Why German Banks Still Get No Respect

Investors are unimpressed by the recent return to profits. Only industrywide banking reform might get them excited now

By David Fairlamb

It was the news that shareholders had waited months to hear. On Aug. 6, Commerzbank, Germany's fourth-largest bank, announced that it had made a better-than-expected net profit of $79.5 million in the quarter ending June 30. That's way above the $2.3 million it reported for the same period in 2002 -- and 20% ahead of analysts' expectations.

The strong showing suggests that the Frankfurt-headquartered bank, which posted a loss of $338.2 million for 2002 as a whole, the first shortfall in its 130-year history, is now on the road to recovery. CEO Klaus-Peter Müller, who instituted a far-reaching cost-cutting and restructuring program last year, is certainly convinced. He points out that the bank's operational efficiency has improved significantly: It's cost-income ratio, a measure of expenses as a percentage of revenues, has fallen from 77.2% a year ago to 71.6% today.

"We have the worst behind us," he insists. "These figures confirm our confidence that we will be back in the black in 2003 as a whole and can lay the foundations for a sustained upward trend."


  So, why did investors respond to the news by dumping Commerzbank's stock, driving down the share price 5%, to $15.23? The reaction is one of several signs that investors remain wary of Germany's big banks, despite their significant progress in recent quarters.

Deutsche Bank, Germany's biggest by far, is another case in point. Its shares dipped 2% immediately after it reported on July 31 that second-quarter net earnings had surged to $649.2 million. That was more than twice the $231.5 million profit the bank reported for the same period last year and represented a marked turnaround after three straight quarters of losses.

Moreover, Deutsche Bank CEO Josef Ackermann, who took the helm in May, 2002, promises more of the same. He has cut 14,500 jobs and made $8.5 billion of asset sales. As a result, the bank's cost-income ratio has plunged from 80% to 74%.


  Ackermann says his priority now is to boost revenues as the markets and economy recover. "We will maintain strict cost, capital, and risk discipline," Ackermann told investors on July 31. "We will not become complacent but will continue to work hard to build on the progress we have made in reducing costs."

Investors remain unmoved. Marijn Smit, an analyst at Dutch bank ABN-Amro, says that's partly because the banks' improvement is the result of an upsurge in trading income, which may not be sustainable for the rest of the year.

It's also not clear what's going to happen on the bad-debt front in the second half. Economists predict that Germany's depressed economy will start growing again later this year, but they say the upswing will be weak, and many companies will find it hard to repay bank loans. Commerz unsettled shareholders by raising its bad-loan provisions from $286 million in the first quarter to $343.9 in the second. Commerz Chief Financial Officer Eric Strutz says that's not because the bank believes bad debts will rise. Instead, it's taking a more conservative approach to provisioning.


  Still, the move exacerbated investor fears of a growing default risk among the small and midsize companies that account for the lion's share of Commerz lending. They had already become worried because just days before, Munich-based HVB Group, the country's second-largest bank, had increased provisions and unveiled its fourth loss in as many quarters for the three months ending June 30.

Frankfurt-based Deutsche, meanwhile, was hit by concerns that changes in U.S. accounting rules could force it to halt its share-buyback program. Although the bank insisted that it would still continue the buyback, shareholders weren't convinced.

Investors also have more fundamental reasons for skepticism. Germany has too many banks, which in turn have too many branches and employees. Although the four biggest private-sector institutions -- Deutsche, Commerz, HVB, and Dresdner (a subsidiary of Munich-based insurance giant Allianz) -- have laid off thousands and closed hundreds of offices, they're still nowhere near as efficient as their more profitable rivals elsewhere in Europe. That's largely because German banks have been too slow to merge, which means they haven't been able to reap economies of scale to the same extent as their neighboring competitors, where a a far-reaching consolidation has been going on for the past five years.


  Competition from Germany's powerful public-sector banks, meanwhile, limits the private players' profit potential. State or municipally owned savings banks and mutually owned cooperative financial institutions account for around 50% of all banking business in Germany. Because they're under less pressure to make a decent return on equity than their private-sector rivals, they're able to lend money cheaply, forcing the private-sector banks to keep their rates low to compete. Until those banks are privatized -- something that's unlikely in the near to medium term -- it will be difficult for the likes of Deutsche, Commerz, HVB, and Dresdner to rival the profitability of their European counterparts.

The result, say analysts, is that despite the best efforts of management, German banks may not live up to shareholders' expectations for years to come. Only a thorough restructuring of the financial system -- not just of individual banks -- will be enough to truly reassure investors.

Fairlamb covers the European banking industry for BusinessWeek from Frankfurt, Germany

Edited by Thane Peterson

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