The failure of German banking

Published in Business Spectator (Melbourne), 30 September 2010

In which country would you expect to find that 15 of the largest 20 banks are state-owned or part-nationalised? If this reminds you of socialist economies like Venezuela or Cuba, have another guess. In fact, the country in question is Germany.

The involvement of German state and federal governments in banking precedes the financial crisis. It has long been one of the defining features of the country’s financial sector. It is a characteristic that bewilders international observers, who aren’t used to such a degree of state intervention. And now it has also become one of the main vulnerabilities of European banking.

The financial crisis has hit the state-owned banks hard, and new banking rules under the Basel III agreement could be the final nail in the coffin of Germany’s antiquated financial system. But the damage has already been done.

The weakest links in German banking are the Landesbanken – regional, state-owned banks. In post-war West Germany, all federal states (Länder) had established their own government banks such as BayernLB for Bavaria or WestLB for North Rhine-Westphalia.

The Landesbanken busiess model, if you could call it that, was built on providing capital to state governments, funding politically desired projects and supporting local businesses. Being profitable was never a primary goal. Nor were public bankers particularly concerned about ensuring a proper capital base.

Until 2005, the public bankers benefited from guarantees for their activities by their state owners. This allowed them to act under the protection of their respective governments’ triple-A ratings – irrespective of the banks’ dubious balance sheets. The result was as predictable as it was scandalous: the public bankers used their guarantees to refinance themselves cheaply on international markets, then used those funds for purposes outside their directives.

For the Landesbanken, no risk was too high, no investment to murky, and no market too remote. It was just too tempting to use the leverage between cheap capital and supposedly highly-profitable investments. Unsurprisingly, the risk appetite of the Landesbanken led to spectacular mistakes.

Düsseldorf-based WestLB, for a while Germany’s third-largest bank, is the best example. It was originally tasked with supporting the regional economy between Cologne and Dortmund, it was remarkable how often it was affected by international developments. The Asian Financial Crisis and the Enron scandal both cost the bank hundreds of millions of Deutschmarks.

WestLB’s venture into British investment banking early last decade was equally disastrous. At one stage, the regional bank held stakes in a UK cinema chain, a pub group, a water utility, a whiskey maker and was also involved in the construction of the new Wembley stadium. It all ended in tears when WestLB lost £347 million through its engagement in a British television rental company. It was a business blunder which cost the then chief executive his job, and it is still the subject of court trials for breach of trust.

None of these engagements were related to, let alone warranted by, the regional bank’s original task of supporting the local economy. That they nevertheless happened, ultimately at the risk of German taxpayers, can only be explained by a combination of two factors: lax controls of the bank’s activities by boards and regulators, and the institute’s symbiotic relationship with state government officials.

Given this background, it was only logical that Germany’s Landesbanken were also the country’s most seriously affected banks in the financial crisis. It is difficult to know precisely how much toxic debt has accumulated within Germany’s public banking sector, but last year, banking regulator BaFin estimated their exposure to be as high as 355 billion euros.

As a direct result of the crisis, the Landesbanken are now desperately trying to merge with each other. The first victim was Saxony’s SachsenLB which had to be taken over by the state bank of Baden-Württemberg LBBW two years ago in an emergency merger. Last week, WestLB and BayernLB announced their intention to negotiate a possible merger. WestLB is under intense pressure anyway since the EU commission had only allowed it state aid on the condition that it is sold to new owners by next year.

Whether a union of sick banks can create a healthy financial institution is another question. This week, Spiegel magazine reported that the EU commission had expressed grave concerns to the German government about the long-term viability of the Landesbanken. It now appear unlikely that Brussels will rubber-stamp any future subsidies for them. To make matters more difficult, new capital adequacy ratios under the Basel III agreement will lead to enormous capital needs for many Landesbanken.

Germany’s public-sector banks have become one of the biggest risks for the German and European economy. The recapitalisation of the sector will be costly and painful. It could also make it difficult to provide credit to business.

Despite positive economic data recently reported from Germany, the country’s financial crisis is far from over. On the contrary, it could re-emerge any minute.

For the rest of the world, the German public banking disaster at least holds one lesson: politicians are no better at running banks than traditional bankers.