by Alexander Fink and Andreas Hoffmann
Since 2009, the role of government in banking has increased substantially in Europe. This is, first, a consequence of capital injections or bailouts of private banks (for instance Dexia in Belgium, Royal Bank of Scotland in the UK, Hypo Real Estate and Commerzbank in Germany, Fortis in the Benelux, ABN Amro in the Netherlands, or Allied Irish Bank in Ireland). Second, the ECB has taken on a more dominant role in financial markets. And third, low-interest rates and mounting EU regulation seem to discourage private bank lending. Whereas private banks de-leverage and roll back their portfolios in the absence of great opportunities, so-called development banks substantially gain market share. This is odd and worrisome at the same time.
Development banks are flourishing all over Europe. Backed by bailout guarantees and outside the standard regulatory framework, public development banks like the KfW (Kreditanstalt für Wiederaufbau, Germany) or the ICO (Instituto de Crédito Oficial, Spain) have aggressively expanded since 2009 (Monnet, et al., 2014). The German KfW now challenges Commerzbank for second largest German bank in terms of assets. Ten years ago, Commerzbank was still twice the size of KfW. As the profits as well as social benefits of development banks are euphorically reported on, some countries that previously did not have a major development bank like Portugal (2014) founded one.
The idea behind development banks is: they finance companies that otherwise would not be granted loans but are most likely to be profitable in the long run or companies that contribute to economic development. Hence, development banks shall remedy identified cases of market failure by improving access to the capital market for select companies and promising industries.
And there is the problem. Even the most benevolent social planner is not capable of identifying relevant market failures and future industries. Additionally, if we consider that the respective agenda of leading politicians influences the investment policy of development banks, our confidence in their ability to spot the correct investments should weaken even more. History has shown and common sense tells us that resources are not put to their best use when the working of the competitive market process is undermined by government interference. Politically influenced misjudgments may lead to high recurring subsidies or a painful reallocation of resources in the future.
There is some evidence of this. Explicit and implicit government guarantees give development banks a competitive advantage over their private counterparts. Due to the guarantees, development banks (and their subsidaries) are able to raise equity and debt at lower costs than other banks. Services therefore may be offered at lower costs. Customers may move away from private banks, even in cases where no apparent market failure exists. For example, the clients of the export financing business of Ipex, a subsidiary of KfW, include well-known companies such as BMW and United Airlines. These companies should have no difficulties in getting loans from other private banks for profitable projects.
Moreover, development banks subsidize companies and sectors that do not seem to fit the profile of eligible projects (for example housing construction). In doing so, they do not solely influence the allocation of resources across industrial sectors, but change the composition of credit portfolios toward supported industries. Consequently, industry-specific shocks may have larger consequences.
In sum, it is rather likely that in the name of public improvements considerable risks have been accumulated in the balance sheets of public banks without appropriate provisions in their home countries’ governments’ budgets. Instead of praising the increase in their business activity, the questionable influence of development banks on the allocation of resources and the resulting risks for taxpayers should be a matter of concern.
 Alexander Fink is a Lecturer at Leipzig University and a Senior Fellow with the Institute for Research in Economic and Fiscal Issues (IREF).
 These authors welcome the revival of state banking.