Germany’s government has agreed to extend its proposed “bad bank” scheme to encourage some of the country’s troubled public sector banks to offload assets in return for radical restructuring.

The proposals could make Germany’s the biggest bad bank scheme in Europe to arise from the financial crisis as a way for banks to spin off unwanted assets and clean up their balance sheets. Proponents of the scheme see it as essential to restore confidence and encourage healthier banks to restart lending.

Berlin’s agreement to widen the scope of the bad bank is aimed at Germany’s seven Landesbanken groups, regionally owned banks that have collectively been among the country’s worst casualties of the financial crisis. It follows a promise by regional political leaders to make significant headway in consolidating the Landesbank sector by the end of next year.

Bad bank legislation going through parliament would be altered to allow the sheltering of a broader range of assets as well as so-called toxic securities, the cabinet of Angela Merkel, chancellor, decided on Wednesday. German banks are thought to harbour about €800bn ($1,100bn, £685bn) in toxic or non-core assets, but it is unlikely the bad bank would be asked to take over this amount. Ireland was the first European country to announce a bad bank plan, pledging to take up to €90bn in assets from the books of its banks.

“The government wants in particular to support the necessary consolidation of the Landesbanken,” the finance ministry said. It hopes legislation will be approved by July.

The agreement shows how the problems of the Landesbanken have given Berlin more leverage over the sector, after the banks’ regional owners had for years resisted pressure to consolidate. The banks’ losses have weakened some regional governments’ finances to the point where they are much more willing to accept the banks’ reform.

But Berlin’s reluctance to shoulder losses arising from assets parked in the bad bank could cut banks’ interest in taking part, reducing the impact of the scheme as a tool for consolidation. The narrower bad bank plan for toxic securities – aimed more at private sector banks – is also thought by many analysts to have terms that banks will find too unattractive.

Peer Steinbrück, finance minister, wanted the commitment to consolidate as the price of letting Landesbanken use the bad bank legislation. Restructuring has been urged for years by competition authorities.

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