The importance of intragroup funding – 19th century US vs. modern Germany

I recently explained the importance of intragroup liquidity and capital flows to prevent or help solve financial crises and why new regulations are weakening banks, and showed the inherent weakness in the design of the 19^th century US banking system. Today I wish to highlight the similarities, and more importantly, the differences, between the 19^th century US banking system and the modern German banking system.

As previously described, the peculiar US banking system had a multitude of tiny unit banks that were not allowed to branch, with very little financial flows and support behind them (at least until they started setting up local clearinghouses). By 1880, there were about 3,500 banks in the US, meaning about 1 bank for 14,000 people. Nowadays, there are about 1,800 banks in Germany, meaning one bank for 45,000 people. Germany’s banking system isn’t as fragmented as the 19^th century US one, but it is still very fragmented by developed economies’ standards.

By comparison, in the UK, there is one bank for 410,000 people, though most banks have no retail banking market share, meaning this figure is probably way overestimated (my guess is that there is actually one bank for about 3m people). In Germany though, most banks have a retail banking market share: the banking system is divided between the large private banks (which actually don’t account for much of the local retail market share and focus mostly on corporate lending and investment banking), the cooperative banks group (the Volksbanken and Raiffeisenbanken, representing around 1,200 small retail banks), and the savings banks group, the largest banking group in Germany (the Sparkassen-Finanzgruppe, representing slightly less than 450 retail banks).

Those Sparkassen, for instance, cannot compete with each other and cannot branch out of their local area, making both their loan books and funding structures highly undiversified, with restrictions very similar to those that applied to 19^th century US banks. Moreover, many of those banks have relatively small capital and liquidity buffers, at least compared to the US banks. Nevertheless, the Sparkassen have demonstrated remarkable resilience over time, experiencing very few failures (all have been bailed out). How to explain this?

First, all Sparkassen depend on local Landesbanks, which, quite similarly to clearinghouses in 19^th century US, play the role of local central banks, moving liquidity around according to the needs of their Sparkassen members. This process alleviates acute liquidity crises. But this isn’t enough to avert regional crises or national, systemic ones.

Second, the Sparkassen rely on another mechanism: several regional and interregional support funds that allow healthy banks to recapitalise or provide liquidity to endangered sister Sparkassen. Those support funds can be complemented by extra contributions from healthy Sparkassen if ever needed. This mechanism is akin to some sort of intragroup funds flows*.

Here we go: instead of insulating each bank, raising barriers to allegedly make them more resilient, the Sparkassen allow funds to circulate when needed. They understand that the actual failure of one of their members would have catastrophic ramifications for the rest of the group (and for their shared credit rating). It is in their best interest to mutually support each other. But guess what? Some Sparkassen now fear that European regulators will take action to make such intragroup mutual support flows illegal…

* The Volksbanken have a relatively similar structure and intragroup support mechanism, though there are differences. Both groups are also actively involved in intragroup peer monitoring, which is important to limit moral hazard.