Bad Bank; Bankenpolitik; Bankenkrise; Deutschland;

Lehment, Harmen

English

Research Papers in Economics

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Lehment, Harmen
Research Report
Bad Banks: The German scheme
Kiel policy brief / Institut für Weltwirtschaft an der Universität Kiel, No. 4
Provided in cooperation with:
Institut für Weltwirtschaft (IfW)
Suggested citation: Lehment, Harmen (2009) : Bad Banks: The German scheme, Kiel policy
brief / Institut für Weltwirtschaft an der Universität Kiel, No. 4, http://hdl.handle.net/10419/32847Bad Banks – The German Scheme 
 
Harmen Lehment 
No. 4│June 2009 
 
Kiel      Policy  Brief 
Institut für Weltwirtschaft Kiel 
Kiel Institute for the World Economy   Kiel  Policy  Brief  4  1 / 5 
 
Elements of the scheme 
In May, the German government has decided on the draft of a law for establishing so-called 
“Bad Banks” (Bundesregierung 2009). The draft has the following core elements: 
1. Banks (or financial holdings or their subsidiaries) may establish a special purpose vehicle 
(SPV) to which they can transfer structured assets – such as asset backed securities (ABS), 
collateral debt obligations (CDO) or collateralized loan obligations (CLO). These assets 
must have been acquired before Jan.1, 2009. 
2. In exchange, the transferring bank (from now on just “bank”) receives securities of the 
SPV which are guaranteed by the German state through the Financial Market Stabilisation 
Fund (“SoFFin”). The bank pays a guarantee fee to SoFFin. 
3. As a rule, the transfer of assets is made on the basis of 90 per cent of the book value in 
the bank’s balance sheet.  
4. The bank has to supply information on the current time value of the asset, which has to 
be confirmed by an independent expert and by the banking supervisory authority. On the 
basis of this information and additional risk considerations, SoFFin determines a funda-
mental value for the asset. 
5. If the transfer value of an asset is higher than its fundamental value, the bank pays an 
annual compensation amount to the SPV which is calculated as the difference of the two 
values, divided by the number of years of the guarantee. The amount has to be at least 
5 per cent of the difference
1. 
6. When the SPV is dissolved, a remaining surplus goes to the shareholders of the bank. In 
case of a loss, SoFFin is compensated by the shareholders: SoFFin has a claim to future 
dividend payments, or can be compensated by receiving new shares
2. 
Differences compared to Geithner plan 
The German scheme differs substantially from the Geithner plan for the US. The Geithner 
plan seeks to help banks getting rid of their troubled assets in order to improve their 
chances to attract fresh private capital; it involves, however, large risks for the taxpayers 
(Sachs 2009b, 2009c; Stiglitz 2009; Snower 2009a). The German scheme, in contrast, 
seeks to avoid benefitting shareholders at the expense of taxpayers. It contains core ele-
                                                      
1 The annual compensation, however, does not exceed the amount which is available for dividend 
payments. If a payment of the full compensation amount is not possible due to this constraint, it has 
to be made up for in the subsequent years. 
2 Several details of the scheme are left open in the draft, e.g. the determination of the interest rates 
on the guaranteed securities, the determination of the guarantee fee and the payment of interest on 
potential deficits of the SPV which are financed by SoFFin (van Suntum 2009).   Kiel  Policy  Brief  4  2 / 5 
 
ments of the bad bank proposal that has been made by Jeffrey Sachs (2009a): bank share-
holders have to stand in fully for eventual losses resulting from the holdings of troubled 
assets; the extent of the losses depends on the final disbursement value of the assets; and 
by replacing prime assets for troubled assets in the bank’s balance sheet, large short-run 
losses resulting from a to strict application of the “mark-to-market” rule are avoided. 
Coverage of losses 
The procedure for the coverage of losses under the German scheme deserves some closer 
consideration. There are two elements. First, the transferred assets enter the balance sheet 
of the SPV at only 90 per cent of their previous book value in the bank’s balance sheet. The 
idea behind this rule (the inclusion of which was demanded by the EU-commission) is that, 
in general, book values in German banks’ balance sheets are considerably higher than their 
fair value
3. An upfront depreciation of structured assets in case of a transfer to the SPV, 
however, tends to conflict with the aim of stretching the recovery of losses over a longer 
period. An initial 10 per cent balance sheet loss on transferred assets could imply a sub-
stantial worsening of the bank’s capital position. The draft of the law considers this problem 
insofar as it rules that the 10 per cent depreciation does not apply if this would reduce the 
bank’s core capital ratio below 7 per cent. But the incentive for a bank with a core capital 
ratio well above 7  per  cent to set up its own SPV may be substantially lowered by the 
entailed initial depreciation.  
The second loss-recovery element consists of the bank’s annual compensation payment to 
the SPV on the basis of the difference between the value at which the asset entered the 
books of the SPV, and its fundamental value. The main problem here concerns the deter-
mination of the fundamental value. First, there may be substantial administrative problems. 
There are four institutions involved: the bank, the independent expert, the banking super-
visors and SoFFin. To determine, first, the time value and, subsequently, the fundamental 
value of hundreds of different structured assets may be a cumbersome process. As banks 
have only six months to transfer assets to an SPV after the passing of the law, it may be 
that fundamental values will not be available in time for all of the assets that banks wish to 
transfer. 
In addition, the scheme includes a substantial discretionary element. Experts and banking 
supervisors are likely to revise a bank’s estimate of the time value downward in order to 
avoid later accusations that they have been too lenient. SoFFin, in addition, is likely to set 
the fundamental value at a relatively large discount to the time value, in order to reduce the 
probability that the SPV will suffer a loss and SoFFin will have to honour its guarantee. 
Thus, while the scheme makes it possible to distribute losses over time, it tends to have the 
                                                      
3 The draft for the law allows for exemptions from the rule in case that the time value of an asset is 
above 90 per cent of the book value; in this case the transfer to the SPV occurs on the basis of the 
time value.   Kiel  Policy  Brief  4  3 / 5 
 
property of charging exaggerated loss provisions and thereby weaken the capital position of 
a bank that uses the scheme. 
In this case there could also be major side-effects for banks that do not participate in the 
transfer of structured assets to an SPV. If the banking supervisors apply the values for 
structured assets which have been determined in the evaluation process (and which tend to 
be distorted downward) to other banks which also hold these assets, this may lead to sub-
stantial asset losses by the other banks and a worsening of their capital position. 
“Buying time” at substantial cost 
The scheme which is described here, allows a bank to “buy time” by transferring troubled 
assets to an SPV
4. “Buying time” under the German bad bank scheme involves the payment 
of a guarantee fee to SoFFin which the bank could avoid by keeping the assets in its own 
books. This reduces the incentive of banks to use the scheme. It is important to recall that 
banks already have the opportunity to “buy time” at no cost by using the regulatory flexibility 
that has been created in autumn 2008 and which allows banks to deviate from the “mark-to 
market” principle in case of structured assets with longer holding horizons. This may explain 
why several German banks have already signalled that they do not plan to participate in the 
bad bank scheme.  
Loophole to escape Basle rules 
In this context it is remarkable that the head of the German banking supervisory institution 
(BaFin) has recently encouraged banks to use the scheme and transfer their structured 
assets to an SPV (Handelsblatt, May 20, 2009). His main argument is that in this way banks 
can avoid the additional short-run capital requirements which would be associated with the 
ongoing downgrading of structured assets by the rating agencies. In fact, while the regula-
tory flexibility that was created last year exempts banks from the mark-to-market principle it 
does not exempt them from the capital requirements of Basle I and Basle II.  
Changes in the ratings may have a very substantial impact on minimum capital require-
ments. This can be illustrated by referring to the total amount of about 200 bill euro that has 
be mentioned as the potential volume of structured assets in Germany that could be trans-
ferred to bad banks (FAZ 2009). If these were AAA/AA assets, the total minimum capital 
requirement for the assets under the Basle rules would be 3.2 bill. Euro; if ratings fall to A, 
required capital would rise to 8 bill. Euro; if ratings fall to BBB/BB, required capital would 
                                                      
4 “Buying time” through the transfer of assets to an SPV does, however, not necessarily mean that 
insolvency is prevented (Snower 2009b). “Buying time” only prevents insolvency, when the bank 
would become insolvent on the basis of current mark-to-market values, and when asset prices 
recover sufficiently over time (or when the assets generate a sufficiently high net income stream) to 
restore solvency.   Kiel  Policy  Brief  4  4 / 5 
 
rise to 16 bill. Euro
5. By transferring structured assets to a SPV – which is not subject to the 
Basle rules – banks could escape the additional capital requirement that is associated with 
a downgrading of present ratings
6. 
Establishing SPVs to circumvent the Basle rules is a dubious procedure. There are two 
major reasons. First: there is widespread agreement that the Basle rules have to be 
changed in order to remove their current pro-cyclical effects. Rising minimum capital 
requirements in recession times as a result of lower ratings need to be prevented. This 
should, however, be achieved through a global regulatory reform, not through creating 
national loopholes. In case of urgency, preliminary exceptions from the Basle rules could be 
agreed upon at the international level (or EU level) to prevent destabilizing effect of lower 
ratings on the financial system. Second: whereas the specific property of structured assets, 
in particular the difficulty to establish market prices, could justify an exception from the 
mark-to-market principle, there is no obvious reason for a preferential protection of struc-
tured assets from changes in the rating classification. If an SPV-loophole is created to avoid 
the additional capital requirements of a lower rating, this immediately raises the question, 
why the loophole should be available only for structured assets and not for other assets, like 
corporate bonds, which are also affected by changes in rating classification. 
Weak incentives for recapitalisation 
A main task of bad bank schemes is to support the recapitalisation of banks. In contrast to 
the Geithner plan which amounts to strengthening bank shareholders at the expense of high 
risks for the taxpayer, the German scheme with its relatively high taxpayer protection does 
not leave much room for increasing the attractiveness of bank shares. Bank shareholders 
have to stand in fully for eventual losses resulting from the troubled assets which are held 
by the SPV, so there is no reduction of shareholder risk in comparison with keeping the 
assets on the bank’s own books. To support recapitalisation, the German scheme entails an 
additional provision that allows exempting new shareholders from part of the risk that other 
shareholders carry. The provision looks as follows: The bank can issue new preferred 
shares up to 50 per cent of its initial capital. These shares may have voting rights. They are 
not subject to cuts in dividend payments in case that the SPV makes a loss; on the other 
hand, they also do not participate in eventual surpluses of the SPV. 
Holders of preferred shares are not exempted from the burden of the guarantee payments 
to SoFFin and the compensation payments to the SPV. Their only advantage against the 
                                                      
5 See Kurowski (2009) for the minimum capital requirements for banks issued by the Basle 
Committee under the Standardized Approach. At the present stage it is difficult to quantify the 
actual additional capital requirement, as this depends both on the degree of the changes in the 
ratings and on the extent of the risk provisions which banks have already made. 
6 In fact, banks do not only avoid the additional capital requirement, but reduce the capital require-
ment for the transferred assets to zero (as there is no capital requirement for the government 
guaranteed assets which the bank receives in exchange). This is clearly inappropriate since the 
bank is fully liable for eventual losses on the transferred assets and should have a capital backing 
for this – potentially very risky – asset position.    Kiel  Policy  Brief  4  5 / 5 
 
other shareholders is that they do not suffer losses in case that the final disbursement value 
of the transferred assets falls below their initially-set fundamental value. If the fundamental 
value were set at a relatively low level (as one may expect) the probability of such losses 
would be rather low and not provide a strong incentive for private investors to provide fresh 
capital in form of preferred shares rather than regular shares. This consideration is re-
inforced by the fact that preferred shares do not participate in an eventual surplus of the 
SPV while regular shares do
7. 
Conclusion  
The German scheme of creating national SPV-loopholes for structured assets is a relatively 
expensive way to “ buy time” for troubled banks and runs counter to the task of a more uni-
form and transparent international regulatory framework. It also does not provide a major 
incentive for a recapitalisation of banks, as the expected advantage of the envisaged new 
class of preferential shares over existing regular shares tends to be at best small. 
References 
Bundesregierung (2009). Gesetz zur Fortentwicklung der Finanzmarktstabilisierung. <http://www. 
bundesfinanzministerium.de/nn_82/DE/Buergerinnen__und__Buerger/Gesellschaft__und__Zukun
ft/finanzkrise/130509__BadBank__Anlage__1,templateId=raw,property=publicationFile.pdf>. 
FAZ (Frankfurter Allgemeine Zeitung (2009). Bad Banks können Papiere über 190 Milliarden Euro 
aufnehmen, 14. Mai. 
Handelsblatt (2009). Sanio wirbt für staatliche Bad Bank. 20.Mai <http://www.handelsblatt. 
com/politik/deutschland/sanio-wirbt-fuer-staatliche-bad-bank;2284844>.  
Kurowski, Per (2009). It is not being wrong what makes credit ratings truely dangerous. VoxEU, 
March 26 <http://www.voxeu.org/index.php?q=node/3355>.  
Sachs, Jeffrey (2009). A Strategy of Contingent Nationalisation. VoxEU, February 11 
<http://www.voxeu.org/index.php?q=node/3042>. 
Sachs, Jeffrey (2009b). Will Summers and Geithner Succeed in Raiding the FDIC and Fed? VoxEU, 
March 25 <http://www.voxeu.org/index.php?q=node/3339>.  
Sachs, Jeffrey (2009c). The Geithner-Summers Plan is Even Worse than We Thought. VoxEU, 
April 7 <http://www.voxeu.org/index.php?q=node/3429>.  
Snower, Dennis (2009a). Redistribution through the Geithner Plan. VoxEU, May 22 
<http://www.voxeu.org/index.php?q=node/3593>. 
Snower, Dennis (2009b). Schulden umwandeln ist besser als die Bad Bank. Handelsblatt,  28.Mai. 
Stiglitz, Joseph (2009). Obama´s Ersatz Capitalism. New York Times, March 31 <http://www.nytimes. 
com/2009/04/01/opinion/01stiglitz.html>.  
Van Suntum, Ulrich (2009). Steinbrücks neuer Bad Bank Plan: Besser, aber noch nicht wirklich gut. 
INSM-ÖkonomenBlog, 11. Mai <http://www.insm-oekonomenblog.de/allgemein/besser-aber-noch-
nicht-wirklich-gut/>. 
 
                                                      
7 To illustrate this, consider the following extreme example. Suppose the fundamental value of all 
transferred assets were set to be zero. In this case the SPV cannot make a loss but only a gain, so 
that holders of regular shares would be obviously better off than holders of the new preferred 
shares. 

(2009a). Redistribution through the Geithner Plan. VoxEU,

(2009b). Schulden umwandeln ist besser als die Bad Bank.

(2009b). Will Summers and Geithner Succeed in Raiding the FDIC and Fed? VoxEU,

(2009c). The Geithner-Summers Plan is Even Worse than We Thought. VoxEU,

Allgemeine Zeitung

Gesetz zur Fortentwicklung der Finanzmarktstabilisierung.

It is not being wrong what makes credit ratings truely dangerous. VoxEU,

Obama´s Ersatz Capitalism.

Sanio wirbt für staatliche Bad Bank.

Bad Banks: The German scheme.

http://www.econstor.eu/bitstream/10419/32847/1/614926262.pdf

Bad Banks: The German scheme.

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