A View From Germany I – How the three-pillared German Banking System has gotten through the crisis

A conservative banking system?

The activity of banking is supposed to be very simple: gathering deposits, and lending money. If you think of it that way, German Banks should have a competitive advantage because they are sitting on a pile of money. Since 2006, German households have been saving around 25% of their income. The comparison with other big economies is striking: in 2012, the French, the Italian and the Spaniards saved around 18%. In the UK, it’s a mere 10.8% (OECD, 2013).

Theoretically, one might think that a higher saving rate might lead to improved financial stability. Yet, banking is now infinitely more complicated than that. In the 1960s, American bankers had an old saying that their profession was governed by the 3-6-3 Rule. Bankers would give 3% interest on depositors’ accounts, lend the depositors money at 6% interest and then be playing golf at 3pm. In a way, the 3-6-3 rule still defines what one could call conservative banking. It is uncompetitive, risk-adverse, only moderately profitable, and possibly even boring. In the United States, there is a lot of literature on the sociological defeat of the old style of conservative banking, to the benefit of risk-taking traders and math geniuses. By contrast, German banks are still widely perceived as conservative, even though they embraced speculative market activities to the same extent as their European and American competitors.

But if German finance is so conservative, why did the government have to commit 9.1% of its GDP to bank bailouts and recapitalisations? In October 2008, the German federal government established the Sonderfonds Finanzmarktstabilisierung (SoFFin), a €480 billion rescue package to provide guarantees and recapitalization.

This revived an old controversy on the merits of the German banking system, and its main feature, the so-called “three pillars”. At this point, the debate is still open. Did it prove a resilient system that helped Germany resist a crisis that would have otherwise been worse? Or did it fail, forcing the government to bail out banks which should never have been so fragile, in a country with such a strong financial position?

The three-pillar system

The German banking system is characterised by an original three-pillar structure, composed of private commercial banks, public banks and cooperative banks:

Private commercial banks. There are around 300 private banks in Germany but until the crisis, five major banks used to dominate the private sector: Commerzbank, Dresdner Bank, Deutsche Bank, Deutsche Postbank AG, and HypoVereinsbank. Those banks are highly internationalised, and focus on business clients and market activities. In total, the German commercial private sector represented only 36% of total assets in 2010 (Brämer & ali., 2011).

During the crisis, the bigger banks came very close to bankruptcy, and had to be saved through publicly-overseen restructurings. Dresdner Bank and Deutsche Postbank AG were respectively taken over by Commerzbank and Deutsche Bank. So there are now only three major leaders. Commerzbank, in which the German State now owns 17%, is still trying to manage the consequences of the crisis and has only made a small profit for the first time since 2008 in 2013.

Public banks. The public banking sector is organised territorially and vertically: cities and local authorities own local Sparkassen, while Länder (regions) own Landesbanken. Other institutions include development banks, in German promotional banks (Förderbanken). German public banks aim to “complement the market where the state regards free market outcomes as insufficient and hence not socially acceptable” (VÖB, 2014). In 2001, the European Commission decided to put an end to the German system of state guarantees for public-law credit institutions (Anstaltslast and Gewährträgerhaftung), which was considered an illegal state aid because it resulted in cheaper funding. In 2001-02, a deal was found between German authorities, public banks, and the Commission. As a result, German law had to be changed and approximately 600 public banks made the transition to being without explicit state guarantees.

How did that pillar resist the financial crisis? The resilience of Sparkassen has been remarkable. Of course, in 2008, they lost money. But as early as 2009, profits were already as high as 2007, while commercial banks were still losing money. To be fair, profits have never been very high in the public sector, which is logical since maximisation of profit is not the main objective.

In stark contrast with local banks, regional banks, or Landesbanken, accumulated large amounts of losses which required deep restructuring and state interventions. Most famously, the bank of Baden-Württemberg had to take over the bank of Saxony, which was profoundly involved in the subprime crisis through an Irish subsidy. How and why public entities engaged in massive speculation on risky products fuelled a big controversy in Germany. Most Landesbanken had unstable structures of wholesale financing, excessively dependent on short-term funding. Consumers and small businesses were appalled by the behaviour of their local bankers, who put so much insistence on trust and differentiation with private-sector giants like DB. Part of the explanation may lie in a loophole induced by the transition arrangements implemented by the Commission in 2001. “For liabilities created between 19 July 2001 and 18 July 2005, Gewährträgerhaftung [state guarantee] will be maintained only for those maturing before the end of 2015” (European Commission, 2001). So between 2001 and 2005, with a strong acceleration after 2003, some Landesbanken borrowed as much as possible with public guarantee, and used that money to speculate. They thought that this strategy might help to smooth the transition.

There is now an academic and political debate on the future of Landesbanken. Is it just that governance was too lax, and favoured excessive risk-taking? In any case, public banks have maintained a strong position: at the end of 2012, they still had an overall market share of 36% (VÖB, 2014).

Cooperative banks. They are the most numerous: 1,162 in 2010 (Brämer & ali., 2011). They are owned by their customers and follow the cooperative principle of one person, one vote. They mostly aim to serve the interests of their members, usually farmers or small businesses. It does not prevent them from trying to make profits by providing services such as savings and loans to members as well as to non-members, which represent about half of their customers.

Obviously, cooperative banking was not directly impacted by the global turmoil of 2008. Considering the state of the economy, cooperative banks did remarkably well. Even in 2008, the worst year of the crisis, they managed to make a small profit. In 2012, net profits reached EUR 6.9 billion. The difficulties of the major banks and the moral disapprobation of customers benefited cooperative banks.

For regulators, an important issue now is the impact of new regulation on cooperative banking, including recognition of the special nature of their share capital (BVR, 2012).

A tradition of self-regulation

Germany has more banks than any other country in the EU. In the 1990s, that dispersion was considered a drawback for the economy. Everywhere in the EU, the number of banks has been constantly declining. But in Germany, that movement was extremely strong. There were 4,582 banks in 1990, and only 1,898 in 2011. Despite that concentration, in 2011, 24% of the banks in the EU are German. On average, they are small, and they own 18% of total EU-27 assets (EBF, 2013). According to an IMF technical note, the high number of banks “is somewhat misleading because the public sector and cooperative banks are closely linked to one another within their respective pillars, through mutual guarantees, the “regional principle,” joint operation of certain businesses and back-office facilities, and the presence of apex institutions, such as the Landesbanken for the Sparkassen”.

The number of banks and the decentralised political system of federal Germany help explain the strong tradition of self-regulation. Bankers continue to behave not only according to principles of law, but also to sectorial agreements. For example, cooperative banks are not legally bound anymore by the principal of territoriality, which keeps them from collecting deposits or giving out loans outside of a certain area. But in practice, they still abide by the rule.

Another important example is the deposit protection scheme. Each of the four banking associations has implemented voluntary schemes, which go beyond the European minimum of EUR 100,000. For example, the Association of German Banks (Bankenverband) secures up to a ceiling of 30% of the relevant liable capital of each bank. This is why they opposed some parts of the proposed Banking Union: German banks are reluctant to move to an integrated European scheme. They believe that their own system has proved more efficient, and that since their system is not purely law-based, it cannot be transplanted as such, and will require a lot of adaptations. Furthermore, the competition from public institutions has made German banks structurally less profitable than the European average, which provides fewer margins for stronger regulatory requirements.

German fondness to its banking system

The three-pillar system has survived the financial crisis. Now it faces a new challenge: adapt to the regulatory changes that are and will continue to be implemented to restore the stability of the European financial industry. In the crisis, German banks have had mixed results. But the problems were essentially the same as everywhere else: excessive risk-taking, and speculative activities that were completely out of line.

However, despite the scandals involving some of the major Landesbanken, the Germans have proven their attachment to the three-pillar system. Indeed, not all Landesbanken have behaved like the Saxon one. More importantly, small and medium-sized businesses, which are often pinpointed as the great success of the German economic model, largely continue to rely on financing from cooperative and public banks (see forthcoming article). To understand Germany’s stance on debates such as Banking Union, and in particular why Landesbanken have opposed common supervision and higher capital ratios, it is essential to keep in mind the peculiarities of a banking system which, to a large extent, is not or at least should not be entirely ruled by the maximisation of profits.

Generally, most observers recognize that the reforms of the 1990s have addressed most of the shortcomings of public governance. Therefore, assessments are usually positive: “German consumers and firms benefit from a system that provides good range and availability of financial services. […]. Thus, German intermediaries may be able to increase social welfare through the provision of services and intertemporal smoothing of returns that a more short-term oriented market has limited incentive to provide” (IMF, 2011).

Lessons from the German banking system

What can be learned from the analysis of the resilience and the fragilities of German banks during the crisis?

First, banks that do not exclusively seek profit are useful to society. Small businesses and consumers benefit from the presence of alternative sources of funding, like public and cooperative banks. German politicians and bankers acknowledge the existence of market failures. This is why despite 25 years of constant reform, “the level of public involvement in the system remains substantially unchanged and continues to be much higher than in other EU countries” (IMF, 2011).

The second lesson is that despite that diversity, different types of banks have taken excessive risks during the crisis. Regulation should therefore to the maximum extent possible treat all banks equally.

Finally, it is interesting to notice that European competition authorities removed formal public guarantee for public banks in 2001, based on strong arguments of unfair competition. But the massive government recapitalisations of 2008 show that there is still an implicit guarantee, and that it foremost benefits private commercial banks. The outcome is a highly unsatisfying paradox: one may wonder why public banks, which are legally bound to pursue public interest, are now less protected than private ‘too-big-to-fail’ institutions which only seek their own profit. In this sense, Germany, as all members of the EU, would clearly benefit from a reform of the EU banking structure, as advocated by Finance Watch, among others.

Fabien Hassan