The Revival of State Banking in Europe

by Alexander Fink[1] 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)[2]. 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.

 

[1] Alexander Fink is a Lecturer at Leipzig University and a Senior Fellow with the Institute for Research in Economic and Fiscal Issues (IREF).
[2] These authors welcome the revival of state banking.

2 thoughts on “The Revival of State Banking in Europe

  1. Reflections on „The Revival of State Banking in Europe“

    Reading the above mentioned article, I like to take the cudgels on behalf at least KfW by correcting some misleading conclusions.

    I share with the authors the unease of the sheer size and the dominante position most of the public banks in Europe have achieved during the last century, but like to point out why KfW might be in some respect unique in ist role as a promotional bank and has considerably paid attention in setting up an organizational model to prevent market distortion and is changing the competitive landscape of the banking sector in Germany / Europe.

    KfW was founded 1948 as a part of the Marshall-Plan to help „reconstruct“ Germany after WWII (KfW means literally „Bank for Reconstruction“) as an instrument of the German State to rebuild the economy and support companies, municipalities as well as private individuals, KfW was based on a special law and not by definition a bank.

    The core of the promotional bank is the distribution of subsidised financing by a precisely defined program enacted and guaranteed by the state (outlining the eligibility of the creditor as well as the social effects for the community) and spread this financing not directly but through the banking system where every bank can get refinancing for customers, which are eligible under the program. As a result, there is no distortion of the banking system because KfW is using the existing banks not short-cutting them. Examples of such financings are student loans, loans for energy efficiency, R&D-Loans for mid-sized companies, etc.

    The article mentioned KfW’s involvement in financing housing construction: These programs focus on energy efficiency and social housing – which are important tasks on the way to a low-carbon economy in combination with smart cities and living.

    In other business segments as VC / Start-up financing and Corporate Structured Finance, KfW can only act as a minority stakeholder / co-financier – so that it might support the project but not distort competition – and it is done carefully only in segments, where financing is scare and effects on the future competitive landscape of Germany will be significant.

    IPEX-Bank is mentioned in the article as well. In this context it is worth to recall, that IPEX is a „real“ bank (supervised by the BaFin, paying taxes, etc.) and is allowed to compete against other banks – nevertheless, it has a well defined „mission“ to focus on business to support German as well as European (non-discrimination-rule) companies in their export business and by financing projects with a significant German content. IPEX is an akronyme and stands for International Project and Export Finance.

    By competing against other private banks, IPEX can rely only on the rating of its credit portfolio (i.e. not on parent support) and at these market rates refinance itself by the treasury department of KfW. This „peer-group-analysis“ is checked internally as well as externally by the auditors and therefore no „subsidized refinancing“ can be used in competing against other banks. As a result IPEX is not invalidating competition but is winning a deal because of an industry-focussed as well as project-orientated business strategy which is valued by its customers. On the other side, there is the „mission“ where people at IPEX are performing beyond average because they believe in what they are doing and that there is a raison d’etre of the company, the project and the work to be done.

    In my view the question is less the size of KfW’s balance sheet it is more its ability to forsee and adopt new trends in societies and support ideas as well as technology in financing them which enables us to accomplish a better and sustainable life – globally. And this mission is more than just a bank job, it is rather spearheading the transmission of our society as a platform between the government, the society and the private business sector . . . and provide financing 😉

  2. Dear Harald Zenke,

    thank you for your reply.

    I agree that KfW’s organization may be better than that of other state banks. But KfW also funds other state banks like Spain’s ICO which makes things a little messier.

    When writing “eligible projects” we were not concerned with whether or not KfW stays within its legally defined mission, which you outline so eloquently. I am sure there are lawyers that oversee that. Our concern is if the activities of state banks are helpful in repairing relevant market failures, which is the central idea behind having them in the first place:

    Let me, first, reply to some of the examples you mentioned. It is true that other banks extend KfW loans to customers. Yet, they are subsidized loans and affect certain sectors as we mention. There are warnings of too much housing support by the KfW. Banks’ mortgage business may grow over-proportional in certain segments. In the US, such loans contributed to a housing crisis not so long ago.

    Moreover, we have a hard time in understanding which market failures might be corrected by subsidizing BMW, Germany’s export industry or the financing of modern penthouses. If anything, this smells like industrial policy outside the central government budget. IPEX certainly benefits from KfW’s rating and access to capital. Therefore, KfW’s IPEX does distort the market for financing the growing export sector. Not sure how this repairs any market failures. I do not share your assumptions about the work ethics at IPEX relative to other banks.

    Second, and more importantly, you are right in saying that the “question is .. more its ability to foresee and adopt new trends in societies”. No single entity is better at singling out future industries and trends than the market process. Political interference makes things even worse for state banks. I have strong doubts Hayek’s famous Pretense of Knowledge argument was understood by those in charge.

    Therefore, I respectfully disagree with your notion that our conclusion needs correction.

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