– Thoughts on Strategy and Management

Financial crisis reveals weaknesses in banks business models

The international financial crisis claimed another victim among German banks this week. It was the specialised mortgage and public sector lender Duesseldorfer Hypothekenbank (Duess Hyp). “The small German bank’s owners have temporarily transferred ownership to the BdB’s depositor guarantee fund, after which it will be sold to a third party.”  The bank is fairly small with a balance sheet total of about 27 billion Euros. Due to this size, the German banking system will not fall into major turmoil because of this bank failure. The only concern was that Duesseldorfer Hypothekenbank is a Pfandbrief issuer (German version of covered bond) and that its failure might further damage the good reputation of the German premium product Pfandbrief. This fact surely motivated the quick rescue activities.

What makes this case interesting is the fact that – unlike the much larger and more prominent IKB-failure – Duess Hyp’s problems were not directly caused by investments in sub-prime related products or MBS notes. Duess Hyp simply failed because of its business model. It probably would have failed anyway sooner or later. The current financial crisis has just brought up their strategic problems quicker:

Duess Hyp is a traditional public sector lender. It was only a few years ago when they discovered that they should better venture into mortgage lending to reduce their dependence from this one business line. They successfully started mortgage lending but the mortgage business still represents only a minor fraction of their total business volume. Public sector lending traditionally is a business with very small margins. It is possible to make good profits in this business but few banks really manage to successfully exist only on the basis of public sector lending alone. Most banks combine mortgage lending and public sector lending in their business model. Last year, public sector lender Depfa was acquired by Hypo Real Estate Bank since its shareholders considered exactly that combination as the better option.

Hence, Duess Hyp already had a fairly risky strategy. This worked well over the last years that generally were good years for banks. However, what was challenging but viable during the good years became now almost impossible during the financial crisis – generating profits. Refinancing costs rose for all banks. For Duess Hyp, they virtually ate up their already small margins. The result is known.

This is not an isolated case. There was another bank failure in Germany lately. It was an even smaller bank, but it had the same symptoms: Weserbank (I am not sure how much longer this link will be active) was a very small bank with total assets of only about 120 million Euros. This is a critical size for a bank. Take alone the costs of complying with ever-changing regulatory requirements like Basle II – in relation to a banks financial and human resources, they are a much higher burden for a small bank than for a larger one. Weserbank was closed by German financial-market regulator BaFin due to the fact that its new business model did not enable it to make enough profits to cover its costs on a sustainable basis.

Hence, again we have a bank with a weak business model which was only good enough to survive in good years.
Almost all banks report falling profits these days. Even if they can proudly point to the fact that they don’t hold any sub prime-related investments, they feel the pressure of rising spreads and refinancing costs on their margins. Banks with a sound business will just have some years with poor profits. They won’t like it and there will be some consequences – layoffs, mergers, fired CEOs and the like. But they will survive. However, those banks with business models merely good enough to survive in good times will have more severe problems. The financial crisis will reveal any weakness in any business model and will require its tribute without remorse. Of course, smaller banks will suffer more than larger ones. They don’t have enough financial muscle to survive of period of losses and they don’t have the advantage of being ‘too big to fail’ – hence, they won’t receive as much system support. But even larger banks will feel the weaknesses of their business models.

Following that, the next months will be very interesting. We will not only see which banks will have to write off even more sub prime-related investments (which isn’t necessarily a sign of a poor business model). We will also see which banks have strong business models that will pass the test of a crisis, and which don’t.

LIKE WHAT YOU'VE READ? If so, subscribe to our mailing list. Just enter your best mail address and press the Subscribe button!