German Bankers in Denial

By: Dr. Sam Vaknin

Also published by United Press International (UPI)

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Written October 2002

Updated June 2005

In August 2002, I conducted on behalf of UPI an interview with an Austrian banker. Notice his arrogant and hubris-filled, responses as he mocks my concerns (which, alas, turned out to have been prophetic):

"Q: Many Austrian banks have aggressively spread to Central Europe - notably the Czech Republic, Slovakia, Poland, Croatia, and Slovenia. Do you think it is a wise long term strategy? The region is in transition and its fortunes change daily. Poland has switched from prosperity to depression in less than 7 years. Aren't you concerned that Austrian banks are actually importing instability into their balance sheets?

A: The move by the Austrian banks into central and eastern Europe is a very good niche market growth strategy. Austrian banks lost a lot of money in the UK, the USA, and in other parts of the world - but were very risk-conscious in central and eastern Europe, where, today, they generate high margins. In the years to come, this will be a strongly growing region. Entering these markets was a very positive decision.

Q: Austria's banks are small by international standards. Do you foresee additional consolidation or purchases by foreign banks, possibly German?

A: I am convinced that there will be additional domestic consolidation coupled with some foreign purchases. The three big German banks - HVB, Bayerische Landesbank, and Deutsche Bank - are already present in Austria.

Q: In 1931, the collapse of Creditanstalt in Vienna triggered a global depression. The markets are again in turmoil, the global economy is stagnant, and trade protectionism is increasing. Can you compare the two periods?

A: Thank you or the honor of triggering a global recession, but Creditanstalt was too small to do so. In my view, you cannot compare the markets today and in 1931. Financial skills and organizations are much more developed today. Social systems are much more secure than in the 1930's."

Denial is a ubiquitous psychological defense mechanism. It involves the repression of bad news, unpleasant information, and anxiety-inducing experiences. Judging by the German press, the country is in a state of denial regarding the faltering health of its economy and the dwindling fortunes of its financial system.

Things are so bad now (June 2005) that Italy's UniCredit Bank is bidding to absorb the second largest German financial institution, HVB, for a mere 15 billion euros in an all-shares deal. UniCreit expects to shell out another 4.2 billion euros to buy out minority shareholders in HVB subsidiaries in Austria (Bank Austria) and Poland (BPH).

This will create a super-bank with more than 28 million customers served by a network of well over 7000 branches. Forty percent of this clientele (11 million) live in Central and Eastern Europe. The merged bank will control one fifth of the banking market in countries as disparate as Bulgaria, Croatia, and Poland.

UniCredit promises cost cutting to be achieved through the prompt sacking of 7% of HVB's bloated workforce of well over 120,000 employees. Alarmed, Handelsblatt, Germany's leading financial paper, urged more "ambition and patriotism" to avoid further encroachments of foreign banks into German turf. The aim, trumpeted the paper, somewhat incongruously, should be "global champions in the financial sector".

How are these xenophobic defenses to be erected? By mergers and acquisitions among German banks in the fragmented domestic market. Consolidation would lead to higher profits and less digestible takeover targets, goes the logic.

HVB itself disproves these self-deluding recipes. It is the sad outcome of a merger between Bayerische Vereinsbank and Hypo-Bank. Weighed down by an under-performing property portfolio in a waning German construction market, it is a dispiriting contrast to the dynamic (and profitable) UniCredit.

The decline and fall of German banking reached its nadir in 2002.

Three years ago, Commerzbank, Germany's fourth largest lender, saw its shares decimated by more than 80 percent to a 19-year low, having increased its loan-loss provisions to cover flood-submerged east German debts. Faced with a precipitous drop in net profit, it reacted reflexively by sacking yet more staff. The shares of many other German banks still trade below book value, after an impressive recovery from lows reached in 2001-2.

By end-2002, Dresdner Bank - Germany's third largest private establishment - had already trimmed an unprecedented one fifth of its workforce. Other leading German banks - such as Deutsche Bank and Hypovereinsbank - resorted to panic selling of equity portfolios, real-estate, non-core activities, and securitized assets to patch up their ailing income statements. Deutsche Bank, for instance, unloaded its US leasing and custody businesses.

On September 19, 2002 Moody's changed its outlook for Germany's largest banks from "stable" to "negative". In a scathing remark, it said:

"The rating agency stated several times already that current difficult economic conditions that are hurting the banking business in Germany come on top of the legacy of past strategies that were less focused on strengthening the banks' recurring earning power. Indeed, the German private-sector banks, as a group, remain among the lowest-performing large European banks."

In October 2002, Fitch Ratings, the international agency, followed suit and downgraded the long-term , short- term, and individual ratings of Dresdner Bank and of Bayerische Hypo- und Vereinsbank (HVB).

These were only the last in a series of negative outlooks pertaining to German insurers and banks. It is ironic that Fitch cited the "bear equity markets (that) have taken their toll not only on trading results but also on sales to private customers, the fund management business and on corporate finance."

Germans used to be immune to the stock exchange and its lures until they were caught in the frenzied global equities bubble. Moody's observed wryly that "a material and stable retail franchise in its home market, even if more modestly profitable, can and does represent a reliable line of defence against temporary difficulties in financial and wholesale markets."

The technology-laden and scandal-ridden Neuer Markt - Europe's answer to America's NASDAQ - as well as the SMAX exchange for small-caps were shut down in October 2002, the former having lost a staggering 96 percent of its value since March 2000. This compared to Britain's AIM, which lost "only" half its worth at that point. Even Britain's infamous FTSE-TechMARK faded by a "mere" 88 percent.

Only 1 company floated on the Neuer Markt in all of 2002 - compared to more than 130 two years before. In an unprecedented show of "no-confidence", more than 40 companies withdrew their listings in 2001. The Duetsche Boerse promised to create two new classes of shares on the Frankfurt Stock Exchange. It belatedly vowed to introduce more transparency and openness to foreign investors.

It's been downhill ever since.

Banks have been accused by irate customers of helping to list inappropriate firms and providing fraudulent advisory services. Court cases are pending against the likes of Commerzbank. These proceedings may dash the bank's hopes to move from retail into private banking.

To further compound matters, Germany is in the throes of a tsunami of corporate insolvencies. This long-overdue restructuring, though beneficial in the long run, couldn't have transpired at a worse time, as far as the banks go. Massive provisions and write-downs have voraciously consumed their capital base even as operating profits have plummeted. This double whammy more than eroded the benefits of their painful cost-cutting measures.

German banks - not unlike Japanese ones - maintain incestuous relationships with their clients. When it finally collapsed in April 2002, Philip Holzmann AG owed billions to Deutsche Bank with whom it had a cordial working relationship for more than a century. But the bank also owned 19.6 percent of the ailing construction behemoth and chaired its supervisory board - the relics of previous shambolic rescue packages.

Germany competes with Austria in over-branching, with Japan in souring assets, and with Russia in overhead. According to the German daily, Frankfurter Allgemeine Zeitung, the cost to income ratio of German banks is 90 percent. Mass bankruptcies and consolidation - voluntary or enforced - are unavoidable, especially in the cooperative, mortgage, and savings banks sectors, concludes the paper. The process is a decade-old. More than 1500 banks vanished from the German landscape in this period. Another 2500 remain making Germany still one of the most over-banked countries in the world.

Moody's don't put much stock in the cost-cutting measures of the German banks. Added competition and a "more realistic pricing" of loans and services are far more important to their shriveling bottom line. But "that light is not yet visible at the end of the tunnel ... and challenging market conditions are likely to persist for the time being."

The woeful state of Germany's financial system reflects not only Germany's economic malaise - "The Economist" repeatedly calls it the "sick man" of Europe - but its failed attempt to imitate and emulate the inimitable financial centers of London and New-York. It is a rebuke to the misguided belief that capitalistic models - and institutions - can be transplanted in their entirety across cultural barriers. It is incontrovertible proof that history - and the core competencies it spawns - still matter.

When German insurers and banks, for instance, branched into faddish businesses - such as the Internet and mobile telephony - they did so in vacuum. Germany has few venture capitalists and American-style entrepreneurs. This misguided strategy resulted in a frightening erosion of the strength and capital base of the intrepid investors.

In a sense, Germany - and definitely its eastern Lander - is a country in transition. Risk-aversion is giving way to risk-seeking in the forms of investments in equities and derivatives and venture capital. Family ownership is gradually supplanted by stock exchange listings, imported management, and mergers, acquisitions, and takeovers - both friendly and hostile. The social contracts regarding employment, pensions, the role of the trade unions, the balance between human and pecuniary capital, and the carving up of monopoly market niches - are being re-written.

Global integration means that, as sovereignty is transferred to supranational entities, the cozy relationship between the banks and the German government on all levels is over. In October 2001, Hans Eichel, the perennial German finance minister, announced OECD-inspired anti-money laundering measures that are likely to compromise bank secrecy and client anonymity and, thus, hurt the German - sometimes murky - banking business. Erstwhile rampant government intervention is now mitigated or outright prohibited by the European Union.

Thus, German Laender were forced, by the European Commission, to partly abolish, between 2002-5, their guarantees to the Landesbanken (regional development banks) and Sparkassen (thrifts). German diversification to Austria and central and east Europe provided only temporary respite. As the EU enlarged and digested the Czech Republic, Hungary, and Poland in May 2004 - German franchises there came under the uncompromising remit of the Commission once more.

In general, Germans fared worse than Austrians in their extraterritorial banking ventures. Less cosmopolitan, with less exposure to the parts of the former Habsburg Empire, and struggling with a stagnant domestic economy - German banks found it difficult to turn central European banks around as successfully as the likes of the Austrian Erste Bank did. They did make inroads into niche structured financing markets in north Europe and the USA - but these seem to be random excursions rather a studied shift of business emphasis.

On the bright side, Moody's - though it maintained a negative outlook on German banking until recently - noted, as early as November 2001, that the banks' "intrinsic financial strength and diversified operating base". Tax reform and the hesitant introduction of private pensions are also cause for restrained optimism.

Pursuant to the purchase of Drsedner Bank by Allianz, Moody's welcomed the emergence of bancassurance and Allfinanz models - financial services one stop shops. German banks are also positioned to reap the benefits of their considerable investments in e-commerce, technology, and the restructuring of their branch networks.

The Depression on 1929-1936 may have started with the meltdown of capital markets, especially that of Wall Street - but it was exacerbated by the collapse of the concatenated international banking system. The world today is even more integrated. The collapse of one or more major German banks can result in dire consequences and not only in the euro zone. The IMF says as much in its "World Economic Outlook" published on September 25, 2002.

The Germans deny this prognosis - and the diagnosis - vehemently. Bundesbank President Ernst Welteke - a board member of the European Central Bank - spent the better part of October 2002 implausibly denying any crisis in German banking. These are mere "structural problems in the weak phase", he told a press conference. Nothing consolidation can't solve.

It is this consistent refusal to confront reality that is the most worrisome. In the short to medium term, German banks are likely to outlive the storm. In the process, they will lose their iron grip on the domestic market as customer loyalty dissipates and foreign competition increases. If they do not confront their plight with honesty and open-mindedness, they may well be reduced to glorified back-office extensions of the global giants.

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