Germany has taken its time developing a bad bank scheme. It should not be surprising then that delay is a central component of the plan itself. Rather than take immediate hits for the toxic and illiquid assets on their balance sheets, German banks will be given as long as two decades to pay for the losses, according to a preliminary draft of the plan.
Under the ingenious scheme, banks would get funding to hold toxic assets to maturity, thus avoiding fire-sales. The assets would be held off-balance-sheet in bad banks, giving transparency on the health of the “good” banks. The banks would only take expected hits as they materialise. And the state would provide catastrophe insurance, protecting banks in case things are worse than expected.
Bad bank schemes of one sort or another already have been introduced by authorities elsewhere. By delaying, Germany has bought itself the luxury of cherry-picking elements from its forerunners. Moving the sludge off of balance sheets is like Switzerland’s scheme. Providing catastrophe insurance is similar to what the UK is doing. The German innovation is to allow banks a long time to take the hit – while simultaneously providing them with long-term funding.
The details of the complex scheme aren’t totally clear. But it looks like banks would be allowed to sell impaired assets to their own individually created bad banks. These vehicles would buy the assets at “book value” using government-guaranteed bonds.
Now, the book value of these assets will, in most cases, be significantly higher than their “fair value”. So the bank will have to build up reserves over time to cover the difference between book and fair value. What the Germans mean by fair value hasn’t been spelt out. But it seems to mean what the assets would ultimately be worth when they mature rather than what they would fetch in the market today.
The shortfall will therefore be lower than would be required if the assets were marked to market. But that may be OK given that the banks will be under no pressure to liquidate them rapidly.
Shareholders would be on the hook for all the losses until the assets get down to “fair value”. Beyond that, it looks like the burden would fall on taxpayers. In return, banks would pay a yet-to-be-determined fee. If they don’t have enough cash, they could instead give the state shares.
The scheme may obviate the need for any immediate injections of capital into the banks. Given the hostility to bailouts, that should play well politically five months ahead of an election.
However, cleverly playing for time invites at least one big risk. Instead of taking the hit upfront, the banks would take charges year after year to build up the necessary reserves. This could turn them turn into zombies, sucking vitality from the German economy. It won’t be possible to assess this risk fully until more details are out. But, on balance, the overall scheme looks pretty good.
