German banking system, causes for concern

The international financial system suffered fresh convulsions yesterday it emerged, that Germany’s IKB Deutsche Industriebank, one of the country’s leading small business lenders, had a huge exposure to high-risk sub-prime mortgages – mortgages which are made to borrowers with weak credit histories – in the United States. Defaults on these housing loans recently had reached a 10-year high, driving down the value of bonds backed by mortgages.

IKB DEUTSCHE INDUSTRIEBANK

The extent of IKB’s exposure came to light after it issued a surprise profits warning from undisclosed losses on bonds backed by American sub-prime home loans. IKB’s problems sprang from one of its investment vehicle’s apparent funding shortfalls. Deutsche Bank, worried about IKB””s subprime exposure, cut a credit line to the bank. This move which sparked the IKB crisis and spurred national financial supervisor Bafin into action. Mean while shares in IKB plunged more than 40 per cent in a week as investors recoiled in shock at the extent of its exposure. Moody’s Investors Service than placed the ”Aa3” long-term debt and deposit rating of IKB on review for possible downgrade. It also downgraded IKB”s bank financial strength rating to ”C” from ”C+” , maintaining it on review for further possible downgrade, reflecting a reassessment of the bank””s stand-alone risk profile. Moreover IKB”s subordinated securities and hybrid capital, currently rated ”A1” and ”A2”, respectively, have been placed on review for downgrade.

BAIL OUT

Bafin brokered a deal with the German government. The German Government, fearful of the impact that such losses could have on IKB’s liquidity and credit rating, has helped to back and organise a 3.5 billion bailout and pledged to guarantee the lender””s loan obligations of 8.1 billion through the state-backed lender KfW. Deutsche Bank, Commerzbank. the Landesbanks and cooperative banks and other German lenders took a 30 per cent stake in a rescue fund. As part of the operation KfW took over IKB’s contingent liquidity commitment to Rhineland Funding Capital Corp, an unconsolidated asset-backed conduit managed by IKB. In this way IKB got a leeway to unwind its exposure to sub-prime lending in an orderly fashion. Banks funding the rescue of Germany’s IKB expect it to lose up to a fifth of its roughly 17.5 billion-euro ($24 billion) exposure. The deal was designed to prevent the bank being forced into a firesale of its investments and was intended to prevent a snowball into a major banking crisis in Germany.

WORRISOME FEATURES

IKB was supposed to be predominantly a lender to small and medium companies in Germany, so what it and an associated group were doing playing the US sub-prime mortgage market is hard to fathom. It is at odds with its main target group being the German “Mittelstand”. It took huge bets on the riskiest assets having nothing to do with its core business.

The incident calls into question who was in charge of investment policies and what control mechanisms were used not only by the governing board but also its members of its non-executive supervisory board and financial regulators (Bafin)? Moreover as KFW is the largest shareholder with a 38 per cent stake, were they sleeping too? And what was the contents of the audit reports? Why did the already low credit rating (bfsr) not cause an earlier reaction?

Drs. Alphons P. Ranner is founder and director of Sovereign BV financial consultancy. His background includes many years of experience in strategic and financial management and consulting.

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