There are, naturally, precious few similarities between North Korea’s brutalist regime and pacifistic Germany’s super-stable banking system, but if you had to pick one, it would be self-reliance.
In Pyongyang, this manifests itself in the word juche, or an ideological-minded dependence on purely and ethnically Korean resources. For German banks, the premise is far more financially simple: even in the worst days of the financial crisis, they rarely if ever needed to look beyond the borders of Europe’s largest economy for financing.
It’s a rare and blessed position for any set of national lenders to be in, let alone a group that co-exists and overlaps, within a single economic union, with so many still-genuinely troubled banks and banking sectors.
While financial service providers elsewhere in Europe have busied themselves issuing convoluted bonds designed to entice North American or Asian investors, Germany’s lenders, from flagship names like Deutsche Bank and Commerzbank, down to smaller regional and savings banks, bumbled along happily, quietly and with minimum fuss shoring up their finances using domestic financial sources.
Even in the dark days of 2009, German banks short on funding were always able to turn for help to the local investor base. Many skated over the worst of that era by issuing stolidly Germanic financing products, like Pfandbriefe, triple-A rated debentures comprising the third-largest segment of the domestic bond market, and Namesschuldverschreibungen, untradable bonds registered in the name of a single person or institution.
“German banks could always rely on domestic investors for funding,” says Marcus Guddat, head of financial institutions capital markets, Germany and Austria, at Citi.
“The financial crisis has strengthened this belief that the German banking market could finance itself domestically, and that it doesn’t need to depend on international investors. The strong connection between savings banks, regional banks, private banks, asset managers and insurers reinforced this trend of people ‘buying what they know best’.”
A classic example of this trend, Guddat notes, was the “massive demand” in 2013 from Germany-based insurers for tier two capital bond issues by domestic lenders.
“There hasn’t been a major recent shift in Germany regarding bank funding,” adds Andreas Strate, Commerzbank’s head of financial institutions advisory in Frankfurt. “Liquidity was always good, which was a benefit for us in the crisis.”
Carolingian durability
This stability also manifests itself in the funding options German financial institutions typically gravitate toward in the quest for fresh capital. While the private placement market remains strong — and by far Europe’s deepest and most liquid — the same cannot be said for senior unsecured bonds, or covered bonds. Total domestic private placement issuance jumped from €5.7bn in 2011, to €42.5bn in 2013, according to data from financial information provider Dealogic. This year has also started strongly, with total issuance hitting €13.4bn in the first seven weeks of 2014.
Issuance of senior unsecured bonds meanwhile has slipped, even as Germany’s economy has picked up pace, falling to €235bn in 2013 from €313bn in 2012, Dealogic says, while covered bond volumes issuance has also dipped, falling to €24bn in 2013, from €29.6bn in 2011 (see separate chapter on page XXX).
“While the depth of the German private placement market has further increased, even in the past nine to 12 months, you hardly see banks issuing, other than covered bonds, any senior unsecured bonds,” notes Oliver Radeke, head of debt capital markets, Germany and Austria, at UBS.
“Most German banks have a healthy liquidity position due to their deposit base and networks and no particular need to tap the markets. We’re likely to see a slow stream of senior unsecured and a steady flow of covered bonds, but no real increase in volumes.”
Falco Lindeholz, director, financial institutions, at Barclays’ investment banking division in Frankfurt, notes that the issuance of covered bonds in Germany in recent years has been characterised by “negative net supply. Due to balance sheet shrinking and limited lending to the public sector, the funding needs for covered bonds have been reduced significantly, especially for public sector covered bonds which have been issued in large or jumbo sizes in the past.” Thus, the overall issuance picture in the past few years has shifted from €1bn-€2bn public sector transactions to smaller mortgage covered bonds sized at around €500m.
That’s not to say that the entire market is now cornered by smaller institutions issuing marginal deals. A few issuers, notably mortgage providers and real estate-financing lenders, have issued senior unsecured bonds in 2014, boosting issuance to €5.7bn in the first two months of the year, according to Dealogic. Notable examples include Berlin-Hannoversche Hypothekenbank, which took advantage of a lull in the market in the first week of February to price a tight €1bn no-grow 1.125% five year deal. January also saw five year deals at a single basis point over swaps from both Deutsche Hypothekenbank and Aareal Bank.
Commerzbank catches the eye
A few other deals caught the eye, notably the return by Commerzbank in November 2013 to the mortgage-backed Pfandbrief market, which it will use alongside its new small and medium-sized enterprise (SME), and public sector programmes.
André Muschallik, head of financial institutions group, Germany, at Deutsche Bank, applauded his rival’s “impressive ability to make good use of existing collateral, thus lowering more expensive senior funding needs”.
Barclays’ Lindeholz describes the 2013 trio of Commerzbank covered bonds as “ground-breaking — the first covered bond backed by SME collateral and the first German structured covered bond.”
The rarity value of the bond and the innovative nature of the product led, he noted, “to a very successful outcome despite a challenging market backdrop”. Bankers also highlighted the importance of Sparkasse’s April 2013 KölnBonn issuance, a €500m mortgage Pfandbrief that also handed investors the same double whammy: rarity value wedded to a senior rating. That deal “highlighted the competitiveness of the public markets in terms of the intrinsic liquidity of the savings banks sector itself,” notes Deutsche Bank’s Muschallik. These however were daubs rather than shards of light in a spotty market, and few market watchers expect a broader theme to emerge going forward. “I can’t see a principal change on the cards,” says UBS’s Radeke. “Banks in Germany are cash-rich, enjoying domestic demand in private placement markets, and are in general becoming much smaller in terms of their balance sheets, so looking ahead, I’d see less issuance on a systematic basis, not more.”
AT1 hope
One bright spot of good news came March 19, when the Bundesverband deutscher Banken, which represents 210 domestic private commercial lenders, said officials in Berlin were preparing to allow German banks to issue additional tier-one (AT1) capital. This would bring Germany in line with the rest of Europe. Lenders in France, the UK, Denmark, and Switzerland, have sold fresh AT1 capital in recent months; JP Morgan tips total new issuance to top €31bn in 2014, with Citi predicting the total to be closer to €20bn.
Either way, it’s a sizeable chunk of change. Several lenders, led by Deutsche Bank, are lining to issue AT1 capital, which can include contingent capital or CoCo bonds, securities created by banks to strengthen their finances that act like conventional bonds. Germany’s flagship global lender hopes to issue at least €5bn by the end of 2014, and others are hoping to follow in their footsteps, notably Aareal, which is planning to issue fresh additional tier one capital in the second half of 2014, in order to repay debts harking back to the €300m of state aid that the Wiesbaden-based real estate financier secured at the height of the financial crisis.
The main stumbling block to the packaging and production of additional tier one capital doesn’t stem from a lack of interest, or even pallid demand. Until now, notes Andreas Kalusche, head of financial institutions group in Germany at JP Morgan, the main barrier to development has been tax-related. “The tax treatment of the coupon, both for issuers and investors, as well as the tax treatment in case of a write-down, is currently being intensively debated by leading financial authorities in Berlin. Following recent discussions among the main stakeholders a workable solution seems within reach.”
So while lenders in other European countries, including the UK and France, worked quickly and in harmony over the past year with regulators to, notes Citi’s Guddat, “reach a consensus on the tax treatment of these new-style capital instruments”, Germany was left playing catch-up. Capital-hungry banks in other jurisdictions opted to issue AT1 capital first, then wait for the regulations to change around them.
Most expect Berlin to make a conclusive decision over AT1 capital sooner than later: with stress tests and asset quality reviews facing all eurozone lenders during the course of the year, German banks are keen to top up their funds while they can. JP Morgan puts Deutsche Bank’s AT1 requirement at around €13bn, with Commerzbank needing to raise as much as €2.5bn.
“We expect to see a strong pipeline of AT1 issuance once the regulatory and tax situation is clarified,” notes Citi’s Guddat. “Given their currently attractive yields, AT1 transactions will also make sense for other German commercial banks and regional Landesbanks due to the regulatory incentive to fill certain capital requirements via these instruments.” Adds UBS’s Radeke: “Once the withholding tax hurdle is taken away, we expect the market to accelerate immediately. Deutsche recently announced its plans to enter the market and other financial institutions are similarly assessing opportunities to join the market in due course. In general, we expect CRD 4-compliant capital to be the most active product in the market from German and Austrian banks apart from covered bonds.”
Tier two flow
Bankers also expect to see a steady flow of tier two instruments issued by Germany-based financial institutions in the months ahead. “They are an important component of banks’ capital structure under Basel III requirements,” notes Citi’s Guddat, “and as the older instruments continue to mature or get phased out, this capital will need to be replaced. A meaningful portion of this has been done in the private placement market in the past year or so, but capacity in the private market is not unlimited.” The Citi banker points to Aareal Bank’s 4.25% €300m 12 year non-call seven tier two issuance — then the first German subordinated financial institutions offering of the year, as a sign of things to come.
Barclays’ Lindeholz is not alone in seeing institutional investors seeking to increase their exposure to Germany’s larger banks across “a number of asset classes”. Covered and senior unsecured bond issuance may be scarce, but dealflow does exist, offering, if nothing else, a rarity value locked within the eurozone’s largest and safest financing market. Bankers even tip smaller financial issuers to venture outside Germany’s safe borders, and beyond the embrace of the single European currency, issuing bonds in in different currencies such as sterling and US dollars as the year progresses.
Dumping assets
Beyond the stellar world of additional tier one capital and the stodgy-and-sturdy confines of covered and senior unsecured bonds, banking in Germany is changing in surprising ways. Some lenders continue to shrink their balance sheets in an attempt further to clean them up ahead of the asset quality review and the stress tests carried out by the European Central Bank, the incoming unified regional banking regulator.
This process is being aided by the divesting either of non-core assets, or of parcels of loans that remain troubled or soured, yet of huge interest to specialised non-bank distressed asset owners. Examples include troubled public sector lender HSH Nordbank, which is seeking to sell around €1bn worth of shipping-related loans to investors during 2014. The lender, which is expected to post a loss of up to €1bn for 2013, said in late February that it may need a further injection of up to €1.3bn of state aid between 2019 and 2025 in order to write off deep losses relating to shipping lending, and to pay back taxes.
Commerzbank is also in the throes of selling a large portfolio of Spanish real estate loans. International investors including US-based funds Lone Star and Blackstone Group submitted bids in March collectively worth upward of €3bn for property loans with a face value of more than €4bn in the southern European country.
Germany’s second-largest lender, which divested a portfolio of UK commercial real estate loans in 2013, is aiming to sell the bundle of Spanish loans before the end of the second quarter, as it seeks to wind down its real estate financing arm in order to focus on lending to corporates and consumers.
Lenders are also diversifying, some teaming up with insurance companies, notes JP Morgan’s Kalusche, to push further into specific asset classes. Thus, Commerz-bank is joining forces with French insurance giant Axa to sell SME loans to smaller German corporate customers, while Deutsche Hypothekenbank joined forces in September 2013 with Bayerische Versorgungskammer to disburse up to €500m of commercial real estate loans. Commerzbank is also working with Nord/LB to issue the regional lender’s second aircraft bonds in less than two years. That sale, notes Commerzbank’s Strate, “shows how much interest there is still in Germany in alternative secured issuance”.
ABS to return
Bankers foresee a big revival of two forms of funding that in recent years lost or, at times, misplaced its footing: hybrid capital and asset backed securities. “The main and most compelling reason for the rush is that older, hybrid bonds are being phased out, and most banks need to replace them for optimising capital structure within the buffer limits. [T]he market is very favourable now for these instruments being issued,” notes UBS’s Radeke. Adds Deutsche Bank’s Muschallik: “Securitisation might witness a renaissance allowing financial institutions to finance granular asset portfolios at attractive spreads.”
This, then, is the state of Germany’s banking sector in 2014. Safe as houses, and as sure a bet as any developed financial services sector, anywhere in the world. But it’s also a banking sector in flux. Covered and senior unsecured bonds may not be the flavour of the day, but a host of rival funding alternatives, from banks seeking to shrink balance sheets, shed bad assets, and shore up tier one capital, are taking their place. This is a banking sector that’s self-financing, and also self-reliant, but it’s also an industry exploring new forms of financing, testing the boundaries of what works, and what doesn’t.
