A German Behemoth

It doesn't take a financial genius to see what ails German banks. Just stroll down the main thoroughfare of any medium-sized city and it's obvious: overstaffed bank branches crowd nearly every corner. What's worse, Germany has seemed stuck in its tracks while nimbler rival banks in Britain, France, Spain and even Italy have pushed ahead with restructuring aimed at securing a place in the scramble for global financial clout.

Finally, Germany may have awoken from its slumber. Last week, Deutsche Bank and Dresdner Bank, the No. 1 and No. 3 banks in the country, announced plans to merge their operations into a behemoth with $1.2 trillion in assets, creating the world's largest bank. "This opens a new chapter in Germany's financial history, and there is sure to be more to come," says Horst Siebert, director of the Institute for the World Economy in Kiel. "It will be a big challenge."

The main benefit of the marriage of the two banks is a huge slashing of costs: estimated at $2.76 billion a year. The savings will be achieved by staff cuts so deep that one analyst dubbed it a "headcount haircut." The two banks are shedding 16,000 jobs, about 11% of the combined workforce of 140,000. The sharp cuts made banner headlines in Germany, which is unused to the massive downsizing long associated with U.S.-style restructuring.

Perhaps more important for the company's bottom line, the new bank is getting rid of all those unprofitable retail operations. The 2,500 bank branches now belonging to Deutsche and Dresdner will be downsized to 1,700 and spun off into a new company called Bank 24, which would become Germany's largest retail bank. One-third of the new retail concern will be sold to the insurance giant Allianz, which gets a ready-made distribution outlet for its insurance products. Allianz is also getting control of mutual fund manager DWS, asset manager Finanza & Futuro and insurance company Deutscher Herold in the swap. That allows the new Deutsche-Dresdner mothership to concentrate on more lucrative wholesale banking activities like mergers and acquisitions and bond issuance. Bank 24, meanwhile, will be floated on the Frankfurt Stock Market within three years. The sale also means that Deutsche Bank is giving up its booming Internet operations, which have attracted more than 700,000 customers. Ironically, the success of the Internet was one of the key reasons the bank realized that the bricks and mortar operations were doomed to be unprofitable, says Matthew Czepliwicz, banking analyst at Salomon Smith Barney.

"This really marks the death of Deutschland AG," said Rolf Breuer, the CEO of Deutsche Bank, referring to the cozy system of cross-holdings between banks, insurance companies and corporate giants that came into widespread practice after World War II, insulating German companies from shareholder pressures. Speaking to reporters last Thursday, Breuer said that he had long maintained that no German bank could succeed globally without first securing its position at home. The new bank, he said, not only has a bigger balance sheet but gains competitive strength in a number of key areas. The combined banks are the world's largest issuers of debt and fourth largest issuers of equity, as well as becoming world-class asset managers and owners of two of Europe's most successful investment bank operations.

Breuer also made clear that the marriage of Deutsche and Dresdner is only the first step in the bank's ambitious plans to expand globally. "We're a powerhouse and we've got money to burn," Breuer claimed. "We're very well positioned for phase two of European consolidation."

Deutsche has long nurtured ambitions to become a global player on the same scale as Citibank of the U.S. and HSBC of the U.K. Two years ago, Deutsche paid $10 billion to acquire Bankers Trust, a mid-sized U.S. bank that specializes in corporate banking activities. But many analysts felt that Deutsche overpaid, especially given the long time needed to blend the different corporate cultures.

The marriage of Deutsche and Dresdner is fraught with perils, as well. For starters, the 62-year-old Breuer has agreed to become co-ceo of the new bank with Dresdner's chief, Bernhard Walter. Such power-sharing arrangements have proved disastrous in a number of ways. While they soothe executive egos initially, the company suffers because no single executive is in charge. What's more, the power sharing is institutionalized in the new bank, which will be 60% owned by Deutsche's shareholders and 40% by Dresdner's. Breuer said that when he retires in 2002, his replacement will be chosen from the Deutsche Bank side of the business. The 58-year-old Walter is getting a five-year contract.

More important to the bank may be the question of its long-term strategy. Can two huge banks with lackluster performance get better by getting bigger? Certainly, shedding the retail operation is bound to increase the return on equity, which in 1998 was only 10.1% at Deutsche and an even more anemic 9.7% at Dresdner. The European average for banks is closer to 17%. But the shift from a retail bank to a wholesale operation has its pitfalls too. Just ask UBS, which was created in 1997 after a merger between Union Bank of Switzerland and Swiss Bank Corp. The company's shares have languished as it lost customers to smaller rivals. "The experience at UBS hardly proves this is a great model," says James Ravine, banking analyst at BNP Paribas in London.

While the combined Deutsche Bank will probably skirt any anti-trust questions because the market share of retail banks is below 50% in Germany, other competition concerns are raised by the merger. For example, Deutsche Bank and Dresdner are the largest pension fund managers in Germany, so the tie-up creates a category killer. Axel Brsch-Supan, an economist at the University of Mannheim, says the market needs more competition to foster creation of innovative products. "The art of making money in Germany is to be a monopolist rather than first offering a good product," he says.

The Deutsche Bank merger with Dresdner is only the latest step in a series of dramatic changes in Germany's corporate landscape in the last few months. Late last year the government of Chancellor Gerhard Schrder announced that it was ending capital gains tax on shares sold by corporations, clearing the way for banks to sell their huge portfolios of cross-holdings when the exemption starts next year. Then in February, Vodafone AirTouch of Britain succeeded in pulling off a hostile takeover of Germany's Mannesmann, the country's largest provider of mobile telephones. Hostile takeovers had been unthinkable in Germany because of complex share ownership rules.

Now that Breuer has proclaimed the death of Deutschland AG it remains to be seen what will rise up in its place. With unemployment still over 10%, massive downsizing is sure to generate popular discontent and even some grumbling within Schrder's ruling Social Democratic Party. And the true test of Germany's intentions about rationalizing its financial services sector will only come when a foreign bank tries to take over a German financial institution. Commerzbank, the country's fourth-largest bank, has been frequently mentioned as a possible target. But France and Italy are still using their regulatory authority to block foreign acquisitions of their domestic banks, so it's not clear how Berlin would respond.

But it is clear that if Europe wants to fulfill Breuer's dream and play in the global financial stakes, mergers like Deutsche-Dresdner have got to move quickly from street corner romances to cross-border marriages as well.