Inside Germany's trillion euro banking blind spot
National election winners will have to tackle their own errant banks, writes Laura Noonan
MANY Germans feel that whoever wins Sunday's election, they should not fund any more bailouts of fellow European countries, whose errant banks are a particular bugbear for Berlin.
But a cornerstone of Germany's own banking system, which has already received state bailouts, is facing fresh challenges, increasing the need for reforms which will be very hard for any new government to deliver.
Founded in the 19th century to promote regional development, the publicly-owned Landesbanken play a hallowed role as low-cost lenders to local projects and the 'Mittelstand', the small and mid-sized firms central to the eurozone's most resilient economy.
With combined assets of a trillion euro, they account for 12pc of the country's total banking assets, and 3pc of Europe's as measured by the European Central Bank (ECB).
The eurozone's steps towards banking union have triggered the toughest stress tests banks have ever faced and new global regulations impose higher capital demands particularly difficult for low-margin banks like the Landesbanken to achieve.
At the same time, their core business is threatened by increasing competition from international banks like France's BNP Paribas, which want a bigger part of the action in Europe's economic powerhouse.
Experts from the Organisation for Economic Co-operation and Development (OECD), ratings agencies and German academia say the best Landesbanken solution is restructuring to leave as few as two players with well-defined businesses.
The prospect appears remote, undermining Berlin's reputation as the driver of European banking reform.
None of the five main Landesbanken – Hanover's Nord LB, Munich's Bayern LB, Stuttgart's LBBW, Hamburg and Kiel based HSH Nordbank and Frankfurt's Helaba – said they thought industry consolidation likely when asked for this article.
As Gunter Dunkel, head of Nord LB and president of the Association of German Public Banks put it in comments to 'Frankfurter Allgemeine Zeitung': "I offer you a bet: neither in my working life or yours will someone take the immense economic and political risks of such a merger."
The risks stem from the Landesbanken's tradition of serving the savings banks and local authorities that own them.
For the municipality-owned savings banks, they provide wholesale banking services and investment products to sell on to customers. For the Laender, they support local businesses and regional projects, accounting for 15pc of all German corporate lending.
Officials in the German administration say Landesbanken are not a source of major concern; where once their woes were a talking point at European finance ministers meetings, a source familiar with their discussions told Reuters the Landesbanken had not arisen recently.
Their top line numbers are comparatively strong, with capital ratios above the international average and four of the five biggest showing higher profits in the first half of 2013.
But experts say the figures belie a more complex reality. Return on equity – a key measure of a bank's profitability – is lower for the Landesbanken than international peers.
More international competition could make margins even slimmer, as banks like Barclays and BNP look to Germany for growth that is lacking elsewhere in the eurozone.
Earlier this year, BNP Paribas's corporate bank lowered its client threshold from companies with €500m of annual sales to those with €250m, putting them further into the Landesbanken's core market.
BNP's sweet spot – and an area attractive to other foreign banks – is exporters with cross-border banking needs.
"It's the largest economy by far in Europe, and the country with the highest share of exports in terms of GDP," the head of BNP's German corporate and investment bank business, Torsten Murke, said.
Fitch Ratings analyst Christian van Beek noted the Landesbanken's public ownership means they do not need the high double-digit returns sought by other banks, so they can do lower margin business.
But low earnings power carries risks. In its 2012 Economic Survey of Germany, the OECD noted Landesbanken "remain vulnerable due to their low capitalisation and profitability and will be especially affected by the regulatory increases in capital requirements".
One of its major sources of strategic investment is drying up. Several sources in savings banks, including Michael Auge, spokesman for Helaba's 69pc owner of the Savings Banks and Giro Association Hesse and Thuringia, said they would not invest further in the Landesbanken.
Long-beset by the problems of politically motivated lenders, and cultivating a work culture several employees describe as "civil-service like" with a clear-out at 5pm, Landesbanken did not begin to build serious problems until 2001.
The trigger, several experts say, was a surprise agreement between Germany and Brussels to end a sovereign guarantee on bonds sold by Landesbanken by 2005. The Landesbanken's response was to sell as much debt as they could before the curtain fell.
They piled into international lending and high-yielding bonds, sponsoring 8.4pc of the global supply of asset backed commercial paper (ABCP) by 2006, according to a major 2012 study on Landesbanken by four German academics.
The Landesbanken expansion ended in bailout. In 2008, German states began the first of five bailouts totalling €52.5bn, including the rescue of and eventual shutting of WestLB, which lost heavily on bets on the US subprime market.
Others stayed afloat, avoiding deep restructuring.
Next year's European stress tests will be a seminal moment.
"Some people suspect these banks will need to take further state aid or at least further substantial writedowns on their portfolios," said Robert Montague, senior investment analyst at ECM Asset Management.
HSH has admitted it is likely to need to set aside extra money to deal with loan losses after the tests, but said it does not expect to need further state support either to deal with the cost of regulation or the tests' outcome. Other banks have yet to comment one way or the other but one thing is for sure; the next few months will be very interesting.