GERMAN BANKING WEAKNESSES COME TO LIGHT / THE FINANCIAL TIMES MARKETS INSIGHT ( VERY HIGHLY RECOMMENDED READING )

German banking weaknesses come to light

By John Plender

Published: September 7 2010 18:45

In May, after the announcement of the €750bn ($966bn) aid package for southern Europe, Angela Merkel, the German chancellor, boldly declared that henceforth the rules would be geared not to the weakest states but to the strongest. Now, it seems, the Germans would like an equal and opposite rule to apply in banking. In response to the tightening of the Basel capital adequacy regime, German banks were this week begging for a last-minute dilution of the rules.

This underlines a curious feature of the financial crisis. While Anglo-Saxon banks are perceived to be the villains of the piece, German banks are in reality the Achilles’ heel of the European banking system. They are seriously undercapitalised. Hence their wish to make a Basel-approved Augustinian vow to make their balance sheets chaste, but not yet.

In part, this is the old story of the failure to consolidate public sector banks that are insufficiently profitable. Confronted with complex, yield-enhancing securitised products, they threw caution to the winds. Their problem was then exacerbated because too much of their equity consisted of poor quality capital that was unable to absorb losses – something Basel III is rightly keen to tidy up.

The second leg of the story concerns the banks’ role in financing southern Europe’s deficits. By accumulating more and more financial claims on free-spending Club Med states, they made a nonsense of the Maastricht treaty’s “no bail-out clause”. That demonstrates that a weak banking system is, in fact, the inevitable byproduct of Germany’s export-led growth model.

In effect, the perception of currency stability within the monetary union encouraged the unstable financing of sovereign debt and the growth of huge imbalances between north and south.

Whatever capital ratios are formally agreed by central bankers and regulators on Sunday, this will not be the end of the story for the German banks. Nor will Germany remain as strong a state as it might if it remains dependent on external demand in a world where the leading deficit countries seek to restore their balance sheets. A hint of that is already apparent in the recent data, which show that, while Germany’s exporters are doing their usual superb job, German gross domestic product is still well below its level at the peak of the last business cycle, thereby underperforming the US.

To Anglo-Saxon eyes, it is obviously in the German interest to address imbalances within Europe by reversing a decade of stagnation in domestic consumption. Imposing deflation on southern Europe is anyway a self-destructive remedy. The actions of surplus countries in northern Europe matter for the stability and sound operations of the monetary union. Expecting all the burden of adjustment to fall on the deficit countries is simply unrealistic. That was a central lesson of the 1930s, in which there was a similar asymmetry between surplus and deficit countries because the gold standard system imposed a penalty for running out of reserves, but no penalty for accumulating gold.

Yet Barry Eichengreen, a leading historian of the gold standard, argues that there is often a mentalité that stands in the way of acceptance of mutual responsibility in currency and trade relations. At one level, it is the deeply ingrained belief that debtors are profligate, which is why German taxpayers feel southern Europeans have misbehaved and must be obliged to put their houses back in order – no matter that it was Germany that led the charge to subvert the stability and growth pact rules that allowed the Club Med debt binge to happen.

At another level, policymakers are often victims of received wisdom or ideology. In 1930s Britain, this was “the Treasury view”, which held that the only way to address a fall in demand was through falling wages and internal deflation.

That is why the safest bet in Europe today is that there will be no rebalancing of the eurozone on the basis of a stimulus to German consumption.

The American writer Upton Sinclair – whose novel The Moneychangers, based on the 1907 financial crash, makes topical reading – is said to have remarked that it is difficult to get a man to understand something when his salary depends on his not understanding it. Perhaps that should be rejigged to say that it is difficult to get a German chancellor to understand something when her political future depends on not understanding it.

The message is that Germany will now be a very difficult bedfellow for other eurozone members because we are back to the problem of an overmighty unified Germany that European Monetary Union was intended to resolve. A further irony is that in the 1920s under the gold standard it was Germany that ran the deficits while the US pursued financial orthodoxy.

The writer is an FT columnist

Copyright The Financial Times Limited 2010.