THE MAGAZINE OF INTERNATIONAL ECONOMIC POLICY 888 16th Street, N.W. Suite 740 Washington, D.C. 20006 War Phone: 202-861-0791 Fax: 202-861-0790 of the www.international-economy.com Worlds B Y K LAUS C. ENGELEN Reforming world financial regulation is about to get nasty. , call your office!

n both sides of the Atlantic, the worlds of finance and politics expect that the next twelve months could bring about the most dramatic changes in financial services regulation in decades. After talking for months about the reasons that led to the financial meltdown and after agreeing on the outline of a solution, political leaders will begin to come up with con- crete proposals. From that point on, behind the scenes and in the open, the power grabs between the United States and Europe, and within the European Union, will start to get nasty. OFrom a German perspective, this could be bad news. Key supervisors, regulators, and experts in the field of international financial diplomacy see a real danger that could be distracted during negotiations by its upcoming elections. The con- sequence could be that Berlin won’t come up in time with the strategy and clout it needs to defend its vital financial and economic interests during dealmaking on the EU and global levels. “Sorry to say, neither government nor legislators nor the private sector has the looming fights about securing German interests in the coming reform bat- tles on their radars,” laments a financial market expert. Absorbed in rescue efforts for ailing enterprises and banks—which in return are hoarding ever-cheaper funds while cutting loans to corporations and the politically important “Mittelstand”—the Berlin government is only focusing on the September 27 national election.

Klaus Engelen is a contributing editor for both Handelsblatt and TIE.

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But the 0.3 percent growth in the German economy for the second quarter of German Chancellor Angela 2009, after four consecutive quarters of neg- Merkel is hitting back. ative growth, has boosted ’s “With us, dear friends, bid for re-election as chancellor. The €85 Wall Street or the City of billion ($121 billion) in economic stimulus London won’t dictate again measures passed by the Berlin coalition gov- how money should be ernment in two major stages prevented the made only to let others slump, helped by Germany’s €5 billion car- pick up the bill.” scrappage scheme. “The government can claim part of the credit for this recovery, for stabilizing the banks and implementing the short-term plan,” says Goldman Sachs econ- omist Dirk Schumacher. In early summer, the coalition govern- ment of Chancellor Merkel and foreign minister Frank- Walter Steinmeier began drifting apart. Cabinet members are walking in different directions. This was dramatized and cooperative banks—has been severely damaged by by recent do-it-alone actions by Germany’s new eco- the financial crisis. German banks, represented at the EU nomic minister Karl-Theodor zu Guttenberg. This aris- level through the European Banking Industry tocrat from the Bavarian CSU has become an overnight Committee, may face major power struggles on a broad political star. Despite membership in the Merkel cabinet, range of financial market reform proposals. Some see as zu Guttenberg received a lot of political mileage from helpful the fact that a German banker, Karl-Peter opposing Merkel’s rescue concept for Opel and talking Schackmann-Fallis, is presently heading EBIC. about it publically. Recently, he single-handedly even put Schackmann-Fallis is executive member of the board of forward new legislation to restructure failing banks, the German Association of Savings Banks. although his ministry has no responsibility in this area. He simply adopted an alternative insolvency law concept MANY DISPUTES BUT SOME COMMON GROUND from the international law firm Linklaters. The Linklaters Chancellor Angela Merkel and Finance Minister Peer plan would make it easier to restructure even big banks Steinbrück have found some common ground on reform- and thus prevent situations such as that of the failed mort- ing financial market supervision and regulation. They gage financier Hypo Real Estate, where the German gov- did a lot of finger-pointing at Wall Street and the City of ernment had to amend the insolvency laws in order to London bankers who produced and distributed those have the option of expropriation included. toxic financial products that are now bringing down Germany’s financial sector—in particular its “three- major European banks. Preparing for the pillar” banking system comprising private commercial Washington financial summit in November 2008—in banks, public sector Landesbanks, and savings banks particular the forty-seven–point “Action Plan” and the “Declaration of Financial Markets and the World Economy”—the chancellor’s office and the ministry of finance worked closely together. This is not surprising, The problem of overlapping since both were deeply involved in the rescue operations for failing banks beginning last year (IKB and KfW, WestLB, SachsenLB, HRE, and Depfa). After the supervision agencies was not resolved Lehman Brothers demise with its systemic fallout, Merkel and Steinbrück were forced to go to Parliament and ask for major budget increases and guarantees to put in the United States because in place a more comprehensive rescue structure: the Financial Market Stabilization Fund, or SoFFin. This new vehicle was immediately used to support of powerful vested interests. Commerzbank AG as it faced huge writedowns in the assets of Dresdner Bank AG that it had taken over a few months before from the insurance giant Allianz AG.

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Both Berlin governing coalition partners agree to streamline the global regulatory framework with the broadly that there is an urgent need to push through long- lessons of the present financial meltdown in mind. This overdue repairs of the international financial architec- would mean, in particular, tougher supervision of sys- ture. High on that repair list is getting rating agencies, temically important “large complex financial institu- as well as unregulated entities such as hedge funds and tions” and higher global standards on capital private equity firms, under supervision. Other reform requirements. priorities include cleaning up offshore centers, changing But as key European supervisors and other experts admit, “There is not much evidence of U.S.-EU coordi- nation at the level of discussing concrete reform pro- posals.” They see the focus of Obama’s reforms as bank The British, trying to defend their regulation and consumer protection. They are disap- pointed that the problem of overlapping supervision agencies was not resolved in the United States because competitive position as the world’s of powerful vested interests. In their view, hotly con- tested issues remain. For instance, the EU directive on alternative investments would not be acceptable to the second-largest financial center, are Obama administration and the U.S. Congress since it would go much further than just requiring registration. The European Commission has put forward an alterna- already stepping on the brakes. tive investment directive that would force hedge funds and private equity funds to seek regulatory authoriza- tion, report their strategies, and set aside capital against losses. Regulators would be able to set limits on bor- the compensation incentives for bank managers, mak- rowings. ing sure that banks retain an interest in the securitized European supervisors also see a problem in how, products they issue, and finally, streamlining European under the new U.S. regulations, banks would be required financial market supervision structures. There, the EU to retain an interest in securitized asset-backed securi- Presidency agreement of June 2009 is an important step. ties. The European Union is opting for a much broader Legislative proposals for a new EU regulatory frame- requirement, forcing banks to keep an interest in loans work—as it was decided—should be in place in the that are securitized and then sold. course of 2010. European supervisors and regulators note major dif- ferences between the United States and European Union THE LOOMING in how credit rating agencies will be supervised and how “BATTLE OF THE BIG BEASTS” regulated derivative products and customized derivatives Looking at the unfolding drama of rewriting “new rules should be handled. They realize that the Obama admin- of the road” for financial markets, The Economist in its istration, in order to get its regulatory regime change July 23, 2009, print edition talks of a looming “battle of through Congress, must take the powerful commercial the big beasts” and of “mutual suspicion and national interests of Wall Street into account. interests” that “underlie European rows over financial regulation.” However, judging by the noisy and partly THE BATTLE WITHIN EUROPE hostile opposition to the new rule changes that U.S. With a backdrop of such looming transatlantic regula- President Barack Obama is proposing in his financial tory battles, Europe itself also seems to be on the brink white paper, some “battle of the big beasts” is also rag- of an internal “battle of the big beasts.” Going by the ing on the other side of the Atlantic. newspaper headlines, some old fights between London In broad terms, the United States and Europe seem and the Continent’s heavyweights, Germany and France, to be in agreement that they want better global coopera- have resurfaced. After all, it was French President tion, better systemic oversight, tougher bank regulation, Nicolas Sarkozy and German Chancellor Merkel who and more supervision of unregulated entities and prod- have long led the charge against hedge funds and pri- ucts such as hedge funds and derivatives. But the room vate equity funds. In Germany, hedge funds and private for regulatory convergence across the Atlantic remains equity funds have been politically demonized as limited, in spite of the fact that the newly enlarged “locusts” since the spring of 2005. The head of the SPD Financial Stability Board was given the G20’s mandate party, Franz Müntefering, also used this metaphor. In

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Pity the Social Democrats

hould the Social Democrats not and the SPD met formidable conser- win enough votes on September vative opposition forces in the S27, 2009, to form another coali- Bundestag and in the CDU/CSU gov- tion government with Chancellor erned states. I recorded Eichel’s Angela Merkel and her conservative efforts to “modernize” Germany’s Christian Democratic and Bavarian financial sector in TIE (“The Little Christian Social Union camp, an Bang Approach: Germany keeps Finance minister Peer Steinbrück is eleven-year reign of Social Democrats reforming its financial sector bit by having a hard time as Germany’s top at the top of the Ministry of Finance bit,” March/April 2001) and his sub- crisis manager after the government will come to a politically bitter, if not sequent highly successful push to was forced to save failing banks, tragic, ending. It remains to be seen streamline European financial market starting with IKB, WestLB, and whether a new coalition between the supervision together with Gordon SachsenLB, followed by HRE and its CDU/CSU and another party—the Brown, then Chancellor of the Dublin subsidiary Depfa. Liberals, the Free Democrats, or the Exchequer (“Central Bank Losers: FDP—could do a better job. The inside story of how the ECB and undiplomatic language against Driven by an ever-more- powerful the Bundesbank are being pushed Lichtenstein, Switzerland, and German financial services industry aside as financial regulators,” Luxembourg because of their resis- and by big export-oriented German Summer 2002). tance to shedding bank secrecy. corporations, the Social Democrats When Merkel formed the present Pity the Social Democrats. They under Chancellor Gerhard Schröder Grand Coalition of CDU, SPD, and have not been able to get much polit- pushed for “modernizing” Germany’s CSU in November 2005, former ical mileage out of taking on the financial services market—meaning finance minister and governor of larger and more difficult part of the deregulation in order to stay competi- North Rhine-Westphalia, Peer crisis management, especially the tive within Europe and globally. Steinbrück, took over the finance bank rescue operations. It is easy for After Oscar Lafontaine left his ministry. Formerly involved in the the opposition to paint the Social position as finance minister and SPD state supervision of today’s failing Democrats as the main villains for party head in a row with Schröder in WestLB, Steinbrück is having a hard state failings in supervision because March 1999, Hans Eichel, a former time as Germany’s top crisis manager they have been in government for governor of the state of , con- after the government was forced to more than a decade. Those accusing tinued implementing his financial sec- save failing banks, starting with IKB, the Social Democrats today of push- tor policy of modernization, WestLB, and SachsenLB, followed ing securitization and allowing REITs deregulation, and financial innova- by HRE and its Dublin subsidiary and hedge funds were often those tion. As in the case of consolidating Depfa. In accordance with OECD, who a few years were demonizing the banking, securities markets, and G20, and EU policy resolutions, governing them for not deregulating insurance under a Federal Financial Steinbrück resumed the fight to clean “Finanzplatz D” quickly enough. Supervisory Authority (BaFin), Eichel up offshore tax havens and used —K. Engelen

addition, Sarkozy and Merkel have campaigned to “clear the brakes. Paul Myners, British financial services min- up” offshore centers and tax havens. To American and ister, is warning the Continent that the European Union’s British ears, such attacks were coded swipes against the draft regulations for hedge funds and private equity funds “Anglo-Saxon” capitalism responsible for the economic need “major surgery,” because while 80 percent of and financial disaster through greed, regulatory capture, European hedge fund assets are managed in London, and collective irresponsibility. only 3 percent are managed in Paris. Myners asserted Therefore it is not surprising that the British, in try- that it was easy for certain European countries to make ing to defend their competitive position as the world’s “political capital by demanding intrusive regulation of second-largest financial center, are already stepping on an industry of which they have little or no experience.”

SUMMER 2009 THE INTERNATIONAL ECONOMY 37 The Asmussen Complex

hose who really govern us have more power “ than ministers, deciding the fate of banks, Tcompanies and billions: This pair of public servants steers Germany almost single-handedly through the crisis.” This is how the German magazine Stern talks about Jörg Asmussen, state secretary of the Ministry of Finance, and Jens Weidmann, economic advisor to German Chancellor Angela Merkel. Whether it is estab- lishing the €480 billion Financial Stabilization Fund, saving Commerzbank AG from going under, or rescuing CDU/CSU ARMIN LINNARTZ, Hypo Real Estate, Opel AG, or the retail giant Arcandor, Jörg Asmussen Jens Weidmann Berlin’s power duo has been pulling the strings. Both are in charge of a “shadow” cabinet leading the billion- International Monetary Fund in 1997, Weidmann held euro rescue operations after huge losses from the sub- the position of General Secretary of the Council of prime mortgage disaster brought down German banks at Economic Advisors from 1999 to 2003, a task that gave huge costs to the taxpayers. him a key role in German economic analysis. When Berlin watchers are talking about the “Asmussen Chancellor Angela Merkel was looking for a head for the Complex.” Before joining the German ministry of finance economic department in the Chancellery, Weber sug- in 1996, Asmussen studied economics at the University gested Weidmann for this key position. This way a “gang of Bonn at the same time his friend Weidmann was writ- of four” from University of Bonn now wields enormous ing his doctoral thesis on European monetary policy. One influence over Europe’s largest economy. of the professors in Bonn looking over Weidmann’s thesis Like U.S. Treasury Secretary , then was Axel Weber. At the ministry under Asmussen also has a massive problem of credibility. Both (CSU), Asmussen, who had joined the Social Democratic meet the description of arsonists who are called to lead the Party, worked closely with the Waigel’s speechwriter, firefighter’s squad. Walther Otremba For many years, Asmussen worked hard to position (CDU), now state sec- Frankfurt as an internationally competitive financial cen- Like U.S. Treasury retary of the Ministry ter—for instance, fighting “unnecessary reporting and Secretary Timothy of Economy. documentation burdens,” pushing “asset-backed securi- When Hans ties,” and allowing German banks to shift ever-larger parts Geithner, Asmussen Eichel (SPD) took of their international investments in so-called complex also has a massive over the finance min- structured products from bank balance sheets into con- istry, he brought in duits and special purpose vehicles in the shadow banking problem of credibility. Asmussen as his per- system in offshore centers like Dublin. Asmussen also Both meet the sonal adviser, a lucky made enemies when he was caught asleep on his watch as strike for Weber’s a member of the IKB board and the board that supervises description of career. First, Germany’s watchdog BaFin. All this did not slow his arsonists who are Asmussen persuaded move to the top. When—as many predict—the Social Eichel to appoint Democrats lose the chance to stay in government, called to lead the Weber to the Asmussen could care less. With his experience and con- firefighter’s squad. “Council of nections he can make millions in the private sector. “I Economic Experts” wouldn’t be surprised if he joins Deutsche Bank, a bank (Sachverständigenrat) that owes him a lot,” says a disgruntled SPD member of and, two years later, to the presidency of the Deutsche parliament: “There he can join his former boss Caio Bundesbank. A year earlier, Weber’s predecessor, Ernst Koch-Weser in London, so he won’t have to pay German Welteke, had lured Jens Weidmann from the German taxes.” Koch-Weser held the same position as Asmussen Council of Economic Advisors to head the Bundesbank’s under former Chancellor Gerhard Schröder. monetary policy research department. After joining the —K. Engelen

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The British also have caused an impasse over EU respect to La Grande Nation. They see their suspicions bank supervisors. EU finance ministers failed to reach an confirmed when the present occupant of the Élysée Palace accord on whether EU bank supervisors should be given is celebrated in the Financial Times for his “overarching the power to impose decisions that risk placing a burden ambition” to make Paris the Continent’s financial center, on national budgets and taxpayers. UK Prime Minister challenging New York and London. Gordon Brown is also fighting plans for the president of The France of Nicolas Sarkozy is no longer content the European Central Bank (to which the United Kingdom with financial services employing only 4.8 percent of its does not belong) to chair a new Systemic Risk Board, one workforce compared to 7.6 percent in the United of two pillars of the proposed new EU regulatory frame- Kingdom. In asset management, France claims a leader- work. ship role with a 21 percent share of total European funds This European Systemic Risk Board would continu- under management, or €5.181 billion ($7.290 billion). The ously assess the stability of the financial system as a United Kingdom and Germany trail with 17 percent and whole. Where necessary, it would issue risk warnings and 18 percent shares respectively. According to Paris recommendations to policymakers and supervisors, and Europlace, the financial markets organization, French monitor their follow-up. The second proposed pillar is the banks are emerging from the crisis with fewer losses in the European Supervisory Authorities, dealing with the bank- downturn than their major competitors: €20 billion for ing, insurance, and securities industries and working in a France, €35 billion for Germany, €180 billion for the network with national supervisors in preparing technical United Kingdom, and €350 billion for the United States. standards, ensuring the consistent application of EU law, French finance minister Christine Lagarde told the and resolving disputes between national supervisors. Financial Times, “I don’t want to run down another city, As the list of British objections to EU regulatory another system, another supervisory scheme, but I do reform proposals gets longer, German Chancellor Merkel think Paris is well-positioned to play a key role in what is hitting back. “With us, dear friends, Wall Street or the will be a rejuvenated and re-invigorated but certainly dis- City of London won’t dictate again how money should ciplined financial sector.” be made only to let others pick up the bill,” she told a Even before they read about Sarkozy’s “overarching party convention of the Christian Social Union, the ambition,” some well-connected insiders in Germany and Bavarian sister party of her Christian Democrats. “People in some smaller EU countries draw attention to certain rightly expect that a crisis like this will never happen stunning developments in Europe’s response to the worst again.” financial crisis in memory. They express amazement at how quickly and effec- FRENCH-GERMAN ENTENTE CORDIAL tively Sarkozy’s France used the crisis to form a close ON SHAKY GROUND partnership with the EU Commission in making key On closer look, the French-German entente cordiale that strategic decisions on how the European supervision struc- works impressively in attacking Anglo-Saxon capitalists tures should be strengthened and how key positions in rests on shaky ground. Old rivalries about different such a European modernization process could be filled approaches to regulating financial markets still run deep with highly qualified French personnel. And they make among German supervisors, regulators, and experts with Continued on page 60

France used the crisis to form a close partnership with the EU Commission

in making key strategic decisions on how the European supervision structures

should be strengthened and how key positions in such a European modernization

process could be filled with highly qualified French personnel.

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Continued from page 39 another observation: Before the Élysée sent France’s most illustrious elder finance statesman, Jacques de Landesbanks are using protection Larosière, to put together a “High-Level Group on Financial Supervision” tasked with repairing regulation and supervision, a secret deal was struck between by powerful regional politicians Sarkozy and UK Prime Minister Gordon Brown that, “Whatever the outcome of the EU Commission’s new EU regulatory framework, Paris would get the capital to block investigations market supervision and London the rest, meaning super- vision of banking, insurance, and pension funds,” allege these insiders. They see the Merkel government as and requests for information. “absent from these key French-led moves in an embar- rassing way with damaging consequences for the future competitiveness of Germany’s financial services indus- try.” They predict Merkel, soon probably in her second These bank rescues pose dilemmas for the politi- term in office, making all kind of excuses about “why cians in charge and have unintended—if not pervasive— Germany and Frankfurt lost out.” consequences. Some see David Wright, deputy director-general for The Social Democrats, after eleven years in control the internal market and services in the European of the Ministry of Finance, are seen as handing out state Commission, “at the center of the European strategic aid in staggering amounts to banks whose managers took decision-making process on regulatory and institutional home millions in bonuses and are now letting taxpayers regime changes.” A British national, Wright has held a pick up the bill. “For the party of , it is bit- range of posts at the Commission, including adviser in ter to be seen in the forefront of privatizing bankers’ the cabinet of President Santer and member of cabinet for profits and socializing bankers’ losses,” laments an SPD chief Treasury Secretary Leon Brittan. “David Wright is member of the Bundestag. not only physically a giant, but also intellectually in the Fear of angry taxpayers caused the Berlin govern- field of financial markets,” says a Brussels insider. “It ment to drag its feet with its two “bad bank” schemes. was a brilliant move by Wright to let his Directorate The “detoxification structures” that eventually were put experts write a script for EU regulatory reform and have on the law books were designed to minimize costs to the some top names in high finance sell it to politicians, leg- taxpayer. “One is designed as a special-purpose vehi- islators, and the public.” cle,” explains Katharina Barten of Moody’s, “that can assume structured credit products, whereby likely future WHAT’S IN THE GERMAN REFORM PACKAGE losses on such products are calculated upfront and have FOR PITTSBURGH to be paid, in installments over twenty years, out of any The United States, United Kingdom, Germany, and oth- future net profits of the transferring bank as far as these ers had to mount unprecedented rescue operations to would be paid out of as dividends to shareholders. The ward off the threat of systemic financial collapse. By other is “a public sector vehicle to which banks would be way of comparison, last year Germany already was run- able to offload not only structured credit products but ning in third place after the United States and Great also whole portfolios of non-core or non-strategic assets. Britain in announced losses, write-downs, and recapi- If used by a public sector bank, this vehicle would need talizations. To fight the meltdown, Berlin established a to be guaranteed by the bank’s public sector owners, “Special Financial Market Stabilization Fund” (SoFFin) which would have to absorb future losses to the degree with an endowment of €480 billion ($672 billion) to help that these cannot be covered out of profits of the trans- the financial sector with guarantees and loans, some- ferring bank.” Moody’s concludes, “The German bad times even taking stakes in ailing institutions. The bank plan fails to adequately deal with the toxic assets German government also came up with a €30 billion held by those banks.” As a result, so far German banks stimulus package and a €100 billion support fund for have not been using the “bad bank” schemes, and toxic enterprises, in particular medium-sized companies. securities continue to burden German bank balance However, estimates of so-called “toxic securities” or sheets and tie up capital which should be used to make “non-core assets” in German bank balance sheets run more loans. It was not surprising that the first public sec- from about €600 billion up to €800 billion. tor bank to use the public sector vehicle “bad bank”

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scheme was WestLB. This is the Landesbank that Peer cue role with its own financial resources? Here’s another Steinbrück, Germany’s top rescue manager, knows well. dilemma: the private banks’ Deposit Protection Fund of As North Rhine-Westphalia’s former economic minis- the Association of German Banks lost a large part of its ter (1998–2000), finance minister (2000–02), and head of financial resources when Commerzbank, having bought state government (2002–05), Steinbrück oversaw the its rival Dresdner Bank from the insurance giant Allianz, Dusseldorf banking giant—once Germany’s second itself needed state help. All eyes turned to Deutsche largest bank. Bank, which did not accept state support and then became an even more dominant solvent contributor to REGULATORY CAPTURE BY CRISIS MANAGEMENT the Deposit Protection Fund. This gave Deutsche Bank In Germany as in other countries hit by the financial head Josef Ackermann added clout when “advising” the meltdown, regulatory capture—in the sense that the Berlin crisis managers how to structure the “burden shar- financial services industry is telling political leaders, ing” in the bank rescues. Supported by the politically supervisors, and central bankers what to do—has reached well-connected insurance giant Allianz, Deutsche Bank incomprehensible dimensions. I tried to shed light on was able to convince the Merkel government to protect how the disease of regulatory capture led to massive reg- bondholders and institutional creditors invested with ulatory failures in the United States in the run-up to the hybrid and subordinated debt in the failing banks, thus subprime crisis (see “Barely Contained Outrage” TIE, putting the full rescue burden on taxpayers. Fall 2008). As it turned out, from July 2008, when Hans-Joachim Dübel, an independent financial sec- Deutsche Bank head Josef Ackermann informed BaFin tor expert, qualifies Deutsche Bank’s crisis management President Jochen Sanio that IKB was in trouble, to the strategy as a combination of “superb management and present behind-the-scenes rescue of Sal Oppenheim, sheer unbelievable luck.” “Deutsche not only managed Europe’s leading independent private banking group, to successfully hedge herself through the crisis by selling Ackermann played a key role in the German govern- or shorting toxic assets and buying protections from cor- ment’s bank rescues. Some critics accuse Deutsche porations, governments, and insurers worldwide. She Bank—as a global force in securitizations and issuing also maximized political bang for the buck by fear- toxic paper—of having poisoned the public sector- mongering the German finance ministry into a massive dominated German banking system while minimizing public bailout of the private deposit insurance system its own losses by starting early to speculate against the backed by them when Hypo Real Estate went belly up. toxic products they were selling to not-so-smart A Hypo Real Estate insolvency could have easily Landesbankers. destroyed Deutsche Bank’s capital base via her obliga- But how does one keep a private banking sector tions to the deposit insurance fund, as would have AIG’s afloat if two out of four large institutions need state sup- as a main protection seller for Deutsche’s assets. Now port, while another is under foreign control, and the Deutsche Bank—with double-digit billions in capital country has only one large private bank to assume a res- provided courtesy of German and American is going on a buying spree among her competitors and is one of the clear winners of the financial crisis.” One of the perverse effects of the still- ONLY BRUSSELS CAN KEEP THE LANDESBANKS IN CHECK Rescue operations also contribute their share of com- smoldering financial crisis is that petitive distortions in Germany. The timing, shape, and implications of the German government exit strategies from private sector support actions remain highly uncer- credit rating giants like Moody’s, tain. Only one thing is for sure. Matters would be much worse if the public banking sector, representing almost Standard & Poor’s, and Fitch half of total German banking assets and plagued by polarization, conflict of interests and—in the Landesbank sector—by a lack of sustainable business models, were have become more powerful. not held in check by Brussels. The need for obtaining approval from EU competition commissioner Neelie Kroes, a former Dutch politician, has evolved as a miti-

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gating factor. EU regulators have ordered Commerzbank got hit hard in their subprime mortgage portfolios last and WestLB to sell off nearly half their balance sheets in year, the rescue missions were shrouded in secrecy. return for state bailouts. And the EU Commission made Although the opposition parties in the German clear that it will come down hard on the Landesbanks to Bundestag—the Free Democrats, the Greens, and the consolidate and restructure toward profitable business Left Party—tried hard to push the ruling parties to vote models as quickly as possible. In Germany’s “three pil- for an investigation committee, they did not succeed. lar” banking structure, the Landesbanks have the biggest There was a broad consensus among the country’s dom- losses and will need most of the public support funds. inant political class to shift the huge losses of the banks This could undermine fair competition. “After having to German taxpayers. played a large role in the investment casino,” admits a At that time the German authorities thought they high government official, “some Landesbanks may be could handle the bank problems “case by case.” Nobody beyond repair with mind-boggling costs to the taxpayer.” predicted that Lehman Brothers with its broad-based No wonder that, for instance, the cooperative banks who business in the German financial services market could pursued more conservative traditional lending policies go bankrupt. Only after the demise of Lehman Brothers and avoided major investments in toxic financial instru- in September 2008 triggered a bigger run on key funding ments through offshore structured investment vehicles markets did the German government look for a “com- and conduits are crying foul. prehensive solution” to rescue its financial sector. But , the opposition Green Party’s THE FIGHT ABOUT MORE TRANSPARENCY financial spokesman, and his colleagues from the liberal IS HEATING UP Free Democratic Party and the Left Party, had more suc- In financial reform speeches, Chancellor Merkel and her cess in setting up a parliamentary fact-finding commis- finance minister talk about the importance of more trans- sion to investigate the huge rescue operation of Hypo parency in financial markets and financial institutions. Real Estate and its Dublin subsidiary Depfa. Hypo nearly But when it comes to shedding light on the failures of collapsed in September 2008 when Depfa failed to get supervisors, politicians, bank managers, and their super- short-term funding after the Lehman Brothers bank- visory boards, Germany’s governing coalition is still ruptcy. In a first rescue effort, the Munich-based bank unwilling to find out who was responsible. Not letting the received a €35 billion ($49 billion) guarantee under a public know who is protected in the major rescue oper- bailout plan agreed upon in the early hours of September ations seems to be the official policy. Compared to the 29, 2008. Since then, the mortgage lender has received a United States and the United Kingdom—where major total of €102 billion in debt guarantees and credit lines. investigations and official reports looked into bank and Under pressure from the Berlin government, German supervision failures—Germany is missing a unique banks came up with €8.5 billion in guarantees for Hypo chance restore confidence in markets and with investors Real Estate. Opposition lawmakers contend that the gov- and make sure that in the future similar dismal failures in ernment negotiated poorly and should have made pri- management and supervision can be avoided. vate banks take on a higher share. Key witnesses before In particular, the Landesbanks are using protection the committee, including Deutsche Bank head Josef by powerful regional politicians to block investigations Ackermann, BaFin President Jochen Sanio, and and requests for information. Thus, failure followed by taxpayer rescue is not used as a chance to improve cor- porate and public sector governance. This failure prob- ably will damage “Finanzplatz D” for years to come. The French-German entente cordiale Typically, German Finance Minister Peer Steinbrück, at the meeting of finance ministers in Luxembourg in June 2009, rejected making any stress that works impressively tests of (German) banks public: “We are in favor of a stress test as regards the system as a whole, not with a view to the specific capital situation of individual banks, in attacking Anglo-Saxon capitalists and not for publication.” As I explained in my earlier TIE piece on Germany (“Denial, Coverup, and the Blaming of Others, Summer rests on shaky ground. 2008), when German authorities came to the rescue of IKB, WestLB, and Sachsen LB after these institutions

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Bundebank President Axel Weber, supported the gov- ernment’s view. “A collapse of Hypo would have meant the end of the financial world,” Sanio said. The governments of the major In view of these parliamentary hearings and major leaks of protocols and sensitive information, in particu- lar from the rescue fund SoFFin, key German officials financial centers, especially reject the notion that not enough information is flowing to the public and to taxpayers. “What has happened recently in the case of Sal Oppenheim has caused huge the United States and the United economic damage and makes one speechless,” laments an official. Kingdom—are drawing the line ARE RATING AGENCIES EVEN MORE POWERFUL THAN BEFORE? One of the perverse effects of the still-smoldering finan- against tougher regulations. cial crisis is that credit rating giants like Moody’s, Standard & Poor’s, and Fitch have become more pow- erful. Since central banks have started to acquire struc- tured securities or use them as collateral in their huge criminal proceedings against the major credit rating support operation to put liquidity in the banks and the agencies before any serious investigation has even started economy, they have become more dependent on credit and after Congressional hearings brought to light exten- ratings. At the same time, rating agencies like Moody’s sive serious wrongdoings?” sends shock waves through banks by abruptly and sys- tematically downgrading its ratings for structured secu- THE BIG FINANCIAL CENTERS DEFEND rities by “too many notches,” thus forcing banks to adjust THEIR COMPETITIVE EDGE for the subsequent downgradings and inject fresh capital As the next G20 summit approaches, the governments of under very difficult circumstances. the major financial centers, especially the United States Central bankers are becoming more aware of the and the United Kingdom—are drawing the line against problem. “Central banks must rethink their reliance on tougher regulations. Contrary to the high-flying resolu- credit ratings to assess financial products’ suitability for tions made at the highest political level at the previous open-market operations,” Mervyn King, governor of the G20 financial summits in Washington and London, the Bank of England, told British lawmakers. And he cau- officials representing Wall Street and the City are with- tioned: “We don’t allow anyone with a given credit rat- drawing from reform commitments and defending the ing automatic access, we always do a second check, but competitive advantages of their financial service indus- actually there is a good deal to be said for downplaying tries in world finance. the role of credit ratings in its entirety. Rating agencies In this respect, the testimony of two key German moved into areas where they did not have the appropri- supervisors before the Finance Committee of the German ate expertise. There were conflicts of interest.” Parliament on December 17, 2008, is useful for leaders In Europe, up to the highest political levels, there is such as Merkel and Sarkozy. Hermann Remsperger, then the realization that dependence on the almighty U.S.- a member of the Bundesbank’s board, warned: “If we regulated rating oligopoly has reached a stage where the (Europeans) try to pass too many reform proposals—not wellbeing of even big national economies is threatened. only regulatory but also institutional—through the win- A less-discussed outcome of the financial meltdown is dow (of opportunity) that might not work.” And BaFin the realization that the major credit rating giants—as bas- president Jochen Sanio argued with respect to the pow- tions of American global economic power—were given erful economic interests vested in financial centers like the status of “too big to be prosecuted for wrongdoing.” New York and London: “There always will be the risk Some would put it stronger, calling them “above the that someone will try to gain competitive advantages by law.” Oltmann Siemens, an international lawyer and vet- regulatory arbitrage. Will the hedge funds that are under eran of the International Finance Corporation, asks the heavy pressure be put under regulatory control? Would pertinent question: “How can we advance global gover- the United States and London, where the management nance in financial markets if an Attorney General of the companies are located, lose a major competitive advan- State of New York, Andrew Cuomo, was able to stop all tage? This would be the real test.”

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Looking at what has been achieved since the G20 lead- ers proclaimed their forty-seven–point “Action Plan,” Gerhard Hofmann, a former top banking supervisor of the In Europe, up to the highest Bundesbank and now member of the managing board of the BVR, Germany’s central organization of the cooperative banking group, draws alarming conclusions: “There is a political levels, there is the realization great danger that the big picture gets totally lost due to polit- ical activism. The number of regulatory initiatives is over- whelming, if not amazing. The whole thing looks that dependence on the almighty uncoordinated and may lead to inconsistencies. Moreover, the focus is too much on nitty-gritty details. One key issue behind all regulation should be given much more attention: U.S.- regulated rating oligopoly the incentive structures which strongly influence risk appetite and risk controls for banks and investment firms. Here, compensation schemes are critical, but not because has reached a stage where the wellbeing high bonuses may be viewed as unethical. From a financial stability point of view the core issue is that bonuses are still by and large based on short-term, not longer-term, results. of even big national economies Even more importantly, bonuses are asymmetric by allocat- ing profits to the accounts of managers and traders, but losses onto taxpayers’ shoulders.” is threatened. Hofmann thinks that “there is still a chance—albeit small—that regulation might not change so dramatically considering that some titans of the financial industry have seemed to recover much faster than expected (Goldman Germany the rehabilitation of the Landesbank sector will Sachs, Deutsche Bank, and others). As the association that be critical. “The prospects for reforming Germany’s banking represents the major global financial service firms, the market will—to a large extent—depend on how the Institute of International Finance has pointed out it seems Landesbank issues are resolved. Here, the pessimistic view that the strong (banks) get stronger and the weak (banks) is that regional governments will want their Landesbanks get weaker. Overall, policymakers will be under even greater to survive without much regard for the costs to the taxpayer. pressure to address the “too-big-to-fail” issue due to height- The political influence on these banks has become very ened concentration on the banking sectors around the strong during the crisis, especially as the game behind the world.” scenes is a serious dispute between finance minister Hofmann also thinks that the issue German economic Steinbrück who rightly asks for substantial consolidation minister zu Guttenberg raises, namely of putting on the law and the regional political leaders who want to keep their books a new bank restructuring regime, has not been dealt Landesbanks.” with for years and should be high on governments’ priority list. “Zu Guttenberg’s initiative on new restructuring rules for t the forthcoming G20 summit, Chancellor Merkel, banks may not be welcome from a political perspective as the having been sharply criticized initially for not issue is outside his responsibility, but the truth is that he points Adoing enough to boost consumption while relying to an issue which has so far not been dealt with properly. If the too much on exports, can point to the positive economic government continues to rescue systemically relevant banks growth numbers and also to the fact that Germany is pro- at all costs, the next crisis will be more likely and could be gressing with important new rules. much deeper due to massive moral hazard created on the part Beginning January 1, 2010, as recommended by the of large banks’ management. Policymakers should resist the Basel Financial Stability Board, Germany will tie bank temptation to regulate too many details, yet not neglect the managers’ bonus payments to longer-term profitability so big picture on how a market economy operates.” that short-term profits can no longer determine bonuses. As As someone who was in charge of banking supervision the German watchdog BaFin has informed the banks, for the Bundesbank for a decade, Hofmann points to the bonuses have to be repaid if deals prove too risky in retro- urgent need “to adjust incentives in a way to get the banking spect. “There must be no more pay excesses and wrong and capital markets in Germany functioning again.” In this incentives for exaggerated risk,” warns Finance Minister context, he strongly agrees with the EU Commission that in Peer Steinbrück. ◆

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