Many European banks were casualties of the global financial crisis that raged from 2008-2010: among them, banks in the German Landesbanken sector were some of the most profoundly affected. At first sight, the sector has undergone a pronounced restructuring since the crisis. Capitalization is higher; the wholesale bias to funding remains while dependence on short-term funding has fallen; and, so far, risk appetite suggests that management has learned the lessons of the exuberance and yield-chasing that presaged the most recent crisis. Cases like Nord LB show that the banks' owners (savings banks and state authorities) remain willing and able to step up if a bank runs into trouble, and bail-in buffers provide a further loss-absorbing backstop to senior creditors in case a Landesbank became nonviable.

While S&P Global Ratings sees the sector as being in good shape to weather another downturn, some residual uncertainties remain, mainly in terms of franchise and profitability. Sector profitability varies a lot, but in some respects, its importance should not be overstated because maximization is not the primary objective that owners set for management. Still, Landesbanken need to be sufficiently profitable, and they share the pain of their domestic and regional peers in facing an unhelpful interest rate environment and a slowing economy. As a result, risk appetite and investment policies could stretch to help compensate for margin pressure elsewhere. Long-term, Landesbanken owners might need to face up to the reality of the ultracompetitive market in which they operate, replete with rivals in the form of commercial banks, foreign banks, cooperative banking groups, and even from within the savings banks sector itself. It is unsurprising, therefore, to see the on-and-off talks about a Super-Landesbank. Given the diverse ownership structures and regional mandates among the Landesbanken, we believe the savings bank sector is unlikely to mirror the German cooperative sector in being served by one central institution (DZ Bank AG). For now, we see collaboration and shared efficiency without ownership change as the likely first step.

Smaller, In Number And Balance Sheet Size

The Landesbanken sector has become smaller since the financial crisis. In the aftermath, a number of Landesbanken needed bailouts and other support, with the notable exception of Landesbank Hessen-Thueringen (Helaba), which emerged from the crisis broadly unscathed. From 2008-2018, the number of classical Landesbanken, i.e. central institutions for regional savings banks associations, fell to five from eight (not counting Landesbank Berlin, which was sold to the savings banks association in 2007 and DekaBank), while their total assets dropped to less than €900 billion from almost €2 trillion (see chart 1). Of the three banks that are no longer Landesbanken, two went under (West LB and Sachsen LB) and one (HSH Nordbank/Hamburg Commercial Bank) had to be privatized after multiple bailouts.

Chart 1

Today, the five remaining Landesbanken, of which we rate only Helaba, appear healthier and more resilient than before the crisis. The notable exception is Nord LB, the remaining Landesbank in Northern Germany that continues to suffer from its material exposure to the struggling shipping industry. Nord LB was faced with an additional almost €2 billion write-down of its shipping loan portfolio in early 2019 and is awaiting the green light from European and national authorities for a planned recapitalization from its owners, the States of Lower Saxony and Saxony-Anhalt, as well as the savings banks network. Yet another at least partially taxpayer-funded bailout is a painful reminder of the fiscal cost that the bailout of Landesbanken entailed.

Local and regional governments, mostly German states but in LBBW's case also the City of Stuttgart, typically remain the majority owners of Landesbanken, except for Helaba, where the States of Hesse and Thuringia only share a 12.15% stake. The remainder of the shares typically belongs to regional savings bank associations. Despite their public sector owners' interest in the Landesbanken to support local economies and their failure to prevent ill-fated strategies before, we believe governance has broadly improved at Landesbanken. Following the financial crisis, bank bailouts have become even less politically palatable. Consequently, policymakers allowed Landesbanken to improve their capitalization, partially at the expense of a lower return on equity (ROE). Moreover, following its write-down on a large shipping portfolio, Nord LB announced it would exit ship financing despite the significant importance for the regional economy in Northern Germany. This is a clear sign that risk profiles are increasingly taking precedence over regional economic considerations.

Profitability: A Mixed Bag, But Broadly Resilient Despite Fierce Competition

Profitability and cost efficiency is uneven in the sector (see chart 2). BayernLB is clearly the most profitable Landesbank, with 9.4% ROE in 2018 and leading efficiency of 62%, whereas other Landesbanken post ROEs of 4%-7% with high cost-income ratios north of 70%. However, BayernLB also benefits from its very profitable online bank DKB, which accounts for one-third of pre-tax profits, risk-weighted assets, and total assets. This performance is broadly in line with DZ Bank, the cooperative sector's central institution, and still stronger than the three largest commercial banks in Germany, Deutsche Bank, Commerzbank, and Unicredit Bank AG.

Chart 2

Nevertheless, Landesbanken are exposed, and even contributing, to the fierce competition in Germany's banking market where net interest margins continue to decline. To some extent, Landesbanken can benefit from their business with savings banks where they provide payment services, trade finance, are the central counterpart for derivatives trade and help with any complex financing and asset liability management. However, as before, Landesbanken cannot rely on the savings banks alone, so they continue to look for other clients and to engage in additional services and activities to support profitability. In this respect, they still have plenty of competition, especially from commercial banks, domestic and increasingly foreign, vying for relationships with corporations. And Landesbanks strongly compete against each other. In this context, they continue to have a competitive advantage in their funding costs as investors seem to factor some implicit support in the funding structure (see chart 3).

Chart 3

Faced with strong competition and declining margins at home, Landesbanken are also starting to chase yields again by increasing their operations abroad. While most of the larger Landesbanken never entirely abandoned their foreign commercial real estate business, they did reduce it in the post-crisis period. Recently, some Landesbanken have started expanding again in markets like Canada, the U.S., or Western European countries. While these foreign ventures certainly indicate an increasing risk appetite among those Landesbanken reentering these markets, the banks can to some extent benefit from longstanding expertise in these markets, and typically do not build up business there from scratch.

Strengthened capitalization and less risky balance sheets

Capitalization has strongly increased since the financial crisis. We view this as an indication that the Landesbanken owners' attitudes have somewhat shifted. Today, the owners prefer soundly capitalized banks that are able to weather adverse market developments and absorb shocks, even if it comes at the expense of a lower ROE. Looking at the three largest Landesbanken, LBBW (total assets: €241 billion), Bayern LB (€220 billion) and Helaba (€163 billion), with a weighted average CET1 ratio of 15.1%, they broadly exceed the weighted average of the 186 European banks monitored by the European Banking Authority in their risk dashboard, which stood at 14.7% at year-end 2018 (see chart 4). Moreover, leverage ratios of 4.5% on average appear sound and continue to improve.

Chart 4

Based on asset quality metrics, Landesbanken balance sheets are less risky compared with the precrisis period. They have reduced their exposures vis-à-vis Southern European markets that came under stress during the Eurozone sovereign debt crisis, both in terms of their sovereign exposures and those real estate markets. In addition, Landesbanken, except for Nord LB, reduced their exposures towards cyclical industries, especially shipping. Overall, Germany's very strong economic cycle has also allowed them to reduce nonperforming loans to an average of 0.7% in 2018, down from a peak of over 4% in 2010.

Nevertheless, Landesbanken are certainly not free from risks. Real estate portfolios continue to present a potential cyclical risk, although they typically account for less than 10% of net exposures (see chart 5 and 6). In addition, the majority of the real estate exposure (over 60% in 2018) is in Germany, but Landesbanken are starting to grow again abroad. Moreover, commercial real estate--a sector that is more cyclical and prone to losses in economic downturns--dominates residential real estate on Landesbanken balance sheets. Still, we see these risks somewhat mitigated by the healthy portfolio structure where, on average, over 80% are investment-grade portfolios in the larger Landesbanken.

Chart 5

Chart 6

Risks might be lurking in other areas that did not feature prominently in the most recent crisis. Project and aircraft finance, for instance, are areas where Landesbanken are growing. Again, these sectors are not immune from risks because legislative changes can affect, for instance, wind farm projects; or technical issues, such as those with Boeing's 737 Max aircraft, can affect airplanes' residual values. Lastly, idiosyncratic risks to Landesbanken home regions might present vulnerabilities too. For instance, some might be proportionally more exposed to the auto sector, especially to suppliers, when they have a large car manufacturer present in their home region. However, we understand that Landesbanken have already taken measures to identify companies potentially more exposed to an increasing shift towards electric vehicles.

Healthier Funding Profiles

Wholesale funding remains an important funding source for Landesbanken and their total balance sheet size remains significant despite recent years' shrinking. But we note positively a significantly reduced reliance on short-term wholesale funding. Fueled by regulatory requirements, liquidity buffers have been significantly bolstered. Today, with liquidity coverage ratios of 154% on average, Landesbanken enjoy healthy liquidity buffers (see chart 7). We also think the close links to regional savings banks networks could stabilize Landesbanks' capital and liquidity, if necessary (for more information, see "An Update On How We Rate German Savings Banks," published Sept. xx, 2019, on RatingsDirect).

Chart 7

What Would Happen If A Landesbank Fails?

In principle, we would not rule out an orderly resolution through bail-in. Similar to other German banks, Landesbanken benefited from the retroactive subordination from senior unsecured debt affording them generally with comfortable bail-in buffers.

While in our rating approach for the savings banks sector, we view the entire savings banks sector as a group, we generally do not consider Landesbanken to be group members given that the savings banks are typically minority owners only. An important and unique exception is Helaba and S-Finanzgruppe Hessen-Thueringen (SFHT). Thanks to the comprehensive group relationship-- including a majority ownership by the regional savings banks association, underpinned by consolidated group accounts, a joint group reserve fund, joint risk management and a joint market presence--we consider Helaba a core entity to its regional savings banks association. We believe that regulators would apply a resolution framework to individual institutions in SFHT and not to the group as a whole. Apart from Helaba, it is unlikely that individual savings banks would be subject to a well-defined bail-in resolution process, given their small size, limited complexity, and low systemic importance in Germany as stand-alone entities. We believe that group support is the strongest external support element for member institutions including Helaba. Given their differing ownership structures and weaker cohesion between the Landesbanken and associated regional savings banks associations, a resolution scenario might take precedence over group support for other Landesbanken if we were to rate them.

So What's Next?

For Landesbanken as a whole, the core business is challenged, particularly with low interest rates--real estate, transportation finance, large corporates are all low-yielding, and well-served also by domestic commercial banks and some foreign banks. There is the obvious case for consolidation in the Landesbanken sector, but it is facing stiff resistance from certain states and savings banks associations, and is therefore likely not going to happen. However, we see scope for increased cooperation among Landesbanken in specific areas such as trade finance, and believe this will likely happen in coming years. This cooperation would likely face the least political resistance, because it would allow Landesbanken to maintain their regional mandates. Finally, fierce competition at home might give Landesbanken incentive to increasingly venture abroad again, especially in commercial real estate, and they would likely enter markets they're already familiar with should they go down this road. But as the most recent crisis has shown, these ventures can come back to haunt you when the credit cycle turns.

Related Research

An Update On How We Rate German Savings Banks, Sept. 25, 2019