The Future of Banking – Between Markets and Institutions

Klaus-Peter Müller
President of the Association of German Banks and Chairman of the Board of Managing Directors of Commerzbank AG

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WHU – Otto Beisheim School of Management, Campus for Finance, Vallendar, January 12, 2007

Ladies and gentlemen,

I’m delighted to have the opportunity once again to be here with you today. The Campus for Finance has become something of an institution in recent years. And Professor Rudolf and his team invariably succeed in bringing together a panel drawn from the political, academic and business communities for a lively exchange of views.

When we were discussing the issue of securitisation at last year’s Campus for Finance, I quoted Charles Darwin and his principle of the survival of the fittest. Allow me to revisit this concept because I believe the future of banking will be an evolutionary rather than a revolutionary process. This goes for the banking business itself as well as for the markets and related institutions.

But who are “the fittest”? According to Darwin, “It is not the strongest, nor the most intelligent who survive, but those most responsive to change”.

In today’s language, neither body building nor improving your I.Q. will be enough to master the future. This suggests that the ability to change is an essential condition for success in mastering future challenges. And globalisation is not just a catalyst for development, it’s also a magnifying glass bringing any flaws in the market into painfully clear focus.

The competition triggered by increasing globalisation is already forcing the banking industry to make continual adjustments. In banking especially, geographical barriers are becoming less and less important.

But the banks cannot tackle all the changes that are needed on their own. Let me be quite clear: it is up to policymakers and regulators to create the right environment in which to establish a competitive financial centre. Wrong decisions and delays can quickly result in innovative markets taking root elsewhere. In the words of Benjamin Franklins: “You may delay, but time will not”.

Ladies and gentlemen, I’d like to illustrate how important the interaction between market participants and institutions is for the future of a financial centre by considering three examples: our German domestic market, the European financial market and finally the global market.

I.
Germany as a financial centre
Let’s start with a look at Germany’s position as a financial centre. The German banks have made good progress in recent years. Average return on equity in 2005 was almost double that in the previous year. But this is no reason for complacency. With an ROE of 13%, Germany still lags far behind other countries in the European Union. The average ROE before tax in the 25 “old” member states is 21%.

One of the reasons for this gap is that the German market undoubtedly remains too fragmented compared to its international counterparts. The five biggest banks in Germany have a combined market share of only 22% – the lowest in Europe. In countries such as Belgium, the Netherlands or Finland, by contrast, the five biggest financial institutions share over 80% of their domestic market.

The three pillars hamper modernisation
This situation is due first and foremost to Germany’s rigid banking system with its three distinct groups, or “pillars”. The public sector still owns over 40% of the German banking market. True, it is possible for public-sector banks to acquire private ones – and indeed they do so. But by law – that is to say because of political decisions – this cannot happen the other way around.

These structural barriers are a major reason why the German banks, despite their notable success in restructuring, are still languishing at the bottom of the European league table for profitability.

And this notwithstanding the fact that numerous institutions – such as the International Monetary Fund, the European Central Bank and the OECD – have been saying for years that a market-driven modernisation process and a dismantling of the current compartmentalisation would bring new momentum to both the German banking market and the economy as a whole.

“The three-pillar system is probably better at preserving the old than encouraging the new. But can Germany afford not to have a vision of how its banking markets should develop over the next 15 years? The point, ultimately, is to organise the system in such a way as to promote sustained higher growth and not to help one particular group or hinder another.”

These aren’t my words, ladies and gentlemen, but the view of Beatrice Weder di Mauro, professor of economics and member of the Sachverständigenrat, Germany’s independent Council of Economic Experts.

And it’s perfectly true: we need a clear vision of Germany’s future as a financial centre. Almost all experts agree that there should be less state involvement and more emphasis on market forces. But this cannot happen without changes to the rigid savings banks acts in the Länder. Conditions need to be put in place which will enable public-sector banks to be privatised. The formation of nominal capital is an important step in the right direction. But further steps must follow.

The German government and the European Commission managed to reach agreement at the end of last year on another controversial issue: Section 40 of the German Banking Act. Fortunately, this has spared Germany the burden of proceedings before the European Court of Justice during its EU Presidency. The agreement provides for the name “Sparkasse” to carry on being used by a new owner even if it is a private one. This will benefit Germany as a financial centre because it means Section 40 is no longer an obstacle to the privatisation of our savings banks.

Ladies and gentlemen, it is to be welcomed that German policymakers have recognised the importance of the financial markets.

Germany’s governing parties have for the first time devoted a specific section to the financial markets in their coalition agreement and have made strengthening Germany’s position as a financial centre one of their key objectives. One of the measures mentioned in the agreement is revising existing rules for private equity by turning the Act on Equity Investment Companies into a Private Equity Act.

Given the growing importance of private equity – especially for German small and medium-sized companies – these plans send out the right signals. We need an internationally competitive operating environment to further strengthen this key segment in Germany. Words must now be followed by action. Up to now, however, I’ve seen far too little political will to actively shape the future.

REITs plans too timid
This also applies to real estate investment trusts. The introduction of REITs in Germany, one of Europe’s biggest property markets, was long overdue and the inclusion of corresponding measures in the coalition agreement was welcome.

On 2 November 2006 the cabinet approved draft legislation on REITs. In response to pressure from some sections of the SPD, however, residential property has been largely excluded. So we’re now finally getting REITs in Germany – but in the form of a half-hearted compromise.

I’m quite frankly totally at a loss to understand why residential property was removed from the scope of the draft bill. No politician can seriously believe that residential property will not change hands just because it can’t be acquired by a German REIT.

Leaving aside the REITs outside Germany, private equity funds and hedge funds also number among potential investors. Policymakers have clearly not gone far enough here.

Ladies and gentlemen, Apple CEO and co-founder Steve Jobs once observed that “innovation distinguishes between a leader and a follower”. The German banking market should stop being the most renowned follower. The REITs story illustrates that we still spend too much time trying to catch up with trends instead of setting them. And it shows, above all, the need for some policy-makers to become more receptive to innovation. Because once innovative markets take root elsewhere, it is extremely difficult to attract some – let alone all – of the lost business back to Germany.

IFD provides impetus
Let me at the same time stress, however, that the financial markets have also seen many positive developments. The creation around four years ago of Initiative Finanzstandort Deutschland, or IFD for short, saw the launch of one of the most ambitious projects to date aimed at strengthening Germany as a financial centre.

Market practitioners and specialists from banks, insurance companies, Deutsche Börse, the Federal Ministry of Finance, Deutsche Bundesbank and last but not least industry associations – including, naturally, the Association of German Banks – work across competitive boundaries on pragmatic solutions.

The idea behind the IFD is to strengthen Germany’s financial industry by promoting product innovation. Its goals are to stimulate growth in our financial services industry and in the economy as a whole. It deals with matters as diverse as improving financial literacy, financing SMEs, eliminating bureaucratic hurdles and developing property markets. And this is just to name but a few.

II.
European financial market
But the future of Germany as a financial centre is not being decided in Frankfurt and Berlin alone. Decisions taken in Brussels by the European Commission have played an increasingly influential role in our industry in recent years. So we also need to consider the competitiveness of the European financial market. This brings me to my second point because Europe’s single market will be the world’s biggest integrated financial market after the US.

Integration is proceeding at different speeds in different sectors of the European market. Where corporate loans are concerned, the proportion of cross-border transactions has already risen sharply since the introduction of European economic and monetary union. Lending by German banks to companies in other member states, for example, more than doubled between 1999 and 2005.

The retail sector, on the other hand, is lagging behind. This is all the more unfortunate since the “European on the street” would benefit directly from greater integration. So there’s an urgent need for action here, not least in view of the fall in public acceptance of the EU.

There are many reasons for the slow progress: differences in language, in payment habits and, above all, continuing differences in national consumer protection rules.

These make it virtually impossible for a bank to offer a product such as a consumer loan in another member state without making substantial changes to ensure that it complies with local rules and regulations. This is hardly conducive to integration. As things stand, consumers are unable to exploit the potential of the European market. I am confident, however, that we will see improvement here in the next few years and believe the European Commission is quite right to put this issue at the top of its agenda.

SEPA needs political support
A key issue in this context is the integration of payment systems in Europe. The Single Euro Payments Area – or SEPA for short – is already in the starting blocks. From 2008 onwards, the banks want to offer their customers additional payment instruments for direct debits, credit transfers and debit card payments. Payments in euros within the EU will then be just as simple, swift and secure as domestic payments are today. This will be a huge advantage, not least for Germany’s small and medium-sized exporting companies.

The European banking industry has laid the foundations for SEPA. We are now waiting for the necessary political decisions to be taken. But the adoption and implementation of the EU Payment Services Directive, in particular, are far behind schedule. To make it possible for all SEPA instruments to be used from 1 January 2008 as planned, the directive would have to have been adopted by the end of last year.

Once again, this delay on the part of policymakers isn’t just bad news for the banks. Consumers, too, will have to wait longer for the new payment instruments. And yet the potential of SEPA is enormous. The European Commission forecasts possible savings for Europe’s economy of between 50 and 100 billion euros.

Consolidation often merely domestic
The integration of Europe’s financial markets is also likely to encourage the consolidation of its banking market in the medium term. It is hardly surprising that most banking mergers still take place at national level since it is, after all, quicker and easier to achieve synergies in a domestic context. In consequence, the last few years have seen a considerable amount of successful consolidation within individual member states.

A single supervisory regime for the single market
The reasons for the comparative lack of cross-border consolidation in Europe so far are many and various. Direct obstacles are outnumbered by indirect ones. Indirect obstacles exist when different legal systems, while not actually ruling out mergers or acquisitions, make them commercially unviable.

One such hurdle is the as yet insufficient level of harmonisation in European banking supervision. The costs generated by the EU’s fragmented supervisory regime reduce the economic benefits of cross-border consolidation quite considerably. Banks wishing to offer products in various member states have to satisfy differing requirements imposed by different national regulators. In today’s EU of 27, there are a total of 53 supervisory authorities. A single financial market needs a single supervisory regime, in my view.

The gradual Europeanisation of financial supervision should lead in the long term to a single institution responsible for supervising banks that operate across the EU. National regulators, on the other hand, would continue to be responsible for banks operating exclusively at national level. The European System of Central Banks could serve as a model. If financial supervision in the EU were organised along similar lines, this would significantly accelerate the integration of its financial services market.

III.
Global markets
Ladies and gentlemen, the EU Internal Market Commissioner Charlie McCreevy recently described the European single market as the “entrance ticket and training camp for the world stage”. And it is perfectly true: if we are looking to the future, we mustn’t focus on Europe alone, but should consider the global perspective. This brings me to my third point: the global financial markets.

The world’s five biggest banks by market capitalisation included only one European bank in 2005, but three US financial institutions and one Japanese bank. The situation is the same if we compare tier 1 capital: three US banks versus one European and one Japanese bank. And since 2006 we have had a Chinese bank at rank 4, ICBC with a market capitalization of 150 bn $.

Despite the successes of recent years, Europe lags behind in profitability, too. Average return on equity at US banks in 2005 was around 29% before tax. As I mentioned earlier on, the ROE for EU banks was only 21%.

The big banks of our day are US financial institutions. But their domestic market now offers them little opportunity for growth in the retail or corporate sectors. So it is only a question of time before they seek to expand their activities in Europe.

US success in investment banking
Let us cast our mind back: we saw a similar development in investment banking. American banks now play a leading role in investment banking in Europe. US banks’ market share in issues of euro-denominated bonds in the euro area, for example, soared from 2% in 1995 to 32% in 2001.

It’s a similar story when it comes to European share issues. The market share of American investment banks rose from around 10% in 1995 to 37% in 2001. So we in Europe have no time to lose; we need to act now.

Growth potential in the BRIC states
What is more, the banks can and must succeed in participating in growth markets not only in Europe and the US, but also worldwide. The countries on everyone’s lips at the moment are the BRIC nations –Brazil, Russia, India and China – with their above-average economic growth. And a number of other threshold countries are highly promising markets, too.

Consumer loans, current accounts and private pension products are still extremely thin on the ground in these markets. Experts have identified a growth potential in the lendings business of 20 to 30% in the medium term. Even today Latin America’s banks, for example, are among the most profitable in the world with an enviable return on equity of 33% before tax. Conversely, it is in the interests of the threshold countries themselves to open up their banking markets to foreign banks since this will deliver higher-quality and more diverse financial products.

Make market access easier worldwide
Nevertheless, ladies and gentlemen, even if the threshold and developing countries currently offer excellent prospects, foreign banks trying to become established there still face considerable disadvantages. Access to the “gardens of growth” is highly restricted at present. Banks are limited to certain forms of establishment, for instance, and there are often constraints on the activities they’re allowed to engage in.

Recent years have seen some progress in eliminating these obstacles – whether by liberalisation measures negotiated under the auspices of the World Trade Organization, the WTO, by means of bilateral free-trade agreements or even by some nations opening up their markets unilaterally.

Even so, a swift revival of the Doha round is needed more than ever. It would be illusory to believe that bilateral negotiations can offer a viable substitute. There is simply too much to do, especially where the threshold and developing countries are concerned.

Regulatory spillovers hamper integration
As well as impediments to market access, differing or even contradictory rules and regulations – so-called regulatory spillovers – also hamper the integration of the world’s financial markets.

It is therefore gratifying that the European Commission has expanded the regulatory dialogues it has conducted with the US since 2002 to include other countries – Japan and China. The EU-US financial markets dialogue has already helped to prevent or at least mitigate the risk of rules spilling over onto the opposite side of the Atlantic.

It is a cause of concern, however, that signals have recently been emerging from the US indicating setbacks to transatlantic financial market integration. The delay in implementing Basel II is among the most serious. Though it is to be hoped that the US will soon get back on track when it comes to implementation, Europe should step up the transatlantic dialogue. All parties have a vital interest in continuing talks.

Ladies and gentlemen, these examples show that the challenges of globalisation demand a joint approach by the business community and politicians – both at national and at international level. It is above all regulatory and legal obstacles which need to be eliminated.

Even Marco Polo – the founding father of globalisation – could count on political support. It is reported that Kublai Kahn, the ruler of the ancient Mongolian empire, gave him two golden tablets when he set off for home. These tablets were a kind of pass instructing the officials of the Mongolian empire to afford the traveller every assistance. Without them, Marco Polo’s return journey would not only have been much more arduous, it would, above all, have taken a lot longer.

Me, I’m a realist. I’m not expecting any golden tablets from our politicians. But I do expect a readiness to respond actively to a changing competitive environment.

There’s a Chinese saying that “when the winds of change blow, some people build walls, others build windmills”.

Anybody who’s been to one of China’s commercial metropolises recently knows that such windmills are springing up there on every corner. Last October’s flotation of the Industrial and Commercial Bank of China (ICBC) – the biggest IPO in world history – is a striking illustration of the country’s ambitions. Germany and some other countries, by contrast, still seem to be relying too much on walls.

In closing, Ladies and Gentlemen, a critical remark towards Germany´s academia. I find it rather surprising how little interest the entrenched situation of the German banking industry seems to generate with the WI-SO faculties. It is the IMF, the OECD, the ECB and other foreign parties which address this topic openly and outspokenly. It is bad enough that more than 3,000 German politicians enjoy mandates with the public banking system. What, I am asking, is causing virtual silence on the part of German academia.

To those who persist in hesitating and procrastinating I can only say this: if we don’t succeed in creating the right environment, we’ll be in danger of losing ever more relevance in a world of global competition.

Or as the American songwriter Bob Dylan puts it: “You better start swimmin’, or you’ll sink like a stone, for the times they are a-changin’”.

Thank you for your attention, ladies and gentlemen.