Banking: It's Brussels Vs. Berlin

The EC says German state banks have an unfair advantage

For years, Germany's state-backed Landesbanks have been a thorn in the side of the country's private banks. With the support of state and federal officials, they have expanded aggressively by lending to local communities and companies on terms that private banks couldn't match. Those balmy days are about to end. In July, the European Commission ruled that Dusseldorf's Westdeutsche Landesbank, Germany's fourth-largest bank by assets, must repay $860 million-plus in interest to its main owner, the state of North Rhine-Westphalia, which gave it a huge subsidy in 1992. Now, Mario Monti, the EC's competition commissioner, wants to end the privileged status of public-sector companies in general. If he succeeds, as seems likely, WestLB and Germany's 11 other Landesbanks will suffer a devastating blow.

Monti's plan, which the EC will review later this month, would eventually strip the Landesbanks of their state guarantees. Landesbanks are house banks to state governments, handle wholesale banking for local savings banks, and are usually owned in part by the states. As a result, they benefit from their owners' strong credit ratings. That means they can raise money up to 50 basis points cheaper than private rivals--and offer borrowers better terms. "The Landesbanks can do lots of big-ticket lending at knock-down rates," says Jens Schmidt-Bugel, associate director for financial institutions at rating agency Fitch IBCA in London. "They wouldn't be able to do that without their guarantees and credit ratings."

The EC plans have wide support outside Germany. But WestLB's management-board chairman, Friedel Neuber, backed by the other Landesbanks, is preparing to fight them with everything he's got. Powerful German politicians, from Chancellor Gerhard Schroder to Finance Minister Hans Eichel and Wolfgang Clement, prime minister of North Rhine-Westphalia, are also rushing to defend the status quo. That's no surprise considering the Landesbanks' usually spirited support for the economic policies of their political masters. "There is going to be a huge battle between Berlin and Brussels over this," predicts Metehan Sen, a banking analyst at B. Metzler seel. Sohn & Co., a private bank in Frankfurt. "The future of the entire German banking sector is at stake."

Germany's private banks are rooting for Monti, too. They resent that the Landesbanks have better credit ratings than they do (table). What's more, state governments are usually satisfied with more meager returns on their shares than private bank shareholders are, so the Landesbanks can lend even more aggressively. Indeed, German private banks have been pushed into a corner. Private banks in France, Spain, the Nordic countries, and Benelux account for more than 40% of all domestic lending, but in Germany, their share is below 20%. That's why Commerzbank Chief Executive Martin Kohlhaussen, who is chairman of the German Bankers' Assn., roundly condemns the Landesbanks' privileges. "We aren't playing by the same rules," he complains.

He has a point. If it weren't for their state guarantees, the Landesbanks would almost certainly have less impressive ratings. WestLB and Bayerische Landesbank, for example, are graded Aa1 and Aaa, respectively. Yet both are saddled with millions of dollars' worth of nonperforming loans in emerging markets and low returns on equity of around 5.4%. Their credit ratings should probably reflect their financial-strength ratings--D and C.

And it's not just inside Germany that the Landesbanks are throwing their weight around. Over the past two decades, they have expanded aggressively abroad. WestLB and Frankfurt's Landesbank Hessen-Thuringen now have sizable capital-market operations in London and New York as well as Germany. Their close links to regional governments also mean that public-sector underwriting mandates come their way. They have become major issuers of bonds in their own right. Sarah-Jo Millan, an analyst at Barclays Capital Inc. in London, figures that the Landesbanks' bond business has soared tenfold, from $2.3 billion in 1990 to $23.3 billion last year. Their top ratings give them a big advantage in the derivatives business. They're involved in local-government financing in Scandinavia, the Australian-dollar capital markets, and even Indian trade financing. Now, they are pushing hard into money management. In April, WestLB Asset Management Co. bought the Houston-based fixed-income business of Nicholas-

Applegate Capital Management; WestLB hopes to have $100 billion under management within three years. "They are far more active abroad than they would ever be without those guarantees," says Peter Vipond, a director of the British Bankers' Assn. "They really have an unfair advantage."

"LOGICAL." Stripped of their guarantees, the Landesbanks would need new sources of equity to underpin their vast balance sheets and sprawling empires. They would have to cut the range of services they offer and sell off businesses. Some might even be privatized. "The idea of selling off Landesbanks has always been taboo," says Metzler's Sen. "But it could be the logical thing if Brussels gets rid of their privileges."

Indeed, senior regional politicians suspect that the likes of Deutsche Bank and Dresdner Bank want to force the privatization of the Landesbanks so they can buy them. "Obviously, we want Brussels to get rid of the guarantees," says a managing board member at one of the largest private-sector banks. "But we don't want to irritate the politicians again. We're scared of retaliation." The banks already irked some pols by complaining to the EC about the transfer of a public housing agency to WestLB, which they claimed amounted to an unfair $1.4 billion subsidy. That was the case Brussels decided in their favor in July. Schroder immediately appealed the ruling.

The private bankers are right to be leery. Many German politicians have close links with their local Landesbanks. North Rhine-Westphalia's Clement argues that they fulfill public-service functions, such as financing regional development programs, that private banks wouldn't touch. But the Landesbanks also provide tons of patronage, such as lucrative directorships for retired politicians. And they are generally enthusiastic boosters of regional governments' policies. When Norddeutsche Landesbank bailed out troubled steelmaker Salzgitter in early 1998, it helped the political career of Schroder, who was then prime minister of Lower Saxony. Aides say Schroder is still grateful and wants to protect the Landesbanks' privileges as long as he can.

However much pressure comes from German pols, Commissioner Monti's persistence is likely to prevail. Short run, he's sugaring the pill by stressing that he isn't targeting any one institution or country. Nor is he calling for an abrupt end to all state guarantees. Instead, Monti wants the EU to limit guarantees such as those the Landesbanks receive and make sure they're paid for at market rates. Once that happens, the Landesbanks will lose much of their present raison d'etre--and the playing field for European financial services will be a lot more level than it is now.