Desperately Seeking Capital Berlin May Have to Nationalize Giant Commerzbank

Europe's banks urgently need fresh capital to meet tougher EU rules, but they will have problems raising it amid the current crisis of confidence plaguing the euro zone. The survival of Commerzbank, Germany's second-largest bank, is at stake, and Berlin is considering a full nationalization of the bank if necessary.
Thunder clouds gather above the headquarters of Commerzbank in Frankfurt.

Thunder clouds gather above the headquarters of Commerzbank in Frankfurt.

Foto: Arne Dedert/ dpa

In the foyer of Frankfurt's Commerzbank Tower stands a Christmas tree decorated with all manner of glitter. The idea is to brighten up the gloomy mood with a bit of seasonal cheer. Next to the tree is a notice board covered with children's wish lists for the Yuletide. Most of the youngsters want computer games and other forms of amusement -- small wishes, for the most part, that can easily be fulfilled.

It will be more difficult to indulge the man sitting on the 48th floor of the building. If Commerzbank CEO Martin Blessing could make one wish, he would presumably ask for a few billion euros, or that someone would take the bank's ailing subsidiary Eurohypo off his hands, or that the entire sovereign debt crisis would simply disappear.

But banks, along with their managers and owners, are not allowed to pin their hopes on miracles. They need money,  as quickly as possible. And since Commerzbank's survival is at stake once again, the major shareholder in Berlin is thinking the unthinkable: One-quarter of Germany's second-largest financial institution already belongs to the state; now the government is considering fully nationalizing the bank if necessary.

According to government sources, if Commerzbank doesn't manage to raise sufficient capital on its own by next summer, Berlin will reactivate the Special Fund for Financial Market Stabilization (Soffin) and purchase additional shares in the bank. The sources say that they assume the government would acquire a majority of the bank's shares in a capital increase.

But things haven't reached that stage yet -- and they won't necessarily have to, either. Commerzbank management is working round the clock to solve the problem without government aid. It's a difficult job that will mainly have to be tackled by the new Chief financial Officer, Stephan Engels, who was appointed by the supervisory board last Friday.

If Commerzbank fails to meet the challenge, though, Blessing's days at the head of the commercial lending giant may very well be numbered. "I'm not going there again," he recently said, in reference to a government bailout of €16.2 billion ($21.7 billion) that the bank received in 2009. His statement was not well received in Berlin.

Euro Crisis Management Has Hit Banks

Relations between politicians and the financial industry are already extremely strained. Bank managers say that the ballooning debts of a number of euro-zone countries are to blame for this renewed banking crisis  only three years after the collapse of Lehman Brothers -- and they contend that the crisis management pursued by Brussels, Berlin and Paris has merely exacerbated the problem. First, the heads of government in the euro-zone pressured their banks to waive a portion of Greece's debts. Then the EU imposed new, stricter capital requirements on financial institutions. By the end of June 2012, European banks will have to raise their core capital ratios to at least nine percent.

The fate of the lending institutions now depends more than ever on how the crisis develops. What's more, "Commerzbank is the clinical thermometer for the euro crisis," said one insider. Financial market players doubt that the euro member countries can get their debt problems under control -- and since the banks have invested heavily in government bonds, investors also mistrust the banks.

True, the world's leading central banks provided some relief to lenders last week. They showered the increasingly dry financial system with cheap money. But the flood of cash has not removed the causes of the crisis. The banks will only stabilize when investors regain trust in their stability. It's hoped that the stress test and the new capital requirements introduced by the EU and its regulatory agency, the European Banking Authority (EBA), will achieve just that. After weeks of wrangling, the regulators have apparently agreed to a compromise; exact figures are expected to be presented this week.

According to sources within the agency, the regulations will be much tougher than what the EBA announced in October. European banks could require up to €200 billion in fresh capital, with the Germans alone needing €10 billion. Commerzbank is likely to account for approximately €5 billion of this, and Deutsche Bank for nearly €3 billion.

Where is the money supposed to come from? "It's a mystery to me how some banks can be expected to meet the higher capital requirements at such short notice," says bank expert Michael Göttgens from the auditing and consulting company Deloitte.

The traditional way would be to raise capital by issuing new shares on the stock exchange. Investors, though, are avoiding European bank stocks precisely because of the sovereign debt crisis. To make matters worse, financial institutions will probably also generate lower returns over the long term due to the more stringent regulatory demands.

Only Italy's largest bank, Unicredit, and Austria's Raiffeisen Bank have dared to announce significant capital increases. Unicredit, which owns Germany's HypoVereinsbank, intends to raise €7.5 billion -- although it recently made a loss of €10 billion in just one quarter.

Scaling Down Loans

The Italian Securities and Exchange Commission (CONSOB) is making a stand against the EBA, which is headed by an Italian, Andrea Enria. CONSOB is afraid that the strict regulations for financial institutions will strangle the Italian economy. In effect, so the argument goes, banks can also increase their capital ratios by reducing their balance sheets -- in other words, by granting fewer loans.

This is also the approach that Commerzbank is likely to take. Industry insiders calculate that the bank could free up some €3 billion in capital by allowing loans and bonds to mature without renewal. Since such transactions have to be backed by equity capital, this would reduce the demand for fresh capital.

However, banks that scale back their operations also pass up opportunities for profits. "It's alarming if Commerzbank has to significantly reduce its volume of business," says a member of the supervisory board. It's not enough, though, for the bank merely to refrain from conducting new business -- it would also have to sell off loan portfolios.

Other banks are considering this as well. This could revive a business that had been pronounced dead after the Lehman crisis: Risks that can't easily be reduced are simply sorted out and sold.

"Regulatory capital relief trades" is the term for the deals that are currently coming into fashion among European banks. This involves, for instance, taking loan packages apart and reassembling them according to risk classes. Elements that entail a particularly high risk of financial loss end up in so-called junior tranches. Banks have to retain an extremely high amount of capital to cover such high-risk bundles. Nevertheless, when converted to securitized investments, banking sector regulations allow for 95 percent of such unwanted packages to be written off the books.

Buyers of such products include US banks, which don't have to adhere to the same equity regulations as European lenders. It's primarily hedge funds, though, that seize upon such opportunities and cash in on fat interest rates.

As long as everything goes smoothly, the deals are worthwhile for everyone involved. Yet such transactions merely shuffle the risk back and forth, says Merck Finck analyst Konrad Becker. "This runs contrary to the goal of making the financial system more secure by introducing stricter equity capital regulations for banks."

Whether such credit swaps will swiftly help the banks out of their predicament is debatable anyway. Indeed, on Friday Commerzbank executives presented the supervisory board with additional ideas to bolster their capital reserves. For example, the board of directors wants to retain profits rather than distribute them. But there are two problems with this: First, the bank recently drifted into the red; second, shareholders don't like their dividends being scrapped. This in turn compounds the difficulties of winning over shareholders for a capital increase.

Commerzbank Mulling Radical Measures

Nevertheless, all of these efforts could ultimately prove insufficient. This realization has prompted government experts in Berlin, as well as in the bank, to examine even more radical ideas.

A top priority is finding a solution for the ailing subsidiary Eurohypo, which holds the shaky sovereign bonds. "As long as Commerzbank fails to get rid of the Eurohypo problem, it won't be able to raise any capital on the market," says an investment banker. The commercial lender is highly unlikely, though, to find a private buyer for Eurohypo. Banks are currently seen as practically unsellable.

Wouldn't it make sense then to hand Eurohypo to the German government? It could pool the toxic assets in a bad bank, allowing Commerzbank to face a brighter future, freed of this burden.

However, it seems very unlikely that Berlin would go along with this. "The state is not a dumping ground for the private economy," says Volker Wissing, the deputy parliamentary leader of Chancellor Angela Merkel's junior coalition partners, the pro-business Free Democratic Party (FDP). He also argues that handing Eurohypo to the German government could trigger a new round of state aid investigations. The arbitrary assumptions of a stress test cannot justify decisions that burden taxpayers, says Carsten Schneider, a finance expert for the center-left opposition Social Democrats (SPD). "If capital is needed, then it should be raised through common stock and without dubious compromises."

Investment bankers say that if the bank were nationalized, it would be possible to hive off Eurohypo and subsequently sell off the healthy remainder of Commerzbank. The proceeds could then be used to balance out any losses sustained from Eurohypo.

Politicians in Berlin express only muted enthusiasm for such a bailout scheme. "The parliamentarians don't want yet another bank that will become a source of political dispute," says one Commerzbank manager. This reluctance is understandable. The MPs still vividly remember a similar situation with Hypo Real Estate: In 2009, the German government took full control of this ailing group of real estate financing banks and split off the riskiest investments into a bad bank. But it still remains totally unclear exactly how much money taxpayers lost during the deal.

The Berlin government and Commerzbank have one Christmas wish in common: that the euro debt crisis doesn't bring down Italy, which would put governments and banks under even greater strain. Cynics, however, would add: If Italy defaults on its loans, the euro crisis will reach such dimensions that Commerzbank's problems will be negligible by comparison.

Translated from the German by Paul Cohen