UNCLAS SECTION 01 OF 04 FRANKFURT 008258

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

E.O. 12958: N/A
TAGS: ECON EFIN EUN
SUBJECT: German Banks: Light at the End of the Tunnel?

T-IA-F-03-0053

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


1. (SBU) Summary: Summary: The first half of 2003
witnessed stabilization in the German banking sector after a
disastrous 2002 - the worst since the war. However, German
banks are not out of the woods yet. Continuing benefits of
cost cutting, consolidation, cooperation on back office
operations and securitization and promise of an economic
recovery would all be for the good. Despite these bad times
for some German banks, Germany is a place where bankers can
make money. Buying distressed loans or selling good ones
through securitization means business. Some investment
banks are ramping up their German operations, a sharp
contrast to the reduction in activity of many German banks -
an indication that the landscape of German finance is
changing. End summary.

2002: Banks Hit Rock Bottom?
--------------


2. (SBU) In its September monthly report, the Bundesbank
carries an article on the earnings situation of German banks
in 2002, which was even worse than the year before. All
banks' operating profits taken together amounted to 6.8
billion euro, after 13.4 billion euro in 2001. Total annual
net profits fell from 14.5 billion euro in 2001 to 10.6
billion euro in 2002. Risk provisions were the most
important factor negatively affecting banks' revenues.
These resulted mostly from domestic loan business due to a
significant increase in insolvencies. Commission revenues
went down because of low turnover at the exchanges and very
few IPOs. Net interest revenues were a positive factor,
largely due to low-interest sight deposits. Net
extraordinary revenues also increased, as a result of write-
ups in the banks' own investment portfolios.

Competitors Exaggerating Crisis?
--------------


3. (SBU) However, the situation is probably not as bad as

some would like to make it out to be. A recent article in
the Financial Times reported that the Financial Supervisory
Authority (BaFin) participated in supervisory board meetings
of at least the top ten German banks. The article suggested
that this was a sign of the desperate situation in the
German banking sector. However, the Federal Association of
German Banks stated that supervisors' participation in
supervisory board meetings are "an absolutely normal
procedure" and by no means crisis management. A BdB
spokesman called the FT's conclusions incomprehensible,
saying that this looked like cheap propaganda against
Germany as a financial center even though the FT knows
better.

German Bankers Face Structural Disadvantages
-------------- --------------


4. (SBU) A study by Boston Consulting Group (BCG), which
focused on retail business, found that it is not so much
poor business models or bad management that are responsible
for German banks' low profits. Instead, structural
differences in the banking markets explain 70% of the
difference in profits between German banks and their
competitors in the EU. There are three factors that put
German banks at a disadvantage: the interest margin is very
low in Germany due to strong competition, labor costs are
high, and households' financial assets are lower than e.g.
in Great Britain.


5. (SBU) Of course, nobody doubts that German bank
managers have also made mistakes, adding to the difficult
environment. However, the BCG study may provide an
explanation why the large German banks have so far not been
taken over despite their low market capitalization - i.e.
any new owners would have to cope with the same problems.
Nonetheless, some foreign banks, such as Citigroup and ING
subsidiary Diba, prove that it is possible to be successful
in the German market. Diba is currently about to overtake
Commerzbank with regard to the number of retail customers.

Effects of Restructuring Efforts Beginning to Show
-------------- --------------


6. (SBU) The good news is that the German banks recognized
their problems and managed to cut costs considerably.
Overall, in 2002 they reduced administrative costs by almost
4% compared with 2001, half of which in personnel costs and
half in other areas. The large private banks were
particularly successful with administrative costs going down
by 11.2%. The German banking sector overall cut 18,300
jobs, so that the number of employees dropped below the
level of 1992. Private banks alone reduced their staff by
12,000, but also the savings banks cut 4,000 jobs.
Reductions in the number of branches also played an
important role: overall it decreased from 37,585 in 2001 to
35,340 in 2002. In the course of last year, the savings
banks closed down almost 1,000 branches, the cooperative
banks over 700 and the large private banks more than 100.



7. (SBU) The Bundesbank believes that banks' profits
reached a low in 2002, and that 2003 will be better.
Stabilization of the economy should contribute to this. In
particular, asset valuation expenses (i.e. marking assets to
their market value) are expected to go down considerably
this year. Moreover, the upswing in the stock markets
should have a positive effect on revenues. The Bundesbank
also argues that the effects of the 2002 cost cutting
programs have not yet fully shown so that costs can be
expected to fall further this year.



8. (SBU) The first positive results of restructuring could
already be seen in the first half of 2003. Deutsche Bank
fared best among large German banks. In the first half of
2003, it made a profit before tax of 1,325 million euro and
of 353million euro after tax, mainly benefiting from
investment banking and business with corporate clients. In
the first half of 2003, Dresdner Bank actually made a loss
before taxes of 450 million euro, which, thanks to a tax
refund, turned into a profit of 25 million euro after tax.
Over that period, Dresdner made an operating profit of 7
million euro, compared with a loss of 873 million euro in
the first six months of 2002. Commerzbank showed with its
result for the first half of 2003 that the worst seems to be
over. Its consolidated profit amounted to 73 million euro.
CEO Klaus-Peter Mller stated that he expects his bank to
make a positive operating profit for the year 2003 as a
whole. In the first six months of 2003, Hypo-Vereinsbank
made an operational profit of 238 million euro, after an
operational loss of 413 million euro in the first half of

2002. It made an overall profit of 144 million euro during
that period



9. (SBU) In particular, massive job cuts have helped to
bring down costs, with more likely to come. Banks focused
on their "core business," and outsourced or closed down
entire business segments. The securitization of "good"
loans was another helpful strategy. Increasing bond issue
business has had a positive effect on profits so far. The
private banks are now focusing more on retail customers, a
less cyclical business segment so far left to savings and
cooperative banks. A Bundesbank contact we spoke with
identified cooperation in back office operations, e.g.
securities settlement as well as large-scale securitization
via a "true sale" of the assets organized by KfW, as another
new trend in the sector and expects it to increase
efficiency. On October 1, Deutsche and Dresdner announced
that their payments will be settled by Postbank.



10. (SBU) The sell-off of "bad" loans will likely pick up
in the course of this year. Experts expect that trading in
such "bad" loans has an enormous potential. According to
Aidan Freyne, Director for distressed debt at Citigroup "all
important competitors want to be present in Germany."
Mattias Mosler, head of Merrill Lynch in Germany, stated
that Germany is becoming the most important market for such
business in Europe. Merrill is opening up an office to deal
with such loans in Germany. More generally, Mosler believes
that Germany is key for investment banking in Europe. "Only
those successful here can play a major role in the other
European countries, too." Merrill Lynch currently has 220
employees in Germany and plans to hire more.

Looking ahead
--------------


11. (SBU) The mood in the German banking sectors is clearly
brightening up. After a phase almost exclusively focused on
cost cutting, the banks are now starting to develop visions
and strategies for the future.



12. (SBU) Deutsche Bank's CEO Josef Ackermann stated that
"we want to be leading at the global level and, at least in
our core business areas, to count among the five best
worldwide". Deutsche Bank is also watching out for
potential takeover targets, particularly in the business
segment "high net-worth clients". Ackermann also announced
that Deutsche Bank will try to sell many of its equity
holdings. Hypo-Vereinsbank (HVB) aims at increasing its
market share in Northern Germany, with the upcoming
integration of the Hamburg-based Vereins- und Westbank. At
the same time, HVB also plans further acquisitions in
Eastern Europe. Moreover, HVB wants to focus more on
certain activities, e.g. in retail banking it will
concentrate on marketing, while production will likely be
outsourced. Commerzbank CEO Klaus-Peter Mller stated that
his bank plans to grow in the asset management and retail
business, which could also involve acquisitions. The bank
also wants to focus its corporate clients business more on
SMEs, aiming at 9,000 new SME customers in the next three
years. This business segment is to be linked more closely
to investment banking.



13. (SBU) Looking further ahead, there is a hot debate on
the process of consolidation of the banking sector. In its
Financial Sector Policy Assessment, the IMF suggests that
consolidation should be permitted across the three "pillars"
of German banking, e.g. the private, state, and
savings/cooperative banks. This has provoked a sharp
negative response from the savings and cooperative banks but
was welcomed by private banks. Bundesbank senior banking
officials have taken the view that the three pillars should
be preserved as they have been a successful model for
Germany in the past. Others in the Bundesbank take a more
nuanced view, namely that the elimination of state subsidies
in 2005 will force the state and savings banks to adopt new
models, including, eventually, injections of share capital.
They would become private in all but name. The Finance
Ministry also sees market forces playing a hand at reshaping
the sector over the longer term but, for the moment, does
not wish to invite the ire of the savings banks.

Not yet safe
--------------


14. (SBU) Even though the situation of German banks is
stabilizing, Rolf Breuer, President of the Federal
Association of German Banks (BdB) and chairman of Deutsche
Bank's supervisory board, stated that "there is no reason
for premature optimism. The level that we will reach this
year is still extremely low." Bundesbank Board Member Edgar
Meister believes that the restructuring measures currently
undertaken by the German banks will strengthen them. He
argues that "the sustainability of the German banks'
recovery is also dependent on economic recovery. Our
Bundesbank contact stated that it is still "not time for
euphoria". She described the current situation as
"stabilization with an upward outlook". She also pointed
out that while cost cutting is indeed necessary, there is
also a risk that banks cut them so much that they destroy
their own income base. Standard & Poor's also believes that
vulnerability still exists in the German banking sector.


15. (SBU) While stock prices of the large German banks went
up in the first half of 2003, this trend now seems to have
come to a halt. During the first six months of the year,
German banks benefited from high interest revenues and low
risk provisions in the loan business. According to some
analysts who claim that in a weak economic environment banks
usually have to increase risk provisions towards the end of
the year, the second half of the year will be more
difficult. Given the bleak economic outlook for Germany,
the number of loan defaults might increase. Moreover, at
the beginning of the year banks had unexpectedly high
revenues from bond trading which are unlikely to continue as
bond returns increase. The large German banks' return on
equity remains low by European standards. In the first half
year, it was 2.4% after taxes for Deutsche Bank, and even
negative for Hypo-Vereinsbank. In contrast, JP Morgan
Chase, Credit Suisse or UBS reach an equity return of more
than 17%.



16. (SBU) In addition, the market capitalization of German
banks, once among the top international banks, is very low
by international comparison. For instance the current value
of HSBC is at 126.6 billion euro, and that of the Royal Bank
of Scotland at 68.3 billion euro, while the market
capitalization of Deutsche Bank amounts to 31.5 billion
euro, that of Hypo-Vereinsbank to 8 billion euro and that of
Commerzbank to 7.3 billion euro. For many observers,
Deutsche Bank is the only one of the large four German banks
that can lay claim to a global role. How times have changed.


17. (U) This cable was coordinated with Embassy
Berlin.


18. (U) POC: Claudia Ohly, Economic Specialist, e-mail
OhlyC@state.gov; tel. 49-(69)-7535-222367, fax
49-(69)-7535-2238.

BODDE