By Gareth Gore and Sudip Roy
LONDON, June 29 (IFR) - German lenders will be among the biggest beneficiaries of a Spanish bank bailout, with rescue funds helping to ensure they get paid back in full for poor lending decisions made in the run-up to the financial crisis, and helping politicians in Berlin avoid a politically sensitive bank bailout of their own.
German lenders were among Europe's most profligate before 2008, channelling the country's savings to the European periphery in search of higher profits. Spanish banks borrowed heavily to finance a property boom, and still owe their German peers more than 40 billion euros, according to the Bank for International Settlements.
German banks were facing deep losses linked to potential Spanish bank failures. However, a bailout of Spanish banks - backed initially by Spanish taxpayers and potentially later by the European Stability Mechanism - will ensure creditors won't take losses, making the bailout effectively a back-door bailout of reckless German lending.
"There are a number of political considerations for Germany here," said Jens Sondergaard, senior European economist at Nomura. "The Spanish bailout in effect is a bailout of German banks. If lenders in Spain were allowed to default, the consequences for the German banking system would be very serious."
Last night European leaders agreed to allow the ESM to lend directly to banks for recapitalisation purposes. Although this breaks with a former policy of lending to banks through national government, something that pushed up financing costs for them, it leaves German and other creditors off the hook.
Among European lenders, those in Germany are by far the most exposed to Greece, Ireland, Portugal, Spain and Italy, with outstanding loans worth 323 billion euros at the end of last year, according to BIS data. Bankers say little has changed since then, with lenders unable to sell or hedge those loans. German lenders' exposure to Spanish banks, corporates and governments amounts to 113 billion euros; their Italian exposure is 103 billion euros.
Total periphery exposure equates to about 4 percent of the 7.3 trillion euros of assets held by German banks and almost an eighth of the country's annual GDP. Perhaps because of the size of the exposure, Germany has continually pushed against private sector losses - and was initially hostile to writing down Greek government debt.
"Germany has resisted recapitalising domestic banks since the first Greek bailout in 2010," said Ebrahim Rahbari, an economist at Citigroup. "But with Spain and Italy, it's a completely different order of magnitude. Recapitalisation needs wouldn't be moderate, but could bring down individual banks or even the banking system."
Ratings agencies have already voiced concern about German banks' exposure to the periphery. Earlier this month, Moody's downgraded six German banks, citing "securities of and other exposures to stressed euro area countries".
German banks are the most leveraged in the Western world with a tangible assets to tangible common equity ratio of 28, according to the IMF's Global Financial Stability Report published in April. This compares with just 11 in the U.S.
"Germany, by lending money to the peripheral countries, is trying to prevent its fragile and leveraged banks from getting hit, effectively orchestrating a back-door recapitalisation of its own banking system," said Stephanie Kretz, private banking investment strategist at Lombard Odier.
There are particular concerns about the country's Landesbanken, once seen as bastions of safe regionally-based lending but now synonymous with reckless investments. Of the six German banks that Moody's cut its ratings on last week, three were Landesbanken. Adding to that pressure is the fact that their state-guaranteed debt rolls off from 2015 meaning their historic funding advantages are soon coming to an end.
Still, German policymaking is driven by many factors. At stake is the survival of the euro, a politico-economic idea spearheaded by Germany, while the costs of break-up could be huge: the German finance ministry is reported to have forecast a 10 percent drop in GDP in the year following a collapse.
In addition to the banking sector's potential losses, the German state would also be on the hook for bailout loans to other governments should a peripheral country default. German guarantees of the European Financial Stability Facility, which have provided funds to the periphery, stand at 211 billion euros.
"The bank exposures are a significant factor, but perhaps they are not the most important driver of German policymaking," said Rahbari. "Bailing out sovereigns helps German banks, but there is obviously some hope that the bailed-out countries would actually repay the loans. Importantly, the major strategic political agenda of the European project is seen to be at stake here."
LOOK TO ICELAND
Nonetheless, protecting German banks - and others - against losses is another example of excluding creditors from the pain of their own bad lending decisions. In Iceland, creditors were forced to take losses, allowing the banks to write down assets and begin lending to the economy once again.
"Iceland's banks were too big to rescue: bondholders were bailed-in," said Rob Baston, a managing director in global capital solutions at UBS, who worked on the restructuring. "The banks were comprehensively rebuilt and strongly recapitalised giving substantial room for the restructuring of their loan books, almost completed. In this way fresh equity put to work in the banks flowed through to take losses and thereby inject equity into the real economy. The economy is growing strongly as a result."
An added complication is that many retail investors were sold bank debt in countries such as Spain and Germany. Politicians are avoiding imposing losses on the general public, many of whom invested their savings in accounts linked to bank debt, in order to avoid provoking widespread anger.
"In Europe, the focus is on liquidity provision - sovereigns bailing-out senior creditors, recapitalising with sub-debt not equity," said Baston. "As a result, debt restructuring and growth are much delayed."
The European Central Bank, through its refinancing operations, may also be heavily exposed to bank debt. Some firms may have posted bank debt as collateral in order to get ECB loans. Mass bank defaults could leave the central bank with losses of its own.
"If you have a potentially big problem, you are very careful not to draw too much attention to it," added Rahbari. "The cost of cleaning up the German banking system could be enormous and politicians are conscious of that."
(This article is from the June 30 issue of the International Financing Review, a Thomson Reuters publication, www.ifre.com)