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Germany has been awash in red ink this year, and no sector has been flooded worse — and with potentially greater consequences — than the banks. Last week Deutsche Bank, Germany's largest and considered its strongest, posted a surprise third-quarter, pre-tax loss of [EURO] 181 million, down from a [EURO]363 million profit for the same period in 2001. Deutsche's Munich-based counterpart HVB, Germany's second-largest bank and Europe's largest lender, also posted a third-quarter loss — of j447 million, compared to a j94 million profit for the same period last year. Commerzbank and Dresdner Bank, a unit of insurance giant Allianz since 2001, look set to follow suit when they publish third-quarter results later this month. Why, in a country once renowned for its scrupulous financial management, are so many banks doing so poorly?

The answer is simple: bad debts, a knock-on effect from Germany's soaring bankruptcy rate. At Deutsche, provisions for loan write-offs rose to j753 million for the third quarter, nearly six times what they were a year before. In addition Deutsche, and to a lesser extent Commerzbank and Dresdner, have spent considerable sums over the past seven years building up their presence in investment banking — bad timing, in the face of bearish markets and the weakest mergers and acquisitions market in decades. Banks hoping to be bailed out by a quick change in the overall economy look set for disappointment. "There are lots of uncertainties," says Metehan Sen, an analyst at Sal. Oppenheim in Frankfurt. "2003 will also be a very difficult year." Even when the tide turns, German banks will still face the underlying problem that has long dogged them: low profitability. A recent study by U.K. firm PA Consulting, for example, found U.K. banks' return on assets was on average almost five times higher than that of the private German banks, and that cost-to-income ratios were more than 30% better. One of the main reasons: fragmentation of the German banking system. Unlike in the U.K., where only a handful of banks compete for customers' business, in Germany there are hundreds of banks doing the same. A report issued last month by Merrill Lynch offers a choice for German banks: keep doing what you're doing and face low margins on your lending, or raise profitability by making it more expensive for customers to borrow money. Easier said than done. Any German bank that makes borrowing more expensive risks being undercut by a slew of competitors.

Indeed, the listed banks — which have less than 20% market share in Germany — compete not only with one another but with Germany's Sparkassen and Landesbanken, regional savings and development banks that are underwritten by the government — a fact that has brought Germany into conflict with other E.U. nations that object to these state subsidies. (In the past, German authorities have been reluctant to facilitate listed banks taking over these public sector banks, delaying what many see as inevitable — and urgently needed — consolidation.) But change is coming; last year, following pressure from the E.U., German leaders agreed that all state guarantees for the Landesbanken would cease as of 2005.

Analysts are comparing the German banking system to that of Japan, largely because in both countries many companies borrow money from banks rather than raise it through capital markets. But some economists say similarities end there. "In the Japanese banks and megabanks, there were a huge number of interlocking shareholdings, so the domino theory applied very rapidly," says Iain Begg, a professor at the London School of Economics. In addition, because the large banks have low market share, he says, "in Germany, even if one of the big banks were to go belly-up, it would not be such a threat to the financial system."

As the economic slump continues, banks are slimming down. As part of a program to take [EURO] 2 billion off its cost base by the end of next year, Deutsche has laid off 10,000 staff and dumped assets. Last month, it sold its stake in Deutsche Börse, raising around [EURO] 360 million, and this week it hopes to announce the sale of its custody business for up to [EURO] 1.2 billion.

Still, it will take more than that to regain the confidence of investors, who've sent shares in Germany's three largest banks plummeting since the start of the economic downturn. A brief rally last Thursday suggested that, after the poor third-quarter announcement, Deutsche might be a takeover target. But the next day, shares fell again. "At the end of the day," says Sen, "the banks are still exposed to Germany."

• JENNIE JAMES
• Soaring bankruptcies have saddled German banks with billions in bad debts.