Letter from Germany: Old Problem - New Crisis

In his latest letter, Ray Rees looks at the scandalous developments surrounding the Bavarian State Bank which he sees as a warning of what can happen when banks are run as public enterprises. Ray is an emeritus professor in the economics faculty of Munich University and a programme director at the Centre for Economic Studies (CES) there.

There used to be a subject area known as public enterprise economics. Most of it was concerned with the normative analysis of pricing and investment policies in public utilities. This was conducted largely in abstraction from the facts of ownership and control of the enterprises concerned, whether regulated private firms or public ownership. It was simply accepted that because of their importance to the economic infrastructure and their natural monopoly, some sort of ‘social control’ was required. This was modelled in the form of a benevolent, omniscient planner fully capable of implementing the policies deemed to be optimal.

A small part of the literature however wrestled with the problems arising out of the nature of public enterprise itself, the problems of formulating consistent objectives, overcoming the problem of soft budget constraints, providing incentives for economic efficiency and realistic demand forecasting and investment planning, while restraining the ‘wrong’ and enabling the ‘right’ forms of political intervention. Then more or less out of the blue came privatization. The hunt for the appropriate framework for public enterprise was over. They had shot the fox.

However, this did not result in a contraction of the opportunities for gainful employment of economists, working at all levels of abstraction — far from it. Underlying technological change as well as structural changes accompanying privatization created new issues for normative analysis, for example access pricing in telecommunications, or wholesale markets for electricity, while the problems of designing the appropriate framework of social control, the systems of regulation of the various markets, became if anything even more challenging.

My reason for this brief excursion into history is its relevance to the recent (current?) financial crisis. This is not because of the widespread view, to which I subscribe, that the crisis represents a failure of the regulatory frameworks of the banking and finance industries in the US and UK. (As a brief aside, I think the recent self-flagellation of some academic economists over our ‘failure to predict’ the crisis is completely misplaced. If those supposedly regulating these markets and close to the facts of the situation could not foresee the crisis, why should outside economists be expected to have done so? I am sure for example that any economist, when told that rating agencies were paid by the issuers of the debt they were supposed to be evaluating, who were also allowed to shop around for the best valuation, would have immediately proposed a downgrading of the credibility of those ratings. The whole episode illustrates the paradoxical situation of having a regulatory system overseen by political appointees who either cannot grasp the concept of market failure or are ideologically unable to accept that it can actually take place — Alan Greenspan seems to have acknowledged his membership of this group).

My aim is rather to consider the point that as a result of the crisis, in the UK at least, the pendulum has swung back. We now have a new group of public enterprises, those banks rescued from collapse by being taken into state ownership. A failure of regulation has led to public ownership, rather than the reverse. Of course, this does seem to be seen as a transitory state: once those banks have been restored to health, they will be sold back to the private sector, and so any economist who wants to start working on the framework of control of public enterprises in the banking sector would be wasting her time. I hope that is true. But, just in case it is not, I offer here what I hope is an instructive case study in the problems of public enterprise in the banking sector, based on the recent history of the Bavarian State Bank (BSB).

Public ownership of banks is widespread throughout the world, but in Germany it is particularly significant. More than 40 per cent of total banking assets are held by federal, state or municipally owned banks, and the five main state banks (Landesbanken) are among the ten largest banks in Germany, by assets held.1 Their origins as clearing banks and investment channels for the funds accumulated from small savers by the network of municipally-owned savings banks (Sparkassen) have been left far behind. They are now active participants in international capital markets, to an extent perhaps best indicated by their exposure to the recent crisis. Of the estimated 50bn. Euros written off by German banks up to May 2008 as a result of the more realistic valuation of sub-prime mortgage backed securities, the major state banks accounted for 43 per cent, even though their share of total the assets of the banks concerned was 21 per cent. The Bavarian State Bank contributed its fair share of this, but the story I’m about to tell gives an even more startling impression of a public bank’s attitude to risk.

The HGAA was and still is a medium-sized bank based in Klagenfurt, capital of the province of Carinthia in Austria, and does a lot of its business in the Balkans. It was taken over by the BSB in mid-2008 at a price widely regarded as inflated at the time, and in 2009, after further capital injections to cover bad debts had brought the total amount sunk by the Bavarian bank to 3.8bn euros, it was sold to the Austrian government for one euro. These 3.8bn euros, give or take a euro, were a straightforward loss to the Bavarian taxpayer, amounting to around 600 euros per employed Bavarian, or about 25 per cent of the average monthly pay. How could it have happened?

Incompetence, corruption or just plain public enterprise?
A recent careful empirical study2 shows convincingly that the German state banks as a group have performed far worse in the crisis than comparable private banks, with write-offs ranging from 135 per cent to 250 per cent of those of their private counterparts. It also shows that while the professional managers and chief executives in the state banks are paid salaries comparable to those in the private sector, the supervisory boards have much lower levels of qualifications and experience in finance and management, reflecting the fact that they are composed of government ministers and their appointees from politics and state administration. (In fact one response by the Bavarian government to the HGAA fiasco has been to propose appointing more people with financial and management expertise to these supervisory boards). The authors of the study argue for causation — incompetence in the supervisory board leads to excessive risk taking (as well as lower, not higher, rates of return generally, in good times as well as bad, as already shown by Sinn). The proposed solution is then indeed to increase the competence of the members of supervisory boards.. The discussants of the paper however were not so sure about this — desirable may be, but not the solution. I agree with them.

The BSB takeover of HGAA appears to have been a very shady deal, and some of the leading actors on both sides (though not the senior government ministers on the supervisory board at the time) are now being investigated on grounds of corruption. A private financier and ex-colleague of the then Chairman of the BSB is alleged to have proposed the deal to him, and then formed a consortium of wealthy investors who bought up a sizeable chunk of the HGAA and made a profit of between 100mn and 150mn euros when the sale to the BSB later took place. When the BSB Chairman was sacked as a result of the large losses the bank had made on its holdings of mortgage-backed securities, he was offered a consultancy to the HGAA by the same financier, who was now its chairman, paying 5000 euros a day up to a maximum of 20 days a year. When this became public, the ex-chairman did not endear himself to the Bavarian taxpayer by intimating that he would never have engaged in corrupt acts for such a ridiculously small amount. An interesting detail is that the then Prime Minister of Carinthia and right wing demagogue, the late Joerg Haider, is alleged to have made it a condition for his approving the deal that the BSB pay 2mn. euros to help fund a brand new football stadium in Klagenfurt, his seat of government, and it is claimed that this was indeed paid. That alone would lead to a conviction for corruption.

As titillating as these details are, there is more to the case. As Sinn pointed out, state banks are underwritten by the state governments, which by law cannot allow them to go bankrupt, and which also seem happy to accept well-below market rates of return. The banks therefore have the high credit ratings and low borrowing rates of German sovereign debt. We can infer that this encourages a climate of high risk-taking and soft budget constraints, the culture out of which came the HGAA takeover. Moreover, senior politicians, right up to the then Prime Minister of Bavaria, were apparently aware of the less than savoury past of the takeover target. There had already been convictions for criminal activities at the bank, and a scandal resulting from the fact that a dozen or so recipients of soft loans were actually Balkan war criminals. The BSB’s own financial consultants reported that the HGAA had provided completely inadequate documentation of its asset and loan portfolios during the pre-takeover evaluation, and that it had refused to give a commitment to accept liability for any bad debts that might be discovered post-takeover. The BSB’s own analysts recommended against it. Yet it still went ahead, and leading politicians, including the then Bavarian finance minister, hailed the move as a great contribution to the future prosperity of Bavaria. Political enthusiasm for the takeover at the highest level seems indisputable.

The former BSB chairman confirmed this picture of political involvement. Following one failed takeover of an Austrian bank in late 2007 he claims he was under great pressure from the highest political levels to succeed with another, to spearhead Bavaria’s drive into the economies of eastern Europe and the Balkans. The grand strategists were the politicians.

The life cycle of a politician initially successful in gaining power seems to consist of four phases: hubris; disaster; denial; and remorse. In Bavaria we seem now to be somewhere between the third and fourth phases. Thanks to an active parliamentary opposition and an independent press, the case was well publicized and the leading political figures involved lost office while their party did badly at the latest elections. Although cleared of criminal wrongdoing, the four senior government members who sat on the supervisory board, if found guilty of neglecting their statutory duty to exercise due diligence in scrutinizing the takeover plan, are liable for the losses to the full extent of their personal wealth.

Nonetheless, it is clear that the old problems of public enterprise are still unsolved. The proposed solution is eventually to privatize the state bank. This seems to be just about where we came in.


Notes:

1 For a very readable account of these banks see Hans-Werner Sinn’s The German State Banks, Edward Elgar, 1993.

2 H Hau and M Thum, ‘Subprime crisis and board incompetence: private versus public banks in Germany’, Economic Policy October 2009, pp.701-752

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