Despite its widely admired conservative approach, Germany’s three pillar system — the division of the banking sector into savings banks, co-operative banks and private banks — is under pressure.
Some challenges have been spectacular, like the Landesbanks’ failed experiments with securitization. Others are smaller, but potentially more dangerous, like the drag of an overbanked population and an inefficient operating environment.
Germany and its banks weathered the fallout from the financial crisis better than many of their peers but the sector is still in recovery. The Landesbanks had rapidly expanded but have been instructed to shrink themselves down to roughly half their size. Many are jettisoning non-core assets, including foreign and peripheral businesses. Occasionally there are discussions of stronger Landesbanks taking over weaker ones — HSH joining with NordLB, or LBBW taking over BayernLB — but the asymmetry of those talks mean they often don’t last long.
“There’s been less change in the German banking sector than might have been expected, given the length and depth of the financial crisis,” says Jan Schildbach, head of the banking research team at Deutsche Bank Research in Frankfurt. “Deep, more structural change had seemed likely. There’s been substantial consolidation, but only really in the private banking pillar. The consolidation process overall has slowed since the crisis. The outlook would be that in the foreseeable future there’s little appetite from banking sector executives and from policymakers to change that dramatically.
“The crisis seemed to prove that a domestic, retail-oriented and SME-oriented business model is sound, and that it shielded those institutions and their clients from the kind of international exposure that proved disastrous for many other banks.”
Going home
Like banks in the other two parts of the pillars, the Landesbanks had been looking outside of Germany for markets with growth, in the absence of any real margins at home. Those businesses have proven both costly and unpopular, and the banks are retreating.
Not all of the sector’s issues have been fixed, and many market specialists expect yet more pain from the ECB’s asset quality review (AQR) later this year. That is likely to be a catalyst for a new wave of change.
“There is scope for consolidation among the Landesbanks, after they have shrunk as agreed with the European Commission,” says Schildbach. “They will have a market position and size that makes it inefficient to run so many independent Landesbanks and this is likely to be an issue that returns to the agenda of management and policymakers.
“But consolidation across pillars will probably be limited: there’s no basis or political support for it. That’s unlikely to change any time soon. Landesbanks, in particular, may move closer together, but private banks are unlikely to take part in consolidation.
“As long as there’s no major crisis in the domestic market, of which there’s no sign at the moment, the political support for the retail institutions may not go away.”
HSH Nordbank, a Landesbank based in Hamburg, is focused on shipping lending. With around €30bn of maritime assets, the bank is likely to struggle with stress tests and may be forced to wind down even more of its balance sheet. Nord/LB, based in Hanover and owned by Lower Saxony and Saxony-Anhalt, is also understood to be fearing the AQR. Their fate might not be as drastic as that of WestLB, which shut completely, but most Landesbanks have little left to get rid of.
The AQR is likely to provoke changes outside of the Landesbanks, too. UniCredit owns HypoVereinsbank, one of the largest institutions in the private sector, but may be forced to reassess its business and perhaps even move out of the country after the AQR, according to several bank analysts insisting on anonymity,
But other regulatory changes in the next year are likely to be helpful for German banks, and the preservation of the three pillars. The move towards banking union, with the ECB regulating the largest private banks and domestic institutions watching over others, should help keep the idiosyncrasies of the banks in each pillar.
Back in favour
The traditional and conservative three pillar system is becoming well regarded again, enough that countries across Europe are also moving to separate their retail savings banks from the larger private banks. Whispers of increased cross-pillar consolidation in Germany, or of scrapping the three pillar system entirely, are abating.
The safety of Germany’s system is becoming regarded as aspirational, rather than old fashioned. As the banks shrink, they are likely to become even more in favour.
“The future of the German banks will be about finding the right size,” says Theo Brockmann, managing director and global head of the institutional clients division in DZ Bank’s capital markets business in Frankfurt. “If they are too small, they won’t be able to deal with the challenges facing them from the regulators, competitors and the low interest rate environment. But if they are too large, any trouble would be dangerous, and it’s likely that the system would have to bail such banks out at the taxpayers’ expense.
“The right size is in between: at the end of any consolidation process, there needs to be a diversified bracket of banking institutions that are strong enough in terms of capital and liquidity and that are healthy and profitable.”
When that process is completed — leaving a shrunken but still ambitious set of Landesbanks — many analysts predict that consolidation will begin again. The market doesn’t have enough capacity or demand to be able to support the seven or eight Landesbanks that are likely to be left, and the issue of consolidation among those institutions is likely to return to the agenda of banks’ management and policymakers.
Governors’ pet banks
Meanwhile, in the co-operative pillar, the twin forces of technology and competition are likely to make themselves felt in the form of consolidation. “In the long term, the challenge from online banking processes on the one hand and the competitive market environment on the other hand is likely to cause cross-border co-operations, and more mergers between co-operatives and savings banks,” says Brockmann. “That consolidation process has not really begun yet, because each institution and pillar seems to be in a convenient and comfortable position. But things are getting much less comfortable for some of the banks, as all of the challenges begin to hit.”
It will be the banks’ boards and local governors that stand in the way of that process. Boards know that they are likely to be rendered powerless by any merger — which would probably be with LBBW, the only Landesbank big and active enough to trigger any consolidation. Governors like the opportunity and independence that having a bank owned by the region represents.
The banks in each pillar are often not as distinct from one another as they seem, or would like to appear. Landesbanks can’t be detached from savings banks, which along with the government are often major owners of the Landesbanks. They are complimentary in terms of client groups: when clients grow too big for co-operative banks they are often referred to Landesbanks, cementing that connection.
But further consolidation between the pillars is unlikely. When Berlin came to sell its stake in the city’s Landesbank in 2006, Commerzbank made a play to buy its stake. The DSGV, the German Savings Bank Association, ended up buying the 81% holding. Even at the time there was little appetite among policymakers for that — now, after the crisis, there would be even less.
“Politicians in Germany, as well as the associations representing the co-operative and public banking sectors, are strongly against an abatement of the three pillar system,” says Brockmann. “That has become the consensus. But before the financial crisis, private banks were loudly debating the possibility of combining institutions.
Despite the low growth and low margin nature of business in the German market, there is a range of foreign bidders looking to gain a hold in the private sector, but that is likely to be equally unpopular among politicians.
The mostly impressive passage of German banks through the financial crisis as well as the country’s stand-out economic growth mean that many other European banking groups would like to stake their claim in the country’s private sector. The German government has a particular hold in that sector through its stake in Commerzbank, which it picked up during the crisis but has diluted from 25% to 17% after a rights issue last year.
Banks like Santander, UniCredit and BNP Paribas would be likely to bid for any German banking assets that were up for sale, but the likelihood of policymakers approving any further moves by foreign banks into the domestic sector is low. The German government is keen on having another private bank both from and focused on the country outside of Deutsche Bank, and so is unlikely to sell its stake in Commerzbank to foreign bidders, or allow any other shareholder to do the same.
Having largely seen off the crisis with any changes confined within each pillar, there are other challenges for the German banking system left to come. Brockmann points out that one of the regional banks’ key selling points — their network of branches throughout Germany, ready to serve clients — is steadily falling away, as digital natives forego savings banks for private banks’ online offerings. Foreign firms’ German operations — such as ING and Santander — are ready to step in, and are grabbing many of those customers.
It will be a nimble response to those challenges that will keep the three pillar system strong enough to resist further crises, but flexible enough to stay profitable. At last, the country’s financial sector can be both the envy of the modern world, and also finally make its banks some money.
