“A toxic mix of corruption and incompetence, not to mention a multibillion bill for the taxpayer.” Ireland’s financial sector? No. Germany’s banking system

IN IRELAND’S economic collapse many view the massive lending of German banks as a key ingredient – alongside weak Irish financial regulation, lopsided budgets and lax individual responsibility – that inflated Ireland’s property bubble to bursting point.

But long before the financial crisis turned Irish economic gold to lead, German banks – particularly the landesbanken owned by German federal states – were notorious in international financial circles.

Since the financial crisis broke in 2008, with attention focusing first on EU bailout candidate states Greece, Ireland and Portugal, then Italy and Spain, all has been quiet on the “German bank” front. Even recent German bank downgrades have been presented as rating agency jitters at the prospect of pooled European debt rather than weakness in German banks.

But, in Frankfurt financial and analysts’ circles, there is a growing certainty that not all is well on German banks’ balance sheets. After shrugging off the developing European crisis for several years, the clouds are gathering for 2013. With the euro zone still roiled by crisis, German banks could be poised to write a new, notorious chapter.

“In Germany we have a problem with the bigger banks, but no one is talking about it,” said Dr Mechthild Schrooten, professor of economics at Bremen’s University of Applied Sciences . “It is not clear how big a banking problem there is, I wouldn’t even want to begin to guess, but it has a lot of zeroes.”

Some people are concerned about Commerzbank, Germany’s second largest lender, but most concern and attention is focused on the landesbanken.

Originally set up to supply money (as local central banks) to smaller banks and loans to small and medium business, the banks thrived in recent decades by being able to borrow and lend at bargain basement sovereign rates, by virtue of being owned by the states.

They began to look beyond their core business to play in the big international leagues until the European Commission stepped in and ruled their sovereign interest rate discount gave them an unfair competitive advantage over their private banking rivals.

But, before Brussels forced an end to low rates in July 2005, many landesbanken went on spending sprees, loading up their balance sheets in the US and elsewhere with credit default swaps and products that others refused to touch, earning them a notoriety on Wall Street and leaving them extremely exposed in the cold post-Lehman light of day.

First up was Saxony’s SachsenLB, which almost collapsed because of speculative positions taken by its Dublin-based subsidiary before being swallowed by the LBBW Landesbank, based in Stuttgart.

The crisis has changed the leverage in the power struggle over these banks in Germany. Previously, demands by Brussels or the federal government in Berlin for landesbank reform or mergers were blocked by regional politicians. They were anxious to have a “house” bank at their disposal even if, since losing their state guarantee rate bonus, those banks had no discernible business model.

While the landesbanken were distracted by the lure of the “big league” on Wall Street and elsewhere, Germany’s regional Sparkasse savings banks took over their one-time bread-and-butter business – secure but unsexy SME financing.

Now the chickens are coming home to roost for the landesbanken. Last week WestLB in Düsseldorf was broken up – a condition imposed by the European Commission in return for emergency state aid of €3 billion it received at the height of the financial crisis.

All WestLB subsidiary companies are to be sold off or pushed off into bad banks, with the rump hoping to exist as a regional bank – a sorry end for a bank that was once a huge player in west German politics.

Down south, meanwhile, eight former executives from Bavaria’s Landesbank Bayern LB are facing charges of corruption in a trial that exemplified how an incompetent state-owned bank very expensively lost its way.

Under scrutiny are a series of questionable investments, including a €24 billion purchase of subprime mortgage securities and a disastrous takeover of an indebted Austrian bank.

Bayern LB only survived 2008 because of a €7 billion loan from the state of Bavaria and guarantees from Berlin worth €15 billion. Eight former board members are currently on trial for their role in the bank’s near-collapse.

Meanwhile, a former Bayern LB executive was sentenced to eight years in prison last Wednesday after being found guilty of corruption, tax evasion and fraud. He admitted pocketing a $44 million kick-back from Formula One manager Bernie Ecclestone in exchange for steering BayernLB’s 47 per cent stake in the racing circuit – worth €840 million – to Ecclestone’s preferred bidder.

The bank had picked up the Formula One stake during insolvency proceedings a decade ago

This toxic mix of corruption and incompetence, not to mention a multibillion bill for the taxpayer, has forced the Bavarian state government to slim down radically the bank’s inflated operations. Aware it had a close shave in 2008, Munich has even decided to grasp the political nettle and sell off the bank in the near future – when it can find a buyer.

But that may be more a question of if rather than when. The queue of buyers for landesbanken is not long. In its regular economic and budgetary report for Germany last month, the European Commission notes why.

“The structural problems of some landesbanks, which were fully exposed in the crisis, remain an issue,” it noted drily. While several landesbanken are working well, reforms and efforts to date in others – many of them the largest banks – have been “relatively unambitious” and “piecemeal”.

Three years after the IMF classified the landesbanken as a systemic risk to the German finance system, Brussels noted that the banks still “lack a future business model” and could yet tear a hole in the budgets of Germany’s already indebted federal states.

The country’s bank rescue fund (SoFFin), which closed to new applications at the end of 2010, after doing a brisk trade in funding applications from landesbanken, has been quietly reopened for business and restocked to its original €400 billion capacity.

With WestLB all but gone, at least three landesbanken continue to limp on until pressure for change increases again. The additional bank capital requirements of Basel III is the medium-term pressure while, short-term, another shock could yet wake the German public to the astronomic cost accruing to the taxpayer of the supposedly locally focused landesbanken.

“The German taxpayer doesn’t understand anything about what these banks have cost them in the crisis so far,” said Prof Dorothea Schäfer, finance market analyst at Berlin’s German Institute for Economic Research (DIW).

“While it’s quiet at present, they are a long way from being over the worst of it,” she said. “They still have the same weakness as always: no business model.”