German Landesbanks' Transformation Still Far From Complete
On 19 July 2005, the state guarantees enjoyed by Germany’s Landesbanks were abolished, ending an era of privilege and competitive advantage within Germany’s banking sector, and ushering in a future where Landesbanks will have to compete increasingly on a par with their private sector counterparts as the benefits from the grandfathering of guaranteed obligations will progressively fade away.
The European Commission ruling to abolish state guarantees was first heralded in 2001, so Landesbanks have had ample lead time to get their houses in order. Indeed, the past 18-24 months has seen various responses on the part of the Landesbanks in an effort to stem the effects of the loss of guarantees.
Besides the Landesbanks’ own efforts to prepare for the new competitive environment, what has also emerged is the strengthening of ties between Landesbanks and their financially stronger owner savings banks, which have increasingly become an important factor in the analysis on Landesbanks over the past two years.
While the Landesbanks have made progress, Standard & Poor’s is of the opinion that the transformation is not yet complete and that ongoing restructuring and successful implementation of agreed measures is crucial to maintain their ratings. Considering that revenue losses from the abolition of state guarantees are expected to hit profits only gradually, as Landesbanks’ issued excess debt ahead of July 2005 and secured funding alternatives, Standard & Poor’s expects the banks’ as yet low or modest profitability and quality of earnings to improve further, based on better market penetration in core segments, re-pricing and de-risking, cost cutting, and higher core capital.
Such improvements would not automatically have positive implications on the bank’s unguaranteed ratings to the extent that such expectations are already reflected in the ratings. Furthermore, it is Standard & Poor’s general view that over time, as the restructuring of individual Landesbanks progresses, the importance of state support in Landesbanks’ ratings might diminish further.
Initially, Landesbanks were slow to review and adapt their business models to prepare for the new competitive environment. Even as far back as 2003, Standard & Poor’s noted that although more than half of the transition period had passed many Landesbanks were not yet sufficiently prepared and raised its concerns about the viability of their largely wholesale-oriented business model and their limited strategic options on a stand-alone basis.
However, over the past 18-24 months, Landesbanks generally have made progress in refocusing their strategies on core businesses and regions, improving their asset quality through accelerated workout and a reduction of concentration risk and cost cutting. Last but not least they have improved their funding and liquidity profiles to mitigate the immediate implications from the loss of the guarantees. Furthermore, ownership support has been demonstrated and agreed upon where necessary and has helped to strengthen or restore capitalization.
With operating profit to average risk assets ranging from 20 to 60 basis points (bps) and adjusted total equity to risk assets ranging from 1.8 per cent to 6.3 per cent, rated Landesbanks’ financial ratios were still predominantly low at year-end 2004, which underlines the need to continue with accelerated efforts seen over the past 18-24 months to reposition the banks. However, pronounced distinctions exist between the business and financial profiles of Landesbanks. Furthermore, the capital base of four rated Landesbanks was reduced in 2004 as they were required to repay state-aid to their respective owner states, whereas capital measures of more than €5bn (including more than €4bn from the owners) will only become effective between 2005 and 2007. Finally, benefits from past and ongoing restructuring measures and the implementation of closer cooperation with the savings banks are expected to lead to earnings improvements already in 2005 as negative implications from the loss of the state guarantees should only filter through gradually.
Overall, profitability levels have continued to improve, and in 2004 all rated Landesbanks recorded operating profits after risk provisions. Given that the banks are at different stages of their restructuring processes, determining a general trend remains difficult. While most banks’ earnings were at their lowest in 2002 having recovered since, WestLB AG, Bayerische Landesbank (BayernLB), and Norddeutsche Landesbank Girozentrale (NordLB) still posted operating losses in 2003. Therefore, these three banks displayed the strongest improvements in 2004 owing to significantly reduced provisioning needs.
The aggregated profits before risk provisions of Landesbanks excluding WestLB rose only 3 per cent in 2004 year-on-year, reflecting modest revenue growth and stable cost levels. Yet 2004 results were 28 per cent higher compared with 2002, mainly reflecting the recovery of income on liquidity portfolio securities and the first round of cost cutting in 2003. The only exception was WestLB, where profit before risk declined about 70 per cent due to lower net interest and trading income in 2004 year-on-year, however. Total aggregate risk assets remained flat in 2004, but were almost 7 per cent below 2002 levels as WestLB and BayernLB had downsized their large exposures over the past two years. Total aggregate operating expenses remained about flat in 2004, but were more than 9 per cent lower than 2002, partly because average staff levels also declined by 9 per cent during this period.
Most banks benefited from lower provisioning needs, which on an aggregated basis fell almost 70 per cent in 2004. The release of loan-loss reserves, particularly at those banks that underwent significant portfolio cleanups, reduced aggregate risk costs to only 30 bps on risk assets (or about 35 bps excluding WestLB whose provisioning needs were nil in 2004), a level that will be difficult to improve upon. Consequently, operating profit after risk rose to about €3.1bn from €1bn or 48 bps on risk assets in 2004.
A total of €2.7bn in state-aid that had to be repaid by the rated banks (excluding NordLB’s payment that was charged directly against capital) were only partially offset by the release of taxed hidden reserves, which means that pretax profit in 2004 is largely understated. The planned capital measures, most of which have already been agreed upon, between 2005 and 2007 will more than offset these one-time charges and should improve the level and quality of capital.
Similar to the private sector banks Standard & Poor’s expects only modest revenue growth for Landesbanks in 2005, while earnings should benefit from cost control and further cost cutting at some banks, further improved risk management in conjunction with a benign credit environment, capital measures, and particularly from lower non-recurring expenses. However, only a few Landesbanks are expected to catch up with large private-sector peers, and their overall profitability levels will continue to compare unfavourably with similar rated international peers.
Improved operating and bottom-line earnings are not expected to lead to widespread rating upgrades as Standard & Poor’s has already largely reflected earnings recovery in its ratings, whereas failure to meet expectations could have negative rating implications.
Over the past two years savings banks have increasingly become an important factor in the analysis on Landesbanks. While Landesbanks have been the regional central institutions of their owner savings banks for many years, both had never really acted as a group or developed joint management systems and business strategies to exploit revenue and cost synergies in an organized fashion.
Standard & Poor’s considers Landesbanks’ renewed focus on strengthening of ties with their owner savings banks, whose business and financial profiles are generally sound, of particular strategic importance, although to varying degrees. In 2001 and 2002, Standard & Poor’s had already discussed Landesbanks’ possible strategic options and concluded that in a first step – similar to many cooperative banking groups – closer cooperation and cohesiveness at the regional level was the most realistic alternative compared with Landesbank mergers or mergers with savings banks. The demonstrated moves to improve cooperation and strengthen the solidarity between Landesbanks and savings banks into this direction, which can be observed in all regions, have confirmed this view.
Of course, the direct revenue implications from cooperation agreements are not sufficient for Landesbanks to counter growing competitive pressure were such moves not supplemented by ongoing restructuring measures. However, Standard & Poor’s considers closer integration and implicit and explicit ownership support from the savings banks to weather the difficult transformation a positive factor benefiting the ratings on Landesbanks, as it strengthens their strategic role as regional central institutions.
At the same time, savings banks stand to benefit as well because closer cooperation reduces their risk from their contingent liability as owners and guarantors of Landesbanks’ grandfathered debt. Furthermore, revenue growth in their traditional banking business is limited due to the inertia of the domestic economic environment and low interest rates. Despite their excellent market position the savings banks have failed to broaden their market penetration due to a limited product range and less developed marketing capabilities, which has allowed innovative and more commercially oriented competitors to gain market shares in attractive niches such as private banking, consumer finance, and corporate banking. Both developments could pressure savings banks’ earnings in the medium term. Therefore, cooperation with Landesbanks could help to better exploit cost and revenue synergies in an overall stagnant market environment and provide growth opportunities in areas that require scale and expertise exceeding individual savings banks’ abilities.
Finally, Standard & Poor’s considers Landesbanks’ and savings banks’ moves to establish stronger regional banking groups a strategically important step to counter competitive pressure and position themselves for future strategic options such as a domestic consolidation or privatization process. While this has been hindered to date by the need for Landesbanks to restructure their operations and by political considerations, Standard & Poor’s expects that over time the willingness of regional governments to consider structural changes and an opening up of the market place will increase.
The “S-Finanzgruppe Hessen-Thüringen” (SFHT), that is, Landesbank Hessen-Thueringen Girozentrale (Helaba) and its owner savings, was the first to introduce a new comprehensive system of cooperation and solidarity in late 2003. The SFHT underpinned its cohesiveness and commitment to its new strategy with the implementation of a special, albeit limited, regional protection scheme to support member banks in times of stress. In contrast to the various existing reserve funds of public law banks, this new regional protection scheme for the first time connects a Landesbank and its owner savings banks under one single fund. Furthermore, for the first time it provides creditors with a legal claim against the fund, whereas the existing reserve funds only act at the discretion of the bodies operating the funds.
While other Landesbanks followed suit in concluding cooperation agreements with their respective owner savings banks, only WestLB and BayernLB have established protection schemes similar to that of the SFHT. NordLB and its owner savings banks are expected to implement such schemes as of 1 January 2006.
In Standard & Poor’s view, implementing regional protection schemes further underpins the key drivers supporting cohesiveness, such as the statutory guarantee (Gewährträgerhaftung) of the owner savings banks for their Landesbank’s grandfathered obligations (jointly and severally with the respective public sector guarantors); savings banks’ ownership; and the extension of operational ties to jointly exploit market opportunities in their region. Furthermore, the new protection schemes underscore the savings banks’ long-term commitment to implement the revised cooperation strategy based on contractual agreements, and support Landesbanks’ transformation process.
Today, the ratings on Helaba, BayernLB, and NordLB reflect Standard & Poor’s view of the three respective regional groups as single economic entities. The ratings on WestLB are also based on implicit support from its financially stronger owner savings banks; but in its analysis on an aggregated basis Standard & Poor’s still makes slight ratings distinctions between the two as operational ties and WestLB’s business profile needs to be strengthened.
Standard & Poor’s has concluded that the role of the respective savings banks for the ratings on Landesbank Baden-Wuerttemberg (LBBW), HSH Nordbank AG, and Landesbank Sachsen Girozentrale (SachsenLB) is comparatively less pronounced, partly because the cooperation strategy lacks the stringency of a cohesive group. It also reflects other specific circumstances such as the limited business potential and smaller size of the savings banks in the North of Germany (HSH Nordbank) and Saxony (SachsenLB) compared with their respective Landesbanks or uncertainties about the strength of the Landesbanks’ roles as central institutions. In the case of LBBW, it still remains to be seen whether the potential conflict due to direct competition of LBBW with its owner savings can be successfully managed.
*This article was published in full in Standard & Poor’s Credit Week.