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

Central banks are making trillions in unusually cheap money available to banks in a bid to restore liquidity to the financial system. But institutions are not passing on the cash to their customers, choosing instead to invest it and make a fat profit.
Von Beat Balzli, Armin Mahler und Wolfgang Reuter

These days, bankers are used to bad press and being scolded by politicians. There's been no shortage of either in the past week.

"Banks Hoard Money," was the headline on the cover of the Financial Times Deutschland, while the tabloid Bild sharply condemned the "Outrageous Overdraft Interest Rates." Consumer Protection Minister Ilse Aigner railed: "It is unacceptable that the financial industry takes months to pass on reductions in the key interest rate, when it only takes a few days to pass on key interest rate increases."

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 -- at 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 -- at least not at reasonable interest rates.

Instead, many companies are struggling to survive because their loans and credit lines are not being extended. Meanwhile, citizens are outraged that they are still expected to pay double-digit interest rates on their overdrafts.

It seems clear that the banks would rather invest the cheap money they can borrow from central banks in safe investments, such as German government bonds offering 2.5 percent interest, than lend it to companies whose prospects, in the middle of a recession,  are anything but rosy. And they are also lining their pockets with the fees they charge customers who are forced to go overdrawn as a result of the crisis.

Are the banks taking advantage of the crisis to turn a profit -- at 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. 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) -- as 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 -- and low-interest loans.

This is especially true now that the banks seem to have survived the worst of the crisis. In the United States, many banks have started to repay the money they received from the government under the Troubled Asset Relief Program (TARP). After last year's record losses, many institutions have reported respectable profits for the first few months of 2009, and the banks' share prices, which had fallen to all-time lows in January, have since doubled.

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.

Ilse Aigner has asked officials in her ministry to carefully examine and document the behavior of financial institutions. She plans to release the results of the study to the public. In her view, banks that do not pass on interest rate reductions to their borrowers are operating in legally shaky territory. Her position is based on an April ruling by the German Federal Court of Justice, according to which banks cannot set variable interest rates and fees at their own discretion.

Even Axel Weber, the chairman of Germany's central bank, the Bundesbank, is relying on public pressure. He knows that banks have steadily tightened their requirements for the creditworthiness of borrowers in recent weeks and months. And he also knows that much of the money the banks have borrowed from the ECB is not reaching businesses and bank customers.

In a startling move, Weber called upon the banks to pass on interest rate reductions. Otherwise, he said, "central banks will be forced to circumvent the banks and take direct measures to support the economy."

That's something they will in fact probably have to do, should politicians fail in their attempts to stabilize the financial sector. Despite the current profits and rising share prices, the banking crisis is far from over.

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).

Although new, more generous write-down rules have eased the problem, they have not solved it. And the real solution, the establishment of functioning bad banks, is something the German government has been struggling with for months.

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.

In return for relieving the banks of their toxic assets, Germany's center-left Social Democrats, and some members of the center-right Christian Democrats, have pushed through strict rules that would hamper the banks for years should they participate in the bad bank program. Under one of these rules, the banks are required to immediately pay the federal government 10 percent of the book value of the transferred securities. Exceptions are only permitted if such a payment would reduce a bank's capital base to such an extent as to sharply curtail its ability to compete.

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 -- and 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 -- especially 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 Steinbrück 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 -- while at the same time wanting the federal government to take on much of the risk associated with those institutions.

It is unclear how the dispute will end. If the legislation is not passed, the German parliament, the Bundestag, will be forced to convene during the summer recess to save one or perhaps several of the state-owned banks from bankruptcy.

The Capital Trap

Two years since the start of the financial crisis, many banks are still on the brink of disaster -- with 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.

No matter how much additional liquidity ECB President Jean-Claude Trichet and his staff pump into the market, banks' capital ratios remain a limiting factor when it comes to issuing credit.

The core capital ratios of German banks have declined in the wake of the crisis, but many are reluctant to bolster their capital base with the help of the government's special Financial Market Stabilization Fund, known as Soffin. The program has significant strings attached, including restrictions on bankers' salaries. Other countries, like the United States, have taken a more rigorous approach, forcing their banks to accept an injection of government capital.

A bank is only permitted to lend money or sell debt securities if a certain portion of the underlying funds is backed by bank capital. The riskier a loan or customer, the more capital the bank is required to keep in reserve as collateral.

The credit ratings of US subprime mortgages or corporate borrowers are now declining faster and faster. The repackaged and resold mortgages on houses in low-income neighborhoods in the United States often lose their entire value at one go.

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 -- thanks to Basel II, an international set of regulations which banks agreed to in 2005 and which came into force at the beginning of 2007.

Basel II was created to make it more difficult for banks to issue loans recklessly, in a bid to prevent crises. Now it is only making the current crisis worse.

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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