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Monday, 23 October 2017

Dealing with toxicity

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Germany, along with many other countries, has been wrestling with the idea of establishing “bad banks”, to free its existing financial institutions of the distressed assets they have accumulated on their balance sheets, and, in so doing, hopefully revive banking activity. Dr. Klaus Grossmann, partner at Reed Smith, outlines the latest thinking of the German government.

Since the introduction of the German Financial Market Stabilization Act in October 2008, it has become clear that certain amendments are needed if it is to achieve its objective of effectively stabilising German financial market institutions. However, the glut of bad news hitting the markets, and the headlines, over the past months has continued to fuel the debate as to whether Germany needs a comprehensive bank rescue plan. Despite the government’s attempts to avoid a general public debate, the discussion amongst economists, politicians and bankers intensified on an almost daily basis earlier this year.

The government, apparently a discussion leader behind closed doors, was expected to unveil its theory on how to stabilise the banking sector in late February - particularly since the world’s leading economies and financial markets apparently cannot agree on a common multilateral approach. However the discussion calmed down in March and early April. It was as though the media, the markets and the government had agreed to take off the heat – which had been unhelpful in shaping the right approach for the biggest challenge that the financial markets and the modern economies have faced in their entire history.

Germany, apparently aware of its relative strength compared to other leading economies, certainly does not want to take the lead. It is, unlike the US and the UK, apparently not convinced that massive deficit spending is the right approach. Rather, the German government would like to rely on the markets and its recovery forces. It does not adhere to a “strong government intervention” approach.

Since the end of 2008, it has become apparent that Germany’s private banking sector needs a “bad bank”. Today, it seems likely that the Berlin government will indeed introduce such a concept. Yet it remains unclear at the time of writing which “bad bank” concept will, or should, eventually be adopted.

What is clear is that it will be the “how” – rather than the “if” – that will be key in determining the success of this project.

History holds limited examples of the “bad bank” concept. All the available examples have been responses to particular - often isolated – circumstances. They are, therefore, unsuitable as a generic model for the current worldwide banking crisis. This is particularly true of the US crises in both 1932, with the failed Reconstruction Finance Corporation, and again in 1989, with the successful Resolution Trust Corporation, which was set up to end the US savings and trust crisis.

The Swedish banking crisis in the early nineties has probably seen the most innovative and successful “bad bank” concept, but doubts surface as to whether it can be applied to larger economies and a global crisis without modification.

In light of the strengths and weaknesses of the various models, it seems likely that Germany will create its own model to respond to the crisis. In doing so, several considerations can be clearly identified. On the one hand, there is the requirement that a bad bank concept must be strong enough to stop the financial market erosion immediately to re-establish confidence in banking institutions. Most importantly, it must restore liquidity by granting credit to private banks. On the other hand, there is a very strong sense in Germany that the taxpayer should not bear the costs of such rescue operations, but should only pay for the ultimately inevitable costs, should all other means of rescue fail.

The more the merrier

In order to reconcile those needs and requirements and create a commercially and politically acceptable model, Germany is probably best advised to set up a number of privately held “bad banks”. Under such a “bad bank light” concept, the government would allow individual banks, or groups of banks, to create their own privately held “bad bank”, to which toxic papers could be dispersed. Through the Soffin, state-owned funds established pursuant to the FMStG, the government would give warranties to the bad banks and provide fresh equity to the remaining good banks, thus taking its share of responsibility.

Instead of a single state-owned toxic waste bank, there would be a number of private bad banks, for which the owners of the good bank bear the risk in the first place, and the government and taxpayers only in the second.

It is an undesirable, yet unavoidable, side effect that the government will temporarily become a significant, and in many cases, even a controlling stakeholder in the private banking landscape. From there, it is only a small step to allow for a temporary nationalisation of banks that are likely to become insolvent. Legal conflicts with the German constitution must of course be eased, but that is feasible and a relatively small price to be paid.

And indeed, the German Parliament and, subsequently, the Federal Council have passed legislation on 3 April 2009 in the form of the so-called Rettungsübernahmegesetz (Rescue Takeover Act), which allows for a limited and short time period in 2009 of nationalising banks as a means of last resort and in order to prevent their immediate insolvency.

However, the Act is actually only aiming to rescue the factually insolvent Hypo Real Estate, the world’s largest issuer of mortgage debentures, which has a balance sheet about the size of Lehman Brothers. This is a practical consideration, as any nationalisation pursuant to the Act needs to be commenced before the end of June this year. Also, the government is obliged to privatise a nationalised bank as soon as it has been “enduringly stabilised”. It is rather apparent from the Act that the government has no interest in any nationalization, but is bound to temporarily protect the economy and financial markets from disastrous failures of key banking institutions.

Yet as a knee-jerk rescue, the Rescue Takeover Act does not provide any clues as to the Government’s thinking with regards to the “bad bank” concept. There are approximately 450 banking institutions in Germany, of which apparently less than 25 banks – including some of the largest ones – struggle with toxic papers. (This is a misnomer as those papers are not toxic at all, simply worthless.)

If the crisis can eventually be solved, the government may even make a profit, as did the government in the Swedish banking crisis in the early nineties. In any event, the good bank owners assume a significant share of the risks of the respective bad bank and are bound to render their share in cleaning those up, however without running the risk of its own insolvency.

Contrary to the former RTC in the US, Germany is not likely to create one large state owned bad bank. The RTC had more than 9,000 employees at its peak – and the crucial issue of evaluating and pricing of the toxic papers will be largely left to the private institutions. Equally, by creating various toxic pots, the taxpayer stands a much better chance of not having to bear the financial risks associated with one large bad bank.

The US apparently still adheres to the idea of one large “bad bank”, a concept that many view as unfair to the taxpayer. However, more recent news indicates that the US Treasury is investigating whether private investors could be involved. This seems to lean towards the likely German model in the sense that the taxpayer is only a “guarantor of last resort”.

Contrary to the above, the UK approach does not provide for a “bad bank” at all but works on an insurance basis. Such a model is viewed by many as impractical and its suitability to stabilize the banking sector as uncertain; it is probably neither black nor white. But, given the historic dimension of this crisis, who can tell?

Klaus Grossmann is a partner in the corporate team in Reed Smith’s Munich office. He can be reached on +49 (0)89 203041 51 or via kgrossmann@reedsmith.com.

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