Financial Reporting, Financial Regulation, and ... - (SSRN) Papers

Financial Reporting, Financial Regulation, and Financial Stability: Evidence from German Bank Failures in 2007-2008*

Oana Maria Georgescu European Central Bank (ECB) and Christian Laux** WU (Vienna University of Economics and Business) & Vienna Graduate School of Finance (VGSF)

June 2015 Abstract We investigate three prominent German bank failures in the financial crisis of 2007-2008, IKB Deutsche Industriebank, Landesbank Sachsen, and Hypo Real Estate (HRE). The cases provide a unique setting to analyze the interrelation between financial reporting, regulation, and financial stability. All three banks were regulated based on German local GAAP, not International Financial Reporting Standards (IFRS) even though IKB and HRE were required to publish reports based on IFRS. Thus, some of the most spectacular failures early in the crisis occurred for banks that were regulated based on historical cost accounting. Regulation based on historical cost did not prevent these banks from taking on very high leverage, and it did not result in an effective cushion in the crisis.

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We thank Ahmed Barakat and Thomas Rauter for excellent research assistance and Jannis Bischof and Christian Leuz for valuable comments. We are grateful for funding from the Frankfurt Institute for Risk Management and Regulation (FIRM), and Christian Laux also thanks the WU Jubilee Foundation for research support. The views expressed in this paper are those of the authors alone and do not reflect the opinions of the affiliated institutions.

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Corresponding author: [email protected]

1. Introduction We investigate three prominent German bank failures in the financial crisis of 2007-2008: IKB Deutsche Industriebank AG (IKB), which was the first European victim of the subprime crisis and was bailed out in July 2007; Landesbank Sachsen Girozentrale (Sachsen LB), which was rescued just one month later; and Hypo Real Estate Holding AG (HRE), which was bailed out in October 2008 after the Lehman bankruptcy. Examination of the three cases is interesting because of specific rules for financial reporting and financial regulation that were in place in Germany and that help to distinguish between effects of financial reporting and those of financial regulation. International Financial Reporting Standards (IFRS) for consolidated financial statements became mandatory for all firms listed on exchanges of EU member states just prior to the onset of the crisis, and the published financial statements of IKB and HRE were based on IFRS reports. However, both banks were not regulated based on these published financial statements. Instead, they were regulated using financial reports based on German local GAAP (HGB), where historical cost accounting prevails. Sachsen LB never published an IFRS report before its bailout. All three institutions had very high debt-equity ratios (in addition to high off-balance sheet debt). For example, HRE had a staggering debt-equity ratio of nearly 65 at the end of 2007, about 3 times the average of large EU banks. The three banks are no outliers. All German Landesbanken and smaller German banks were regulated based on HGB, and the regulatory capital of these banks was not affected by fair value accounting. However, the unrealized gains on their trading assets and available for sales securities increased the equity in the published IFRS reports. Thus, in a boom, the banks’ debt-equity ratios based on IFRS should be lower than their debt-equity 1

ratios based on HGB. If the choice of accounting rule has a first order effect on banks’ leverage, German banks should have a lower debt-equity ratio compared to other EU banks, when comparing these ratios based on IFRS reports. However, the IFRS debt-equity ratio of German banks was about twice the level of UK banks despite the higher levels of trading assets and available for sale securities held by the average German bank (see Table 2). Thus, the use of German local GAAP rather than IFRS seems to have played a limited role in constraining the leverage of these banks.1 In addition to their on-balance sheet debt, IKB and Sachsen LB had huge off-balance sheet obligations. Would these banks have chosen less debt if they had to consolidate their conduits? In February 2008, and therefore after its bailout, IKB published a restated financial statement for the fiscal year ending March 31, 2007 in which it consolidated its main conduit, Rhineland Funding, increasing total assets by 25 % and the debt-equity ratio from 36 to 52. However, total risk weighted assets did not change. Again, the example shows that there is often no close link between financial reporting and regulation.2 Although consolidation would not have constrained management through the regulatory channel, investors might have forced management to react, when observing IKB’s high consolidated debt-equity ratio. However, IKB disclosed its credit commitments in its prior annual report. Considering the disclosed credit commitments, it was easy to derive IKB’s total debtequity ratio without the need for a consolidated balance sheet. Moreover, IKB’s debt-equity ratio

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It is important to note that a direct comparison of the leverage ratios is difficult as many German banks, in particular Landesbanken, use subordinated debt and hybrid capital that is reported as debt in the financial statement but counts as regulatory capital. However, standard equity and subordinate debt are very different when it comes to financial distress. Differences between financial reporting and regulation are discussed in Section 3; see also, for example, Acharya and Schnabl (2010), Barth and Landsman (2010), and Laux and Leuz (2010).

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after consolidation was still lower than that of some other banks. It seems to be more likely that investors were not concerned about the high off-balance sheet obligations than that the lack of consolidation mislead them.3 Indeed, KfW Bankengruppe, a large German publicly owned bank, held nearly 40 % of IKB’s shares, and it is difficult to argue that IKB’s key shareholders were naive. IKB and Sachsen LB failed because they were unable to honour their financial commitments from their off-balance sheet conduits investing in US mortgage backed securities. Because of these commitments, both banks did run into refinancing problems. Sachsen LB issued HGB reports, but this did not help, and it is also highly unlikely that IKB would have been better off publishing HGB reports instead of IFRS reports. Just 10 and 7 days, respectively, prior to their bailout, both banks reassured the market that the problems in the US mortgage market did not affect them (IKB) and that they had sufficient liquidity (Sachsen LB). Investors realized that the judgment of management might not be reliable and outdated within a couple of days, which certainly contributed to general market concerns and mistrust about the risk exposures of individual banks. HRE heavily relied on short-term funding and ran into refinancing problems after the bankruptcy of Lehman Brothers in October 2008. The problems spilled over from its Irish subsidiary DEPFA, which it acquired in the middle of 2007. DEPFA focused on public sector and infrastructure finance. At the end of 2006, DEPFA had total assets of € 223 billion and a staggering debt-equity ratio of 73.3. Moreover, more than 40 % of its total liabilities had a maturity of less than three months and more than 57 % of these liabilities were deposits from

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See Niu and Richardson (2006) and Landsman et al. (2008) for evidence suggesting that investors took into account even implicit guarantees provided by banks for the SPVs they sponsored.

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other banks. In contrast, less than 7 % of its total assets had a maturity of less than 3 months (DEPFA, Annual Report 2006, p. 143). HRE was in no position to deal with the refinancing problems encountered by DEPFA. As already noted, HRE’s regulatory capital was based on HGB. While HRE’s published reports are based on IFRS, it is implausible to believe that investors would have continued to finance HRE if HRE could have avoided reporting fair values in the crisis given its high leverage and reliance on interbank funding. Our evidence complements evidence on Northern Rock provided by Shin (2009). When financing with commercial paper became increasingly difficult in August 2007, Northern Rock was not able to roll over is short-term funding (Shin, 2009). The problem was not attributable to fair value accounting, as most assets on Northern Rock’s balance sheet were loans and advances reported at historical cost. Instead, its problem was high leverage and unsecured short-term financing. IKB, Sachsen LB, and Northern Rock were the first European banks that failed. It is hard to argue that they were victims of the contagious effect of fair value accounting at other banks.4 Politicians, regulators, and the popular press voiced strong concerns that accounting played an important role in fuelling the financial crisis of 2007-2008. For example, in September 2008, Nicolas Sarkozy gave a speech to the French in which he argues: “Banks were subjected to accounting rules which provide no guarantee on the proper management of the risks but which, in the event of a crisis, contribute to exacerbating the situation instead of cushioning the shock. It

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The problems of investment banks, money market funds, and conduits at that time stemmed from refinancing problems and the role that market values play for financing, not financial reporting. See, for example, Ashcraft and Schuermann (2008), Brunnermeier (2009), Gorton (2009), Hellwig (2009), and Rajan et al. (2015) for a discussion of some of the main problems at the beginning of the crisis.

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was a madness for which we’re paying the price today!” Steve Forbes (2009) writes, “Mark-tomarket accounting is the principal reason why our financial system is in a meltdown.” Several studies analyse the role of fair value accounting in the crisis of 2007-2008, focusing on US banks. These studies do not find evidence that fair value accounting was a main culprit in the crisis.5 However, the concern that an excessive reliance of accounting on market values played a key role in the crisis is still widespread, and politicians in the European Union think about measures to gain a larger influence on the development of accounting standards. (See, for example, the Maystadt (2013) report on whether IFRS standards should be more European, prepared by the request of Michel Barnier, who was at that time European Commissioner for Internal Market and Services.) Understanding the possible channels through which accounting might cause problems and the specific rules applicable is important to improve financial reporting and regulation to foster financial stability. The differences in accounting rules for financial reporting and for regulatory purposes for the German banks provides a unique setting to analyze the issue. All three banks were regulated based on German local GAAP (HGB), where historical cost accounting prevails, not IFRS or US GAAP. In contrast, the banks in the US studies were regulated using their financial statements based on US GAAP. For the banks in our study, market values played a very limited role both in accounting and in regulation; however, they were arguably very important for the banks’ ability to obtain financing. Because of regulatory rules that required very low or even zero risk weights for certain types of assets and guarantees, these banks could take on very high leverage. Historical cost accounting did not constrain these banks’

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See Penman (2007), Benston (2008), Ryan (2008), SEC (2008), Laux and Leuz (2009, 2010), Barth and Landsman (2010), Bhat et al. (2011), Badertscher et al. (2012), Huizinga und Laeven (2012), and Laux (2012) for a discussion of the pros and cons of fair value accounting and evidence on its role in the crisis. See, for example, ECB (2004), Banque de France (2008), IMF (2008), and Banca d’Italia (2009) for the regulatory perspective on fair value accounting and procyclicality and, in particular, Allen and Carletti (2008) and Plantin et al. (2008) for the theoretical foundations.

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leverage. The cases also illustrate the limitations of the argument that historical cost accounting is appropriate for loans if or because they are held for the collection of cash flows. A bank’s business model might very well be to hold loans (or other financial assets) until maturity. However, if a bank is financed short term, it might not have a choice in a situation where investors are unwilling to refinance their business model. Thus, it is important to consider the portfolio of assets and the level of short-term funding. Although it is not possible to generalize from these cases, they help to understand specific deficiencies of financial reporting and financial regulation and can guide regulators and standard setters. Thereby, our cases provide important evidence that compliments the studies focusing on US banks. We provide a quick overview over some of the key rules underlying financial reporting and financial regulation in Sections 2 and 3, respectively. In Section 4, we turn to the three case studies, IKB, Sachsen LB, and HRE, to analyze the interrelation between financial reporting and financial stability for these banks. We conclude in Section 5.

2. Financial Reporting In March 2002, the European Parliament passed regulation requiring all firms of EU member states listed at exchanges of EU member states to apply International Financial Reporting Standards (IFRS) for consolidated financial statements for fiscal years starting on or after Jan 1, 2005. IFRS replaced Local GAAP or US GAAP, which a few large firms in Europe used. Firms that only listed debt securities, but no equity securities, and firms that used US GAAP and had listed securities in the US were granted a transition period for required adoption that ended for fiscal years starting on or after January 1, 2007.

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As US GAAP, IFRS uses a mixed-attribute model. Firms have to recognize trading assets, trading liabilities, and derivatives as well as those assets and liabilities for which the bank chooses the fair value option at fair value and fair value changes directly affect net income.6 Available for sale securities are also reported at fair value, but changes in fair value only affect net income if the securities are other than temporarily impaired (US GAAP) or there is objective evidence of impairment (IFRS) in which case the firm has to write the securities down to their fair value. Otherwise, a change in fair value of available for sale securities is recognized in other comprehensive income. Loans and receivables as well as held to maturity securities are reported at amortized cost (“historical cost”) and subject to impairment testing. In Tables 1 and 2, we provide an overview of the key assets held by German and European banks that published IFRS reports.7 We include the numbers for European banks to put the numbers for German banks into perspective. The numbers are for the year 2007 despite the start of the crisis in 2007 to include also those banks that did not use IFRS reporting before 2007 given the transition period from 2005 to 2007. The numbers for 2006 are very similar. - Tables 1 and 2 The largest category for most European banks is loans, which are reported at historical cost. However, EU banks also have a very high level of trading assets. As the distribution of holdings is very uneven with the largest banks holding the largest fraction of trading assets, we report both value weighted and equally weighted averages in Table 1. For example, for Deutsche Bank trading assets and derivatives are 70 % of total assets (see Table 3).

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Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. See, for example, Laux and Leuz (2010) for an overview over the types of assets that US bank holding companies and investment banks held prior to the crisis.

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When comparing the balance sheets of European and US banks, two differences between IFRS and US GAAP can be important. First, application of IFRS versus US GAAP can have a large effect on the leverage ratio of a bank. A prominent example is Deutsche Bank, which switched from US GAAP to IFRS in 2007. Table 3 reports Deutsche Bank’s balance sheet under IFRS and US GAAP as of December 31, 2006. Total assets, and in particular trading assets, are considerably higher with IFRS than with US GAAP mainly due to different netting rules for derivatives. As a consequence, the debt-equity ratio increased from 33 to 46. However, Deutsche Bank is an extreme case. Often the difference is less pronounced and it can go in the opposite direction. For example, UBS’s total assets under US GAAP are 10 % higher than under IFRS at the end of 2006 (UBS, Annual Report 2006). - Table 3 Second, under IFRS a bank can classify debt securities in any category including loans and receivables if the debt securities are quoted in an active market. If they are not quoted in an active market, they must not be classified as held to maturity but they can be classified as loans and receivables.8 In contrast, US GAAP does not allow the classification of debt securities as loans and receivables. This difference can be important when analyzing how the crisis and policy measures affected European banks’ willingness to provide loans. For example, if reported loans and receivables did not decrease (substantially) for European banks, the reason might be that the amount of debt securities (e.g., government bonds) held in this category increased, not that the banks did not reduce lending to households and firms.

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“A financial instrument is regarded as quoted in an active market if quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency, and those prices represent actual and regularly occurring market transactions on an arm’s length basis” (IAS 39, Appendix A, Application Guidance AG71).

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The initial classification of financial assets depends on whether management intends to hold the assets for trading or until maturity. US GAAP allows reclassifications in rare circumstances. The reclassification option did not exist under IFRS until October 13, 2008, when the IASB amended the rule in response to strong political pressure. (See Bischof et al., 2014, for an analysis of which banks used the reclassification option and the stock market reaction.) IFRS requires that a sponsor bank has to consolidate the assets of a special purpose vehicle (SPV) if it maintains substantially all the risks and rewards in relation to the SPV, if it effectively controls the SPV, or if it is undertaking activities on its behalf (IAS 39 §16-30 and SIC 12 §8-10). However, in practice, the criteria carry some degree of ambiguity and whether some of these criteria are satisfied depends on the exact terms of the liquidity facilities and the program wide credit enhancement (if any) in place. In many cases, prior to the crisis, banks chose the structure of the SPVs to avoid consolidation. Prior to the introduction of IFRS, most German banks reported under HGB (German local GAAP). In contrast to IFRS and US GAAP, HGB distinguishes primarily between two reporting categories: current and fixed assets. In both categories, banks report the assets at amortized cost, but the two categories differ with respect to the impairment rules. Banks have to write down current assets to their market value when the market value falls below the reported amortized cost (strict lower of cost or market value principle). If no market price is available, banks have to use models to determine the present value of financial assets, using available market information. A decrease of the market value below historical cost has a direct impact on net income, and not only if the asset is other than temporarily impaired as for available for sale debt securities under IFRS or US GAAP. In contrast, a bank has to write down fixed assets only if the decrease in value is likely to be non-temporary.

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Management chooses the initial classification of financial securities and classifies financial securities that it intends and is able to hold until maturity as fixed assets. If management intent changes and management decides to hold financial securities until maturity, which it initially classified as current assets, it has to reclassify these securities (IDW, 2009). In general, the basis for recognition in the case of a reclassification from current to fixed assets is the value reported in the previous year, but if interim reports are available, the reporting entity may choose to use the interim value. Thus, if management decides and is able to hold these securities until maturity, it is possible for a bank to reclassify debt securities from current to fixed assets if the market value falls below the historical cost. The bank can pick these assets with hindsight and thereby avoid writing them down to their market value if the market deteriorated in the reporting period and this decrease in market value is considered to be temporary.

3. Prudential regulation In Europe, prudential regulatory standards are set on a national level, based on the standards of the Bank of International Settlement. In general, banks’ published financial statements are underlying regulatory capital requirements, but regulators make important adjustments for regulatory purposes. For example, unrealized fair value changes of a bank’s liabilities that stem from changes in a bank’s own credit risk, as well as changes in goodwill and intangible assets do not affect regulatory capital even when they affect the equity reported under IFRS or US GAAP. Another example that was particularly important in the crisis concerns fair value changes of debt securities held in the available for sale category. In most countries, including the US, fair value changes on available for sale debt securities do not affect regulatory capital, both on the upside as well as the downside: The regulator chose to add back unrealized losses of available for sale debt securities to the regulatory capital. Notable exceptions are Austria, Germany, Italy, Portugal, and 10

Spain. In these countries, unrealized losses of available for sale debt securities did reduce regulatory capital. Thus, for those German banks regulated based on their IFRS report, unrealized losses of available for sale debt securities did reduce their regulatory capital.9 Most German banks were not regulated based on IFRS reports. Even banks that were required to publish IFRS reports could choose between using either their published IFRS reports or financial statements prepared using German local GAAP for regulatory purposes. Deutsche Bank and Commerzbank chose IFRS, but most other banks, including most Landesbanken, IKB, and HRE, chose German local GAAP. Consequently, for these banks, financial statements prepared in accordance with HGB, not IFRS, determined regulatory capital requirements. As HGB allowed for reclassifications provided there was a change in management intent, German banks regulated based on HGB were able to reclassify assets to avoid the “lower of cost or market” rule for regulatory purposes. Since banks are not required to publish the HGB reports, which they submit to the regulator, no systematic analysis is possible. However, the example of Bayern LB suggests that this type of reclassification might have played an important role. Bayern LB reclassified debt securities with a book value of € 37.5 billion from current assets to fixed assets in 2007, which amounts to more than 50 % of the debt securities held as current assets (Bayern LB Geschäftsbericht, Einzelabschluss, 2007). By reclassifying the assets, Bayern LB avoided writing the assets down to their market value. The level of risk-weighted assets is of central importance for prudential regulation. Regulators determine risk weights, not standard setters. An interesting divergence of accounting and regulation arises in the treatment of asset backed commercial paper (ABCP) conduits. Even

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The regulator changed the this treatment of unrealized losses of available for sale debt securities in July 2009, allegedly in order to mitigate the procyclical effect of accounting standards on regulatory capital (Bundesanstalt für Finanzdienstleistungsaufsicht, 2009).

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when US GAAP and IFRS required the consolidation of ABCP conduits for which a sponsoring bank provided liquidity facilities, some regulators treated them as off-balance sheet and required a zero risk weight. (See Acharya and Schnabl (2010) for a discussion of differences in financial reporting and prudential regulation of ABCP conduits in selected countries.) Liquidity facilities were generally considered off-balance sheet under Basel I and there was no capital requirement for these facilities in Germany until the introduction of Basel II in 2008/2009.10 Even then, regulatory capital requirements for assets held through conduits were lower than for comparable assets held directly. In contrast, Spanish banks had to consolidate off-balance sheet assets for regulatory purposes as early as 2000, which is often seen as one of the reasons for why securitization played a negligible role for Spanish banks (Acharya and Schnabl, 2010).

4. German Bank Failures in the Crisis In 2007, conduits and investment funds that relied on short-term capital for funding experienced refinancing problems due to the problems in the US mortgage market.11 These problems also affected European financial institutions that sponsored conduits and investment funds that invested in US mortgage backed securities.

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European banks were required to comply with Basel II capital standards starting with 2008, while the phase-in process for US bank holding companies was initially scheduled for 2009. Thus, in contrast to US bank holding companies, at the height of the crisis in autumn 2008, large European banks had generally implemented Basel II. See the references in footnote 5 for some discussion. Refinancing problems of conduits spilled over to banks that had (explicit or implicit) credit obligations towards their conduits. Acharya et al. (2013) estimate that by the end of 2008, the largest part of the total losses on ABCP conduits were born by the sponsors, rather than outside investors.

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4.1. IKB Deutsche Industriebank AG (IKB) IKB Deutsche Industriebank AG (IKB) is a German bank that specializes in long-term financing of small and medium-sized enterprises. July 30, 2007, IKB run into financial problems because of liquidity facilities it provided to its conduits and KfW Bankengruppe, a publicly owned bank, which held a 38% stake in IKB’s shares, had to bail it out. IKB was the first European bank that had to be rescued, feeling “the impact of the crisis in the US sub-prime mortgage market, as spreads widened sharply during last week’s violent fluctuations, causing massive uncertainty amongst institutional investors. In this context, the ability of the Rhineland Funding conduit (managed by IKB) to access funding appeared to be threatened, in which case IKB would have been drawn upon liquidity facilities provided to Rhineland Funding. Rhineland Funding – and, to a lesser extent, IKB itself – have invested in structured credit portfolios, which include exposures to US sub-prime real estate loans.” (Ad hoc announcement “KfW backs IKB”, issued by IKB on July 30, 2007.) Just 10 days prior to the bailout, IKB issued a press release in which it confirmed its outlook for the fiscal year 2007/2008 and argued that the developments in the financial market “due to instabilities in the US mortgage market” will not have a notable impact on IKB.12 Management issued the press release and early publication of quarterly figures to calm investors who were concerned about IKB’s subprime exposure (see, e.g., Streckert, 2007). The fact that IKB had to be bailed out just 10 days after actively reassuring investors about its

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“Over the last few weeks the development within the European financial sector – especially in the equity and capital markets – has seen extreme volatility, especially due to instabilities in the US mortgage market. Moody’s analysis of this segment released last week does not have any impact on IKB’s investments in international loan portfolios nor on the advisory activities of IKB Credit Asset Management GmbH. In this context Moody’s has put quite a number of tranches “on watch” for possible downgrade, whereof IKB is only affected by a single digit million figure. Furthermore, IKB is in no respect affected by the most recent analysis carried out by Standard & Poors with regard to the CDO-market. It is worth noticing that the bulk of our investments are in portfolios of corporate loans.” (Press release “Preliminary results for the first quarter (1 April 2007 – 30 June 2007)”, issued by IKB, July 20, 2007.)

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strength certainly contributed to general market concerns and mistrust about the exposure of individual banks to US mortgage risk and credit guarantees. Rhineland Funding, from which IKB’s problems originated, is the largest of several conduits (investment vehicles) that invested in collateralized debt obligations (CDOs) and mortgage backed securities (MBS) with a strong exposure to US mortgages for which IKB acted as originator and portfolio manager. At the beginning of the crisis, Rhineland Funding had assets with a notional value of € 13.2 billion under management and financed these assets with shortterm asset backed commercial paper (ABCP) for which IKB provided guarantees. Initially, IKB did not consolidate its conduits. In the original Annual Report 2006/2007, IKB reports total contingent liabilities and other commitments of € 17.7 billion in the notes to the balance sheet, including credit commitments of € 12 billion in favour of off-balance sheet special investment vehicles. To put these obligations into perspective, IKB’s total assets were € 52 billion as of March 31, 2007. When it was impossible to refinance IKB’s conduits at the beginning of the crisis, the refinancing problems of the conduits spilled over to IKB through the credit commitments. - Table 4 The refinancing problems of the conduits had nothing to do with how the conduits reported the assets. To be able to hold the conduits’ assets until maturity, IKB would have had to be able to repay the short-term investors that initially held the conduits’ assets using own funds. However, IKB was already highly levered with a debt-equity ratio of 36 so that it was not possible to raise a sufficient amount of additional funds that could be backed by IKB’s assets, and the assets that IKB held were not sufficiently liquid to generate the funds internally. In the original annual report, IKB reported shareholder equity of € 1.4 billion and Tier 1 capital of € 2.4 14

billion on March 31, 2007. The biggest asset class are long-term loans and advances to customers (more than € 29 billion) and bonds and other fixed-income securities (more than € 16 billion). IKB states that it advised Rhineland Funding on “investing in portfolios comparable to those in which IKB is itself investing” (Annual Report 2006/2007, p. 42), which suggests that IKB invested in similar fixed-income securities as Rhineland Funding, which it had problems to refinance in the market. More than one third of the liabilities had a maturity of less than a year and about 15 % matured within 3 months after the reporting date of March 2007. IKB’s problems started when IKB did not obtain funding in the interbank market and Deutsche Bank withdrew its credit line. Main reasons for the funding problems were IKB’s liquidity guarantees to its conduits and a lack of information. Josef Ackermann, who was at that time the CEO of Deutsche Bank, states that Deutsche Bank cut the credit line because IKB did not respond to Deutsche Bank’s request for additional information about Rhineland Funding (Matussek, 2010).13 It is implausible to assume that IKB’s need to publish financial reports based on IFRS fuelled its problems. In any case, German GAAP, not IFRS, was underlying IKB’s regulatory capital requirements. Fair value accounting also did not fuel IKB’s growth and high debt-equity ratio, as unrealized fair value gains did not relax IKB’s regulatory capital.

Instead, the regulatory capital

requirements for securitized assets (not the accounting rules per se) allowed IKB to expand its business. As IKB’s CEO at that time, Stefan Ortseifen, pointed out in the Annual Report 2006/2007 (p. 4): “2006/2007 was another highly successful financial year for IKB. We succeeded in increasing the volume of new business by 13.3 % to € 12.8 billion… Supplementary raising of hybrid and subordinated capital, and the placement of credit risks

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IKB notes: “Because of the threat that IKB’s liquidity facilities for the Rhineland Funding conduit would be drawn upon, other banks duly froze their credit facilities made available to IKB” (restated Annual Report 2006/2007, p 15).

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through synthetic securitisation, will enable us to expand the volume of business without having to increase the share capital.” It seems that management, the board, and supervisors did not take the high contingent liabilities and credit commitments seriously. In the original Annual Report 2006/2007, IKB mentions “Rhineland Funding” as an example for how the bank is able to use its expertise “to advise external companies – against a fee – on their own investments in international loan portfolios” (p. 42). IKB does not explicitly mention its commitment in the form of a credit facility of € 8.1 billion for Rhineland Funding, which constituted a large part of the total reported credit commitments of € 12 billion. IKB also does not report any compensation for the risks that the credit facility involved; it is likely that the fee “for advisory expertise” included a compensation for this risk. The misjudgement of risk is problematic and can distort managerial incentives, but in this case fair value accounting is not the cause. In February 2008, and hence after its bailout, IKB published a restated financial statement for the fiscal year ending March 31, 2007 in which it consolidated its conduit Rhineland Funding. The interesting question is whether it would have mattered if IKB consolidated the conduit before the crisis. After consolidation, IKB’s total assets increased by 22 % to € 63.5 billion, but IKB’s risk weighted assets as well as the Tier 1 and total capital ratios hardly changed in the restated annual report. This example shows again that there is no direct link between financial reporting and regulation. Of course, the case of IKB is particularly extreme as the annual IFRS report is not underlying capital regulation. However, the effect would not have been different if IKB were regulated based on its IFRS report: German regulators did not require any regulatory capital for liquidity facilities under Basel I even though IFRS required the consolidation of such conduits (Acharya and Schnabl, 2010).

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Consolidation can still matter because it provides information to investors beyond any implications for regulatory capital requirements. Consolidation increased IKB’s debt-equity ratio from 36 to 52, which is certainly a high number, but would it have made a difference? Such leverage ratios were not unheard of, e.g., HRE had a debt-equity ratio of nearly 65 at the end of 2007. Moreover, IKB disclosed its credit commitments in the annual report. Considering the disclosed credit commitments, it is easy to derive the “consolidated” debt-equity ratio without the need for a consolidated balance sheet. Of course, it might be argued that some investors were not sophisticated enough. However, these investors might just have been interested in the regulatory capital ratios anyway (which did not change). More importantly, given the high reliance on interbank funding and the high ownership stake of KFW, it does not seem likely that naive investors were decisive. Consolidation also affected IKB’s net income. The net income before taxes is € 114.5 million in the restated financial report and thus € 148.5 million lower than in the original report (restated Annual Report 2006/2007, p. 104). A large part of the reduction, € 121 million, stems from fair value losses of securities and derivatives that were included due to the consolidation of Rhineland Funding and parts of an issuing entity whose securities serve as an investment vehicle for IKB’s economic capital (restated Annual Report 2006/2007, p. 21 and 36).14 One problem with interpreting this number is that it is not clear whether management would have recognized the fair value losses if it had originally published a consolidated financial statement: The restated annual report was prepared with hindsight of the developments in the market by a new management team. Another important change concerns the level of fee income versus interest

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After consolidation, IKB had to account for the mortgage bonds and derivatives, which it securitized, separately, “so that these items are measured at fair value instead of at amortized cost.” (Restated Annual Report 2006/2007, p. 21.)

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income. After consolidation, the net fee and commission income decreased by € 56 million and the net interest income increased by € 31.5 million as fees from one consolidated unit to another cancel out. Instead of the fees, IKB was able to recognize “only” the interest differential earned on the assets held by the consolidated investment vehicles over the funding rate. It is not clear why this accounting difference alone should have changed the way IKB conducted its business.

4.2. Landesbank Sachsen Girozentrale (Sachsen LB) Landesbank Sachsen Girozentrale (Sachsen LB) was the smallest of the German Landesbanken

and the central institution for savings banks in Saxony with total assets of € 68 billion and a total exposure of € 26 billion to off-balance sheet conduits in mid 2007 (Sächsischer Rechnungshof, 2009, p. 35). The largest share, € 17 billion, originated from its credit arbitrage conduit Ormond Quay. Ormond Quay invested primarily in AAA-securities financed through short-term ABCP, which Sachsen LB de facto guaranteed. When investors withdrew from investment vehicles, Sachsen LB ran into problems honouring its commitments towards the conduit Ormond Quay, and Sachsen LB had to be bailed out. On August 17, 2007 Deka Bank together with a group of German Landesbanken took over the credit line granted by Sachsen LB to Ormond Quay, and a takeover of Sachsen LB by Landesbank Baden-Württemberg (LBBW) was announced on August 20, 2007.15 The bailout occurred just 7 days after Sachsen LB issued a press release in which it argues that Ormond Quay can rely on a broad basis of more than 100 institutional investors for refinancing and that Sachsen LB has sufficient liquidity. - Table 5 -

15

See, for example, the report of the comptroller’s office of Saxony (Sächsischer Rechnungshof, 2009), Simensenin (2007), and http://europa.eu/rapid/pressReleasesAction.do?reference=IP/08/849 on the bailout of Sachsen LB and Acharya and Schnabl (2010) for a more detailed discussion of the structure of the conduit Ormond Quay.

18

Sachsen LB never issued an annual report based on IFRS; all reports until the takeover by LBBW used German local GAAP. Obviously, avoiding IFRS reporting did not help Sachsen LB in the crisis nor did it constrain it in the boom. As in the case of IKB, Sachsen LB had high offbalance sheet obligations stemming from credit lines for which regulatory capital requirements were insufficient. Given a high debt-equity ratio of 42 and reliance on short-term unsecured funding, Sachsen LB was not prepared to honour its obligations, as it was not sufficiently capitalized and unable to raise sufficient capital in the midst of the turmoil that caused the refinancing problems of its conduit. Sachsen LB had included a “stop-loss” clause to limit its exposure from the commitments, which required a sale of the assets whenever the value of the portfolio would lose more than 3% of its notional value. However, a 3% loss in the value of Ormond Quay’s assets implied a loss of € 0.5 billion for Sachsen LB, which had core capital of only € 1.5 billion (Sächsischer Rechnungshof, 2009). Unrealized gains in the boom did not amplify the problems of Sachsen LB. Instead, state guarantees contributed to the problems as they distorted investors’ incentives to price the involved risk and thus allowed Sachsen LB to pursue a risky strategy. In anticipation of the removal of state guarantees in July 2005, many Landesbanken issued bonds maturing after 2005 that still enjoyed a state guarantee (“grandfathered debt”). Moody’s (2011) estimated that Landesbanken had about € 250 billion of grandfathered debt outstanding in May 2011. The banks often employed these funds in wholesale banking activities and cross-border banking, particularly via conduits investing in US MBS (Fischer et al., 2013). Sachsen LB was particularly active and from the middle of 2001 to the middle of 2005, the average yearly volume of bonds issued by Sachsen LB was nearly eight times higher than the average yearly volume from the middle of 1999 to the middle of 2001.

19

According to Moody’s (2011), the high rating obtained by Ormond Quay was only possible due to Sachsen LB’s grandfathered state guarantee. The comptroller’s office of Saxony argues that “the credit facilities granted to Ormond Quay were targeted to exploit the state guarantee” (Sächsischer Rechnungshof, 2009, p 36) and that Sachsen LB’s business model was not viable without these state guarantees. Sachsen LB’s capital market activities grew six times from the end of 2003 to € 41 billion in the middle of 2007 (Sächsischer Rechnungshof, 2009, p. 35 and 46). The possibilities to overcome distorted incentives and the effect of state guarantees through accounting or regulation are limited.

Consolidation of the conduits for financial reporting

purposes might have improved transparency for the supervisory board, but regulatory capital requirements and market discipline seem to be more important.

4.3. Hypo Real Estate Holding AG (HRE) Another spectacular failure of a German bank is the case of Hypo Real Estate Holding AG (HRE) with total assets of € 400 billion at the end of 2007. In October 2008, HRE received € 50 billion provided by a consortium of banks, insurers, and the government after it experienced refinancing problems at its Irish subsidiary, DEPFA BANK plc. (DEPFA), which spilled over to HRE. HRE took over DEPFA in the middle of 2007. DEPFA focused on public sector and infrastructure finance and, at the end of 2006, had total assets of € 223 billion and a staggering debt-equity ratio of 73.3. Moreover, more than 40 % of total liabilities had a maturity of less than three months and more than 57 % of these liabilities were deposits from other banks. In contrast, less than 7 % of total assets had a maturity of less than 3 months (DEPFA, Annual Report 2006, p. 143). It should hardly come as a surprise that a bank with such a high leverage and reliance on short-term financing could run into solvency and liquidity problems at the height of the crisis in 20

2008. Indeed, as HRE states in its Annual Report 2008 about DEPFA’s problems: “Funding of its operations was dependent to a significant extent on the interbank market and other short-term unsecured funding sources such as, in particular, deposits of US money market funds. Large volumes of funds which were refinanced on the short-term basis were extended in the form of long-term loans. This business model has proved not to be robust in a crisis.” (p. 37) HRE was in no position to deal with the refinancing problems encountered by DEPFA. After the merger, its debt-equity ratio increased from an already high level of 44.9 at the end of 2006 to 64.88 at the end of 2007. Thus, HRE’s debt-equity ratio was twice as high as Northern Rock’s debt-equity ratio and nearly three times the average of large EU banks. Moreover, a substantial part of the equity value amounted to goodwill (which does not count towards regulatory capital); HRE’s tangible debt-equity ratio actually exceeded 110. - Table 6 It is interesting to take a look at the possible role that accounting might have played. One possible link is the effect of financial reporting on regulatory capital. As for the other two banks, HRE’s regulatory capital was based on German local GAAP, not IFRS. Thus, the general argument that fair value gains relaxed regulatory capital prior to the crisis and contributed to the high leverage is also not true for HRE. It is also unlikely that the effect of impairments based on market values for regulatory capital played a major role for HRE in the crisis. HGB allowed the reclassification of financial securities to a category, where impairments were required only if the loss is non-temporary. Thus, HRE was in principle able to largely avoid writing down financial assets to their market value for regulatory purposes by arguing that management intent changed. Unfortunately, it is not clear to what extent HRE reclassified assets in its HGB reports. It is

21

possible that HRE used the option, but still had problems. Alternatively, HRE did not use the option; but then it is likely that it did not use the option because it believed that it would not help. Thus, any effect of IFRS reporting must stem from the reaction of investors. In January 2008, HRE made an ad hoc announcement in which it stated that it had to write down its US portfolio of collateralized debt obligations (CDOs) by € 390 million, with € 295 million reducing income, and that it plans to reduce the dividend for 2007 to € 0.5, from € 1.5 in 2006. The announcement came as a complete surprise to market participants after HRE wrote down only € 4 million related to US CDOs in the third quarter of 2007 and its continuous reassurance that the US mortgage crisis does not affect it; at the day of the announcement HRE’s stock price lost 1/3 of its value. (See, for example, Fromm et al., 2008, and Krämer, 2008.) These losses, which were related to fair value accounting, might have contributed to investors’ anxiety and HRE’s refinancing problems. However, the majority of the losses did stem from other than temporary impairments of available for sale securities.16 Moreover, market participants were concerned about the assets that banks held and their exposure to US mortgage risk. Thus, another interpretation of the stock market reaction is that shareholders felt deceived after management failed to inform the market about the bank’s exposures earlier. When HRE released the ad hoc announcement, investors were concerned that management was not truthful and feared additional risks. Indeed, in the first half of 2008, HRE had to recognize additional losses on its CDO portfolio of € 320 million with a direct effect on HRE’s income (other than temporary impairments of € 214 million and fair value losses of € 106 million on embedded

16

HRE reports total losses of € 466 million from the CDO portfolio affecting income in 2007. € 198 million stem from synthetic CDOs, for which the fair value changes of the embedded options component have to be recognized in income, and € 268 million were other than temporary impairments of CDOs held as available for sale. HRE released allowances of € 165 million, resulting in a reduction of income of € 301 million. (See HRE Annual Report 2007, p. 125.)

22

options). The market might have understood that a bank with such a high leverage and a large fraction of unsecured short-term funding can run into problems quickly when the value of its assets declines. The press coverage and comments of analysts after the ad-hoc announcement is consistent with this interpretation. (See, for example, Fromm et al., 2008, Hay, 2008, and Krämer, 2008.) In any case, the decline of HRE’s stock price started well before the ad hoc announcement. HRE’s stock price fell 20 % between its announcement of the takeover of DEPFA in July and the takeover in September 2007. During the same time, the mark-up that HRE initially offered for DEPFA’s shares fell from 17 % to 3 % (Reuters, 2007). In October 2008, HRE reclassified assets with a carrying value of € 80.3 billion into loans and receivables retrospectively as of July 1, 2008 (Annual Report 2008, p. 56 and 65). The value of the remaining assets recognized at fair value at the end of 2008 amounts to € 53 billion and these assets were mainly “measured on the basis of a model which partly uses non-marketobservable parameters like expected maturity and cash flow assumptions” (Annual Report 2008, p. 165). Thus, accounting did not force HRE to mark their assets to potentially distorted market prices, and it is unlikely that published financial reports based on HBG rather than IFRS would have made it easier for HRE to refinance its assets.

The main problem was the general

uncertainty in the market and the general freeze of the money and interbank market. Moreover, concerns about its risk management and its ability to integrate DEPFA might have exaggerated HRE’s problems. For example, Dettmer and Weiland (2009) quote from an audit report that the Bundesbank prepared on HRE for the German Federal Financial Supervisory, BaFin. In this report, the auditors list several violations against legal requirements on proper risk management practices.

23

5. Conclusion Our paper analyzes three prominent failures of German banks in the crisis of 2007 and 2008. The evidence, although specific, challenges the general validity of “conventional wisdom” on the relation between financial reporting, financial regulation, and financial stability.

First, the

recognition of banks’ assets at fair value as introduced by IFRS did not play an important role in the demise of the banks in this study. For all three banks, refinancing problems were the key problems and it is hardly plausible that these banks could have addressed these problems more successfully if the companies had recognized their assets at historical cost. Indeed, Sachsen LB never published financial statements based on IFRS, but based on German local GAAP (HGB). Second, there was no direct and inevitable link between published financial statements and bank capital regulation. All three banks were regulated based on financial statements prepared in accordance to German local GAAP despite the legal requirement of IKB and HRE to publish IFRS reports. Third, historical cost accounting did not constrain the banks’ ability to take on excessive leverage. HRE in particular, but German banks in general, had very high leverage even though they were generally regulated based on HGB. Thus, some of the most prominent arguments on the relation between accounting and regulation in the crisis played no role for the two first European bank failures and the largest German bank failure.

24

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Moody’s (2011), German Landesbanken: Moody’s to reassess support assumptions, Moody’s Investor Service, May 2011. Niu, F. and Richardson, G. (2006), Are securitisations in substance sales or secured borrowings? Capital-Market Evidence, Contemporary Accounting Research, 23(4): 1105-1133. Penman, S. H. (2007), Financial reporting quality: Is fair value a plus or a minus?, Accounting and Business Research, Special Issue: International Accounting Policy Forum: 33–44. Plantin, G., H. Sapra, and H. S. Shin (2008), Marking-to-market: Panacea or Pandora’s box? Journal of Accounting Research, 46(2): 435–460. Rajan, U., A. Seru, and V. Vig (2015), The failure of models that predict failure: Distance, incentives and defaults, Journal of Financial Economics 115(2): 237–260. Reuters (2007), Depfa owners agree to $7 bln takeover by Hypo Real, Sep 24, 2007. http://www.reuters.com/article/2007/09/24/us-depfa-hyporealestate-merger-voteidUSL2464248920070924 Ryan, S. G. (2008), Accounting in and for the subprime crisis, The Accounting Review, 83(6): 1605–1638. Sarkozy, M.N. (2008), International financial crisis - Speech by M. Nicolas Sarkozy, President of the Republic, 25 September 2008. Sächsischer Rechnungshof (2009), Sonderbericht nach §99SäHO Landesbank Sachsen Girozentrale. Securities and Exchange Commission (SEC, 2008), Report and recommendations pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on mark-to-market accounting.’ Shin, H. (2009), Reflections on Northern Rock: The bank run that heralded the global financial crisis, Journal of Economic Perspectives, 23 (1): 101–119.

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Appendix Table 1: Key assets on the balance sheet of EU member banks publishing IFRS reports Large banks

Smaller banks

Value weighted

Equally weighted

Value weighted

Equally weighted

Trading assets and derivatives Net trading assets and derivatives Available for sale Held to maturity Loans Total financial instruments

25,63% 9,07% 10,92% 0,75% 53,59% 90,89%

15,44% 6,41% 12,12% 1,33% 62,12% 91,00%

6,15% 4,03% 10,07% 1,80% 73,69% 91,72%

5,18% 3,73% 9,60% 1,82% 73,76% 90,35%

Total assets

100,00%

100,00%

100,00%

100,00%

Debt-equity ratio

22,62

27,10

10,52

14,93

Number of banks

66

66

178

178

Note: The table reports averages over the year-end amounts of 2007 for various bank assets of EU member banks that use IFRS. EU member countries are Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and United Kingdom. Bank numbers are from Bankscope. Large banks include banks with total assets greater than € 77 billion. Smaller banks include banks with assets between € 0.77 billion and € 77 billion.

30

Table 2: Key assets on the balance sheet of banks reporting at IFRS in Germany, UK, France, and Spain Germany Large banks

UK

France

Spain

Smaller banks

Large banks

Smaller banks

Large banks

Smaller banks

Large banks

Smaller banks

15,25%

5,13%

18,37%

6,29%

27,95%

2,81%

6,13%

1,54%

14,20%

4,63%

1,81%

7,45%

5,30%

15,02%

2,41%

2,67%

0,37%

16,73%

8,76%

21,91%

18,91%

9,90%

9,12%

17,30%

8,99%

6,28%

7,94%

Held to maturity

0,29%

0,00%

0,42%

2,17%

0,07%

3,67%

5,93%

2,94%

1,54%

1,55%

Loans

57,48%

43,18%

57,77%

70,51%

65,46%

64,16%

40,42%

78,88%

76,13%

82,39%

Total financial instruments

93,69%

93,76%

95,35%

96,72%

93,81%

83,24%

91,59%

93,62%

90,08%

93,41%

Total assets

100,00%

100,00%

100,00%

100,00%

100,00%

100,00%

100,00%

100,00%

100,00%

100,00%

Debt-equity ratio

44,35

39,30

50,71

27,90

25,93

16,45

21,69

6,76

14,09

13,29

Tier 1 capital ratio

7,76%

8,20%

6,75%

8,31%

8,52%

8,27%

Total capital ratio

11,42%

12,07%

10,37%

12,45%

10,76%

11,80%

Number of banks

17

3

8

3 largest banks

Landesbanken

19,20%

41,81%

4,82%

Available for sale

Trading assets and derivatives Net trading assets and derivatives

7

8

13

8

12

6

Note: The table reports (equally weighted) averages over the year-end amounts of 2007 for various bank assets of banks that use IFRS. Bank numbers are from Bankscope. Large banks include banks with total assets greater than € 77 billion. Smaller banks include banks with assets between € 0.77 billion and € 77 billion. For a high fraction of smaller banks capital ratios are not available in Bankscope. Thus, the average capital ratios are not reported for smaller banks. In the case of France, the average capital ratio of large banks consists of only 5 banks. Germany: 17 large banks, including the three largest banks, Deutsche Bank, Dresdner Bank and Commerzbank, as well as 8 Landesbanken.

31

42

Alternative Table 2: Value weighted key assets on the balance sheet of banks reporting at IFRS in Germany, UK, France, and Spain Germany

UK

France

Spain

Smaller banks

Large banks

Smaller banks

Large banks

Smaller banks

Large banks

Smaller banks

17,23%

7,33%

27,58%

3,76%

37,75%

5,03%

10,42%

1,83%

20,86%

5,98%

2,45%

9,36%

2,66%

14,11%

4,60%

5,07%

-0,06%

12,21%

6,17%

19,08%

16,89%

8,38%

10,88%

11,91%

10,65%

6,18%

8,51%

Held to maturity

0,16%

0,00%

0,30%

3,72%

0,13%

0,71%

2,02%

3,59%

0,81%

3,09%

Loans

45,52%

28,89%

58,63%

68,23%

56,37%

76,40%

40,53%

76,40%

70,46%

80,37%


92,80%

91,24%

95,24%

96,17%

92,46%

91,75%

92,22%

95,66%

87,86%

93,80%

Total assets

100,00%

100,00%

100,00%

100,00%

100,00%

100,00%

100,00%

100,00%

100,00%

100,00%

Debt-equity ratio

40,19

42,28

41,02

26,94

22,41

13,33

21,69

6,84

14,49

11,72

Number of banks

17

3

8

7

8

13

8

12

6

42

Large banks

3 Largest banks

Landesbanken

34,91%

56,18%

11,17%

Available for sale

Trading assets and derivatives Net trading assets and derivatives

Note: The table reports weighted averages over the year-end amounts of 2007 for various bank assets of banks that use IFRS. Bank numbers are from Bankscope. Large banks include banks with total assets greater than € 77 billion. Smaller banks include banks with assets between € 0.77 billion and € 77 billion. Germany: 17 large banks, including the three largest banks, Deutsche Bank, Dresdner Bank and Commerzbank, as well as 8 Landesbanken.

32

Table 3: Comparison between IFRS and US GAAP – Deutsche Bank Balance Sheet as of December 31, 2006 IFRS

US GAAP

€ billion

% of total assets

€ billion

% of total assets

Trading assets and derivatives

1104

70%

517

46%

Net trading assets and derivatives

410

26%

298

26%

Available for sale

38

2%

22

2%

Held to maturity

-

0%

-

0%

179

11%

168

15%

247

22%

Loans Repo assets* Total assets

1584

100%

1126

100%

Total equity

33

2%

33

3%

Debt-equity ratio

46

33

* Repo assets are included mostly in trading assets and loans under IFRS and amount to € 281 billion under IFRS

33

Table 4: Key assets on the balance sheet of IKB as of March 31, 2007 IKB (original)

Trading assets and derivatives Net trading assets and derivatives Other securities Available for sale Held to maturity

IKB (restated)

Absolute value (€ million)

% of total assets


6636

12,75%

18249

28,72%

5624

10,80%

17085

26,89%

% of total assets

942

1,81%

2106

3,31%

942

1,81%

2106

3,31%

0

0,00%

0

0,00%

Loans

43446

83,47%

42144

66,33%


51024

98,02%

62499

98,36%

Goodwill and intangible assets Total assets

38

0,07%

38

0,06%

52053

100,00%

63545

100,00%

Total equity

1397

2,68%

1198

1,88%

Total liabilities

50656

97,32%

62347

98,12%

Deposits from banks

13913

26,73%

13913

21,89%

Deposits from banks maturing < 3 months

5132

9,86%

5132

8,08%

9471

18,19%

9471

14,90%

Net borrowing from banks Total liabilities maturing < 3 months

8066

15,50%

18650

29,35%

Total assets maturing < 3 months

7772

14,93%

7748

12,19%

Capital structure ratios

Ratio

Ratio

Debt-equity ratio

36,27

52,06

Tangible debt-equity ratio

37,28

53,77

Tier 1 capital ratio*

7,20%

7,10%

Tier 1 + Tier 2 capital ratio*

12,30%

12,20%

* Reported capital ratios are based on annual reports prepared in accordance to German local GAAP.

Note: Data taken from IKB’s published financial statements.

34

Table 5: Key assets on the balance sheet of Sachsen LB as of December 31, 2006 SACHSEN LB (2006) Absolute value (€ million)

% of total assets

26374

42,36%

Securities Fixed assets

2945

4,73%

Current assets

23429

37,63%

34903

56,06%

Loans Equity investments in associates Total financial instruments Goodwill and intangible assets Total assets

738

1,18%

62015

99,60%

14

0,02%

62261

100,00%

Total equity

1437

2,31%

Total liabilities

60824

97,69%

Deposits from banks

26657

42,82%


15907

25,55%

6533

10,49%

Total liabilities maturing < 3 months

17065

27,41%


9988

16,04%

Tier 1 capital

1368

2,20%

Total regulatory capital

2102

3,38%

Risk weighted assets

16692

26,81%

Net borrowing from banks

Capital structure ratios

Ratio

Debt-equity ratio

42,32


42,73

Tier 1 capital ratio

8,20%

Total regulatory capital ratio

12,60%

Note: Data taken from Sachsen LB’s published financial statement.

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Table 6: Key assets on the balance sheet of HRE as of December 31, 2007 (after the acquisition) & HRE and DEPFA as of December 31, 2006 (prior to the acquisition) HRE (2007) * Absolute value (€ million) Trading assets and derivatives Net trading assets and derivatives Other securities Available for sale Held to maturity

HRE (2006) **

DEPFA (2006) **

% of total assets


% of total assets


34465

8,61%

20633

12,77%

10266

4,60%

5557

1,39%

6899

4,27%

-2317

-1,04%

% of total assets

82196

20,54%

37445

23,17%

50833

22,80%

82196

20,54%

29521

18,27%

50833

22,80%

0 ***

0,00%

7924

4,90%

0

0,00%

Loans

264243

66,03%

98672

61,06%

159955

71,75%


380904

95,18%

156750

97,00%

221054

99,15%

2555

0,64%

69

0,04%

53

0,02%

Total assets

400174

100,00%

161593

100,00%

222945

100,00%

Total equity

6074

1,52%

3445

2,13%

2777

1,25%

Goodwill and intangible assets

Total liabilities

394100

98,48%

158148

97,87%

220168

98,75%

Deposits from banks

111241

27,80%

24609

15,23%

63199

28,35%


75219

18,80%

14982

9,27%

53354

23,93%

59266

14,81%

6599

4,08%

28491

12,78%

Total liabilities maturing < 3 months

124708

31,16%

27837

17,23%

92045

41,29%


23497

5,87%

10095

6,25%

15808

7,09%

Net borrowing from banks

Capital ratios

Ratio

Ratio

Ratio

Debt-equity ratio

64,88

45,91

79,28


111,99

46,84

80,83

Tier 1 capital ratio****

8,70%

7,00%

9,40%

Total regulatory capital ratio****

11,40%

9,30%

13,50%

* As of 31/12/2007. ** As of 31/12/2006 *** "The entire portfolio of Held-to-Maturity investments was reclassified as of 1 July 2007 in accordance with IAS 39.51 into the category Available-for-Sale" (HRE Annual Report 2007, page 111). **** In the case of HRE, reported capital ratios are based on annual reports prepared in accordance to German local GAAP.

Note: Data taken from HRE’s and DEPFA’s published financial statements.

36