This chapter examines some of the issues that arise in the process of integrating the monetary and financial system of the former German Democratic Republic (GDR) into that of the Federal Republic of Germany (FRG). The topic is divided into three broad areas: an analysis of the currency conversion, an examination of difficulties that will be faced in conducting monetary policies in the new environment, and issues related to the restructuring of the financial system and its prospective performance at a microeconomic level.

Garry J. Schinasi, Leslie Lipschitz, and Donogh McDonald

This chapter examines some of the issues that arise in the process of integrating the monetary and financial system of the former German Democratic Republic (GDR) into that of the Federal Republic of Germany (FRG). The topic is divided into three broad areas: an analysis of the currency conversion, an examination of difficulties that will be faced in conducting monetary policies in the new environment, and issues related to the restructuring of the financial system and its prospective performance at a microeconomic level.

The conversion of GDR marks into deutsche mark was a monetary event and thus, in principle, should not have a long-lasting effect on the real economy. However, the conversion process will influence inflation, current payments (such as wages) in the very short run, and the distribution of wealth between debtors and creditors. For east Germany, the conversion rate has important implications for the distribution of wealth: between the State and households on one level, and within the old state sector (comprising the Government, the banking system, and the state enterprises) on another. Under the old system, households were financial creditors (through their savings deposits), while the State was a net financial debtor; obviously the redenomination of the creditor and debtor positions affects both. Within the old state sector, the distribution of financial positions is important because the economic reform entails a breaking up of this sector into a banking system and an enterprise system that are independent of government. The financial solidity of the banking system and the burden of debt on the enterprise sector are the key considerations in this context.

Monetary control will be more difficult. The Deutsche Bundesbank is determined to maintain a low-inflation stable financial environment. A combination of higher fiscal deficits, rapidly rising demand, and an anti-inflationary monetary policy would create tensions in most circumstances; given the limited guidance as to how the demand for money and credit will evolve in east Germany, the conduct of monetary policy will be even more challenging in the present circumstances.

At a microeconomic level, it is important that the restructuring of the east German financial system transform it quickly into an efficient channel of intermediation. Given that the financial market is open to the participation of banks from west Germany and other countries and is subject to the same laws and regulations that govern the financial markets in west Germany, the efficiency of the financial system is unlikely to be limited by its structure. The principal concern is to ensure that bank lending and deposit policies are responsive to market signals, economic incentives, and a proper evaluation of risks and returns. In particular, it is important that lending decisions are consistent with an efficient distribution of resources and are not determined by a perception that the Trust Fund (Treuhandanstali) or the Government will stand behind certain preferred credits.

Mechanics of the Conversion

Following the announcement of currency union, there was widespread debate on the conversion rate. Some considered a rate of M 1 = DM 1 to be appropriate, as it was judged to be the rate that would set starting wages in the GDR relative to those in the FRG in line with relative productivity levels.1 Others suggested conversion rates ranging as high as the prevailing free-market rate.2 There was also some discussion of a schedule of conversion rates varying by type of asset and liability, as was done in the conversion of reichsmark to deutsche mark in 1948.3

The broad outlines of two official proposals were made public before agreement was reached by the two Governments: the Bundesbank’s proposal and a proposal that emerged from the Government in Bonn.4 The Bundesbank proposal, published on April 2, 1990, called for a conversion rate of M 2 = DM 1 for all assets and liabilities denominated in marks, except for bank accounts up to M 2,000 per person, which would be converted at the rate of M 1 = DM 1. Other important features of the proposal were as follows: participation in GDR state properties would compensate holders of bank accounts in excess of M 2,000 for the less favorable conversion rate; the Bundesbank would have full control over monetary policy in the GDR; the GDR would adopt FRG banking law, with banks from the FRG and abroad allowed to set up establishments in the GDR; and interest rates and foreign currency transactions would be fully liberalized. Current payments would also be converted at the rate of M 2 =DM 1, but wages and pensions would be adjusted to compensate for subsidies removed before currency union and for the introduction of social security contributions.

The Bonn proposal, announced on April 23, 1990, differed somewhat concerning the treatment of savings deposits and current payments. It called for a rate of M1 = DM 1 for currency and deposits up to M 4,000 for each individual and a rate of M 2 = DM 1 for the remaining balances; a rate of M 2 = DM 1 for all other assets and liabilities denominated in marks; and a rate of M 1 = DM 1 for wages and pensions, with no compensation for the removal of subsidies.

On May 2, 1990 the Governments of the GDR and the FRG announced a jointly agreed plan for currency conversion that would take effect on July 1, 1990. Financial claims and liabilities of permanent residents and enterprises would be converted at M 2 = DM 1. However, as an exception to this general formula, individuals would be allowed to convert limited sums at a more favorable rate of M 1 = DM 1, according to the following schedule: M 2,000 for persons under 14 years; M 4,000 for persons of 14 to 58 years; and M 6,000 for persons 59 years and older. Wages, salaries, stipends, rents, leases, and other maintenance payments would be converted at M 1 = DM 1, with wages and salaries set initially at their gross levels as of May 1. GDR pensioners would be provided the same benefits in relation to earnings as in the FRG.5 Deposits in marks held by persons with residence outside of the GDR would be converted at M 2 = DM 1 if acquired up to December 31, 1989, and at M 3 = DM 1 if acquired between January 1, 1990 and June 30, 1990. The official exchange rate between the mark and the deutsche mark, which was used chiefly for tourism, was changed from M 3 = DM 1 to M 2 = DM 1 on May 2, 1990.

The consolidated balance sheet for the banking system of the GDR as of June 30, 1990 was not available at the time of writing. However, the balance sheet implications of the conversion agreement can be approximated from the position at the end of May (Table 1). As of that date, financial assets with a book value of M 447 billion were on the books of the various financial institutions in the GDR. Credit to enterprises amounted to DM 232 billion (52 percent of assets), balanced in part by enterprise deposits of DM 57 billion. Credit to the housing sector totaled DM 103 billion. On the liability side of the balance sheet, the largest single item was deposits of households totaling M 182 billion (40 percent of total liabilities). The other key liability for the conversion process was the liability position of the State Bank to future exporters—the Richtungskoeffizienten (RIKOs), see below—reflecting the difference between the official exchange rate and the exchange rate used in foreign trade.

Table 1.

German Democratic Republic: Consolidated Balance Sheet of the Credit System Before and After Currency Conversion

(Based on figures for May 31, 1990; in billions of marks and deutsche mark)

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Sources: Deutsche Bundesbank; and authors’ calculations.

Average conversion rate.

A small part was deposited after December 31, 1989 by nonresidents and was therefore converted at M 3 = DM 1.

M 2,000 million for each of 3.2 million residents under age 14, plus M 4,000 million for each of 10.1 million residents between ages 14 and 58, plus M 6,000 for each of 3 million residents over age 58, are all converted at M 1 = DM 1; the remaining deposits are converted at M2 = DM 1.

Of this, M 31.2 billion constituted credits to the Government for the revaluation of Richtungskoeffizienten—RIKOs (see text) and M 4.9 billion was a credit to the Government for the minting of coins and currency during the conversion of 1948. Thus, only M 24.5 billion was actually converted.

Table 1 shows the results of applying the conversion rates to the balance sheet at the end of May. On this basis, the banking system would have had assets with a book value of DM 246 billion and a net worth of DM 23 billion (9½ percent of total assets). It is useful to describe the key elements of the conversion of assets and liabilities.


Taking into account the favorable conversion rate for a portion of household deposits, the average conversion rate for GDR mark deposits was about M 1.6 = DM 1. For foreign currency liabilities, market rates were applied as far as possible, while equity capital was converted at M 1 = DM 1. However, the average overall conversion rate was M 1.8 = DM 1. This reflected the nonconversion—that is, a writing down to zero—of the R1KO fund.

The RIKO fund can be interpreted as a reserve to help finance future export activities of GDR enterprises. The valuation of the fund resulted from an internal accounting system involving an official exchange rate and a more depreciated commercial rate. The difference between the two exchange rates was in essence a tax on importers and a subsidy to exporters.6 The surplus in the fund reflected past trade deficits with hard-currency trading partners. Unlike deposit liabilities, there were no actual claimants on the RIKO fund. On conversion day, the deutsche mark became the legal tender of the GDR and the need for these cumbersome accounting procedures disappeared. Accordingly, the RIKO fund was used partly to balance some of the credit outstanding to Government (due to revaluation of foreign currency liabilities) and partly to finance other aspects of the conversion process. In effect, it was not converted into deutsche mark.


The average conversion rate on domestic credit of the banking system was about M 2.2 = DM 1. This was above the conversion rate of M 2 = DM 1 because of the special treatment of the above-mentioned credit outstanding to the Government. Of the total claims on Government of DM 60½ billion, only M 24½ million was actually converted. Most of the balance reflected credit extended to the Government associated with revaluations of the RIKO fund7—consistent with the treatment of this fund, these credits were not converted. With hard-currency foreign assets valued at market exchange rates, the overall conversion rate on the asset side was M2 = DM 1. Given that the average conversion rate was more depreciated on the asset side than on the liability side, an infusion of capital from the Government was required to balance assets and liabilities. These equalization claims (Ausgleichsforderungen) were estimated at DM 26½ billion on the basis of the May balance sheet.8 This sum did not represent a measure of the insolvency of the banking system; rather it reflected the infusion necessary to maintain equity and reserve funds (converted in this initial stage at the rate of M 1 = DM 1) at the preconversion level. The banking system was technically insolvent, however, as, without equalization claims, the gap between the liability and asset sides would have been larger than the converted value of equity.9 The process of conversion will not be completed until the initial balance sheets of the banks and the enterprises can be closely evaluated; what is described above represents only the first stage. The status of enterprise debt, in particular, is still uncertain, both as to its value and the extent to which it will be borne by the enterprises themselves. The size of the equalization fund and the starting equity position of the banking system will thus not be determined until the end of 1990 or early 1991.

The Implications of the Conversion Rate

Effects on Liquidity

The money supply in the GDR was determined initially by the rate at which marks were converted into deutsche mark. Table 2 examines how the conversion rate would have influenced M3 in the GDR and in the unified German economy on the basis of the balance sheet position of the banking system at the end of May.10 At a conversion rate of M 1 = DM 1 for currency in circulation and all domestic deposit liabilities of the banking system, M3 in Germany would have been roughly 20 percent above the level of M3 in the FRG. Under the Bundesbank proposal, M3 after unification would have been 11½ percent higher than M3 in the FRG before unification, while under the Bonn proposal it would have been 13 percent higher, the same increase as under the plan actually implemented.

Table 2.

Estimates of the Money Supply in Germany Under Various Conversion Proposals

(In billions of marks and deutsche mark)

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Sources: Consolidated Balance Sheet of the GDR Banking System, May 31, 1990 provided by the Deutsche Bundesbank; Deutsche Bundesbank, Monthly Report; and authors’ calculations.

Converted at M 2 = DM 1.

Excludes insurance company deposits of M 14.2 billion.

Assumes that the population of 16.3 million residents each had a M 2,000 deposit which was converted at M 1 = DM 1. All other deposits are assumed to have been converted at M 2 = DM 1.

Assumes that each resident had a deposit of M 4,000 which was converted at M 1 = DM 1. All other deposits are assumed to have been converted at M 2 = DM 1.

Assumes that each resident between the ages of 14 and 58 (10.1 million) had a deposit of M 4,000, that each resident under 14 years of age (3.2 million) had a deposit of M 2,000, and that each resident age 59 or older (3 million) had a deposit of M 6,000, and that these deposits were converted at M 1 = DM 1. All other deposits are assumed to have been converted at M 2 = DM 1.

Assuming underlying productivity at about one third of the level in the FRG, output in the GDR was about one tenth of the level in the FRG. Thus, if one assumed velocity of M3 in the GDR similar to that in the FRG, the actual terms of the currency conversion seemed unlikely to produce a dangerous increase in liquidity. It was thought that even if velocity in east Germany turned out to be higher than in west Germany, there was not much basis for concern. Bank deposits in the GDR represented the entire financial holdings of households at the time of conversion; it was reasonable to expect, therefore, that a significant part of the deposits of households would be shifted into higher-yielding nonmonetary assets that would become available after July 1. In this context, it is interesting to note that the ratio of households’ financial assets to income in the FRG in the late 1950s and early 1960s was similar to that in the GDR in recent years. Moreover, in view of the uncertainties about short-term employment and income prospects, it seemed likely that households would be quite cautious in their expenditure behavior in the immediate aftermath of currency union.

Implications for the Labor Market

While the actual rate of conversion is unlikely to have had much influence on the equilibrium real wage in the GDR, it did set the initial wage rate. Actual GDR wage rates at the end of May 1990 were converted at a rate of M 1 = DM 1 on July 1. As such, the conversion rate influenced starting demand and supply conditions, migration decisions, and the initial cost of the social safety net.

One might have expected the extent and duration of this influence to depend on a number of economic factors: for instance, the degree of flexibility in wage formation, the initial level of wages relative to the equilibrium level, and the rate of change of productivity. To the extent that nominal wages were inflexible downward over an extended period, setting initial wages too high could have had adverse supply effects in the economy, with ramifications for unemployment and government finances. However, on the basis of the evidence available prior to GEMSU, it did not appear that the average level of wages was initially pitched too high. First, wage levels relative to the FRG seemed to be roughly proportional to relative productivity levels.11 Moreover, it was thought likely that productivity would rise fast in the early stages of GEMSU as labor dishoarding occurred. The level of wages would not greatly affect the dishoarding of surplus labor, although it would, perhaps, influence the absorption of dishoarded labor into other activities.12

Developments in the opening months of GEMSU have called into question earlier judgments on relative productivity levels and the pace of dishoarding. However, the clearest indication that the conversion rate was not, in the event, of great consequence in the labor market was the pronounced upward pressure on wages immediately after the currency union. Wage demands seem to have been determined more by aspirations for parity with west Germany (and possibly by a belief that the Government would protect employment) than by any realistic economic assessment.

Distributional Effects

Central to the currency conversion were its distributional effects. Two aspects of this are interesting to explore. First, did the currency conversion in itself represent a direct subsidy to the GDR? It is popularly supposed that the Bundesbank simply swapped deutsche mark for marks so that, to the extent that the rate of exchange was not an equilibrium one, there was a subsidy involved. In fact there was no such exchange. The Bundesbank did not take mark notes on its books in return for the supply of deutsche mark-denominated base money to the GDR. Rather the banks in the GDR, having called in all the cash in the economy, simply redenominated assets and liabilities in deutsche mark. To the extent that deutsche mark cash was then needed for cash withdrawals, deutsche mark were borrowed from the Bundesbank at the discount or the Lombard rate. Thus, the currency conversion, in itself, did not represent a subsidy to the GDR. Indeed, the Bundesbank gained seignorage through the supply of reserve money to banks in the GDR.

Second, the currency conversion did influence the distribution of wealth between households and the State. The mechanics of this process are clearest if, as a simplification, one thinks of the GDR as being made up of two sets of agents: households, whose wealth consists entirely of financial assets, and the State which is a net debtor in financial terms (largely the counterpart to household net financial assets) but which owns all of the real assets in the economy. The difference between the value of real assets and the net financial liabilities of the State reflects the equity position of the State. At this level, the conversion rate can be seen as determining the distribution of the net worth of the GDR between the financial wealth of households and the net worth of the State.13 But, as there is no objective way of deciding upon the correct distribution of wealth, these distributional considerations do not provide any useful criteria for determining the appropriate exchange rate.14

A number of other considerations may have entered into the determination of the appropriate conversion rate. First, caution was needed to ensure that the overall level of liquidity provided was appropriate. This liquidity constraint could have been circumvented by effecting the conversion partially in the form of nonmonetary assets (as was, for example, suggested in the Bundesbank proposal), but nonmonetary wealth might also have influenced spending decisions. To the extent that the conversion rate was determined mainly by liquidity considerations, any unwanted distributional effects could easily have been altered by fiscal mechanisms. Second, the architects of GEMSU may have believed that the private rate of time discount was high relative to the social one,15 and that it was therefore desirable for the State itself to marshal resources to restructure the economy. Third, the national wealth would depend, inter alia, upon how efficiently assets were managed; it is possible that views on the conversion rate were influenced by an assessment of how efficiently the State would manage the assets entrusted to it. In the final analysis it is likely that the choice of the conversion rate was determined chiefly by a desire to maintain a reasonable amount of wealth and liquidity at the level of households on the one hand, without stimulating excessive consumption or crippling the finances of the State on the other.

The conversion process, aside from its effect on household wealth and the overall financial position of the State, redistributed the net financial debtor position of the State between its various components—banks, the Government, and the producing enterprises. For example, changing the conversion rate from M 2 = DM 1 to M 3 = DM 1 (while still retaining a rate of M 1 = DM 1 for a portion of household savings) would have increased the value of producing enterprises (by reducing their debt) and hence the value of the State’s equity position in these enterprises. Offsetting this, however, there would have been a drop in the net worth of state-owned banks or an increase in the capital infusion needed to maintain the equity position of the banking system. In principle, therefore, there would not have been any net effect on the Government’s financial position.

One should not interpret the foregoing analysis as implying that the actual distribution of the State’s net financial position is irrelevant. In particular, to the extent that the separation of institutional responsibility, especially the enterprise sector from the Government, is strictly maintained, the level of debt left on the books of enterprises is likely to be an important practical determinant (next to their underlying competitiveness) of whether they are able to survive the transition and how easily they can be privatized. In particular, enterprise debt levels that are too high would prejudice the ability of enterprises to raise financing and would divert earnings from investment to debt service.16

Monetary Control During the Early Stages of GEMSU

The track record and recent statements of the Bundesbank leave little doubt about its determination to keep inflation under control. With higher fiscal deficits and strong demand pressures, however, one can imagine circumstances under which monetary policy would come under pressure in the period ahead. Moreover, in guiding monetary policy, the Bundesbank will face technical challenges related to uncertainties about how to implement monetary policy in east Germany.

Thus far, the Bundesbank has monitored monetary developments separately in west and east Germany. In the west, it has not departed from its traditional methods of operating (see Box 1), with its primary focus on keeping monetary growth in line with potential output and an acceptable inflation rate. Initially, statistics in the west may not be greatly distorted by money held in the east, although it will be difficult to identify the geographic distribution of currency holdings. As the two economies become more integrated, however, segregated monetary statistics and monetary management will become less reliable.

In the early stages of GEMSU, with monetary targeting only in the west and a single currency with free capital flows between east and west, the money supply in the east will be determined by demand. In normal circumstances this should not pose an inflation risk—after all, for the smaller countries participating in the exchange rate mechanism of the European Monetary System, whose currencies are effectively pegged to the deutsche mark, the situation is not very different.

In the case of east Germany, however, there are two important differences. First, a substantial increase in certain prices—chiefly for services—may be warranted as part of the unwinding of distorted relative prices in the GDR. Monetary conditions will accommodate this and it may be difficult to distinguish these relative price changes from general inflation pressures. Second, normal credit extension by banks, in line with the production decisions of enterprises and reasonable expectations about inflation, would not constitute a problem; but credit extended under government guarantees to fund unrealistic wage increases by enterprises with very short life expectancies could result in a monetary expansion that is out of line with real developments. This second mechanism is largely a “fiscal” as opposed to a “monetary” problem—the government guarantees are the essence of the problem.

It is difficult to see any alternative to the approach followed by the Bundesbank in the first stage of unification. There is no reasonable basis for determining how much liquidity to supply to the east German market. Traditional indicators are of little use: there is no sound statistical base, and no basis for extrapolating the demand for money or the behavior of velocity from historical relationships. The relative scale of the two economies, however, is such that errors in the provision of liquidity to the east are unlikely to have any major effect on the German economy as a whole.17

Monetary Policy Instruments and Procedures in the FRG1

Overall Strategy

After the final breakdown of the Bretton Woods system of fixed exchange rates in early 1973, domestic anchors had to be found to limit monetary expansion in individual countries. In late 1974, the Bundesbank introduced a target for monetary growth through 1975. The Bundesbank chose central bank money (CBM), comprising currency in circulation and banks’ required reserves on domestic deposits (measured at constant 1974 reserve ratios), as its target aggregate. CBM served as the target aggregate through 1987, but in 1988 the Bundesbank shifted to announcing targets for broad money (M3). The Bundesbank’s experience of using monetary targets to anchor inflation and inflation expectations has been successful; while targets (or target ranges) were exceeded in some years (owing, inter alia, to turbulence in foreign exchange markets), the targets themselves provided a clear and transparent point of reference for an anti-inflationary monetary policy that was widely accepted.

In setting its monetary targets, the Bundesbank seeks to accommodate not current real growth but the rate of growth of productive potential and a minimal (and acceptable) rate of inflation. This means that monetary developments provide stabilizing feedback to the real economy: if actual growth exceeds potential, monetary conditions tighten, while if growth falls below potential, monetary conditions ease. This method of setting monetary targets requires the Bundesbank to estimate potential growth and to determine an “acceptable” and achievable rate of price inflation. Consumer price inflation has averaged less than 3½ percent in the period since monetary targeting began, despite some major global bouts of inflation. In the cyclical upswing from 1983—89, consumer price inflation has averaged only 1¾ percent.

The Bundesbank’s Instruments

The Bundesbank uses both interest rate and liquidity policy instruments to influence money and credit market conditions and the reserve position of the banking system. These mechanisms accommodate two key features of financial markets in the FRG: the dominant role of the universal commercial banking system, which represents the main channel of transmission of monetary policy, and the almost exclusive reliance of banks on the interbank money market for short-term money management.

The Bundesbank uses its interest rate instruments, chiefly the Lombard rate and the discount rate, to establish upper and lower bounds, respectively, for the movement of short-term interest rates over a time horizon measured in months.2 Over a shorter time horizon, measured in weeks, the interest rate on repurchase transactions influences the rates in the short-term interbank money market more directly. The interest rate corridor established by the discount and Lombard rates is used by the Bundesbank to signal its intentions regarding the general stance of monetary policy; within this corridor, the repurchase rate is used to determine the center of gravity of money market rates.

Within the established interest rate band, the Bundesbank employs its liquidity instruments to vary the ease, predictability, and timing with which reserves are made available to the banking system. Because the FRG does not have a well-developed short-term market for securities, the Bundesbank has relied on supplementary instruments known as “reversible assistance measures.” These measures take the form of short-term bilateral transactions between the Bundesbank and the commercial banks in the money, foreign exchange, and long-term securities markets. The Bundesbank also injects reserves into the system by shifting federal government deposits into the money market for short periods.

Since 1985, open market transactions under repurchase agreements in fixed-interest securities (repurchase agreements) have been the Bundesbank’s main instrument for influencing bank liquidity, as well as short-term money market rates, on a week-to-week basis. Such transactions are short-term agreements, which usually run for one or two months.

For day-to-day fine-tuning of bank liquidity and short-term interest rates, the Bundesbank uses its other reversible assistance measures. From an operational point of view, the day-to-day management of money market conditions is guided by operating constraints on the level and structure of key interest rates and the development of the banking system’s liquidity position. The monetary authorities monitor key balance sheet indicators of the banks’ liquidity position—including unutilized rediscount quotas, indebtedness to the Lombard facility, and net liability positions resulting from “fine-tuning” operations.


For further discussion, see Deutsche Bundesbank, The Deutsche Bundesbank: Its Monetary Policy Instruments and Functions (Frankfurt, 1989); Deutsche Bundesbank, “The Longer-Term Trend and Control of the Money Stock,” in Monthly Report (Frankfurt), January 1985, pp. 13–26; and Hermann-Josef Dudler, “The Implementation of Monetary Objectives in Germany—Open Market Operations and Credit Facilities,” in Central Bank Views on Monetary Targeting, ed. by Paul Meek (New York: Federal Reserve Bank of New York, 1983).


The Lombard facility is a borrowing facility for exceptional financing with an administered interest rate (the Lombard rate). While there are no explicit ceilings on Lombard credit, the Bundesbank discourages the use of Lombard credit by an individual bank continuously, in large amounts, or over long periods. The Lombard facility is designed to offer liquidity at a penalty rate; the rate on overnight money in the interbank market, the call-money rate, is usually below the Lombard rate. The discount window offers a rate below both the Lombard rate and market rates. The quantity of borrowing at the discount window is limited by quotas that are generally fully utilized. The Bundesbank also has established an intervention rate at which it offers short-term treasury bills, usually with a maturity of three days. This rate places a lower bound on the call-money rate, above the discount rate. Thus, the call-money rate is bounded from above by the Lombard rate and from below by the interest rate offered by the Bundesbank on short-term treasury bill transactions.

At a technical level, even access by banks to Bundesbank resources initially presented problems insofar as banks did not have financial instruments eligible for refinancing. To solve this problem, the Bundesbank Act was amended to allow east German banks temporary access to the discount window and to the Lombard facility against equalization claims and single signature paper (i.e., banks’ own IOUs).18 Pending the issuance of equalization claims, liquidity operations by the Bundesbank have been exclusively against single signature paper.

Structural Reform of the East German Banking System

The Banking System in the Centrally Planned Economy

As in the other socialist countries, the banking system of the GDR had to contribute to the execution of the central plan. Accordingly, it was organized as a one-tier system with the State Bank (Staatsbank) at the head and a few commercial and a larger number of savings banks at the lower levels. The State Bank was the “central organ of the Council of Ministers for the implementation of the monetary and credit policy issued by the party and the government.”19 In this regard, it served as both a central bank and a commercial bank. As a central bank, it had the exclusive right to issue bank notes and coins and, with the agreement of the Council of Ministers, to set the official exchange rate between foreign currencies and the mark, the rate between foreign currencies and the valuta mark (the unit of account for foreign trade), and the domestic rate between the valuta mark and the mark.20 The commercial banking activities of the State Bank consisted of serving the state-owned enterprises and the Kombinate in industry, construction, transportation, and domestic trade. In order to execute this function, the State Bank maintained 41 branches.

The commercial banking activities of the State Bank were supplemented by a number of state-owned and cooperative banks. Among the former were the Deutsche Aussenhandelsbank AG (DABA), the Deutsche Handelsbank AG (DHB),21 and the Bank für Landwirtschaft und Nahrungsguterwirtschaft (BLN). DABA and DHB were the designated special institutions for all international trade and financial transactions of the GDR; BLN was the state-owned bank for the agricultural sector. The cooperative banks comprised the Genossenschaftsbanken für Handwerk und Gewerbe (GHG) and the Bauerliche Handelsgenossenschaften (BHG). The former served the crafts and trade sector, while the latter provided banking services to farmers.

The municipal and county savings banks (Stadt- und Kreissparkassen) together with railways and postal banks (Reichsbahn- und Postsparkassen) had the function of collecting the monetary savings of the population and passing them on to the commercial banks and the commercial arm of the State Bank as a source of funding for their lending business. About 80 percent of private sight and savings deposits were held at the savings banks. The remainder was distributed over the BLN, GHG, BHG, as well as the railways and postal banks.

The Banking Reform of March 1990

On March 6, 1990, the GDR parliament, in preparation for GEMSU, passed a law (Gesetz über die Änderung des Gesetzes über die Staatsbank der DDR) that replaced the one-tier, socialist banking system by a two-tier system compatible with that of the FRG. The State Bank gave up its commercial banking activities but remained the central bank of the GDR. The larger part of the commercial branch of the State Bank was used to create the Deutsche Kreditbank AG, and the smaller East Berlin operation (Stadtkontor Ost) was transformed into the Berliner Stadtbank AG. The central operation of the BLN was used to create the Genossenschaftsbank Berlin der DDR, while the branches of the BLN together with the BHG were merged into rural cooperative banks (Genossenschafts- und Raiffeisenbanken); the GHG formed the nucleus of the Volksbanken, the cooperative banks for the crafts and trade sector.22 The municipal and county savings banks remained. The organization of the GDR commercial banking system and the constitution of its components as universal banks set up a structure similar to that of the banking system in the FRG.

At the time of the reorganization, however, ownership of the GDR commercial banking system remained with the State or the cooperatives. The State Bank was given more than 80 percent of the shares in both the Deutsche Kreditbank AG and the Berliner Stadtbank AG, which were both constituted as joint-stock companies.23 The State Bank was also the main shareholder in DABA and DHB (also both organized as joint-stock companies), which, in addition to their commercial activities, continued to perform the functions of a house bank for the external trade companies engaged in trade with member countries of the Council for Mutual Economic Assistance (CMEA).24 In contrast to the above-mentioned banks, the Genossenschaftsbank Berlin and the savings banks (Stadt- und Kreissparkassen) were organized as public corporations.25 The Genossenschafts- und Raiffeisenbanken and the Volksbanken continued to be organizated as cooperatives.

The Equalization Fund and Equalization Claims

The establishment of a two-tier banking system compatible with that of the FRG was an important prerequisite for the currency conversion that took place on July 1. Since the assets of most banks were converted into deutsche mark at a lower rate than the liabilities, in order to maintain the equity of the banks, the assets of the banking system had to be topped up with claims issued by the Equalization Fund, that is, the equalization claims discussed above. The Equalization Fund, in turn, covered its liabilities by claims against the State Bank and the GDR Government. Reflecting the structure of their assets and liabilities on the day of conversion, however, individual banks were affected differently by the currency conversion.

On July 1, 1990, the State Bank ceased to exist as a central bank. It nevertheless continued to perform an important role as a “money market bank” linking the savings deposits of the population held at the savings, postal, and cooperative banks to the business and housing credits extended by the Kreditbank. Since an important liability, the RIKO fund, was eliminated in conversion, and since it had no deposits that were converted at parity, the State Bank registered a gain from currency conversion (after converting its equity position at the rate of M 1 = DM 1) and was allocated a corresponding liability to the Equalization Fund (Chart 1).

Chart 1.
Chart 1.

German Democratic Republic: Simplified Outline of the Banking System and Interbank Relations at the Time of the Currency Conversion1

Source: Deutsche Bundesbank, Monthly Report, July 1990, p. 17.1 Excluding the Bundesbank. The joint venture banks established since the currency conversion, and the restructuring of the GDR banking system effected since then, are not included.2 Now known as State Bank Berlin.3 Now known as Cooperative Bank Berlin.

All other major banks suffered conversion losses and had to be given claims on the Equalization Fund. Since the savings and cooperative banks held the lion’s share of the population’s sight and savings deposits, part of which was converted at parity, their conversion losses, and hence equalization claims, were the largest. Banks holding foreign liabilities (DABA and DHB) also incurred substantial conversion losses as their liabilities to Western countries had to be valued at market rates while their assets had to be converted at a rate of M 2 = DM 1.26

Based on calculations using data from end May 1990, the Bundesbank estimated that the GDR banking system would have gross claims of about DM 57 billion on the Equalization Fund. These would be offset in part by liabilities of the State Bank to the Equalization Fund so that the net claim on the Government by the Fund was estimated at about DM 26½ billion. A preliminary calculation, as well as an allocation, of equalization claims, would be made as soon as the end-June balance sheets became available. A final calculation would be made only after east German companies had published their opening balance sheets in deutsche mark, the distribution of enterprise debt was decided, and banks had evaluated their portfolios incorporating this information.

Developments in East German Banking After GEMSU

As mentioned above, the commercial operations of the GDR banking system were placed with the newly created Deutsche Kreditbank (DKB) in March 1990. Subsequently, the DKB entered into joint ventures with the two largest west German commercial banks. Deutsche Bank invested DM 1 billion in a joint venture with DKB that encompasses 122 of the DKB’s branches and 8,500 of its employees. Dresdner Bank also entered into a joint venture with DKB covering 72 branches of DKB with an original investment of DM 150 million effective July 1, 1990. An additional investment of DM 350 million was made in September 1990, which increased the Dresdner Bank’s stake in the joint venture from 49 percent to 85 percent. At that time, Dresdner Bank also had 35 branches in the GDR which it had established de novo, including its original headquarters in Dresden.

The Westdeutsche Landesbank, another FRG bank, has entered into a joint venture with the Deutsche Aussenhandelsbank (DABA), taking over 200 branches and approximately 1,200 employees. The joint venture is called the Deutsche Industrie- und Handelsbank (DIHB). Likewise, the Berliner Handels- und Frankfurter Bank (BHF) has taken a 64 percent stake in the Deutsche Handelsbank (DHB).

In contrast to the other large FRG banks operating in east Germany, the Commerzbank decided not to engage in joint ventures with former GDR banks; instead it adopted the strategy of opening new branches in the east. Commerzbank expects to have 50 branches operating in east Germany by the end of 1990; as of the end of September, its east German operations had total assets of about DM 6 billion, with about 80,000 customers and DM 2 billion in deposits.

There are also a number of non-German banks operating in east Germany: Citicorp has established representative offices in East Berlin, Dresden, and Leipzig; Salomon Brothers and Barclays Bank have offices in East Berlin; and the Bank of Tokyo has received permission to establish a branch in East Berlin.

Savings institutions, which are generally owned by municipalities in west Germany, will be similarly structured in the east. As of mid-October, there were 4,000 branches of savings banks (Spaarkassen), with 20,000 employees, which accounted for about 80 percent of total deposits in east Germany. Like in west Germany, there were also a number of cooperative banks (Genossenschaftsbanken): 95 in urban areas and 272 in rural areas catering to the agricultural community.

Role of Banks in Economic Reconstruction

The central position of the banking system in the allocation of resources gives it a key role in the transformation of the east German economy. The March banking system reform initiated the refashioning of the GDR’s banking system to this end. The establishment of the necessary institutional structure has been embodied in the State Treaty on GEMSU. In particular, after July 1, financial markets in the GDR were opened to external competition both in terms of cross-border business and the participation of external banks (i.e., from the FRG and other countries) in the domestic market. Furthermore, laws regulating financial markets in the FRG were adopted by the GDR although, in certain circumstances, they could be applied more flexibly than in the FRG.27

It will no doubt take some time before banks in east Germany operate as efficiently as those in the west. The principal concern about the operations of the banking system, however, would seem to be that the incentives facing banks in their lending decisions are appropriate. Credits to enterprises extended before July 1, 1990 appear to have an implicit guarantee from the Trust Fund or the Government. But for new credits, and given the desire not to distort the allocation of credit by government intervention, the situation is more difficult. Uncertainties about the underlying competitive position of enterprises are likely to persist for some time. Banks will therefore be extremely cautious in extending new credits without government guarantees, at least until decisions are made on the allocation of existing enterprise debt and on enterprise balance sheets. In the period July-September, the Trust Fund was authorized to guarantee working capital loans to enterprises up to a total of DM 30 billion. A significant portion of these guarantees, at least in the first tranche of DM 10 billion in July, was allocated to enterprises that are unlikely to survive the transition to a market economy. It now appears likely that the system of guaranteeing working capital credits will be continued through the first quarter of 1991.

A second consideration relates to the next step of balance sheet reorganization that will occur with the valuation of enterprise debts and perhaps also the redistribution of these debts. The redistribution of assets and liabilities within the state sector may have important consequences for the success of the restructuring effort as it will influence assessments of the creditworthiness of individual enterprises. It is important that as a result of this process, viable economic entities not be excessively burdened with debt related to decisions under the previous system.


See the discussion of wage and productivity levels in the GDR in Chapter III, section on “Economic Background.”


In December 1988, the market rate in West Berlin averaged M 7.75 = DM 1. In January 1990, it was about M 7 = DM 1. The mark appreciated following the announcement of currency union to M 5.75 = DM 1 in February and to M 2.75 = DM 1 in June 1990.


For a discussion of the 1948 currency conversion see Thomas Mayer and Günther Thumann, “Radical Currency Reform: Germany,1948,” Finance & Development (Washington), March 1990, pp.6–8.


In line with lower wage levels in the GDR, pension payments would be lower in the GDR.


There are two ways of viewing the operations of the RIKO fund. That presented here starts with the assumption that the actual exchange rate between the deutsche mark, the valuta mark, and the GDR mark was DM 1 = VM 1 = M 1, but that hard-currency trade was subject in effect to export subsidies and import taxes that were paid out or received by the RIKO fund. Alternatively, one might see the actual exchange rate at DM 1 = VM 1 = M 4.4 with exporters receiving M 1 directly and M 3.4 through the RIKO fund for each DM 1 of exports. In either case the change in the exchange system meant that the RIKO fund became obsolete, and, since there were no actual claimants on it, it could be used to help bridge the asymmetry between the conversion of assets and liabilities.


From time to time, the RIKO fund was revalued in line with changes in the commercial exchange rate. The Government absorbed the valuation losses, sometimes through budgetary contributions but more recently through borrowing from the State Bank.


The mechanics of the equalization claims and the establishment of the Equalization Fund are described below.


Interpretation in a normative sense is, however, hazardous. First, the insolvency reflected the arbitrary asymmetric conversion rate. Second, the distribution of assets and liabilities within the state sector had had little economic meaning under the former system.


M3 in the GDR was approximated by the sum of currency in circulation held by individuals and total domestic deposits.


See Chapter III, section on “Economic Background.”


Given the shortage of capital and the inevitable mismatch of skills in the labor market, the extent to which lower wages would have eased the unemployment situation in the short run is not clear.


It is, of course, impossible to estimate the net worth of the State with any confidence at the present juncture because of uncertainties about the value of its holdings of land and industrial capital.


Indeed, if one saw the net worth of the State as being ultimately attributable to households, one could argue that the distribution of wealth between the two is unimportant; this, however, would be an extreme view.


Particularly given concerns about an impatience for rising consumption levels in the GDR after many years of living standards far below those in the FRG.


It is worth noting that the distribution of debt between various components of the State had little to do with economic fundamentals. It reflected the arbitrary nature of the pricing system under central planning and the role of enterprises as the major source of government revenue.


Moreover, there is nothing to prevent the Bundesbank reacting to any disturbing inflationary tendencies in the east by tightening monetary conditions in the west—there is room within the target range for discretionary action and the Bundesbank’s concern, after all, is with inflation in all of Germany. The Bundesbank has not yet announced its monetary policy intentions for 1991.


As in the west, each bank has been assigned a rediscount quota. In total, these amount to DM 25 billion. The banks have access to additional funds from the Lombard facility.


See Gesetz über die Staatsbank der DDR, December 19, 1974.


The system seems to have been logically inconsistent in that cross-restrictions between these exchange rates did not always hold. For example, the official exchange rate between the deutsche mark and the mark, as well as the rate between the deutsche mark and the valuta mark, were both 1:1. In 1989, however, the internal rate between the valuta mark and the mark for hard-currency trade was VM 1 = M 4.4. A fund was created at the State Bank (RIKO fund) to finance differences between the official and the internal exchange rates (see above and Chapter III).


In order to facilitate business with Western countries, the GDR Government had given DHB and DABA the status of Aktiengesellschaften, that is, joint-stock companies, already at the time they were founded in 1956 and 1966, respectively.


The Genossenschaftsbank Berlin was created as the head organization for the local Genossenschafts- und Raiffeisenbanken, as well as the Volksbanken.


The remainder of the equity interest was acquired by state-owned enterprises and Kombinate.


DABA, in particular, remained the designated bank for transactions with the two CMEA banks—the International Bank for Economic Cooperation (IBWZ) and the International Investment Bank (IIB) that are located in Moscow.


This form of ownership is also common for savings banks in the FRG.


Reflecting the allocation of responsibilities that existed in the one-tier banking system, the State Bank, the DABA, and the DHB had undertaken foreign borrowing on behalf of the Government. The authorities decided to leave the foreign liabilities after conversion with the banks that had incurred them and to give the banks offsetting claims on the Equalization Fund.


For example, the Banking Supervisory Office in the FRG could, under certain circumstances, grant exemption from the banking law to east German banks.

Economic Issues Occasional Paper No. 75
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    German Democratic Republic: Simplified Outline of the Banking System and Interbank Relations at the Time of the Currency Conversion1