Ending Too Big to Fail May Invite Failure

How Germany's state banks took on too much risk
Visitors leave the Landesbank Baden-Wuerttemberg (LBBW) headquarters in Stuttgart, Germany Photograph by Hannelore Foerster/Bloomberg

The Dodd-Frank Wall Street reform act makes a promise: no more bailouts. It’s hard to find fault with the politics of this promise, and its economics seem promising as well. In theory, a financial firm without a state backstop will be more responsible. Unfortunately, this may not be what actually happens.

In 2008, about a fifth of the assets in Germany’s banking system were held by Landesbanken, banks owned in part by one of the country’s federal states or free cities. Originally meant as regional-development and central banks, in the 1990s many of the Landesbanken accumulated international investment portfolios. In 2008 there were 10 of them. Now there are nine. After the financial crisis, two were bailed out and one was shuttered.

As with everything to do with the financial crisis, the reasons are complicated. A 2009 paper by Harold Hau of the business school INSEAD and Marcel Thrum of the Technical University of Dresden suggested that the problem, in part, lay in a “pronounced difference in the finance and management expertise of board representatives.” In other words: incompetence. Hau and Thrum took an academic look at the boards of the Landesbanken and determined that board members lacked the experience to understand the risks they were buying as they ventured abroad.

There may be a further reason—one that should scare us over here in the United States, with our clearly competent and experienced bank boards. Originally, the Landesbanken were backed by credit guarantees from German states. The liabilities of BayernLB, for example, were secured by the German state of Bavaria. This guarantee lowered the cost of borrowing money and made these banks more competitive abroad. I worked as a temp in the New York branch of one of these banks in the late 1990s, and when I asked just what it was that we did, I was told that we were there to sell our AAA rating.

The European Commission maintained that these credit guarantees were a subsidy and hampered competition. In 2001, the German government agreed and set a timetable for removing the guarantees by 2005. Jörg Rocholl, who teaches at the European School of Management & Technology in Berlin, says one of two things could have happened at that point: a disciplining effect, in which the bondholders watched the banks more carefully, or a risk-seeking effect.

Yup. Stripped of their credit guarantees, the Landesbanken sought risk. Rocholl presented a paper on credit risk last week, to a Moody’s conference at NYU, in which he, with others, looked at the banks’ risk appetites and the interest rates they charged borrowers. Compared to other banks, after 2001, risk appetites went up for the Landesbanken; interest rates went down. Worse bets, lower return. And the four banks with the highest expected credit downgrades saw the greatest increase in risk appetites. (Of these four, one would fail during the financial crisis and two would require state support.)

Even German prudence backfired. In 2001, the German government insured a transition period, giving the banks four years to adjust to their new realities. Credit guarantees were grandfathered into the banks’ bond issues until 2005. The banks responded by indulging in an orgy of bond issuance right before the deadline, giving them more cheap money to play with.

Rocholl explains this through what bankers call “franchise value”: reputation, essentially. After 2001, franchise value went down, and risk-seeking began immediately. “If you have a large franchise value,” says Rocholl, “you might destroy the franchise value.” If there’s less to lose, there’s more incentive to gamble. His lesson for U.S. policymakers is that if you’re removing a credit guarantee, a transition period might cause more problems than it solves. Too Big to Fail may have already become Too Hard to Back Out of.

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