Promotions-Projekt: Finance, Financialisation and Financial Regulation

PhD project: Finance, Financialisation and Financial Regulation – the changing financial environment in Germany and some macroeconomic effects

Daniel Detzer, M.A., PhD candidate at the Berlin School of Economics and Law
Supervisors: Prof. Dr. Eckhard Hein, HWR Berlin; Prof. Dr. Hans-Michael Trautwein, Carl von Ossietzky Universität Oldenburg

This PhD projects analyses the changes in the German financial system in the era of financialisation and their macroeconomic impact. The thesis is laid out as a cumulative project in which the research topic is analysed selectively in a range of connected research papers.

Over the last decades an increasing attention has been devoted to the connection between finance and economic development. Still opinions are widely differing about the importance and the effect of finance. Some economists like Robert Lucas regard the role of finance as “very badly over-stressed in popular and even much professional discussion”. At the other extreme some economists like Merton Miller see financial markets contribution to economic growth as a proposition “too obvious for serious discussion”. While Miller seems to regard the role of finance as largely positive, an alternative view is taken by a range of economists who stress the dual role of finance. Those include for example Joseph Schumpeter or Hyman Minsky, who argue that finance can be an important ingredient for growth, but also can lead to crisis and a slow-down of economic development for many years. Also Karl Marx and John Maynard Keynes acknowledge the importance and dual role of financial markets in their writings. Empirical research on the role of finance has often found a positive relationship between more finance and growth. However, more recent results have drawn this clear cut relationship into doubt. Some authors find diminishing returns to the expansion of the financial sector for growth; others even identify negative effects when the financial sector expands beyond a certain threshold.

Those potentially negative roles of finance for economic growth, beyond the effects due to financial crises, were highlighted by many heterodox economics authors. In the Post-Keynesian literature the phenomenon of financialisation is a widely discussed issue. It includes a variety of phenomena such as the deregulation of the financial sector and the proliferation of new financial instruments, the explosion of financial trading, the liberalisation of capital flows and instability in exchange rate markets, a shift toward market-based financial systems, the emergence of institutional investors as major players in financial markets, the booms and busts in asset markets, shareholder-value orientation and changes in corporate governance of non-financial business, increased access to credit by previously underbanked groups, changes in the level of (real) interest rates and an increasing economic and political power of the rentier class.

In this literature, the negative impact finance can have on macroeconomic outcomes such as growth or inequality is well established: increasing functional and personal income inequality, with higher income shares going in particular to profits and top management incomes; depressed investment in capital stock mainly due to the so called ‘preference channel’ and the ‘internal means of finance channel’; and an increasing role of debt financed and wealth based consumption. It is also shown that there is a detrimental effect on financial stability. On a global scale, depending on the importance of the different elements of financialisation and the institutional structure of the national economies, different growth regimes have developed, which led to increasing current account and debt imbalances.

Another issue in the literature is financial structure, which traditionally distinguishes between bank-based and market-based intermediation. While in all actual financial systems both forms of intermediation are present, the relative importance of each varies across countries.

The case of Germany is a particularly interesting example for a variety of reasons: In the bank based / market based dichotomy Germany has been, together with Japan, a prime example of a bank based financial system. Therefore, the financialisation process - most extensively researched for the case of the US, a typical market based financial system - may have taken a different form in the case of Germany. In addition, in the 1990s major changes have taken place in the German financial system. Some of the big banks have actively withdrawn from the central role they played in the German financial system and extended their investment banking activities. Additionally, in a range of reforms the legal framework for financial institutions and markets was changed, with the explicit aim of developing the German financial markets. Simultaneously, the size and activity of debt and equity markets increased rapidly, which could be interpreted as a shift towards a more market based financial system. Other indicators for market based financial systems, e.g. takeover activity, also increased. However, this increase of activity and size of markets was not at the expense of banks’ size or activity, which also increased their balance sheets during that period. This overall increase in the financial indicators corresponds to the financialisation phenomenon.

In this thesis I intend to investigate the changes of the financial system in the era of financialisation for the case of Germany and its impact on its macroeconomic development. Here a broad view is taken to elaborate the different aspects of such change. The thesis will focus on two main areas:

1. Financial regulations and the German Financial System, and
2. Financialisation in Germany and some macroeconomic effects.

Substantial reforms occurred in the area of financial regulation allowing for many of the changes in banking activities, financial market development and financial innovations, as we have seen in Germany in the last three decades. A first paper will give an overview of the German financial system and its regulatory and supervisory structure and then will focus on the main regulatory changes and the main driving forces behind those changes.

After this more general paper, one of the most prominent areas of financial regulation, capital requirements, will be investigated. While capital requirements are seen as a buffer for each individual bank to bear losses and thus aid in stabilising the financial system, from a macroeconomic point of view they can also be an impediment for excessive growth of the financial sector. However, in a range of regulatory reforms starting in the 1980s, capital requirements have gradually been softened and so allowed for an expansion of banks’ activities. A particularly important step has been the introduction of internal risk models to determine the risk of assets and therefore regulatory capital. Therefore, in one of the papers of this thesis, the development of capital requirements for the case of Germany will be investigated and in particular the use of internal risk models will be examined critically.

Since the financial crisis, macro-prudential regulation has been another important area of discussion and regulatory innovation. Another paper will therefore take a more theoretical approach and compare two different regulatory instruments, asset based reserve requirements and asset based capital requirements, in their usefulness for macro-prudential regulation. In particular their effectiveness in preventing asset price bubbles will be investigated.

Finally, one of the papers in this thematic area will examine the role of the German financial system during the financial and economic crisis. While Germany was hit heavily by the crisis in 2009, it recovered rapidly, despite the fact that the banking sector had to bear heavy losses. A connection to the specific organisational structure of the German banking system, with many publicly owned and cooperative banks, often only locally active, will be made.

Parallel to these regulatory changes, many related changes in the structure of the German financial system and the corporate governance system have occurred, which are connected to the financialisation phenomenon. Those changes and their effects on different macroeconomic outcomes (external position, inequality, financial stability, etc.) will be investigated within this thesis as well. One paper in this second thematic area will investigate the long run effects financialisation had in the areas of inequality, investment, consumption and on the current account, and then analyse the financial and economic crises in Germany in the light of these long run tendencies.

Another paper will take a closer look on the impact of financialisation and neoliberalism on income inequality in Germany. A Kaleckian approach provides the theoretical framework for this analysis.

Finally, the era of financialisation was paralleled by increasing financial instability as most recently demonstrated during the financial crisis. Therefore, in a more theoretical work the understanding of financial instability and fragility will be deepened by discussing the financial crises in different economic paradigms. By combining different ideas in a unified framework a general idea of elements of financial crises is gained and based on this, instruments and regulations to address those issues will be discussed.

The trade and current account imbalances in the Euro Area are a major concern since the Euro Crisis and Germany as the biggest surplus country is a major contributor to those imbalances. While the developments of the German current account surpluses and its relation to financialisation have already been analysed empirically, a further paper will, on a more abstract level, give a theoretical account of the occurrence of current account imbalance in the Euro area and investigate the role financialisation and increasing inequality played in this process. A stock flow consistent model will built the basis for this analysis and it will be structured to be able to simulate changes in functional and in wage inequality and to observe the effects on the current account. It is intended to simulate hypothetical surplus and deficit countries in the Euro Area and show how different aspects of financialisation have contributed to the divergence in the Euro Area and the occurrence of different growth regimes (debt-led private demand and export-led mercantilist). In particular, the depressing effects of changes in income distribution, but also the countervailing forces due to credit availability and for example emulation effects will be examined.

In a more policy oriented paper alternatives to the current reforms employed in the Euro Area to tackle the problem of current account imbalance are proposed. In this paper it is analysed how different macroeconomic policy areas (fiscal, monetary, incomes, regulation, etc.) can be employed to reduce current account surpluses and deficits. This alternative approach is based on Thirlwall’s idea of a ‘balance of payment constraint growth rate’.

Publications related to the project

• New Instruments for Banking Regulation and Monetary Policy after the Crisis. In: INTERVENTION. European Journal of Economics and Economic Policies, Vol. 9, No. 2, 2012, pp. 233–254
• The German Financial System and the Financial Crisis, in: Intereconomics Review of European Economic Policy, Vol. 49, March/April 2014, No. 2, pp. 56 – 64.
• Financial Regulation in Germany, in: Kregel, J., Tonveronachi, M., Kattel, R. (eds.), Financial Regulation in the European Union, London: Routledge, forthcoming (with H. Herr
• Financial market regulation in Germany: capital requirements of financial institutions, PSL Quarterly Review, Vol. 68, No. 272, 2015, pp. 57-87
• Theories of financial crises as cumulative processes – an overview, in: Hein, E., Detzer, D., Dodig, N. (eds.), The Demise of Finance-dominated Capitalism: Explaining the Financial and Economic Crises, Cheltenham: Edward Elgar, 2015 (with H. Herr)
• Financialisation and the financial and economic crises: the case of Germany, Berlin School of Economics and Law, Institute for International Political Economy (IPE) Working Paper, 44/2014, and FESSUD Studies in Financial Systems No. 18, 2014, University of Leeds (with E. Hein); forthcoming in: Hein, E., Detzer, D., Dodig, N. (eds.), Financialisation and the Financial and Economic Crises: Country Studies, Cheltenham: Edward Elgar
• Finance-Dominated Capitalism and Income Distribution: A Kaleckian Perspective on the Case of Germany, Italian Economic Journal, Vol. 1, No. 2, July 2015, pp. 171-191, DOI 10.1007/s40797-014-0001-4 (with E. Hein)
• Post-Keynesian alternative policies to curb macroeconomic imbalances in the Euro area, Panoeconomicus, Vol. 62, No. 2, 2015, pp. 217-236, DOI: 10.2298/PAN1502217H. (with E. Hein)