Crumbling Pillars Trouble Ahead for German State-Owned Banking System

The near-collapse of SachsenLB, Saxony's state bank, uncovered major flaws in the German state-owned banking system. The banks are inflexible, outdated and lack a convincing business model. Consolidation may be on the way.

By Beat Balzli, Wolfgang Reuter and

The two meetings were strictly confidential. They were not marked on anyone's schedule, none of the attendees was permitted to take notes, and there were no minutes available once they were finished. Jürgen Rüttgers, the governor of the state of North Rhine-Westphalia, and Roland Koch, his counterpart from the state of Hesse, had only brought along their planning directors. No one was to have the opportunity to sabotage the plan the two men eventually fleshed out.

The skyscraper housing Landesbank Hessen-Thueringen -- also known as Helaba -- in Frankfurt.

The skyscraper housing Landesbank Hessen-Thueringen -- also known as Helaba -- in Frankfurt.

In the end the two governors, both Christian Democrats, shook hands to seal their agreement to approve a merger of their respective state-owned banks, WestLB and Landesbank Hessen-Thüringen (Helaba). Koch promised Rüttgers that he would stand behind the agreement, even if it ended up being a thorn in his side in the current election campaign.

Both men know that the beleaguered WestLB is no longer the central issue. Nothing less than the future of the entire public banking system in Germany is on the line. Under the agreement, the two banks pledged to support each other financially, which essentially means that if one bank is at risk the other bank will bail it out.

But if a number of these state-owned banks run into financial difficulties, it could jeopardize the entire system. Although this scenario was considered extremely unlikely until now, the American subprime mortgage crisis has done more than just upset worldwide financial systems. It has also mercilessly exposed the weaknesses of state-owned banks in Germany.

Desperate Attempt

The most spectacular losses in this crisis have been limited primarily to non-German financial institutions until now. For instance, Citigroup, one of the world's largest banks, has already been forced to write off $17.5 billion (€12.2 billion) in bad debt. Merrill Lynch and Morgan Stanley have had to take write-offs of $8.4 billion and $2.4 billion, respectively. Last week the prominent Swiss bank UBS added another €10 billion to its existing write-offs.

The world's key central banks did what they could to help ease the crisis. In a concerted move, European Central Bank President Jean-Claude Trichet and US Federal Reserve Chairman Ben Bernanke injected fresh, low-interest cash into the credit markets to avoid liquidity shortfalls. But this effort only helps offset the banks' most serious problems, while at the same time making it clear that the situation is precarious. Germany, and especially its state-owned banks, has been especially hard-hit.

Last week the relevant officials launched a desperate attempt to save another ailing state-owned bank, SachsenLB. Incompetent and overstressed managers had driven the bank to the brink of ruin with irresponsible investments running into the billions.

SachsenLB's struggle to survive began two Saturdays ago in the eastern German city of Dresden. Siegfried Jaschinski, the head of the state-owned bank Landesbank Baden-Württemberg (LBBW), attempted to cash in on the bank's woes. After its risk ratings had mushroomed almost weekly, Jaschinski demanded that the state of Saxony provide loan guarantees for at least €4.3 billion. Otherwise, he said, LBBW would pull out of a deal to acquire SachsenLB.

But Stanislaw Tillich, the finance minister for the state of Saxony, refused at first to furnish Stuttgart-based LBBW with more than €1 billion in guarantees. Tillich reiterated his position on Monday in a second round of negotiations in the offices of Jochen Sanio, the president of the German Federal Financial Services Authority (BaFin). But Jaschinski's team refused to back down from its demand for the higher amount of €4.3 billion.

Unclear Fate

Sanio concluded the negotiations by setting an ultimatum: Unless he was presented with a solution by the weekend, he would shut down SachsenLB.

Germany's Sparkasse Group: The Quiet Giant.

Germany's Sparkasse Group: The Quiet Giant.

The final marathon round of negotiations took place last Wednesday at BaFin's Frankfurt offices, where the state government and bank executives haggled until the early morning hours. Sanio and Axel Weber, the head of the German Central Bank, the Bundesbank, moderated the negotiations.

Georg Milbradt, the Christian Democrat governor of Saxony, joined the group at midnight, and an agreement was fleshed out in the late-night session at roughly 3:15 a.m. The state of Saxony agreed to provide guarantees of up to €2.75 billion as security against losses. To circumvent the state parliament in Saxony, the guarantee will be broken down into two payments. Reducing the individual sums involved in this way means that only the approval of the state budget committee, which Milbradt will likely win over, will be needed. But what this move will do to Milbradt's political fate remains unclear.

Not everyone is convinced that the guarantee will be sufficient. If SachsenLB suffers even more losses, LBBW will be required to bail out the bank for up to €6 billion. After that, the remaining state-owned banks and DekaBank would be required to step in. The relevant parties are negotiating the distribution of the burden at a closed-door meeting in Berlin on Wednesday.

New Ideas Needed

One thing is clear: Many state-owned banks are not even in a position to help in a bailout. Most of them have also been involved in high-risk deals with US mortgage-backed securities. In fact, the state-owned banks have committed significantly larger shares of their assets to these investments than the private banks.

This is because in the past the government was generally liable for the state-owned banks, which enabled them to lend money at lower rates. But when government liability for the state-owned banks was eliminated in 2005, the banks lost their old business model and its capacity for attracting borrowers. They were urgently in need of new ideas.


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