Germany never participated in the upswing of the housing bubble. This fact has led German politicians of all stripes to mistakenly believe their banking system was somehow immune to the problems infecting bubble markets like the US or Spain. Unfortunately, it has not worked out that way because the globalization of finance has shifted risk far and wide within the global financial system.
German banks have long had low returns on assets with bloated balance sheet and low margins in both retail and wholesale banking, particularly at the state-owned Landesbanken. This has caused the largest German financial institutions to either move into investment banking or reach for yield abroad.
During the credit bubble years that meant loading up with higher yielding but supposedly bullet-proof AAA paper in markets like America’s residential mortgage-backed security market. Unfortunately, many of these assets were toxic. And as these market bets have gone pear-shaped for Germany’s banks, these poorly capitalized institutions have become weak, limiting their ability to serve their traditional function domestically.
To date, there has been relatively little open debate about how sick the German banks are. Sure, HRE has been nationalized and Commerzbank has been topped up with cash. But, the Landesbanken have become a bottomless pit, with repeated bailouts having been necessary. Government officials have threatened the Landesbanken. But little else has been done. Most German leaders – politicians, bankers and academics, have had their heads in the sand, thinking minimal recapitalization and reform efforts along with manoeuvres to fix a few bad apples would do the trick.
Have things now changed? Read the excerpt from an FT editorial below. It was written by the president and research director of Financial Markets at DIW Berlin, the German Institute for Economic Research. I see this as a very public call for reform by high profile German finance professionals. Let’s see what kind of response it receives.
Germany has seven independent state banks, or Landesbanken, which are jointly owned by the state governments and the savings banks. Established to provide state guarantees for regional business development, this practice was essentially outlawed by the European Commission back in 2002. Since then, Landesbanken have faced corporate governance problems. For example, the advisory boards of Landesbanken are supposed to control the top management but professional expertise plays no role in the allocation of seats. In some Landesbanken, neither the management nor the board had reliable information about their holdings of subprime mortgage products when the crisis hit.
Worse, the already doubtful sustainability of their business model – international wholesale banking – has been shattered by the financial crisis.
To compensate for their low rates of return compared to private banks of equal size, many Landesbanken before the crisis created structures to hold assets outside their balance sheets. Protected by state guarantees, they borrowed large sums of money in capital markets, which they invested in supposedly high-yielding subprime products with good credit ratings. When the products were subsequently downgraded, two state banks were forced to merge immediately. Four of the remaining seven state banks lost much of their equity and had to be bailed out by various state governments with tens of billions of euros.
This situation could get much worse: If the Landesbanken fail to clean up their balance sheets, the next decline in equity capital could prove lethal. To avert such an outcome, it is imperative to establish a “bad bank” to receive their toxic assets – and then continue the clean-up by reducing the number of Landesbanken through mergers.
The full Op-Ed is provided at the link below with recommendations and preamble lamenting a similar lack of reform-mindedness in America.
No time to waste in reforming German banking – Klaus Zimmermann and Dorothea Schäfer, FT