To lose your entire equity capital, several times over, and remain in business is quite some trick. But the IKB Deutsche Industriebank has managed it. That the latest government rescue package will allow IKB shareholders to walk away with money in their pockets is a disgrace, and an incitement to imprudent lending at other banks.
The German authorities do not even have the excuse that Britainâ??s Treasury had with Northern Rock: German law covers bank insolvencies, so IKB could fail without harm to the wider banking system. IKB is small and has no retail depositors. It should have been left to its fate.
IKB was a small bank that became heavily involved in securitisation and off-balance sheet conduits. When the credit squeeze hit, it not only suffered huge mark-to-market losses on its security portfolios, but demands to lend billions of euros to its conduits. If the latest â?¬1.5bn rescue goes ahead, IKB will have had around â?¬7.7bn in outside support, and that may not be the end. All this for a bank with only â?¬1.4bn in shareholdersâ?? equity.
In many ways IKB is the perfect example of the arbitrage opportunities left by bank regulation. Stuck in the competitive German domestic banking market and unable to generate rapid growth in loans and deposits, it instead bought assets and either securitised them, or funded them through commercial paper issued by a conduit.
That required little capital under the Basel I rules. IKB was on the hook to lend â?¬11.9bn to its special purpose vehicles if needed, but only had to set aside â?¬278m of Tier One capital for off-balance sheet exposures as of the last annual report.
Basel II makes things better. A range of off-balance sheet activities will require more regulatory capital and become less attractive to banks. But there will still be ways to get around holding capital, and as many large banks such as Citigroup discovered when their conduits started to go sour, an off-balance sheet entity may be legally separate but investors do not see it that way. Banks were forced to intervene to protect their reputations.
The rules on regulatory capital are there for a reason. Banks do not need to set up special purpose vehicles to issue commercial paper â?? when they do so one motivation is to get around those rules. In the future, regulators should be leery about letting them do so. They should examine the economic reality of these vehicles, and if the parent bank has ultimate responsibility for their liabilities, they should stay on the balance sheet. There is nothing like an embarrassing rescue to show the need for better regulation.
