LBBW, the German public-sector bank, has agreed to buy Sachsen LB, bailing its smaller peer out of its exposure to volatile credit markets in a deal that could spark consolidation in the country's fragmented banking industry.

Landesbank Baden-Württemberg, based in Stuttgart, said on Sunday that it would pay €250m ($342m) as an "immediate measure" for its Leipzig-based rival. The final price - which the state of Saxony said would be settled at the end of the year - remained unclear, but could be €300m-€800m, according to LBBW's state owners.

Banks in Germany have been hard hit by the recent volatility in credit markets, with Sachsen LB the second lender - after Düsseldorf-based IKB - to be bailed out. The state of Saxony said market volatility had shown that the bank was too small.

Eastern Germany, like the rest of the country, has traditionally relied on regional state-backed funding for its
Mittelstand (SME) companies. But the sale of Sachsen LB leaves the most economically challenged part of the country with no Landesbank of its own.

This month, Germany's public-sector savings banks
took over a €17.3bn credit facility that Sachsen LB had pledged to an off-balance sheet fund it operated.

As part of Sunday's deal, LBBW has secured a right to cancel the sale and return Sachsen LB to its previous owners if more losses from investments in capital markets are unveiled.

The takeover will cement LBBW's position as Germany's biggest Landesbank ahead of its southern rival BayernLB.

Unlike many other Landesbanken, which pursued growth in new markets and products, LBBW has focused on dominating its home region in south-west Germany. It was created from the merger of the wholesale-focused Landesbank and Stuttgart savings bank in 1999.

The takeover of Sachsen LB marks a shift in its expansion under Siegfried Jaschinski, its ambitious chief executive.

Mr Jaschinski wants to be the driving force in the long-awaited consolidation of the Landesbank sector, and will line up to bid for WestLB, the Düsseldorf-based Landesbank, which is hiring strategic advisers for a potential sale.

A combination with WestLB would catapult LBBW from Germany's fifth-biggest bank by assets today to the number two slot, behind Deutsche Bank but ahead of Commerzbank.