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German Banks May Limit Trading Rather Than Split

Some of the banks that qualify for a potential split under draft legislation agreed by the German government last week may choose to stop the restricted activities rather than incur the costs of separation, as the affected businesses make relatively small contributions to earnings, Fitch Ratings says.

Only a few banks would end up putting trading activities into separate subsidiaries, although up to a dozen may fall under the scope of the proposed legislation.

Placing "risky activities" into separate subsidiaries would be neutral to slightly positive for bank credit profiles. We understand that the parent banks would not be allowed to make declarations of backing ("Patronatserklaerung") or profit-sharing agreements, which are typical support arrangements for German companies. We would expect some support to flow to the subsidiaries to avoid reputational damage. However, as the regulator would restrict parent banks from supporting them in times of stress, downside risk for the parent banks could reduce.

The separation will have minimal impact at the consolidated group level. However, it could lead to greater ratings differentiation between legal entities within a banking group.

Banks with "risky activities" assets that exceed EUR100bn, or 20% of balance sheets greater than EUR90bn would be affected under the draft legislation. This limit covers the entire trading book, which includes derivatives for hedging purposes (those that do not technically qualify for hedge accounting) and part of the German GAAP liquidity reserves.

Proprietary and speculative trading, credit and guarantee business with hedge funds and leveraged alternative investment funds, and high frequency trading will have to be separated or closed according to the draft legislation. Like their French peers, German banks would not be required to separate market-making activities. This runs counter to the initial recommendations of the European Liikanen Group. Deutsche Bank is the most obvious candidate for setting up a separate subsidiary, but smaller capital market banks may also be affected, for instance Commerzbank, LBBW and Unicredit Bank AG.

If collateralised exposures, such as secured prime brokerage operations, are included the activities being separated would be much greater than just cordoning off unsecured exposures. In addition, the regulator, BaFin, could force a stop or spin-off of market-making or other businesses that it views as risky or speculative if they pose a threat to the solvency of the bank. BaFin has discretionary power to assess all lenders.

The German banking reforms are likely to come into force in 2014, before any structural reform is decided at European level. They would require banks to separate their risky businesses by July 2015. If ring-fencing additional trading activities becomes a requirement under European legislation, Germany would have to comply.

Fitch , February 2013

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