A View From Germany III – Local solutions to a global crisis

From German Sparkassen to the fuss on local banking

Long portrayed as archaic and inefficient, the German banking system now enjoys a growing reputation in Europe. German SMEs benefit from the novel structure of the German banking system, and especially from the existence of a dense network of local and regional government-owned saving banks, the Sparkassen and the Landesbanken (for more on this, see previous blog). Interest in them and other kinds of alternative finance has received a boost thanks to the poor image of the big players of the financial industry.

Local banking existed everywhere in industrialised European countries in the 19th century. But big universal centralised banks have taken over the lion’s share of the market in countries like France, the United Kingdom, Belgium, or Italy. Could we and should we try to revive community banking?

The functioning of Sparkassen is ruled by three core principles: autonomy, local implantation (Regionalprinzip), and public service (öffentlicher Auftrag). Of course, they are controlled by cities and regions (Länder), which raises a certain number of questions. Is it possible for highly-indebted European states to invest in a new banking structure, without any experience in the management of risk? Would it not create an environment favourable to favouritism and corruption? And in the UK, a strong tradition of market liberalism sits uncomfortably with a strengthened role for the state in the allocation of capital.

The importance of being local

However, one could argue that the most important feature of Sparkassen is not ownership. On the contrary, public guarantees and political support might have allowed tolerance of high leverage and extreme asset–liability mismatch**, which led to unnecessary exposure to Wall Street complex structured products in 2008. Another state-owned German bank, KfW, was deeply hurt by losses due to the failure of Lehman Brothers. To this day, most Germans are still wondering what management was thinking when they decided to speculate on American mortgages.

So the thing that might really matter is local implantation. Taking local deposits and granting loans to local businesses used to be the core activity of banks. International finance made big banks drift away from this activity. Very importantly, being local implies that credit-granting decisions are not centralised or subject only to statistical algorithms and automated credit scoring. Sparkassen have proven resilient thanks to “the importance that they grant to the qualitative weighing of risks – especially for loans to businesses. It is the intimate knowledge of their clients which enables them do so” (Schackmann-Fallis, 2011).

Local banking is not a return to the past. German Sparkassen have sophisticated, centralised back-office systems that they share with each other through a common organisation called Sparkassen-Finanzgruppe. Local Sparkassen are also vertically integrated to regional Landesbanken, who have access to international markets and offer a full array of financial products. In other words, being local means that you focus on a home market where you benefit from improved access to information. But the next step, in which the Germans excel, is to connect your local clients to the wider world. The conceptual difference with purely local intermediation is best phrased by Anthony Thomson, the founder of Atom, a new online bank in the UK. He claims that: “The future is not regional banks; the future is regionally-based banks”.

On its website, the Sparkassen-Finanzgruppe claims that: “The savings bank concept is European at heart”. But how does the rest of Europe understand the concept of local savings banks?

The dominance of major banks

London is the capital city of global finance in Europe. Part of the British economy depends on the City, which explains why the UK is often reluctant to accept stronger regulation of its financial industry. Despite and maybe because of the strength of the major globalised banks it hosts, England is also the place where Sparkassen have attracted the most attention in the last five years among reformers. The financial crisis and the accumulation of scandals at large banks, in particular the LIBOR manipulations, made a strong impression on British citizens.

It is less true in France, where the hegemony of huge banks like Crédit Agricole, BNP and Société Générale remains unquestioned in the political debate. Yet French banking has not always been centralised in Paris. Finance historian Pierre-Cyrille Hautcoeur recognises that local banks played a key role during the industrialisation of France, but doubts that they could develop again in the present economic and political context: “Private initiative, especially at the local level, cannot be imposed from Paris. The dominance of large banks is massive, their influence on banking regulations is considerable, and their attractiveness to the best students still strong” (Hautcoeur, 2012).

Moreover, France already enjoys a solid network of savings banks. Since 2009, this network has been merged into Banques Populaires to form BPCE, which is now so big that it is on the list of the systemically important banks of the EU. Contrary to the image of the village bank which takes deposits from the baker and lends them to the butcher, local banking may also take the form of a network of regional-based institutions which together manage assets worth hundreds of billions.

DSGV, the umbrella organisation of Germany’s Sparkassen has published a series of reports on saving banks throughout Europe, which constitute a good overview. The reports also show that there are significant national differences in terms of organisation, legal structure, market share, liability… For example, BPCE is fully owned by its 8.8 million cooperative shareholders. So in France, savings banks are actually a form of cooperative banks, which also exist in Germany but under another name. This creates more confusion, making it all the more important to define precisely what is meant under the idea of reviving ‘local banking’ or ‘savings banks’.

The revival of local banking in the UK

In the United Kingdom, politicians from all horizons are now speaking of importing aspects of the German banking structure. This is all the more noticeable on the left. As German magazine Der Spiegel put it: “The British left has always admired Germany’s concept of the social market economy […], the state-owned savings banks whose purpose is to promote public welfare, the presence of strong, family-owned businesses that take a long-term approach in ther decison-making — this is very much in line with the social democratic traditions of the opposition Labour Party.” Beyond the left, conservative MP Guy Opperman hopes that: “ultimately, there should be local banks in every town in the country, bringing choice, competition and innovation back to communities and small businesses”. This is not a purely English phenomenon. In Wales, The Party of Wales, Plaid Cymru, also advocates the creation of a government-owned Bank of Wales to operate in a similar way as German Sparkassen and Landesbanken and “address market failures”.

The media love the – somewhat populist – idea of local people gathering their savings to support their community instead of giving deposits to globalised banks. This explains the incredible media treatment of the “Bank on Dave” initiative in Burnley, Lancashire. Created by a former minibus entrepreneur, it is so popular that it had to resort to a waiting list, even though it does not even have a banking licence yet… Its founder, Dave Fishwick, is hardly alone in perceiving an opening for new competitors: the Financial Conduct Authority has announced last April that 29 firms have applied for a banking licence in the UK.

The resolution of the financial crisis provides a great opportunity for reform. Rescuing RBS left the British government with a 64% share in the group. The UK classical liberal think-tank Civitas said in a press release entitled “Britain needs German-style banking to reignite growth” that, instead of simply waiting for RBS to recover and then selling it back, a more ambitious plan would be to “transform the branch network of state-owned RBS and Lloyds TSB into a network of local community banks covering the whole country”. Several Labour MPs seem to support the idea.

Nevertheless, the official plan of the UK government is still to hold its share while RBS recovers by placing its bad assets into an internal bad bank and buying back the special rights that government received for rescuing the bank. Then, government’s shares will simply be sold back to the market, once the price is considered acceptable by the Treasury. That process is more advanced for the other bailed-in giant bank, Lloyds, which is expected to return to private ownership before the election in May 2015.

Meanwhile, another actor is consolidating its market share. Swedish Handelsbanken enjoys considerable success in the United Kingdom. It now operates around 175 branches, against 117 two years ago. Active in six countries throughout Northern Europe, Handelsbanken cannot be called a local bank, but its philosophy and governance are inspired by principles of local banking, sometimes referred to as “church spire” banking (lending only to the area visible from the top of the local church). In practice this involves a partly qualitative assessment of risks, decentralisation, and conservative management of risks. Actually, Handelsbanken is hybrid in the sense that branch managers are fully responsible for the granting of individual loans – up to a certain amount – but credit policy is centralised and non-negotiable (Handelsbanken, 2014).

Bigger banks still have a very significant market share. For example, there are more than 1,500 Barclays branches throughout the UK. But certain fringes of the retail and small businesses market are clearly considering new parameters when they choose who will handle their money, so there is a significant market opportunity for fresh competitors, especially since financial regulators have decided to reduce barriers for new entrants.

All-or-nothing?

The big question is whether it is possible to introduce the benefits of the German banking system without the drawbacks. Having a huge public banking sector is uncommon in advanced economies. Until the 2000s, this was perceived as a major source of inefficiency, and the market share of public banks has been steadily declining until the crisis. The system only survived because the Länder considered regional public banking as an important prerogative against the federal government: “The German government, the Association of German Banks, the European Commission and the Bundesbank all support[ed] the elimination of the three-pillar German system but change has been strongly resisted by Land governments” (Hardie and Howarth, 2009).

Public service and local lending have now become a powerful communication tool. But several authors pinpointed that the actual market behaviour of German Landesbanken did not match this image. Before the crisis, international exposure of the main Landesbanken was comparable to that of Deutsche Bank. “One estimate of LB off balance sheet vehicles totalled $45.3 billion in October 2006. The vast majority is likely to be financing the US mortgage market”. These figures are “hard to reconcile with LB as ‘not strictly profit-maximizing entities’. The absence of private share-holder pressure did not prevent, for example, LB Sachsen in 2003 setting a target for return on equity higher than was then being achieved by Deutsche Bank” (Hardie and Howarth, 2009).

In fact, German banks, both public and private, were in general more exposed to the subprime crisis than their French counterparts. That does not mean that the German system is bad, or unstable. On the contrary, the Sparkassen came through the crisis almost unscathed and Germany is one of the few European countries that did not experience a credit crunch in the aftermath of the crisis. But let us not be naïve: the German public banking sector is not just a constellation of local banks. It is also one of the most powerful financial actors in Europe, aggressively internationalised, and risk-taking in periods of boom. Furthermore, the 2008 rescue accelerated the process of consolidation, loosening geographical ties. Without this, it would probably be unable to rival with private-sector colossuses like Deutsche Bank.

So there is undoubtedly a fuss on local banking. But each European country has its own idea of a local bank. England pretends to be importing the German model, but actually seems to try to resuscitate competition through the creation of small local private competitors, which is a deeply liberal approach. Germany now boasts a model that has been deprecated for decades. France promotes its banking champions and seems to believe that bigger is always better, even when it comes to managing mutual savings banks. Banking locally, thinking nationally, and competing globally: the coherence of the geography of post-crisis banking is still to be found.

Fabien Hassan*