The German Banking Sector -- Something Happens

UNCLAS SECTION 01 OF 04 FRANKFURT 010327

SIPDIS

STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA
STATE PASS FEDERAL RESERVE BOARD
STATE PASS NSC
TREASURY FOR DAS SOBEL
TREASURY ALSO FOR ICN COX, STUART
PARIS ALSO FOR OECD
TREASURY FOR OCC RUTLEDGE, MCMAHON

E.O. 12958: N/A
TAGS: ECON EFIN EUN
SUBJECT: The German Banking Sector -- Something Happens

T-IA-F-03-0067

This cable is sensitive but unclassified. Not/not for
Internet distribution.


1. (SBU) Summary and Comment: From speculation over
banking mega-mergers, to mooted collapse of the three-
pillared banking system, to a circling of the wagons to
protect against foreign invaders, the German banking sector
is abuzz with rumor. With too many German banks and an
acute need to improve profitability, the lines between
public and private banking sectors are becoming blurred. In
advance of withdrawal of state guarantees in 2005, public
savings and state banks are waking up to the need for
restructuring and perhaps cooperation. Meanwhile, private
sector banks in the "third pillar" have tightened their
belts only to find themselves possible takeover targets.
The Finance Ministry now seems to recognize the need for
market-based solutions, but many politicians want to
preserve the German banking tradition in the face of global
pressures. Where is this all headed? The answer remains
unclear -- however, Germany's three-pillared system is
obviously beginning to wobble.


2. (SBU) Something is clearly going on in the sector,
though exaggerations and misfires by the financial press
make it difficult to separate fact from fiction. Comments
from Eichel, Koch-Weser and Breuer appear to be aimed as
shaking up the system, at stimulating change rather than
closing Germany's banking sector to outside interest.
Public sector banks are running scared, faced with loss of
state guarantees in 2005, poor ratings and mostly miserable
returns. Politicians will be eager to protect local jobs,
the German tradition and state influence over Landesbanken
and public savings banks. Nevertheless, under global
pressures the entire German banking system appears likely to
undergo significant change in the midterm. Bankers are
warily sizing up competitors and seeking allies. Outside
banks, to include U.S.-based institutions, will be watching
the process closely.

3. (SBU) While it is not so surprising that the public
banks seek government support for safeguarding the current
three-pillar system, it is strange that the otherwise market-
oriented private banks evidence a sudden concern for the
financing of domestic companies. It was the private banks
that recently significantly reduced their lending to small
and medium-sized enterprises (SMEs). This appears a
possible change in business strategy, seeking to demonstrate
that private banks would ensure there is no drop off in
lending to SME's with any cross-pillar mergers -- a sure way
to win the hearts and mind of otherwise reluctant government
officials. End Summary and Comment.

Bank Mergers Back on the Agenda?
--------------

4. (SBU) With the German economy apparently in the early
stages of recovery, historic agreement on structural reforms
and equity markets up significantly from recent lows, German
banks -- showing improvement after a round of cost-cutting,
balance sheet cleanup and internal restructuring -- are
mooted to have become attractive takeover targets, not least
because their market capitalization remains relatively low.


5. (SBU) In its recent analysis of the EU banking sector,
the ECB predicted increasing consolidation if the banking
environment improves and the gradual economic recovery
proves to be durable. It suggests factors such as the EU
Takeover Directive and the further withdrawal of the state
from domestic banking activity will also facilitate
consolidation and cross-border mergers. According to the
news magazine "Der Spiegel", a high-ranking German federal
official is certain of a merger wave next year after German
banks post 2003 results. Fitch Ratings sees potential for
further domestic consolidation in the German banking sector
that will remain constrained by the existing three-pillar
system. Speculation about imminent mergers and acquisitions
has heated up, helping improve large German banks' stock
valuations.


6. (SBU) However, Standard & Poors has meanwhile issued a
report critical of German banks, arguing that profitability
and capitalization are so weak that outside banks would find
them uninteresting. Fitch Ratings still sees German banks
at the bottom end of the European scale, despite signs of
weak recovery in the third quarter. Moreover, a Frankfurt
investment banker believes German labor law, banks' poor
loan portfolios and the cultural differences still function
as effective deterrents to international takeover.

Foreign "Conquerors" at the Gate...
--------------

7. (SBU) But rumors are circulating that Citibank may be
interested in taking over Deutsche Bank. While the latter's
costs are high by international comparison, it has more than
12 million retail customers worldwide and has relationships
with many of Europe's most important companies. "Der
Spiegel" reports that Sanford Weill, chairman of Citibank,
has met with both Chancellor Schroeder as well as the
Minister President of Hesse soliciting political support for
a potential takeover. According to "Der Spiegel", Citibank
might even transfer its European headquarters from London to
Frankfurt in order to make such a deal politically
acceptable in Germany. Other reportedly interested buyers
are Credit Suisse, BNP Paribas and the Royal Bank of
Scotland.


8. (SBU) German banks are apparently so concerned about
takeovers from abroad they have sought help from the
government. After closed talks with government officials,
the President of the Federal Association of German Banks
(BdB) and head of Deutsche Bank's supervisory board Rolf
Breuer, publicly warned political decision-makers to beware
that "conquerors" are on the doorstep. Breuer asked
"shouldn't it make a difference to us whether domestic
industry can fall back on German banks or whether they
depend on foreign credit institutions?" Breuer argued that
there is a risk, for instance, that American banks would
"for obvious reasons" (referring to the conflict between
Berlin and Washington due to the war in Iraq) would take
more account of U.S. government interests. Referring to the
need for German banks to increase competitiveness and
inflexibilities due to the rigid separation between
Germany's three banking pillars, Breuer also stated "we
don't have any time to lose. German banks must at last free
themselves from their bonds."


9. (SBU) Apart from any possible interest in takeovers,
foreign banks do appear to regard Germany as an increasingly
attractive place to do business due to sector growth rates
that are the highest in continental Europe. Several of
banks, among them Lehmann Brothers, JP Morgan and UBS
Warburg, are currently increasing staff in Germany,
particularly in investment banking and equity business.
Peter Coym, chairman of the Association of Foreign Banks and
board member of Lehmann Brothers finds "the prevailing mood
regarding Germany is positive. Some Anglo-Saxon banks are
responding with decentralization and a stronger local
presence."

... a National Solution?
--------------

10. (SBU) Given the "threat" of takeover by foreign banks,
the idea of a merger among large German banks has received a
great deal of press play, despite earlier failures such as
deals between Deutsche Bank and Dresdner, and between
Dresdner and Commerzbank. Recent rumors have all four large
banks considering a mega-merger, either completely or of
individual segments such as retail banking business.
According to "Financial Times Deutschland," Deutsche Bank's
CEO Josef Ackermann pronounced himself in favor of a
"national" solution (Ackermann is Swiss). The German press
reported that Finance Minister Eichel was pushing for a
merger of the country's large banks. The Federal Finance
Ministry, however, denied that Eichel had made any such
statement, claiming that he had only suggested thinking
about cooperation. According to "Handelsblatt," Rolf Breuer
called speculation over a mega-merger absurd.


11. (SBU) Many experts have weighed in as well, decrying
the likelihood of such a merger on the grounds of high
restructuring costs and acute politically sensitivities to
probable job cuts and branch closures.

12. (SBU) According to press reports, the Bavarian state
government favors a merger between HVB and the Bavarian
Landesbank in order to safeguard Munich as a banking center
and is pushing the two banks to start talks. However, a
number of hurdles would have to be cleared before such a
deal could happen. Landesbank representatives called the
idea completely unrealistic.

Cooperation and Mergers in the Public Sector
--------------

13. (SBU) Given the Federal Government's agreement with the
European Commission to abolish state guarantees for state
(Landesbanken) and public savings banks, the public banks
know that they need to restructure. In particular, the
Landesbanken face a bleak outlook unless they fundamentally
improve their profitability and credit standing. According
to the controversial and yet unpublished analysis by
Standard & Poor's, the ratings of the Landesbanken are
expected to fall to the "BBB" level once they lose state
guarantees. Mergers and cooperation may be one way to
prevent that from happening.


14. (SBU) The Landesbank Hessen-Thringen (Helaba) has
revealed plans for a new structure of their cooperation with
the savings banks. Helaba intends to establish a "network
bank" with the core functions of marketing and project
management for the savings banks' products. Landesbank
Baden-Wrttemberg recently concluded a cooperation agreement
with all 57 savings banks in the state in order to make use
of synergies. Similarly, the BayernLB and the Bavarian
savings banks have agreed to establish a network.


15. (SBU) Moreover, Landesbank Baden-Wrttemberg is
is
currently in merger talks with Landesbank Rheinland-Pfalz,
even though speculation of an imminent merger was denied by
the institutions. Nonetheless, the consolidation trend is
building steam.

Breaking up the Three Pillar System?
--------------

16. (SBU) The IMF's recent controversial country report on
Germany found public bank ownership leads to competitive
distortions in the banking business. It recommended
following the example of other EU countries that have turned
their public banks into joint stock corporations allowing
private investment. Moreover, the IMF's Financial Stability
Assessment Program Paper called for expeditious creation of
a "legal framework to reduce barriers to consolidation,
within or across pillars, and thereby facilitate market
oriented restructuring."


17. (SBU) In a speech at the end of October, Caio Koch-
Weser, Ministry of Finance State Secretary, also called for
banking sector reform in order to gear it toward market
signals and permit a higher share of private (equity)
capital throughout the sector. Koch-Weser suggested
alternative legal forms be introduced for public sector
banks in order to permit mergers possible within and between
the three pillars. Moreover, he criticized Germany's
"regional principle," which carefully divides the market
between the local savings banks. In his view, this barrier
to competition also needed to be reformed. Other countries
in Europe have outpaced Germany's banking reform, he warned.


18. (SBU) Finance Minister Eichel also voiced support for
the IMF's recommendations for a loosening of the banking
structure. His ministry shares the view that "an efficient
banking system must be open to market-oriented change."
Eichel stressed the need to focus reform to ensure stability
of and viability of Germany's banking system, and he urged
that caution be used in crafting a medium-term strategy.


19. (SBU) For their part, public sector banks vehemently
rejected the IMF's analysis along with Koch-Weser's
comments. Their defense of the Germany's unique three-
pillar model was subsequently supported publicly by
politicians from across the political spectrum.
Outrider in the East
--------------

20. (SBU) At the end of November, the mayor of Stralsund, a
Baltic sea-coast town, announced his intention to put the
local savings bank up for auction, stating his preference
for a private bank buyer. Such a sale would generate
privatization revenues not forthcoming in an alternative
merger with another public savings bank. Moreover, a
privatized private bank would no longer be restricted to
doing business only in its designated region. However, sale
to a private bank would set a precedent for savings banks in
Germany. The mayor's plans led to public intense debate
over the damage they might inflict on the three-pillar
system. Given the current financial problems of many
municipalities, others may be eager to follow Stralsund's
example. Some pundits speculated that private banks might
be willing to pay a premium for the Stralsund savings bank
just to "break the ice" legally. Among the large private
institutions even Commerzbank expressed an interest.


21. (SBU) The Finance Minister of the German state of
Mecklenburg-Vorpommern where the bank is located has
challenged the mayor's plan, claiming that it would be
illegal under state law. The Stralsund mayor and his legal
advisors take a different view. The issue remains in legal
limbo pending review.

Increasing Cooperation Between Pillars
--------------

22. (SBU) While mergers between private and public pillars
are still visions for the future, cooperation across sectors
already exists in restricted areas, mostly for back-office
operations. The most recent development is a late November
decision by Dresdner Bank to out-source its securities
settlement to DWP Bank, which is owned by cooperative sector
institutions DZ and WGZ Bank and the savings banks'
association in North-Rhine Westphalia. State-owned KfW's
cooperation with private banks for a joint securitization of
loans to the SME sector is another example.


23. (U)This cable coordinated with USEU and Embassy Berlin.


24. (U)POC: James Wallar, Treasury Representative, e-mail
wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)-
7535-2238

Bodde