What Is Public Capital?

Floyd Norris really missed the boat this morning in his column on the European Banking Authority’s latest round of stress tests. There are big issues with the stresses EBA elected to test, but that’s a story for another day. For now, focus on Norris’ criticism of Helaba, the state bank (landesbank) for Hesse and Thuringia:

Helaba is outraged that the E.B.A. will not count “hardened silent participations” as core capital. And what is that? As near as I can tell, it amounts to promises by the two states that own the bank that the states will put up more money if needed....

The fact that these arguments are going on does provide some evidence that the stress tests are more credible than previous ones. They also remind us that one of the games that banks have played in the past — often with support from bank regulators — has been to count some pretty dubious things as capital. When the crisis hit, a lot of that “capital” turned out to not be of much use.

This makes it sound as though Helaba is a band of sharp operators trying to hide how overleveraged they are—like some of the Wall Street players that blew up in 2008. There is a lot you could say about the landesbanken, but sharp is not what comes to mind.

The first thing you need to know is what the state banks like Helaba are. They are publicly owned entities that rest on top of a pyramid of thousands of municipally owned savings banks. If you add in the specialized publicly owned real estate lenders, about half the total assets of the German banking system are in the public sector. (Another substantial chunk is in cooperative savings banks.) They are key tools of German industrial policy, specializing in loans to the Mittelstand, the small-to-medium size businesses that are at the core of that country’s export engine. Because of the landesbanken, small firms in Germany have as much access to capital as large firms; there are no economies of scale in finance. This also means that workers in the small business sector earn the same wages as those in big corporations, have the same skills and training, and are just as productive.

But the EU doesn’t like the landesbanken. They denounce the explicit and implicit public subsidies that state ownership entails, saying they violate the rules of competition policy. For over a decade they have fought to have the system privatized. In the end, the dispute is simply ideological: if you think that public ownership should only be an exception, narrowly crafted to address specific market failures, you want to see the landesbanken put on the auction block. If you think an economy should be organized to meet socially defined needs, you would want a large part of capital allocation to be responsive to public input, and you’d fight to keep the landesbanken the way they are. (There is a movement afoot in the US to promote public banking.)

One result of the EU attack has been pressure on the landesbanken to demonstrate competitive rates of return. The folks who move money in these banks are public servants, very good with forms and checklists in hallowed German tradition, but not very savvy in nouveau finance. Sadly, some of these naive beamters loaded up on the mortgage-based securities that collapsed in the financial crisis, since the returns were what Brussels was demanding, and, well, they were AAA.

But on to the topic at hand. What constitutes equity for the landesbanken? For a privately owned bank, capital is raised by drawing on private funds, for instance through a share offering. For a public bank, capital is the financial commitment authorized by the public institutions that guarantee the bank’s liabilities. It’s pretty obvious when you think about it, and that’s the position taken by Helaba and the other landesbanken.

According to the EBA, however, public commitments don’t count. They don’t think there should be public banks in the first place, and they don’t want to legitimize the financial structure of the German public banking system. In other words, their opposition isn’t about whether the landesbanken can cover their liabilities, but is pure ideology.

My guess is that Norris is unaware of the battle lines that have formed around the landesbanken and has adopted the EU position by reflex, out of distrust for all financial institutions. The cynicism that serves so well in the US, however, has to be translated into the European context before you can understand why Helaba is so stressed about its stress test.