Are Germany's Banks About to go the Same Way as Japanese Counterparts?

One problem is that German banks are not profitable enough to counter rising bad debts

October 30, 2002
By Katherine Griffiths, Banking Correspondent

A surge of disappointing results and profit warnings from Germany's largest banks have shaken confidence in one of the world's largest and most powerful economies. Now the talk is that if a banking crisis is brewing as a result of the last two and a half years of economic downturn, it will be in Germany and not the larger US market.

Speculation about the possible demise of one of Germany's big four banks has become so intense that it has prompted public figures to make statements trying to assuage fears.

Ernst Welteke, president of the Bundesbank, said it was "dishonest" to talk of a banking crisis. Mr Welteke acknowledged that Germany's banks are having a rough time, due to the stagnant state of its economy and the sickliness of some of its largest companies. But he said Germany's banks would emerge "strengthened rather than weakened" from this latest bout of economic downturn.

Mr Welteke's comments echoed those of senior banking executives. Klaus-Peter Mƒller, chairman of Commerzbank, insisted that despite a warning on Monday that the bank might suffer a loss this year, it was not in the middle of a full-blown crisis.

Neither statement bolstered confidence in the market. The German banks, which have seen their shares hammered this year, yesterday suffered a further sell off, becoming the largest fallers among European banks.

One German banks analyst said: "Their shares are currently valued at about half of their book value. From the point of view of their equity, the German banks are already in crisis."

Senior banking executives argue their underlying businesses are not in quite as bad a shape as the slump in their share price would suggest.

But indications are more worrying. The spread on German banks' borrowing has more than tripled in the past month, indicating serious doubts in the market about the institutions' credit worthiness (See table).

Some commentators have warned, the recent pattern at the country's top four banks is looking worryingly similar to that of Japanese banks in the late 1990s, which were swamped by a mass of bad corporate debts following the spectacular bursting of its asset-price bubble.

Germany may also be tottering on the edge of a deflationary spiral similar to the one Japan is now stuck in, increasing the risk of bad debts and making it more difficult for the country's banks to offset the problem with new business from individuals and companies.

HVB, Germany's second-largest bank, last week shocked the market by posting a deeper-than-expected third-quarter pre-tax loss, which included a doubling of provisions against loan losses.

Commerzbank, the number three bank, has suffered a crisis of confidence among investors over rumours that it has been saddled with heavy derivative losses. Meanwhile, Deutsche Bank, Germany's largest bank, has raised capital by selling off large swathes of cross holdings in other companies while Dresdner, owned by the insurance giant Allianz, is considering selling the most unprofitable bits of its business and slashing its headcount to preserve capital.

German banks' record on bad debts is quite respectable. One analyst said: "As a percentage of the loan book we expect German banks to take a charge of between 0.8 to 1 per cent for the full year. A charge of that nature for UK banks would hardly make them sneeze."

The trouble for German banks is they are either pocketing a negligible profit or have plunged into the red, making the effect of bad debts more serious than for their UK counterparts, which this year produced impressively for shareholders.

Observers say that if there is a German banking crisis, it is in why this sector is so unprofitable compared to UK or US banks ö a situation which has made it particularly ill-prepared to deal with the economic downturn.

John Rushton, a consultant at analysts PA Consulting, found earlier this year that UK banks' return on capital is on average five times higher than of the German big four, and the British banks' cost income ratios are between 20 and 40 per cent better than those in Germany.

This lack of productivity and profitability in Germany have meant that Deutsche bank, despite being the third largest bank in the world, has a market capitalisation of less than Halifax, the UK bank which merged with Bank of Scotland last year.

The reasons for the stodginess of Germany's banks lies in the political and economic role they have had in the last 50 years and, critics say, still have now.

Dr Bob Hancke, a lecturer in political economy at the London School of Economics, said: "After the Second World War, a highly regimented financing system was needed as a way to create growth with very little capital."

Just as in post-war Japan, the pattern adopted in Germany was for banks to provide far more of the capital to drive industrial growth than the capital markets. This led to banks, such as Deutsche bank, taking large stakes in important and nationally symbolic companies, such as the car maker Daimler Benz, to stop them from going under.

In Germany's case, the government also underwrote a range of regional saving and corporate banks, which continue to compete with commercial banks for the business of individuals and companies. The effectively state-owned savings banks, known as sparkassen, and the regional development banks, known as landesbanken, have remained very powerful. Despite their high international profile, Germany's private banks only have a 20 per cent market share at home.

This has meant that even Germany's premier private banks are not competing on a level playing field, because their costs of lending remain much higher than those of the public institutions, which are underwritten by the government.

Those who are optimistic about Germany's banking sector say that the current economic crisis is acting as the nasty dose of medicine politicians need to finally renounce the post-war economic model, known as "Germany Incorporated".

Last year the German government changed the capital gains tax rules. This allowed banks and insurers, which have massive cross holdings in each other and in industry to start to unwind them ö a change some senior executives have wanted to do since the mid-1990s to boost shareholders returns.

Allianz has been praised for its decision to sell its holding in HVB, while taking control of Dresdner, which it is now subjecting to radical surgery to try to boost its profitability.

At the same time banks and politicians are proving to be increasingly willing to let struggling German companies fail rather than be propped up by the banking establishment. Kirch, the media empire, was the most high profile casualty of this new tougher line this summer.

The final step is consolidation, which analysts say is urgently needed to strip out some of the over-capacity in banking market.

There have been some attempts at this ö HVB is the product of major mergers, while Deutsche has signalled it is scouting around for a deal outside Germany, possibly with Lloyds TSB. The stumbling block remains the public banks. Despite encouragement by the European competition authorities to open them to competition, German politicians have made it clear they will not allow private banks to take over the state-sponsored banks.

The consensus is that Germany is not another Japan, and that if there is to be a financial failure from this downturn, it is more likely to be in largest banking market in the world ö the US.

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