From Berlin to Basel: what can 1930s Germany teach us about banking regulation?

Tobias Neumann.

Two of the country’s largest banks collapse.  The subsequent panic brings the banking system to its knees and only a costly government bail-out prevents even greater catastrophe.  A radical re-think of regulation is needed.  No, it’s not London or New York in 2008.  It is Berlin in the 1930s.  It’s when risk-weighted capital regulation was born, notably to be used alongside a range of other tools; for example, liquidity requirements and such modern ideas as bonus deferrals and capital conservation.  But the idea that no single regulatory measure is likely to be sufficient on its own was forgotten.  In 2008 it had to be painfully re-learned making this episode a striking example of the importance of studying past financial crises.

The 1931 banking crisis

The German banking system was in a parlous state in 1931:  it was undercapitalised, over-risked, illiquid, held afloat only by flighty funding, and steered by CEOs of dubious quality.  This is never a good combination.

The average capital-to-asset ratio in the German banking system had fallen from 14% in 1925 to 8.5% at the end of 1930.  The six largest banks had an aggregate capital-to-asset ratio of only 6.8%.  In itself, this was not out of line with banks elsewhere.  For example British banks saw their capital-to-asset ratio shrink to similar levels, yet escaped the 1930s banking turmoil relatively unscathed.

But British banks held much safer assets (see Chart 1).  In Britain, banks mostly provided short-term credit  to corporate clients; long-term financing tended to be done via highly developed capital markets.  In Germany, in contrast, banks provided longer-term financing.  The need for long-term capital was immense as a result of war, reparations and hyperinflation.  But there was no deep capital market to provide this financing.  Banks themselves could not raise sufficient own funds to keep up with the expansion in credit they provided to German companies.  So they relied on debt financing.  This created highly leveraged banks that held the debt of highly leveraged companies – often with little due diligence.  As described by Dr von Bissing, professor at the Königsberg business school at the time:

“[Banks] did not understand their customers well enough, neither at the top of the bank nor in the branches; the organisation of the big Berliner banks tended towards bureaucracy and box ticking.  Banks did not perform sufficient due diligence […] and did not say ‘no’ to customers for competitive reasons.’

The flipside of German banks’ investing a lot in corporate loans is that they held few ‘liquid assets’.  Those are assets that can be sold quickly with little impact on their value.  Their point is to keep operations going in case external funding dries up for a time.  The German central bank, the Reichsbank, distinguished between three tiers of liquidity (which is, by the way, quite similar to the distinction made in the current Basel liquidity coverage ratio).  The holdings of the highest form of liquidity recognised by the Reichsbank, cash, declined markedly over the 1920s.  Again, this stood in contrast to the UK where banks held much more cash (Chart 2).

Chart 1: Loans, safer assets and capital as percent of total assets, end-1930(a)(b)(c)
Source: Sheppard (1971), Untersuchungsausschuß für das Bankwesen (1933)
(a) Sample includes the 11 London clearing banks, and the 6 Berlin great banks.
(b) Safer assets includes cash, cash-equivalent, short-term discount notes, and all government and government-guaranteed debt.
(c) For UK banks, it was not possible to determine the maturity of some discount instruments on a comparable basis to the German system.  These were omitted, which explains why the two bars do not add up to 100% for the UK.

Chart 2: Cash and cash equivalents as percentage of liabilities(a)
Source: Sheppard (1971), Untersuchungsausschuß für das Bankwesen (1933)
(a) Sample includes the 11 London clearing banks, and the 6 Berlin great banks.

The weakness of the banking system was compounded by a bad year generally in financial markets.  In May, the Austrian bank Creditanstalt collapsed, sending jitters through financial markets.  The problems in Vienna were also felt in Berlin.  Foreign creditors started to withdraw money from the banking system showing how easily a lack of confidence can spread across borders and de-stabilise vulnerable banking systems. The final source of fragility in the German banking system was its overreliance on short-term, foreign funding.  This is a very flighty funding combination to have:  a short-term loan is easily withdrawn, and foreign creditors tend to be the first to do so.  At the end of 1930, more than a third of German funding was from abroad, almost all was short-term.

All this came at a time of heightened political uncertainty within Germany.  Hitler’s NSDAP had increased its votes from less than a million to over six million and had emerged as the second largest party in parliament.  To make matters worse, a reparations crisis was looming.  The German government, still democratically elected without NSDAP participation, declared that Germany was no longer able and willing to pay reparations.  US President Hoover proposed a debt moratorium in response.  But France resisted, as records from the Bank of England’s Archive illustrate.   When the Governor of the Bank of England, Montagu Norman rang his counterpart, George Harrison at the Federal Reserve Bank of New York, he made clear the severity of the situation:

‘[I]f the French do not come into line or something else is not done, the Berlin situation will smash: the Governor could not over-estimate the severity of the danger. […] Any change [of the Hoover proposal] would ruin the Germans’

It did not take much to set this tinderbox alight.  When failure came it was spectacular.  On 13 July 1931 Danat Bank collapsed.  It was the second largest German bank by assets.  And its CEO had introduced a rather cavalier attitude towards credit risk – even taking into account the low standard Dr von Bissing identified.  Its downfall came with the bankruptcy of Nordwolle, Europe’s biggest textile company.  Nordwolle owed Danat 48 million Reichsmark.  That was a whopping 40% of Danat’s entire capital!  Nordwolle deliberately hid losses and inflated earnings.  But the lack of due diligence meant that this was discovered much too late (though when it was discovered, it sufficiently enraged Danat’s CEO to throw a chair at his Nordwolle counterpart).

A general banking panic ensued.  It engulfed Dresdner Bank, the country’s third largest bank, and led to a run on the entire German banking system.  The banking system was temporarily suspended and capital controls were imposed.  The government and Reichsbank bailed out the five largest banks and provided emergency loans and guarantees to the system.  Overall fairly similar to the experience of advanced countries in the recent crisis.

The 1934 Banking Act

The German Banking Act of 1934 was drafted by Reichsbank officials and responded to the main causes of the crisis:  high risk, low liquidity, and management failure.

The main innovation was that the act defined the world’s first risk-weighted capital ratio: total liabilities less liquid assets should not exceed a percentage of regulatory capital.  Subtracting liquid assets is of course the same as giving them a 0% risk weight.  This appears to be the first time capital adequacy became associated with the risks on a bank’s balance sheet.  In fact, looking at binding capital ratios was a fairly novel idea to begin with.  Supervision in the United Kingdom, for example, remained informal rather than legalistic: it relied on the Governor’s ‘raised eyebrow’ with a firm focus primarily on liquidity, not capital.

The risk-weighted ratio meant that the real economy loans that brought the German banking system to its knees were captured more directly than if an unweighted ratio had been used.  As shown in Chart 1 above, a simple leverage ratio did not pick up the greater exposure of German banks to riskier loans compared to UK banks.  But removing safer assets from the equation would have changed the picture dramatically.

Despite its historical significance, the risk-weighted ratio was not the only tool in the Act: it included such modern ideas as a minimum liquidity requirement, a large exposure limit (complete with a sovereign exemption), distribution restrictions if requirements were breached and bonus deferrals for senior management.  All in all it was an eclectic response to a crisis with many causes.

What can we learn from this?

The main lesson from the German 1931 crisis is perhaps best expressed in the German idiom ‘Ein Unglück kommt selten allein’ – which translates to ‘misfortune rarely comes alone’.  The German crisis had many causes – risky loans, due diligence failure by management, low capital, low liquidity, flighty funding, contagion and events outside a bank’s control such as political risk.  The German Banking Act responded by introducing several tools to deal with these risks, including – but not limited to – a risk-weighted capital ratio.  That’s in stark contrast to the Basel I and II frameworks in place just before the recent crisis. There was only a risk-weighted ratio. Important as it is, it was not enough to prevent the recent crisis.

Regulators had to painfully re-learn this lesson: a single tool, no matter how sophisticated, cannot guard against the manifold risks banks are exposed to, many of which are difficult to quantify. For example, what risk weight should be ascribed to a negligent CEO liable to throwing chairs in a fit of rage?  In response to the crisis we now have a leverage ratio, stress testing, and a senior management regime (from March 2016) in the UK; and internationally we agreed liquidity requirements and large exposure limits.  We’ve forgotten this lesson from the past before.  Let’s not forget it this time.

Tobias Neumann works in the Bank’s Policy Strategy and Implementation Division.

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One thought on “From Berlin to Basel: what can 1930s Germany teach us about banking regulation?

  1. Timely and Very Good article.

    But, Bankers, Politicians, and many Central Bankers have not learned their lessons, from the past and they still commit the same mistakes over and over. They continue to try to find ways around the rules and sound banking.

    In 2008/09 rather than propping up the Banks and MKTS the Central Banks and Politicians should have allowed the system to clean itself and start with a sound/solid base. Yes, there would have been pain and losses but a sounder system going forward. Now we are confronted with the same issues but even worse for banks and the system.

    Bottom Line until Banks, Politicians and Central Banks learn from History and avoid the problems of the past, they are doomed to repeat the same mistakes but this time even on a larger scale.

    Yes, I am very Bearish on the state of the Global Financial System and have been for some time, prior to 2008.

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