ERisk.
com
the promotion of regional growth
led to wheeling and dealing that
undermined rigorous bank risk man-
agement.
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 sys-
tem, 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 Ger-
many’s public banking system. But
the way the bank was structured
and managed left it vulnerable to
weak controls and conflicts of inter-
est.
One issue was that German
banking law insisted on a clear sep-
aration of management between
different kinds of banking institu-
tions. BgB’s complex mix of busi-
nesses made it difficult for the super-
visory 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 institu-
tions – 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 com-
mercial and industrial clients that
helped Germany’s other major
banks to ensure they were not too
exposed to any single business sec-
tor.
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 guaran-
tees against much of the risk inher-
ent in their investment as part of the
deal. (The names of investors in
these ‘VIP funds’ were gradually
made public between 2001 and
‘
The real economic damage began
when the institution offered the
opportunity to invest in similar
funds to a wider public’
summer 20023, embarrassing many
of Berlin’s political and financial
industry luminaries.)
But the real economic damage
began when the institution mar-
keted 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 guaran-
tees, 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
July 2002
Timeline continued
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.
continued overleaf
02

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 mil-
lions of euros to fund the refurbish-
ing of Cold War period flats in the
Berlin region, with the aim of gener-
ating premium rental income.
But Landowsky was not just a
bank executive; he had also built a
parallel career as a regional politi-
cal grandee, and was entrenched
in the Berlin senate as the long-term
leader of the Christian Democrat
parliamentary party, which con-
trolled the coalition that dominated
Berlin’s political life from 1991 until
the summer of 20014.
Later investigations revealed that
the two businessmen who con-
trolled Aubis (and who themselves
had strong historical links to the
Christian Democrat party) had
made a campaign donation to
Landowsky’s party5. 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 prop-
erty developers.
But the Berlin Hypo’s decision to
extend credit to the property devel-
oper 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 com-
pany’s under-performing assets
rather than force the property com-
pany 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 stream-
line 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 invest-
ment bankers, was to sell off the
more profitable operating business
assets of property subsidiary IBG,
using an offshore investment vehi-
cle 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 prop-
July 2002
ERisk.com
Timeline continued
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.
continued overleaf
03

erty-linked liabilities that remained
in the bank’s portfolio. On 2 January
2001, the business press duly
reported that BgB’s real estate busi-
ness had been transferred to IBAG
in preparation for the spin-off6.
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 inves-
tigation by BaKred, Germany’s fed-
eral 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 repur-
chase of the IBAG vehicle, and
promised to make clear the conse-
quences of this buy-back in its dis-
cussion 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 depar-
tures. In early March 2001, Klaus
Landowsky stepped down as head
of Berlin Hypo. Other senior man-
agers at the Landesbank Berlin
stepped down a few days later
after concerns that they had
allowed certain major creditors
‘freedom from liability’ in transac-
tions 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 politi-
cal parties, gathered pace, with
calls for the resignation of
Landowsky from his post as leader
of the Christian Democrat parlia-
mentary group in the Berlin senate.
In May the Berlin senate, unable
to accept the idea of closing BgB,
and aware that it could not repudi-
ate many of the bank’s commit-
ments (or easily disentangle the pri-
vate and public components of the
institution), pledged backing for the
bank.
‘
In May, the Berlin senate,
unable to accept the idea of
closing BgB, 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, forc-
ing veteran Christian Democrat
mayor Eberhard Diepgen – a close
political ally of Landowsky – to step
down7. 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 bil-
lion 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
July 2002
ERisk.com
Timeline continued
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
continued overleaf
04

portfolio. About half the loss provi-
sions 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 perform-
ances, and without the state’s inter-
vention 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
information8.
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 year9.
The aftermath
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 accept-
ed 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-cri-
sis headcount10.
The recapitalisation was not the
end of the pain for Berlin’s taxpay-
ers. 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 authori-
ties felt obliged to offer the bank a
‘risk shield’ (or Risikoabschirmung)
that put the Berlin taxpayer on the
hook for the incalculable risks asso-
ciated 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 recapitalisa-
tion of the bank and the new ‘risk
shield’ contravened EU competition
regulations, summed up the finan-
cial 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 rea-
sons 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 ceil-
ing lower than the theoretical maxi-
mum 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 pre-
condition to the long-term restruc-
turing 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 trans-
July 2002
ERisk.com
Timeline continued
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.
05
 ERisk.com

fer also forestalled examination of
the bank’s activities in the bank-
ruptcy 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 prose-
cutor continues to extend a long-
running investigation into the scan-
dal. 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 strategi-
cally uncertain. The bank is largely
under new management, and is
implementing its new organisational
structure and its more modest busi-
ness strategy. It looks possible that it
will be privatised, with an August 14
deadline for bids for the bank fast
‘
It might be a decade
or more before
Berlin can hope to
put behind it the
cost and the political
reverberations of the
BgB debacle’
approaching, though if a bid is
accepted the deal is unlikely to be
sealed before early 200312.
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 bank13.
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 – chair-
man 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 pro-
testors who blame the bank and its
past management for continuing
cuts in Berlin’s social spending14.
If the near-collapse and recon-
struction of Paris’ Credit Lyonnais is
any guide, it might be a decade or
more before Berlin can hope to put
behind it both the financial cost
and the political reverberations of
the BgB debacle. ■
This case study was contributed
by Rob Jameson, ERisk

Notes:

1 Berlin owed at least E38.9 billion as of 2001, and continues to have a weaker tax base than other major German regions.
2 A figure of E35 billion is also often quoted, but this is the result of double counting some of the liabilities.
3 The names of many being published on the Internet by activists.
4 “Bank Collapse Points To the Many Roles Of Klaus Landowsky – Executive and Politician, He Defined Clout in Berlin – Celebrity
Funds’ Bombed”, Ian Johnson, Cecilie Rohwedder and Marcus Walker, The Wall Street Journal Europe 1, 2 August, 2001.
5 “Debt-laden Berlin Sinks into Political Crisis over Bank Losses”, Geir Moulson, Associated Press, 5 June, 2001.
6 “Bankgesellschaft Tranfers Unit”, Dow Jones International News, 2 January, 2001.
7 “All change? Shambles in Berlin: Berlin's City-state Government is in a Financial Hole. An Election? Probably”, The Economist,
June 9, 2001.
8 “Troubled Berlin Bank Boosts Provisions”, Haig Simonian, Financial Times, 30 August, 2001.
9 “Berlin Mayor Says BGB Chairman Is Prepared to Quit – Shareholders Likely to Press For Answers About Huge Debt”, Vanessa
Liertz, Handelsblatt Correspondent, 29 August, 2001, The Wall Street Journal Europe 2.
10 “Berlin Bank to cut 4,000 jobs, Tackling Losses that Toppled Long-serving Mayor', Associated Press Newswires, November 30, 2001.
11 “Commission to Carry out Detailed Investigation of Aid to Bankgesellschaft Berlin”, EU Commission Press Release, 4 September,
2002.
12 “Bidders for BG Berlin Assess Bank's Health”, Haig Simonian, Financial Times, 4 June, 2002.
13 “EU Welcomes Moves To Privatize Bankgesellschaft Berlin”, Dow Jones International News, 19 July, 2002.
14 “Berliners Protest at Troubled Bank's Annual Meeting”, Nick Antonovics, Reuters English News Service, 19 July, 2002.

July 2002
06