'A Real Free Lunch' How German Banks Are Cashing In on the Financial Crisis

By Beat Balzli, Armin Mahler and Wolfgang Reuter

Part 3: A Gift to Gamblers

Under Basel II, banks are permitted to set aside fewer reserves for loans to customers with strong creditworthiness than to those with lower credit ratings. In a crisis, however, the solvency of almost all customers declines. As a result, banks in a downturn must constantly increase their equity reserves to be able to satisfy the requirements for existing loans. In many cases, they can only do so by not extending expiring loans.

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 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-Württemberg called for a temporary suspension of Basel II for banks. According to the three politicians, Thorsten Schäfer-Gümbel, Franz Maget and Claus Schmiedel, the rules only exacerbate the difficulties companies face in securing loans at favorable terms.

Senior government officials in Berlin are all too familiar with the sensitive nature of the issue. But they also know that it is impossible for a country to go its own way when it comes to Basel II.

The German Finance Ministry is currently examining options to "provide banks with short-term relief regarding the capital requirements during this severe economic crisis," according to a letter Karlheinz Weimar, the finance minister of the state of Hesse, received two weeks ago. But the federal Finance Ministry officials also pointed out that any such efforts would have to reflect the fact that the capital requirements that apply in Germany are based, for the most part, on international and European rules "that are difficult to change in the short term."

Weimar wrote to German Finance Minister Peer Steinbrück in late May, pointing out a specific German accounting problem. In Germany, unlike most other EU countries, so-called revaluation reserves are included as part of equity capital. This doesn't present a problem as long as the stock markets are booming and security portfolios are showing high returns. Reserves increase, the capital base virtually grows by itself and bankers are perfectly happy.

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 -- together 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, 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 Steinbrück 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 -- with 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.

For many business customers, this means that they don't stand a chance of getting any money from banks, regardless of the interest rate or how much liquidity the central bank makes available.

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 -- unsuccessfully, as is still evident today.

Since last October, the average interest rate for overdraft loans to private households has declined by about one percentage point, from 12.1 to 11.0 percent, according to the German Bundesbank. Rates on consumer loans have dropped by 0.5 points to 5.3 percent, while rates on mortgages with a maturity of up to five years have declined by 1.4 percentage points to 4 percent, meaning that rate is almost at a historic low for Germany.

But the ECB's key interest rate has been reduced much further, falling by 3.25 percent in the last 12 months. In other words, this crisis is not that bad for banks after all.

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

Translated from the German by Christopher Sultan


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