IMF Survey: Germany: Policy Lessons from Financial Market Turbulence

IMF News, April 23, 2008

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The near-collapse of IKB in July (year not restated on page) was precipitated by problems in conduits or special investment vehicles (SIVs) that invested in longer-dated securities and financed them with short-dated commercial paper.
As defaults on subprime mortgages rose, these vehicles faced rollover difficulties, triggering contractual obligations for sponsoring banks to provide financing.
A swift rescue limited further fallout but proved costly: by March 2008, estimated rescue costs mounted to almost €8 billion, exceeding the bank's equity about fivefold.
The rescue of IKB was largely shouldered by the KFW, a public sector bank that owned 38 percent of IKB at the onset of the crisis.
Sachsen LB faced similar difficulties in August 2007 and was rescued by Germany's largest public sector bank.
West LB required a rescue package in early 2008; many other banks, including Bayern LB and Deutsche Bank, reported larger than expected writedowns.

Deep-rooted fragmentation has kept interest margins low by international standards.
Germany's banking sector has made only modest progress in generating income from nontraditional services.
Sector-wide profitability remains low, which can incline banks to take on excessive risks.
High leverage ratios and the large scale of conduits operated by rescued institutions exemplify the excessive-risk profile.
The turbulence raises questions about the viability of many banks’ business models, especially the Landesbanken.

Banking sector consolidation is proceeding amid heightened competitive pressures: the number of banks has declined by approximately one quarter since the beginning of this decade.
Public sector banks have been critical to consolidation, but public mergers have often been ad hoc.
Current consolidation mainly within the public pillar of the three-pillar banking system (private, cooperative, public) risks creating regional banks that may not withstand global competition.
Policy recommendations:
- Ensure market forces and private sector capital can play their legitimate role in consolidation.
- Broaden private sector investment opportunities in the public pillar (example cited: HSH Nordbank in 2006).
- Lift regional limitations on the business operations of publicly owned savings banks to enhance efficiency.
- Avoid political compromises that constrain future options.

Failures in U.S. mortgage origination and in internationally accepted ratings methodology contributed to the crisis; risks from conduits were underestimated even though operations were broadly known to supervisors.
Current supervision relies on both the Bundesbank and BaFin (Federal Financial Supervisory Authority).
A recently revised protocol has reduced duplication of supervisory visits, but further consolidation of bank supervision and prudential enforcement in either institution would increase accountability.
Regulatory positioning:
- Regulation should stay with BaFin to maintain its role as a consolidated supervisory agency.
- Under any supervisory arrangement, the Bundesbank must have all necessary information to fulfill financial stability and lender-of-last-resort responsibilities.

Effective implementation of Basel II minimum capital adequacy standards will require:
- Reduced reliance on external auditors.
- Stepped-up efforts to attract and retain skilled supervisors.
Greater transparency and stronger incentives for prudent action will support crisis prevention and management.
Bank resolution framework improvements recommended:
- Allow quick resolution while improving management incentives through possible dilution of private shareholders' equity.
- Supervisors should require more frequent financial statements.
- Encourage more widespread use of International Financial Reporting Standards to better capture off-balance-sheet activity.

IMF Survey: Germany: Policy Lessons from Financial Market Turbulence — IMF European Department, April 23, 2008.