Abstract: In a recent book, the author and his team presented a comprehensive study of the German financial system and drew lessons for Chinese financial reformers.
Why on German financial system? We are actually encouraged by four impressive facts.
The first fact is that Germany has kept a fine balance between finance and the real economy. As a modern developed economy, Germany has managed to keep the share of manufacturing in GDP at over 20%, the highest among major developed economies, while its financial industry accounted for only 3.7% in 2018.
Second, Germany has maintained long-term financial stability. There has been almost no major financial crisis in Germany since World War II. Even during the 2008 GFC, the German financial system still showed great resilience, with few mentions of a German financial or debt crisis by scholars and media. Even under the impact of the COVID-19 pandemic, Germany’s financial sector still remained stable throughout 2020, and economic contraction in the country was smaller than most EU members.
Third, Germany and China share many similarities in economic and financial development and institutional arrangements, such as dominance of banks in the financial system, high proportion of state-owned or public financial institutions, emphasis on the real economy which is export-oriented, use of civil law systems, and so on.
Furthermore, in China, there has been more research on the financial systems of the UK, the US and Japan than on that of Germany. Within the small body of Chinese literature on the German financial system, many are more descriptive than analytical, and some even contain inaccurate or misleading descriptions.
Of course, our research is problem-oriented, driven immediately by the problems currently facing China. As China strives to become a high-quality economy, it requires a development strategy that prioritizes the domestic market while allowing domestic and international markets to complement each other, posing higher requirement on the financial system's adaptivity, competitiveness, and inclusiveness.
Is China's financial system up to the challenge? As China develops its financial sector and carries out regulatory reforms, what international best practices can it adopt? What are the strengths and weaknesses of the financial systems in the US and UK? How to appropriately assess a country's financial development from political, economic, social, cultural, and historical perspectives? What foundations need to be strengthened and inertias to be overcome in developing the financial system? China must address these questions in its effort to build a modern financial system.
China initially followed Japan and Germany's models in financial reforms and opening-up by developing the banking system, mobilizing savings and transforming them into investment to support industrialization, and emphasizing the role of finance in serving the real economy.
However, in the last two decades, China has shown a greater willingness to learn from the UK and the US, for example, expanding direct financing, establishing capital markets, and modernizing and improving the international competitiveness of its financial sector. China has charted a pathway for tis financial development not based on theoretical analysis, but through trials and errors.
In reality, there is little time for contemplation when navigating a path of compressed economic development. In such a process, a combination of factors are at play, the inevitable and the accidental, the planned and the unintentional, what is available and what is not.
Between 2003 and 2016, marketization of China’s financial markets and financialization of the economy advanced rapidly. However, few people in 2003 would have predicted that China, unlike the UK, the US, Japan, or Germany, would expand its financial sector primarily through shadow banking, off-balance sheet transactions, and interbank businesses. It's also difficult to imagine the rapid expansion of the financial sector, the imbalance between finance and the real economy, and the accumulation of financial risks.
As a participant in this process, I have gained a better knowledge of the endogeneity of financial system's evolution. On the other hand, it motivates me to explore the internal and external forces that shape bank-led financial systems.
That is why I looked to Germany for experience in developing a solution for China.
The German financial system stands out for its order, a steady structure, and distinct layers. Where it has succeeded and failed is intriguing and can provide many inspirations for exploring China's own path.
As a result, this book is organized around problems and goals, and underpinned by a comparative analysis of the financial systems of the US, the UK, Japan, China, and the Eurozone, with the aim to elucidate the basic facts and underlying logic of the German financial system and to provide some food for thinking to Chinese reformers.
I. The Overlooked German Financial System
Germany, recognized as "the country of poets and thinkers", is also a modern state that has benefited from its well-known financial sector.
Finance played a crucial role in the second industrial revolution after German unification in the 1870s, as well as the "economic miracle" after World War II. The success of the German economy has always been inscribed with the greatness of German finance. The German-Japanese model is also considered to be a prominent financial system model comparable to the US-UK model, followed and emulated by many countries and studied by a large number of scholars.
After the 1990s, the US economy grew strongly, much outpacing that of other industrialized countries, whereas Germany and Japan were both in decline, with Germany emerging as Europe's "sick man" and Japan enduring the "lost 20 years". In 1990, the ratio of German and Japanese economy to the US economy was 26.8% and 52.5% respectively, but declined to 18.0% and 24.0% in 2019.
The large disparity in economic growth had a significant impact on how the two financial models are valued, with the US-UK model increasingly being considered the best practice and the German-Japanese model marginalized.
As a result of this tendency, Chinese reformers shifted to follow the US-UK model, and the German financial sector made similar attempts. In this process, the merits of the German financial system have become overlooked.
Following the global financial crisis and the Euro debt crisis, the German system showcased its unique strength in avoiding imbalances between the financial and real estate sectors and the real economy, limiting macro leverage, and maintaining financial stability. It was until then that the merits of the German model finally gained recognition.
Apart from the many parallels in their economic and financial development pathways and institutional arrangements that China and Germany have, what's more intriguing is that some of the difficulties that have occurred in China's financial development have been precisely fixed or avoided in Germany.
Understanding the facts, logic, and merits of the German financial system will be extremely beneficial to China's efforts to construct a modern financial system. Unfortunately, German financial system has received much less research attention in China than the financial systems of the US and the UK, and some of the literature even contains inaccurate description and misinterpretation of facts.
For example, most of the studies consider German savings banks to be state-owned, but they are actually a form of public banks with a unique governance structure operating under municipal trusteeship. But municipalities do not own any shares of these banks nor have the authority to sell them.
As another example, some authors misinterpret the phenomenon that German banks can hold shares of some firms as the fact that firms can possess controlling interests in banks, and use this as an example of industry controlling banks.
Although the German cooperative financial system was restructured in 2016 to a two-tier structure consisting of central cooperative banks and local credit unions, most Chinese scholars continue to describe it as a three-tier structure of central cooperative banks, regional credit unions, and local credit unions.
It's also a common misconception that in Germany where the relationship between banks and their corporate clients are strong, banks rely on mutual trust built over time rather than collaterals to lend. But in reality, German banks, even the Hausbanks (house banks) which have the closest ties with businesses, rely on collaterals.
Therefore, in our research we mostly relied on primary data source to ensure accurate description of facts and fact-based analysis, in order to provide the reader with credible and usable references for further research.
II. Puzzles of the German Financial System
The German financial system is full of mysteries that pique our interest.
For example, the global wave of financialization and privatization since the 1980s has had little impact on Germany's financial system, which was at the heart of capitalism. In retrospect, this has demonstrated the stability of the German financial system and strong resistance to disruption to its functions and structure, rather than stubbornness or ossification. This is an outcome of Germany's distinctive political, economic, and cultural tradition, as well as its historical legacy.
Germany has eschewed financialization in favor of a small financial sector and a large real economy. In contrast to the US and the UK, where the share of financial sector in GDP has been trending up while manufacturing's share falling sharply, Germany has maintained a small financial sector and a large manufacturing sector, with the former taking up less than 5% of the economy for a long time and the latter, consistently above 20%. The share of rentier income in non-financial firms has remained stable, and there are no evident signs of production factors flowing from the real economy to the financial sector.
In contrast to many developed countries, Germany has maintained a low leverage ratio. As a result of financialization and the response to the financial crisis, macro leverage has risen sharply in industrialized countries such as the US during the last 20 years or so. Germany's macro leverage ratio was 180.6% at the end of 2019, over 70 percentage points lower than the average for major developed countries and even lower than the average for developing economies.
Germany has remained mostly unaffected by the drift to privatization, retaining a high number of non-profit-maximizing banks. Due to the municipal trusteeship system for savings banks, federalism, etc., privatization of public banks (savings banks, state banks, policy banks) and co-operatives has been virtually absent in Germany during the global privatization wave, in stark contrast to the US, the UK, the rest of Europe, and most transition economies. As a result, the private commercial banking industry does not dominate in terms of the number of institutions or asset size, and non-profit-oriented banks are the leading players. In this context, the global wave of shareholder interest maximization had limited impact in Germany.
III. German financial system boasts a sense of order
Germany is good at using finance or regulating the relationship between the government and the market in finance to establish an order that conforms to the concept of social market economy.
After World War II, Germany had committed itself to maintaining currency stability, adhered to the principle of regional operation of small and medium-sized banks, insisted on the competitive neutrality of policy banks, and ensured a dominant position of the real economy in the remuneration structure. This reflects Germany’s pursuit of order when dealing with the relationship between the government and the market, finance and the real economy, as well as the internal relations of the financial system.
The two rounds of hyperinflation after the war vividly demonstrated the tremendous destructive power of price instability on the relationship between the government and the market, and the order of competition, which sowed the seeds of fear of inflation among Germans. As a result, the Federal Republic of Germany resolutely introduced the concept of a social market economy and implemented currency reforms, and the Deutsche Bundesbank turned itself into the most successful central bank in the world to tame inflation. Effective price signals helped establish and maintain the order of market competition, and systematically reduced government intervention in the market and prices. Germans’ fear of inflation and the central bank’s persistent pursuit of currency stability are also known as stability culture (Stabilit?tskultur), which is essentially a culture of order.
The position of finance vis-à-vis the real economy in the German remuneration structure also reflects an order. Remuneration structure determines the allocation of factors, which in turn affects the performance of economic growth. If we take financial activities as non-productive activities, and real economic activities as productive activities, then the order required for sustainable economic growth is a remuneration structure in favor of the real economy.
Unlike the reversal of the remuneration structure in the US and the UK since the 1980s, Germany has always maintained a remuneration structure that features the dominance of real economy, showing the characteristics of high returns in the real economy and low returns in the financial industry. From 2005 to 2018, the return on net assets of the German banking industry averaged only at 7.7%, while non-financial companies over 20%. This significant difference in the rate of return is also known as "strong firms and weak banks."
Within the financial system, Germany emphasizes the order of competition more than competition itself. In Germany, most banks need to strictly abide by the “regional principle”, and are not allowed to operate across regions. Mergers and acquisitions can only occur between banks that are geographically close to each other. Although this kind of restriction has received many criticisms as it limits banks’ operational autonomy and hinder internal competition in the banking industry, adherence to such principle can provide small and medium-sized banks with a “protected territory”, avoid excessive competition within the banking sector, and maintain the diversity of the banking system.
IV. A highly stable financial system
The German financial system has shown extraordinary stability, which is reflected not only in the continuity of the financial structure and financial culture, but also in the long-term robustness.
The banking industry has maintained a three-pillar framework for a long time. Since the formation of the three-pillar framework featuring commercial banks (privately-owned banks), savings banks (state-owned or public banks), and credit unions (cooperative banks) in the middle and late 19th century, the German banking structure has remained stable on the whole after going through the two world wars, an economic miracle and the global privatization wave. In the meantime, the three-pillar framework in many European countries such as Spain, Italy, France, and Belgium has died out. In addition, large-scale policy banks have survived. The continuity of the three-pillar framework, not the three-pillar framework itself, is the most important feature of the German banking structure.
The “pro-real economy” attribute of the financial system has been preserved. We use the term “pro-real economy” to characterize the long-term close interactions between the financial system and the corporate sector. In the second half of the 19th century, Germany developed a banking system that can provide long-term capital for the development of businesses and industries, which became one of the country’s key advantages in the second industrial revolution. An epitome of the “pro-real economy” attribute of Germany’s financial system is the so called Hausbank relationships, which still exist widely between small and medium-sized banks and their SME (small- and medium-sized enterprise) clients. Under the Hausbank model, banks provide firms with implicit long-term financing commitments, assuming the roles of long-term financing providers, liquidity guarantee providers, and proactive financial aids providers. Partially because of the prevalence of this model, it is less common for German banks to withdraw lending when business conditions deteriorate.
The financial system in Germany has remained robust over a long period. Unlike the US, Japan, and the UK, Germany has never suffered a large-scale financial crisis after World War II. Currency stability, housing (financial) market stability and corporate independence are the three major supporting factors for Germany's financial stability.
The stability of the housing (financial) market or the virtuous cycle between finance and real estate have greatly benefited from currency stability ensured by Deutsche Bundesbank, the developed housing rental market and the prudent housing finance system. The prudence of the housing finance system is embodied in many aspects, such as collateral valuation based on mortgage lending value (MLV), low loan-to-value ratio calculated based on MLV, predominance of fixed interest rates, and the primary use of Pfandbrief in refinancing. MLV is a conservative assessment of the real estate value, usually producing the lowest value during the economic cycle. These institutional designs can help shield the real estate market from the disturbance of monetary policy changes, weaken the reinforcement of pro-cyclical fluctuations in the financial and real estate markets, and avoid the spiral cycle of rising housing prices and expanding housing loans.
V. Difficult transition of the German financial system
Against all the economic changes and global financial trends, the German financial system has undergone many changes while maintaining continuity.
The "great reversal" of the stock market. This is the most significant change in the German financial system in the past 100 years. From the late 19th century to the beginning of the 20th century, the German stock market was once comparable to that of the US. Affected by the restrictions imposed by the Nazis, the German stock market declined rapidly in the 1930s. Stock markets in the UK, the US, France, and Japan have expanded rapidly since the 1980s, and the securitization rate (the ratio of the market value of listed companies to GDP) increased significantly in these countries. Germany made great efforts to promote the development of its stock market, but the gap has only further widened.
The development of the German stock market has lagged behind chronically due to institutional, policy and even cultural reasons, but essentially it is more affected by the real economy. Compared to the second industrial revolution period, German companies have grown more conservative, and the protagonist of the German economy has given way to traditional industries and large listed companies since the 2000s. The "great reversal" of the stock market has weakened the modernity of German finance.
The close relationship between banks and firms has weakened. Germany is not entirely unaffected by the strong financial culture. The halo effect of the US and British model and the decline in the financing needs of large German companies have caused major German banks to transform since the 1990s. Business models have shifted from Hausbanks featuring relationship financing to transaction banking and investment banking featuring arm’s-length financing. In addition, due to factors such as tax reform and adjustments to laws, major banks sold most of their corporate shares, and lost sizable seats on the board of supervisors and voting rights of escrow shares in major companies. The “big bank-big company” model that has lasted for more than 100 years is on the brink of collapse. The asset structure of major German banks has undergone a fundamental change with the proportion of corporate loans in total assets falling to less than 10%.
The privatization of public banks made a breakthrough. In 2018, HSH Nordbank completed privatization, the first public bank in Germany to be privatized. The privatization of HSH Nordbank was the result of a combination of factors, including its legal status as a limited liability company, the severe operating losses it suffered, and EU State aid rules. Although the event has some iconic significance, considering that other public banks adopt the legal form of public institutions, and that savings banks maintain operational stability, the privatization of HSH Nordbank does not signal an incoming wave of public bank privatization in Germany.
VI. Implications from the Germany financial system
The German financial system is not perfect, being plagued by problems such as the lagging development of venture capital and stock market, and insufficient financing capabilities for the future. In the meantime, the political, economic, and cultural background of the German financial system is also very different from that of China. Nevertheless, its existence itself is inspirational as it shows us the diversity of the modern financial systems and the uniqueness of the financial system of Germany.
There are at least ten takeaways from the German financial system.
The first is to build a modern financial system that aligns with national conditions and development. The core of the unique evolution path of the German financial system in the past 200 years or so and its unique role in the modernization process lies at its adaption to national conditions and development needs.
The second is to rebalance the remuneration structure between the financial sector and real economy. German practice shows that excessive financialization and the financial industry's dominance in the remuneration structure are not a historical inevitable, and the lack of financial dominance in the remuneration structure does not necessarily affect the function of the financial sector as the core of the modern economy.
The third is to sustain a virtuous economic cycle to help reduce the leverage ratio. German practice shows that maintaining a low macro leverage ratio should not only be a matter for the financial sector. The low leverage ratio of the corporate, household, and government sectors brought about by the virtuous cycle of the national economy is more important for reducing the macro-leverage ratio.
The fourth is to maintain financial diversity and competitive order. German practice shows that the secret of providing efficient and stable financial services to SMEs lies in the diversity of the financial system and the order of competition that ensures diversity. The diversified structure can function as a stabilizer, which can help avoid the homogeneity of financial institutions and reinforcement of pro-cyclical fluctuations, and maintain the resilience of the financial system.
The fifth is to develop relationship financing and patient capital. German practice shows that relationship financing and patient capital are at the core in forming the relationship featuring resilience and mutual benefits between banks and firms. German-style relationship financing has not reduced banks to Japanese-style "zombie banks". This is related to factors such as Germany's avoidance of a real estate bubble, banks' emphasis on collaterals, and corporate self-reliance.
Sixth is to promote the steady development of housing finance. German practice has demonstrated the systemic importance of housing finance as the cornerstone of financial stability. Prudence and discipline are keys to maintaining a stable housing finance market.
Seventh is to improve the corporate governance of state-owned banks and enhance the basis for the rule of law. German practice indicates that public banks are not necessarily less efficient; instead, they could function as the stabilizer for the banking system, but only when they have effective corporate governance systems and respect the rule of law without being subject to undue government interference.
Eighth is to promote corporate self-reliance and increase endogenous capital. German experience tells us that any discussion of a country’s financial system without touching upon the corporate sector is incomplete. There is a sound interplay between finance and the real economy in Germany because the two sectors are well aligned; to a certain extent, this is a result of corporate independence and the importance that firms attach to endogenous capital. And such independence comes from firms’ competitiveness and self-discipline.
Ninth is that excessive issuance of currency is not a path toward prosperity. German experiences, both good and bad, show that a stable currency is critical to maintaining a sound order for competition, economic prosperity and people’s wellbeing. Monetary policy should not be deemed merely a short-term tool for counter-cyclical adjustment; instead, it has fundamental implications for the order of competition. In today’s world where the Modern Money Theory (MMT) prevails, the German experience is ever more enlightening.
Tenth is to promote the development of the stock market with patience and determination. German experience, both positive and negative, has illustrated the importance of a sound stock market, how hard it is to build such a market and what it requires.
Of course, the German financial system is relatively conservative and stable, which hinders its ability to support innovation. This is fatal to the technological advancement and sustainable development of a country over the long run. China needs to learn the lessons when drawing on the German experience.
International comparison is important in economic and financial research. However, it’s also important not to blindly copy other countries’ practices given the difference in national conditions and development logics.
We are delighted to see that since 2018, with a new leadership in the Financial Stability and Development Committee, China has made breakthroughs in finding a suitable development path and model for its financial system.
First, the finance system has become more adaptive, its financial functions have returned to normal, and the policy toolkit has improved to enable finance to better serve the real economy. The government has been steadily encouraging financial service providers to better support the real economy, and channeled funds toward the real economy with monetary, financial, fiscal, taxation, industrial and regulatory policies. Incentives and restraints have been strengthened to ensure the financial sector provides better support to the real economy, especially SMEs, agriculture, rural areas, and farmers.
Second, a solid and flexible framework for monetary and financial policy is taking shape. Monetary policy enjoys more independence, with a more effective b interest rate transmission mechanism, and none of the policy measures has deviated from the targets. Even amid COVID 19’s blows, Chinese policymakers did not blindly followed the MMT; instead, they worked to balance the multiple goals of maintaining growth, promoting reforms, upgrading structure, preventing risks and improving people’s livelihood.
Third, China has been continuously improving its multi-tiered, wide-reaching and diversified financial institution system. The tiered structure of financial institutions in China has improved. They have made a financial service network that covers all counties across the country, and financial services at the township level and below have become much more accessible. In addition, the government has put market competition under due regulation, improving the social benefits it creates.
Fourth, China has attached huge importance to improving the institutions underpinning its financial system and made great headways, which will have profound and far-reaching implications. China continues to press ahead with the registration-based IPO reform, focusing on improving the fundamental system, no direct market intervention and zero tolerance for irregularities. As a result, the capital market has become much more resilient, functional and vibrant, establishing a new paradigm for government-market relationship in the financial sector. Douglass C. North, the prestigious institutional economist, said in his book The Rise of The Western World: A New Economic History: “Efficient economic organization is the key to growth; the development of an efficient economic organization in Western Europe accounts for the rise of the West.” This also applies to the development of China’s financial system.
Fifth, China’s endeavors to contain financial risks and reset financial market orders have paid off. After over three years’ hard work, Chinese regulators have managed to prevent and resolve major financial risks, solving a series of historical problems including financial leverage, government debts and the debts of large- and medium-sized businesses, shadow banking, non-performing loans and financial irregularities. Similar to Germany, China is also very concerned with risks associated with real estate bubbles, and sustains efforts to prevent speculation on real estate in order to stabilize asset prices. Regulators have also worked to prevent funds from circulating within the financial sector without entering the real economy.
Sixth, China has basically set up a modern framework for financial regulation. Financial regulation has become more coordinated, and regulators are more capable of holding the bottom line in prevent systemic financial risks. These explorations and progress will have fundamental and far-reaching impact on China’s financial system.
China’s economic success is largely owed to the fact that policymakers who have been practical and realistic, grounding policies on the country’s own situation while drawing from international experience, thus breaking a unique path. This is also the key to future development.
I believe we will see a financial system in China with its own characteristics and different from that of the US, the UK, Germany or Japan. It will take shape based on China’s own political, economic and cultural background, amid ongoing interplay between the market and regulators, and between finance and the real economy.
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