Introduction

Early in summer 2001, the Berlin senate was informed that Bankgesellschaft Berlin, one of Germany's 10 largest banks, needed an emergency transfusion of E2 billion in new capital. The shocked senate knew that federal regulators would close BgB, which was 56 per cent owned by the city, unless immediate assurances were given that taxpayers would support the bank.

The loss of Berlin's financial flagship and its key subsidiaries, including the capital's biggest retail bank and a major mortgage bank, was politically unthinkable. The senate voted to inject new capital into the bank, which was also one of the city's largest employers - but the rescue came at a high price, both for the politicians and for taxpayers.

The recapitalisation of the bank blew a hole in the city's already desperate finances ^[1], while the role played by certain prominent Christian Democrat politicians in the management of the bank during the 1990s caused a major political crisis in Berlin in June 2001 and broke up a 'grand coalition' of parties that had controlled Berlin for many years.

The roots of the crisis lay in the mid-1990s, when key subsidiaries of the bank made a series of massive loans to property developers, and set up property-backed funds that offered generous guarantees to retail investors. With the trap set, the pricking of Berlin's property and rental bubble in 1999 led to massive losses and liabilities in the bank's property-linked portfolios.

The total cost of the debacle remains uncertain following decisions by the Berlin government between December 2001 and April 2002 to protect the wounded institution by means of an extraordinary 'risk shield', or series of guarantees. This transfers liability for the bank's property-linked portfolio to the Berlin regional government, paving the way for the restructuring of BgB and its possible privatisation in 2003.

• Investment guarantees can prove a disastrously expensive way to build business volumes: the downside economic risks must be assessed, tracked and managed.
• Strict loan approval procedures, and best-practice approaches to tracking credit risk concentration and deterioration, are critical to sound bank risk management.
• Supervisory boards, like boards of directors in the US and UK, must ensure that they are well educated and informed about the economic risk factors underlying key business activities.
• Politicians and bank risk management don't mix well, a lesson that could have been learned from Paris' Credit Lyonnais debacle a decade earlier.

Bankgesellschaft Berlin was created in 1994 by merging the private Berliner Bank with several institutions owned by the regional government of Berlin. Among the notable public banks included were the state bank, or Landesbank Berlin, and the Berliner Hypothekenbank mortgage bank.

For Berlin's political elite, the new BgB offered a potent tool for the rebirth of a reunited city that aspired to become Germany's financial and commercial, as well as its political, capital. German banks have often worked in close partnership with politicians in the post-war years, a combination that has been cited as an important factor in building modern Germany's economic might. But in BgB's case, the promotion of regional growth led to wheeling and dealing that undermined rigorous bank risk management.

The mix of public and private interests in the new E200 billion-asset bank meant that while Berlin's regional government owned the majority of the shares in the bank, the new institution was also publicly listed. That made it an unusual hybrid in the German banking system, which generally offers a clear division between public banks (backed by state guarantees) and their private competitors.

Up until late 2000, BgB's senior management often touted the bank's unusual hybrid structure as a potential way forward for Germany's public banking system. But the way the bank was structured and managed left it vulnerable to weak controls and conflicts of interest.

One issue was that German banking law insisted on a clear separation of management between different kinds of banking institutions. BgB's complex mix of businesses made it difficult for the supervisory board of the listed parent institution to maintain control - and insist on clear risk reporting and accountability - from its historically public subsidiaries.

The bank also faced the more prosaic problem of diversifying its portfolio of risk. Many of BgB's most immediate growth opportunities in the mid-1990s, particularly from 1994 to 1997, were associated with the rebuilding of Berlin's housing, infrastructure and cultural institutions - a process that led the world's business magazines to label the city as 'Europe's biggest building site'. As it would turn out, that meant the bank lacked the wide base of commercial and industrial clients that helped Germany's other major banks to ensure they were not too exposed to any single business sector.

In this heady atmosphere of renewal, BgB's subsidiaries rushed to set up closed real estate funds that would allow wealthy clients - including select members of Berlin's political and banking elite - to invest in the property boom.

Controversially, investors in the funds were given financial guarantees against much of the risk inherent in their investment as part of the deal. (The names of investors in these 'VIP funds' were gradually made public between 2001 and summer 2002 ^[3], embarrassing many of Berlin's political and financial industry luminaries.)

But the real economic damage began when the institution marketed the opportunity to invest in similar property funds to a wider public. With a product range that offered attractive rates of return, together with generous rental income and repurchase guarantees, BgB quickly became one of the leading players in Europe's real estate investment fund market. But the institution was buying market share by assuming real estate risks that were not properly measured or managed.

The concentration of property-related risk in BgB's portfolio also arose from conventional loans to property developers. These loans included the funding of a property development company called Aubis AG in a deal that later came to be regarded by the Berlin press as symbolic of the bank's poorly controlled loan approval process.

In 1995-96 Aubis persuaded the Berlin Hypo, controlled by veteran bank executive Klaus Landowsky, to extend loans worth hundreds of millions of euros to fund the refurbishing of Cold War period flats in the Berlin region, with the aim of generating premium rental income.

But Landowsky was not just a bank executive; he had also built a parallel career as a regional political grandee, and was entrenched in the Berlin senate as the long-term leader of the Christian Democrat parliamentary party, which controlled the coalition that dominated Berlin's political life from 1991 until the summer of 2001 ^[4].

Later investigations revealed that the two businessmen who controlled Aubis (and who themselves had strong historical links to the Christian Democrat party) had made a campaign donation to Landowsky's party ^[5]. Landowsky later strongly maintained that the donation had nothing to do with his role at the bank, or with the bank's decision to grant credit to the property developers.

But the Berlin Hypo's decision to extend credit to the property developer proved expensive for the bank when Aubis found itself unable to rent out its refurbished properties at appropriate rates. In 1999, with the East German and Berlin property market in freefall and Aubis in deep trouble, BgB took over the company's under-performing assets rather than force the property company into bankruptcy. As with many other BgB property-linked deals, the recovery rate on the loan was poor.

The potential problems at the bank did not go unmarked in Berlin in the mid-1990s. In 1997 a new management board chairman, Wolfgang Rupf, took charge, and there was an opportunity to streamline the bank's organisation and improve risk reporting. But Rupf did not succeed in uncovering the full extent of the bank's risk exposures or in pushing through the necessary changes.

Instead, the bank attempted to improve itself in a piecemeal way while developing grand ambitions to merge with other major German institutions and to acquire strategic banking assets in emerging Central European markets such as the Czech and Polish markets. BgB's senior executives continued to talk publicly of further expansion in Central European markets until well into 2000. Closer to home, however, the parent bank's fate now hung largely on how accountants and regulators chose to value the credit and investment guarantee risks that had been embedded deep in the portfolios of its subsidiaries during the mid and late 1990s.

In late 2000, the bank embarked on a bold plan to re-engineer this increasingly ominous risk portfolio. The idea, developed with investment bankers, was to sell off the more profitable operating business assets of property subsidiary IBG, using an offshore investment vehicle called Immobilien und Beteiligungen AG (IBAG), which could subsequently be listed. The money from the sale could then be used to plug the hole in the property-linked liabilities that remained in the bank's portfolio. On 2 January 2001, the business press duly reported that BgB's real estate business had been transferred to IBAG in preparation for the spin-off ^[6].

But if the transaction was to be more than a confusing piece of financial engineering, it required enthusiasm from investors, on the one hand, and some certainty about the level of the bank's real estate liabilities, on the other. Neither was forthcoming, and in early Spring an ever-widening investigation by BaKred, Germany's federal banking supervisors, forced the bank into a series of humiliating about-turns.

In March, BgB postponed its annual shareholder meeting and admitted it could not complete its 2000 accounts because of BaKred's continuing investigation and deep uncertainties about the potential risk in the property-linked portfolios of BgB's subsidiaries. Soon after, the bank announced that its supervisory board had approved the repurchase of the IBAG vehicle, and promised to make clear the consequences of this buy-back in its discussion of the year 2000 accounts. Meanwhile, a special enquiry by regulators into the bank's credit approval procedures led them to question the reliability of several (unnamed) senior executives.

The bank's growing disarray led to a rash of resignations and departures. In early March 2001, Klaus Landowsky stepped down as head of Berlin Hypo. Other senior managers at the Landesbank Berlin stepped down a few days later after concerns that they had allowed certain major creditors 'freedom from liability' in transactions without telling chairman Rupf.

Meanwhile the political scandal over the mismanagement of the bank, linked in many Berliners' minds to a much wider scandal in Germany over the funding of political parties, gathered pace, with calls for the resignation of Landowsky from his post as leader of the Christian Democrat parliamentary group in the Berlin senate.

In May the Berlin senate, unable to accept the idea of closing BgB, and aware that it could not repudiate many of the bank's commitments (or easily disentangle the private and public components of the institution), pledged backing for the bank.

But on 7 June the city's coalition government collapsed as the Social Democrats pulled out of the so-called 'grand coalition' in protest at the handling of the bank crisis, forcing veteran Christian Democrat mayor Eberhard Diepgen - a close political ally of Landowsky - to step down ^[7]. Diepgen, who had led Berlin through much of the 1980s and 1990s, handed his successor, Social Democrat Klaus Wowereit, the task of coping with the scandal-weary city's E36-billion debt mountain.

When BgB belatedly reported its official figures for 2000 on 16 July 2001, it revealed a startling E1.65 billion loss for the year 2000, and said that it had been obliged to set aside over E2 billion provisions against losses in its property-linked portfolio. About half the loss provisions were to cover property-linked lending, and the other half were to cover the rash guarantees the bank had given to investors in its property funds. It was one of corporate Germany's worst-ever performances, and without the state's intervention would have led to the country's worst post-war financial institution bankruptcy.

At the much-delayed annual shareholder meeting at the end of August, chairman Rupf admitted that the bank had suffered failings in its controls, management and information ^[8].

The bank also put forward a plan to restructure itself: cutting costs, bringing its subsidiaries more firmly under control, and re-focusing on its core domestic retail and savings business. But it seemed increasingly unlikely that Rupf would see out the five-year tenure generously extended to him by the supervisory board as recently as the beginning of the year ^[9].

In October 2001, the Christian Democrats were punished for their perceived sins by a 17 per cent point drop in their vote in regional elections, attributed largely to voter anger at their handling of Bankgesellschaft Berlin, now more than 80 per cent owned by the city following its recapitalisation of the bank in the previous month.

In November, the bank accepted the resignation of chairman Rupf, who was succeeded by deputy Hans-Joerg Vetter. As part of its reconstruction plans, the bank also announced that it would cut 4,000 jobs, or a quarter of its pre-crisis headcount ^[10].

The recapitalisation was not the end of the pain for Berlin's taxpayers. Through the autumn of 2001, worries began to surface that the full extent of BgB's potential losses had still not been uncovered. In December 2001, the city's authorities felt obliged to offer the bank a 'risk shield' (or Risikoabschirmung) that put the Berlin taxpayer on the hook for the incalculable risks associated with the bank's real estate dealings, for up to 30 years.

The European Commission, which announced an investigation in April 2002 into whether the recapitalisation of the bank and the new 'risk shield' contravened EU competition regulations, summed up the financial implications in this way: "The theoretical nominal maximum value of this risk shield is about E35 billion. That value will never in fact be reached, because for legal reasons some risk items are covered several times over, and a total loss of value is not a realistic prospect. But the risks involved do amount to several billion. So far it has not been possible to calculate and set a ceiling lower than the theoretical maximum of E35 billion, and it is therefore that figure that the Commission has to take as the value of the risk shield." ^[11]

Expert commentators think that likely losses, should BgB's historical portfolio of risk deteriorate, will fall somewhere between E3.7 billion to E8 billion.

The risk shield was endorsed by Berlin politicians as an essential precondition to the long-term restructuring and possible privatisation of the bank: without it, regulators would have obliged the bank to continue to put aside billions of euros in provisions. But the risk transfer also forestalled examination of the bank's activities in the bankruptcy courts, and ensured that many well-heeled fund investors would continue to receive their guaranteed investment returns at the expense of Berlin's social projects.

Meanwhile, Berlin's public prosecutor continues to extend a long-running investigation into the scandal. On 13 June 2002, the German press reported that the private homes of some 14 former top BgB managers had been raided.

As of July 2002, BgB's future is financially more stable but strategically uncertain. The bank is largely under new management, and is implementing its new organisational structure and its more modest business strategy. It looks possible that it will be privatised, with an August 14 deadline for bids for the bank fast approaching, though if a bid is accepted the deal is unlikely to be sealed before early 2003 ^[12]. On 19 July 2002, after meetings with Berlin mayor Klaus Wowereit on the issue, the EU Commission said that the privatisation of BgB would be a helpful sign of confidence in the restructuring of the bank ^[13]. Berlin politicians have also hinted they will accept the breaking up of the bank following any successful privatisation, suggesting that the relationship between the city and its flagship bank has indeed changed.

In mid-July 2002, Vetter - chairman since December - said the bank would make a modest loss again this year and would need a considerable time to rebuild its reserves (even after the help extended to it by the taxpayer). At shareholder meetings, executives continue to have to face down protestors who blame the bank and its past management for continuing cuts in Berlin's social spending ^[14].

1989: Berlin Wall comes down, signalling the reunification of Germany and the rebirth of Berlin as the country's political capital. From 1991 until the BgB scandal breaks, the city is governed in most years by a 'grand coalition' led by the Christian Democrats.

1994: BgB created by merging institutions owned largely by the Berlin regional government, notably Landesbank Berlin and the Berlin Hypo mortgage bank, with the private Berliner Bank.

Mid-1990s: BgB sets up property-backed funds that are a lot riskier for the bank than for its retail investors. It also approves a series of risky loans to property developers and becomes involved with many of Berlin's landmark regeneration projects.

1997: Wolfgang Rupf becomes chairman of the bank. But the bank does not succeed in streamlining its organisation or sufficiently improving its risk reporting.

1999: The property bubble bursts in Berlin and surrounding regions.

Late 2000: There are growing worries about the potential for mounting losses from the bank's real estate portfolio, but few yet suspect the extraordinary size of the problem.

January 2001: BgB says it has placed assets from its real estate business into a special vehicle, Immobilien und Beteiligungen, or IBAG.

February 2001: Press reports in Germany fuel rumours that BgB has lost billions of euros from its property-linked funds. Inside the bank, there is a crisis brewing.

March 2001: The bank postpones its shareholder meeting and annual report and is now in full crisis. Senior managers at its subsidiaries step down and the bank announces that it will buy back and reabsorb its IBAG real estate investment vehicle.

March - May: There is increasing disquiet in Berlin's ruling 'grand coalition' over the past conduct of the Christian Democrat party in relation to BgB.

6 May 2001: Landowsky announces his resignation as Christian Democrat parliamentary party leader.

May 2001: Berlin Senate guarantees that it will back the bank for fear that the regulators will otherwise close down the crippled institution.

7 June 2001: Berlin coalition government collapses as Social Democrats pull out of grand coalition in protest at handling of bank crisis by Christian Democrats.

16 July 2001: BgB reports a massive loss of E1.65 billion for the year 2000.

August 2001: Leading up to its delayed annual meeting for shareholders at the end of August, the bank announces its plan to bring its subsidiaries back into the main structure of the bank to improve risk management. From now on it will concentrate on its core strength in retail banking.

September 2001: Berlin pumps E1.75 billion of new capital into the bank to secure its future.

October 2001: Christian Democrats suffer fall-out from the scandal with a 17 per cent point drop in their vote in regional elections.

Early November: BgB denies press rumours that it faces a E1 billion-plus loss for 2001, following its E1.65 billion loss in 2000, though it agrees that losses will be substantial.

30 November 2001: The bank accepts resignation of chairman Wolfgang Rupf, who is succeeded by deputy Hans-Joerg Vetter. The bank plans to lay off 4000 employees, about a quarter of its pre-crisis headcount.

December 2001: Berlin's regional government announces plans for a 'risk shield' under which the city will assume many of the risks and liabilities of BgB's real estate portfolio over the next 30 years.

9 April 2002: EU Commission says it is running a formal enquiry into the restructuring aid that the Berlin government has granted to BgB.

2 May 2002: US financier Christopher Flowers and Texas Pacific Group join forces to bid for the 81 per cent of BgB owned by the city government.

June 2002: Four bidders, three of them foreign, are allowed into the 'data room' stage of the bidding process so that they can consult detailed records about Bankgesellschaft's financial condition prior to making offers.

2 July 2002: EU Commission institutes a formal investigation into the transfer in 1992 of a housing loans institution, Wohnungshau-Kreditanstalt, to the Landesbank Berlin (from 1994, a subsidiary of BgB), which the Commission is concerned might qualify as state aid. The Commission is eager to sort out the legality of the transfer as it might affect other rulings on the general restructuring of BgB.

8 July 2002: The bank names Italy's Unicredito bank as preferred bidder for its dominant holding in Zivnostenska Banka, a medium-sized retail Czech bank. It's all part of the unravelling of BgB's cross-border investments as it refocuses on its core regional German business.

19 July 2002: At its annual shareholder's meeting, BgB's management faces protestors who blame the troubled institution for continuing cuts in Berlin's social spending. Chairman Vetter says BgB will make a loss again this year.

August 2002: The deadline for bids for potential purchasers of BgB is 14 August. If a bid is successful, the bank could be privatised by early 2003, and senior executives have suggested that by 2004 it could be making a profit. But the German taxpayer will remain disastrously out of pocket, whatever the future holds for the institution.

NOTES