The mysterious political economy of the IKB bailout

If ever a bank was sufficiently systemically insignificant and small enough to fail by any metric except for the political embarrassment metric, it is surely IKB, the German small and medium enterprise lending bank that got itself exposed fatally to the US subprime crisis through a conduit (wholly owned off-balance sheet entity) devoted to speculative ventures involving instruments it did not understand.

Yet after two bail outs by its shareholders (which provided funds or guarantees for just over €6 bn), we now have the German Federal Government about to inject €1bn out of a third rescue attempt total of €1.5bn. The earlier rescue attempts were largely public sector bail outs in any case. The largest shareholder of IKB is KfW, a state-owned development bank which holds 38% of the shares of IKB. 

I can think of no better way of encouraging more appropriate future behaviour towards risk by German banks than letting IKB go into insolvency now. The institution gambled recklessly and irresponsibly. It lost. Liquidation and sale of its assets would be the market-conform reward for its failures.

We are not dealing here with an institution facing a liquidity crunch. This is no Northern Rock which invested reasonably sensibly but got caught in a funding crunch when global wholesale markets froze in August 2007 as a result of circumstances beyond its control. This is an institution which, through its out-of-sight-and-out-of-mind conduit, invested badly and paid the price. It deserves to fail. And it is in the interest of future sound banking in Germany that it be allowed to fail. Contagion effects are extremely unlikely, as it is plain as a pikestaff that it is insolvency because of bad investment decisions rather than illiquidity because of disorderly financial markets or other irrational herding behaviour that is causing the downfall of this minor German bank.

The €1.5bn stumped up in this third rescue attempt is in any case unlikely to be enough to recapitalise IKB in a sustainable way. If this misguided half-rescue goes ahead, it will have to be followed up shortly by a further larger injection of funds (public or private but government-cajoled) within a couple of months at most.

Peer Steinbrück, the German Federal finance minister, talks a pretty good game about market discipline. The proposed bail-out of IKB is a form of socialism for the rich and well-connected that should appeal neither to market disciplinarians nor to the left wing of the SPD. So what is driving the politics of this bail out?  Surely it could not be fear of political embarrassment?  Let’s hope that the European Commission will view a politically motivated rescue of IKB for what it is: an illegal use of state aid.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website