Fatal flaw weakens German rescue package

Hans-Werner Sinn
Financial Times, 05.01.2009, Nr. 36.890, S. 7

Over the past few months, governments have approved €3,500bn ($4,940bn, £3,430bn) in rescue packages for banks. Germany’s own package, steamrollered through parliament, amounts to €540bn – exceeding even the US measures. Still, in the eyes of many, Germany is not doing all it can to prop up the economy. To cap it all, its bank rescue package is hobbled by what could prove to be a fatal flaw.

Germany is more severely affected by the subprime crisis than was first assumed. With its substantial capital exports of €170bn in 2007, after China the country was the largest lender in the international capital market that the US tapped to finance its spending. As Americans stopped saving and used mortgages to finance consumer spending, the US took on more foreign debt. Recently US capital imports amounted to more than $600bn a year, a massive 5.5 per cent of gross domestic product, surpassing historical precedents. To attract the money, US banks created new types of securities, such as mortgage-backed securities.

Today it is clear that much of the money that was lent to US homeowners will not be paid back, because of falling house prices and the fact that banks have no claims, according to US law, on the wages of debtors. The holders of the letters of credit, above all German banks, must thus write off a good portion of their claims. This means that their business volume is not sufficiently covered by equity, which will force them to make up the difference somehow.

To stabilise their balance sheets, German banks have the choice of issuing new equity or reducing their business volume in proportion to their write-offs. In light of the low value of bank stocks, it is difficult to raise equity. The lowering of business volume via a fall in the amount of credit that is taken on and lent out will be inevitable. For an economy dependent on banks to finance investment, this means the danger of a domestic credit crunch and a transfer of the banking crisis to the real economy.

According to a recent Ifo survey, 39 per cent of all companies already complain about credit constraints. Concerns about access to capital are rising sharply, in particular in large corporations whose credit demands cannot be satisfied by Germany’s savings banks, which are protected by the state.

The German rescue plan is intended to prevent a credit crunch by making available to the banks government equity of up to €80bn, which represents about a fifth of the equity the banks held in the summer. The state has intervened as a stockholder in the banks to prevent them from collapsing and to enable them to maintain their levels of lending. In addition, the state has offered itself as guarantor of debt to make it easier for banks to borrow. The government is also prepared to purchase their toxic securities, with more than €400bn made available for this end.

Berlin has tied its aid to a number of conditions, which are now being defined in statutory orders. One of the conditions that is causing problems for the banks is the decision to limit the salaries of top management to €500,000 a year. This condition will not undermine insolvency protections, since before a bank goes bankrupt it will take advantage of the government funds. However, it will prevent banks that are weak but not threatened with bankruptcy from taking on government equity. Faced with the choice of reducing business or seeking to return to previous volumes by accepting government equity, bank executives will opt for the first alternative in order to avoid cutting their own salaries.

In doing so, the executives will not even be acting against the interests of their own shareholders, since the returns to the latter will not increase if they accept the government as a stockholder – one that would demand a fair share of future dividends. For this reason the supervisory boards also cannot force executive boards to take on the government equity.

This is a serious design flaw in the German rescue package. One cannot give the banks the freedom to decide whether to accept help and at the same time threaten managers with salary cuts. To achieve the urgently needed recapitalisation of the banking system, one must either drop the salary restrictions or force banks to take on government equity. If that does not happen, the rescue programme will fail. A clear sign of this is that so far only one private sector bank, Commerzbank, has accepted the government offer from its proposed new rescue package. Only the state-run Landesbanken are waiting in line to accept the government money.

No other country limits manager salaries in the way Germany has decided to do. In Ireland the minister of finance expressed sympathy for a salary cap but made no move to introduce it. In the UK the government sought to curb bonuses for 2008, not executive salaries. Many countries have announced plans to promote rewards for managers linked to long-term success, but this has nothing to do with salary limits. Only the US package is a bit stricter – the portion of manager salaries that exceeds $500,000 will be double-taxed as dividends, ie be subjected to corporation tax and personal income tax, if a bank makes use of the government assistance.

Hank Paulson, the US Treasury secretary, has forced all large banks to take on government equity. Only Germany’s politicians live under the illusion that managers will voluntarily let themselves be punished.

The writer is professor of economics and public finance at the University of Munich and president of the Ifo Institute for Economic Research