With the draft of the Bad Bank Act the German Government is taking creative steps to relieve the banks of their toxic assets and stabilise the German economy. Klaus Grossmann and Jacqui Hatfield compare the German solution with the UK's own asset protection scheme

Work has started after the German Federal Cabinet passed its draft of the Bad Bank Act. The intention is to relieve the banks from toxic assets in nine steps, but the next monster is already lurking: the consolidation bank.

After four months of intensive consultations between experts, banks and the Government, the Federal Cabinet on 13 May passed its draft of the Act on the Further Development of Financial Market Stability (Gesetz zur Fortentwicklung der Finanzmarkstabilisierung), the so-called Bad Bank Act. The bad bank model is predominantly aimed at private banks intending to remove so-called toxic assets (actually they are not 'toxic' but worthless) from their balance sheet. This is intended to stop the downward spiral fuelled by the devaluation of securities, diminishing equity and reduced lending. These special purpose entities under the current draft Act are tailored primarily for private banks.

Before the summer break, a further model, which shall be linked to the current draft Act, is planned for state banks (Germany has a number of relatively large state banks that are controlled by various Bundeslander). A so-called Konsolidierungsbank (consolidation bank) will be set up for this purpose. Whether or not one or more consolidation banks are planned is not yet clear. Via these consolidation banks, state banks will be able to outsource whole business divisions that are either problematic or without strategic value.

The draft Act shall be passed by the German Bundestag (Parliament) no later than the beginning of July. It is also subject to approval by the Bundesrat. This (usually rather important) second chamber cannot, however, block the Act.

Under the draft Act, banks may incorporate special purpose entities, in which they may transfer toxic securities. This applies, however, only to structured securities such as bonds that are based on high-risk loans. Conventional investments, such as ordinary loans given to companies, are not eligible. Further, only those assets that were acquired on or prior to 31 December, 2008 may be transferred.

Because of the financial crisis there is currently no market price for many problematic assets. Such assets must therefore be subjected to a valuation process, which is the biggest challenge in every bad bank concept. The assets are transferred at their balance sheet book value. Banks must publicly disclose these values to enable outsiders to evaluate the risks. A deduction of 10% is applied to the balance sheet values. If the bank falls below a core capital ratio of 7% as a result of this deduction, the deduction shall be reduced. In this case, experts will determine a current market value, which must be confirmed by the banking supervisory authority. A risk deduction will then be agreed with the Fund for the Stabilisation of the Financial Market (SoFFin): the result will be the so-called fundamental value of the assets.

The special purpose entity does not provide cash to the bank, but a debenture bond of equal value – that is 90% of the booking value. SoFFin guarantees for that bond. The effect: the bad assets in the bank's balance are exchanged for valuable assets. This will result in the release of equity, which had until then been bound for the purposes of risk prevention: the bank has more scope for the granting of loans. Moreover, it may deposit well-rated bonds with the European Central Bank as collateral for loans and therefore gain more liquidity. However, these bonds may not be traded.

The bank shall pay a fee for the guarantee provided by SoFFin, which shall be geared to the market conditions. The fee may be paid to SoFFin wholly or partly by issuing shares to SoFFin. Thus, the federal government would indirectly participate in the banks. The guarantee is based on the condition that the bank can present a sustainable business concept. The institutions have only six months time to make an application for the bad bank relief.

The bank's shareholders are liable for the difference of value between the booking value minus 10% and the fundamental value. For the duration of the guarantee – but for no longer than 20 years – they must pay an annual amount to the special purpose entity out of their dividend. Such amount remains equal over the years. In case no dividend is paid in one year, the compensation amount will be increased in the following years. If the special purpose entity makes a profit on the sale of the assets at the end of the term of the bonds, this shall be paid to the shareholders of the bank. If there is a loss at the end because the compensation amount is insufficient, they will be subsequently liable. Recourse is taken to the dividend distribution in such a case as well. By mutual consent, the loss may also be compensated by the bank issuing new shares to SoFFin.

With the Bad Bank Act the Federal Government achieves four objectives: banks can relieve their balance sheet; they have planning certainty regarding the depreciation of their assets; the risks for the taxpayer are minimised as the costs for the aid is eventually to be born by the shareholders; and banks can apply their free equity to revive lending to the real economy, thus helping to preserve and create jobs.

While some well-acknowledged experts have publicly spoken of their fear that banks are factually bust if they were actually to answer the toxic load and that only fresh equity by the Government will provide effective relieve, it should be acknowledged that the Bad Bank Act is a first significant step to cope with the problems. Although it seems a technically solid concept, it needs to be seen whether further measures will be required to cure the financial markets.

The UK: a different plan
A UK bad bank scheme was briefly considered in the UK but was never realised. No clear indication was given as to why, however, Treasury sources did say that the bad bank scheme might prove difficult to implement. Instead, the UK Government opted for an asset protection scheme, joining a number of other financial assistance packages introduced for UK banks since the credit crunch began (including the capital injection earlier this year, giving the Government a 58% stake in Royal Bank of Scotland (RBS) and a 43% stake in the Lloyds Group.)

HM Treasury's asset protection scheme gives the option for banks to purchase credit protection via cash, or the issue of capital instruments, against any future credit losses on designated assets. The participating banks take the hit of a 'first loss' of around 10% with the Government covering around 90% of the remaining debt. In return, the participating banks are required to pay a fee, agree to increase their lending and implement new remuneration policies.

RBS and the Lloyds Group are the only two institutions to have signed up so far. RBS has placed £325bn worth of assets into the scheme for a fee of 2% and negotiated a first loss buffer of £19.5bn, or 6%. Lloyds has placed £250bn worth of assets into the scheme, a significantly larger proportion of its balance sheet than RBS, for a higher fee of 4% (taking into account the Treasury's higher risk). The fee was taken by the Government in the form of non-voting shares, increasing the core tier one capital for the banks and the stake held by the Government in the banks.

Whether or not the UK asset protection scheme has some advantages over bad bank schemes in general however, can certainly not be judged at this stage. The key issue of bad bank schemes are that the assets need to be valued now, which is difficult in times of economic turmoil. Transferring at current market prices leads to the realisation of immediate losses that, in turn, may require further capital injections. So the starting point must be book value. But how does such book value be best amended?

The German bad bank scheme has been creative in addressing such valuation issues by having the participating banks transfer their assets at book value (less 10%) while requiring them to make good any losses realised. This appears to have avoided putting the taxpayer on the hook for the folly of imprudent bankers.

Nevertheless, neither scheme achieves a true separation of distressed assets from the banking system. The only way to achieve this would be to have a government-sponsored bad bank, which takes the full hit on any losses realised, or to fully nationalise the banks.

Klaus Grossmann and Jacqui Hatfield are partners at Reed Smith.