1 Introduction

"Structural change" is a watchword dominating many economic policy debates. Digitalisation, globalisation and demographic change are having a far-reaching impact on the economy. In this setting, a functioning financial system is a key catalyst – to finance innovation, support competition, help insure against risks and – at a very basic level – secure payment systems.

Yet one thing that is often overlooked is that the financial system itself is affected by structural change. Digitalisation and technological change affect core functions of financial intermediaries – gathering and preparing information and ultimately fostering growth and stability. At the same time, the competitive conditions in the financial system itself are changing. New providers are entering the market, existing business models are being questioned or rendered obsolete.

More competition can ultimately lead to greater efficiency. But more competition in the financial sector can also have side effects and destabilise the markets. This year’s central banking symposium in Jackson Hole therefore discussed how regulation should flank competition in the banking sector – by setting adequate requirements for institutions’ capital and safeguarding appropriate corporate governance structures in the financial sector (Corbae and Levine 2018).

Structural change in the banking sector throws up a whole host of questions. Has market concentration increased and is there less competition? What impact does this have on financial stability? Are these trends being influenced by regulation? Are uncompetitive banks exiting the market? How effective is macroprudential policy? How can policymakers support structural change in the financial system – in the banking sector, for example – without jeopardising the efficiency and stability of the financial system? What do the new technologies mean for the trade-off between efficiency and stability?

To many of these questions, there is no conclusive answer. Not least of all, we need good theoretical and empirical research to better understand these interrelationships. Today, then, I’d like to confine myself to three questions and outline possible answers.

• What does "structural change" mean in the banking sector?
• What role do new financial intermediaries play in the German financial system?
• What challenges are currently facing financial stability in Germany?

2 Structural change in the banking sector

Phases of regulation and deregulation

One of the financial system’s core tasks is to support growth and change in the real economy. At the same time, the financial system itself is undergoing a structural change. In the past, phases of deregulation in which markets were opened up were always followed by phases in which the markets were protected by capital controls and other regulation, and competition was thus suppressed (Rajan and Zingales 2003). Often, spells of isolationism were triggered by financial crises and the associated recessions (Kaminsky and Reinhart 1999).

Periods of isolationism cast long shadows. It was only in the 1980s that the previously heavily regulated banking systems of the United States and Europe were gradually opened up and liberalised. Restrictions on regional activity were lifted; cross-border business was made possible. In Europe, the First Banking Directive of 1977 allowed banks to establish branches in other Member States. The Second Banking Directive of 1989 opened up capital markets across European countries.

Empirical studies for the United States give an indication of how these changes have affected risk in the banking sector. Between 1970 and 1985, the franchise values of US banks were low; market and book values were relatively equal, and implicit government guarantees were small (Atkeson, d’Avernas, Eisfeldt and Weill 2018).[1] This pattern changed significantly between 1996 and 2007: the market values of bank equity rose sharply, banks took on more risk, and the value of implicit government guarantees increased.

This shows that bank profitability can provide only limited information about the stability of a financial system. A low or declining return on capital can, for example, reflect fierce competition. If weaker banks fail to exit the market, this supports high risk-taking overall. However, low profitability can also be a reflection of high capital levels at institutions. The implications for competition and stability can vary depending on which of these drivers dominates.

The efficiency of banks has barely changed in the past few decades (Phillipon 2015). In the United States, the costs of financial intermediation have remained broadly constant throughout the past 130 years, at around 1.5% to 2%. The situation in Europe is similar in that, as a rule, the costs of intermediation did not fall between 1950 and 2007 (Bazot 2017).

Since the 1980s, the pace of deregulation has picked up. On the one hand, this has given banks the ability to tap new markets and business lines. On the other hand, this deregulation may have turned out to be something of a boomerang. The fact that negative consequences for financial stability could emerge was underestimated. Catchwords like “systemic risk” and “macroprudential policy” barely played a role in economic policy discussions up until the financial crisis, although academic debate had certainly drawn attention to these mechanisms (Hellwig 1998).

Causes and consequences of the financial crisis

Post-crisis developments in the financial sector have been shaped by interactions between the existing framework conditions, long-term trends in the financial system, macroeconomic and financial shocks and, not least, policy responses to these.

The financial crisis ultimately revealed predetermined breaking points in the international financial system (Rajan 2011); implicit government guarantees materialised. In Germany alone, spending on support measures for banks was higher than spending on European rescue programmes – as measured by the effects on the debt level (Federal Ministry of Finance 2012). It quickly became clear that the financial crisis was not just a liquidity crisis, but that many banks and financial systems were affected structurally and had to combat solvency problems.

At the macroeconomic level, several shocks interacted in the crisis, triggering a macroeconomic crisis, which led to a decline in demand for credit and, in some regions, a sovereign debt crisis (German Council of Economic Experts 2011, Shambaugh 2012).

The structural conditions and degree of competition in the financial system have a decisive influence over how banks adapt to the new setting. Even before the crisis, some banking systems already displayed weaknesses in terms of capitalisation and profitability. The margins of German banks were already observed to be narrowing ahead of the financial crisis, for example (Hellwig 2018, Chart 1). The post-crisis adjustments therefore varied fairly widely.[2] Many banks consolidated their international operations in the wake of the crisis. Others were less affected by the crisis developments, had sufficient capital buffers, and seized the opportunity to expand into new markets.[3] Market shares were reallocated from weaker to stronger banks.

Policy responses were shaped, on the one hand, by the acute pressure to act in the crisis and, on the other, by the institutional options for dealing with banks in distress. A number of policymakers intervened early to bolster financial institutions’ capital (Borio 2016). Others took a more cautious route, possibly in the hope that the banks’ situation would improve over time as the macroeconomic recovery took its course. Regardless of which individual route was taken, the choices policymakers made back then are still shaping the competitive structure in the banking sector today.

G20 reforms

At the international level, the G20 leaders agreed on a comprehensive set of reforms in 2009 with the objective of making the financial system more resilient. One of the new requirements was for banks to hold more capital to render themselves more crisis-proof. The newly established field of macroprudential policy put the regulatory objective of safeguarding financial stability at centre stage. In Germany, the Bundesbank plays an important role in this.

At the end of the day, many of the reforms that were adopted and implemented have a direct or indirect impact on the competitive situation in the financial system. For instance, higher capital requirements for credit institutions shift market shares towards well-capitalised institutions. Reforms designed to reduce misincentives at big banks also affect competitive structures. Fewer implicit government guarantees for big banks and additional capital requirements for systemically important institutions correct existing competitive distortions.

For these measures to be effective, it must be possible even for major institutions to exit the market, just as in any other sector. That’s why the creation of resolution regimes for banks is a core component of the reforms initiated by the G20. In Europe, this was implemented in the form of the Bank Recovery and Resolution Directive (BRRD). The Single Resolution Mechanism (SRM) in the banking union is built on this directive.

Another objective of the reforms, namely to transform the shadow banking system into a resilient, market-based funding system, changes the nature of competition through non-banks.

Global developments intensify the pressure to make adjustments. Technological change and competition from “FinTech” and “BigTech” players are affecting the business models not just of banks. The question of how changes in international markets, global value chains and protectionist measures will affect the activities and stability of banks is still largely unresolved. And the development of macroeconomic framework conditions will play a role in the future structures of the financial system. Last but not least, the normalisation of monetary policy will have implications for financial institutions.

3 Structural change and new technologies in the German banking sector

The German financial sector is heavily shaped by banks.[4] At the same time, the number of banks in Germany has dropped in the past few decades (Chart 3). The concentration of the German banking sector has thus increased over time, and yet the German banking sector is more strongly fragmented than the banking systems of other G7 countries (Chart 5).

At first glance, the declining number of banks in Germany indicates strong market dynamics. While the Bundesbank’s monthly balance sheet statistics still covered around 4,000 banks in the early 1990s, this number has roughly halved since then. However, market exits mainly took place in the form of mergers (Chart 4), particularly in the savings bank and cooperative bank sector. The impact on capacity in the banking sector was thus rather small.

Previously, the number of market entries of banks lay relatively consistently in low two-digit territory. In terms of numbers, the most market entries were of foreign banks, at more than 60%. These entries barely affected capacity, however – with market shares of around 5%, foreign banks play just a minor role in Germany (CGFS 2017).

Competition and structural change are not just affected by market entries and exits on the domestic market. The margins of banks heavily involved in international business have been narrowing continually over the past few decades (Chart 1). Recently, their margins have come under added pressure owing to low interest rates, because the banks effectively do not charge negative interest on customer deposits (“zero lower bound”) to compensate for the decline in lending rates.

FinTech firms could increase competition in parts of the financial system and thus put the squeeze on margins – and they could do so by means of services such as direct lending via loan brokerage platforms (crowdlending) or the provision of investment services and asset management by robo advisors (Chart 6). Equally, however, BigTech firms such as Google, Amazon and Facebook could build on their own technology platforms to develop products and services that stand in direct competition to traditional intermediaries in the financial system. BigTech companies’ established customer base, and particularly the information that they have already gathered on their customers, is likely to be a major competitive factor in this regard. The way in which competition evolves in the German banking sector will depend crucially on how successful new technologies and competitors are in gaining a foothold in the financial system and how quickly the traditional players in the financial system can adapt to new technologies.[5] The framework in place for data protection and competition law will play an important role here.

FinTech firms can benefit the financial system if they improve innovation, efficiency and transparency, lower costs, complete markets and bring about better risk diversification. They are associated with a higher degree of automation, which lowers search and transaction costs. Established intermediaries such as banks can profit from these reduced costs. New access channels to financial services – via mobile phone, for instance – and greater recourse to data can boost the transparency of the financial system and reduce information asymmetries. In addition to impacting on competition and innovation, FinTech firms can also impact on financial stability (Deutsche Bundesbank 2016, Chart 7). They can help make the financial system more stable by improving lending and risk dispersion.

However, a higher degree of automation brought about by robo advisors in making investment decisions can also exacerbate procyclicality and promote herding behaviour if it encourages the taking of similar risk positions, for example. Another downside of FinTech firms are the risks arising from their economic functions. Where they go beyond functioning solely as brokers and interfaces to traditional intermediaries, risks typically associated with bank-like transactions are chief among those which can spark systemic risk. Such risks include those stemming from funding transactions that are highly leveraged or involve a high degree of liquidity and maturity transformation. On top of this, the growing importance of new technologies could cause operational risk to rise. This would be the case if, for instance, such intermediaries were to suffer a technical breakdown or disruption.[6]

Viewed from today’s perspective, it is barely possible to gauge how FinTech might impact on the structure of the financial system, given the early stage of innovation, an insufficient data pool and the endogenous response to the changing environment on the part of established financial intermediaries. From a macroprudential perspective, FinTech firms need to be monitored from an early stage in order to identify potential changes in incentive patterns, shifts in risk and contagion risk before they grow to systemically important dimensions. Building on this, the adequacy of the regulatory framework should be reviewed on an ongoing basis (Minto, Voelkerling, Wulff 2017). 

4 Current challenges facing financial stability in Germany

Technological innovations, together with the provision of financial services by not only FinTech firms but also BigTech companies, spells structural change for the financial sector. Existing business models could be called into question. Measured by size, however, the key players in the German financial system tend to be traditional participants such as banks and insurers (Chart 2). As a result, they remain the focal point for macroprudential policy.

Structural change and competition can give rise to financial stability risks if financial institutions do not have sufficient capital buffers in place to absorb shocks. But looking at one sub-sector of the financial system in isolation is not enough to identify risks to financial stability. A macroprudential, system-wide view of the overall financial system is needed. Both large banks, which are exposed to misincentives and take on too much risk (too big to fail), and many smaller banks, which are exposed to similar risks at the same time (too many to fail), can destabilise the system.

The body responsible for financial stability in Germany is the Financial Stability Committee consisting of representatives from the Federal Ministry of Finance, which acts as chair, the Bundesbank and the Federal Financial Supervisory Authority (BaFin). The Committee presented its latest report to the Bundestag in June 2018 (Financial Stability Committee 2018).

The starting point for the analysis of stability risk in this report is the current favourable economic setting in Germany: the country’s economy has been expanding for nine consecutive years now. This is the longest period of upswing since German reunification. According to the Bundesbank’s latest projections, the economic boom will continue, with gross domestic product rising by 2% this year and 1.9% next year (Deutsche Bundesbank 2018).

Favourable economic conditions in Germany and Europe are encouraging the interest rate level to rise. What this means is that, assuming the economy does indeed follow its expected path, the risks to financial stability will probably be limited.

However, a resilient financial system should also be equipped to deal with negative scenarios. If economic conditions take an unexpected turn for the worse, if there is an unforeseen downturn in real economic momentum and interest rates remain low – and close to zero – for even longer, or if there is a spike in risk premiums in financial markets, unexpected risks could arise.

But the longer booms persist, the greater the inclination to extrapolate them into the future. In their search for yield, investors can underestimate risk, form overly positive expectations regarding macroeconomic developments and be too poorly prepared for possible asset price corrections. Given the current favourable conditions, there is a danger that market participants are not holding sufficient capital to absorb future losses. In such a situation, many market participants would be blindsided by a sudden economic slump, rendering its effects all the more acute.

German banks have improved their resilience and built up their capital bases since the financial crisis. However, market participants’ expectations are adapting in light of the favourable economic environment. Furthermore, banks could dismiss high-loss scenarios such as an abrupt hike in interest rates. In recent years, for instance, the percentage of new loans issued by banks with long interest rate fixation periods has risen significantly. Many banks are similarly vulnerable to such a scenario – the interest rate risk is too high. Additionally, the risk models of larger banks with the potential to pose a systemic risk currently incorporate crisis periods with cyclical downturns and correspondingly higher loan default rates to an only limited extent. Bundesbank analyses suggest that these banks might not have sufficient capital to cover the losses incurred in the wake of an extreme event – an unforeseen economic slump, say. Lastly, the value of loan collateral in real estate financing could be overstated. For example, borrowers and lenders might not give adequate consideration to overvaluations on the housing market when calculating the mortgage lending value of real estate collateral. If the value of loan collateral is overstated, the risk of banks facing losses in the event of loan defaults rises.

Assessing the risk situation on the real estate markets is also still hampered to a significant extent by the lack of systematic data. It is impossible to gauge using the official statistics available how mortgages are secured, the level of risk associated with financing models, and how German banks’ lending standards have evolved across the banks.

5 Conclusion

Competition in the financial sector can have a positive impact on efficiency. At the same time, bank can take on greater risks, thereby jeopardising the stability of the system. The theoretical and empirical literature provides no clear indication as to whether the correlation between competition and financial stability is positive or negative (Freixas and Ma 2014). Current research suggests that greater competition may have a destabilising effect, making it necessary to have an adequate level of regulation in place (Corbae and Levine 2018). From a financial stability perspective, the debate should not be misinterpreted as an appeal for less competition. Instead, it is about identifying the root causes of systemic risk that may become much more apparent, particularly amid fierce competition.

Technological change is a major driver of competition and stability. As things currently stand, it is not clear what form the technologically transformed financial system of the future will take, or whether FinTech and BigTech will play an important role in it. Up to now, traditional financial intermediaries such as banks, insurers and investment funds have dominated the German financial system, but competitive processes could be disruptive. In addition, the financial market reforms of recent years will give rise to shifts in the competitive structure. Banks that have previously benefited from (implicit) government guarantees will likely see their market shares shrink. Institutions lacking a sustainable business model will, like every other enterprise in their position, ultimately be forced to exit the market.

All the more reason, then, to ensure that the banking sector as a whole can withstand headwinds. A key prerequisite in this regard is that it has sufficient capital. Higher capital levels yield competitive advantages, as they make it possible to finance investment and innovations while simultaneously serving as protection against risk. The German economy is currently in good shape. It is precisely while the going is good that the financial system should prepare itself to ensure that, when the situation takes a turn for the worse – in the event of a cyclical downturn, for instance – it remains able to exercise its key economic functions. At the end of the day, economic models cannot fully gauge future global risks, economic risks, or technological changes and their implications for the financial sector. We need to take this model uncertainty into account when assessing financial stability.

List of references

• Atkeson, Andrew G., Adrien d’Avernas, Andrea L. Eisfeldt and Pierre-Olivier Weill (2018). Government Guarantees and the Valuation of American Banks. National Bureau of Economic Research, June 2018. Cambridge, MA.
• Financial Stability Committee (2018). Fünfter Bericht an den Deutschen Bundestag zur Finanzstabilität in Deutschland. June 2018.
• Bazot, Guillaume (2017). Financial Consumption and the Cost of Finance: Measuring Financial Efficiency in Europe (1950-2007). Journal of the European Economic Association, 16(1): 123-160.
• Borio, Claudio, Lombardi, Marco and Fabrizio Zampolli (2016). Fiscal Sustainability and the Financial Cycle. BIS Working Papers No 552, March 2016. Bank for International Settlements, Basel.
• Buch, Claudia M. and Linda Goldberg (2017). Cross-Border Prudential Policy Spillovers: How Much? How Important? Evidence from the International Banking Research Network. International Journal of Central Banking, 13(1): 505-558.
• Federal Ministry of Finance (2012). Monthly Report. April 2012.
• Committee on the Global Financial System (CGFS) (2017). Structural changes in banking after the crisis. Bank for International Settlements. CGFS Paper 60. Basel.
• Corbae, Dean and Ross Levine (2018). Competition, Stability, and Efficiency in Financial Markets. August 2018. Mimeo.
• Deutsche Bundesbank (2016). Financial Stability Review. November. Frankfurt.
• Deutsche Bundesbank (2017). Financial Stability Review. November. Frankfurt.
• Deutsche Bundesbank (2018). Monthly Report, June 2018. Frankfurt.
• Financial Stability Board (FSB) (2017). Financial Stability Implications from FinTech. Basel.
• Freixas, Xavier and Kebin Ma (2014). Banking Competition and Stability: The Role of Leverage. CEPR Discussion Papers No 10121, August 2014. Centre for Economic Policy Research, London.
• Hellwig, Martin (1998). Banks, Markets, and the Allocation of Risks. Journal of Economic Theory, 67: 299-326.
• Hellwig, Martin (2018). Germany and the Financial Crises 2007-2017. Annual Macroprudential Conference, June 2018. Sveriges Riksbank, Stockholm.
• Kaminsky, Graciela L. and Carmen M. Reinhart (1999). The Twin Crises: The Causes of Banking and Balance-Of-Payments Problems. American Economic Review, 89(3): 473-500.
• Minto, Andrea, Moritz Voelkerling and Melanie Wulff (2017). Separating Apples From Oranges: Identifying Threats to Financial Stability Originating from FinTech. Capital Markets Law Journal, 12(4): 428-465.
• Philippon, Thomas (2015). Has the US Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation. American Economic Review, 105(4): 1408-1438.
• Rajan, Raghuram G. (2011). Fault Lines: How Hidden Fractures Still Threaten the World Economy. Princeton University Press.
• Rajan, Raghuram G. and Luigi Zingales (2013). The Great Reversals: The Politics of Financial Development in the 20th Century. Journal of Financial Economics, 69(1): 5-50.
• German Council of Economic Experts (2011). Jahresgutachten 2011/12. Wiesbaden.
• Shambaugh, Jay C. (2012). The Euro’s Three Crises. Brookings Papers on Economic Activity, 43(1): 157-231.

Footnotes:

1. Similar studies of German banks are restricted by the fact that only a comparatively small proportion of German banks are listed on the stock markets.
2. For a detailed discussion of the structural adjustments at banks globally, see the report of the Committee for the Global Financial System (CGFS) based at the Bank for International Settlements (BIS): https://www.bis.org/publ/cgfs60.htm
3. See Buch and Goldberg (2017).
4. This includes central banks, banks, building and loan associations and money market funds.
5. The following remarks are based on information taken from the Bundesbank’s Financial Stability Review (Deutsche Bundesbank 2017). They are also derived from the findings of a working group of the Financial Stability Board (FSB 2017).