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* Landesbanken set up to promote regional development
* Public ownership and regional role make reform difficult
* International competition, stress tests are key challenges
* Experts recommend consolidation, banks say this unlikely
By Laura Noonan
HAMBURG, Sept 17 Many Germans feel that whoever wins Sunday's election, they should not fund any more bailouts of fellow European countries, whose errant banks are a particular bugbear for Berlin.
But a cornerstone of Germany's own banking system, which has already received state bailouts, is facing fresh challenges, increasing the need for reforms which will be very hard for any new government to deliver.
Founded in the 19th century to promote regional development, the publicly-owned Landesbanken play a hallowed role as low cost lenders to local projects and the 'Mittelstand', the small and midsized firms central to the eurozone's most resilient economy.
With combined assets of a trillion euros, they account for 12 percent of the country's total banking assets, and 3 percent of Europe's as measured by the European Central Bank (ECB).
The eurozone's steps towards banking union have triggered the toughest stress tests banks have ever faced and new global regulations impose higher capital demands particularly difficult for low-margin banks like the Landesbanken to achieve.
At the same time, their core business is threatened by increasing competition from international banks like France's BNP Paribas, which want a bigger part of the action in Europe's economic powerhouse.
Experts from the Organisation for Economic Cooperation and Development (OECD), ratings agencies and German academia say the best Landesbanken solution is restructuring to leave as few as two players with well-defined businesses.
The prospect appears remote, undermining Berlin's reputation as the driver of European banking reform.
None of the five main Landesbanken - Hanover's Nord LB, Munich's Bayern LB, Stuttgart's LBBW, Hamburg and Kiel based HSH Nordbank and Frankfurt's Helaba - said they thought industry consolidation likely when asked by Reuters for this article.
As Gunter Dunkel, head of Nord LB and president of the Association of German Public Banks put it in comments to Frankfurter Allgemeine Zeitung: "I offer you a bet: neither in my working life or yours will someone take the immense economic and political risks of such a merger."
The risks stem from the Landesbanken's tradition of serving the savings banks and local authorities that own them.
For the municipality-owned savings banks, they provide wholesale banking services and investment products to sell on to customers. For the Laender, they support local businesses and regional projects, accounting for 15 percent of all German corporate lending.
Officials in the German administration say Landesbanken are not a source of major concern; where once their woes were a talking point at European finance ministers meetings, a source familiar with their discussions told Reuters the Landesbanken had not arisen recently.
Their top line numbers are comparatively strong, with capital ratios above the international average and four of the five biggest showing higher profits in the first half of 2013.
But experts say the figures belie a more complex reality. Return on equity - a key measure of a bank's profitability - is lower for the Landesbanken than international peers.
More international competition could make margins even slimmer, as banks like Barclays and BNP look to Germany for growth that is lacking elsewhere in the eurozone.
Earlier this year, BNP Paribas's corporate bank lowered its client threshold from companies with 500 million euros of annual sales to those with 250 million euros, putting them further into the Landesbanken's core market
BNP's sweet spot - and an area attractive to other foreign banks - is exporters with cross-border banking needs.
"It's the largest economy by far in Europe, and the country with the highest share of exports in terms of GDP," the head of BNP's German corporate and investment bank business, Torsten Murke, said.
Fitch Ratings analyst Christian van Beek noted the Landesbanken's public ownership means they do not need the high double-digit returns sought by other banks, so they can do lower margin business.
But low earnings power carries risks. In its 2012 Economic Survey of Germany, the OECD noted Landesbanken "remain vulnerable due to their low capitalisation and profitability and will be especially affected by the regulatory increases in capital requirements".
One of its major sources of strategic investment is drying up. Several sources in savings banks, including Michael Auge, spokesman for Helaba's 69 percent owner the Savings banks and Giro Association Hesse and Thuringia, told Reuters they would not invest further in the Landesbanken.
"CIVIL SERVICE" CULTURE
Long-beset by the problems of politically motivated lenders, and cultivating a work culture several employees describe as "civil service like" with a clear-out at 5 p.m., Landesbanken did not begin to build serious problems until 2001.
The trigger, several experts say, was a surprise agreement between Germany and Brussels to end a sovereign guarantee on bonds sold by Landesbanken by 2005. The Landesbanken's response was to sell as much debt as they could before the curtain fell.
They piled into international lending and high-yielding bonds, sponsoring 8.4 percent of the global supply of asset backed commercial paper (ABCP) by 2006, according to a major 2012 study on Landesbanken by four German academics.
The Landesbanken expansion ended in bailout. In 2008, German states began the first of five bailouts totalling 70 billion euros, including the rescue of and eventual shutting of WestLB, which lost heavily on bets on the U.S. subprime market.
Others stayed afloat, avoiding deep restructuring.
Next year's European stress tests will be a seminal moment.
"Some people suspect these banks will need to take further state aid or at least further substantial writedowns on their portfolios," said Robert Montague, senior investment analyst at ECM Asset Management.
HSH has admitted it is likely to need to set aside extra money to deal with loan losses after the tests, but said it does not expect to need further state support either to deal with the cost of regulation or the tests' outcome.
Nord LB noted it had completed an extensive capital conversion and boosting programme in 2012. "Our earnings potential will enable us to bolster our capital further. We will meet the regulatory and market challenges coming up," it said.
LBBW said it would not comment on "possible consequences of tests, regulations, market conditions which are still unknown". "We think that LBBW is prepared to satisfy the higher future capital requirements," the bank added.
Helaba and Bayern LB were not immediately able to comment on the effect of the stress tests, and whether they could need state aid.
A senior official at the German finance ministry said Berlin had pushed for the tests to be rigorous, regardless of the potential consequences for its own banks. "It's necessary to bring the (European) banking sector back to health," he added.
This will force all banks to be more transparent.
The 2012 study on Landesbanken lending said that between 2001 and 2005 they loaned money to riskier German companies than other banks, and charged lower rates. Some of these loans are medium term facilities, still on the banks' books.
"They (Landesbanken) have lots of risky loans on their balance sheets, sometimes it can be very difficult to see," said Joerg Rocholl, the president of the European School of Management and Technology (ESMT) in Berlin and one of the authors of the 2012 study on Landesbanken lending.
Another area of concern is "if they are zombie banks, if they invest continually in bad companies," Rocholl added, a concern heightened by their public-spirited ownership.
Curth Flatow, a Berlin-based managing partner of real estate advisory firm FAP, said there were write-downs of between 15 and 50 percent in the German real estate loans market this year, mainly by international lenders and banks being wound down.
"I haven't seen a deal yet where Landesbank have made a huge write down," he added.
Not taking write-downs protects banks' short term earnings, but risks storing up losses for later.
While Germany has weathered the eurozone's economic headwinds well, 2013's first half results showed the five remaining Landesbanken had a combined 260 billion euros of international exposure at the end of last year.
Despite a pullback from international lending, data from Thomson Reuters' Deal Scan shows they have been lead arrangers for more than 30 international syndicated deals in the first half of 2013, spanning Israel, Korea and Bermuda.
A more fundamental Landesbanken concern is the viability of their business models. A former ratings agency analyst describes their old business model as "funding arbitrage" - borrow at cheap rates under the guarantee of AAA Germany, lend at slightly higher rates, and pocket the difference.
In post-guarantee world, that no longer works.
"There is a problem with the business model of Landesbanken in general, they often compete with private banks and it's not obvious what public service function they provide, why they should be publicly-owned banks," said Andres Fuentes, a senior economist with the OECD who is working on the 2014 Economic Survey of Germany.
His concerns are echoed by ratings agencies and analyst Montague, who said investors doubt Landesbanken's purpose in life. "They need to restructure," he added.
Announcing their results for the first half of 2013, the chief executives of HSH, Helaba, Nord LB, LBBW and Bayern LB all said their business models were sustainable and their efforts to cut costs and restructure were paying off, albeit against a difficult backdrop.
Several experts point to the differences between banks. The southern banks, LBBW, Bayern LB and Helaba are broadly seen as healthier than their northern rivals.
The biggest concern is HSH, a shipping lender being reviewed by the European Commission's state aid team over its request to increase a state asset guarantee from 7 billion euros back to its original 10 billion euros. A public service role will not save it, or any other EU bank, from scrutiny.
"All business activities are judged on their own merits in terms of viability and profitability," a European Union official told Reuters, not speaking specifically about HSH.
"There is no room to accept, for example, subsidised interest rates or the like on the grounds that such rates might be beneficial for the regional businesses."
OPERATION DO NOTHING?
Sources in the Landesbanken sector insist the sector has not stood still as their crises unfolded.
When they hit problems, Landesbanken could have turned to a Joint Liability Scheme run by the Deutsche Sparkassen und Giroverband (DSGV), the umbrella group which includes the savings banks and Landesbanken and argues for consolidation.
But taking bailouts from the DSGV would have allowed it to change Landesbanken's management and merge institutions. Instead, the states footed the bill for the bailouts themselves.
"There has been some restructuring, balance sheets have been reduced, the number of institutions has been reduced, but we think it's not quite enough," said the OECD's Fuentes.
"We think there could be more consolidation to keep decreasing the risk of influence of individual states in the management of these banks."
DSGV president Georg Fahrenschon said told Reuters that was unlikely: "I do not see a trend of more changes at the moment."
Moodys' analyst Katharina Barten, Fitch's van Beek and ESMT's Rocholl all advocate consolidation, and Fuentes also argues for privatisation, with unprivatised Landesbanken taking the savings banks' business left by their privatised peers.
Privatisation has been attempted before. U.S. investor J.C. Flowers spent 1.25 billion euros on 26.6 percent of HSH in 2006, anticipating a stock market flotation. Instead, HSH was forced to seek a bailout, and J.C. Flowers' stake fell to 9.3 percent.
Merging HSH with another Landesbank would "make a lot of sense, but there are a lot of political issues and it is unlikely that they will do it," a source familiar with J.C. Flowers' position told Reuters.
Lower Saxony, the majority owner of NordLB, reiterated that it does not want a merger with HSH: "That's not an issue," Stephan Weil, the governor of Lower Saxony, told Reuters.
Auge, of Helaba's main savings bank owner, takes a similar perspective. "Maybe there's a need," he said. "But I think there is no chance for further consolidation in the Landesbanken."
* says South Carolina Public Service Authority outlook revised to negative from stable on financial problems with contractor
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