both strong at the moment, that ought not to be a significant problem."

  • 13 Nov 2007

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