Ahead of losing their state guarantees in order to comply with European Union competition law, the German landesbanks are going through a series of mergers and restructurings, and are implementing new business strategies.

One sector currently attracting considerable attention is infrastructure finance, and several landesbanks are making a push into this area at a time when big private German commercial banks such as Commerzbank and Dresdner Bank have been scaling back their project finance operations.

Within the expanded infrastructure finance departments there is also a growing focus upon Public Private Partnership (PPP) projects, both within Germany and in regions such as Scandinavia and the Baltic States.

In the domestic market PPP finally looks set to make some serious headway during 2003, after several years when there has been more talk of projects than actual activity.

The German economy is currently in a state of crisis, with low economic growth, high unemployment, and tax revenues falling off sharply. Massive spending cuts are being pushed through at both Federal level and within the sixteen individual states. In such an environment it is not surprising that German politicians and officials are finally looking towards PPP as a financing solution, and states such as North-Rhine Westphalia are quite well advanced.

In fact PPP opportunities over the next five years are likely to be better in continental Europe than in the UK, which led the way, but where returns on projects have fallen as new players have entered the market.

?In UK PPP projects the margins went down quite dramatically over the past few years, so that is not that attractive for us anymore,? comments one banker. ?It might have been attractive for a typical landesbank in the past, but not any more. Our target return is increasing from year to year, and within two years our target return will be above 15 per cent.?

Within Germany the landesbanks enjoy the advantage of already having excellent contacts at municipal and state level, where politicians and officials are studying the possibility of using PPP financing models for everything from waste water projects to school buildings and hospitals.

These state level officials tend to have quite a conservative approach, and it has taken a long time for the idea of PPP to gain acceptance. But once the first few deals are done, the track record suggests that more will quickly follow, a pattern already seen in financing techniques such as cross border leveraged leasing of municipal assets.

There are already PPP competence centres set up in states such as North Rhine Westphalia, Lower Saxony, and Berlin Brandenburg, and the Federal Government is currently in the process of looking at tenders from a number of banks to set up a Federal level competence centre to promote PPP.

The same municipal officials like to deal with familiar faces, and initially at least, the landesbanks are likely to win PPP business as a result of their longstanding banking relationships.

One landesbank with a strong infrastructure focus is Landesbank Schleswig-Holstein, commonly known as LB Kiel, which acted as arranger on one of the most high profile PPP projects completed in Germany to date, the Herrentunnel toll project under the River Trave in Luebeck in northern Germany.

LB Kiel is currently in the process of merging with Hamburgischen Landesbank, a deal which should be finalised at the end of the year, and infrastructure finance will be an important business sector for the merged institution.

Having already advised on a real toll road in the form of the Herrentunnel, LB Kiel should be well placed to get involved in the system of shadow toll roads that is soon to be introduced across Germany. Schools are another likely area of interest.

Under the new shadow toll model a series of motorway concessions are planned, and will be financed via the new toll which will be levied on all heavy trucks using German motorways, starting sometime in 2003.

Part of that money will be used to finance the widening of certain stretches of motorway, typically around 75km long, with concessionaires doing the construction work and then having the right to collect the shadow toll associated with usage.

LB Kiel also has a focus on the Nordic and Baltic regions. It is advising a consortium featuring Skanska for the E39 Lyngdal to Flekkefjord state highway in Vest Agder County in the southern part of Norway, which is one of three pilot PPP projects soon to be awarded by the Norwegian Public Roads Administration.

LB Kiel is also advising one of the consortia that recently lodged bids for the PPP toll bridge and road which will connect the island of Ruegen with the mainland on the Ostsee coast in northeast Germany. Three bids were eventually lodged for this Strelasund Bridge project, after five participated at the pre-bidding stage.

Another landesbank which has undergone major changes this year is the Westdeutsche Landesbank group. Since September this has been split into the commercial bank WestLB AG, and the public credit institution known as Landesbank NRW.

Landesbank NRW will have a strong focus on supporting structural policy in North Rhine Westphalia, and this will include involvement in PPP. Chairman Dr Bernd Luethje has noted that, in view of the reorganisation of the EU public promotion programmes and the strain on public authority budgets, Landesbank NRW will not confine itself purely to the tasks of a development bank.

?We will develop new products which promote infrastructure expansion in accordance with the EU Treaty and help create jobs and at the same time we will step up efforts to acquire public sector mandates,? says Luetje. These will include, for example, financing for the public sector, project development, and project management for public sector clients.

Meanwhile, on the other side of the split, WestLB AG is now an internationally operating European wholesale bank, and has a stated business policy of concentrating in particular on profitable business segments such as structured finance, asset backed transactions and equity investments.

The Managing Board of WestLB AG has set some ambitious objectives, and by the end of 2004 the cost/income ratio is to be lowered to 65%, the return on equity increased to 18%, and core capital raised to 6.5%

Ironically, in the light of growing interest in PPP within Germany, it is the new WestLB AG which has the well established track record in PPP in countries such as the UK, whereas PPP in North Rhine Westphalia would fall under the remit of Landesbank NRW.

But though WestLB AG and Landesbank NRW are now operating independently of one another, they will continue to co-operate closely. The state of North Rhine Westphalia remains the main owner of Landesbank NRW, of which WestLB AG is a wholly owned subsidiary.

Another German institution with its roots as a German public sector bank, though not a landesbank, that is looking hard at the infrastructure sector, is DEPFA Bank. In June of this year DEPFA Bank was split into two separate entities, with the property lending bank becoming known as Aareal bank AG, and a specialised public sector finance bank known as DEPFA Bank set up with its headquarters in Dublin.

Fitch noted at the time of the announcement of the restructuring that the ROE within the public sector financing arm was considerably higher than for the property lending division.

The Special Finance Unit (SFU) headquartered in Dublin is now responsible for structured finance services. The emphasis is upon long term lending in the 20-25 years range, and indeed DEPFA Bank recently provided 32 year finance on one deal. The SFU will provide long term limited recourse lending and arranging services in infrastructure, and this includes PPP projects involving hospitals, schools, prisons, government offices and roads.

?We see a growing interest in continental Europe in the use of the private sector and private sector financing for the development of key infrastructure,? says Andrew Bride, Managing Director in Special Finance at DEPFA.

In contrast to these various institutions which have been gearing up their PPP and project finance activities, earlier this year Berliner Bank closed its project finance unit, though this move was less to do with any strategic focus than a side effect of the financial crisis within the Bankgesellschaft Berlin group, as a result of problem real estate lending.

?A capital injection needs to be approved by Brussels, and there needs to be a clear business focus, which is being a bank in the Berlin Brandenburg area,? says a banker within the group. Half the project finance team went in June, and are now a few left in caretaker function, looking after a project loan portfolio in excess of $1bn which is now being hawked around the market for sale.

But in spite of the exit of Berliner Bank, internationally the German landesbanks are likely to remain big players in both PPP and project finance, even if they are set to lose their state guarantees, and thus will no longer be able to raise cheap triple A funding.

?The disappearance of state guarantees is really not as important to us as the Basel II treatment for project finance,? comments one New York based executive at a landesbank. ?That is going to be a much broader issue that could impact everyone including us. If we think that project finance is a good business the dropping of the state guarantees simply means that we will continue doing it and hope to get good returns doing it. It is a question of where else we will deploy our capital.?

?We are gearing up for both Basel II and the dropping of the guarantees, but we still think we will remain in this business, and I have heard no indication to the contrary that we will not be interested in doing project financing,? he adds. ?I don't see that happening. On the contrary, because project finance normally yields a little more return, we may aim to do more of that business.?

?With regard to Basel II each landesbank has different ideas or solutions which are not finalised yet,? adds another banker based in Germany. ?We are in the process of doing a special rating system for project finance, together with a few other landesbanks, and I know that many other banks are working on a similar tools, which will enable to continue to do project financings. It is a very sophisticated tool to evaluate the excepted losses, defaults, which gives us a good tool to reply to the basic ideas that have been in the market since the beginning when Basel was first discussed.?

?I think that we will still have an important role to play, especially still as some commercial banks are turning their back on the market for various reasons,? the banker adds.