German Banking

Ingrid Matthäus-Maier, a member of the center-left Social Democratic Party (SPD) and the CEO of the state-owned KfW banking group, is undoubtedly in one of Germany's highest earnings brackets. Although her annual salary of €418,000 ($614,000) is substantially lower than that of her counterpart at Deutsche Bank, Josef Ackermann, who earns a tidy €13 million a year, she does earn more than twice the salary of German Chancellor Angela Merkel, who has to make do with a mere €200,000.

That's nice for Matthäus-Maier. A lawyer by profession who was a financial expert for the SPD for many years, she would not have been able to get on the board of a private bank in 1999, the year she joined the board of KfW -- she lacked the banking experience required by law. But KfW is not subject to the same regulations as other banks, which explains why Matthäus-Maier doesn't owe government auditors an explanation -- not even now, in the wake of recent public accusations that she botched the IKB crisis.

As the head of KfW, Matthäus-Maier is a major shareholder in IKB, the Düsseldorf-based bank that is on the brink of bankruptcy and is only being kept afloat by a series of government bailouts running into the billions (more...). Last week was marked by one crisis meeting after the next, but the headstrong government banker had more than the future of IKB on her mind. Indeed, she seemed more concerned about her employment contract and whether it would be extended. Her demands triggered an irritated reaction from the head of the KfW supervisory board, Economics Minister Michael Glos, as well as from others present at the meetings.

Two days later, it was announced that former IKB CEO Stefan Ortseifen could look forward to a princely retirement pension of €31,500 a month -- effectively a token of appreciation for his failures. Ortseifen, after investing billions in the high-risk US subprime mortgage sector, insisted that the "uncertainties in the American mortgage market" would have "practically no effect" on IKB's investments. A few days later, IKB was on the verge of bankruptcy, with its supposed wonderful US investments worth little more than the paper it was printed on.

And German banks are not the only ones being hard hit by the subprime crisis. In the UK, the government earlier this week announced plans to temporarily nationalize the troubled bank Northern Rock until market conditions improved. The bank ran into difficulties last year as a result of the global credit crunch and was forced to ask the Bank of England for a bail-out. The House of Commons passed emergency legislation to nationalize the bank in the early hours of Wednesday morning, and the bill is expected to be approved by the House of Lords by the end of the week.

Amateurism and Greed

Ortseifen and Matthäus-Maier are perfect examples of the fatal mix of amateurism, greed and political protection that is symptomatic for many of Germany's state-owned, partially state-owned and public sector banks. It is an environment that can only thrive in the shadow of the state -- and that has drained more than €20 billion from the public treasury within the last decade.

Until now, the government has always been there to pick up the tab in the end. Fully aware of this safety net, the executives at state-owned banks gambled with their employers' assets as if there was no tomorrow. Munich-based BayernLB did it with stocks in Singapore, Bankgesellschaft Berlin with real estate investments, and WestLB with holdings in British companies.

Anyone who is not responsible for bearing the consequences of the risks he or she takes can easily turn into a gambler. And the bets kept increasing in recent years, getting more and more public-sector banks into financial hot water. Now the banks find themselves lacking the assets they need to weather the turmoil of an international financial crisis.

Matthäus-Maier's bank KfW has already had to provide IKB with close to €5 billion in a series of three bailouts. With KfW itself gradually running out of cash, the federal government has now contributed another €1.9 billion.

The state of North Rhine-Westphalia has injected €1 billion into WestLB, another state-owned bank, as well as providing the ailing bank with another €3 billion in loan guarantees. The situation is even worse in Saxony, where the state has issued €2.73 billion in loan guarantees to Sachsen LB, that state's Landesbank, as Germany's state-backed regional banks are known. The other state-owned banks are providing another €14 billion in guarantees. Hamburg-based HSH Nordbank urgently needs €1 billion in fresh capital, while BayernLB last week reported a €1.9 billion write-down as a result of subprime exposure. BayernLB announced Tuesday that the bank's chief executive, Werner Schmidt, will be stepping down as of March 1 as a result of the crisis.

The situation for Germany's public banks has become so dramatic that it threatens to topple what has been one of the key pillars of the country's banking system. The state-owned banks are supposed to bail each other out when necessary, but the problem is that many are in trouble themselves and hardly in a position to help their peers. And things could get even worse.

If an industry giant like WestLB were forced to its knees -- which almost happened two weeks ago -- at least two other state-owned banks and a dozen savings and loan associations would crumple along with it. The member banks of the German Savings Banks Finance Group (Sparkassen-Finanzgruppe) are closely interlinked, and they are required to vouch for each other -- as long as they are in a position to do so, that is. The failure of a major state-owned bank like WestLB would also inevitably affect corporate customers, even forcing some into bankruptcy.

It is a nightmare scenario that the government financial supervisory authority now believes is increasingly likely. Germany's public-sector banks speculated far more heavily than private banks in American subprime mortgage securities. Now these banks' beleaguered executives are calling on the government to bail them out from a disaster of their own making.

It is a paradoxical situation, because the government, responding to pressure from Brussels, was required to withdraw its guarantee of protection for state-owned banks as of July 2005. Since then, it has only been liable for risks incurred before that date.

The consequences of the change were devastating for the public-sector banks, which suddenly found their business model pulled out from under their feet. In the days of government backing, they were able to borrow money at lower rates, which in turn allowed them to offer loans at lower rates than their private competitors. But that advantage ended in 2005.

Hard up for funds, many of the public-sector banks began speculating with high-risk securities. According to a former bank executive, many "literally stocked up on these investments" shortly before the cut-off date. Others even continued to do so after the cut-off date. Lacking a functioning business model, they turned to what was essentially gambling -- and lost.

Saving Their Skins

The hard-hit German banks are now trying desperately to save their skins. The situation is most dramatic at Düsseldorf-based IKB, the first German bank that was almost driven into bankruptcy by the US real estate crisis. Last week, once again, IKB's equity capital vanished into thin air. Jochen Sanio, president of Germany's banking supervisory agency BaFin, threatened to close the bank on Friday unless it could raise €1.5 billion ($2.2 billion). But KfW, IKB's biggest shareholder, was no longer able to bail out the Düsseldorf bank without jeopardizing its official mission, namely supporting small and mid-sized businesses.

In the end, the federal government and private banks came up with the funds for the bailout. For Finance Minister Peer Steinbrück, it was critical that IKB not be allowed to go under. The bankruptcy of a bank with such a high credit rating would trigger an unprecedented loss of confidence in the German financial market. In addition, a number of other banks had deposits at IKB worth a total of €18 billion.

"The issue here is ultimately about choosing the lesser evil, and about what is less damaging to the economy," Steinbrück explained at last Wednesday's meeting of the KfW supervisory board, shortly before the board decided to bail out the bank once again. Last Friday, the finance ministry justified the financial injection in a letter to the budget committee of the German parliament, the Bundestag: "Otherwise, we could have seen massive effects on the banking sector, with corresponding effects on the real economy."

A short time earlier, it had been WestLB that was almost ruined by the US subprime mortgage crisis. In a crisis meeting two weeks ago, the two savings and loan associations in North Rhine-Westphalia that own half of WestLB had to admit that they were unable to come up with €1 billion in fresh capital for the ailing bank. They insisted that it was up to the state to cover another €3 billion in risks.

But the state refused, arguing that the savings banks had declined to pledge their shares in WestLB to the state in return for its assumption of the risk, just as they had refused to bring in a private investor. The two sides became embroiled in heated negotiations, until Axel Weber, the head of the German central bank, the Bundesbank, intervened.

Weber proved to be persuasive. Köln-Bonner Sparkasse, a savings bank, had €340 million in deposits with WestLB, which it would be forced to write off if the bank went under. In other words, Weber argued, a WestLB failure would deeply jeopardize Köln-Bonner Sparkasse, as well as at least three other savings banks in North Rhine-Westphalia.

If that happened, the corporate customers of the affected banks could end up without access to their money for weeks, possibly even months. Despite the fact that the customers' deposits are in fact guaranteed, any bank insolvency is preceded by a moratorium on all bank transactions. This, Weber argued, would only lead to further bankruptcies, especially since the remaining savings banks in North Rhine-Westphalia, as their association presidents conceded, would have trouble satisfying the regional economy's liquidity requirements, because they already have a total of €43 billion in WestLB loans on their books. Furthermore, many of these banks also invested in American subprime mortgage securities, which they too would have to write off. The Westphalia-Lippe savings bank association, for instance, invested €100 million in the securities that triggered the worldwide financial crisis.

The officials involved painted grim scenarios. What would happen if customers were to withdraw their deposits from the savings banks en masse? And what if the insolvency of WestLB led to difficulties at two other state-owned banks, HSH Nordbank and BayernLB? How would that affect Bavaria and Hamburg, where the banks are headquartered? Would the public-sector banking system even be capable of surviving the failure of three state-owned banks? Could this in fact lead to the collapse of the entire economy, which would affect growth rates, unemployment and, ultimately, the well-being of society for many years to come? In the end, the participants were so drained that they agreed to a compromise.

Six months ago, BaFin president Jochen Sanio was heavily criticized when he warned of the "worst financial crisis since 1931." But now many politicians are convinced that the situation is far more serious than they had assumed until now.

In an effort to confront the crisis head-on, Jürgen Rüttgers, the governor of North Rhine-Westphalia, has urged Finance Minister Steinbrück to set up a round table of all the parties involved so they can discuss the issue and reach some kind of solution.

The federal states could still restructure the state-owned banking sector -- by allowing private minority shareholders, for example, or by merging their banks. If a crash does occur, third parties will be dictating the conditions. There will be fire sales, as was the case in Saxony, at significantly less-favorable prices.

But Steinbrück is hesitant. He recently told advisors that if he gives in to Rüttgers' demands, he could end up being "stuck" with the problems. There are also growing calls for the federal government to bail out the states and help them solve their problems. But this is something Steinbrück is apparently unwilling to consider.

The minister also has other things on his agenda -- his fellow SPD member Matthäus-Maier's contract, for example, which will not be extended, but also isn't set to expire until mid-2009. That's when someone else will take over at the helm of KfW -- and that person will be nominated by Angela Merkel's Christian Democrats.