German stance on ECB shows European ideal is defunct

It seems irrational for a German finance minister to question the independence of the European Central Bank and to mount a strong campaign against negative interest rates. But there is a reason why this is happening - not a good one, but a powerful one.

Rightly or wrongly, Wolfgang Schäuble regards the policies of the ECB as an attack on Germany’s economic model, which is heavily dependent on the viability of the country’s peculiar banking system. If the banks and insurance companies get into trouble, the model could collapse. So this is not about a philosophical disagreement over the goals of monetary policy. It is about money pure and simple – and the Sparkassen, the local savings banks, and the small mutual banks are losing tons of it.

The business models of German financial institutions depend critically on the presence of positive nominal interest rates. The International Monetary Fund noted in its latest Financial Stability Report that the pre-tax profits of German and Portuguese banks are most affected by negative rates.

Vulnerable

German life insurers are also vulnerable. They have to guarantee a minimum rate of return, which is now 1.25 per cent a year. This is hard to do when the yield of the 10-year German government bond is only 0.13 per cent.

Germany and Sweden are the two EU countries where life insurers face the biggest gap between market rates and guaranteed rates.

To achieve the promised returns, the insurers have to take on more risk, for example by buying corporate bonds or tranches of complex financial products. If, or rather when, the next financial crisis begins and triggers a change in the valuation of these assets, we may find that sections of the German financial sector are insolvent.

Of the German banks, the Sparkassen and the mutual savings banks are most affected. They are classic savings and loans outlets in that they lend locally and fund themselves through savings. Credit demand is more or less fixed.

So when savings exceed loans, as they now do in Germany, the banks deposit their surplus with the ECB at negative rates - known as “penalty rates” in Germany. They cannot offset the losses by cutting interest rates on savings accounts because of the zero lower bound. Savers would switch from accounts to cash in safe deposit boxes.

Absurdity

One realises immediately the absurdity of the attempt to try to influence monetary policy in order to safeguard the commercial interests of the financial sector. The Germans clearly have it the wrong way round. Can they not just change the business models of the banks and life insurers instead?

The answer is that they cannot, at least not in practice. To force such a change would require an unlikely coalition of federal and state politics, and would run against vested interests. Many German companies depend on their friendly local neighbourhood bank to provide them with easy credit. There is nothing out there that could fill the gap in the short term.

German corporate bond markets are underdeveloped, as is the market for venture capital. Germany should have reformed its banking sector decades ago, but political pressure has prevented that from happening. The management boards of the Sparkassen are a power base for local politicians. The Landesbanken are run by regional politicians. They, in turn, are partly owned by the Sparkassen. They all hang together.

So where does this end? For the time being, the ECB will, I suspect, not cut interest rates further unless there is another economic shock, but nor will it raise them. If the current economic climate persists, negative short-term rates could continue for several years. Ultimately, this could threaten the very existence of many savings banks.

At one level, this could be a good thing because it might trigger the long overdue restructuring of the banking system. But since Germany will resist this, my expectation is that we would end up in a balance of terror: the ECB fearing a German backlash to its policies, and the Germans trying to sit through it.

This is clearly not the way a healthy monetary union is supposed to work. The ECB’s governing council is meant to take a euro zone-wide perspective. It is not supposed to defend the national interests of their home countries, let alone act as lobbyists.

The banking systems should not be run as national fiefdoms. In a monetary union, no government is supposed to question the independence of the central bank, let alone threaten co-ordinated Group of Twenty action in support of a particular monetary policy, as Mr Schäuble did.

This episode is a reminder that the collective spirit that was so strongly present in the first years of the euro zone has gone. That - not the presence of imbalances or other technical problems - constitutes the single biggest danger to the long-term viability of Europe’s monetary union.

Copyright The Financial Times Limited 2016