COMPARING FINANCIAL SYSTEMS. Lesson 12 The German financial system

Transcription

1 COMPARING FINANCIAL SYSTEMS Lesson 12 The German financial system

2 What you will learn in this lesson The monetary and financial upheavals in Germany s past The role of these upheavals in creating a financial stability culture The characteristics of universal banking The dominant role played by banks in the German financial system The comparatively small use made of plc status by German firms The small role played by securities and equities in German savings

3 Introduction Germany (like Italy) is very different from the other countries in that banks play a far more important role and markets much less of a role than in the other countries. Since 1960 the German economy emerged as the strongest in Europe and its financial system has acquired an outstanding reputation for stability. Before the Euro, other countries tried, from time to time, to link their currencies to the Deutschmark in order to acquire some of the reputation that it enjoyed as a currency with a low risk of depreciation. The strength of the Deutschmark was often said to be the result of certain institutional features of the German financial system, in particular the independence of its central bank (Bundesbank). However, in the twentieth century, Germany has suffered the effects of violent currency fluctuations. The institutional features of the German financial system and the independence of its central bank is partially the result of this experience.

4 German inflation during the World War I The first and most spectacular of these had its origins in the financing of Germany s war efforts, when the Reichsbank, the then central bank, provided finance to the government by accepting large quantities of treasury bills: financing a budget deficit by printing money. The government issued its own treasury bills and the central bank credited the government account with corresponding deposits. As government deposits were spent, the broad money supply increased by a corresponding amount and notes and coin increased in step as some of the deposits were converted to cash. An indication of the rate of expansion is given by the fact that notes and coin in circulation increased by 50 60% per year in the period

5 German inflation in the 1920s After 1920, punitive reparations payments imposed by the allies made matters worse. The payments had to be made in US dollars and the only means of paying for these dollars, given the state of the German economy, was to buy them with Marks created by selling treasury bills to the Reichsbank. The Mark fell rapidly in value against other currencies. In an attempt to end the process, in 1922 the allies forced the passage of a law making the Reichsbank independent of government. However, this law made not the slightest difference. The independent Reichsbank saw inflation as a means of undermining unfair reparations. Consumer prices rose at an exponential rate. (in 1923, prices rose nearly two billion fold)

6 German inflation in the postwar period When stabilization finally occurred in November 1923 the exchange rate was M4.2 trillion per US dollar. At inflation rates of this magnitude (hyperinflation), conventional payment systems collapse and exchange takes the form of barter. Savings in the form of financial wealth, especially where the assets are of fixed nominal value, are also destroyed. Another case of serious effects of hyperinflation upon savings tooke place in the conversion of the Mark in The Reichsmark was virtually worthless and, under allied supervision, the Bank Deutscher Länder, forerunner of the Bundesbank, embarked on a process of converting Reichsmarks into Deutschmarks. Current payments, including wages and salaries, were converted at a one-for-one basis in June But savings were converted in October 1948 at the rate of DM6.50 to RM100. Financial wealth was drastically reduced.

7 The origins of Bundesbank s features These experiences have made all German institutions and administrations strongly inflation averse than those of other countries. This aversion generally explains: 1. why the Bundesbank was established with such a high degree of independence 2. why the Bundesbank has had a comparatively simple task in maintaining low rates of inflation; 3. why it has enjoyed widespread support throughout German society. These experiences probably also explain some other characteristics of the German financial system: 1. the low levels of equity holdings in household portfolios; 2. the correspondingly low levels of equity finance in German firms.

8 The Bundesbank The Bundesbank was formally established in 1957 with a constitution that made the stability of the currency its principal objective. Its constitution also stressed its independence from government, though the Bundesbank was technically owned by the central government, which has the power to appoint the president and other members of the directorate. Today Bundsbank is a member of the Eurosystem (made up of the ECB and the NCBs of the EU Member States whose currency is the euro) The Bundesbank is organized along federal lines. Each state (Land) has a central bank (effectively regional offices of the Bundesbank) and each of these has one representative on the governing body of the Bundesbank. Commercial banks hold operational balances with the Land central bank, which maintains balances with the Bundesbank in Frankfurt. Intra-regional payments are thus reflected in banks balances at the Land central bank while net transfers between banks in different regions will be reflected in changed Land central bank balances at the Bundesbank.

9 The Bundesbank and the Eurosystem With the launch of stage three of economic and monetary union on 1 January 1999 responsibility for deciding and implementing the single monetary policy in the euro area was transferred to the Eurosystem. Within this system, member central banks are required to implement the monetary policy decided upon by the ECB but otherwise retain most of the functions that one would expect to see in a national central bank. The Bundesbank, with its regional counterparts (the Land central banks), continues to act as the bankers bank. It is banker to the Federal Government and the guardian of Germany s monetary reserves (though it needs the approval of the ECB for foreign exchange operations above a certain level). It is responsible for monitoring national and international payments mechanisms and stability of German financial markets. Supervision of the banking system is the job of the Federal Banking Supervisory Office, although the data required for monitoring bank behaviour is collected and published monthly by the Bundesbank (Banken Statistik ).

10 The Bundesbank and the ECB German banking system liquidity remains guaranteed by the Land central banks and then the Bundesbank, but the (repo) rate is set by the ECB. Because of its record in maintaining price stability between 1948 and 1999, the Bundesbank has had considerable influence on the evolution of the ECB and the Eurosystem. The ECB has inherited an apparent preoccupation with monetary growth rates. It publishes what it calls a reference growth rate for broad money (M3) and uses departures from this target as one indicator of what should happen to interest rates. But it is the short-term interest rate that is the operating instrument (just as it was under the Bundesbank) rather than the monetary base. The ECB has also inherited much of the Bundesbank s pragmatism. The rate of monetary growth has rarely been below its reference rate but this has never stopped the ECB from cutting interest rates when other indicators required it.

11 Bundesbank regulation Banks were (and are under the ECB) subject to mandatory reserve ratios. However, the system uses lagged reserve accounting (reserves today must match deposits of an earlier date) there is no attempt to control reserves directly. Like other central banks, it provided reserves on demand to ensure the stability of the financial system. Like other central banks, the Bundesbank varied short-term interest rates to influence the demand for loans and only through that the demand for reserves and monetary growth.

12 Universal Banks Unlike the UK, USA and Japan, Germany has a tradition of universal banking. Any recognized bank is able to provide a full range of banking services and many other services that elsewhere would be called financial. Thus German banks can offer the usual range of retail banking services but also engage in wholesale and investment banking. They can even buy and sell securities on behalf of customers. In the UK and USA it often appears that a single bank offers this range of services but strictly speaking it does this only by creating separately capitalized subsidiaries with names similar to the parent. It does not follow that banks are obliged to offer a full range of services with equal emphasis.

13 Universal Banks

14 Ownership structure The reason for distinguishing between commercial banks, savings banks and credit cooperatives is not because their functions differ. The reason for distinguishing between them is because their ownership structure is very different: 1. commercial banks are private sector institutions; 2. savings banks are public sector institutions; 3. credit cooperatives are mutuals.

15 Commercial banks Commercial banks range in size from the big four, through regional banks, to branches of foreign banks. Today the big four (the Großbanken) are: Deutsche Bank AG, DZ Bank AG, Commerzbank and KfW. They are universal banks that provide a whole array of services to both firms and consumers. They offer retail, wholesale and investment banking though their business is concentrated especially in investment banking, the financing of firms and foreign trade. On the firm side, they provide both short- and long-term loans. They can also hold equity in firms and so can provide equity finance. On the consumer side, they provide a wide range of products, including the provision of savings instruments, loans, and life insurance products. Deutsche Bank has its own insurance subsidiary, while other big banks have formed strategic alliances with major insurance firms. The Großbanken account for approximately 60% of all commercial bank total assets.

16 Kreditbanken The universal banks known as Kreditbanken are smaller, but still significant among commercial banks. Some are regionally based banking groups (the Regionalbanken) such as the ING BHF-Bank (taken over by the Dutch ING group in 2002). Their description as regional banks is a reference to their geographical origin and the fact that their branches tend still to be concentrated in those regions. However, they have branches throughout Germany (and abroad) and they are publicly quoted, limited companies in the same way as the big four. Much smaller in aggregate are the branches of foreign banks (Zweigstellen ausländischer Banken). The German financial system has always been fairly open to foreign participation and currently many foreign banks have branches in Germany, mostly operating in Frankfurt.

17 Landesbanken The Landesbanken began life as regional banks (Postbanks) whose main function was to operate a payments system. While continuing with this function, they now offer a full range of banking services including international banking. They are large institutions, measured by total assets.

18 Sparkassen Much smaller, but also more numerous, are the Sparkassen (savings banks). They are not profit-maximizing entities but are operated in the public interest. There are three tiers: local savings banks, state savings banks, and the central savings bank. As separate firms they number around 400, with approximately 10,000 branches between them. Many date from the nineteenth century when they were founded by local and regional government authority. Their function was to provide finance for local and regional infrastructure and to make loans to disadvantaged groups in the community. They attract small, retail, deposits from households and firms.

19 Sparkassen In return for their public-spirited lending policy, the solvency of savings banks is guaranteed by the owning public authority which imposes some restrictions on the riskier areas of banking business. They are subject to lower capital adequacy requirements. The emphasis upon attracting small deposits from the widest range of clients meant that the Sparkassen were in the strongest position in the early German banking system to develop a cheque payment system. This they did after 1900 by associating themselves with a regional Postbanks which conducted the clearing operations. The Postbanks developed into the Landesbanken while the Sparkassen have maintained their emphasis upon retail deposit-taking.

20 Kreditgenossenschaften Cooperative banks (Kreditgenossenschaften) constitute the third category of universal banks. They are mutual organizations owned by their members. Their origin was often linked to particular trades and professions, deposits being taken from members of the profession and loans being made to enterprises in that field, the objective being to further the interests of the profession. In 2016 there were 972 with around 10,000 branches. There are many similarities between the savings and cooperative bank sectors. On the liability side, the individual cooperative banks have remained committed largely to retail deposit business. On the asset side they make loans to a regional cooperative bank. As with the Landesbanken, it is these regional cooperatives (Genossenschaftliche Zentralbanken) that are the genuinely universal banks.

21 Specialist credit institutions These are tipically classified by function, with various patterns of ownership within each category. Germany has both mortgage banks (Hypothekenbanken) and building and loan associations (Bausparkassen). Both accept deposits but also finance their lending by the sale of bonds known as Pfandbriefen. The Hypothekenbanken are usually private companies. The Bausparkassen are owned by public authorities or are mutuals. The function of both is to provide finance for construction though the mortgage banks have also taken up considerable holdings of general government debt. The Bausparkassen have benefited from the increasing aspiration of people to own their own homes and from tax incentives which encourage borrowing for home purchase.

22 Specialist credit institutions The instalment credit banks are mostly subsidiaries of the biggest commercial banks. Their lending consists largely of overdrafts to customers who also hold deposits with the bank and have their main income credited to an account held at the bank. The remaining specialized credit institutions are institutions established by the state for some specific purpose, often linked to post-war reconstruction problems. They include: 1. the Equalization of Burdens Bank (Lastenausgleichsbank) whose main function was to settle claims for damages and to help with restitution claims by refugees. 2. the Reconstruction Loan Corporation (Kreditanstalt für Wiederaufbrau), founded in 1948 to administer public funds for reconstruction purposes and now handles much of Germany s aid to developing countries. 3. specialist institutions dealing with the requirements of forestry and agriculture. 4. a Post Office Savings Bank (Deutsche Postbank) which holds personal sector deposits and operates a payments mechanism.

23 The balance sheet total in banking industry

24 Loans to domestic individuals

25 Non-deposit institutions In the comparison between the German financial system and that of the UK or the US, two major differences rise up: 1. the predominance of universal banks. 2. the absence of pension funds. In both the US and the UK, pension funds constitute a major division of the institutional investors and the importance of their behaviour, in securities markets in particular, is considerable. In Germany, the major provider of pensions is the state which operates a pay-asyou-go (as opposed to a funded) system in which pensions are paid out of current taxation (no investment fund is created). Where companies operate a pension scheme, they retain contributions within the firm as working capital so that pension payments are a charge on the firms profits. For savers who wish to make further provision for old age, there are tax incentives to do so by subscribing to life insurance policies.

26 Non-deposit institutions Insurance companies have grown rapidly in recent years. In common with other European countries, Germany now has a rising proportion of retired to working population which is beginning to cause problems for the state scheme. It seems likely, therefore, that the future will see increasing private sector provision of pensions but that in itself does not necessarily mean the growth of a pension fund sector. This may simply mean the further expansion of insurance companies.

27 Non-deposit institutions The two major non-bank groups of financial institutions in Germany, therefore, are the insurance companies and the investment funds, which function broadly as open-end mutual funds. The instruments held by savers are known as certificates. Looking at the distribution of asset holdings, it is apparent that investment funds hold much higher proportions of securities. That said, the proportions are more similar now than they have been in the past and this represents a shift by insurance enterprises away from assets held with banks (primarily time deposits) towards securities of all kinds, a shift that would certainly be necessary if pensions are to become more fully-funded in future. However, in both cases the equity holdings remain considerably smaller than they are for corresponding institutions (long-term insurance companies and unit trusts) in the UK.

28 Features of the financial system Universal banks and the lack of a pension funds sector are just two of the distinctive features of the German financial system. Others are: 1. the limited use of equity finance by firms; 2. the small size of equity markets relative to GDP; 3. the small number of publicly quoted firms; 4. the portfolio preference amongst households for deposits and bonds over equity; 5. the dominant role of bank intermediation in channelling funds from surplus to deficit units.

29 Financial markets Equity markets (Stock markets) There are seven regional exchanges, with Frankfurt being the most important. Relatively few companies are listed. These markets have traditionally been an insignificant source of funds for firms. Bond markets (Debt markets) They are important source of funds for all levels of government as well as for banks. However, they are not important for nonfinancial firms. Derivative markets They are relatively undeveloped. Financial options and futures markets opened only in 1990, and the volume of trade has remained relatively unimportant.

30 Bond and equity markets The importance of bond finance is mainly explained by the fact that banks and other financial institutions rely very heavily upon bond finance. Equity finance is more important to non-financial firms. However, it is important to get this into perspective. The value of company shares listed on the London Stock Exchange is more than twice the value of company shares in German capital market. The number of firms listed on the London Stock Exchange is more than three times the number listed on all German exchanges. In some years, in Germany, there were no new net issues of company shares. A small number of shares were bought back by German firms and replaced with other (mainly bond) finance.

31 Equity market Equity financing is still relatively small for firms of all kinds, and makes up a small part of household savings. These characteristics are interrelated: if firms do not issue a large numbers of shares, households cannot hold them as a large part of their wealth They must hold alternative assets. Households are actually reducing their direct shareholdings, but increasing investment indirectly in shares via mutual funds Part of households aversion to equity investment lay with Germany s turbulent financial history and anti-inflation consensus since With low inflation one of the main arguments for equities as a form of saving disappears

32 Households holdings features Other striking features are: 1. the large holdings of monetary assets (34%); 2. the large holdings of savings schemes with insurance companies (25%); 3. low investment in pensions (5%). The latter reflects the continued prevalence of PAYG schemes. In the last decade there is some evidence of a declining commitment to monetary assets and of an increasing investment indirectly in shares via mutual funds Taxation has also worked against household equity investment for a long time, subjecting shareholders to double taxation (taxation of the company s profits and then taxation of the dividends paid to shareholders) and high rates of capital gains tax. However, tax reforms in 1977 abolished the double taxation of dividend income and introduced a capital gains tax exemption for gains on shares held for more than six months.

33 The financial wealth of private households

34 Forms of corporate ownership As in other countries, there are two main forms of corporate ownership in Germany: 1. public, limited liability joint stock companies (AGs) (which separate ownership and control) 2. private limited companies (GmbHs). The latter outnumber the former in Germany by nearly 100 to 1. Through the 1960s and 1970s the number of AGs actually declined, though this was reversed in the 1980s. Three reasons for this unpopularity of AG status for many years were: 1. the relatively high rates of corporation tax in Germany which gives a large subsidy to (taxdeductible) interest payments on bonds; 2. the legal requirement of a two-tier management board structure which requires worker representation; 3. a long tradition of family ownership and control of firms, which can be preserved as a GmbH. The latter has developed into a fear of the short-termism and instability of corporate control alleged to be characteristics of Anglo-Saxon economies.

35 Incentives towards shareholding In last decades, governments tried to tip the balance further towards equity financing and shareholding. In 1994, the Companies Act was amended to simplify the formation of an AG and also removed employees rights of co-determination, for AGs with fewer than 500 employees. The Federal Government disposed of holdings in several major undertakings during the 1960s and did so on terms designed to attract broad groups of shareholders. The initial sales of these Volksaktien were initially successful but within a few years most had found their way to institutional investors. When Deutsche Telekom was privatized in November 1996 the flotation was designed with features to appeal to personal shareholders.

36 Equities and pension arrangements The main reason for the increased interest in equities on the demand side lies in the recognition by government that alternatives have to be found to the dominant position of PAYG pension arrangements. In 2001, the German government introduced a major reform of the German pension system called the Riester reform (after the German Minister of Labour, Walter Riester). This had as its main objectives: 1. the stabilization of contribution rates which threatened to reach unsustainable levels as a result of demographic changes; 2. secure the long-term stability of the replacement rate; 3. increase the take-up of private, funded, supplementary pensions by offering various types of tax subsidy. The decision remains at the discretion of individual savers.

37 Equities and pension arrangements The crucial question obviously is whether the package will succeed in stabilizing the replacement rate at reasonable cost. This depends crucially on whether people can be induced to participate (voluntarily) in a supplementary private pension scheme. The subsidies are quite large (up to 40 50% of their contribution for some groups). But the initial take-up was slow. Many polls, however, suggested that a majority of workers would have favoured a compulsory scheme and so it remains to be seen whether the take-up will continue to increase. More serious for the success of the scheme is the suggestion that demographic trends will not allow a replacement rate of 67 per cent with a maximum contribution of 22 per cent of earnings (present government goal) Growing doubts about the adequacy of these reforms has led to a further proposal, the Rürup proposals (August 2003) with a proposal to raise the retirement age from 65 to 67 years, beginning in 2011 and proceeding in monthly increments until 2035.

38 References Bain K., Howells P., The Economics of Money, Banking and Finance. A European Text, Pearson Education, 2008, ch. 5 Allen F., Gale D., Comparing Financial Systems, MIT Press, 2001, ch. 3