Global Economics

German Banks Cash in on the Crisis

The government has provided billions in backing, yet some critics say banks still aren't lending enough or passing on lower interest rates



The new attacks on banks have been prompted by the fact that base rates are at a historic low and that central banks are injecting money into the market like never before. In the last week alone, the European Central Bank (ECB) allocated the record sum of ??442 billion ($619 billion) to 1,100 financial institutions??t a paltry 1 percent interest rate.

And yet the money is not going where the central banks want it to go, namely into the pockets of businesses and consumers??t least not at reasonable interest rates.



Are the banks taking advantage of the crisis to turn a profit??t the expense of the very citizens to whom they owe their survival?

Previously Unimaginable Sums

It is now almost two years since the financial crisis began in Germany with the government's dramatic bailout of IKB Deutsche Industriebank. IKB was one of the many banks around the world who had speculated unwisely, investing billions and even trillions in new, supposedly safe securities that were essentially nothing but repackaged and securitized loans to so-called subprime borrowers. When the bubble burst, the financial world teetered on the brink of collapse.

If the government had not come to their rescue with previously unimaginable sums, many banks would no longer exist today. The German government has already spent a total of ??760 billion ($1.06 trillion), in the form of loan guarantees and bailouts, and it even took a 25 percent stake in Germany's second-largest bank, Commerzbank (CBKG.DE). To limit the consequences for the real economy, the government also spent billions on economic stimulus programs.

The bill for taxpayers is equally enormous. In the coming year, the federal government will have to borrow ??86 billion ($120 billion)??s opposed to the ??6 billion ($8.4 billion) figure that was planned before the crisis. Politicians, as well as central bankers, business owners and, most of all, citizens, expect something in return: a functioning financial system??nd low-interest loans.


Nevertheless, the economic crisis threatens to get even worse, because the credit system is still not working the way many politicians specializing in financial issues believe it needs to, if greater damage is to be prevented.





Toxic Assets and Hidden Losses

Banks still have unimaginable amounts of toxic securities on their balance sheets. The International Monetary Fund (IMF) estimates that potential global write-downs resulting from the financial crisis could be over $4 trillion (??2.85 trillion). Crisis-related write-downs to date amount to only about $1.5 trillion (??1.1 trillion).


So-called "bad" banks are companies into which banks can deposit their toxic securities. This removal of troubled assets from balance sheets frees up equity capital otherwise needed as a buffer against risk. It also prevents banks from being further downgraded by the rating agencies, which would mean that they would have to establish even larger buffers.


All other potential losses are estimated and must be paid in installments over a 20-year period. A bank is only permitted to pay a dividend if its profits exceed the payment it owes the federal government. But a bank that is restricted in this way would be unable to raise money on the capital markets??nd therefore would have no capital to invest. In the worst case scenario, the bank would exist in a comatose state for decades.

More generous rules were not feasible, for political reasons. Bank bailouts are unpopular??specially at the moment, when parties are campaigning in the run-up to Germany's Sept. 27 national election. It is difficult to convince voters that such aid averts far more serious consequences, especially when banks are reporting profits and their share prices are rising sharply.

The current debate over an amendment of the law governing Germany's ailing state-owned regional banks, the Landesbanken, is even more strongly marked by partisan interests. Ironically, it was precisely these publicly owned banks that enthusiastically snapped up the exotic high-yield securities that have since proven to be toxic during the boom years. Should they be written down, some of the state-owned banks would be forced into bankruptcy. And should a Landesbank go bust, the state that owns it could also go bankrupt, a scenario which currently looms over the northern state of Schleswig-Holstein, for example.

Hence the state-owned banks are in particularly urgent need of a way to dispose of their toxic assets. Finance Minister Peer Steinbr??ck is aware of this, and he is demanding something in return. He wants the governors of the states in question to finally move forward on a long-overdue consolidation of the Landesbanken. But the governors, who perceive the pressure from Berlin as unreasonable intervention, want to be allowed by law to establish their own bad banks??hile at the same time wanting the federal government to take on much of the risk associated with those institutions.


The Capital Trap

Two years since the start of the financial crisis, many banks are still on the brink of disaster??ith devastating consequences for the real economy. Hans-Werner Sinn, the president of the influential Munich-based Ifo Institute for Economic Research, sees the "under-capitalization of the banking system and the high levels of hidden losses that have not yet been disclosed" as the main obstacle to Germany's further economic development.





A similarly disastrous development is beginning to emerge among companies. According to Creditreform, a German company that collects creditworthiness data, 16,650 companies with a total of 250,000 employees have had to file for bankruptcy since the crisis began. Experts predict German banks will be hit by up to ??170 billion ($238 billion) in recession-related loan defaults by the end of next year.

The effect on bank balance sheets is devastating. Their relatively thin equity capital reserves are either evaporating or suddenly being tied up as mandatory reserves??hanks to Basel II, an international set of regulations which banks agreed to in 2005 and which came into force at the beginning of 2007.


A Gift to Gamblers


The formula used to compute the required equity reserve for a security with a face value of ??1 million ($1.4 million), with US mortgages as collateral, demonstrates how brutal the mechanism is. If the US rating agency Moody's (MCO) issues its highest rating, Aaa, the bank only needs to keep ??5,600 ($7,840) of its capital in reserve for the security. But if Moody's lowers its rating by 10 levels to Ba1, the required reserve increases to ??200,000 ($280,000). And if the rating drops even lower, to B1, the bank must keep the full value of the security, ??1 million ($1.4 million), in reserve. A different computation factor applies to corporate loans, but the logic remains the same.

Politicians have been up in arms over these balance-sheet restrictions for weeks. Two Sundays ago, the SPD's state floor leaders from Hesse, Bavaria and Baden-W??rttemberg called for a temporary suspension of Basel II for banks. According to the three politicians, Thorsten Sch??fer-G??mbel, Franz Maget and Claus Schmiedel, the rules only exacerbate the difficulties companies face in securing loans at favorable terms.




But in the current situation, German banks must either record the reduction in the value of assets on their profit and loss statements or see their revaluation reserves rapidly shrink??ogether with their capital base. This clearly benefits competing banks in France and Great Britain.

The government-supported Commerzbank, for example, showed more than ??22 billion ($31 billion) in equity capital on its Dec. 31, 2008 financial statement. But because of the bank's negative revaluation reserve of ??2.2 billion ($3.1 billion), CEO Martin Blessing was forced to book only ??19.9 billion ($27.9 billion). The difference at rival Deutsche Bank (DB), on the same date, was ??882 million ($1.23 billion), while at Postbank, which Deutsche Bank acquired, it was ??724 million ($1 billion).

If Weimar has his way, this mechanism will be eliminated, a move Steinbr??ck supports. He has told Weimar that the federal government is "fundamentally open" to adjustments, and that the appropriate authorities would "intensively expedite" the necessary efforts. A Finance Ministry spokeswoman confirmed, however, that the banking industry will be consulted before any final decisions are reached.

Relief is urgently needed, or else equity capital will continue to shrink and banks will have to restrict lending even further??ith the consequence that even more companies will go out of business and even more business loans will have to be written off, causing capital bases to shrink even further. In other words, the crisis will become self-perpetuating.


This makes it all the more tempting for banks to invest the money to turn a profit. "This is a real free lunch," comments one Frankfurt banker who did not want to be named. It is also a gift to gamblers and speculators within the banks, who are apparently prepared to put up with a bit of public outrage for the sake of such a profitable opportunity.

Besides, the banks are largely immune to criticism of their behavior. For instance, consumer advocates have been outraged for decades over the banks' practice of inadequately passing on base rate changes to customers. They have sharply criticized this behavior again and again??nsuccessfully, as is still evident today.



Provided, that is, they have enough capital to survive.

Translated from the German by Christopher Sultan

The Good Business Issue
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