LANDESBANKEN:BayernLB and WestLB are talking about pooling resources, write JAMES WILSONand Gerrit Wiesmann

A MONDAY in late September normally means nothing more exciting at BayernLB’s Munich offices than the prospect of the year’s first after-work trip to the Oktoberfest.

But last week’s revelation that BayernLB, one of the group of German public sector banks known as Landesbanken, was in talks about a merger with WestLB, a direct counterpart, gave staff plenty to discuss in the beer tent. Not only would a combined bank be Germany’s third-biggest, it would dramatically alter one of the most controversial parts of Europe’s financial landscape.

For years, critics of the Landesbanken have called for fewer, stronger institutions with less state support – to little effect. Suddenly, two banks that needed billions of euro in aid to get through the financial crisis were making the running. “Now is the right time to start the consolidation process,” said Dietrich Voigtländer, WestLB’s chief executive.

The sense that change could be on the way will be reinforced on Tuesday in Berlin. Politicians and other regional barons who control the Landesbanken have been ordered to the finance ministry to discuss the banks’ future. Behind the curt summons from Wolfgang Schäuble, Germany’s finance minister, is a clear message: sort out your banks or we will sort them out for you.

Sceptics know Landesbanken owners usually ignore such threats. Reform has been discussed for years but it has always seemed to come behind the interests of the banks’ regional political paymasters in terms of local jobs, power and prestige.

This time, the plight of WestLB – likened by one senior German banker to a “jumbo with the engines on fire and nowhere to land” – is the most obvious reason for urgency. A formal process will begin this week for the sale of the Düsseldorf-based bank, demanded by the European Commission by the end of next year as the price of a bailout during the financial crisis. The commission is likely to want WestLB wound down if a buyer does not emerge. Furthermore, the commission, which has wide powers over European banks that need state aid, has other concerns. It has still not approved the way WestLB has spun off €77 billion of unwanted assets into a bad bank. It has deep reservations about the aid given to other Landesbanken, including BayernLB. Without approval, the banks’ survival is at stake. “We have new pressures. Doing nothing isn’t an option,” says Steffen Kampeter, deputy finance minister.

Landesbanken reform matters because they are the most obviously troubled part of a banking system that ranks as one of Europe’s weakest – certainly in comparison to the rest of the German economy. While Germany’s companies export their way to world success, most of its banks have remained shrunken and accident-prone, earning poor returns. Josef Ackermann, chief executive of Deutsche Bank, last week lamented that Germany had only one world-class bank – his own. “We have to decide what kind of banking system we want,” Ackermann said, praising the WestLB-BayernLB talks and calling for “more such courageous steps”.

Germany also knows the onus is on it to sort out its banks in the interests of European stability. With investors still jumpy about the euro zone’s health, suspicions about financial weakness can quickly reverberate.

Market fears over the Landesbanken were one factor that forced European regulators to submit banks to publicly revealed stress tests this year. Landesbanken strongly resisted such tests and Germany’s demands for exceptional treatment of its banking – it has a huge share of state-owned banks thin on conventional equity – have increased the complexity of global efforts to co-ordinate regulation.

At the heart of demands for Landesbanken reform is the criticism of their business model. Having evolved to provide services for smaller local savings banks and help regional development, Landesbanken have struggled to adapt as this role has waned. They have tried to compete head-on with Europe’s larger commercial banks but most have virtually no retail deposits and rely heavily on funding direct from capital markets. To many private-sector rivals – as well as think tanks such as the Organisation for Economic Co-operation and Development – they are unstable, market-distorting competitors which should be privatised or wound down.

The last big potential trigger for change in the sector was ignored – and contributed to the banks’ current plight. The Landesbanken used to rely on funding themselves cheaply with the help of guarantees from their state owners. When the EU ordered an end to such practices by 2005, many Landesbanken used a last flurry of cheap debt to invest heavily in foreign commercial property, subprime debt and other structured securities – with disastrous consequences.

This time a net may be closing on the Landesbanken from several directions. First, Brussels’s patience is almost exhausted – expressed last year by Neelie Kroes, the EU’s former competition commissioner, who said bluntly that the “saga had to end” at WestLB. It may be forced to pay a high price to win approval for its “bad bank”. Others, including BayernLB, may also be forced to agree to sales.

Second, Berlin now has more than just sharp words for the Landesbanken. As part of WestLB’s bailout, the bank received a €3 billion capital injection from the national government – the first such stake in the heavily regional sector.

Third, the regulatory burden is growing. The recent Basel negotiations on new bank capital rules produced protests from the Landesbanken’s lobby group. Individual banks, and some analysts, are more sanguine. But a post-crisis levy on German banks and a possible tax on financial transactions will reduce banks’ profitability and may make Landesbanken owners think harder about how they respond.

Yet finding the right answer remains a complex and uncertain process. “It is true that there is more political will than before to do something,” says the banker. “But there is nothing more dangerous than a politician under pressure.”

Gerd Häusler, chief executive of BayernLB, says consideration of a merger with WestLB will be based on “business issues”. According to Häusler – who worked at Dresdner Kleinwort, Lazard and the International Monetary Fund before BayernLB – there is room for a “house bank” for German industry. Bavaria and North Rhine-Westphalia, the home regions of his bank and WestLB, are home to half of Germany’s Dax 30 companies and a swath of smaller industrial names. The idea is supported by a feeling banking may become less, not more, global after the financial crisis.

But combining the banks faces formidable hurdles. One is funding. A bigger bank with virtually no retail deposits would be reliant on market finance: would such a bank meet a goal of reducing risk after the crisis? As for the idea of being a house bank for German companies, one rival banker says: “Everyone really likes to be in this segment but no one really excels in it – I have doubts whether the model can work.”

According to Katharina Barten, an analyst with Moody’s, the rating agency, a tie-up might keep WestLB in business but would be risky and give limited strategic fit for BayernLB. “There are a number of potential long-term benefits if the merger proceeds and creates a ‘super Landesbank’,” Barten said. “However, for several years, liquidity and funding risks would likely offset any such benefits.”

Schäuble has entrusted Tuesday’s talks with the Landesbanken owners to two deputies, Kampeter and Jörg Asmussen. Kampeter said three alternatives had been mooted: the privatisation of West LB; combining WestLB and Bayern LB; or a combination of WestLB with Helaba, Deka and Landesbank Berlin, institutions majority-owned by or close to Germany’s savings banks. The latter combination might take “several steps”, said Kampeter.

“Whatever model we end up choosing, we have to have a strong business case. Beyond that, we have to consider EU law, the political acceptability and the taxpayer burden,” he said. “It’s a process that’ll take a while. I don’t think we’ll get anything definitive by year’s end. But we’ll see the contours by spring 2011.”

A Frankfurt investment banker said: “The main question is the complexity of any first move. Could we really manage a three- or four-way merger? That sort of thing hasn’t been done for 20 years.”

A wider question is whether a merger – whether aiming to be a more commercial universal bank, as Bayern-WestLB would, or an institution closer to Germany’s savings banks – would really solve the “Landesbank problem”. Germany would still have a series of public-sector banks of middling size and prone to political interference – hardly what many rivals and investors would welcome.

Joaquin Almunia, Kroes’s successor as EU competition commissioner, has made clear a merged Landesbank would face the test already applied to each bank – will it restore long-term viability? Given the history of Landesbanken problems, it would be no surprise if Brussels were to be highly sceptical.

A senior Landesbank executive says that, in the long term, the sector needs private capital. A Bayern-WestLB merger would not preclude that – there is a political commitment in Bavaria to try to take BayernLB to the capital markets within a few years. But not everyone is convinced BayernLB, or WestLB, will easily find a private-sector investor.

Given the record of frustrated progress, few would be certain of Landesbanken restructuring coming rapidly to a conclusion – even with pressure from Brussels. Nor would it be clear for years whether a Bayern-WestLB merger had succeeded or merely compounded Germany’s banking woes. As people in Munich know, behaving rashly in the autumn sunshine can lead to a nasty headache.