Mergers between Germany's federal state banks, which are seen as crucial to boosting their profits, are unlikely to happen in the near term, but more consolidation of functions may be seen soon.

The idea of combining the remaining landesbanken into one central institution for the public savings banks sector in Germany has been pushed by the federal savings banks association DSGV. Such consolidation would be similar to the merger of DZ BANK AG and WGZ Bank in 2016, which created one central institution for Germany's cooperative banks.

The landesbanken face concentration risk in their portfolios, along with low profitability. But little progress has been made on the merger project due to conflicting interests of the various stakeholders. Savings banks share ownership of the landesbanken with the German federal states.

Merging the landesbanken into a single entity would be highly complex and difficult for political reasons due to the involvement of the German states, Roger Schneider, a director at the financial institutions group of Fitch Ratings, said in an interview.

Political barriers

Even though they have a commercial bank focus, they are not the same as privately held institutions such as Deutsche Bank AG and Commerzbank AG. The landesbanken are public law institutions that have a mandate to support the economy in the federal states they operate in, Schneider said. The states have special laws for the landesbanken sector that dictate what duties and powers they have.

So much will depend on the states of Bavaria, Baden-Württemberg and Lower Saxony in supporting the merger of the landesbanken, and so far they are resisting the M&A plan, Dierk Brandenburg, head of the financial institutions group at Scope Ratings, said in an interview.

In the last two years, DSGV President Helmut Schleweis, who spearheaded the super state bank project, has proposed various combinations as a first step toward the all-in-one merger, including the takeover of Norddeutsche Landesbank Girozentrale, or NordLB, by one of its peers. Discussions have faced opposition not only from federal states, but also from some landesbanken. In early 2019, Rainer Neske, CEO of Landesbank Baden-Württemberg, or LBBW, said the bank was not interested in taking part in a sector-wide merger because it will bring no discernible benefits to the owners of LBBW.

At the beginning of 2020, savings bank leaders reportedly agreed on the launch of merger talks between Landesbank Hessen-Thüringen Girozentrale, or Helaba, and DekaBank Deutsche Girozentrale. This merger is seen as a better candidate to kick-off the tie-up of the landesbanken because of the smaller state involvement.

Deka-Helaba tie-up easier

Unlike NordLB and LBBW, Helaba is majority-owned by savings banks and not the federal states of Hesse and Thuringia, Schneider said. Therefore, that transaction should be easier to complete, according to Brandenburg. There is still some resistance from regional savings banks associations, namely from Baden-Würtemberg and to a lesser extent from Bavaria, but these organizations are still open to discussions about a potential merger between Helaba and Deka, which handles the securities trading and asset management business of the savings banks sector, Schneider said.

Any deal between the two is not expected soon, according to the analysts.

"It would not be realistic to assume a merger could be completed in the next year or two," Schneider said.

Furthermore, the two banks may delay the talks until they see the full impact of the COVID-19 pandemic on their organizations.

At the presentation of Helaba's first-half earnings on Aug. 13, CEO Thomas Groß said merger talks with Deka have been put on hold for the time being due to the crisis, with both banks needing to focus on supporting their clients.

M&A needed

However, with more credit losses expected in the short term and interest rates remaining lower for longer, the M&A question will remain on the cards for the landesbanken, according to Brandenburg.

"Landesbanken cannot really improve in this environment without taking some drastic M&A action," he said. "What they can do is stand still at best. The only way out is some form of M&A, starting with Deka and Helaba."

What is more likely in the near term is closer cooperation between the landesbanken, according to Schneider. Recently, LBBW agreed to take care of the hedging business of Bayerische Landesbank AöR as the latter bank is trimming down its capital markets business. Similar rationalizing of functions within the sector should become more frequent, Schneider said.

Consolidation among landesbanken started in the aftermath of the global financial crisis as the federal state banks were severely impacted and many required state aid to survive. Some, like NordLB have still not shed all of their legacy toxic debt. The number of landesbanken had shrunk to six at 2019-end from 12 in 2007, according to Bundesbank data.