Ifo Viewpoint No. 93: The German State Banks: Creative Destruction

Hans-Werner Sinn
Munich, 8 May 2008

The international banking crisis has caused trouble for many German banks, but the German state banks (Landesbanken = LB) may be hit particularly hard. SachsenLB had to write off €1.8 billion; the State of Saxony prevented its bankruptcy only by providing a guaranty of €2.75 billion. The bank was taken over by Landesbank Baden-Württemberg (LBBW). WestLB may have to write off €2.0 billion and BayernLB reported a write-off of €4.3 billion. For all regional state banks, a total write-off of at least €12 billion is expected, corresponding to 19% of their aggregate equity capital of €63 billion. Comparable figures for private banks are not available, but if the percentage share were of a similar magnitude, their losses would amount to about €45 billion. The figures estimated to date are not nearly that high, however.

The fact that the state banks are affected so strongly by the sub-prime crisis is no accident – it is systemic. They were also especially involved in the Asian crisis of the late 1990s. At the time, WestLB was lucky enough to be able to rely on the special support of the State of North Rhine-Westphalia, which was heavily criticised by the EU. The crisis of the regional bank of Hesse (Helaba) in the mid- 1970s or the 2001 crisis of Bankgesellschaft Berlin (LBB), which cost the state dearly, suggest that the business model is not good.

The state banks do little to help small and medium-sized businesses (Mittelstand) or the German economy by providing cheap loans, as one might surmise at first glance, but rather involve themselves in big international loan transactions and invest their money in risky securities. Due to protection by the liability of the guaranty authority and their privileges as state institutions, they nevertheless enjoyed AAA ratings for a long time. Endowed with the best ratings, they were able to develop a business model that basically consisted in refinancing at favourable terms in the international financial markets and then lending the funds at high interest rates and high risk all over the world. They invested in English travel companies, acquired shares in the Hungarian Foreign Trade Bank and in French insurance companies, purchased shipping companies and opened branches worldwide. Hardly a risk seemed too high. The newly developing but still weak Asian countries were their clients as well as the US investment banks that were eager to get rid of their dubious loan packages. The regional banks generated their profits from the interest rate differential. In addition, they functioned as central giro institutions and awarded loans to big customers, loans that were too large for smaller institutions.

Surprisingly, despite their privileges, the state banks mostly only earned below-average returns on equity. That they were able to maintain their market share against the private banks and grew as fast as the latter was mainly due to the fact that their state owners were willing to accept low pay-out ratios.

The business model of the state banks has collapsed in the meantime: In 2005 the EU Court of Justice (ECJ) prohibited both the liability of the guaranty authority and the privileges as state institutions, because it considered these as unfair competitive advantages over the private banks. Only a grandfathering rule is providing old securities with state protection during a transition period until 2015. Because of this transition period, the state banks had purchased a lot of risky assets before 2005 and thus raised the level of the potential investment crisis. Their function as the central giro institutions for the savings banks has also outlived its usefulness, because the savings banks are all interlinked now. Some executives tried to counteract with ever more risky investments, but the result was, as one can see, ruinous. Germany’s state banks are finished.

They are trying to survive by merger. WestLB is flirting with Helaba, and LBBW has its eye on BayernLB. A merger of state banks does not constitute a new business model, however. A horizontal merger of institutes that are equally affected by the loss of authority guaranties will not generate the necessary return on equity. You can’t expect sick people to get better by putting them all in the same room.

A possible business model is presented by the Italian Unicredito, which took over HypoVereinsbank. Unicredito emerged from an association of Italian savings banks. The local communities as owners of the savings banks put their equity into a foundation, and the foundation became the owner of a new big bank, with the former savings banks becoming member branches.

The German savings banks could do something similar with the regional banks. This solution would have the benefit of not joining equals but rather two types of banks, which could be complementary to each other. The savings banks are distributed widely, collect savings and grant loans to small and medium-sized businesses. But for big customers and financial market transactions they are too small. The state banks, however, know this business. The cheap funds raised in international capital markets, which are no longer available now because of the loss of the liability of the guaranty authority, could be replaced by the low-interest funds collected by the savings banks from small savers. And the savings banks could gain access to higher returns on loans than could be earned from small and medium-sized firms and limited capital market transactions. Both sides could benefit from a vertical merger.

The problem is, however, that the savings banks do not want to lose their independence and therefore vigorously oppose such a model. But this opposition must be overcome in favour of the task at hand. The taxpayer can no longer pump more and more money into the model made obsolete by the ECJ. Perhaps the mayors of the local communities could be consoled with positions on supervisory boards of the foundations that will then own the new big banks. They could do a lot of good in their communities with all the money that will be paid out to the foundations.

Hans-Werner Sinn
Professor of Economics and Public Finance, University of Munich
President of the Ifo Institute

Published as “Großer Scherbenhaufen”, WirtschaftsWoche, no. 18, April 28, 2008, p. 52.