German Public Banks, Financial Competition, and Crisis: Institutional Change in German Banking and Financial Vulnerability Before the Global Financial Crisis

Abstract

This paper asks why Landesbanks, public banks designed to provide credit to German firms in regions underserved by private banks, embraced risky asset and liability balances in the years before the Global Financial Crisis, and subsequently lost billions of dollars in write-downs after the US subprime mortgage bubble burst in 2007. It argues that the German government’s decisions to eliminate protections for Landesbanks increased competitive pressure for public banks, increased the propensity for those banks to adopt risky strategies in order to maximize profits. These actions by Landesbanks and large private banks exposed German households and firms to greater risk and financial vulnerability, and indirectly exposed European financial systems to subprime mortgage risk. It uses balance sheet analysis for different sectors of German finance to show that Landesbanks and Germany’s large private banks adopted higher risk asset and liabilities, engaged in more international activity, and shifted from lending to security acquisition while competing for profits, while Sparkassen, small public savings banks, did not adopt such risky strategies, and successfully shielded German households and small businesses from credit market spillovers following the Global Financial Crisis. The paper contributes nuance to debates about whether public banks are beneficial institutions to promote, and shows that Landesbanks’ failures stemmed from external pressures for them to increase their profits, which increased financial and economic instability in Germany and beyond.