Public versus Private Banking

By: Wolfgang Munchau

This is what I said at a dinner speach in Frankfurt on Nov 17, 2006, during the International Conference on Public versus Private Ownership of Financial Institutions, November 17-18, 2006, Frankfurt

Ladies and Gentlemen,

I am very honoured to be here with you at a conference that is surely one of the highlights of an extraordinary financial and economic conference season in this great city of Frankfurt.

Last week the European Central Bank held a conference about the use of money, which as you are all probably well aware is the second part of its two-pillar strategy. Our conference here is about public versus private sector ownership of financial institutions, and it relates directly or indirectly to a system known in Germany as a three-pillar banking system – das Dreisäulenmodell. I am not speaking about this subject in all its generality, but in relation to Germany, where there is much debate about the future of this system.

The architects of ancient Athens also knew three basic types of pillars – Ionic, Doric and Corinthian. The religion of Islam is based on five pillars, the Shahadah, the testimony of faith; ritual prayer; obligatory almsgiving; fasting and the pilgrimage to Mecca.

A pillar is defined by a physicist as a static element, not meant to crumble under pressure. A multi-pillar strategy is thus a contradiction in terms. Likewise, Germany’s three-pillar banking system is not a strategy. It was meant to endure.

My first observation is that it has indeed lasted for a relatively long time. But banking is neither a temple, nor a religion. The question we should be addressing is not whether the system was successful during the 20^th century. I would be ready to concede that it was. The question is whether it will – and should - survive the 21^st century, an age of globalised goods and factor markets, including globalised financial markets. My prediction is – let me say this outright - that it won’t and that it shouldn’t.

There are some parallels between this debate, and a wider debate about the future of Germany’s much celebrated social market economy. I have argued in my recent book on the German social market economy that one of the distinguishing elements of a social market economy is not the degree of social provisions. In comparison with other European countries, Germany is not an extreme example of a country with a particularly high degree of distribution of wealth and income. I have argued that the essential characteristics of the German model is the banking system and the close-knit relationship – I used a more pejorative expression – between banking and industry. So when we are challenging the three-pillar strategy, we are talking more than just banking. This is in reality a debate about the future of Germany’s unique economic model. This is why this is such an emotional debate.

The first one has to realize about this system is how peculiar it is in an international context. In Germany, the non-private sector is the dominant sector in the banking industry. In economics, the case for the public sector involvement in an industry relates to its public good characteristics. We agree that defence and policing are public goods. There is a some political disagreement to which extent health is a public good. Since money has the characteristic of a social contract between the individual and the state, there is no question that the provider and protector of money, the central bank, should be a public sector institution.

But to make the case for a large part of the banking industry itself to be in the public sector is less straightforward. Since money itself is clearly not a public good, I can only think of one valid argument: to protect the public against market failure. Two concrete questions that arise immediately from this consideration are: could a private sector banking system provide the same high quality regional coverage, and could a private sector banking system provide as much liquidity to all sectors of the economy.  Another issue is financial stability, which I will not address.

Let me first address the question of sufficient liquidity. One of the most commonly heard defences of the system in Germany is its orientation towards the Mittelstand – a difficult to translate word, meaning small-to-mid-sized companies under private ownership. The Mittelstand, so the story goes, is part of Germany’s industrial success story, the part of the economy that creates most jobs. It requires a supportive banking system. Note too that the world Mittelstand also contain the static word “Stand”, and it is no coincidence that a “Stand” requires pillars to rest on.

My own personal experience of foreign banks – and I have lived in several countries, US, UK, Belgium and Italy, to have experienced the advantages and disadvantages of the banking system of each – is that there is generally no shortage of regional banks, though I know of no country where the branch coverage is as extensive as in Germany. But with computer and telephone banking on the rise, and holes in the wall everywhere, this argument is increasingly retrospective. In any case, even a public sector banking system has to control its cost base. The reduction in the number of regional branches occurs one way or the other.

Preferential relationships with specific customers is a valid argument, though not necessarily a desirable argument. A banking system that bails out ailing companies distorts competition, slows down structural change, and ultimately a country’s ability to seek new specializations in the age of globalization. The system is good at protecting jobs, but bad at creating new ones. I find it hard to accept that this could be in the interest of the economy in the long run at a time of so much rapid global change.

Unless you believe that a privately-owned Mittelstand is going to be the backbone of the German economy in the next 50 years, as it was in the previous 50, it is difficult to find a justification for a public sector banking system. In the case of Germany, as the economy gradually becomes more normal – in terms of ownership structure, the role of the stock market as a source of capital for mid-sized companies, and more generally in terms of the relative sizes of the manufacturing and services sectors - I would expect the banking system to become more normal as well.

My main argument in favour of change is a different one. It is monetary union – an event whose long-run implications for our economic system are still widely underestimated. We have a monetary union that is not a political union, and one that is unlikely to develop into a fully fledged political union in the foreseeable future. But there are nevertheless some conditions necessary for a monetary union to function well in the long run, conditions that extend beyond the establishment of a central bank, and a credible fiscal policy framework. I would argue that a further precondition for long-run sustainability is the development of a genuinely single market for financial services, a Euro-Area-wide banking industry, coupled with a Euro-Area-wide supervisory framework. Just how Germany or any other euro member state can pursue a national route in such an environment is not clear to me.

Last year, we saw what happened when a protectionist banking regulator desperately tried to keep foreign banks out of his home turf. The governor of the Banca d’Italia got effectively evicted from office, at great damage to his personal reputation, to the Banca d’Italia, and to the reputation of the Italian state. The situation in Italy is different than the situation in Germany. The banking system there is significantly less developed. And there are many foreign banks already present in Germany, not least Italy’s Unicredit, the owner of HVB.

An important continuing trend is the European Commission’s serial assault on the public banking sector in Germany. After the long investigation into WestLB, and the imposition of a large fine, the Commission continues to pursue the German public sector banking sector relentlessly on several fronts. In combination with the gradual development of a single market for financial services, European competition policy will continue to act as a powerful instrument of change.

Where does this leave the public banking system in this country? I am making no predictions about the timing. It will probably still last for a while. But I have no doubt that eventually Germany will be weaned off from its Mittelstand/public sector banking obsession in due course, probably kicking and screaming.

In this sense, the use of the term “pillar” is probably justified. Pillars are strong and static. But they don’t adapt. Pillars hold up or they don’t. They last until they crumble. This is how I see the future of public sector banking in Europe. In the words of the unforgettable Herb Stein, former economic adviser to President Nixon: when something can’t last, it won’t.