Are Germany's banks about to go the same way as their Japanese rivals?

The major players cannot find enough profit growth to counter rising bad debts

Disappointing results and a recent surge of profit warnings has heightened speculation about the collapse of one of Germany's big four banks, sparking fears of a banking crisis in Europe's largest economy.

Disappointing results and a recent surge of profit warnings has heightened speculation about the collapse of one of Germany's big four banks, sparking fears of a banking crisis in Europe's largest economy.

Until recently, analysts worrying about a brewing banking crisis after two-and-half-years of economic downturn have focused on Wall Street, where high-profile corporate scandals have left banks under intense scrutiny from regulators and lawmakers alike.

But the slew of warnings from Germany's largest banks has shifted attention to Europe, with commentators warning of disturbing echoes of the banking crisis in Japan. The speculation has become so intense that leading German bankers have spent the past few days trying to assuage the markets' fears.

Ernst Welteke, the president of the Bundesbank, said it was "dishonest" to talk of a banking crisis. Mr Welteke acknowledged that Germany's banks are having a rough time, due to the stagnant state of its economy and the sickliness of some of its largest companies. But he said Germany's banks would emerge "strengthened rather than weakened" from this latest bout of economic downturn.

Mr Welteke's comments echoed senior banking executives'. Commerzbank's chairman Klaus-Peter Müller insisted that despite the bank's warning on Monday it might suffer a loss this year, it was not in the middle of a full-blown banking crisis.

Neither statement bolstered confidence in the market. The German banks, which have already seen their shares hammered this year, yesterday suffered a further sell-off. One German banks analyst said: "Their shares are currently valued at about half of their book value. From the point of view of their equity, the German banks are already in crisis."

Senior banking executives argue their underlying businesses are not in quite as bad a shape as the dramatic slump in their shares would suggest. But indications are more worrying. The spread on German banks' borrowing has more than tripled in the space of a month, indicating serious doubts in the market about the institutions' credit worthiness (See table).

Some commentators have warned the recent pattern at the country's top four banks is looking worryingly similar to that of Japanese banks in the late 1990s, which were swamped by a mass of bad corporate debts following the spectacular bursting of its asset-price bubble.

Germany may also be tottering on the edge of a deflationary spiral similar to the one Japan is now stuck in, increasing the risk of bad debts and making it more difficult for banks to offset the problem with new business from individuals and companies.

HVB, Germany's second-largest bank, last week shocked the market by posting a deeper-than-expected third-quarter pre-tax loss, which included a doubling of provisions against loan losses.

Commerzbank, the number three bank, has suffered a crisis of confidence among investors over rumours it has heavy derivative losses. Meanwhile, Germany's largest bank Deutsche has raised capital by selling off cross-holdings in other companies while Dresdner, owned by the insurance giant Allianz, is considering selling the most unprofitable bits of its business and slashing its headcount to preserve capital.

But German banks' record on bad debts is actually quite respectable. One analyst said: "As a percentage of the loan book we expect German banks to take a charge of 0.8 to 1 per cent for the full year. A charge of that nature for UK banks would hardly make them sneeze."

The trouble is German banks are either pocketing a negligible profit or have plunged into the red, making the effect of bad debts more serious than in the UK, where banks have still produced impressive returns for shareholders this year.

Observers say that if there is a German banking crisis, it is in why this sector is so unprofitable compared with UK or US banks ­ a situation which has made it particularly ill-prepared to deal with the economic downturn.

John Rushton, a consultant at analysts PA Consulting, found earlier this year that UK banks' return on capital is on average five-times higher than of the German big four, and the British banks' cost income ratios are between 20 and 40 per cent better than those in Germany.

This lack of productivity and profitability in Germany have meant that Deutsche, despite being the third largest bank in the world, has a market capitalisation of less than Halifax in the UK.

The reasons for the stodginess of Germany's banks lies in the political and economic role they have had in the last 50 years and, critics say, still have now.

Dr Bob Hancke, a lecturer in political economy at the London School of Economics, said: "After the Second World War, a highly regimented financing system was needed as a way to create growth with very little capital."

Just as in post-war Japan, in Germany banks to provided far more of the capital to drive industrial growth than the capital markets. This led to banks such as Deutsche taking large stakes in "national champions" such as the car maker Daimler Benz, to stop them from going under.

In Germany's case, the government also underwrote a range of regional saving and corporate banks, which continue to compete with commercial banks for the business of individuals and companies. The savings banks, known as Sparkassen, and the regional development banks, known as Landesbanken, are in effect state-owned and have remained very powerful. Despite their high international profile, Germany's private banks only have a 20 per cent market share at home.

This has meant even Germany's premier private banks are not competing on a level playing field, because their costs of lending remain much higher than these rivals, which are underwritten by the government.

Those who are optimistic about Germany's banking sector say that the current economic crisis is acting as the nasty dose of medicine politicians need to finally renounce the post-war economic model, known as "Germany Incorporated".

Last year the German government changed the capital gains tax rules. This allowed banks and insurers to start to unwind some of the massive cross-holdings they have in each other and in industry ­a change some senior executives have wanted to do since the mid-1990s to boost shareholders returns.

Allianz has been praised for its decision to sell its holding in HVB, while taking control of Dresdner, which it is now subjecting to radical surgery to try to boost its profitability.

At the same time banks and politicians are proving increasingly willing to let struggling companies fail rather than be propped up by the banking establishment. Kirch, the media empire, was the most high profile casualty of this new tougher line this summer. The final step is consolidation, which analysts say is urgently needed to strip out some of the over-capacity in banking market.

There have been some attempts at this ­ HVB is the product of major mergers, while Deutsche has signalled it is scouting around for a deal outside Germany, possibly with Lloyds TSB. The stumbling block remains the public banks. Despite encouragement fromEuropean competition authorities, German politicians have made it clear they will not allow private banks to take over the state-sponsored banks.

Yet the consensus is that Germany is not another Japan, and that if there is to be a high-profile failure from this downturn, it is still more likely to be in largest banking market in the world ­ the US.