US embassy cable - 03FRANKFURT10327

UNCLAS SECTION 01 OF 04 FRANKFURT 010327 
 
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: The German Banking Sector -- Something Happens 
 
T-IA-F-03-0067 
 
This cable is sensitive but unclassified.  Not/not for 
Internet distribution. 
 
1.    (SBU)  Summary  and  Comment:  From  speculation  over 
banking  mega-mergers,  to mooted  collapse  of  the  three- 
pillared  banking  system, to a circling of  the  wagons  to 
protect against foreign invaders, the German banking  sector 
is  abuzz  with rumor.  With too many German  banks  and  an 
acute  need  to  improve profitability,  the  lines  between 
public and private banking sectors are becoming blurred.  In 
advance  of  withdrawal of state guarantees in 2005,  public 
savings  and  state  banks are waking up  to  the  need  for 
restructuring  and perhaps cooperation.  Meanwhile,  private 
sector  banks  in  the "third pillar" have  tightened  their 
belts  only  to  find themselves possible takeover  targets. 
The  Finance  Ministry now seems to recognize the  need  for 
market-based  solutions,  but  many  politicians   want   to 
preserve the German banking tradition in the face of  global 
pressures.   Where is this all headed?  The  answer  remains 
unclear  --  however,  Germany's  three-pillared  system  is 
obviously beginning to wobble. 
 
2.    (SBU)  Something is clearly going on  in  the  sector, 
though  exaggerations and misfires by  the  financial  press 
make  it  difficult to separate fact from fiction.  Comments 
from  Eichel, Koch-Weser and Breuer appear to  be  aimed  as 
shaking  up  the system, at stimulating change  rather  than 
closing   Germany's  banking  sector  to  outside  interest. 
Public  sector banks are running scared, faced with loss  of 
state  guarantees in 2005, poor ratings and mostly miserable 
returns.   Politicians will be eager to protect local  jobs, 
the  German  tradition and state influence over Landesbanken 
and   public  savings  banks.   Nevertheless,  under  global 
pressures the entire German banking system appears likely to 
undergo  significant  change in the  midterm.   Bankers  are 
warily  sizing  up competitors and seeking allies.   Outside 
banks,  to include U.S.-based institutions, will be watching 
the process closely. 
3.   (SBU) While it is not so surprising that the public 
banks seek government support for safeguarding the current 
three-pillar system, it is strange that the otherwise market- 
oriented private banks evidence a sudden concern for the 
financing of domestic companies.  It was the private banks 
that recently significantly reduced their lending to small 
and medium-sized enterprises (SMEs).  This appears a 
possible change in business strategy, seeking to demonstrate 
that private banks would ensure there is no drop off in 
lending to SME's with any cross-pillar mergers -- a sure way 
to win the hearts and mind of otherwise reluctant government 
officials.  End Summary and Comment. 
 
Bank Mergers Back on the Agenda? 
-------------------------------- 
4.    (SBU) With the German economy apparently in the  early 
stages of recovery, historic agreement on structural reforms 
and equity markets up significantly from recent lows, German 
banks  -- showing improvement after a round of cost-cutting, 
balance  sheet  cleanup and internal  restructuring  --  are 
mooted to have become attractive takeover targets, not least 
because their market capitalization remains relatively low. 
 
5.    (SBU) In its recent analysis of the EU banking sector, 
the  ECB  predicted increasing consolidation if the  banking 
environment  improves  and  the  gradual  economic  recovery 
proves  to be durable.  It suggests factors such as  the  EU 
Takeover  Directive and the further withdrawal of the  state 
from   domestic   banking  activity  will  also   facilitate 
consolidation  and cross-border mergers.  According  to  the 
news  magazine "Der Spiegel", a high-ranking German  federal 
official is certain of a merger wave next year after  German 
banks  post 2003 results.  Fitch Ratings sees potential  for 
further domestic consolidation in the German banking  sector 
that  will  remain constrained by the existing  three-pillar 
system.  Speculation about imminent mergers and acquisitions 
has  heated  up, helping improve large German  banks'  stock 
valuations. 
 
6.   (SBU) However, Standard & Poors has meanwhile issued  a 
report  critical of German banks, arguing that profitability 
and capitalization are so weak that outside banks would find 
them  uninteresting.  Fitch Ratings still sees German  banks 
at  the  bottom end of the European scale, despite signs  of 
weak  recovery in the third quarter.  Moreover, a  Frankfurt 
investment  banker believes German labor  law,  banks'  poor 
loan  portfolios and the cultural differences still function 
as effective deterrents to international takeover. 
 
Foreign "Conquerors" at the Gate... 
----------------------------------- 
7.    (SBU) But rumors are circulating that Citibank may  be 
interested in taking over Deutsche Bank.  While the latter's 
costs are high by international comparison, it has more than 
12  million retail customers worldwide and has relationships 
with  many  of  Europe's  most  important  companies.   "Der 
Spiegel"  reports that Sanford Weill, chairman of  Citibank, 
has  met  with  both Chancellor Schroeder  as  well  as  the 
Minister President of Hesse soliciting political support for 
a  potential takeover.  According to "Der Spiegel", Citibank 
might even transfer its European headquarters from London to 
Frankfurt   in  order  to  make  such  a  deal   politically 
acceptable  in  Germany. Other reportedly interested  buyers 
are  Credit  Suisse,  BNP Paribas  and  the  Royal  Bank  of 
Scotland. 
 
8.    (SBU)  German banks are apparently so concerned  about 
takeovers  from  abroad  they  have  sought  help  from  the 
government.   After closed talks with government  officials, 
the  President  of the Federal Association of  German  Banks 
(BdB)  and  head of Deutsche Bank's supervisory  board  Rolf 
Breuer, publicly warned political decision-makers to  beware 
that   "conquerors"  are  on  the  doorstep.   Breuer  asked 
"shouldn't  it  make  a difference to  us  whether  domestic 
industry  can  fall  back on German banks  or  whether  they 
depend on foreign credit institutions?"  Breuer argued  that 
there  is  a  risk, for instance, that American banks  would 
"for  obvious  reasons" (referring to the  conflict  between 
Berlin  and  Washington due to the war in Iraq)  would  take 
more account of U.S. government interests.  Referring to the 
need  for  German  banks  to  increase  competitiveness  and 
inflexibilities   due  to  the  rigid   separation   between 
Germany's  three  banking pillars, Breuer  also  stated  "we 
don't have any time to lose.  German banks must at last free 
themselves from their bonds." 
 
9.    (SBU)  Apart from any possible interest in  takeovers, 
foreign banks do appear to regard Germany as an increasingly 
attractive  place to do business due to sector growth  rates 
that  are  the  highest in continental Europe.   Several  of 
banks,  among  them  Lehmann Brothers,  JP  Morgan  and  UBS 
Warburg,   are  currently  increasing  staff   in   Germany, 
particularly  in  investment banking  and  equity  business. 
Peter Coym, chairman of the Association of Foreign Banks and 
board member of Lehmann Brothers finds "the prevailing  mood 
regarding  Germany is positive.  Some Anglo-Saxon banks  are 
responding  with  decentralization  and  a  stronger   local 
presence." 
 
... a National Solution? 
------------------------- 
10.   (SBU) Given the "threat" of takeover by foreign banks, 
the idea of a merger among large German banks has received a 
great  deal of press play, despite earlier failures such  as 
deals  between  Deutsche  Bank  and  Dresdner,  and  between 
Dresdner and Commerzbank.  Recent rumors have all four large 
banks  considering a mega-merger, either  completely  or  of 
individual   segments  such  as  retail  banking   business. 
According to "Financial Times Deutschland," Deutsche  Bank's 
CEO  Josef  Ackermann  pronounced  himself  in  favor  of  a 
"national" solution (Ackermann is Swiss).  The German  press 
reported  that  Finance Minister Eichel was  pushing  for  a 
merger  of  the country's large banks.  The Federal  Finance 
Ministry,  however, denied that Eichel  had  made  any  such 
statement,  claiming  that he had  only  suggested  thinking 
about cooperation.  According to "Handelsblatt," Rolf Breuer 
called speculation over a mega-merger absurd. 
 
11.   (SBU)  Many experts have weighed in as well,  decrying 
the  likelihood  of  such a merger on the  grounds  of  high 
restructuring  costs and acute politically sensitivities  to 
probable job cuts and branch closures. 
12.   (SBU)  According to press reports, the Bavarian  state 
government  favors  a merger between HVB  and  the  Bavarian 
Landesbank in order to safeguard Munich as a banking  center 
and  is  pushing the two banks to start talks.   However,  a 
number  of  hurdles would have to be cleared before  such  a 
deal  could  happen.  Landesbank representatives called  the 
idea completely unrealistic. 
 
Cooperation and Mergers in the Public Sector 
-------------------------------------------- 
13.  (SBU) Given the Federal Government's agreement with the 
European  Commission to abolish state guarantees  for  state 
(Landesbanken)  and public savings banks, the  public  banks 
know  that  they  need to restructure.  In  particular,  the 
Landesbanken  face a bleak outlook unless they fundamentally 
improve  their profitability and credit standing.  According 
to   the  controversial  and  yet  unpublished  analysis  by 
Standard  &  Poor's,  the ratings of  the  Landesbanken  are 
expected  to  fall to the "BBB" level once they  lose  state 
guarantees.   Mergers and cooperation  may  be  one  way  to 
prevent that from happening. 
 
14.  (SBU) The Landesbank Hessen-Thringen (Helaba) has 
revealed plans for a new structure of their cooperation with 
the savings banks.  Helaba intends to establish a "network 
bank" with the core functions of marketing and project 
management for the savings banks' products.  Landesbank 
Baden-Wrttemberg recently concluded a cooperation agreement 
with all 57 savings banks in the state in order to make use 
of synergies.  Similarly, the BayernLB and the Bavarian 
savings banks have agreed to establish a network. 
 
15.    (SBU)   Moreover,  Landesbank  Baden-Wrttemberg   is 
is 
currently  in  merger talks with Landesbank Rheinland-Pfalz, 
even though speculation of an imminent merger was denied  by 
the  institutions.  Nonetheless, the consolidation trend  is 
building steam. 
 
Breaking up the Three Pillar System? 
------------------------------------ 
16.  (SBU) The IMF's recent controversial country report  on 
Germany  found  public bank ownership leads  to  competitive 
distortions   in  the  banking  business.   It   recommended 
following the example of other EU countries that have turned 
their  public  banks into joint stock corporations  allowing 
private investment.  Moreover, the IMF's Financial Stability 
Assessment Program Paper called for expeditious creation  of 
a  "legal  framework  to reduce barriers  to  consolidation, 
within  or  across  pillars, and thereby  facilitate  market 
oriented restructuring." 
 
17.   (SBU)  In a speech at the end of October,  Caio  Koch- 
Weser, Ministry of Finance State Secretary, also called  for 
banking  sector  reform in order to gear  it  toward  market 
signals  and  permit  a  higher share  of  private  (equity) 
capital   throughout   the  sector.   Koch-Weser   suggested 
alternative  legal  forms be introduced  for  public  sector 
banks in order to permit mergers possible within and between 
the   three  pillars.   Moreover,  he  criticized  Germany's 
"regional  principle," which carefully  divides  the  market 
between  the local savings banks.  In his view, this barrier 
to  competition also needed to be reformed.  Other countries 
in Europe have outpaced Germany's banking reform, he warned. 
 
18.   (SBU) Finance Minister Eichel also voiced support  for 
the  IMF's  recommendations for a loosening of  the  banking 
structure.  His ministry shares the view that "an  efficient 
banking  system  must  be  open to market-oriented  change." 
Eichel stressed the need to focus reform to ensure stability 
of  and viability of Germany's banking system, and he  urged 
that caution be used in crafting a medium-term strategy. 
 
19.   (SBU)  For their part, public sector banks  vehemently 
rejected   the   IMF's  analysis  along  with   Koch-Weser's 
comments.   Their  defense  of the Germany's  unique  three- 
pillar   model  was  subsequently  supported   publicly   by 
politicians from across the political spectrum. 
Outrider in the East 
-------------------- 
20.  (SBU) At the end of November, the mayor of Stralsund, a 
Baltic  sea-coast town, announced his intention to  put  the 
local  savings  bank up for auction, stating his  preference 
for  a  private  bank  buyer.  Such a  sale  would  generate 
privatization  revenues not forthcoming  in  an  alternative 
merger  with  another  public  savings  bank.   Moreover,  a 
privatized  private bank would no longer  be  restricted  to 
doing business only in its designated region.  However, sale 
to a private bank would set a precedent for savings banks in 
Germany.   The  mayor's plans led to public  intense  debate 
over  the  damage  they might inflict  on  the  three-pillar 
system.   Given  the  current  financial  problems  of  many 
municipalities,  others may be eager to  follow  Stralsund's 
example.   Some pundits speculated that private banks  might 
be  willing to pay a premium for the Stralsund savings  bank 
just  to  "break the ice" legally.  Among the large  private 
institutions even Commerzbank expressed an interest. 
 
21.   (SBU)  The  Finance Minister of the  German  state  of 
Mecklenburg-Vorpommern  where  the  bank  is   located   has 
challenged  the  mayor's plan, claiming  that  it  would  be 
illegal under state law.  The Stralsund mayor and his  legal 
advisors take a different view.  The issue remains in  legal 
limbo pending review. 
 
Increasing Cooperation Between Pillars 
-------------------------------------- 
22.   (SBU) While mergers between private and public pillars 
are still visions for the future, cooperation across sectors 
already  exists in restricted areas, mostly for  back-office 
operations.  The most recent development is a late  November 
decision  by  Dresdner  Bank  to out-source  its  securities 
settlement to DWP Bank, which is owned by cooperative sector 
institutions  DZ  and  WGZ  Bank  and  the  savings   banks' 
association  in  North-Rhine Westphalia.  State-owned  KfW's 
cooperation with private banks for a joint securitization of 
loans to the SME sector is another example. 
 
23.  (U)This cable coordinated with USEU and Embassy Berlin. 
 
24.  (U)POC: James Wallar, Treasury Representative, e-mail 
wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
7535-2238 
 
Bodde