A Welfare Comparison of the German and U.S. Financial Systems

One of the most striking differences among developed countries is the wide variation in the form of their financial systems. Cross-country differences in financial systems and economic performance raise a host of interesting questions. What are the advantages of bank-based systems and what are the advantages of having sophisticated financial markets? Did Germany, Japan, and France succeed because of their bank-based systems or in spite of them? Given the pace of financial innovation in recent years, and the decision of countries such as Japan and France to move away from bank-based systems toward more market based systems, these and other related issues are of great interest. In this paper, the authors compare two idealized extremes. In one, referred to as the "German model," banks and other inter-mediaries predominate. In the other, refer-red to as the "U.S. model," financial markets play the predominate role. The authors are primarily interested in analyzing the welfare properties of different financial systems from a theoretical perspective. In addition, they focus on issues of risk sharing and information, and adopt a systemic perspective. To compare the efficiency with which a financial system shares risk, provides information, and allocates resources, they focus on the functional categories of the system as a whole rather than on institutional categories. To discover the limits of the welfare properties of the different system, the authors focus on ideal cases. The theoretical analysis is divided into two parts - the household side of the market, and the firm side. Household Perspective - From the house-hold side, the contrasts between the U.S. and German systems could be summarized by saying that German banks take short term deposits and convert them into holdings of corporate securities, whereas U.S. banks leave the investment in corporate securities to other institutions and convert short term deposits into mortgages, loans for consumer durables, and business loans. The assets held by German banks thus appear to the authors to be fundamentally more risky than those held by the U.S. commercial banks. In testing various risk scenarios, the authors illustrate how risk can be shared between current and future generations in the German model, but not in the U.S. model. Although the U.S. financial system provides a tremen-dous variety of financial instruments, it cannot provide intergenerational risk sharing because markets are incomplete. Current investors cannot trade with future generations of investors before uncertainty is resolved. The German model, because it is charac-terized by a lack of competition between banks and is not constrained by competition from financial markets, may be able to over-come the liquidity constraint and the prob-lems associated with writing individualized contracts. Alternatively, the authors argue that the U.S. financial system provides many cross-sectional risk sharing opportunities because of the diversity of instruments and markets. In Germany, investors have very restricted opportunities to share risk cross-sectionally. Most invest in bank accounts. The authors suggest there is a risk sharing trade-off in deciding on the structure of a financial system. If generations are homogeneous, there is no possibility for cross-sectional risk sharing and there is no cost to adopting the German model which allows intergenerational risk sharing. If there is enough heterogeneity that the benefits from cross-sectional risk sharing outweigh the benefits from intergenerational risk sharing, the U.S. model would be preferable. There is considerable evidence that U.S. stock prices are very volatile. The traditional explanation is the arrival of new information about payoff streams and discount rates. One of the differences between the German and U.S. financial systems is the amount of information provided to the public. In Germany, relatively few companies are publicly listed and disclosure requirements are limited. The authors suggest that to the extent such excess volatility occurs and has negative implications for welfare, the noise suppression associated with the German financial system will be advantageous. According to the authors, the differences in the number of branches per capita cannot be explained entirely by the fact that German branches perform more services than do U.S. commercial bank branches. Given the large number of banks operated in the public interest in Germany, it is more appropriate to think about these entities as rent-seeking institutions rather than value-maximizing entities. Because management maximizes the aggregate rents, it has an incentive to increase service beyond what a profit-maximizing firm might choose. To the extent that rents are generated by services provided to customers, there will be a tendency to expand the range of services provided beyond what customers would choose if German banks faced the true cost function. Firm Perspective - From the firm side, German firms would appear to be at a significant disadvantage in making invest-ment and entry decisions because firms lack the breadth of information available to U.S. investors. It could be argued that the German system permits substitute mecha-nisms, as the banks have a large amount of information about the profitability of firms. Nonetheless, without an active stock market, deciding on appropriate risk adjusted dis-count rates may present serious problems. In Germany, an active market for corporate control does not exist. Concentration of ownership may be the single most important factor that makes it difficult for outsiders to obtain control and prevent a proper market from developing, according to Franks and Mayer (1993). However, given banks' extensive inside knowledge of firms, their views are presumably weighted heavily in board rooms. Kaplan (1993) has found that poor stock returns and earnings increase the likelihood of top management turnover in Germany by about the same amount as in the U.S. The fact that it appears difficult to identify gains in operating efficiency in takeovers indicate that the value gains may arise from other factors. One is the availability of internal financing. The size and lumpiness of information costs suggest that it maybe easier to get funds from a single source without the use of the debt or equity markets. The transaction cost may be further reduced if the transfer of capital takes the form of a merger or an outright takeover. In Germany, an equivalent allocation of resources may be achieved by the banking system. One crucial aspect of a financial system is in constraining managers. The authors compare and contrast the potential impact on manager performance that may be caused by differences in financial systems. Traditional economic analysis has been concerned with situations where production technologies are well known and managers are aware of the consequences of the actions they take. Because production technologies and the consequences of actions are well known, there is wide consensus on how the firm should be managed. In many modern industries these assumptions are not satisfied. Allen (1993) argues that bank-based systems such as Germany's are much more suited to traditional industries where there is consensus on operating requirements, and financial market based systems are more suited to dynamic industries where there is not wide agreement. Summary - The authors conclude that in an imperfect world it is not immediate that markets are the best institutions available. Markets impose constraints in the form of equilibrium conditions that must be satisfied. They may prevent arrangements which are ex ante inefficient. Thus, more analysis is required before conclusions concerning the desirability of particular financial systems can be drawn.