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FINAL DRAFT

Changes in the German Banking System

Reorientation of public banks due to the discontinuation of state guarantees

Master Thesis

Submitted in fulfilment of the requirements

for the degree of

Master of Science (M.Sc.)

in

General Economics

at the

Faculty of Economics

Rijksuniversiteit Groningen

Thesis supervisor: Prof. Dr. Klaas H.W. Knot

Macro - Economy

Submitted by: Christian Geissler

Fr. - Stellwagen- Weg 5

18435 Stralsund

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Abstract:

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Preface:

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Table of contents

Abstract... I

Preface ...II

Table of contents ... III

List of Figures and Tables... V

List of abbreviations ... VII

1. Introduction ... 1

2. The structure of the German banking market...3

2.1. Banking groups - An overview ... 3

2.2. Commercial Banks ... 5

2.3. Savings Banks ... 6

2.4. Landesbanks ... 9

2.5. Cooperative Banks ... 11

2.6. Special banks... 12

3. Legal improvements in banking regulations... 14

3.1. An Overview... 14

3.2. Basel II ... 15

3.2.1. Development of the concept... 15

3.2.2. Accord in operation ... 15

3.2.3. Consequences and further progress... 16

3.3. Other regulatory factors... 18

3.3.1. The Financial Services Action Plan... 18

3.3.2. The Lamfalussy procedure ... 19

3.3.3. The International Accounting Standard... 19

3.4. Abolition of State Guarantees ... 20

4. Economic trends in the German banking market... 22

4.1. An Overview... 22

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4.3. Modified costumer behaviour ... 24

4.4. Economic debility of the banking sector ... 25

4.5. Market entries of competitors ... 28

4.6. Changes in equity financing... 29

4.7. Exceptional position of SMEs... 32

5. Expected developments and further changes ... 36

5.1. Overview ... 36

5.2. Distortion of competition ... 37

5.3. Adjustment of bank concentration... 38

5.4. Revaluation of bank ratings... 40

5.5. Reform approaches for banks under public law ... 43

6. Conclusion ... 48

7. Figures and Tables ... 51

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List of Figures and Tables

Figures:

Figure 1: Banking structure in Germany by banking groups...51

Figure 2: Balance sheet of commercial banks (1976 - 2006)...53

Figure 3: Government Ownership of Banks in selective countries (2000)...55

Figure 4: Balance sheet of savings banks (1976 - 2006) ...56

Figure 5: Balance sheet of Landesbanks (1976 - 2006)...57

Figure 6: Comparison of total assets between Landesbanks and savings banks (1976 – 2006) ...58

Figure 7: Balance sheet of credit cooperatives (1976 - 2006) ...59

Figure 8: Balance sheet of regional institutions of credit cooperatives (1976 - 2006)...60

Figure 9: Three Pillar Graphic of Basel II (2001)...61

Figure 10: Number of bank institutes in Germany (1990 – 2006)...61

Figure 11: Number of German bank branches (1990 – 2005) ...62

Figure 12: Number of German bank and online - accounts (1995 – 2005) ...62

Figure 13: Net interest income / total assets ratio (1979 – 2003)...64

Figure 14: Non - interest income / interest income ratio (1979 – 2003)...64

Figure 15: Operating costs / gross income (cost/ income) ratio (1979 – 2003) ...65

Figure 16: Profit before tax / equity (return on equity) ratio (1979 – 2003)...65

Figure 17: Return on equity of German bank groups (1995 – 2006) ...66

Figure 18: Comparison between all German banks and foreign banks (1985 – 2006)...66

Figure 19: Development of German banks’ nominal extension of loans ranked by borrowers (1991 – 2006)...67

Figure 20: Evaluation of banks with repsect to credit business with companies in Germany (2003 – 2007)...67

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Tables:

Table 1: German banking groups and number of banks...51

Table 2: The 30 largest German banks by total assets (end 2005)...52

Table 3: The CR5 and HHI based on the balance sheet total in European comparison ...53

Table 4: Worldwide Top 20 banks ranked by total assets (2004)...57

Table 5: Development of the banking sector in selective countries (1995 – 2005)...63

Table 6: Credit ratings of all German Landesbanks (LB) before and after abolition of the state guarantees ...70

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List of abbreviations

AG - Aktien Gesellschaft ( publicly traded company) AMA - Advanced Measurement Approach

BaFin - Bundesanstalt für Finanzdienstleistungsaufsicht (Federal Financial Supervisory Authority)

CR5 - Concentration ratio 5

DBDG - Deka Bank Deutsche Girozentrale

DG Bank - Deutsche Genossenschafts - Bank (German cooperative bank) DSGV - German Savings Bank Association

DZ - Bank - Deutsche Zentral - Genossenschaftsbank EU - European Union

FSAP - Financial Services Action Plan GB - Government ownership of banks

GZ - Genossenschaftliche - Zentralbank (German cooperative central bank)

Haspa - Hamburger Sparkasse

Helaba - Landesbank Hessen - Thüringen (state bank of the states of Hesse and Thuringia)

HHI - Herfindahl Hirshman index HVB - HypoVereinsbank

IAS - International Accounting Standard IRB - Internal Rating Based Approach

KfW - Kreditanstalt für Wiederaufbau (Reconstruction Loan Corporation) KWG - Deutsches Kreditwesengesetz (German Banking Act)

LB - Landesbank (German Federal State Bank)

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SRP - Supervisory Review Process US - United States of America

US – GAAP - United States Generally Accepted Accounting Principles West LB - Westdeutsche Landesbank

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1. Introduction

On January 31st, 2007, the European Commission presented under the supervision of Neelie Kroes a comprehensive report about major competition barriers in Europe. Within this report, the commission argued that cooperation within the compound of savings banks or credit cooperatives are usually common in countries such as Germany or France. In addition, it may benefit consumers and the national economy1. However, the commission pointed out that, "(...) if

the banks together have a strong position in the market and their cooperation has the target or the effect of limiting the competition among themselves or exclude new provider of financial services from the market, than it is possible (...) that the competition is constrained."2

The presented report, with its indirect criticism of the German regional principle of public banks and credit cooperatives, raised serious concerns about the German banking system. Additionally, current disposition of the Bankgesellschaft Berlin AG (Banking Corporation Berlin)3 intensified the discussion about the possible privatisation and merging of the German Sparkasse Financial Group. Facing radical transformation caused by typical market changes such as new consumer needs and market entries of rivals, the German banking sector and precisely the sector of public banks are exposed to enormous pressure. Therefore, a critical aspect is the abolition and discontinuation of the state guarantees for banks, regulated by public law, i.e. the maintenance obligation (“Anstaltslast”) and the guarantee obligation (“Gewährträgerhaftung”) decided by the European Commission on July 17th, 2001.4 After a transition period of almost five years this modification became effective on July 19th, 2005. For this reason, public regulated banks are concerned about downgrade in the banking ratings which can lead to rising refinancing costs. Although the European Commission agreed on a long transition period, which will end in 2015,5 effects are already apparent. Nevertheless, the actual state of affairs does not yet provide proper and well - defined data to prove statements of these issues with appropriate evidence. Therefore, in the following, I will demonstrate solutions and prospects where comparable and eligible surrogate - variables can be used to explain situation.

The main focus of the thesis will not concentrate on the aspects of legal questions, because in recent years, a lot of literature was published discussing the more legal and judicial point of view. For example, with respect to the question, if a merger or privatisation within the

1 European Commission; (2007b)

2 Corresponding translation of Neelie Kroes’ statement in the official press release European Commission; (2007) 3 This conglomerate includes the savings bank and Landesbank of Berlin; further details you will find in section 5.5. 4 Further details in Section 3.4.

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public banking sector would be legitimately acceptable, Niggermeyer (2005)6 and Tröger (2003)7 investigated the chronological procedure in case of an amalgamation between savings bank including their legal regulatory status in the German legislation. However a general and more macroeconomic abstract about these circumstances and especially precise perspectives could not be given.

The structure of the remainder of this thesis is as follows: chapter 2 gives an overview about the German three - pillar banking system and the detailed setup of each bank group. Especially, the particularities of the German Sparkassen Financial Group, including the savings bank and Landesbanks are examined. Chapter 3 discusses legal improvements in banking regulation, monetary policy and fiscal policy in Germany and Europe. The fourth chapter provides information on the economic trends and prospects in the German banking market and compares them to developments in other European countries and the Unites States. The main focus will be on technological, economical and commercial changes viewed from the supply and demand side of financial services. Chapter 5 gives a forecast and outlook on further developments with respect to reform approaches and new adjustments for banks under public law. The main focal point will be on the effects of the abolition of state guarantees and the resulting revaluation of bank ratings for public banks. Finally, chapter 6 concludes and summarizes the presented results.

In this context, the thesis will attempt to answer the following questions: What are the impacts on the market structure; e.g. what are the effects on banks as creditors and firms / consumers as borrowers caused by the past developments in the German banking sector? What are the options with respect to the reorientation (possible privatisation or merger) of the German Sparkasse Financial Group including the savings banks and Landesbanks? What are the impacts on small and medium enterprises (the German Mittelstand) in terms of capital raisings through loans, since the savings banks and credit cooperatives are the largest lender to those credits in the German financial market? Can a shift from a bank - oriented to a market - oriented financial system in Germany be expected? Consequently this thesis is testing whether the break down of inflexible structures in the sector of German public banks and the associated reorientation was intensified by the abolition of state guarantees or whether this legal readjustment was the main reason of the mentioned developments.

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2. The structure of the German banking market

2.1. Banking groups – An overview

The German financial and bank system is characterized by two major criteria: First, the German bank market structure consists of a bank - based financial system, in which enterprises and private households finance themselves primarily through bank credits known as the house bank principle8. On the contrary, in a market - based system, existing in Great Britain or the United States, capital raising is taking place mainly via the capital market9. For instance, the balance sheet total of all German banks amounts to approximately one third of the German gross domestic product. This ratio is extraordinarily high in comparison to its European neighbours10. In contrast, the meaning of the stock market in Germany is rather small with a market capitalization of only approximately 45 percent in relation to the nominal gross domestic product in the year 2005. Comparatively, the value for the United States ranges around 136 percent.11

The second major characteristic of the German financial and bank system are the three existing groups of universal banks, operating in all banking transactions. They are better known as the German three - pillar structure12. In particular it consists of commercial banks, banks under public law (primary savings banks and Landesbanks) and credit cooperatives banks (credit cooperatives and regional institution of credit cooperatives). Besides these three major groups, it is necessary to combine all remaining banks to the group of special institutions (special banks and other monetary financial institutions). However, despite its immense market share, which is even bigger than the one of the credit cooperatives banks, its relevancy should play only a minor part in the further process of this thesis. The reason to exclude this group is the variety of its composition, consisting of different and diversified financial institution types. An overview of the entire banking structure and their bank groups is given by Figure 1 (Banking structure in Germany in banking groups by total assets), showing their total assets and market shares in the German banking market with a total value of 7.069 billion Euros in October 2006. Banks under public law take the majority with a market share of 34.1 percent, followed by commercial banks with 28.5 percent, special banks with 25.7 percent and credit cooperatives banks with 11.7 percent.

8 Krahnen, Jan Pieter; Schmidt, Reinhard H.; (2004) 9 Allen, F. and Gale D.; (1994)

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Regarding the structural framework, Table 1 (German banking groups and number of banks) is showing that out of the roughly 2.200 monetary financial institutions that existed at the end of 2006, 1.997 were universal banks and 214 were special institutions. The latter includes 149 entities that, in the further context, should be classified as non - bank financial institutions (e.g. investment companies etc.).

Further information is given in Table 2 (The 30 largest German banks by total assets) that contains a list of Germany’s 30 largest banks sorted by total assets. It is interesting to note that only 14 of these 30 largest banks in Germany are strictly profit - maximizing entities, i.e. commercial banks. Banks are listed by name, total domestic and international group assets, number of branches and employees and by bank group. Thus it is evident that the first four positions are claimed by private owned bank institutes, although they are outnumbered in this table. In total, these listed 30 banks amount to roughly 50 percent of all German bank assets.13

As already mentioned, in connection with competition questions, the relative market structure measures are usually the number of banks, active in a market and their balance sheet total. There are also additional formal measurements like "concentration ratios" (CR), which illustrate the proportional market share of the largest banks in the market or indices such as the Herfindahl Hirshman index (HHI). This index is defined as the sum of the squares of the market shares of each individual bank in a market.

In this formula, si is the market share of firm i in the market and n is the number of firms.

The index considers both the total number of banks and the distribution of its market shares within a market and weighs larger market shares particularly high by squaring them. This leads to the assumption that the higher the index, the lower the degree of competition. If the index is high, a single institution may have a dominant market share and / or the market shares of all the other survey participants are more insignificant. A market can, therefore, have a relatively low index, in which several institutions have very large market shares. Markets that have a HHI between 1.000 and 1.800 points are considered “moderately concentrated” and those with a HHI in excess of 1.800 points are considered “concentrated”. A Herfindahl index below 1.000 indicates an “unconcentrated” market.14 Typically, the reference sizes for the respective market and the formal measures of concentration are usually the balance sheet total as well as asset portfolios or deposit volumes on national levels. The bank concentration, computed on a

13 Bundesverband Deutscher Banken (Association of German banks); (2006)

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national basis, vary widely within Europe. An evaluation, shown in Table 3 (The CR5 and HHI based on the balance sheet total in European comparison), demonstrates that the German banking market is the least “concentrated” market in the European evaluation in both the HHI and the CR515 for the years 2001 and 2005. With a HHI value of 175 for the year 2005, Germany seems to experience a very high level of competition. However, this assumption is associated with the fact that all banks in the German financial market are considered as individual and independent bank institutes. Especially due to the compound structure of savings banks and credit cooperatives and unclear definition of the relevant market, these numbers can be misleading. This issue will be further examined in chapter 5.3.

The following sections will introduce the individual banking groups in detail, starting with the commercial banks (Section 2.2.) followed by the public banks (Sections 2.3. and 2.4.), credit cooperative institutes (Section 2.5.) and, finally the special banks (Section 2.6.), which are only briefly discussed in this thesis.

2.2. Commercial Banks

Commercial banks are composed of the big banks16, regional banks, private bankers and branches of foreign banks. They are usually organized as incorporated companies as well as unincorporated firms and usually operate strictly for profit - maximizing.

All four big banks in Germany are truly universal banks and their retail and corporate banking businesses are complemented by growing investment banking activities. For instance, the Deutsche Bank acquired the British investment bank, Morgan Grenfell, in 1989 and the US institution Bankers Trust in 1997. The Dresdner Bank followed suit by acquiring Kleinwort Benson in 1995 and the American investment bank, Wasserstein Perella, in 2001. Both institutions have been aggressively expanding their international investment banking arms since the 1990s. The big banks’ fully - or majority - owned mortgage banks17, their building and loan associations, and their investment companies are among the largest in the German market. Nevertheless, the current bancassurance strategies differ considerably. The Deutsche Bank, for instance, bought the Berliner Bank18 and the Norisbank in 2006, but had already sold its

15 The CR5 of a country is the percentage share of the five largest credit institutions, ranked according to assets, in

the sum of the assets of all the credit institutions in that particular country

16 The German Central Bank includes in this category the Deutsche Bank AG, Dresdner Bank AG, Commerzbank

AG and Bayrische Hypo- and Vereinsbank AG

17 Because of its status as a hybrid mortgage bank, HVB is the only German big bank that is exempted from the

provision of the German mortgage act from 1899, which prohibits commercial banks from conducting mortgage banking business on their own behalf

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insurance arm in 2001, making its operations rely heavily on the German national market. The Dresdner Bank was taken over by Allianz, Germany’s largest insurance group, in the year 2001. In contrast, the Commerzbank is cooperating with Generali, Italy’s largest insurance group, and the Hypo Vereinsbank (HVB) was sold to the Uni Credit Group, one of Italy’s largest financial groups, in 2005.

Figure 2 (Balance sheet of commercial banks) depicts the aggregated balance sheet over

the last 30 years from 1976 to 2006 for German private commercial banks. Loans to non - banks as a portion of total assets have declined from roughly 60 percent in the 1970s, 80s and early 1990s to 50 percent during the late 90s and have plummeted under 50 percent in early 2000s. The portion of loans to banks, however, has increased from 31 percent in 1976 to over 38 percent in 2006, indicating an increase in the importance of operations in close proximity to capital markets. The liability structure of commercial banks has changed even more dramatically. Although the banks in the group have managed to retain a market share roughly between 24 and 28 percent over the last 30 years, the share of deposits from non - banks in total liabilities has dropped from over 50 percent in the 1970s to 36 percent in the late 90s and was under 35 percent in 2000. However, this value revived over the last five years up to 41 percent in 2006. The liabilities side of the balance sheet shows that big banks refinance themselves in addition to deposits from non - banks to a large part by liabilities opposite to other banks. This structure has consequences for the refinancing costs of the big banks, since deposits from banks are more expensive than deposits from non - banks.19

2.3. Savings Banks

The savings bank structure is divided into the primary savings banks (Sparkassen) and Landesbanks, appertaining to institutions owned by public law. Until July 2005, municipalities, communities and their organizations were responsible for the banks’ liabilities pursuant to the maintenance obligation (Anstaltslast) and the guarantee obligation (Gewährträgerhaftung).20

Based on the balance sheet total, Landesbanks and savings banks in Germany have a market share of more than one third (34.1 percent). Adding the proportion (11.7 percent) of public development banks (credit cooperatives banks)21, the market share of the public sector is rising to approximately 45 percent.22 In comparison to other industrialized countries, the relevance of the public sector is notedly high. Based on uniform indicators, La Porta et al. (2000)

Bankgesellschaft Berlin AG (Banking Corporation Berlin) already mentioned

20 Detailed information of state guarantees are explained in the later chapter 3.4. 21 See section 2.5.

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compiled an international comparison regarding the proportion of public authorities in the banking sector within the respective country for the year 1995. This evaluation is displayed in

Figure 3 (Government Ownership of Banks in selective countries). When examining the ratio of

the ten largest banks of a country, which belong at least to 90 percent to public authorities (GB 90), among eighteen sampled industrialized countries, Germany ranked second with 29.9 percent behind Finland with 30.7 percent. Considering the ratios, where banks belong at least to 50 percent and respectively 20 percent to public authorities (GB 50 / GB 20), Germany placed third with 37.5 / 37.5 percent, behind Norway with 65.7 / 88.3 percent and Austria with 70.2 / 70.2 percent.

The savings banks’ business policy is not solely focused on the realization of profits, but to serving the public interests of their region by fostering individual savings and by satisfying the credit needs of their local communities. Therefore they concentrate on the needs of employees, small and medium - sized enterprises – which are commonly referred to as the German Mittelstand - and their public authority. According to articles of the savings bank law of North Rhine - Westphalia23, this is exactly what the objective of the savings banks is:

Article 3 paragraph 1

“…to provide money and credit - economical supply to the population and economy in the particular business area as well as to serve its own founding entity"

Article 3 paragraph 2

“The savings banks strengthen the competition within the German banking sector. They encourage the population to save money and accumulate assets as well as to support the solely responsible behaviour of the youth about economic affairs. Savings banks make a contribution to the financing of debtor consultation in consumer - and debtor advisory boards. The supply of credit is primarily used to provide credit to small and medium enterprises as well as to economically weaker population groups."24

Those and similar formulations of a savings banks’ basic concept exists in every single savings bank law of the 15 remaining federal states in Germany.

The savings bank’s core business is characterized by three criteria. Firstly, the market of the savings banks is locally limited according to the so - called regional principle25. According to this regional principle, each institution is prohibited from operating outside its local area of responsibility of the respective public entity and encroaching upon its neighbours’ territories. In

23 Nordrhein-Westfalen Gesetz- und Verordnungsblatt (2004)

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rural areas, they typically compete with smaller cooperative banks, whereas in metropolitan areas they rival branches of the large private commercial banks. Nevertheless, the regional principle prevents neither possible mergers nor privatisations of savings banks. However it must be emphasised that even potential mergers between savings banks from different federal state are difficult due to the municipal ownership and the different national legislation within the federal states.26

The second criterion, according to the present definition of most national savings bank laws, is that savings banks may not be sold to private investors and only under certain circumstances to other public institutions.27 The third major attribute is the specific characteristic of the cooperation between savings banks in various but important business areas, particularly in joint liability as well as in the field of product development, credit transactions or marketing. In this manner, despite high decentralised banking structure, it is possible for the savings banks to realize economies of scope.28

In addition to the 458 public savings banks, seven so - called “free savings banks” exist, which are fundamentally self - controlled and, thus, do not benefit from state guarantees but are otherwise comparable to their public counterparts. One of them, the Hamburger Sparkasse (Haspa), with a total asset of 31.8 billion Euros in 2005, is also the largest savings bank in Germany measured by balance sheet total.

The governance structures of savings banks are similar to those of private commercial banks. The executive board reports to a supervisory board called the "Verwaltungsrat". Two third of the seats of the supervisory board are typically determined by the founding entity (the owner of the bank) and the employees elect the remaining third. A third body, the credit committee, consists of at least three members of the supervisory board and gives the founding entity the opportunity to exert influence on important credit decisions.29

Figure 4 (Balance sheet of savings banks) shows the unconsolidated, domestic balance

sheet of the primary savings institutions for the past three decades. Because of their apparent focus on traditional commercial banking, loans to non - banks represent the majority of the savings banks' domestic asset base. Their share has been nearly constant between 63 percent in the late 1970s to around 65 percent throughout the 1990s and even increased to 71 percent in the early 2000s. In harsh contrast, the share of deposits from non - banks in total liabilities has sharply decreased from 87 percent to 65 percent over the three decades and reached an all - time low of 62 percent at the end of 2000. As a consequence of these divergent developments, the role

26 Niggemeyer, Jörg; (2005)

27 For further explanation see chapter 5.5. 28 Altunbas, Y et al; (2001)

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of savings banks as providers of funds to other banks decreased over time from 27 percent in 1976 to 23 percent in 2006. Instead, as a whole savings banks became net - borrowers in the inter - bank market. This fact is reflected in the development on the asset side of the Landesbanks, which lent an increasing portion of their funds to primary savings banks in the form of long - term contracts for the matched funding of their mortgages.30 On the liability side of savings banks, it is interesting to note that deposit from non - banks declined progressively from 87 percent in 1976 to roughly 65 percent in 2006. At the same time, bank deposits increased from 6 to 21 percent, respectively.

2.4. Landesbanks

Landesbanks and regional savings associations constitute the second tier of the savings bank group. Germany’s eleven Landbanks have two primary functions. Firstly, they serve as the house bank to their federal state(s) and, as such, provide cash management services and grant loans, which are mainly refinanced by means of public "Pfandbriefe"31 (mortgage bonds) and public sector bonds. Secondly, as part of the savings bank structure, the Landbanks’ task is to offer refinancing possibilities to savings banks in their regional business areas and when capacities of an individual savings bank exceed its own overall budget, to bear its credits. Furthermore, Landesbanks are carrying out more complex capital market transactions for the savings banks and work in foreign - exchange trading. Moreover, they are truly universal banks in their own right by also providing commercial and investment banking services to larger domestic and foreign bank, non - bank and public clients. For that reason, in the last few years, the Landesbanks started to compete directly with the large private commercial banks, as they operate in similar business fields.

Most Landesbanks are owned by the respective state, other Landesbanks32, or the 12 regional savings associations. The main function of these regional associations is to provide administrative services to their members - the regional savings banks. They run data centres to develop new financial products, conduct marketing campaigns, and provide economic and market research insights, as well as training, procurement and auditing services. As a link between savings banks and Landesbanks, they also coordinate the activities between these two bank institutions of the Sparkassen Financial Group.

30 Further explanation in section 2.4.

31 The bond is characterised by the fact that apart from the reliability of the emitting bank in case of insolvency,

additionally cover funds are available to the investor.

32 For example, at the end of 2000, the West LB, the largest Landesbank, owned 39,9 percent of Landesbank

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The Deka Bank Deutsche Girozentrale is the central bank to all Landesbanks and along with the German Savings Bank Association (DSGV), in which all savings banks hold a stake, it constitutes the third tier. The Landesbanks and the DSGV own 50 percent of Deka Bank Deutsche Girozentrale (DBDG), which fully controls the investment funds of the savings group. At the end of 2005 approximately 96.6 billion Euros of the 141 billion Euros under the DBDG’s management were invested in retail funds equalling a 16.5 percent domestic market share.33

Considering all savings banks and all Landesbanks, the organisation of public banks, under the leadership of the Deka Bank Deutsche Girozentrale and with the German Savings Bank Association, is forming the so called Sparkassen Financial Group (savings bank group). This financial group also encompasses eleven regional public loan and building associations, seven leasing companies, two factoring companies, 36 public insurance companies and 80 venture capital companies.34 With an exception of the high degree of independence in case of the primary savings banks, which is granted by the “federal corporatist” type of organization, the form of labour division within the savings bank group resembles the hierarchical structure of the big four universal private sector banks with their headquarters, regional centres, branches, and subsidiaries. Hence, the savings bank group may theoretically be perceived as one large bancassurance entity. As such, it would constitute, by far, the largest financial institution in the world with roughly 3.300 billion Euros35 of total assets at the end of 2005 as shown in Table 4 (Worldwide Top 20 banks ranked by total assets), which compares the 20 largest financial institutes in the world ranked by their balance sheet total. Furthermore the combined market share of the entire financial group in non - bank loans fell slightly from 43 percent in the 1970s to below 39 percent in the early 2000s. Nevertheless, the bancassurance entity has been and will remain as the largest provider of loans to non banks in Germany.36

Compared to savings banks, which became net - borrowers in the inter - bank market over the last 30 years, this development is mirrored on the earnings side of the Landesbanks- They lent an increasing portion of their funds to primary savings banks in the form of long - term money for the matched funding of their mortgages. Traditionally, Landesbanks obtained these funds through either bank debentures, which were sold to private and institutional investors or via deposits from other banks as shown in Figure 5 (Balance sheet of Landesbanks). While the

portion of non - bank loans decreased over the last 20 years constantly from 68 percent in 1976 to 39 percent in 2006, loans to banks increased simultaneously from 27 percent in 1976 to 56 percent in 2006 and now constitute the majority of the asset side. The reason for this is for

33 BVI - Bundesverband Investment und Asset Management; (2006)

34 Stand January 2006 according to Finanzgruppe Deutscher Sparkassen und Giroverband; (2006) 35 Including foreign branches as well as subsidiary companies

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certain extent a result of the increasing importance of wholesale banking for Landesbanks. Consequently, it was not surprising that they surpassed the primary savings banks in terms of total assets in the late 1990s as shown in Figure 6 (Comparison of total assets between Landesbanks and savings banks). Furthermore, the Landesbanks represented almost a fifth of Germany’s total domestic banking assets37 and 17 percent of total loans to non - banks in 2005.38 Because of different balance sheets of Landesbanks and savings banks, especially the former, faces a far - reaching and lengthy transition period because of the recent abolition of state guarantees, which is discussed in detail in the next chapters (section 3.3. and 5.4.).

2.5. Cooperative Banks

Similar to the savings banks, the cooperative banking institutions are divided into credit institutes on a local level (credit cooperatives) and two mutual saving central banks (regional institutions of credit cooperatives). These two banks have a total market share in the German banking system of 8.4 percent and 3.3 percent, respectively.39 Credit cooperatives were founded by Franz Hermann Schulze Delitzsch and Friedrich William Raiffeisen in the middle of the 19th century based on the basic principles of self - aid, self - responsibility and autonomous administration in order to mitigate the former constraints. These two businessmen independently created the first credit cooperatives. While Delitzsch’s so - called “Volksbanken” (people’s bank) predominantly occurred within urban areas, the “Raiffeisen” banks were created in rural areas. To this day, most credit cooperative institutes carry in their company name the expression: “Volksbank” ("Voba"), “Raiffeisen” bank ("Raiba") or “Volks - and Raiffeisen bank (VR bank). From the onset, depositors’ savings were transferred to members with financing needs and, once a year; the profits of a credit cooperative were distributed among its members. Additionally, cooperative banks, much like savings banks, realized scale effects over a compound system. In 1972, all German credit cooperatives were united to form the German Association of Volks - and Raiffeisenbanks. For historical reasons, the multi - tier structure comprises the primary credit cooperatives that provide mainly retail banking services to their local market and specific industrial sectors, such as medium - sized enterprises (German Mittelstand). The banks’ members can individually exercise their control rights at members meetings and via a supervisory board. The balance sheet structure of the primary cooperative banks is shown in Figure 7 (Balance sheet of credit cooperatives) and bears resemblance to the structure of savings banks. Further

37 According to Figure 1 (Banking structure in Germany in banking groups)

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loans to non - banks hold the majority of assets with a constant value of approximately 65 percent over the last 30 years. However, on the liability side deposits from non - banks declined from 84 to 70 percent between 1976 and 2006, which is similar but less severe to the developments of savings banks.

Similar to the Landesbanks, two central institutions of the cooperative banking group - the Westdeutsche Genossenschafts Zentralbank (WGZ bank) and the Deutsche Zentral -Genossenschaftsbank (DZ - Bank)40 - provide a wide array of services to their primary institutions. They act as clearing institutions, allow access to national and international financial markets, provide asset liability management support and offer centralized back - office functions. In addition to their role as the central body, they compete with larger private sector banks in the investment and commercial banking areas. However, cooperative central banks operate on a small scale with non - banks, and unlike Landesbanks, they do not attempt to compete much as aggressively with commercial banks. The balance sheet structure of the regional institutions of cooperative banks, as it is shown in Figure 8 (Balance sheet of regional institutions of credit cooperatives), demonstrates their role as central banks for the primary institutions. While more than 60 percent of their assets are claims to other banks, more than 60 percent of their liabilities are debts to other banks. In the second half of the 1990s, the two banks increasingly substituted bank loans and deposits by purchasing bank securities and issuing bearer bonds. The market share of two central institutions in loans to non - banks and in deposits from non - banks has risen slightly over the course of the last 30 years.

2.6. Special banks

Special banks accounted for 25.7 percent of all German banking assets in October 2006.41 23 mortgage banks controlled more than 12 percent. In late 2001, the mortgage banking subsidiaries of Dresdner Bank (Deutsche Hypothekenbank), Commerzbank (Rheinhyp) and Deutsche Bank (Europäische Hypothekenbank - Eurohypo) merged to create Germany’s largest mortgage bank - the Eurohypo AG - with a 26 percent share of the German mortgage market. With roughly 234 billion Euros in total assets, this new entity moved up into the group of Germany’s top 10 banks.42 In order to avoid misunderstandings in the further process of this thesis it has to be clarified that the second largest commercial bank, the HypoVereinsbank AG

40 In 2001, the DG Bank (Deutsche Genossenschafts- Bank) , the former apex institute of the co-operative banking

group merged with GZ Bank (Genossenschaftliche- Zentralbank), one of two former regional co-operative central banks, to form DZ Bank.

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(HVB) can be considered as a hybrid mortgage bank. Bound by the law for mortgage banks, the HVB operates during the entire banking transaction as a universal bank, but is also legitimated as a mortgage bank to emit public mortgage bonds (Pfandbriefe).43 According to the German mortgage bank law, mortgage banks are restricted in their business practises to granting loans, either backed by liens on property or by assets and tax income of public authorities, and to refinancing those loans by means of long - term deposits and bank debentures, such as commercial and public mortgage bonds (Pfandbriefe). Commercial and public mortgage bonds are funded by a pool of residential or commercial mortgage loans (loans to and securities issued by public sector borrowers). Bond holders have a pari - passu first charge over the entire collateral pool and the mortgage bank remains liable, if the assets in the pool turn out to be insufficient to meet any obligation arising from its outstanding mortgage bonds (Pfandbriefe).

Another category containing in the group of special banks are the 26 German building and loan associations that accounted for merely 3 percent of total German bank assets in October 2006.44 In all associations the method of operation is basically the same. After signing a contract with a building and loan association, a customer enters the savings phase in which he makes constant monthly payments. After a minimum savings amount has been accumulated (typically 40 percent of the defined total contract amount) and subject to a customer - specific threshold value has been reached, the customer is allotted the mortgage loan. During the second phase of the contract, the customer repays his loan and thereby replenishes the society’s capital pool. After a sufficient number of pay periods, this configuration creates a closed system in which the interest rates on deposits and on loans can remain almost constant over time.

The third big group of special banks are the 16 German banks with special functions. They all have in common that they grant loans to individuals, enterprises and projects that are deemed ineligible for promotion by the German government. The private IKB Deutsche Industriebank AG, for example, promotes small and medium enterprises (SME) that would otherwise not have access to capital markets. As another example, the private Liquiditäts - Konsortialbank GmbH, which all German universal banks back, provides the necessary liquidity to a bank in a financial shortage situation. As a result this supporting institution guarantees the settlement of domestic and foreign monetary transaction of the financially stricken bank. In this way, the insolvency and, thus, the losses of respective account deposits should be prevented. The combined asset base of all banks with a special function amounted to 11 percent of total domestic assets in October 2006.45

43 See also footnote 15

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3. Legal improvements in banking regulations

3.1. An Overview

The entire German banking structure has experienced constant changes over the past years. Besides various economic trends, which are specified in the fourth chapter, the German banking system has faced drastic changes in banking regulation. Although taking place across Europe, certain adjustments have had far - reaching effects on the further development of the German banking sector. Increasing regulation is a major contributor to the changing general conditions in the European banking environment. Commonly the banking supervision is intended to be a guarantee for individual bank costumers with respect to investor protection and cost control. In economic perspective it guarantees maintenance of solvency provision in the economy and thereby assists in avoiding a banking system crisis.46 Examples of the most important regulation instruments are credit institutions' capital requirements, portfolio restrictions, organisational instructions like information and balance regulations, as well as an obligation to maintenance of a deposit and institute securitisation establishment.

In the following chapter, crucial developments in banking regulations which had a joint guilt of changing general conditions are discussed. Section 3.2. will give a review over the Basel II Accord, which had major impacts on the European banking system and its implications in the European financial sector. Secondly, additional regulatory innovations are examined in Section 3.3.. There will be specifications about the progress within the Financial Services Action Plan in detail, approved by the European commission in May 1999; the Lamfalussy procedure which opened the chance to create more technical implementing measures in specific areas of securities regulation and the adopted International Accounting Standard regulations. Section 3.4. will deal with the most import development, regarding the German savings banks and Landesbanks. It will discuss how these banks under public law used to benefit from governmental aid and how this assistance has been eliminated.

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3.2. Basel II

3.2.1. Development of the concept

At the end of June 2004 - after nearly six years of negotiation - the Basel committee of banking supervision published a revised general agreement for the "International Convergence of Capital Measurement and Capital Standards" (Basel II).47 The preliminary work to this new standard were the suggested and submitted alterations of the old 1988 Capital Accord (Basel I)48, which were published in June 1999, January 2001 and in May 2003. These amendments had been gradually modified after consideration of public consultations and results of three quantitative reform effective studies.49 Final changes were incorporated in the middle of 2004 and, finally, an entire framework was intended to be in force by the end of 2006 depending on the pace of implementation in the participating member states.

The goal of the new Basel accord - compared with the current Basel I - is the more differentiated linkage of credit risk, collateral and own capital backing. In contrast to the old Basel I accord, an unchanged average of credit institutions' capital requirements was aimed at a value of 8 percent of the risk - weighted assets. In addition to internationally uniform regulation Basel II was intended to prevent distortion of competition and eliminate incentives for credit institutes for relocating their headquarters to other countries, in which they could find more favourable and cost - efficient conditions of banking supervision. 50

3.2.2. Accord in operation

The Basel II concept consists of three complementary columns. In the context of the first column, the core of the reform manages the maintenance of regulatory capital calculated for three major components of risk that banks are facing: credit risk, operational risk and market risk. Basel II transfers the decisions to the institutes to choose between the three evaluations methods of credit risk. In the standardized approach, allocated credits are classified as a function of external agencies’ ratings into solvency and are dependent on groups of risks, to which special risk weights are assigned. In the internal ratings (IRB approach), the risk weights and the group of risk depends on additional variables, e.g. the probability of failure, the loss ratio or the maturity

47 Bank for International Settlements (2006) 48 Bank for International Settlements (1988)

49 that includes the first consultative paper on revising the Capital Accord (Basel II) 1999, the second consultative

paper on Basel II 2001 and third consultative paper on Basel II 2003

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of the credit. Whether the banks select the basic IRB approach or an advanced IRB approach, depend on those variables, which are externally given or which are determined bank - internally. In the design of these approaches, incentives were created for credit institutes, to steadily advance their systems for risk management and to substitute for more advanced and more risk - sensitive approach of the revised general agreement. For the new involvement of the operational risk, Basel II gives guidance to three broad methods of capital calculation for risk. These three different procedures are: the basic indicator approach, which is based on annual revenue of the financial institution; the standardized approach, which is derived from annual revenue of each of the broad business lines of the financial institution; and the advanced measurement approach (AMA), which is dependent on the internally developed risk measurement framework of the bank adhering to the prescribed standards. For the third type of (market) risk, the value at risk approach is the preferred choice. This procedure is based on the concept for statistic determination of the amount that a bank can maximally lose with a certain probability and on a definition of a desired value to minimize the over all risk of the bank.

The second column handles with the regulatory response to the first pillar and gives the regulators the tools to control the banks permanently and locally in the respective country. It also provides a framework for dealing with all the other risks banks might face, such as reputation, liquidity and legal risks, which are combined as residual risk.

The third column is intended to guarantee a larger transparency of the capital requirements. It is derived from extended disclosure for supervision by the market. For instance regulations are designed to allow the market to better evaluate of the bank’s overall risk position and to allow the bank’s counterparts to price and deal accordingly. Figure 9 (Three Pillar Graphic of Basel II) offers a visual aid of the overall framework and concept of Basel II.

3.2.3. Consequences and further progress

In the year 2001, the second draft of the new capital regulations was submitted and triggered some criticism in Germany. This was because medium - size enterprises (SME) were especially worried about substantial disadvantages with the credit supply that these new regulations caused. Consequently, in the third draft, changes in the regulations were made regarding the risk weights and the consideration of long period relations and diversification effects.51

51 Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung (Expert advisory board for survey

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Compared to the third consultative paper on Basel II and the improvements from May 2003, the new published regulations from June 2004 were only slightly changed. The adjustments affected particularly the handling of securitisation transactions and certain demands of the private customers. Furthermore, the introduction of the regulations took place in two stages which was not originally intended: By the beginning of 2006, in order to gain experience, the credit institutes were using the new rules "in theory" and in tandem with the old equity capital regulations. By the end of 2006, the standard approach and the base IRB approach was completely adapted. In contrast, the advanced IRB approach will not become effective deviating from the original schedule until the beginning of 2009, because of the United States’ urging, to extend the preparation.52

Nevertheless, some detail questions in this general agreement remained open, such as the final definition of the risk weights. Background in this context are the concerns of drastically sinking equity reserves of some banks, which could be connected to smaller equity stocks to the entire banking system and thus could contradict with the goals of the Basel committee. Therefore, the maximum capital savings are limited in relation to the status quo of the bank institutes, which use the IRB approach in the first years after the introduction of the new standard: at 5 percent in 2007, at 10 percent in 2008 and at 20 percent in 2009.53 In addition to the simultaneous validation of the old and new rules that started from the year 2006, further studies about the effects of the new changes are planned. The results of these studies will assist the Basel committee in deciding on an imposition of a lump - sum loading to the calculated equity capital to reach the aimed equity goals. A scaling factor value should be applied to the weighted risk assets from the loan business, which is determined according to the IRB approach.54

Furthermore, the rules must be sequentially developed in detail, in order to give consideration to new financial instruments. Moreover, the Basel committee plans the permission and application of more developed systems of risk management, in which banks can lower their prescribed equity demands by diversifying their credit portfolios more skilfully. Additionally, in the long run, the definition of liable equity will be further refined, because of the introduced and differentiated treatment of expected as well as unexpected losses and therewith the connected value adjustments, which were suggested by the United States in October 2003.55 The reason for these innovations is the fact that in many cases a decrease of the core capital requirements in relation to the total capital requirements could be associated. A distant prospect is the permission

52 Schieritz, Mark; et al (2006) (Financial Times Germany) 53 Bank for International Settlements (2006)

54 Deutsche Bundesbank; (2001); p. 29 ff.

55 Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung (Expert advisory board for survey

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of the so - called "Pre - Commitment approaches"56, which aims at the dismantling of supervision bureaucracy and a stronger self - regulation of banks.

In the course of the adoption from Basel II to an EU – legislation, the Basel rules will not only be applied to internationally operating major banks, but will also be prescribed in principle for all lending institutions and banks in the EU member states. Thus, distortion of competition within the European Union can be prevented and the introduction of modern risk management techniques can be promoted. Appropriate guidelines were published in the mid July 2004 and are expected to be converted into the respective national law of the European Union member states by the end of 2006. These guideline concepts are fitted even more into the adaptability of smaller bank institutes as it was the case of the original suggestions of the Basel committee, and they provide continually unchanged competitive conditions between large and small banks. Examples for these kinds of guidelines are planned facilities such as durable and partial applications of the internal rating approach, creditable collateral and the banking supervisory examination processes as well as disclosure requirements.

3.3. Other regulatory factors

Besides the increasing financial market integration that the Basel II developments have primarily caused in recent years, a rising international competition pressure on the European banking sector has become apparent. Consequently also other regulatory innovations must also have been responsible for this trend.

3.3.1. The Financial Services Action Plan

Among others, the large progress within the Financial Services Action Plan (FSAP) was one of the new regulatory improvements. The European commission approved this plan in May 1999, which contained suggestions on the advancement of a European domestic market for financial services and is expected to become law in the next five years. The three central goals of the FSAP were the guarantee of a standardized corporate client markets for financial services, the creation of open and safe private client markets, and the modernization and monitoring of supervision rules.57 Nearly all measures of the 42 planned legislation arrangements were put into force by June 2004.58

56 Kupiec, Paul H.; O'Brieny, James M.; (1997)

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3.3.2. The Lamfalussy procedure

Another important development for European financial markets was the Lamfalussy procedure, which opened the door to create more technical implementation measures in specific areas of securities regulation. Named after the chairman of the so called Committee of Wise Men Baron Lamfalussy, a report with the same name provided additional information, regarding the improvement of basic conditions for financial markets. This Lamfalussy procedure intends to ensure that the basic legal conditions are adapted more swiftly to current developments within the financial service sector. Furthermore, it attempts to create improved conditions for an effective co - operation and convergence within the range of financial market supervision while contributing to a more uniform transformation of European Union directives in its member states. Only principle questions and matters of implementing power were arranged in the guidelines and regulations within the securities sector. At the same time the European Parliament was constantly informed on the progress of the work. Originally, the Lamfalussy procedure was introduced for the European securities sector. In December 2002, however, the European Council recommended an expansion of the body of rules and regulations to the entire EU financial sector. Partly due to these expansion plans, in November 2003 a number of new committees were created, for example in the field of banking supervision, state insurance and financial conglomerates.59

3.3.3. The International Accounting Standard

In September 2003, the European Commission adopted the International Accounting Standard (IAS) regulations, which were followed by a convergence between the IAS and the United States Generally Accepted Accounting Principles (US - GAAP) capital market rights. Starting in the year 2005, capital market oriented enterprises must provide their consolidated financial statements on the basis of those international accounting regulations. Based predominantly on Anglo - American traditions these regulations are significantly different from the German accounting principles, particularly with respect to the historical performance of the accounting based on the acquisition value. However, with the new accounting regulations common enterprise’s accounting variables are now replaced by key data, which are now based on the current economic value. A combined model was in effect before these adjustments for the financial statements of banks. In that case financial instruments, which were acquired in the

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banking books such as loans, were set with the acquisition value. Instruments, which were kept for short term commercial purposes, were acquired in the accounting books. They had to be stated to market prices.60

3.4. Abolition of State Guarantees

Bodies under public law, such as the German Landesbanks and primary savings banks benefited from two separate support mechanisms: the maintenance obligation (Anstaltslast) and the guarantee obligation (Gewährträgerhaftung).

The maintenance obligation is derived from the banks’ public law status. In the past an unwritten rule of German administrative law, it meant that the founding entity of a public law entity (Anstalt) was obliged to meet its financial obligations at all times. The founding entity was required to inject capital or to provide liquidity support. Further, the maintenance obligation was an internal obligation from the founding entity (community or municipality) to the public law entity (in this case the bank) not the creditors and stated that a public law bank could not be subjected to insolvency proceedings.61 One of several examples of a troubled public sector bank, receiving support from it owners, was the Hessische Landesbank, during the late 1970s and early 1980s, which was beset by credit problems and received a capital injection from the state of Hesse and the Hessian Sparkasse.

In accordance with this specific law establishing a public sector bank generally (but not always) also involved a guarantee obligation (Gewährträgerhaftung), which was a formal unlimited guarantee by the founding entity to the bank’s obligations. As an external guarantee, it gave creditors a direct claim on the public sector owners of the bank. In the case of multiple owners, they were jointly and individually liable. The guarantee obligation was, in essence, an alternative solution of the maintenance obligation. If the owner of a public sector bank fulfilled its obligations under the maintenance obligation, the guarantee obligation was not necessary.62

Public banks enjoyed these advantages of governmental guarantees until mid - 2005. Especially for the Landesbanks, these benefits created considerably refinancing advantages. This compensation provided an opportunity to the banks to open additional business fields as well as operate increasingly in global financial markets. The resulting competition distortions led to a complaint by the European association of banks to the European Commission, which found this

60 Gregoriou, Greg N.; Gaber, Mohamed; (2006) 61 Biondi , Andrea; et al (2004)

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regulation to be an illegitimate government aid63. Hence, the decided agreement between the German Government and the European Commission from July 17th, 2001 was planned to expire public guarantees (maintenance obligation and guarantee obligation) for savings banks and Landesbanks. However generous transition periods were agreed upon:

- For liabilities, which were accepted before July 2001, the public guarantees are still applicable.

- Liabilities, which were accepted between July 2001 and July 2005 and have a maturity of no later than 2015, can only benefit by the guarantee obligations

- Accepted liabilities after July 2005 are subject to no more guarantees 64

Consequently over eight years will pass before the final expiration of the guarantees. For savings banks these guarantees were less important, since they refinanced themselves particularly by their own deposits. However, Landesbanks financed themselves to a large part via the capital market. Hence, starting in July 2005, they have to manage the impacts of higher refinancing costs. Section 5.4.below gives a forecast of possible effects for Landesbanks and their refinancing businesses, including a revaluation of the German bank ratings in the public sector.

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4. Economic trends in the German banking market

4.1. An Overview

Chapter 4 outlines major trends in the German banking market and compares them to developments in other European countries and the United States. Different but partially interlocked factors caused the resulting needs for reforms in the German financial sector and especially in the field of public banks. Following the basic standpoints and details of these factors should be traced and exposed. While the previous section (Chapter 3) illustrated initially the legal regulatory changes, this chapter will deal with technological changes in the banking sector (Section 4.2.), followed by modified competition conditions on the demand side (Section 4.3.) and economic changes which happened over the last few years in Germany and the rest of Europe (Section 4.4.). In the process a preliminary assessment will be made of whether the German banking structure compared to other European systems is indeed in the middle of structural change and if so, whether it is a change of decline or growth. Section 4.5. will present different threats to the German banking system in the form of new market entries by both foreign competitors as well as new forms of banking business. The last sections (Section 4.6. and 4.7.) will discuss the changing conditions in the area of company’s equity financing and the exceptional position of small and medium enterprises (SMEs) in comparison to public and cooperative banks.

4.2. Technological progress as initial point

Rapid technological progress in the areas of information and communication commonly generate the primary source and background of changes in all financial systems. A key improvement is the internet as the new and future technological foundation in the banking business. It is used as information - and trading platform, communication instrument and as a marketplace as well as distribution channel for banking products. For this reason, some literature labels the internet as the “catalyst” of commercial alteration.65 This technological development affected both demand and supply side in the banking business.66 Indeed the application of modern technologies can lead to tremendous cost savings for banks. However, typically

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technological progress itself comes along with significant primary investment costs. Most small and medium bank institutes can often not afford these investments, so that already from such tendency an accumulation of bigger entities via mergers or acquisition can be emanated.67 In addition, the necessary transaction volume of banks is often unachievable until a merger occurs, because only then an entry in a new business segment is actually legitimate. When examining at the development of the numbers of German commercial -, savings - and cooperative banks and their branches over the past 16 years, the result of such tendencies become evident. The total number of bank institutes in Germany has decreased dramatically, from nearly 4.700 in 1990 to roughly 2.000 at the end of the year 2005 as shown in Figure 10 (Number of bank institutes in Germany). This decline of over 56 percent was mainly due to the consolidation within the cooperative sector which dropped by over 65 percent during the same time period. Responsible for most of this reduction was the absorption of very small or distressed financial institutions by other members of the cooperative or savings banking group, which had a better economic and financial standing. In fact, the number of total branches (excluding those of the postal bank Postbank AG)68 increased in the early 1990s reaching a peak of over 49.000 branches in 1992, caused by the German reunification and the reorganization of the banking sector in the eastern parts of Germany. However eventually the numbers of bank branches declined over the past years by over 15.000 or 29 percent to nearly 35.000 branches in 2005. This decline is shown in

Figure 11 (Number of German bank branches). Taking into account the numbers of branches of

the Postbank AG, the reduction becomes even more noticeable. In that case the numbers dropped from around 68.000 in 1995 to about 46.000 in 2005, which equals a decrease of over 33 percent. Mainly the savings banks, the cooperative banking group and particularly the Postbank AG, which trimmed their branch network through substantial closings, were responsible for this significant decline. Despite of this downward movement, many authors still consider the German financial system still as “over – banked” compared to other countries with similar banking systems.

Similar trends could be observed for the time period from 1995 to 2005 in other European countries and the United States, as shown in Table 5 (Development of the banking sector in selective countries). Although the developments in their respective banking industries show different characteristics, the number of banks decreased in almost all these countries, as well. For example, similar to Germany the number of French banks dropped by around 40 percent, in the United States, Belgium and the Netherlands by round about 25 percent, in the United Kingdom by slightly more than 30 percent and in Italy by roughly 15 percent. The only

67 Tröger, Nils H; (2003) p. 152 ff.

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exception is Sweden with an increase of 8 percent. As a result of this development it is remarkable, that the proportion of German banks in relation to the total number of European banks has remained fairly constant at almost 40 percent during the time period of 1985 through 1999.69 With respect to branch network density, the German trend mirrors the general European trend as well. While the number of German branches per 1000 inhabitants fell from 0.83 (1203 inhabitants per branch) in 1995 to 0.56 (1787) in 2005, the number declined in other European countries, too. For example, in France the branch network density fell from 0.81 (1239) to 0.65 (1546), in the Netherlands from 0.42 (2384) to 0.27 (3704), in Belgium from 0.93 (1070) to 0.57 (1768), in Sweden from 0.44 (2269) to 0.30 (3387) and in the United Kingdom from 0.63 (1580) to 0.47 (2117). Despite a declining European average there are also countries with an increasing branch network density. Such an opposite development realized Italy with an increase from 0.67 (1503) in 1995 to 0.76 (1313) in 2005 and the United States with 0.27 (3645) to 0.31 (3272), respectively. With the exceptions of France, Italy and Belgium, the German branch network density in 2005 is the highest among the other compared countries, even compared to capital market oriented countries like the United Kingdom and the United States. Hence, with respect to European and also US standards, Germany might still be considered as “over – banked”, but nevertheless, compared to most other European countries Germany ranks in the midfield.

Additionally in most of the European countries the consolidation wave led to a significant increase in the market share of the five largest banks of the respective country in terms of total asset. As a result, the concentration ratio (CR5) in European average increased as shown in

Table 3 (The CR5 and HHI based on the balance sheet total in European comparison) from

roughly 38 percent in 2001 to over 42 percent in 2005. Estonia (98.1 percent), Belgium (85.2 percent) and the Netherlands (84.8 percent) are showing the highest values for the year 2005. However Germany had by far the lowest value of all presented countries with slightly above 20 percent in 2001 and almost 22 percent in 2005. This fact encourage the assumption of a German “over- banked” financial system.

4.3. Modified costumer behaviour

The technological progress, especially the introduction of new distribution channels like internet - banking, changed the demand behaviour of consumers considerably. Cross - subsidisation of product - and consumer groups within a bank institute is only severely possible, as a result of remarkably improved price transparency. This fact ultimately puts the pressure on

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