The German Financial System and the Financial and Economic Crisis

The development of the German financial system has been characterised by two key features, both of which have their origin in the country’s pattern of industrialisation in the second half of the nineteenth century. The first is that Germany is a prime example of a bank-based financial system. Germany required large amounts of capital to industrialise, and this was mobilised primarily by banks. A major role was played by large joint-stock banks which were established in the early 1850s and the early 1870s. The second key feature is that, in addition to profit-oriented commercial banks, the German financial system has also included two other sectors that are not primarily motivated by making a profit, namely the publicly-owned savings banks, and the cooperative banks. By 1913 the German banking system consisted of a private sector, dominated by eight big banks, a large public savings bank sector, and a somewhat smaller cooperative sector. In the 1920s, the big private banks faced major challenges from inflation and competition from foreign banks, and three big banks emerged because of mergers and failures. At the end of the Second World War, the three big private banks were broken up because of their complicity in German war crimes but, following successful lobbying, could re-establish themselves as unified institutions in the 1950s. The big banks played a major role in financing larger firms during Germany’s post-war reconstruction, while savings banks and cooperative banks contributed significantly to the growth of Germany’s very successful small and medium-sized enterprises.

The value of financial assets in the German economy grew rapidly in the 1990s, both in absolute terms as well as relative to GDP. The activity of banks, as measured by the ratio of deposits, bank loans and securities held by banks to GDP, also grew strongly in the later period. At the same time the size and activity of financial markets has grown, although to a lesser extent. Despite the growth of financial markets, however, they are still rather underdeveloped by international comparison. More significant changes can be observed in the non-financial corporate sector. Non-financial corporations have increased the share of their investments assigned to financial assets; a larger part of their profits has been generated from financial sources; and the share of their earnings distributed to financial investors has increased. There were important changes in ownership and control of the German corporations, which coincided with those trends. In the early 1990s, the most important shareholders in companies were non-financial corporations, but such cross-holdings subsequently declined quite strongly. The second most important shareholders were households, although their holdings also declined subsequently, partly due to a shift towards indirect holdings through institutional investors. The most striking increase in share-holdings has been that by foreign investors. Institutional investors grew rapidly in the decade from 1990 to 2000. However, their size is still small by international comparison. Over all, the data and comparisons suggest that the growth of finance is a quite recent and still relatively modest phenomenon in Germany.

The German financial system has historically been a prime example of a bank-based system although, in contrast to most other developed capitalist countries, a significant part of the banking system has consisted of publically-owned savings banks and cooperative banks that are not driven primarily by the search for profits. Big private banks had traditionally functioned as house banks to big industrial companies, but investment and borrowing by industry declined after the 1970s. In the mid-1980s, the big private banks responded by promoting the development of securities markets in Germany with the aim of increasing their earnings from investment banking activities. This has resulted in some strengthening of the role of securities markets since the 1990s, although banks continue to occupy a predominant position in the German financial system. Amongst non-bank financial institutions, insurance companies have historically been the most significant, although investment funds expanded very rapidly in the 1990s, and are now almost as large. Pension funds have been much less significant. Highly leveraged financial institutions, such as hedge funds and private equity funds, have also had a relatively limited presence in Germany.

Germany abolished all controls on international capital flows in 1981 and, in the course of the 1980s, the country’s international financial integration increased steadily, but from a low base. Between the late 1990s and 2008, when Germany generated a large current account surplus, international financial integration increased strongly, with a marked growth of both portfolio investment and bank lending from Germany to other countries. The bank lending was predominantly to other European countries, with the largest part going to Euro area countries. German banks also extended their lending in the US during this period and, in addition to funds from Germany, German banks drew extensively on funds raised in the US itself. As a result, German banks were strongly exposed to the financial crisis when it broke in the US in 2007. Following the dramatic deepening of the crisis in September 2008, German international financial integration was partly scaled back and German banks reduced their lending abroad at the same time that there was an outflow of foreign funds held in German banks. However, as a result of increased international financial uncertainty following the outbreak of the financial crisis, there was a large inflow of funds from other countries into German government bonds, which consequently registered unprecedentedly low interest rates.

The regulatory regime in Germany from the 1930s up to the 1990s could be characterised as a stakeholder-oriented and bank-based model. Regulations stabilised the widespread system of house-banks and the extensive cross-holdings of shares between big financial and industrial companies. Formally, a universal banking system existed, but investment banking was in practice unimportant. This started to change in the 1990s, gained speed following the election in 1998, and triggered a transition to a regime where shareholders’ interests began to gain importance in regulations. From 1995, Germany initiated changes that aimed to move the financial system in the direction of a more Anglo-Saxon type system. Regulatory changes aimed at strengthening the power of shareholders, and at limiting the influence of banks. This has led to a threefold decline in banks’ direct involvement in corporate governance: in the number of bank representatives on company supervisory boards; in banks’ majority ownership in large firms; and in banks’ role in proxy voting. The regulatory changes were promoted by German governments in an attempt to strengthen the position of Germany as a host for international financial markets, and by the European Commission, which pushed for financial market harmonisation in Europe as part of a neo-liberal agenda. However, the German financial system has not changed substantially. Although Germany has clearly been moving away from a purely bank-based model, it has not adopted a market-based one.

At a national level, concentration measures and the number of independent organisations indicate a very low level of concentration in the German banking sector. However, if the cooperative and the public sectors are each considered as large, single institutions, concentration ratios are much higher. The interest margins of German banks have been slightly higher than in some other developed capitalist countries, such as Japan and France, but since 1995 margins have shown a downward trend. This can be related to increased competitive pressure in the deposit market due to the entrance of new financial institutions, in particular money market funds. At a regional level, concentration is considerably higher. Focusing on big cities and measuring competition by the number of branches in a certain area, savings banks and cooperative banks are the main players in the retail markets, while the big German banks are fringe players. Before 1995 the market for investment banking services was small, highly concentrated and dominated by German-owned banks. Since 1995, however, the market has grown, and foreign-owned banks have become much more important. The entrance of these new competitors led to a decline in the concentration ratios. However, the market for large IPOs today is dominated by a relatively small number of international investment banks, and only two German banks, Deutsche Bank and Commerzbank, belong to the big players.

The profitability of German banks, measured by the rate of return on equity or on assets, has been low by international comparison since the early 1980. Pre-tax profitability tended to fall from the early 1980s until the recent crisis, although after-tax profitability did not. The pre-tax profitability of the cooperative banking sector has been higher than that of the private banking sector, with the latter being far more volatile. It has also been higher than that of the public savings banks because of the particularly low profitability of the Landesbanken. After-tax profitability has converged and private banks have gained relatively most from government re-distribution. The profit share of the financial corporate sector has shown no pronounced trend since the early 1980s, but has fluctuated quite widely, with major declines during the crisis in the early 2000s and the recent financial and economic crisis. The profit share of the non-financial corporate sector started from a lower level in the early 1980s, but then showed a tendency to rise until the recent crisis with only minor fluctuations. Since the early 2000s, it has exceeded the profit share of the financial corporate sector. The rate of return of the financial corporate sector has shown a falling trend. Although the financial and the non-financial sectors had similar rates of return on equity in the early 1990s, in contrast to the financial sector, the rate of return tended to rise in the non-financial sector until the recent crisis.

The evidence regarding the efficiency of the German banking system is mixed. For international comparisons, it is important to note that a large part of the German system consists of savings and cooperative banks that do not aim at maximising profits. Savings banks use part of their surplus to promote community activities and are also obliged to provide financial services to all customers, regardless of the profitability of the business relationship. Additionally, it seems that savings banks lend at rates below those charged by the private and cooperative banks. The primary aim of cooperative banks, in turn, is to benefit their customers and members. Local banks from all groups (private, cooperative and public) seem to be superior to the big nationally active banks in terms of efficiency. Among local banks, public and cooperative banks are found to be more efficient than private banks. There is therefore no evidence that opening up the public sector for private capital would improve the efficiency of the German banking system. Suboptimal size of German banks is not a significant factor either. Furthermore, since the optimal size for banks is not known, and the threshold where risk-return decisions are found to deteriorate is rather low, there is little evidence that a consolidation strategy would improve efficiency. There is also no evidence for the existence of significant economies of scope. This indicates that a separation of investment and commercial banking would not have a negative effect on efficiency.

The profitability of the non-financial business sector increased considerably from the early 1990s until the Great Recession, but investment in capital stock was weak. There seems to be some evidence that the ‘preference channel’ and the ‘internal means of finance channel’ constrained investment in capital stock under the conditions of financialisation and the increasing shareholder value orientation of management. Increasing received financial profits (interest and dividends) indicate an increasing orientation of the management of non-financial corporate business towards investment in financial assets, as compared to investment in capital stock (‘preference channel’). And increasing dividends paid out to shareholders indicate a decrease in internal means of finance available for fixed investment purposes (‘internal means of finance channel’). As in other countries, internal means of finance have been the most important source of investment finance for German corporations; the contributions of equity issues have historically been negligible and they have been negative since the mid 1990s, indicating share buybacks in this period. Bank credit, as well as corporate bond issues, have not been necessary for real investment finance but have been used for the acquisition of financial assets since the mid-1990s. SMEs and non-corporate firms also finance investment predominantly from internal sources. Periods of high investment are associated with increasing credit and increasing debt-capital ratios. The decline in credit to non-corporate firms since the financial and economic crisis has been mainly caused by a lack of demand for the output of these firms, and not by a lack of access to credit.

After World War II the German company network was characterised by strong ties between management, capital, and labour and by a low level of M&A activity. M&A activity increased in Germany from the 1990s, mainly as a result of developments associated with German unification, and continued to rise in the 2000s. The increase was a little smaller than in Europe as a whole, and much smaller than in the US or the UK. Although Germany did not adopt an Anglo-US-American type of M&A regime, changes in the strategy of bigger German banks and enterprises encouraged M&A from the early 1990s on. This was supported by the policies of the German government and the European Commission. These developments involved moderate changes rather than a decisive leap towards a liberal market economic model with easy and frequent takeovers. Hostile takeovers have not been very common in Germany and, if they take place, they are generally of a managed type, involving a compromise between all the stakeholders. The German M&A regime can be judged as hybrid, combining elements of a market radical approach with a strong non-market stakeholder orientation. Vodafone’s hostile takeover of Mannesmann in 2000 was a shock for the traditional German corporate governance model and led to a form of consensus that takeovers should be possible, but not in a market radical way.

The structure of the German banking system, involving private, public and cooperative banks, has not changed significantly in recent years, despite some pressure for liberalisation and privatisation. In other sectors of the economy, however, privatisation has had an impact. In quantitative terms, the post-unification wave of privatisations in East Germany was the most important. It was organised by the federal agency Treuhandanstalt, whose aims were to save as much as possible of East German industry. Whether planned or not, in practice, the Treuhandanstalt’s activity resulted largely in the takeover of East German enterprises by West German companies. Because of the Treuhandanstalt’s extensive role, that of financial institutions was quite limited. Another important field for privatisation concerned public utilities. This was in part motivated by a desire to either raise revenue or to sell off loss-making units, and in part a response to European Commission directives. Privatisation has affected former state monopolies such as the postal, telecommunications and, to some extent, transport sectors. The healthcare sector was never a state monopoly, but public hospitals have been increasingly privatised since the early 1990s and private hospitals are now a dominant form of healthcare provision. In the course of the crisis several privately-owned financial institutions were either partly (Commerzbank) or completely (Hypo Real Estate Holding AG) nationalised. On the other hand, the German Industriebank, IKB—up until the crisis in majority ownership of the government—was privatised after German government had taken over all of its debts.

After a decline in the German private saving rate during the 1990s, the average propensity to save increased after the new economy crisis. The main reasons for this increase were as follows: first, the redistribution of income at the expense of the labour share of income and of low-income households; second, an increase in precautionary saving in the early 2000s in the face of weak growth, high unemployment and ‘reform policies’ aimed at the deregulation of the labour market and a reduction of social benefits; and third the absence of wealth effects on consumption. The savings of private households were directed mainly to deposit and saving accounts with banks, and to policies with private insurance and pension funds. The significance of shares and investment funds increased during the new economy boom in the second half of the 1990s, but then returned to the level of the early 1990s. The attractiveness of stock markets and the rise of a ‘stock market culture’ in Germany were, therefore, very short-lived. The relationship of the total financial assets held by private households to nominal GDP has seen a tendency to increase since the early 1990s, as has the relationship of real estate wealth to GDP. However, financial and real estate wealth have been extremely unequally distributed and inequality increased in the early 2000s. Financial liabilities tended to increase slightly in relation to disposable income in the course of the 1990s, but then declined somewhat until the Great Recession, and remained low by international comparison.

In Germany, unlike many other countries, a real estate bubble did not develop in the 2000s. The stability of the German real estate market is the result of a combination of specific institutional features. Firstly, government intervention in the real estate sector led to a diversified supply of housing in all housing segments. Although the government has reduced its active role in the sector in recent decades, the established structures continue to prevail. There was a sufficient supply of rental dwellings, so that households only decided to purchase their own homes when it appeared beneficial. Secondly, a relatively conservative system of real estate financing has contributed to the stable development of the real estate market. Those factors appear to have reinforced each other and to be beneficial for the system as a whole. The most important financial investors in the real estate market are open or closed real state funds. These have, until now, been relatively unattractive for international investors due to a lack of transparency and the way they are taxed. While this has meant that less capital has been available, it may have sheltered the German market from foreign capital inflows that could have led to Germany also developing a real estate bubble. Since the Great Recession there have been signs that a real estate bubble could develop in Germany in the future due to very low interest rates, a distrust of monetary forms of wealth and the limited supply of appropriate property in bigger cities.

Germany has seen considerable re-distribution of income since the early 1980s, which accelerated in the early 2000s: a tendency of the labour income share to decline; rising inequality in the personal and household distribution of market and disposable income (although government redistribution has not been weakened), in particular at the expense of very low incomes; and a rise in top income shares, considering the top-10% income share. Examining the three main channels through which financialisation (and neo-liberalism) are supposed to have affected the wage or the labour income share and also inequality of household incomes, there is evidence for the existence of each of these channels in Germany since the mid 1990s, when several institutional changes provided the conditions for an increasing dominance of finance. First, the shift in the sectoral composition of the economy away from the public sector and towards the corporate sector, without favouring the financial corporate sector, however, contributed to the fall in the wage and the labour income share for the economy as a whole. Second, the increase in management salaries as a part of overhead costs together with rising profit claims of the rentiers, in particular rising dividend payments of the non-financial corporate sector, have in sum been associated with a falling wage and labour income share. Third, financialisation and neo-liberalism have weakened bargaining power of German trade unions through several channels.

The German type of development prior to the crisis can be characterised as export-led mercantilist. This German type of development determined the channels of transmission of the crisis to Germany. The foreign trade channel became effective, because the openness of the German economy had rapidly increased since the mid-1990s, and aggregate demand had been driven considerably by net exports. Rising current account surpluses and the respective accumulation of net foreign assets, as well as increasing integration into the world financial markets made the financial sector, and commercial banks in particular, vulnerable for the financial market channel of crisis transmission. Regarding policy reactions towards the crisis, the immediate bailout of the financial sector detained the financial crisis in Germany. Economic recovery was initially mainly driven by German exports in the course of the recovery of the world economy, and it was strongly supported by expansionary fiscal policies in 2009 and 2010. However, this German type of recovery suffers from two major drawbacks. First, to the extent that it was driven by net exports, it had to rely on the neo-mercantilist type of development that had contributed considerably to world and regional imbalances and to the severity of the crisis in Germany in the first place. Second, as a political precondition for the German stimulus packages, the so-called ‘debt brake’ was introduced into the German constitution and enforced on the Euro area member countries, which will limit the room of manoeuvre for German and Euro area fiscal policies in the future.

Summing up, we conclude that the German financial system has somewhat changed over the last decades towards a more financialised system. But strong attempts by the German government and lobby groups, as well as policies by the European Commission had only limited effects. Financialisation of the German economy has been less pronounced than in the US or the UK, for example. The German macro-economy has witnessed some of the features of financialised economies, for example rising income inequality, falling wage shares and weakened investment in the capital stock. However, what has distinguished Germany from several other countries was the absence of any debt-financed private demand boom, and a private consumption boom in particular, which prevented private household debt from piling up before the crisis. There are several reasons for this more modest ‘financialisation made in Germany’. Institutional inertia of big parts of the German system seem to be important—for example the relevance of local savings banks and cooperative banks, trade unions and the defence of the stakeholder corporate governance system in parts of the economy, or the reluctance of the German population to adopt a stock market and consumption credit culture. This prevented an even more severe financial crisis and it improved the condition for a rapid recovery from the crisis. However, we hold that unless the German export-led mercantilist regime will not be given up, any such recovery will remain highly fragile, both economically and politically.