More than a decade had passed until the last German private creditors who were owed money by the US investment bank Lehman Brothers were finally reimbursed a portion of their invested money a few days ago. It seemed to take forever to wind up the bank’s Dutch subsidiary, Lehman Brothers Treasury, the issuer of Lehman certificates sold in Germany.

The bad news is that European banks are still burdened by bad loans. According to the European Banking Authority (EBA), the total amount of non-performing loans (NPLs) in the balance sheets of European banks is estimated at EUR 813 billion, with banks in Southern Europe accounting for a predominant share of such NPLs. The EBA considers the amount of NPLs at banks in Greece, Cyprus and Italy to be high by historical standards.

As far as German banks are concerned, non-performing loans account for EUR 49.6 billion of banks’ balance sheets, which corresponds to a relatively low ratio of 1.9%. But even banking locations that appear robust are not immune to risks according to the EBA, especially due to the risk of contagion across the European banking system as a whole.

For some institutions, the situation is already tense. And if the European Central Bank continues to lower interest rates in the foreseeable future, as it has indicated, the situation could escalate.

“There’s no use beating around the bush: things will be tougher in that case,” BaFin President Felix Hufeld anticipates. He said plainly what this would mean in concrete terms. “More banks would have to exit the market, and there would be more and quicker consolidations,” he said. In his view, small and medium-sized private banks would be particularly affected.

BaFin is prepared if a crisis should occur

Despite this looming threat, the good news is that BaFin is prepared if a small number of banks have to exit the market. “We do not have a problem with banks being forced out of the market,” Hufeld explained. But if this occurs, it must be done as part of an orderly process. For this reason, resolution plans have been drawn up for significant banks in particular.

The Single Resolution Mechanism (SRM) at EU level is one of the lessons learnt from the bank bailouts in Europe during the last financial crisis over a decade ago. BaFin has been Germany's national resolution authority (NRA) since the beginning of last year. In this role, it is also part of the Single Resolution Mechanism at European level.

In Europe, an agreement was reached to split responsibilities for the resolution regime for financial institutions. While the Single Resolution Board (SRB), based in Brussels, is mainly responsible for significant institutions (SIs), the national resolution authorities in EU Member States – such as BaFin in Germany’s case – are responsible for less significant institutions (LSIs) along with financial market infrastructures.

The expertise of BaFin’s staff is vital in the context of resolution planning for significant institutions and actual resolutions, as they work in close collaboration with their counterparts at the SRB and other resolution authorities in third countries, such as the United States, the United Kingdom and Switzerland.

BaFin is directly responsible for resolution matters in the case of less significant institutions. These include small and medium-sized banks and the branches of banks from neighbouring countries in the EU, certain holding companies of banking groups and CRR investment firms, i.e. financial services institutions engaged in principal broking services or underwriting business. The number of these institutions is growing as an increasing number of financial institutions are moving their administrative offices from the United Kingdom to Germany due to Brexit.

Chief Executive Director/Crisis Manager

The chief crisis manager in Germany is Dr Thorsten Pötzsch. As the Chief Executive Director of BaFin’s Resolution Directorate, he is also responsible for money laundering prevention and appears to be predestined for highly complex cases. When the global financial crisis struck in 2008, he was in a senior position in the Financial Market Policy Directorate at the Federal Ministry of Finance – throughout the entire duration of the crisis.

“Since then, I’ve been even more aware of the importance of being well-prepared for a crisis,” said Pötzsch. This includes effective tools and staff you can rely on, he explained, as well as established processes within a legal framework.

“Every bank must be resolvable,” said Pötzsch. In his experience, the existence of a bank resolution regime itself ensures self-discipline. His motto is: “The resolution rules generate market discipline.”

It is only when a bank is failing or likely to fail and all the tools available to banking supervisors and the private sector have been exhausted that the crisis managers in BaFin’s Resolution Directorate come into play. If there are increasing signs that a bank is failing or likely to fail, BaFin initiates the crisis management procedure: the crisis unit meets, goes into “crisis mode” and assesses whether the legal requirements for a resolution are met.

This is a complex decision that depends on many internal and external factors and parties. Is the resolution of the bank in the public interest? What losses are to be expected? How is the bank’s liquidity situation developing? Is there a threat to financial stability? How are the markets reacting? How can the resolution plan be implemented? It is only when all the information has been gathered that an overview of the crisis situation can be obtained.

The crisis managers in BaFin’s Resolution Directorate examine all the above on a regular basis to prepare for a crisis event. During a simulation exercise, an order to resolve a fictitious medium-sized bank that is failing or likely to fail must be issued within 48 hours in almost realistic conditions. This is where Holger Helms comes in: he has been the Head of Crisis Management in BaFin’s Resolution Directorate since the beginning of 2018. As a business economist and a former officer in the Bundeswehr, he has experience when it comes to dealing with crises.

“We have worked intensively on the preparations for a resolution in just a few specific cases” said Helms, without giving any names. His work mainly involves refining internal processes. New developments can occur anytime, such as the imminent withdrawal of deposits.

The objective: at the end of the simulation – as in real life – the order to resolve the bank must be issued. In the event of a crisis, the resolution experts from different teams work around the clock to prepare the administrative act. Such an act may comprise thousands of pages, including annexes. Expertise in tax and business law, company valuations, balance sheet analyses or transactions is required in this context.

Market exit

Resolution orders are legally binding as soon as they are published on the BaFin website. This can mean that the bank in question, together with its business model up to that point, is forced out the market.

But also in times of economic stability and normal business operations, BaFin’s crisis managers are in contact with banks as part of regular resolution planning. The focus here is the prevention and early detection of crises. BaFin’s experts draw up a resolution plan for every single bank within BaFin’s remit. They regularly assess the resolvability of each institution, too.

BaFin may also contact the senior management of banks to strengthen crisis governance, streamline the company’s structure, separate EU and non-EU activities, or enhance IT equipment and data availability in dry runs, for instance, to ensure that it is possible to react swiftly in the event of an actual crisis.

Race against the clock

The reason for this is that a bank resolution is a race against the clock. If BaFin’s crisis management team has to meet in a specific case, this is a red alert for Germany's financial sector. In BaFin’s bug-proof meeting rooms in Frankfurt, all of the stops are pulled out to maintain financial stability in the country.

All meetings, including the minutes of these meetings, are kept secret; confidentiality is of utmost importance. During these meetings, decisions on the risk and data situation, group structure and resolution strategy of the institution concerned are reached – as quickly as possible.

What needs to be done in order to resolve a bank in Germany? “The most important factor is the availability of reliable data on the bank in question,” said Helms. On this basis, BaFin examines the extent to which shareholders’ equity and creditors’ claims can be used to offset losses (bail-in).

Unclear group structures can be problematic as well. In the event of a bank resolution, BaFin must be able to break up the bank. But in order to do this, the crisis managers at BaFin need to know how the individual units can be separated in the first place.

The resolution regime is aimed at ensuring that taxpayers will not foot the bill for bank losses – as was still the case during the financial crisis. For this reason, the regime ensures that moral hazards are eliminated and that banks are not tempted to take excessive risks.

In addition, models are intended to allow banks to exit the market without jeopardising financial stability or the real economy – either within the context of normal insolvency proceedings or a resolution.

Shareholders and creditors that have lent money to the bank must bear part of the losses in the event of a resolution. This is another lesson that was learnt after the global financial crisis.

Resolution tools

In addition to the bail-in of shareholders and creditors, there are other ways to conduct an orderly resolution. Banks can also be sold to competitors or financial investors or transferred to a bridge institution following an order issued by BaFin. However, the resolution strategy for smaller banks usually involves normal insolvency proceedings, after assessing the proportionality of the tools available. The focus is on ensuring that the measures taken are in the public interest.

Although a systemically important bank has not yet been resolved to completion under government supervision in Germany, several small and medium-sized banks have had to exit the market for various reasons. The Munich-based investment bank Dero became insolvent in 2018; this was also the case for Maple Bank in Frankfurt two years prior. Both institutions had encountered financial difficulties due to high tax claims. BaFin’s crisis managers found that they were failing or likely to fail, and the institutions underwent normal insolvency proceedings.