1. The German Banking Market: Structural Policy Guidelines MANAGERKREIS DER FRIEDRICH-EBERT-STIFTUNG 1.1 The necessity of state intervention in the banking market The banking sector needs a different regulatory framework from other sectors of the economy, because the possibility for actors to be“punished” by exclusion from the market is very limited or non-existent. Adequate transparency and state supervision of risk are therefore essential: • Risks must be recognisably accounted and not be removed from bank balance sheets. • The regulatory framework must set proper incentives for sensible and productive behaviour in the markets. Sweeping deregulation of the financial markets turned out to be a boomerang. So deliberately creating international financial conglomerates and breaking open traditional banking structures cannot be the way forward for structural policy. 1.2 Preserve pluralist structures in the banking sector The German three-tier banking system(state-run, private and co-operative banks) has demonstrated its resilience and represents a significant competitive advantage for Germany. It prevents herd behaviour in the markets and strengthens competition. The crisis-resistance of the German savings banks shows that it remains imperative to have a public-sector banking system in local authority ownership. But within the public-sector banking system the business orientation of the state banks (“Landesbanken”) needs to be reconsidered. Capital market speculation on their own account cannot be their primary business strategy. The raison d’être of state banks is to supply credit to regional SMEs together with the savings banks. 1.3 Tackle the risks of system-relevant banks Banks that are“too big to fail” expose the state to blackmail and distort the economy as a whole. In a crisis there is de facto no alternative to intervention and support; this restricts the state’s fiscal options and especially leads to neglect of state investment needed in the wider economy. Both at the fiscal level and the market level“too big to fail” produces system-destabilising risks: • Excessive risk-taking: The expectation that a large credit institute will receive state support if things go wrong can lead to excessive risk-taking. This implicit state guarantee tempts management to enter into greater risks than if the bank were expecting to bear all risks and losses itself(moral hazard). • Distortion of refinancing costs: Because of the implicit state guarantee for big banks the effective return – that should be tied to the risk class of the investments – becomes almost independent of the actual risk associated with the financial business conducted by the bank. As a consequence, big banks have lower refinancing costs than smaller institutions in any given risk class. 2