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

UNCLAS SECTION 01 OF 04 FRANKFURT 008258 
 
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: 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