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Is Germany bailing out euro-area countries to save its own banks?

IF THE euro zone were an old-fashioned family, Germany would be the stern father telling his wayward children to go to bed early and not to spend all their pocket money at once. It has resisted efforts to ease the conditions attached to the bail-outs of Greece and Ireland, and is insisting that Portugal, which started negotiations on a bail-out this week, also gets licked into shape. (The European Central Bank, too, has a ring of the stern German in its insistence that banks in weaker euro-zone countries, Ireland’s in particular, pay back their debts in full.) That seems fair: Germany is putting more money at risk in funding the errant trio than any other country. But some observers argue that the real bail-out is of Germany’s own banks.

That depends, in part, on the assumptions you make about what might happen if one of the peripheral countries were to default. Start with government debt. Germany’s two biggest banks, Deutsche Bank and Commerzbank, have a surprisingly low direct exposure to Greek, Irish and Portuguese governments. They held less than €6 billion ($8.7 billion) in government debt from the three bail-out recipients at the end of last year, according to company disclosures. But the total exposure of the German banking system is a lot larger, at almost €27 billion.

This suggests that the bulk of these sovereign-debt holdings are buried in small, not very savvy German banks. Germany’s publicly owned Landesbanken would fit that bill nicely. They are already beset by low profitability, so cannot easily earn enough to offset losses, and their capital cushions are thin and partly composed of hybrid debt that under new rules will soon no longer count as capital. Many will have to raise equity to pass the next round of European stress tests. Among the first out of the gate is NordLB, which announced plans this week to convert hybrid capital into equity.

Sovereign defaults would also harm Hypo Real Estate, a bust German property and public-finance bank that is now owned by the state. In July last year it said it was owed almost €8 billion by the Greek government and €10 billion by Ireland.

Sovereign exposures nevertheless look manageable when set against total assets in the German banking system of some €2.5 trillion. Most of the burden of a peripheral default would fall on banks in the defaulting countries themselves. A deep home bias has made many of them the largest holders of their own governments’ debt. Calculations by the Bank of England on losses that would arise from haircuts to Greek, Irish, Portuguese and Spanish debt suggests that a 50% haircut would wipe out 70% of the equity in Greek banks, almost half of it in Portuguese and Spanish banks and about 10% of the equity in German and French banks.

That spells trouble of a different kind. Sovereign defaults would entail much more than just a haircut on German banks’ government-bond exposures. It could easily lead to a slew of bank defaults—and corporate ones, too. German banks are owed twice as much by banks in the three bailed-out countries as they are by governments. Once corporate loans and other exposures are included, Germany’s vulnerability is clear: its banks are owed some €230 billion. These numbers would ratchet up further were Spain to default. German banks have an exposure to Spain that is about three-quarters as great as it is to Portugal, Greece and Ireland combined.

Not all of these debts would be affected by a sovereign default, let alone be wiped out. Derivatives exposures are already marked to market, for example. But compared with the potential costs of full-blown default, the amounts that Germany and other countries are likely to put into the three bail-out packages look like excellent value (see chart). The rescuers need not be quite so sanctimonious.

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