EUROPEAN COMMISSION

Brussels, C(2005)3311 fin

Subject: NN 72/05 –– Capital increase BayernLB,

Sir,

The Commission wishes to inform the Federal Republic of Germany that, having examined the information supplied by your authorities on the measure referred to above, it has decided that the increase of BayernLB’s share capital by an amount of EUR 640 million does not constitute aid or contain aid elements in the meaning of Article 87 (1) of the Treaty.

I. PROCEDURE

(1) The Commission on 20 October 2004 decided that the transfer of housing- promotion by the Free State of to BayernLB in 1994 constituted State aid and that illegal State aid of EUR 260 million had to be recovered1. Including interest BayernLB had to repay a total aid amount of EUR 320 million which it did on 12 January 2005.

(2) In the context of the preparation of that recovery decision, Germany and BayernLB informed the Commission that the bank’s shareholders planned to increase the bank’s share capital, the amount of which was not yet fixed. More detailed information including information on the amount of the capital increase and more details on the timing was submitted in a meeting on 10 November 2004 and by letter of 29 November 2004

(3) By letter of 30 November 2004 the Commission informed Germany that investments taking place after recovery raise concerns with respect to the effectiveness of the Commission’s recovery policy and, therefore, established criteria relevant for the Commission’s assessment of such investments by the Landesbanken in question, for instance, the requirements to provide capital only after the expiry of the State guarantees on 18 July 2005 and to submit a robust investment calculation proving that the remuneration for the capital provided would be in line with the market investor principle.

1 Commission decision C (2004) 3927 final of 20 October 2004 on Bayerische – Girozentrale (procedure C70/2002); not yet published. (4) On 7 March 2005 Germany submitted a capital market oriented evaluation of BayernLB’s business carried out by an independent consultant to demonstrate the market conformity of the planned capital increase.

(5) Following the submission of the evaluation the Commission sent a request for information on 18 March 2005, to which Germany replied on 1 April 2005 and 9 April 2005. The Commission sent a further request for information on 13 April 2005, to which Germany replied on 15 April 2005 and 19 April 2005, and on 22 April 2005, to which Germany replied on 2 May 2005.

(6) On 12 May 2005 representatives from Germany, the Free State of Bavaria, the bank and its consultants presented BayernLB’s investment case in the premises of DG COMP in a meeting with the Commission.

(7) Upon information request of 23 May 2005 and 6 July 2005, the Commission received concluding information from Germany on the remaining issues in the context of the investment calculation on 7 and 22 June 2005 and 6 July 2005 respectively.

(8) Another issue which had emerged during discussions and which needed to be clarified before the Commission could conclude its assessment of the investment concerned the tax treatment of the recovery in the Landesbanken decisions of October 2004. Due to the fact that six of these decisions, including the decision on BayernLB calculated the recovery amount as an after tax figure and that only these after tax amounts were recovered, the tax deductibility of the repayment of the aid in the view of the Commission was not given. The Commission, therefore, demanded a confirmation of the tax neutral treatment by the competent tax authorities of Bavaria which it received on 11 May 2005.

II. DESCRIPTON

1. Bayerische Landesbank - Girozentrale (BayernLB) (9) Bayerische Landesbank - Girozentrale (BayernLB), , was formed in 1972 as a result of the merger between Landesbodenkreditanstalt (“LABO”) and Bayerische Gemeindebank (Girozentrale). It is a publicly owned credit institution operating in the form of a public institution (Anstalt des öffentlichen Rechts). It is indirectly owned by the Free State of Bavaria and the Bayerische Sparkassen- und Giroverband (Sparkassenverband Bayern), each with a 50% holding. In 2002 the two owners agreed to transfer their stakes in BayernLB, in exchange for shares, to BayernLB Holding AG, in which they each hold 50% of the shares. BayernLB Holding AG is the sole owner of Bayerische Landesbank and is not a bank itself.

(10) BayernLB operates as an international wholesale bank active in the area of investment and commercial banking and focusing on the core market in Bavaria and neighbouring regions. Given its ownership structure BayernLB also functions as the principal bank of the Free State of Bavaria and as the central clearing institution of the Bavarian savings banks. BayernLB claims to be one of the leading issuers of bonds in Germany. BayernLB target customers are the Free State of Bavaria and municipal authorities, savings banks, multinational

groups, domestic firms, private and commercial real-estate developers, institutional customers and financial institutions. BayernLB maintains LABO (an instrument for the housing policy of the Free State of Bavaria) and Landesbausparkasse Bayern (“LBS”, the Bavarian home and savings bank) as legally independent institutions.

(11) The bank had a balance sheet total of EUR 313 billion in 2003 and of EUR 333 billion in 2004; it employed 9061 people in 2003 and 8940 people in 2004.

(12) Despite the repayment of the aid of EUR 320 million (including interest) which was included in the annual accounts of 2004, BayernLB had a core capital ratio (tier 1) of 8.3% and an own capital ratio of 12.5% on 31 December 2004. The State guarantees (Anstaltslast und Gewährträgerhaftung) expired on 18 July 2005. According to Standard & Poor’s BayernLB achieves now an unguaranteed rating of a single A2 raised from A- in July 2004.

(13) Since 2002 BayernLB went through a major strategic reorganisation to transform its business model. The primary strategic initiatives were:

• Improve credit risk management and workout of its problem loan portfolio and strongly reduce risk-weighted assets and concentration risks; • Rescale predominately wholesale-oriented commercial bank activities while streamlining other operations to risk adjusted profitable levels; • Improve its cooperation, business relation, synergies and profitability with the Bavarian savings banks; • Address its low efficiency by risk-adjusting pricing and cost-cutting measures; • Rescale its equity and nonstrategic investment holdings.

(14) The reorganisation has to a large extent been accomplished. BayernLB has refocused on its core competency as bank for mid-size and larger corporate, institutional clients as well as savings banks in the core market of Bavaria, Germany and selected foreign countries. One of the core pillars of BayernLB’s new strategy is the close cooperation with the Bavarian savings banks. BayernLB has also reshaped its risk management and enforced both centralization as well as transparency between business areas and segments. In order to leverage is existing client base, the bank has also started numerous initiatives to foster cross-selling.

2. The measure at stake: capital increase by EUR 640 million

(15) In May 2005 the two owners of BayernLB, the Free State of Bavaria and the Sparkassenverband Bayern decided to increase the share capital of BayernLB by EUR 640 million. This decision only came into effect after 18 July 2005, i.e. after the expiry of the State guarantees. The capital increase is supposed to take place in two instalments of EUR 320 million each on 1 August 2005 and 1 July

2 “Shadow” (= unguaranteed) rating of June 2005.

2006. Both owners will participate in each instalment of the capital increase according to their current shareholding, i.e. with equal amounts.

(16) The need for a capital increase was already identified by the shareholders of BayernLB in August 2004. BayernLB’s main objective that it pursues by the capital increase is a qualitative improvement of its capital endowment in order to secure a sustainable rating of “A/A+” from Standard and Poor’s after the abolition of the State guarantees on 18 July 2005.

(17) The capital endowment and the capital adequacy is an important factor for the rating of a bank. There are different concepts to measure capital adequacy from a regulatory as well as from a rating agency point-of-view. The main difference between both approaches is the treatment of silent participations which count as tier 1 capital in the regulatory framework but are not considered by the rating agencies for the calculation of ACE capital3.

(18) In order to improve its capital endowment and adequacy and to secure its rating BayernLB will therefore not prolong expiring dated silent partnership participation and will (partly) replace them by ACE capital, i.e. by the fresh capital stemming from the capital increase.

(19) Standard & Poor’s rating report dating from July 2004 had identified the moderate capitalization among one of the weaknesses for an improved rating. As BayernLB made significant progress in 2004 as regards the other identified weaknesses through its strategic repositioning and risk downsizing, the strengthening of the capital basis remained the major requirement for an improved rating. In July 2005 Standard & Poor’s raised to A from A- the unguaranteed rating of BayernLB4, already taking into account the capital increase.

III. ASSESSMENT

1. Existence of aid within the meaning of Article 87(1) of the Treaty

(20) Article 87(1) of the Treaty states that, save as otherwise provided in the Treaty, any aid granted by a Member State or through State resources which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods is incompatible with the common market, insofar as it affects trade between Member States.

1.1. State resources

(21) The capital is injected by the two shareholders of BayernLB, the Free State of Bavaria and the Sparkassenverband Bayern. The Free State of Bavaria is a German Land. Consequently, there is no doubt that the funds provided by the Free State of Bavaria are State resources and are imputable to the State. As regards the Sparkassenverband Bayern, the question whether the funds provided

3 ACE = Adjusted Common Equity

4 In July 2004 Standard’s & Poor had established a “shadow” (= unguaranteed) rating of A- for BayernLB.

by this shareholder are State resources and whether the investment is imputable to the State, can be left open, if the measure in question is not favouring BayernLB in the meaning of Article 87 (1) of the Treaty.

1.2. Favouring of a particular undertaking

(22) A broader capital base provides for a greater lending capacity and the associated possibility of expanding business. If additional capital is made available to the undertaking on conditions better than normal market conditions, this ranks as favouring within the meaning of Article 87(1) of the EC Treaty. In examining this matter, the Commission applies the "market-economy investor" principle. The Court of Justice and the Court of First Instance have accepted and developed this principle in a number of cases, in particular in the ruling by the Court of First Instance of 6 March 2003 in the WestLB5 case.

1.2.1. The market investor principle

(23) According to this principle, no state aid is involved where funds are made available on "terms which a private investor would find acceptable in providing funds to a comparable private undertaking when the private investor is operating under normal market-economy conditions".6 In contrast, a financial measure such as a capital injection is deemed unacceptable for a market-economy investor if the expected return on the investment is below the return a market- economy investor (“market investor”) would expect for comparable investments.

(24) The market-economy investor principle is likewise applicable to all public undertakings, irrespective of whether they are profit- or loss-making. This position of the Commission has been confirmed by the Court of First Instance in WestLB.7

(25) The key question in examining this case therefore is whether a market-economy investor would have provided the share capital to BayernLB under the same conditions as were given for BayernLB’s shareholders.

(26) This is the case when the investment into the share capital increases the market value of the firm. An increase in the market value can be estimated by carrying out a valuation of the bank’s business with the investment and a valuation of the bank’s business without the investment. If the difference between the two (net present) values is positive and higher than the invested amount, the market

5 Judgement in Joined Cases T-228/99 and T-233/99 [2003] ECR II-435 et seq.

6 Commission communication to the Member States: Application of Articles 92 and 93 of the EEC Treaty and of Article 5 of Commission Directive 80/723/EEC to public undertakings in the manufacturing sector (OJ C 307, 13.11.1993, p. 3; see paragraph 11. Although this communication deals expressly with manufacturing, the principle doubtless applies likewise to all other sectors of the economy. As regards , this approach was confirmed by a number of Commission decisions, e.g. in Crédit Lyonnais (OJ L 221, 8.8.1998, p. 28) and GAN (OJ L 78, 16.3.1998, p. 1). 7 See footnote 5.

value of the firm increases due to the investment. It can then be concluded that a private investor acting in a market economy would find acceptable to provide the share capital on the same terms and the investment can be considered to be market conform.

1.2.2. Valuation of BayernLB with and without capital injection

(27) In order to apply the market economy investor principle the Commission decided to use the Discounted Cash Flow / Dividend Discount Model valuation methodology in order to determine the market value of the bank’s business with the capital injection and without the capital injection. If the difference between the two (net present) values is positive and higher than the invested amount, the market value of the bank increases due to the capital injection. The Commission considers that a private investor acting in a market economy would then find acceptable to provide the share capital on the same terms and that the investment could be considered to be market conform.

(28) The Discounted Cash Flow / Dividend Discount Model valuation methodology is chosen because it is a standard method to determine the value of a company. The DDM valuation methodology is a variant of the Discounted Cash Flow methodology for the valuation of financial institutions taking into account their specificities. Because of supervisory requirements and rating aspects a bank’s business can only grow to an extent that it is still underpinned by an appropriate level of own capital. The DDM thus determines a bank’s value through discounting the future distributable dividends, i.e. the annual surplus less the own capital needed. The thus established value is future oriented and accordingly should theoretically be the correct manner to assess the future earnings potential.

(29) Under a DDM approach, forecasted distributable dividends are discounted back to the present date, generating a present value for the dividend stream of the bank. A terminal value at the end of the explicit forecast period is then determined and that value is also discounted to the valuation date to give an overall value of the business. In a DDM analysis, the forecast period should be of such a length to enable the business to achieve a stabilised level of earnings. Typically a forecast period of at least five years is required.

(30) The Commission takes the view that this method is appropriate to carry out the assessment of an envisaged investment in share capital of a specific company because it reflects an ex-ante approach commonly used by institutional market players planning to invest significant amounts of cash money. This approach is not be confused with an ex-post assessment of an investment that had been implemented without any such ex-ante analysis of the expected returns taking into account the business plan and where, therefore, only fixed remuneration could ensure a market return for the investor.

(31) BayernLB engaged Rothschild to evaluate, on the basis of BayernLB’s mid- term planning, the market conformity of the capital injection. To this end Rothschild evaluates BayernLB’s business including a capital increase (post- money) as well as without a capital increase (pre-money).

The valuation of BayernLB with capital injection

(32) Rothschild’s starting point for the valuation is the mid-term planning established by BayernLB which takes into account the capital increase (post- money scenario). This mid-term planning covers the usual 3-years-period, i.e. 2005 to 2007, and contains detailed projections regarding the main income, cost and result elements. Rothschild does a plausibility check of the mid-term planning of BayernLB and adjusts certain items. Rothschild furthermore extrapolates the assumptions and figures to also cover the period 2008 to 2010. For the years after 2010 sustainability was assumed.

(33) The main adjustments done by Rothschild following its plausibility check of BayernLB’s mid-term planning concerned the administrative costs and the cost income ratio as well as the risk margin (on risk weighted assets). Rothschild assumes […]∗ .

(34) Rothschild establishes three post-money scenarios about the future development of BayernLB: upside, downside and Rothschild. The upside scenario corresponds largely to the management planning of BayernLB. The main assumptions for the scenarios are:

− Rating of A/A+ in all scenarios;

− Increase of ACE ratio from […] % in 2004 to […] % in 2010 in all scenarios;

− Sustainable growth rate of 2% after 2010 in all scenarios;

− Growth of risk weighted assets (RWA) from € 113 billion in 2004 to € […] billion in 2010 in the upside scenario, to € […] billion in the Rothschild scenario and to € […] billion in the downside scenario; RWA had been reduced in 2002 and 2003;

− Net interest margin: slight increase of margin in upside scenario, constant margin of […] bps in Rothschild scenario and slightly decreasing margin in the downside scenario;

− Provision income: significant growth (more pronounced growth in upside scenario and lower growth in downside scenario); currently the provision income of BayernLB is significantly below the average of the Landesbanken;

− Cost income ratio: between […] % in upside scenario and […] % in downside scenario in 2010; BayernLB already now has one of the lowest cost income ratios among the Landesbanken;

− Risk margin: constant risk margin of […] bps in upside scenario, of […] bps in Rothschild scenario (average of Landesbanken and commercial banks)

∗ Confidential information, marked by […] also below.

and of […] bps in downside scenario; historically the risk margins of BayernLB have been significantly higher.

(35) The individual steps of the DDM calculations for all scenarios (upside, downside, Rothschild) are the following

− Rothschild uses a discount rate of 9.2% until 2009 and a discount rate of 10.5% from 2010 onwards. The discount rate was calculated as the costs for equity based on the CAPM8 with a risk free rate of 3.7% until 2009 and of 5.0% from 2010 onwards, a market risk premium of 5.0%, and a Beta of 1.19. The Beta is based on Rothschild’s view on BayernLB’s systematic risk and backed by an analysis of Beta factors of comparable but listed European banks (EuroStoxx Banks).

− Rothschild thus calculates the discounted dividends for the period 2005 to 2010.

− Furthermore, Rothschild calculates the present value of the so-called terminal value (“TV”); the TV is the dividend per annum for the sustainable period (after 2010) divided by the cost of equity minus the growth rate assumed for the scenario (2%)10.

− To arrive at the full DDM valuation for one scenario Rothschild finally added to the total of the discounted dividends the present value of the TV.

(36) Rothschild establishes the value of BayernLB in the post-money scenario at € […] in the upside scenario, € […] in the Rothschild scenario and € […] in the downside scenario.

The valuation of BayernLB without capital injection

(37) Once the value of BayernLB in the post-money scenario is established Rothschild determines the value of BayernLB in a pre-money scenario. For a pre-money scenario it is assumed that BayernLB would reduce its business volume in accordance with the lower capital available and would keep the target ACE ratio of BayernLB unchanged when compared to the post-money scenario. Keeping the same ACE ratio is considered necessary to sustain a rating of A/A+ also in the pre-money scenario as a lower ACE ratio would create a threat of a downgrade of BayernLB. Rothschild focuses on the ACE capital approach used by Standard & Poor’s because as pointed out above rating agencies use this indicator to determine the level of capitalization.

(38) For the calculation of the pre-money scenario all margins and ratios are assumed constant leaving BayernLB a smaller bank with a smaller capital base but with identical business mix and capital ratios as in the post-money case. Rothschild

8 CAPM = Capital Asset Pricing Model

9 Discount rate = risk free rate + Beta x market risk premium

10 TV = dividend / (cost of equity – growth rate)

considers that a reduction of business only in one area would not be possible as there is an important correlation between the loan book of BayernLB and its opportunity to cross-sell other products.

(39) Following lower capital of EUR 640 million as the capital increase is not taken into account and under the assumption of a constant target ACE ratio, BayernLB’s business volume measured in risk weighted assets (RWA) will contract. Following a reduction of RWA, the earnings will equally decrease.

(40) While reduced business volume inevitably leads to lower revenues, Rothschild assumes that there is no full cost flexibility as many components of BayernLB’s cost base are not flexible. Rothschild assumes a cost flexibility of 50%.

(41) On the basis of the above Rothschild calculates that BayernLB’s value is reduced by EUR […] in the pre-money scenario compared to the post-money scenario. This value reduction is higher than the planned capital increase of EUR 640 million. In other words, the capital injection of EUR 640 million will lead to an increase of EUR […] of the bank’s value.

(42) Rothschild carries out a sensitivity analysis with respect to its assumption on the cost flexibility. Even in the case that costs can be reduced in line with the cost income ratio, i.e. a cost flexibility of 100%, the negative value impact would be EUR […] which is higher than the capital increase of EUR 640 million.

(43) The value increase due to the investment therefore clearly exceeds the value of the equity investment of EUR 640 million.

(44) The Commission has no reason to doubt the method and estimates used for the valuation including the parameter to calculate the cost of equity on the basis of the CAPM. The BdB submitted comments criticising the used method for determining the beta factor, in particular the calculation of the arithmetic average, and arguing that the applied Beta factor would be too high. In this context the BdB points out that the Beta factor which was applied in the decision of 20 October 2004 was significantly lower (0.593 on 31 December 1994 and 0.475 on 31 December 1995).

(45) The Commission does not agree with this criticism. The Commission points out that the Beta factors used in the decision of October 2004 relate to the asset and capital transfer that occurred in 1994 and 1995. Consequently, the Beta factor agreed upon was supposed to reflect the situation of BayernLB at that time. In addition, Rothschild establishes the Beta factor for BayernLB on the basis of comparable banks. The Commission does not see any reasons for doubting the applied method for determining the Beta factor.

(46) The Commission also notes that in case a lower Beta factor would be applied to calculate the value increase on the basis of the DDM, this would result in an even higher value increase resulting from the capital injection than in the analysis presented above.

1.2.3. Plausibility check of valuation with market multiples

(47) The valuation is subject to a plausibility check with market multiples. The market or trading multiples valuation methodology values the company based on multiples at which similar companies (“peers”) trade on the stock market. The value is expressed as a multiple of the net income, operation income or book value. Rothschild calculates the price/earnings (“P/E”) multiple and applies it to the normalised net income of BayernLB.

(48) Rothschild defines a comparable group of publicly listed financial institutions in Europe for the calculation of the P/E multiple. It calculates the median of this P/E multiple at 12x, the first quartile at 10.9x and the third quartile at 12.9x. The application of these multiples to BayernLB’s net income results in an equity value of BayernLB between EUR […] and EUR […] The result based on the P/E multiple is comparable with the “fair” equity value derived from the DDM which ranges between EUR […] and EUR […].

1.2.4. Return on equity

(49) The DDM analysis measures return on equity (post-tax) using net income (i.e. income after tax) and average ACE. ACE is used because it is considered as a suitable approximation of the tangible equity and is not distorted by silent participations. Unadjusted return on average ACE (RoaACE) will thus grow from […] % in 2005 to […] % in 2010. As […] and […] 11 distort earnings for the projected period, Rothschild calculates also the normalised earnings eliminating both effects. Normalised RoaACE is […] % in 2005. Over the projection period, normalised RoaACE is relatively constant at around […] %.

(50) In that context it should however be noted that the RoE is not the decisive criterion for an investment. A rationally acting investor would base the decision to invest primarily on the return earned on his investment rather than on the RoE of the underlying asset. The price at which the investor makes his investment and the subsequent exit would be additional critical factors that would determine the return on investment (RoI).

(51) The Commission includes the RoE in its assessment only as an additional indicator, not as the decisive criterion, which is the valuation analysis based on the methodology outlined before.

1.3. Result

(52) The Commission considers that the valuation by Rothschild is in line with the Commission’s requirement of a DDM valuation methodology. It also considers that the assumptions and estimates of the pre-money and the post-money scenario are realistic. The valuation by Rothschild shows that the value created by the investment (beyond the servicing of cost of equity of 9.2% until 2009 and of 10.5% from 2010 onwards) is above the value of the equity investment of EUR 640 million.

11 […]

(53) The Commission therefore comes to the conclusion that a private investor would find acceptable providing the capital increase under the same terms and that the market economy investor principle is fulfilled.

(54) The Commission thus considers that the planned capital increase of EUR 640 million by the Free State of Bavaria and the Sparkassenverband Bayern conforms to the behaviour of a market economy investor and does not favour BayernLB. It therefore does not constitute State aid in the meaning of Article 87(1) of the Treaty.

2. Effectiveness of the Commission's recovery policy

(55) As indicated in paragraph 4 above, during its assessment, the Commission took into account the need to ensure that the increases of capital concerned did not undermine the effectiveness of its recovery policy. The Commission is satisfied that the illegal aid granted to BayernLB has been entirely recovered on 12 January 2005. Furthermore, the State guarantees have been abolished on 18 July 2005.

(56) Both from the standpoint of payment and accounting, the capital increase take effect only after that date. The capital increase has been subjected to a robust analysis and found to be entirely in accordance with the market economy investor principle, and thus does not contain any element of State aid. Accordingly the Commission is satisfied that this is the case.

IV. DECISION

(57) The Commission has accordingly decided that the capital increase of EUR 640 million by the Free State of Bavaria and the Sparkassenverband Bayern does not constitute State aid.

(58) If this letter contains confidential information which should not be disclosed to third parties, please inform the Commission within fifteen working days of the date of receipt. If the Commission does not receive a reasoned request by that deadline, you will be deemed to agree to the disclosure to third parties and to the publication of the full text of the letter in the authentic language on the Internet site: http://europa.eu.int/comm/sg/sgb/state_aids/. Your request should be sent by registered letter or fax to:

European Commission Directorate-General for Competition State aid Greffe B-1049 Brussels Fax No: + 32-2-296.12.42

Yours faithfully, For the Commission

Neelie KROES Member of the Commission