Cablegate: Structures and Trends in German Banking Industry:

This record is a partial extract of the original cable. The full text of the original cable is not available.





E.O. 12958: N/A
SUBJECT: Structures and Trends in German Banking Industry:
Bleak Outlook Gets Better; Consolidation Scenarios For A
Financial Stronger System


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

Stability Pact Revision: Art Imitates Life

Ref: (a) Warsaw 1108; (b) Warsaw 1624

1. (SBU) Summary: There is a lively debate about whether
the relatively poor performance of the German banking sector
is related to its "three pillar" structure of (1) private
commercial, (2) public state and savings, and (3)
cooperative banks. The discussions were triggered by the
continuing weak performance of the German banks relative to
other European banks. Although German banks are slowing
recovering, the very large German banks no longer rank among
the top tier European banks.

2. (SBU) The German Council of Economic Advisors'
examination of this structural question found no clear
answers. A more recent Frankfurt University study suggests
that German banks have not been able to generate increases
in revenues as much as their EU competitors nor have they
priced credits according to risk, both attributed to the
intense competition offered by public savings and
cooperative banks.

3. (SBU) Changes are underway in the German banking
sector, but none that would suggest an overhaul of the
current system. Consolidation will continue, but the key
question is how. Current market wisdom is that
consolidation will continue as in the past, taking place
within the pillars. The IMF asserted that opening up
consolidation across pillars would allow for market-oriented
solutions for developing profitable products. Even if some
local laws were changed to permit this, large banks are
unlikely to develop a robust national retail network by
snapping up random sales of a few regional savings
institutions. Cross border mergers could be another avenue,
but also unlikely at this juncture. More intriguing would
be the possibility for increasing competition with savings
banks that arguably are structured and perform as though
they are one large banking entity. If such competition were
to alter the present German banking system, the Frankfurt
University study suggests such changes would come quickly.
Time will tell. End Summary.

Structure of the German Banking System

4. (SBU) The German banking system is characterized as a
bank-based financial system composed of three pillars. Bank-
based means that enterprises, and households, finance
themselves via bank credits rather than via the capital
market. The balance sheet total of all German banks is
roughly three times German GDP, extremely high compared to
other European countries. The three pillars are private
credit banks (big banks and regional banks), public banks
(savings banks and State banks) and cooperatives (local and
central cooperatives).

5. (SBU) Although the private credit banks are
individually large, together they account for a market share
of 16% in terms of total balance sheet. Savings banks and
their regional lead institutes, the State banks, have a
market share of more than one third. By law, the business
policy of the savings banks is to provide financial
resources to the population. Thus, more than one third of
total assets in Germany is not managed by economic
objectives such as profit maximization. The market of
savings banks is locally restricted according to the so-
called "regional principle." Cooperative banks have a
market share of approximately 12%. Cooperatives are
distinguished from other banks by the fact that their
customers are also the owners of the banks by means of share
certificates. Apart from that, cooperatives act like
savings banks as they do their business on a locally
restricted market and profit from co-operation among

Situation of German Banks: From Bleak to Better
--------------------------------------------- --
6. (SBU) German banks have endured difficult conditions,
suffering from an increasing number of credit losses as a
result of the economic downturn, stock market collapse, and
a record high number of insolvencies. The return on capital
of German banks fell sharply in 2003 to 0.73% from 11.2% in
1999. Profitability has developed quite differently in the
three bank groups: Big banks, state banks and central
cooperatives recorded a severe reduction of earnings, with
negative returns on capital ranging from 4-6%, while savings
banks and local cooperatives increased their profit for the
financial year experiencing a return on capital of 11%.

7. (SBU) One reason savings banks and local cooperatives
turned out good results is because they are anchored in
retail banking, deriving most of their income from net
interest earnings. Only a small part of their revenues are
from more volatile activities, such as trading or fee-based
business. In contrast, several years ago the big banks
shunned retail activity and concentrated on investment
banking. The result is well known: large banks destroyed a
considerable amount of their economic value, relegating most
of them to the second tier of European banks.

8. (SBU) The German Bundesbank expects an improvement of
the bank's earnings performance in 2004 and 2005 during the
anticipated economic upturn. Improved earnings are likely
as many banks have introduced cost reduction programs in
recent years that are now showing results. Apart from that,
value adjustments taken in 2003 will decrease risk
provisions for the credit business for 2004 and 2005. The
outlook for revenues is still uncertain, being dependent on
the economic cycle and trading business. These potential
improvements do not disguise the fact that the return on
capital of German banks is very low in both historical and
international comparison.

Does the Weak Performance Stem from the German Banking
--------------------------------------------- --------------

9. (SBU) In its 2003 Financial System Stability Assessment
of Germany the IMF posited the thesis that the tree-pillar-
structure of the German banking system causes an inefficient
use of resources. The German Council of Economic Advisors
investigated this thesis in its annual report for 2005. They
found that the density of branches in Germany is very high
compared to other banking systems, but that the savings
banks and the cooperatives profit from their respective co-
operation in core activities that allows them to realize
economies of scale. Thus, the Council concluded that the
number of branches per inhabitant does not throw light upon
the efficiency of the German banking system.

10. (SBU) The Council considered that the high incident of
mergers between German banks implied an inefficient use of
capital. On the other hand, competition in banking appears
to be keen, which should instill efficiency. The five
biggest institutes possess 22% of total assets, low by
international comparison, suggesting contestability of the
market. Apart from the U.S. with a concentration level of
24% and Italy with 27%, in all other big industrialized
countries the largest banks enjoy concentration levels
between 40% and 90%. This result changes if savings banks
and cooperatives are no longer treated as separate,
autonomous units, but a single banking group. If all
savings banks and State banks were counted as one banking
group, the Council reckons it would be the largest credit
institute in the world. The market share of the five
biggest institutes would amount to 67% of total assets,
suggesting lower levels of competition.
11. (SBU) A January 2005 study by the Frankfurt University
suggests that the structure of German banking may have
hindered its overall profitability. While German banks have
been able to reduce total operating expenses over total
assets, out-performing other EU banks, they have not be able
to generate nearly as much revenue growth as their EU
competitors from both interest as well as non-interest
income. In addition, loan loss provisions in Germany have
remained high while declining in other EU banking systems.
High provisions combined with declining interest margins
imply that, on average, German banks have not priced credit
risk appropriately, according to the study. Low revenues
and lower interest margins suggest robust competition - good
for consumers but not good for banks' profitability. These
results are a function of the large market share commanded
by the public savings bank and cooperative banks.

Changes Underway in German Banking

12. (SBU) The three-pillar system has been resistant to
change. That does not mean that there are no changes afoot
in the German banking industry. Among the changes
anticipated this year are:

Continuation of consolidation. The number of banks has
declined from 4,543 in 1987 to 2,466 in 2003 and the
number of branches per 100,000 people has declined from
65 to 46 over roughly the same time period. Much of
that consolidation has taken place within the
cooperative bank sector. For example, since 1999 the
number of banks in Germany has declined by 769, the
number of cooperative banks dropped by 640 to 1,392.
The savings bank sector also shrunk according to the
number of savings banks by 89, bringing the total
number of savings banks to 489 at the end of 2003.
These consolidations reflect financially larger or
stronger neighboring co-operative or savings banks
taking over weaker institutions.

Designation of a new "big bank." The Post Bank that was
recently privatized will be designated as a "big bank,"
bringing the total number to five. The Post Bank is
substantially different from the other large banks as
it has an extensive branch network that covers the
entire country and concentrates in the retail sector.

More lending to retail and SME's. Big banks have
shifted their focus to give more attention to retail
sector and SME lending.

State banks to adopt and refine new business models.
This adjustment is underway as these State banks seek
ways to continue operations without State guarantees.
Some are merging with other state banks, others are
seeking new investors or spinning off their commercial
operations from the public lending activities. Private
banks have argued that the credit rating of these
institutions would weaken absent the state guarantees,
driving up their financing costs and making them less
competitive. However, preliminary judgments by credit
rating agencies suggest very little deterioration in
the State banks' creditworthiness so far. Retaining
these ratings will depend on successful implementation
of their new models.

Increased competition in bond issuance business. This
will result from the new law on Pfandbrief (bonds
backed by mortgages or public assets). The law will
allow all banking institutions to issue such
instruments, not just mortgage banks and public law
banks. Pfandbrief issuance had been a growing activity,
leading Finance Ministry officials believe that the
legal change will contribute to more bank
consolidation. Bundesbank officials, however, believe
the market will not be as robust as before, implying
that opening up competition will not have a significant
influence on the banking structure.
Better pricing of credits to risks. The new risked-
based Basel II capital requirements, likely to be
adopted by the European Parliament before the end of
the year, should result in more risk-sensitive pricing
of credits. While this indicates higher credit costs
for some borrowers in the future, as the Frankfurt
University study indicates, the pricing of credits has
been too low relative to banking risks. This suggests
that interest rate margins should increase.

Consolidation Scenarios

13. (SBU) The notion that the predominance of public
savings institutions is an impediment to consolidation and
strengthening of the overall German banking sector was given
support by the IMF. In its report on Germany's banking
sector, IMF staff declared, "a reduction in existing legal
and other barriers to restructuring, within or across
pillars, would expand the scope of possible market-oriented
solutions." Another IMF study shows that other countries
that underwent banking sector restructuring witnessed an
increased role by private banks, accompanied by financial
strengthening. This has intensified the debate about the
reforms of public sector banks.

14. (SBU) It is controversial whether a high participation
of the government and the States are good or bad for the
German banking system. Supporters of reforms cite
efficiency losses for the whole system due to the public
participation. Moreover, in their opinion, government
intervention cannot be justified from a regulatory point of
view since there is no market failure. Reform opponents, on
the other side, deny efficiency losses, referring to the
high return on capital of the savings banks. They point out
that the predominance of profitable savings banks in Germany
mirrors the structure of German industry to which these
banks lend, i.e. small and medium size "mittlestand" firms
that are widely dispersed throughout the country.

15. (SBU) While many other European countries have
experienced successful restructuring of their banking
systems, the German situation is different in its remarkable
resistance to change. Whether this is due to the political
inability to take necessary reforms or because the existing
system, after weathering a heavy storm, is not so bad and
fills a need, are discussable points. However, it is true
that local politicians are reluctant to give up controls
over their local financial institution on which they can
rely for local lending and jobs. On the other hand, if the
savings banks are so good, then why should they be protected
from competition by laws that restrict their ownership? The
Frankfurt University study differs from the IMF view in
asserting that academic research does not make an a priori
case for private banks, driven by shareholder value, as
delivering superior performance in terms of growth and
welfare, than public banks.

16. (SBU) Consolidation of the banking sector will continue
and, most likely, contribute to its gradual strengthening.
There are several consolidation scenarios.

A. Within pillars: Savings and cooperative banks would
continue to consolidate among themselves as weaker
institutions are absorbed by larger neighboring
institutions, exploiting economies of scale through having
one central location provide back office functions. Mergers
among large private banks appear less attractive as they
cannot realize greater economies of scale, would face costs
of redundant branch networks, and have little influence on
the institution's overall competitiveness in light of the
large market share commanded by public institutions.
B. Across pillars: In some German states reform proposals
were made on the back of the bad financial situation of the
lender and communes. The fact is, that the laws on savings
banks in the individual lender allow for different
participation schemes of private institutions or persons at
the public institutions. One case that attracted attention
was the attempt of the mayor from Stralsund to sell the
savings bank of Stralsund. In the end this was prevented by
the state government of Mecklenburg-West Pomerania by a
change of legislation. A recent example is the planned
takeover of the Bank of Berlin (a private bank) by the
Berliner Volksbank (a cooperative) and the
Mittelbrandenburgische Sparkasse in Postdam (a savings
bank). Such approaches to cross-pillar consolidation would
be piecemeal, at best. If a large private bank were to
purchase such a savings bank, it would likely face intense
competition as savings institutions from neighboring areas
would move into the region. Account holders fiercely loyal
to savings institutions would shift accounts away from the
procured thrift to the new one. As one expert commented,
private banks would find themselves in deeper competition
than before, like "bailing water with a fish net."

C. Product Consolidation: Rather than merging entire
organizations, banks will join together to realize economies
of scale by having joint products (like mortgages) or back
office operations.

D. Cross Border Mergers or Acquisitions: The European
Central Bank's 2004 Report on EU Banking Structure points
out that since the flurry of M&A activity in the run up to
the adoption of the euro, M&A activity has been subdued and
primarily confined to domestic consolidation. However, in
light of increased liquidity in the sector and the increased
concentration of domestic markets, cross border M&A activity
may increase. Higher fixed investments associated with IT
costs, more transparent accounts under the EU adopted
International Accounting Standards, and the need to make
more efficient use of capital under Basle II are other
reasons that could drive such activity. Although there has
been a significant number of cross-border M&A activities in
Germany, something on the scale that would alter the German
banking landscape seems improbable at this time. The large
private banks do not appear to be attractive candidates for
purchase, as suggested by weak revenue performance, low
market share, and limited possibilities to trim costs.
Again, the dominant position of savings and cooperative
banks makes foreign entry into the German banking difficult.

E. Increased Competition to Savings Banks: As noted above,
the Economic Council hypothesized that if the savings banks
were counted as one group, they would be the largest bank in
Germany and the world. The Frankfurt University study notes
that the 482 public savings banks operate on the "regional
principle," not engaging in competition between regions.
State banks and Dekabank provide them services that enable
individual savings bank to realize economies of scale.
Considered from this point of view, German competition
authorities should take a hand in breaking up what appears
to be collusive market behavior, in the view of one banking
expert, an unlikely prospect. Alternatively a savings bank
from another EU country could seek to crack the domestic
German market by not respecting the regional principle. Or
perhaps the Post Bank would adopt a more assertive strategy
in its lending businesses.

17. (SBU) A combination of many if not all of these
scenarios should play out in the coming years. The
Frankfurt University study holds out a tantalizing thought.
It suggests that the current banking structure of the
savings banks relies on complementary elements, like the
regional principle or reliance on economies of scale. Since
such a system has strong dependencies, gradual changes
produce at least temporary welfare losses. To their mind,
this suggests that if the system breaks down, the banking
system "will inevitably also undergo far-reaching structural
changes." Even more tantalizing is their last thought: "We
cannot rule out that this might happen soon." Time will

18. (U) This message has been coordinated with US Embassy

19. (U) POC: James Wallar, Treasury Representative, e-mail; tel. 49-(69)-7535-2431, fax 49-(69)-


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