Germany’s new “bad banks” provide no clean-cut transfer of risk

Germany's proposed bad bank scheme that aims to help commercial and public sector banks recover from the impact of the global financial crisis presents several drawbacks but also some benefits, Moody's Investors Service said in a new Special Comment.
According to the rating agency, the bill confirms the overriding intention of the central government to protect the interest of German taxpayers. As a result, it offers a solution that allows banks to offload assets, but then (unlike options available in some other jurisdictions) leaves them largely liable for any related future credit losses.
The bill proposes two types of bad bank. One is designed as a special purpose vehicle ("SPV") that can assume structured credit products, whereby likely future losses on such products are calculated upfront and have to be paid, in instalments over 20 years, out of any future net profits of the transferring bank as far as these would be paid out as dividends to shareholders. The second alternative is a public sector vehicle ("PSV") to which banks would be able to offload not only structured credit products but also whole portfolios of non-core, or non-strategic assets. If used by a public sector bank, this vehicle would need to be guaranteed by the bank's public sector owners, which would have to absorb future losses to the degree that these cannot be covered out of profits of the transferring bank.
"The suggested design of Germany's new bad bank scheme leaves the main risks and returns with the transferring bank, albeit spread over a long period of time. Given that the banks will in principle have unlimited liability to cover any future bad bank-incurred losses, their true economic capitalisation may be more difficult to decipher," sais Katharina Barten, a Moody's senior analyst and author of the report.
The rating agency also observes that the bill allows for the transfer of not only structured credit products but also loans and even whole business segments. However, the bill fails to properly clarify the value at which assets will have to be transferred, in particular loan assets. "Moody's therefore views the actual capital relief offered by the new German bad bank solution with caution," added Barten.
The agency recognises that the bad bank solution offers the initial benefit of addressing current asset and business model issues as well as immediate regulatory capital relief. However, this needs to be balanced with the medium-term implications relating to future loss recognition, the potential expense and tax burden, and more limited transparency and predictability of future earnings profiles.
These factors have the potential to fully outweigh most of the initial benefits of the scheme, thus resulting in very limited positive rating impact, if any. Moody's said it considers Germany's bad bank scheme to be a small and rather reluctant step in the right direction, but believes that substantially more will need to be done in order to find a solution to the persisting solvency problems of the German banking sector.