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  Crumbling Pillars: Trouble Ahead for German State-Owned Banking System

Crumbling Pillars Trouble Ahead for German State-Owned Banking System

By Beat Balzli, Wolfgang Reuter and Steffen Winter

Part 2: Inflexible and Outdated State-Owned Banks

To satisfy that need, WestLB employed competent investment bankers in London and New York who were extremely expensive but ultimately had little to do. After the first disaster in this business, which led to losses of more than €3 billion four years ago, the bank's supervisory board vetoed many international deals.

In the domestic market, the savings banks were quick to curtail WestLB's activities. Whenever lucrative deals were in the offing, the banks, identifiable by the red "S" on their logos in cities like Cologne and Düsseldorf, insisted on handling them themselves. WestLB's owners, the savings banks, instructed it to deal only with small or mid-sized commercial borrowers with at least half a billion euros in sales. The business coming from this group of customers was insufficient to produce reasonable profits. Other state-owned banks have similar problems with the savings banks, which play a significant role in the German financial services industry.

The upshot is that the entire state-owned banking sector in its current form is outdated. In addition to being inflexible and inefficient, the institutions lack a convincing business model.

They have also fallen on hard times. For several years now, they have expended much of their energy on fending off private investors, despite the fact that these investors are urgently needed. This is time-consuming and expensive.

• In 2000, when HypoVereinsbank expressed an interest in acquiring the Stuttgart-based BW Bank, a bank organized under private law that was 40-percent owned by the state of Baden-Württemberg, LBBW quickly stepped in and foiled the would-be takeover.

• Three years later, the city of Stralsund in northern Germany wanted to sell its savings & loan bank. But the German Savings Banks and Giro Association (DSGV) quickly pushed to have the laws changed to prevent Stralsund from following through with its plan.

• In a bidding war for Landesbank Berlin, the savings banks, eager to prevent private investors from acquiring a stake of the bank, were even prepared to offer €2 billion more than any potential private buyer.

These activities were so costly that they weakened the publicly-owned banking sector overall. They also caught the attention of politicians. According to officials at his ministry, Minister of Finance Peer Steinbrück became contemplative when faced with the question of whether it was absolutely necessary to preserve the three-column model of private, public and cooperative banks.

The reason for Steinbrück's gradual change of heart was the behavior of the private banks during the bailout campaign for Deutsche Industriebank (IKB), which, like SachsenLB, was facing the brink of bankruptcy as a result of its dealings in the US mortgage market. The private banks responded far more quickly and reliably than their public competitors.

A New Model?

Governors Rüttgers and Koch also know that the future of the state-owned banks depends on private investors being allowed to invest in them, at least as minority shareholders. The bank that will result from the merger between WestLB and Helaba could set an example in this regard.

The two politicians agreed that the new bank will also throw its hat into the ring to acquire IKB, which would create a mid-sized bank with offices throughout Germany. This, in turn, would provide the bank with a feasible business model. When it comes to raising the funds needed to acquire IKB, financial investors will be welcome. The private customer business would become a second segment of the new organization's business. Helaba, which also includes Frankfurter Sparkasse, which it acquired in a bailout purchase, is already active in this business.

The savings banks have barred WestLB from merging with Düsseldorfer Sparkasse until now. But this could soon change, now that the savings banks -- hoping to improve WestLB's rating and its profitability -- have indicated a willingness to abandon their opposition to the merger, which would create an entity that would be known as Metropolbank.

Rüttgers also made it clear that if his compromise proposal is not accepted, he would sell the state's share of WestLB. The savings & loan bank would then have the first right of refusal. But because of the purchase of Berliner Landesbank and other local problems, the savings banks currently lack the additional billions such expenditures would necessitate.

Günther Merl, the CEO of Helaba, was taken aback when he learned of the two governors' plans last Wednesday. But his disgruntlement and the displeasure of other savings & loan bankers quickly subsided. The powerful savings & loan association DSGV had understood the signals correctly. Rüttgers had categorically ruled out a merger between WestLB and LBBW. The compromise at least offered the face-saving option of preventing Rüttgers from selling the state's share of the bank to private investors.

Whether the merger will in fact materialize remains unclear. Rüttgers wants the merger and is willing to make the necessary personnel changes to make it happen. Insiders in Düsseldorf assume that Alexander Stuhlmann, the hapless interim CEO, will not be serving out his full contract, which ends in March 2008.

The Failed Plan

Bernd Fahrholz is seen as his potential replacement in January or February. Fahrholz, a former chairman of Dresdner Bank, is considered a close associate of Koch. For this reason, Rüttgers is unlikely to encounter much resistance in Hesse.

At the remaining state-owned banks, vanity continues to trump reason. The Bavarians, for example, under former Governor Edmund Stoiber, were open to overtures from WestLB. But the Düsseldorf-based bank's takeover bid, which it had intended as a rebuff to the advances of Stuttgart-based LBBW, fizzled. A few weeks later, Siegfried Naser, the president of the Bavarian Savings & Loan Bank, tried to revive the so-called southern rail by proposing a merger of BayernLB and LBBW. This plan also failed.

But if the planned merger of WestLB and Helaba brings momentum to the banking industry, a fear of being left out in the cold could take hold in Munich, where the Bavarians also have their problems. The credit crisis has also caused enormous difficulties in Munich.

Three shaky funds with a volume of about €16 billion must be taken into account. Accountants anticipate a loss in payments nearing €100 million as a result of the bad mortgages in the US. Revaluation reserves will have to be added to these losses, because the prices for the complex credit products have collapsed. According to internal estimates, the total bad debt could run upwards of €800 million.

Translated from the German by Christopher Sultan