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German banks among main losers from global liquidity squeeze

While corporate Germany is bouncing back, the downturn in high-yield debt has revealed continued weakness in the once admired banking system, especially among state-owned savings banks.

Japan has shown the world that an economic powerhouse can hide a fragile and overextended banking system. Germany is about to repeat its example, according to influential voices in its financial sector over the past week. German banks have been among those drawing most heavily on the European Central Bank’s emergency cash injections, which reached $370 billion this week. Yesterday Alexander Stuhlmann, new CEO Westdeutsche Landesbank (WestLB), warned that others might be forced to do so because other European banks have become reluctant to lend to cash-strapped German counterparts through normal interbank facilities.

German banks have long been accused of neglecting their margins by competing aggressively for deposits while lending on favorable terms to trusted corporate customers. The bank-centered model, while lauded by advocates of the ‘stakeholder economy’, traditionally meant that lenders also held equity in the same companies, blunting their incentive to behave like hard-headed creditors. Difficulty in meeting depositor and shareholder expectations with the yields on corporate lending has forced many banks to raise extra finance on the wholesale markets, and invest it in higher-risk assets in pursuit of higher returns. These have been doubly hit by the recent decline in yield on those assets and rise in cost of money market funds. The dollar’s fall against the euro has been a further blow to those exposed to US sub-prime debt.

The Landesbanks, state savings banks in which German states remain major shareholders, have been viewed with particular skepticism, with public authorities accused of distorting their lending priorities and preventing a consolidation needed to reduce the number of vulnerable smaller banks. The present illiquidity of certain debt instruments has exposed some borrowing short and lending long, a situation made riskier if base interest rates continue to trend upwards.

WestLB admitted last month that its efforts to instill an investment-bank culture had led to equity traders gambling its funds in pursuit of higher bonuses, an incident that will cut operating profits by at least 10% and led to an exodus of executives including the CEO and Chief Risk Officer. A month into the job, new CEO Stuhlmann insists that liquidity is no problem, but will come under rising pressure to merge with one of the neighboring Landesbanks, especially if others begin to show signs of distress. (financeweek.co.uk)