Issue #17 of Net Interest, and welcome to all new subscribers. Every Friday I distil 25 years of experience looking at financial institutions into an email that explores key themes trending in the industry. If you’re reading this, but haven’t yet subscribed, join over 5,000 smart, curious people by signing up now. Thanks!
The German Bank Paradox
In a few weeks time, Germany will celebrate thirty years since reunification. One thing locals will celebrate with special fervour is their economy, whose strength is a subject of national pride. Despite the current wobbles linked to coronavirus, the German economy is the fourth largest in the world; second only to the US among bigger countries in terms of GDP per capita. As a unified country, Germany dislodged the US as the world’s biggest exporter of goods (before being overtaken by China). It weathered the Great Recession of 2007-09 better than most of its European neighbours. And its unemployment rate is one of the lowest in the Western world.
Yet its banking sector is a mess. It’s been two years now since the last remaining German bank was kicked out of the Euro Stoxx 50 index of leading European companies. The combined market capitalisation of German banks is currently less than US$30 billion, about the same as a single mid-level US bank. Such a low valuation reflects a poor track record of profits. In thirty years of trying, the country’s biggest bank, Deutsche Bank, has not once managed a 9% return on capital without recourse to excessive leverage. Its current target is 8% by 2022. One of its peers, Commerzbank, sets the bar even lower, psyching itself up with a target of only 4% by 2023.
The strong economy should give these banks a leg-up, at least that’s what their management would have you believe. On his earnings call in July, the CEO of Deutsche Bank told investors, “We are happy to have a leadership position in Europe's strongest economy.” Commerzbank’s CFO said something similar back in May: “We are well positioned for this unprecedented crisis. In Germany, we operate in one of the strongest economies.”
But if there’s one thing the past thirty years of German economic history has shown us, it’s that a strong economy does not equate to strong banks.
There may even be an alternative hypothesis: what if the strong economy arises precisely because banks are weak? Rather than the positive sum relationship typically brandished – “a strong economy needs strong banks” – what if Germany exploits a more zero sum relationship, in which value is actively transferred from banks to the wider economy?
It’s an important question because other countries are toying with the idea. In China, banks have been told to sacrifice US$210 billion in profits to prop up their economy. If that ask turns into something more permanent, like it may have done in Germany, it has big implications for the way the economy works—not all bad, but big implications.
A Short History of German Banking
To see what’s going on in Germany we need to go back in time, to the industrial revolution.
Germany in the nineteenth century was a latecomer to industrialisation. Earlier industrialisation in Great Britain had been a gradual process and was financed via earnings generated from trade and from capitalist agriculture and later from industry itself. Banks played a part but their role was primarily to provide short-term credit to finance trade.
In order to catch up, Germany needed quickly to establish large units of production which could benefit from economies of scale. The way to finance these was through long-term loans, provided by banks. Deutsche Bank and Commerzbank were both founded in 1870 to fulfil this mission.
Over the next few decades, industrial production in Germany really ramped up. In 1880 Britain produced twice as much steel as Germany; by 1913 the position was reversed. Reinvested profits and equity injections were not enough to cover the high investment needed and the contribution of banks was therefore critical. Bank balance sheets ballooned as they intermediated all these loans. On the eve of the First World War, the three largest enterprises in Germany by balance sheet were all banks.
These banks obtained a lot of influence among the companies they financed and frequently picked up shareholdings in them as well as positions on their boards. However, their focus on large industrial projects came at the expense of other sectors notably agriculture, housing and small business. As a result, lending to small businesses was left to savings banks and cooperative banks. Savings banks, known as Sparkassen, were set up by city and county governments as vehicles for channeling local savings to local businesses. Cooperative banks fulfilled similar functions although they were owned by their members.
In the interwar period the savings and cooperative banks strengthened their position. A clearing system was formed in 1918 to link all the savings banks together into a national network. Their exclusive focus on small business helped to foster the growth of small businesses in Germany. These days around 90% of all businesses in Germany are so-called Mittelstand small businesses and they make up around 80% of GDP. The support of the savings banks helped them get off the ground. (Although inheritance tax exemptions may be keeping them in the air.)
The founding mission of the big private banks in Germany – to support industry – was revitalised in the aftermath of the Second World War. Yet again, industrial production ramped up. Between 1948 and 1958 the economy grew an average of 8% a year—consistent with what they would today regard in China as an appropriate rate for an emerging power.
Behind this ‘economic miracle’ were the big banks. Between 1950 and the early 1970’s, around 60% of big banks’ lending was geared towards the manufacturing industry. As before, the banks stuck close to the companies they lent to. They positioned their representatives on company boards, they assumed proxy voting power of small shareholders and they maintained a web of corporate cross shareholdings. (A model not dissimilar to the one that appeared in Japan.)
However, the big private banks continued to lose share.
Regional Landesbanken were as old as the savings banks. They were originally established to act as banker to their local regional state and to act as clearing banks for the savings banks in their region. After the war, they expanded their share of lending and began to compete with big banks for business with larger firms. They benefited from a guarantee from their regional state which enabled them to raise capital at lower interest rates than the private banks. By 1975 they accounted for four of the biggest ten banks in West Germany.
At about that time cooperative banks also started flexing their muscles after having been given approval to conduct business with non-members. By the time of reunification, private banks had less than a 25% share of the market in Germany, and the biggest ones had less than 10%.
Squeezed in their domestic market, the big banks turned to investment banking. Deutsche Bank acquired London-based Morgan Grenfell in 1990 and New York-based Bankers Trust in 1998. Dresdner Bank (now part of Commerzbank) followed suit, acquiring London-based Kleinwort Benson in 1995 and New York-based Wasserstein Perella in 2000.
The foray of these banks into global investment banking did not end well, but that’s a story for another time. The point for now is that these big banks do not have the presence domestically that their global prominence suggests (not to mention their names—I mean, Deutsche Bank).
The Role of the State
Today there are around 1,800 individual banks operating in Germany. That makes it one of the most fragmented markets in the world. However, many of these banks act in concert, as part of a collective. Savings banks operate in specific geographic areas and, depending on their size, may have many branches, but they are prohibited from competing with savings banks outside their territory. The savings banks and Landesbanken together have around 30% of the loan market. Likewise, the cooperatives together have around 20% of the loan market.
That puts half the market in the hands of two organisations. Collectively they are eight times bigger than Deutsche Bank in loans. And the defining feature of these organisations is that they are not profit maximising. Savings banks are required to serve the public interest in their local community and, although they are required to avoid making a loss, profit maximisation is not their primary aim. Cooperatives have a mandate to serve their members and so are less profit-centric than private banks.
Landesbanken no longer enjoy the state guarantees they once did, after they were deemed unfair by the European Commission, but the savings banks do benefit from a raft of special privileges:
They are regulated as lots of small banks rather than as one big bank. Consequently, they are not subject to the same ‘too big to fail’ regulations that hover over larger banks. As small banks, they are supervised not by the European Central Bank (ECB) but by the local German banking authority, BaFin. (Yes, the same BaFin that supervised Wirecard and has oversight of Greensill.) It’s a safe assumption that the local regulator is less strict than the European regulator. Indeed, one German bank took the ECB to court over its preference to be supervised locally. (It lost.)
State aid is a big no-no in Europe, even though it’s being relaxed somewhat in light of the coronavirus crisis. This means that states are not allowed to provide financial support to their banks in a way that could tip the playing field in their favour. It was on the basis of these rules that the European Commission deemed the Landesbanken guarantees unfair. When the state owns the bank outright, though, as is the case for German savings banks, deciding whether a capital injection constitutes state aid, or whether it’s simply a case of shareholder-puts-in-more-money, becomes a bit murky. Last December a German Landesbank received a cash injection from its public overlords that appears more generous than a third-party investor would have provided.
Unlisted companies don’t have to abide by the same accounting standards as companies which are stock exchange listed. So the savings banks report under German GAAP and not the International Financial Reporting Standards that most other banks in Europe – and the world – use. German GAAP has a wrinkle in it which allows banks to smooth their earnings by dipping in and out of a general reserve. Over the years the savings banks have exploited this wrinkle to build up quite the nest egg.
Germany is not unique in operating a dual banking system comprising publicly owned banks in one lane and private banks in another. Publicly owned banks are active in most emerging economies like India and China, where they have over 50% of the market, and Brazil and Indonesia where they have over 40%.
However, in developed markets outside Germany public ownership of banks has been unwound. In Austria, savings banks were consolidated into the private Erste Group. In Spain, most local savings banks (cajas) suffered in the financial crisis and were rolled up into private entities. Several of them came together to form Bankia, which is now in merger talks with another private bank to form Spain’s largest bank by loans.
What is it that sustains public ownership of banks in Germany?
There are a couple of factors. First, the savings banks survived the financial crisis quite well. Their focus on small business shielded them from the brunt of the crisis and their ability to carry on lending won them plaudits. At the height of the crisis in late 2008, savers pulled deposits from the big private banks to open accounts at the Sparkasse on Berlin’s Friedrichstraße. The savings banks are still financially sound and their owners don’t push them to deliver high returns, so there’s no real impetus for change.
The second factor is that they are enmeshed in the German political establishment, so even if there were economic impetus, political motivation is lacking. Most Sparkassen are chaired by elected local politicians. The role enhances their influence but also provides a payday—they can supplement their government salary by over 10%.
Prospect of structural change? Don’t hold your breath.
Reconciling the Paradox
Which brings us back to the economy. The savings banks give away banking services at prices no private bank can afford. Germany has some of the lowest banking margins in the world. In 2011 the International Monetary Fund (IMF) went into Germany to survey its banking sector. They came away with the conclusion that by lending at lower than market rates, Sparkassen subsidise the broader economy at an average rate of 0.05 percent of GDP. And that estimate is conservative.
In addition, the very structure of the German economy pulls value away from banks and towards the corporate sector. Gone are the days of nineteenth century industrialisation and post World War II rebuilding, when the industrial sector was reliant on banks to fund its growth. Germany’s export-led growth model doesn’t need banks nearly as much.
Since reunification, Germany has transitioned from balanced growth – with both domestic consumption and exports contributing to demand growth – to an overwhelmingly export-led model. Behind the shift was a reduction in labour costs, triggered by the liberation of Eastern Europe. All of a sudden there were millions of accessible low-cost workers on Germany’s doorstep. The threat of German companies relocating jobs was enough to keep wages down domestically. Lower wages at home were not conducive to higher consumption, but no matter, there was always the export market and that’s where Germany thrived. Exports doubled from just under 20% of GDP in the early 90’s to more than 40% by 2007.
These lower wage costs were captured by German companies through higher retained profits. And higher profits increased the financial independence of German companies. Their borrowing demand declined, leaving banks starved of lending opportunities. Not only were the big banks muscled out of the market by the savings and cooperative banks, but the market itself was shrinking.
In other countries the response would be for banks to shift their strategic focus towards household lending opportunities. The track record elsewhere has been exactly that. In France, Italy, Spain and the UK, to say nothing of the US, lending to households has increased substantially since the mid 90’s. Not so in Germany. It’s a curiosity as to why that’s the case. Almost half of the population say in surveys that if they ever had to buy anything on credit they would be embarrassed, so maybe it’s cultural. But with no alternative domestic outlet to divert resources, corporate lending became a sinkhole of profitability.
The problem with the banking sector in Germany, then, is that there are a sufficiently large group of banks that are spoiling profitability for the others and a sufficiently large group of customers that don’t really need banks at all. The consequence is a transfer of value over from banks to their corporate customers.
The shrinking role for banks in corporate finance as evidenced in Germany is a source of risk to the extent that these banks aren’t going anywhere and have a motive to generate profit. This could explain the blunders that Deutsche Bank keeps walking into. Espionage, money laundering, interest rate fixing, violation of US sanctions—it’s hard to believe that a bank would have time for any of these things if it had enough to do in its core market.
The flipside is that the savings banks, from a societal perspective, are not doing a bad job. They are required to meet all requests for a bank account so they promote financial inclusion. By pooling their back office functionality nationally they extract the economies of scale that community banks in the US, for example, cannot. Most financial systems pass on some kind of subsidy somewhere. In the US, the subsidy flows into consumption via government support of the mortgage market. In Germany, the savings banks are the vehicle for the subsidy and the private sector banks are collateral damage.
Several books and papers were helpful in putting this piece together. I would particularly highlight this overview of the German financial system undertaken as part of the FESSUD project, this paper by Benjamin Braun and Richard Deeg, this Bruegel blog post by Nicolas Véron and chapter 5 of the book, Trade Wars Are Class Wars, by Matthew Klein and Michael Pettis. For a fresh journalistic account of contemporary Germany I would also recommend the book, Why the Germans do it Better, by John Kampfner.
More Net Interest
We talked about fraud in Net Interest at the end of June. Finance companies sit at the centre of its Venn diagram—as victims of it, vehicles for it and occasional perpetrators of it. JPMorgan became embroiled this week, after discovering that some employees had improperly applied for and received money under the Economic Injury Disaster Loan programme. However, the issue is much wider. The UK tax authority estimates that £3.5 billion in furlough money may have been spent on fraudulent or mistaken claims, some 5-10% of the total.
At a high level, a bit of fraud is no bad thing. Dan Davies explains in his book, Lying for Money, that fraud can be described as an equilibrium quantity:
“We can’t check up on everything, and we can’t check up on nothing, so one of the key decisions that an economy has to make is how much effort to spend on checking. This choice will determine the amount of fraud. And since checking costs money and trust is really productive, the optimal level of fraud is unlikely to be zero.”
The pandemic presents all economies with a consistent challenge, allowing an analytical assessment of how their models perform. Scholars will be busy for years after a vaccine is released. One area of research will no doubt be fraud and we will be able to see where the equilibrium is for different countries.
Switzerland was forced to dismantle its bank secrecy regime a decade ago. Since then, it has walked a fine line around money laundering. Every few years the Financial Action Task Force (FATF), the global money laundering and terrorist financing watchdog, conducts surveys of countries, to assess how they are combating money laundering. In 2016 it gave Switzerland a mixed report. An interim report in January this year placed the country “in enhanced follow-up”.
One of FATF’s issues is that Swiss anti-money laundering laws do not extend to people, typically lawyers, who are involved in setting up ‘letterbox’ companies or trusts. As it stands, these people are not subject to the same due diligence obligations or reporting requirements as those with more direct roles. This week an amendment was put to Parliament to include them in the scope of the law, but it failed to pass.
One reason could be the strong lobby that lawyers form in Switzerland. (The article states that lawyers represent 30 out of 246 federal lawmakers, yet the proportion in the UK is around the same.) However, the fact is that even after banking secrecy, Switzerland is heavily reliant on international money flows. At the end of 2014, the country managed US$6.8 trillion of assets, half of which belong to foreign customers. It also has a quarter of the global market for cross-border private banking.
Money laundering has become a bigger risk area for banks in the past ten years but in Switzerland at least the heat is now on lawyers rather than on bankers.
Over the past few weeks, Net Interest has published a series of articles on exchanges, culminating in last week’s piece, The New Power Brokers, about the shift in power from big banks to global exchanges. The London Stock Exchange will move closer to the pinnacle of this power group of global exchanges if it can pull off its merger with Refinitiv. To get it done, the exchange needs to sell off its Borsa Italiana arm in order to assuage monopoly concerns (or not).
Euronext confirmed today that it is a bidder for Borsa Italiana in partnership with state-backed Italian lender Cassa Depositi e Prestiti. It’s difficult to think of another industry, except perhaps telecoms, where assets have been swapped around as regularly. Euronext was once aligned with New York, now it’s not; London is aligned with Milan for now, soon it won’t be. Yet the new configuration makes sense. London and ICE (New York’s parent) will dominate on the data side, while Euronext consolidates Europe. In an industry where M&A is a permanent feature, there’s bound to be another act and a combination between SIX (Switzerland/Madrid) and Euronext (Paris/Amsterdam/Brussels/Milan) could be it.