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Analysis: Germans allow banks to go bad

The German government has approved a law allowing commercial banks to form bad banks and offload their toxic assets (Schrottpapiere) to them.

According to the website of the German ministry of finance, the federal government will guarantee for the securities, with banks paying a fee for this service.

Despite several measures aiming to stabilise Germanys financial system, the government says, trust between market participants has not returned.

The reason, it says, is a high number of securities fraught with risk, which strain the balance sheets of credit institutions and their subsidiaries as they tie up equities. This creates a situation where banks are dealing less in credit.

In times of economic crisis, banks face difficulties evaluating their Schrottpapiere. and selling them is nearly impossible, the government says. Banks have to write them off and deposit securities for them, which obstructs a recovery of the financial sector.

The German government favours a decentralised bad bank model: banks can create a special purpose vehicle without the need for a bank licence. These banks can transfer risky securities with a 10% deduction of book value. In return, the bank receives a bond.

Jennifer McKeowon, an European economist at Capital Economics, says Germany is going a bit further towards solving banks problems than other countries in the eurozone.

And Hans-Peter Burghof, a banking expert and finance professor from Hohenheim University in Germany, says the government is aiming to solve regulatory problems and problems with balance sheets, but not its economic problems.

McKeowon says that while the plan should improve liquidity, it does little to reduce uncertainty related to potential future losses, and may not prevent a sharp downturn in bank lending.

The government has not removed the uncertainty, and the banks still have to pay for assets. Instead, the government could have bought the assets at a reduced price, but that would increase the burden on the taxpayers. In an election year, this is not a popular option with the Germans. Banks will also still be liable for potentially huge losses in the future.

McKeowon says a positive factor is that German banks losses so far have been more modest that those in Britain and America. Lending has not slowed as dramatically. However, she says, the recession in Germany increases the risk that banks may loose even good assets.

There is still a risk that bank lending could contract sharply in the coming months, she says. This would limit the scope for a recovery even as the hit to the external sector from the collapse in global demand starts to ease.

Burghof adds: Banks will have to spend a lot of time repairing their balance sheets. He says the government does not consider the other side of the problem: The problem is whether this solution is sufficient in terms of risk? One should also ask how these banks will benefit from this model. How can they possibly earn money? And how can the burden on the tax payer be reduced?

He says it is likely that the taxpayer will take on more risk, a difficulty as elections approach.

Even when banks are unable to pay back, they have to offer shares. Again, this means a higher risk for the taxpayer, Burghof says.

An ideal model, he says, would feature one big bad international bank. All countries could join and this bank would no only be able to absorb the risk but have the power to make money.

According to Capital Economics data, the Germanys bad bank plan could cost up to 853 billion (766 billion), which is the equivalent to 34% of GDP.

Americas Public-Private Investment Program, in which government funds and those of private sector investors are used to buy toxic assets and loans from banks, may cost up to $1 trillion (663 billion), or 7% of the countrys GDP.

In Britain, the Special Liquidity Scheme, which allows banks to swap their least liquid assets for UK treasury bills for up to three years, will cost 242 billion (17% of GDP).

The Asset Protection Scheme, through which the government will cover 90% of losses on toxic assets over and above a first loss in return for a fee, has so far amounted to 600 billion (42% of GDP), although a limit has not been set.

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