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The transformation of the German financial system

Article in Revue d économie politique · July 2006

DOI: 10.3917/redp.164.0431 · Source: RePEc

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 Andreas Hackethal, Reinhard H. Schmidt
and Marcel Tyrell†

THE TRANSFORMATION OF THE GERMAN FINANCIAL SYSTEM*

Frankfurt/Main

March 2006

Forthcoming in „Revue d’économie politique“ 2006

†
Andreas Hackethal holds the Chair for Financial Services Sales and Distribution at the European Business
School in Oestrich-Winkel, Germany. Reinhard H. Schmidt is the Wilhelm Merton Professor for Inter-
national Banking and Finance at the Johann Wolfgang Goethe-Universität in Frankfurt am Main. Marcel
Tyrell is a lecturer at the Universities of Trier and Frankfurt.
The corresponding author is Reinhard H. Schmidt, email: [email protected]
*
Earlier versions of this paper were presented at the 22. Journées d‘économie monetaire et bancaire,
Strasbourg, as well as at the annual meeting of DGF in Augsburg, at a German/Japanese conference in
Tokio, at the Max Fry Workshop in Birmingham (all in 2005) and at Université Paris X (Nanterre) in 2006.
The authors are grateful to all those who provided feedback and advice. The usual disclaimer applies.
 The Transformation of the German Financial System

Abstract

Until the end of the last decade, German banking and corporate governance and the
financial system as a whole were characterized by a remarkable degree of stability. Its
most important characteristics were bank dominance of the entire financial sector, a
strong role of not strictly profit-oriented banks and a stakeholder oriented and insider
controlled corporate governance regime. In looking at the German financial system as it
used to be, one can easily recognize that it constituted a well-balanced system, as the
authors show in section III..
However, the past seven to ten years have witnessed an array of changes in the legal,
financial and business environment of German banks and corporations and in the
financial system as a whole. Most notably, the role of public banks and the stakeholder
orientation of the corporate governance system have come under pressure, and the
possible demise of these elements may imply a fundamental transformation of the entire
German financial system. These developments are described and analyzed in section IV.
One way of explaining the former stability of the German financial systems is to point
out that its main elements were complementary to each other and also consistent. Recent
developments, most notably a change in the behavior and the strategy of Germany’s large
private banks, have already undermined this systemic consistency. Consideration
pertaining to the systemic character may also shape the process of a possible
transformation. As the authors argue in the concluding section of their paper, it is
precisely because of the importance of complementarity, that this possible transformation
might not be a gradual process but rather abrupt and possibly also painful and that it
might even lead to the adoption of an economically inferior financial system.
I. Starting Point: A Financial System under Stress

Until the end of the last decade, German banking and corporate governance and the financial
system as a whole were characterized by a remarkable degree of stability. Its most important
characteristics were bank dominance of the entire financial sector, a strong role of not strictly
profit-oriented banks in the banking sector and a stakeholder oriented and insider controlled
corporate governance regime. In fact, the German financial system has long been regarded as the
international prototype of a system that is bank-based and insider-controlled. In looking at the
financial system as it used to be, one can easily recognize that it constituted a system in the
specific sense of the term which we will explain below. Bank dominance and stakeholder
orientation are essential elements of this system, and the systemic character is likely to be a main
reason for the “stunning degree of institutional stability”1 of the German financial system.

However, what appears to be stability may also be an indication of rigidity and a lack of ability to
adapt to a new situation shaped by the forces of globalization and European integration, thus it
may in the final analysis be the very opposite of stability. There are signs which point in this
direction. The past seven to ten years have witnessed an array of changes in the legal, financial
and business environment of German banks and corporations and in the financial system as a
whole. Most notably, the role of public banks and the stakeholder orientation of the corporate
governance system have come under pressure, and the possible demise of these elements may
imply the collapse and a fundamental transformation of the entire German financial system.

These developments suggest addressing the following questions:

- Have recent developments now led to a structural change in German banking, corporate
governance and in the German financial system as a whole?

- If yes, has there been a convergence to the market-based structures of Anglo-Saxon countries,
as it occurred in France in the course of the last twenty years?

- And if no, can we expect such a change to occur relatively soon, and if it occurred would it be
a desirable development as numerous observers seem inclined to believe who regard the
Anglo-Saxon model as inherently superior to the German model?

1
See Abelshauser 2003, p. 177 (our translation). Abelshauser, an economic historian, refers not only to the
German financial and corporate governance system but more generally to the entire institutional
infrastructure that has shaped the German economy for a long time. An equally broad perspective is
adopted in the work of several authors who discuss “varieties of capitalism” and compare the German case
to that of other countries, such as Streeck 1991, Hall/Soskice 2001 and Amable 2003.
In a recent central bank publication which compares the institutional structure of the financial systems in
different countries, the chapter on Germany starts by stating “Germany’s financial system has proved very
robust over the past 50 years” (Group of 20, 2005, p. 91).
 2

One way of explaining the former stability of the German financial systems is to point out that its
main elements were complementary to each other and also consistent. Recent developments, most
notably a change in the behaviour and the strategy of Germany’s large private banks, have
already undermined this systemic consistency. Consideration pertaining to the systemic character
may also shape the process of a possible transformation. As we will argue, it is precisely because
of the importance of complementarity, that this possible transformation might not be a gradual
process but rather abrupt and possibly also painful. Thus while many authors argue that the forces
of internationalisation put pressure on countries to adopt a “good” financial and corporate
governance system and usually consider the capital market-based Anglo-Saxon model as the
“better” model2, we consider the quest for consistency as the driving force of change.

The paper is structured as follows. In Section II we provide some definitions and introduce the
concept of a system shaped by complementarity and consistency, on which the main argument of
this paper is based. Then, in Section III, we characterize the German financial system with
particular focus on banking and corporate governance as it used to be and point out why it
appeared as a well-balanced or consistent system. Section IV describes and assesses recent
changes, leading to the conclusion that the system has not yet changed in a fundamental way.
However, its consistency has been challenged and as we argue in the concluding Section V, this
loss of consistency can lead to an abrupt and fundamental transformation, which is largely
independent of any assumption as to which financial system would in general be better.3

II. Definitions, Classifications and Concepts

1. Definitions and classifications

In this paper, we use broad definitions of the terms ‘financial system’ and ‘corporate governance’
and treat corporate governance as an element of the financial system.

The financial system is more than merely the ’financial sector’, i.e. the institutions such as banks,
investment funds and organized capital markets that specialize in providing capital and other
financial services to the real sectors of an economy. In contrast, we define the financial system as
comprising both supply and demand, which is determined by the use that non-financial or real

2
Very strong statements of this kind can be found in Walter 1993 and Hansmann/Kraakman 2004.
3
This paper builds on the outcome of a research program on the convergence of financial systems in
Europe that has been funded by the Deutsche Forschungsgemeinschaft (see Schmidt/Hackethal/Tyrell
2002 for a summary) and later work such as Hackethal/ Schmidt 2005 on banking, and Schmidt/Spindler
2003 and Hackethal/Schmidt/Tyrell 2005 on corporate governance.
 3

sector units make of financial services offered by the financial sector. According to this
definition, financial decisions and activities that do not affect the financial sector such as
corporate dividend policy and household saving in the form of accumulating real assets are also a
part of a country’s financial system.

A simplified but common classification of financial systems distinguishes between bank-based

and capital market-based systems. In a bank-based system, banks are important providers of loans
to non-financial firms; they play a major role in attracting household savings; they are involved in
the governance of other firms; and they often have a strong influence on other parts of the
financial sector such as investment companies and stock exchanges. In contrast to banks,
organized capital markets are unimportant as a source of funding for firms and as an instrument
of corporate governance. Typically, banks are universal banks, and bank financing of firms is not
only considerable in volume terms but also long-term.

A capital market-based financial system is the polar opposite. Capital markets are important as
places where household put their savings, as a source of firm financing and also as “markets for
corporate control”. Bank lending is rather restricted in terms of volume and of loan maturities.
Often banks are specialized either by law or tradition, and if universal banking is allowed, as is
now the case in most industrialized countries, banks are organized in a way which separates
investment and commercial banking activities. In capital market-based financial systems non-
bank financial intermediaries play an important role and invest a large part of their assets in the
stock market.

The financial systems of most European countries have long been bank-based while Anglo-Saxon
countries have capital market-based financial systems. Classifying countries according to which
type of financial system they have is now more difficult than it used to be, but the classification is
sufficient for the purpose of this paper.4

Corporate governance is an integral part of the financial system. It is hardly conceivable that
external financing of firms would happen at all if the providers of funds were not assured in some
way that their interests are taken into account when decisions are made by the firms they finance.
This consideration suggests to define corporate governance as the totality of mechanisms which
assure that managers’ decisions are made in the interest of shareholders and possibly other
providers of capital so that these can expect “a return on their investment”5.

4
On the potential and the limitation of this classification, see, among others, Allen/Gale 2004.
5
Shleifer/Vishny 1997
 4

However, this definition is rather narrow and reflects the features of Anglo-Saxon capital market-
based financial systems.6 In a broader definition, which is frequently used in Europe and Japan
and more appropriate to the situation in these parts of the world, the term corporate governance
refers to the totality of mechanisms through which stakeholders can exert influence on how
important decisions are taken in firms. Even though this definition emphasizes the aspect of
conflicts of interest between stakeholder groups it also includes the monitoring of management as
an important aspect.

A widely accepted classification of corporate governance system distinguishes between outsider

control systems and insider control systems.7 Outsider control systems, which prevail in the
Anglo-Saxon world, do not take account of different interests and are based on market
mechanisms and public information. In these systems, the only obligation of management is to act
in the interest of shareholders. The dual task of aligning the interests of shareholders and
managers and of controlling management is mainly performed by a functioning market for
corporate control, by executive compensation tied to the share price and by competitive factor
and product markets. Flexible capital and labour markets also serve to protect stakeholders who
are not shareholders, since they provide “exit” opportunities and thus reduce the need of these
stakeholders to have “voice” as a means of safeguarding their interests.8

Insider control systems, which used to prevail in most of continental Europe and Japan, are more
complex since they leave room for conflict. They are based on internal mechanisms for exercising
influence and private or non-public information available to those who are in a position to
influence management decisions. Most insider control systems are at the same time stakeholder
oriented in the dual sense of treating the interests of different stakeholder groups as genuinely
relevant – that is, not only as relevant to the extent that taking their interests into account helps to
increase shareholder value – as well as of giving several stakeholder groups an active role in
corporate governance.

The dual task of aligning interests and supervising management is performed – and facilitated –
by the role and the composition of a supervisory board (or some functional equivalent) which is
separated from the management or executive board by equity participations of banks and cross-

6
See Schmidt 2004 for more details.
7
See Franks/Mayer 1994 for a lucid exposition of this distinction, which is, however, much older. By now
it is generally accepted, even though the extent to which specific corporate governance systems fall under
one of these two categories is a matter of dispute, as one can expect from any classification scheme. For a
discussion of this and other classifications, see e.g. Prigge 1998.
8
Hirschman’s (1970) typology of „exit“ and „voice“ as two ways of reacting to negative developments of
an organization is frequently used in the literature on corporate governance; see e.g. Mann 2002.
 5

shareholdings among non-financial firms and by an active involvement of employees in the

corporate governance of large corporations.

A stakeholder orientation needs mechanisms for coming to terms with conflicting interests. The
main arena in which stakeholder interests are expressed and conflicts are, to a certain extent,
resolved is the supervisory board (or some functional equivalent). Long-term relationships
between the stakeholders and the firm and repeated interaction between the various influential
stakeholder groups serve to harmonize interests and to limit conflicts.

Evidently, there is a correspondence between outsider-controlled corporate governance and a

capital market-based financial system as well as between insider-controlled corporate governance
and a bank-based financial system respectively.

2. Concepts: The systemic approach

The complexity of financial and corporate governance systems requires a system perspective. We
find the conceptual framework of „complementarity and consistency” a useful tool for
understanding and analyzing these systems.9

Complementarity of system’s elements is given - or a system is characterized by complementarity

- if the elements can take on values such that they mutually reinforce each other in their positive
effects and mitigate any negative effects they may have. However, complementarity only
indicates the potential of achieving a benefit arising from the elements being well adjusted to
each other. A real system can be characterized by complementarity without this potential being
realized. The additional concept of consistency addresses this aspect: A system of complementary
elements is termed consistent if all elements, or at least the most important ones, take on values
that fit together well.

Complementarity has important implications. First and foremost, the fit between the values which
individual elements take on is very important, and there is a certain economic pressure towards
consistency. Second, multiple “good” systems constituting local maxima with respect to some
suitable valuation function may co-exist. Third, “middle-of-the-road” systems that combine
features which appear attractive in different systems are problematic. Fourth, there may be path-

9
This approach has first been developed by Milgrom and Roberts in a series of highly stimulating papers
that mainly focus on corporate structure and strategy as a field of application. See especially Milgrom/
Roberts 1995. Amable 2003 discusses institutional complementarities of different varieties of capitalism.
We have transferred this approach to financial and corporate governance systems in Hackethal/Schmidt
2000 and Schmidt/Tyrell 2004.
 6

dependence in how systems develop over time, a feature that makes the success of piecemeal
reforms unlikely.10 Finally, complementarity suggests a methodological rule: Instead of analyzing
financial system elements in isolation, it is crucial to understand “la logique du système”.11

It is a theoretical question whether a given set of institutional features is a system of

complementary elements, and mainly an empirical question whether a given system is also
consistent. Among others, Aoki (2001) has shown that financial systems and corporate
governance systems are systems in the sense of being composed of complementary elements. As
we will argue in the next section, the German financial system has also been largely consistent
until quite recently.

III. Characteristics of the Traditional German Financial System

1. General features of the old German financial system

The German financial system has for a long time been bank-dominated. Banks were the main
actors in the financial sector, providing the lion’s share of external financing of firms and
attracting a considerable part of the financial savings generated by households.

Since the beginning of the 20th century, the big private universal banks12 also played an important
role in the governance of large corporations.13 In addition to their power as lenders, their
influence was based on three factors: depository voting rights, blocks of shares and seats on
supervisory boards of other corporations.

During the early years of the 20th century before and after World War I and then again for a long
period after World War II, top mangers of the big private banks seemed to regard themselves as
bearing a special responsibility for the development of German enterprises and tried to act
accordingly; and many politicians and even the general public largely shared this view. Together
with large insurance companies, which had multiple close links with the big banks, these banks
had built up the dense network for capital and personal links between Germany’s largest
corporation that is often referred to as “Deutschland-AG”. Not surprisingly, banks also dominated

10
On path dependence, see Bebchuk/Roe 2004 and the extension in Schmidt/Spindler 2003.
11
This rule shows an important methodological – as well as substantive - similarity between the concept
presented here and the approach of the French “école de regulation”, see Boyer/Saillard 2002.
12
For the time after World War II, this group includes Deutsche Bank, Dresdner Bank and Commerzbank.
13
Fohlin 2005, who is quite critical on the role of the banks in the pre-war period, admits that the big banks
were rather active.
 7

the stock markets, in whose governing bodies they were represented, as well as other elements of
the financial sector.

Banking regulation in Germany has always been rather restrictive concerning entry into the
banking business and very liberal in so far as it allows banks to operate as true universal banks.
For a long time, special disclosure rules permitted banks to build up hidden reserves and to draw
them down as required from time to time. Regulation and disclosure rules greatly contributed not
only to the importance of banks but also to the stability of the German financial system as a
whole in the years after World War II.14

Given the strong role of banks it is not surprising that Germany’s organised capital markets have
long been neglected. They were fragmented institutionally, almost irrelevant as a source of
enterprise financing and completely irrelevant as a force in corporate governance. The big banks
seem to have used their clout to prevent the stock market from becoming an effective competitor
for the banks in their functions as providers of loans to large enterprises and as collectors of
household deposits.15 That hostile takeovers were virtually unknown in Germany had its root in
the refusal of banks to provide the necessary funding for public takeover bids since hostile
takeovers would only have undermined the close bank-client relationships.

An additional characteristic of the old German financial system is that for a long time firms had
ample opportunities for self-financing, not least in the form of internally accumulated pension
reserves. Together with a generous pay-as-you-go pension system, this fact in turn contributed to
the low level of stock market development: There was no need to have pension funds, and
therefore such funds did not exist, did not supply capital to the market and did not require and
demand the services of well developed stock exchanges.

The features of the traditional German financial system described so far already show a great deal
of complementarity, consistency and stability. This impression will become even stronger when
we now discuss banking and corporate governance in more detail.

2. Characteristic features of the German banking system

Even though the big private commercial banks have shaped the entire financial system and even
the entire German economy over a long period of time, it would be wrong to assume that they are

14
See Allen/Gale 1995 on the importance of this feature of a financial system: it permits the banks to
smooth the income of the real sector of the economy and thus reduces intertemporal risk.
15
An additional factor which contributed to the “underdevelopment” of German capital markets was the
policy of the Bundesbank which feared that liberalised stock markets might endanger its policy of monetary
stability; see Fischer/Pfeil 2004.
 8

the largest banking group in the country. Germany has a so-called three pillar banking system
composed of public savings banks, private commercial banks and cooperative banks. They are all
universal banks and generally subject to the same regulatory regime.

In terms of total bank assets, the largest group is the savings bank group. At the end of 2005 it
comprised 463 local savings banks and 12 Landesbanken (regional or state banks) and accounted
for 35% of total German banking assets. Savings banks mainly cater to a local business and
household clientele and they still benefit from having a huge stock of stable and cheap deposits.
Landesbanken are big public sector commercial and investment banks and act as central banks to
the savings banks in their respective regions and as the house bank of the respective state in
which they are located.

The private commercial banks are the second largest banking group. The so called “big banks”16
hold almost two thirds of the domestic assets of all private commercial banks but less than one
fifth of all German banking assets, even though this clearly underestimates their economic
importance. The third largest banking group is the co-operative group. At the end of 2005 it
consisted of 1,293 small local cooperative banks and two large second tier organisations, which
are big universal banks in their own right.

Table 1: The structure of the German banking system as of end 2005

Number of Number Domestic assets
banks of outlets (in € bn)

Local savings banks 463 22% 14,801 40% 1,014 15%

Landesbanken 12 1% 618 2% 1,365 20%
Local credit co-operatives 1,293 62% 13,357 37% 592 9%
Co-operative central banks 2 0% 12 0% 224 3%
Big private banks 4 0% 2,454 7% 1,227 18%
Regional private banks 247 12% 2,421 7% 706 10%
Private and public mortgage banks 50 2% 2,903 8% 1,079 16%
Special purpose banks 18 1% 27 0% 696 10%
Total 2,089 36,593 6,903
Source: Deutsche Bundesbank

16
This term is also used by official central bank statistics. In addition to the three banks mentioned above,
the group of big banks also includes HVB, a big bank that has emerged from the merger of two regional
banks located in Bavaria and was recently acquired by the Italian banking group Unicredit.
 9

Table 1 above shows the number of institutions and banking outlets as well as total bank assets in
the three groups mentioned above and in a fourth group which comprises banks with a special
status such as mortgage banks and other special purpose banks like the development bank KfW,
which is owned by the federal state.

Table 1 suggests a number of characteristic features of German banking. The high number of
banks indicates that bank concentration seems to be rather low in comparison to other European
countries. However, this impression can be misleading since the local savings banks and the
primary cooperative banks operate under a relatively strict regional principle and therefore hardly
compete for local markets within the respective groups.17

Then there is the preponderance of the public banks, especially that of the savings bank group. It
suggests that there is much state influence on the banking sector in Germany. However, almost all
local savings banks are owned by the respective municipalities. Therefore, the federal
government and those of the states (Länder) do not have any influence on their operations, and
also that of the municipal authorities is severely restricted by law and in practice.

A corollary of the size of the savings bank group and that of the cooperative banking group is the
relatively small market share of the big banks in comparison to other European countries. Since
neither the savings banks nor the cooperative banks are by their design and statutes strictly profit
oriented, a feature which in former years also applied for the private banks, the overall level of
profit orientation in German banking is limited. This may be a reason why profitability has
always been relatively low in the German banking sector. Surprisingly however, over the five-
year period from 2000 to 2004 the profitability as measured by average post-tax returns on equity
of the local savings banks (4.9%) and co-operative banks (5.1%) exceeded that of the big private
banks (-1.2%)

Typically, banks in Germany are universal banks. They have the right to offer all kinds of
banking services and they also use this right in ways which correspond to their respective sizes. A
characteristic feature of German banking, which is related to the universal banking tradition, is
that banks have close ties to the enterprises they finance. There are still the so called “house bank
relationships” between firms and banks. In a series of interesting studies, Elsas and Krahnen have
shown that (1) many firms still have a house bank, i.e. one bank enjoying a preferred status
among the set of banks with which the firms maintain banking relationships. Thus, house bank
status does not imply exclusivity. (2) In almost all cases, there is no question which one among a

17
However, if one considers the entire savings bank and cooperative bank groups as two complex
institutions bank concentration in Germany does not differ from that in other European countries.
 10

firm’s banks is the house bank. (3) More importantly, house banks seem to behave differently
from other banks when a firm experiences difficulties, probably because the house bank has more
and better information than the other banks. If a firm’s financial situation becomes weaker, all the
banks reduce their combined lending exposure, whereas the house bank increases its lending or at
least maintains its level.18 Thus, German banks seem to offer a kind of liquidity insurance to their
established long-term business clients. This behaviour may explain why German firms use more
bank loans for external financing than firms in most other countries, as has been shown by
Hackethal and Schmidt (2004).

3. Characteristic features of the German corporate governance system

At the macroeconomic level, corporate governance is a crucial determinant of innovation, growth

and economic welfare. Sound corporate governance increases the extent to which firms obtain
critical resources and shapes the effectiveness of their use.19 Similar considerations apply at the
micro level. Firms need external resources. This exposes the providers of these resources to risk.
However, the risk they bear is not just given by technological and market factors. It also depends
on decisions that are made later by those who are in a position to make important decisions. Thus,
there is a moral hazard problem. All long-term contracts are inevitably incomplete creating the
danger of moral hazard and especially of a “hold up” in the course of formal and informal
contract renegotiations,20 and since the results of these renegotiations depend on governance
rules, these rules are of the crucial importance.

Most obviously, this moral hazard problem makes external equity financing difficult. If potential
providers of equity, i.e. owners or shareholders, have reasons to doubt that the governance regime
provides some protection for them, they would hardly be prepared to invest, to become “residual
claimants” and thus a firm’s primary risk-bearers. But the situation of banks and employees is not
all that different if banks provide sizable long-term loans and if employees develop and apply a
great deal of firm-specific knowledge. Both large long-term loans and firm-specific knowledge
have for a long time been characteristic features of the German economy.21 Therefore, granting
governance rights to all those who are expected to provide valuable resources and in this context

18
For a summary of their findings, see Elsas/Krahnen 2004. The existence of house banks has been
questioned in the still best-known English-language book on German finance and banking by
Edwards/Fischer 1994. Thus the Elsas-Krahnen studies can be regarded as a refutation of the Edwards-
Fischer proposition.
19
See e.g. Schleifer/Vishny 1997.
20
See Hart 1995 on incomplete contracts and Klein/Crawford/Alchian 1978 on the danger of a hold-up.
21
On the case of loans see Hackethal/Schmidt 2004 and on firm-specific knowledge Abelshauser 2003.
 11

to undertake specific investment with sunk-cost features, i.e. to shareholders, long-term lenders
and core employees, reduces the risk perceived and borne by these parties and makes it easier for
firms to obtain their resources. This is the economic rationale of a stakeholder-oriented corporate
governance system.22

If more than one group of stakeholders has governance rights the question naturally arises
whether the rights of different stakeholder groups work in a similar direction – or are
complementary - or rather have antagonistic effects. The answer to this question depends on how
governance is implemented in a specific case like that of a given country.

One characteristic of the governance of large German corporations in the legal form of a joint
stock corporation is the dual board structure. There is the board of management (Vorstand) which
has the obligation to determine and implement the corporate strategy, and the supervisory board
(Aufsichtsrat) which appoints, dismisses and monitors management. But apart from these and
some other functions which clearly have an indirect effect on how management operates, the
supervisory board is not involved in determining business strategy and policy. Its role differs in a
fundamental way from that of a British or American unitary board or a French conseil
d’administration. Nevertheless, even the indirect influence of a German supervisory board is
quite strong.

The main arena in which corporate governance is implemented in German corporations is the
supervisory board. But how are supervisory boards composed, how do they operate, and which
board members are powerful? The legal basis is again the company law. By law, half of the
positions in the supervisory board are determined by the general assembly of shareholders, while
the other half is determined by the labour side.23

The formal rules on who elects supervisory board members are not enough to understand the
German corporate governance system. It is also crucial to know how share ownership is
distributed and who the people are who sit on supervisory boards. Share ownership in Germany is
highly concentrated. Other corporations, founding families and banks and insurance companies
hold large share blocks in the majority of listed corporations.24 Moreover, a considerable number
of supervisory board members elected by the shareholders are former members of the same
corporations’ management boards or other business leaders or bank representatives.

22
For an extended analysis, see Schmidt 2006.
23
However, the “capital bench” has a slightly stronger position since in the case of a tie the chairman casts
the deciding vote and the chairman is determined by the shareholder side.
24
For empirical evidence, see Becht/Böhmer 2001.
 12

These structures of ownership and supervisory board composition are consistent with the legal
rules which determine what the management board and also the supervisory board are expected to
do: Both boards are supposed to act “in the interest of the firm”. This vague legal term is
interpreted by most lawyers as meaning that not only do shareholder interests count but also those
of several stakeholder groups, making it an important part of the tasks of management and the
supervisory board to strike a balance between the interests of the different stakeholders and not
simply maximize shareholder value.

Taken together, these stylised facts suggest regarding the (former) corporate governance system
of large German companies as being based on a “governing coalition” which is composed of four
groups. One group is top management, the others are shareholders, employees and banks and
insurance companies. The power basis of the latter three groups are not only their supervisory
board seats but often also other long-term relations with the corporation such as their roles as
lenders and the codetermination of employees at the floor-shop level. In the case of shareholders
it is important to point out that only block holders are part of the “governing coalition”, while
small shareholders are not included. They are in fact not even well represented on German
supervisory boards.

The parties which used to make up the “governing coalition” largely shared long-term objectives.
In accordance with their legal mandate, most German top managers used to see their role as being
responsible to various stakeholder groups and not only to shareholders. Thus, they would
typically not aspire to maximise shareholders’ wealth but rather to assure stability and growth of
the firm.25 This is in line with the long-term or “strategic” interests of those who own blocks of
shares, of the banks who are mainly interested in the firms’ ability to repay loans, and of labour
representatives who care most for secure employment and career prospects for staff members.
This common interest, which in all likelihood “genuine shareholders” would not share, has been
the basis on which a high degree of consensus among those who have influence could emerge.

4. Complementarity and consistency of the old regime

The feature of German corporate governance suggests that they form a consistent system
composed of complementary elements: The legal mandates of the two boards, the division of
functions between them, the composition and the functioning of the supervisory board, the
distribution of power within this board and not least the common interest in stable growth are

25
To the extent that management is monitored and possibly also disciplined by the supervisory board, its
interests are of course opposed to that of the supervisory board.
 13

elements that fit together well and tend to mutually reinforce their respective effectiveness. Under
the aspect of consistency, it is important to add that a market for corporate control in the form of
hostile public takeover bids did not exist in the old regime. If it existed, it would put a strong
pressure on management to maximise shareholder value. With this pressure in place and
anticipated by the others, the implicit contracts between management and shareholders on the one
side and banks and employees on the other side would no longer be credible. As a consequence,
these two groups of stakeholders would lose their interest in playing an active role in governance.
In particular, they would hardly have a motive to contribute the specific knowledge they can
rightly be expected to have, and to strive for consensus.

Complementarity and consistency are not only given within the governance system as it used to
exist in Germany but also between the governance system and the rest of the financial system.
Stakeholder-oriented and insider-controlled governance is consistent with the dominant role of
banks in the financial sector, extensive financing with bank loans and a relatively weak role of
capital markets in the financial sector and little capital market financing, the pension finance
regime, the lender-friendly German accounting rules and the general consensus-orientation in the
entire financial system.26

To conclude this brief and necessarily highly stylized and even idealised exposition of the old
German financial system, we wish to emphasize two things. Firstly, given the high level of
complementarity and consistency it is not surprising that the German financial system has been
very stable for a long time. Secondly, the big private banks seem to have occupied the central
position in the system, and therefore a possible change in their role warrants special attention
when we now look at recent developments.

IV. Recent developments in the German financial system

1. Developments in the German financial system at large

Around the turn of the millennium, the German financial system has been exposed to a number of
developments which point to the possibility of a fundamental transformation from a bank-based
to a capital market-based system. Since we will discuss changes in banking and corporate
governance in detail in the following subsections, this introductory section only offers a short
glimpse at the general financial landscape.

26
For further details see Hackethal/Schmidt 2000 and Schmidt/Tyrell 2004.
 14

The last three years of the past century were characterized by a stock market rally. As in other
countries, share prices in Germany increased more than twofold until March 2000, creating the
expectation that the transition to a market-based system would occur almost by itself. As part of
this development,

- the first big takeover case in Germany occurred with Vodafone taking over Mannesmann,
making it clear to everybody that in principle hostile takeovers are possible in Germany as
they are in other countries;

- merger talks between Deutsche Bank and Dresdner Bank were at an advanced state, possibly
leading to a situation in which several big banks would no longer uphold a system of mutual
support and at the same time mutual control;

- there were talks about merging Deutsche Börse AG and the London Stock Exchange, which
foreshadowed a further strengthening of the role of the stock market in Germany, which had
already greatly improved its efficiency as a secondary market;

- a far-reaching tax relief for profits from the sale of share blocks was announced, intended to
induce an unravelling of the network of crossholdings in Germany;

- induced by a complaint by the private banks placed with the European Commission,
Landesbanken and savings banks came under pressure because of the public guarantees they
enjoyed so far;

- a shareholder-friendly takeover law was in preparation, which would, among other things,
facilitate hostile takeovers and create an active market for corporate control;

- a far-reaching pension reform was announced and enacted, which puts much more emphasis
on capital-based pensions and was expected to boost the interest in, and the importance of,
the stock market; and

- stock-based and stock option-based executive compensation schemes were introduced in

many corporations aligning managers’ interests with those of small shareholders much more
than in the past.

All of this happened in an environment in which the catchword of “shareholder value orientation”
was used widely and with general approval by almost all commentators and in which the banks
that were involved in capital market operations aspired to become almost full-fledged investment
banks, considering retail banking and financial intermediation as an outdated business model.
 15

In March of 2000, the stock market bubble burst, stock prices started to fall almost precipitously
and for a long period bringing stock market capitalization and direct shareholder ownership back
to their former low levels. The ambitious merger projects fell through. Many of the far reaching
changes such as that of the pension system and of the takeover law turned out to be more limited
in scope and importance than had originally been expected. Shareholder value ceased to be the
generally acclaimed maxim. All in all, the smooth system transformation which had appeared to
be around the corner did not materialize, or so it seemed at least in the early years of the new
millennium. Not much later, the so called new market for young technology-oriented stocks, a
symbol of the boom years, was closed, and the situation of German banks, especially those that
had turned to capital market-related activities, deteriorated consistently until 2004.

2. Recent developments in German banking

We now take a closer look at developments in the banking sector focusing on the years after
2000. Looking back, one can see that for many years German banks have not earned a return on
equity which would have covered their cost of capital, irrespective of how one defines this
benchmark. With only a few exceptions, both big private and public banks were affected by this
trend despite various cost cutting initiatives.

Net interest margins have dropped everywhere, indicating an intensification of competition and
requiring banks to seek alternative sources of income. However, even the increasing fee revenue
from capital market-related business did not suffice to support the bottom line of German banks.
This again affected all big banks more than smaller ones, and those that were most hit reacted by
scaling back their commercial lending operations which they considered to be largely
unprofitable and overly risky.

Almost as much as the years of the stock market boom, the ensuing difficult years for the banking
sector may in themselves have pointed to a structural change. But do these developments really
indicate that the role of banks in the German financial system has changed; has the banking
structure changed, and have the peculiarities of the German banking system disappeared? Some
more observations help to answer these questions.

First of all, the structure of the banking sector has not changed. Over a long period of some 30
years, the distribution of market shares among the “three pillars” has remained almost stable. As
an implication, the role of private banks and especially that of the so-called big banks remained
low by international standards. Bank concentration has hardly changed except for the fact that
many very small cooperative banks merged.
 16

Despite a worldwide trend in banking towards diversification, bank revenues in Germany are still
largely interest-related. German banks have followed the international trend, but with a lesser
intensity than their peers in other countries. This shows the enduring focus on their role as
financial intermediaries and suggests that banks remain important lenders to the enterprise sector,
a fact which is also supported by a comparative analysis of the financing patterns of non-financial
firms in different countries.

In spite of an economic environment which does not seem favourable for banks, there are no
strong indications that banks have lost their overall importance in the financial sector and even
the entire German economy. The ratio of bank assets to GDP has continually increased over the
years; total staff of the banking sector has remained at the level of ten years earlier; long-term
bank loans are still the most important source of external financing for German firms; and banks
– and their asset management units - are still the most important collectors of household savings
in Germany.

One can sum up the developments in the banking sector by identifying more continuity than
change. Thus, the recent statement of the now retired CEO of one of Germany’s largest banks that
“no stone has been left unturned” in German banking does not seem to be fully supported by the
facts. However, it represents the situation in the group of big private banks quite appropriately.
As far as banking in general is concerned, the easily observable indicators of a transition to a
capital market-based system are as yet weak despite the turbulence of the past decade, while the
role of the big banks seems to be fundamentally changing. This suggests that there may be more
forces of a less visible kind which justify the expectation of more change and less continuity in
the near future.

3. Recent developments in German corporate governance

As it seems at first glance, there was even more change in the field of corporate governance than
in banking during the past decade. The potentially most important developments took place in the
political arena. Corporate governance has become a “hot topic”, now also attracting the attention
of policy makers and the general public. Several groups of high-level experts have recently
deliberated fundamental issues of corporate governance and produced statements and reports
including that of a high level "Government Commission on Corporate Governance" from 2001
and the Corporate Governance Code issued by the so-called "Cromme Commission" early in
2002.27 All in all, in their attempts to address "the corporate governance problem" in Germany,

27
See German Corporate Governance Code (2002), Düsseldorf, Feb. 26, 2002.
 17

these groups seem to come to a rather simple conclusion: There does not seem to be a need to
modify the basic structure of corporate governance in Germany. Of course, all shareholders
should be treated fairly and in particular small shareholders should certainly be treated better than
in the past and management control should be made more effective28, but none of the expert
groups has made an attempt to reinstate shareholders as the sole and supreme authority in
corporate governance matters. Most importantly, the dual board structure and mandatory
codetermination, which are core elements of the insider control system, were not addressed in the
experts’ reports and recommendations.29

Investor protection has been strengthened by introducing first elements of capital market law in
Germany. The legal prohibition of insider trading and the creation of a Federal Authority
supervising certain aspects of the stock market activity in 1994 and the introduction of a
mandatory bid into the new German takeover law of 2001, to name just the most important
regulatory changes of the past decade, have improved the quality of investor protection. Viewed
in isolation these innovations seem to be simply positive. However, they also need to be looked at
in a broader context, as we will discuss later.

Moreover, the newly created supervisory authority which is now a part of the integrated financial
services authority created in 2001 has not been given the broad mandate of the SEC and largely
lacks enforcement powers. This fact limits the effectiveness of legally mandated investor
protection,30 and that by itself would make it difficult to assess the new elements of capital market
law as introducing a capital market-based system of corporate governance. Private benefits of
control seem to have decreased but are still much higher than in the Anglo-Saxon countries.31

The law of joint stock corporations has been modified to a considerable extent. The most
important part of this modernization is the "Law for the Strengthening of Control and
Transparency" (KonTraG) of 1998. The KonTraG has led to a certain shift of power to the
supervisory board, thus limiting the powers of the management board. Moreover, it curtails the
influence of banks. However, it did not address the questions of how the board should be
composed and what the legal obligations of the management board should be. As this law has a

28
Nevertheless, it is not at all clear that German shareholders fared badly in the past and that management
control in Germany has been less effective than in other countries. For a summary of the evidence see
Hackethal/Schmidt/Tyrell 2005.
29
In the introduction of the Report of the Government Commission (Regierungskommission 2001) it is
clearly spelled out that these two topics were not addressed in an effort to reach the unanimity of the expert
group that the government wanted to see.
30
A more general criticism of the lacking enforcement is presented in Ehrhardt/Nowak 2002.
31
See Nenova, 2003 and Dyck/Zingales 2004 for empirical evidence.
 18

clear focus on improving internal governance one can also not qualify it as contributing to a
paradigm shift from insider to outsider control.

Mandatory codetermination, another peculiarity of German corporate governance, is a backbone

of the stakeholder-oriented insider control system. Codetermination has not been challenged
greatly during the past decade. This may be a matter of political correctness, but it rather seems
that codetermination has worked reasonably well within the traditional system.32

In a capital market-based and outsider-controlled governance system, the market for corporate
control plays an important role. The Mannesmann-Vodafone takeover battle of 1999 and 2000
was indeed a hostile one, and its ultimate success seems to have given a clear and simple signal of
modernisation: Hostile takeovers are possible in Germany. But the success of Vodafone in its
attempt to take over Mannesmann has so far not led to the wave of hostile takeovers which many
observers had expected and hoped for.

A highly relevant recent legal development is the adoption of a German takeover law in 2002. It
was enacted immediately after the narrow defeat of the EU takeover directive in the European
Parliament in 2001. The German law contains most of the elements of the EU directive, including
a mandatory bid rule, but stops short of disallowing all counter moves. This can be taken as
evidence that attempts are made to make more investor protection compatible with the traditional
view that not only shareholder interests matter, i.e. with the traditional stakeholder orientation.

One of the most important factors which used to support the traditional German corporate
governance system were close capital and personal links among the large corporations in
Germany. Traditionally, big banks and insurance corporations were in the center of this network.
Perhaps the most evident sign of change is that this network now seems to be considerably less
dense than it used to be. At least this is the impression one gets from the graphical representation
provided by the Max-Planck Institute in Cologne which regularly provides data on corporate
networks to the German Monopolies Commission. However, there is also contradictory empirical
evidence in a recent paper by Kogut/Walker 2003. Using different methods to identify links
between corporations, they suggest that links between German companies are still strong even
though they may now be less evident than they used to be.

32
This applies particularly to the so-called floor-shop level codetermination; see Frick/Lehmann 2005.
 19

But irrespective of methodological details, all observers agree that the thinning out of the network
mainly concerns the capital links within the financial sector and between the financial sector and
the rest of the economy.33 The big banks are reducing their investments in other companies.

Supervisory board composition has also changed. The number of board seats and especially that
of board chairs held by top bankers has almost constantly decreased during the last decade, while
- interestingly enough - the role of managers of other companies and especially that of former
managers of the same company has increased and the number of seats on the supervisory boards
held by genuine shareholder representatives stagnated. As Höpner 2003 reports, the decrease in
the number of top banker holding the position of a board chairman is compensated one-to-one by
an increase in the number of chairs held by former managers of the same corporations. One group
of insiders merely replaces another. Thus, again the facts do not support the proposition that the
insider control system is giving way to an outsider control system.

4. A preliminary conclusion

In summing up, one can say that much has indeed changed, which appears to be closely
connected to corporate governance in Germany. Especially investor protection and the
institutional basis for the control of management seem to have improved. Nevertheless, some of
the developments, which appear to be relevant, only seem to exist but are not real or will not last;
others exist but will hardly have an impact on the German corporate governance system, while
still others are there, yet lack significance to support the assessment of a fundamental shift.

As we mentioned above, individual developments need to be analyzed in a broader context. This

holds in particular for the improvements in the field of investor protection. They may have
consequences for the consistency of the entire insider-controlled German corporate governance
system for the following reason. Better protection of outside shareholders tends to reduce the
economic rents of private control since it tends to reduce their private benefits of control, and this
in turn might make it less attractive for the powerful actors, the controlling insiders, to continue
playing an active governance role.

The only feature of corporate governance which has definitely changed is the involvement of the
big banks in corporate governance. They are increasingly withdrawing from their former role.
They are reducing their shareholdings and withdrawing from corporate boards.

33
For details see Höpner 2003.
 20

Here we see an interesting parallel to the development in banking and corporate finance. For a
long time, bank financing was the dominant source of long-term external financing of German
companies, and large corporations were the favourite clients of the big banks. Their risk exposure
due to large scale financing of business seems to have been a major reason for being involved in
corporate governance. At a general level, the role of bank financing has not changed so far. But
there is a need to differentiate. Firstly, the large corporations have become increasingly
independent from long-term bank financing. Secondly, especially the big banks have reduced
their corporate lending activity. These two developments together might motivate them to also
withdraw from their traditional governance functions. Moreover, competition in the banking
sector seems to be getting stiffer and the big private banks are directing their strategic focus to
different business areas (e.g. investment banking for Deutsche Bank, bankassurance for Dresdner
Bank, mortgage and SME-banking for Commerzbank). This might undermine the willingness of
the big banks to act in as coordinated a way as they used to do when it was necessary for the
traditional system to function.

V. Implications and Possible Future Developments

In the last section we have argued that, looked at one by one, the recent developments in the
German financial system do not show that the structure of the German financial system has
already been fundamentally transformed to become capital market-based and outsider-controlled
instead of maintaining its old character of being bank-based and insider-controlled. The evidence
is mixed, and one might even be inclined to say that continuity is more visible than change. One
could interpret recent developments as representing a modernization of the old system as opposed
to a convergence towards a capital market-based system.

However, it may not be sufficient to look at individual developments in isolation if one wants to
fully understand their implications. It may even provide a wrong picture. The impact of a given
change of relevant factors may depend very much on other – stable as well as changing -
elements of the entire financial system. This is the level at which our main question as to whether
there is or may be a fundamental transformation of the financial system as a whole needs to be
answered, and to this we now turn our attention.

The question is this: Can the assessment that stability dominates be sustained when we look at the
German financial system as a whole and “as a system”? We search for an answer by invoking
three views on how financial systems develop in general and apply this to the German case.
 21

One position concerning how financial systems and the role of banks in these systems and
corporate governance systems develop is that of a „natural progression“ from a bank-based and
insider controlled system to a capital market-based and outsider controlled system. This is the
most widely held view, shared by most practitioners and politicians as well as by some eminent
scholars such as Rajan/Zingales 2003. The international experience of the last 15 years makes this
position plausible since it seems to demonstrate the economic superiority of the capital market-
based systems of the U.S. and the U.K. However, if one looks at the debate of only fifteen years
earlier, one finds the opposite assessment expressed by influential authors such as Michael C.
Porter.

Some support for this view is provided by Raymond Goldsmith’s 1985 historical account of how
financial systems have developed in the past. However, Goldsmith’s famous study was written
before the advent of modern econometric techniques and before large scale data bases were
available. More recent and more sophisticated empirical work of a group of researchers
associated with the World Bank does not support the underlying conviction that capital market-
based financial systems are in some well-defined sense better than bank-based systems and that
there is a “natural progression”. Most importantly, if there is not the assumed “pull” of the
allegedly superior system, the view discussed here loses much of its appeal.34

Equally, recent theoretical arguments question the assumption of a “natural progression” based on
economic superiority. Among others, Allen and Gale have developed a set of models which
correspond to the “agnostic” position of empirical researchers and point out that both systems
have specific strengths and weaknesses and that a general comparative assessment is not possible.
The final argument is that if the capital market-based system were indeed superior one would
require some argument showing why the transition to this system should take time and occur
more or less gradually.

The second view is based on the assumption that the dichotomy of bank-based and capital
market-based financial systems is not generally valid. It only represents a specific historical
situation in which it may have been impossible to combine the strength of both system types.
Financial innovation changes this situation and may generate new options including some which
permit the combination of the strengths of a bank based-system with those of a capital market
based system. The strength of the former is that it invokes the benefits of relationships, as is the
backbone of relationship lending and house bank relationships. That of the latter is that it opens
up the possibility to tap a large resource base and to optimally allocate risk. Seen from the

34
A great deal of this work has recently been compiled in Demirgüc-Kunt/Levine 2004.
 22

situation of today, what might some time soon emerge would appear as “hybrid systems”. The
main example of how the strengths of both systems can be combined successfully is
securitization35. The World Bank (2001) also argues that a synthesis – or a “hybrid system” – is a
perspective that is attractive and possibly also empirically relevant because it strengthens both
efficient capital allocation in a short term perspective and competition as a determinant of long-
term welfare.36 However, so far there are only very few convincing examples showing that a
synthesis can be viable and economically attractive, Moreover, the step from one financial
instrument such as collateralised debt obligations to an entire financial system has so far not even
been discussed. Finally, there are strong theoretical arguments that speak against the possibility of
having a „hybrid model“.37

The third view38 builds on the concepts of complementarity and consistency presented in Section
II of this paper. We argue that financial systems are shaped by strong complementarities and that
consistency of a financial system is extremely important in welfare terms. Inconsistent systems
imply welfare losses which can be substantial. Assume for the moment that welfare differences
between different financial systems can be quantified (by an outside observer who has nothing to
do with policy making). Let δ be the welfare difference between a consistent capital market-based
system and an equally consistent bank-based system, and let β and γ be respectively the welfare
differences between a consistent bank-based system and some given clearly inconsistent system
and between a consistent capital market-based system and some inconsistent system. As we
argued above, we find it difficult to say in general terms whether a consistent bank-based or a
consistent capital market-based system is superior. Therefore we assume that the δ is not large
and can even be negative. But we are agnostic in this respect and only for the sake of simplicity
assume here that δ > 0.

If complementarity is an important feature of a given system, δ is smaller than both β and γ. In

other words, starting from a situation of inconsistency, the possible welfare gain that could be
achieved by re-establishing consistency – if this were possible - is larger than the welfare gain

35
For an exposition of how securitization functions and an explicit reference to the issue discussed here,
see Franke/Krahnen 2005.
36
In a paper that is more closely focused on corporate governance Vitols 2004 offers a similar argument. In
his view, there is the possibility of combining the positive sides of ownership concentration and of more
recourse to capital markets. The condition under which this may be achievable is that the degree of
ownership concentration is lower than it used to be in Germany but higher than in the Anglo-Saxon
countries. As he reports, ownership concentration in Germany has developed towards this new optimum in
the course of the last ten years.
37
See e.g. Boot/Thakor 2000.
38
We have developed this view in earlier papers; see Hackethal/Schmidt/Tyrell 2005, Schmidt/Tyrell 2004
and for the case of corporate governance systems Schmidt/Spindler 2003.
 23

that could possibly be achieved by “jumping” from one consistent system to another one. Or
again in other words, the valley which separates the two peaks is deeper than a possible
difference in height of the two peaks (or local maxima).

In this case, which we find plausible, complementarity would prevent an efficiency-induced

convergence if the possible transformation process started from a consistent system. This has two
reasons. One is that no one knows which system is really better or which local maximum is also
the global maximum. The other reason is that the transition from one consistent system – say the
bank-based one – to the other one would cause severe, though temporary, welfare losses or, in
other words, would require passing through a “deep valley of tears”.

Now we return to the discussion of the German financial system. As we have argued, it used to be
a largely consistent bank-based system. Recent developments have undermined its consistency.
The most important development which had this effect is the retreat of the major private banks
from their former roles as important long-term lenders, as active participants in the corporate
governance and as players in the financial system that contributed to keeping the competition
from the capital market at bay.

Of course, this change in the strategy of some large banks is not an autonomous move of the
banks. In withdrawing from their former central coordinating role in the German financial system
they merely reacted to developments which can be attributed to European integration and even
more to globalization. Thus, indirectly, integration and globalization and the adoption of some
elements of the capital market-based financial system have introduced inconsistencies into the
German system. What could be the consequences?

Quite clearly, there is the possibility of marching through the “valley of tears”, as the French
financial system seems to have done for some 15 years after 1983. This may be justified if, but
only if, there were some evidence that the Anglo-Saxon financial system is indeed better. But this
evidence does not exist (δ may be negative or very small). Moreover, with advanced integration
and globalization the valley of tears may now be even deeper than it was only a few years ago (β
and γ may be very large).

For those who believe that a bank-based and insider-controlled system is superior (δ < 0), the
question arises if there is a possibility to return to what was once the consistent German financial
system, and more specifically if such a possibility also exists in a situation in which inconsistency
has reached a high level and the efficiency and stability of the financial system is threatened. We
call this situation a crisis. Especially in a crisis, the return may prove impossible. The reason for
 24

this assessment is to be found in the peculiarities of the German system and the ways in which it
functioned: House bank relationships and the subtle balance of the old stakeholder regime are
features which are to a great extent based on trust, implicit contracts, consistent expectation,
repeated interaction, reputation based mechanisms of cooperation and coordination and – above
all – a certain moderation of short-term profit orientation. Re-establishing these core building
blocks of the German system as a reaction to a crisis situation, in which inconsistency has
reached a high level, would be impossible since trust, confidence etc. cannot be imposed by fiat,
i.e. they cannot be imposed at all.

Inconsistency in the financial system of an economically important country above a certain level
is not tolerable – β and γ are likely to be large – and therefore something would have to be done
to regain consistency in a crisis situation. Since the return to the former financial system is
precluded, the only option is the transition to the Anglo-Saxon system. It would not be a smooth
transition, it would have to be fast, and it would occur independently of the question which
system is better if there were no 'crisis'.
 25

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