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UNCLAS SECTION 01 OF 06 FRANKFURT 002671 
 
SIPDIS 
 
SENSATIVE 
 
STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY FOR DAS LEE 
TREASURY ALSO FOR ICN COX, HULL 
PARIS ALSO FOR OECD 
TREASURY FOR OCC RUTLEDGE, MCMAHON 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EUN
SUBJECT: Structures and Trends in German Banking Industry: 
Bleak Outlook Gets Better; Consolidation Scenarios For A 
Financial Stronger System 
 
 
T-IA-F-05-018 
 
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 
  themselves. 
 
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 
Structure? 
--------------------------------------------- -------------- 
 
¶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 
  tell. 
 
¶18.  (U) This message has been coordinated with US Embassy 
  Berlin. 
 
¶19.  (U) POC: James Wallar, Treasury Representative, e-mail 
  wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
  7535-2238 
 
Bodde