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«FESSUD FINANCIALISATION, ECONOMY, SOCIETY AND SUSTAINABLE DEVELOPMENT Working Paper Series No 26 Financial Market Regulation in Germany Capital ...»

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This project is funded by the European Union under

the 7th Research Framework programme (theme SSH)

Grant Agreement nr 266800

FESSUD

FINANCIALISATION, ECONOMY, SOCIETY AND SUSTAINABLE

DEVELOPMENT

Working Paper Series

No 26

Financial Market Regulation in Germany Capital Requirements of Financial Institutions

Daniel Detzer

ISSN: 2052 8035 This project is funded by the European Union under the 7th Research Framework programme (theme SSH) Grant Agreement nr 266800 Financial Market Regulation in Germany - Capital Requirements of Financial Institutions Daniel Detzer Institute for International Political Economy, Berlin School of Economics and Law This paper examines capital adequacy regulation in Germany. After a general overview of financial regulation in Germany, the paper focuses on the most important development in the area of capital adequacy regulation from the 1930s up to the financial crisis. Two main trends are identified: a gradual softening of the eligibility criteria for regulatory equity and the increasing reliance on banks’ internal risk models for the determination of risk weights. The first trend has been reversed with the regulatory reforms following the financial crisis. Internal risk models still play a central role. The rest of the paper focuses on the problems with the use of internal risk models for regulatory purposes. The discussion includes the moral hazard problem, the technical problems with the models, the difference between economically and socially optimal capital requirements, the procyclicality of the models and the problem occurring due to the existence of fundamental uncertainty. The regulatory reforms due to Basel 2.5 and Basel III and their potential to alleviate the identified problems are then examined. It is concluded that those cannot solve the most relevant problems and that currently the use of models for financial regulation is problematic. Finally, some suggestions of how the problems could be addressed are given.

Key words: Banking Regulation, Financial Regulation, Capital Requirements, Capital Adequacy, Bank Capital, Basel Accord, Risk Management, Risk Models, Germany Date of publication as FESSUD Working Paper: February 2014 Journal of Economic Literature classification: G18, G28, N24, N44 This project is funded by the European Union under the 7th Research Framework programme (theme SSH)

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Contact details: Daniel.Detzer@hwr-berlin.de; Badensche Straße 52, 10825 Berlin

Acknowledgments:

The research leading to these results has received funding from the European Union Seventh Framework Programme (FP7/2007-2013) under grant agreement n° 266800.

For helpful comments I would like to thank Andreas Audretsch, Natalia Budyldina, Nina Dodig, Trevor Evans, Eckhard Hein, Hansjörg Herr and Barbara Schmitz. Remaining errors are, of course, my own.

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1 Introduction Since the beginning of the financial crisis in 2007 Germany has experienced a series of problems in the banking sector unseen for decades. Massive government intervention causing high costs to the public wallet was used to contain a more severe crisis. Similar interventions were also necessary in a range of other countries. The financial crisis not only unveiled serious weaknesses in the supervision and regulation of the financial sector, but also revealed substantial flaws in financial institutions’ internal risk management and governance structure. A major problem was the severe undercapitalisation of banks prior to the crisis. Therefore, capital adequacy was central in the debate on the crisis and major reforms in this area will be initiated with Basel III. Capital requirements have a long tradition in the banking regulation of Germany. While for many countries capital requirements were first adopted in the 1970s (Krahnen and Carletti 2007), in Germany such regulation had already been introduced in the 1930s. This paper will review the capital requirement regulation in Germany from a historical perspective, whereby it will identify general trends and point out some severe problems associated with the current approaches in regulation. To give the reader some background information, a general overview of the regulatory framework for banks and financial markets in Germany is presented. Thereafter, the focus will be on capital requirements. First, a short overview of the theoretical justifications for capital regulation is given. Then, the development of regulatory capital requirements in Germany before the financial crisis is examined in detail and its most important trends are highlighted. These include the gradual softening of the eligibility criteria for regulatory equity, and the reliance on internal risk models for the determination of risk weights. While the former trend has been reversed after the crisis, the latter is still pursued. Therefore, the problems inherent to internal risk models to determine capital requirements will be discussed. The changes due to Basel 2.5 and Basel III in this area and their potential to address the identified problems will be examined. The paper concludes with an outline of the implications for capital adequacy regulation.





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2 A general overview of financial regulation in Germany In Germany, banking regulation was established relatively late during the banking crisis in 1931 when Chancellor Brüning established it by emergency decree. In 1934 the Law of the German Reich on Banking (Reichsgesetz über das Kreditwesen) was implemented which put all credit institutions under supervision. The Banking Act (Gesetz über das Kreditwesen) established in 1961, which is still the central law governing banking today, was based on this law (Lütz 2002, pp. 116 – 33). The law organised the Federal Banking Supervisory Office (FBSO, Bundesaufsichtsamt für das Kreditwesen) as the new supervisory authority on a federal level. It was central to the German banking regulation that it was restricted to set certain standards, like liquidity or capital requirements, but that direct intervention into banks’ business decisions remained limited. Limits on banking activities, portfolio composition, interest rate regulations or branching restrictions were not important or were abolished much earlier than in other countries (Detzer et al. 2013, pp.

115-36).

Germany always followed the universal banking principle; hence, there are only few restrictions on the types of financial service activities banks can pursue. At the same time the Banking Act has a very encompassing definition of banking so that many financial service activities, not regarded as banking in many other countries, have been monopolised by the banking sector. This limits the development of non-bank financial actors to certain restricted areas (building and loans, insurance, securities industries) that are governed by special laws. Due to their restrictions on assets and liabilities, those actors are not competing with the main business areas of the banks. This encompassing regulatory framework limited regulatory arbitrage and the development of a shadow banking system (Vitols 1995).

While banking was regulated tightly, financial market regulation was underdeveloped.

Security exchanges were organised regionally and were largely self-regulating. The formal supervisory authority was the respective German states (Länder), which pursued a policy of

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non-interference (Lütz 2002, pp. 79-89). The regulatory framework was characterised by a lack of transparency and accountability, low protection of minority shareholders and no binding rules against insider trading. Additionally, German accounting rules were geared towards creditor protection (Detzer et al. 2013). Capital markets were dominated by the big banks, which had a strong position in most of the self-regulating bodies of the German exchanges. Their power allowed them to stabilise the regional structure by distributing business among the different exchanges. The corresponding higher costs had to be borne by the customers in the form of higher fees and commissions (Lütz 2002, pp. 79-89).

Prior to the 1990s the regulatory framework remained relatively stable. The stability of the existing system was supported by the big banks and the Bundesbank. The big banks had lucrative businesses in providing long term finance to large German corporations and were, therefore, not interested in a change of the existing framework (Lambsdorff 1989).

The Bundesbank resisted liberalisation and the introduction of many financial innovations due to monetary policy concerns. The main regulatory changes during this time were due to weaknesses in the existing framework discovered during crises occurring in single institutions, like the default of the Bankhaus Herstatt in 1974 or the near default of the Bankhaus Schröder, Münchmeyer & Hengst due to large loan losses (Detzer et al. 2013, pp.

115-36).

Two main trends starting in the 1970s had major impacts on the German system of financial regulation. Within Germany the support of the bank-based system through the big banks decreased. Traditionally, there were strong links between the big banks and the large German industrial companies. Financial institutions formed the core of a dense network of cross-shareholdings among the big German corporations. Additionally, those financial institutions were members of many supervisory boards. By acting as house banks for those large firms and by providing long-term and stable financing to them, the big banks occupied a profitable field of business (Detzer et al. 2013, pp. 73-91). However, since the 1970s the demand of big firms for external finance declined. Lower fixed investment compared to the post-war years and high retained earnings in the non-financial corporate sector were the main reasons. Additionally, international banks as well as the

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Landesbanken, which are the head organisations of the savings banks, started to compete for business with the big banks. Simultaneously, the big firms increased their financial independence from the banks overall by establishing their own finance departments or inhouse banks and by increasingly using financial markets directly to acquire external finance (Deeg 1999, pp. 73-122). Initially the big banks tried to increase their business with small and medium sized companies, but then focused on pushing for the development of security markets, where they could earn fees instead of interest income. Their efforts took the form of the initiative “Finanzplatz Deutschland” (Germany as a financial center). Big German firms and the German government both supported this initiative (Perina 1990).

Those efforts led to major changes in German financial regulation, particularly in securities and securities market regulation. The authorisation of new financial innovations started in the 1980s. The following four financial market promotion acts between 1990 and 2002 increased investor protection and criminalised insider trading and allowed new financial actors like money market funds and later hedge funds to evolve. It also set the regulatory framework for a market for corporate control. To sum up, the regulatory structure was changed in such a way that it got more favourable for the development of financial markets (Deeg 1999, pp. 73-122).

At the same time attempts to coordinate and harmonise financial regulations at the level of the European Economic Community (EEC) as a whole impacted the German system of financial regulation. Starting in 1977, directives were released to gradually harmonise regulatory frameworks among member states and to create a single market for financial services. Starting with the First Banking Co-ordination Directive (77/780/EEC) minimum licensing requirements were established. After only minor impacts on the EEC-level in the areas of consolidation and accounting rules were observed other major steps were taken and presented in the form of the Second Banking Coordination Directive which had to be fully implemented until 1992. It introduced the European Passport for banks. It allowed a licensed bank in one member state to conduct business in any of the other member states, while supervision remained in the responsibility of the home country. This required a further harmonisation in other areas. Hence, parallel to the implementation of the

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European Passport capital requirements were harmonised on the basis of Basel I.

Subsequently, many directives adopted similar measures in a range of areas such as large exposure rules, investment services, deposit insurance, financial conglomerates and crisis management and only a few fields in banking and financial market regulation remained purely national (Heinrich and Hirte 2009).

3 Theory of capital requirements

In banking regulation capital requirements are one of the main regulatory tools and the discussion about their appropriate size and application gained new prominence in the aftermath of the financial crisis. Allen and Gale criticised the fact that the development of financial regulation was based on an empirical process – a process of trial and error – rather than on formal theory. For capital requirements there is no commonly agreed theoretical basis. However, there are different theoretical ideas and a range of intuitive arguments that enrich the general discussion (Allen and Gale 2002).

In a hypothetical world where financial markets are complete, so that depositors are perfectly informed about risks and failure probabilities of banks, the Modigliani-Miller indeterminacy principle would apply and the market value of banks would be independent of their capital-asset ratio. If a bankruptcy cost is introduced, banks would choose an optimal asset composition spontaneously so that failure would not occur. This is due to market discipline. Perfectly informed creditors and depositors would demand higher returns when the risk increases. In such a world regulatory capital requirements would not be needed (Freixas and Rochet 2008).



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