The Little Bang Approach.

Germany keeps reforming its financial sector bit by bit.

Whenever Berlin's top-finance officials appear at international meetings these days, they bear a message foreign investors should like: There is no reform fatigue in Germany, Europe's largest economy!

After enacting radical changes to income and corporate capital gains taxes in 1999, the center-left government of Chancellor Gerhard Schroeder is moving on with other far-reaching reforms to modernize the German economy. That was the theme that Finance Minister Hans Eichel put forward at the Davos World Economic Forum. And that was the good news that Caio Koch-Weser, Schroeder's state secretary of finance, brought to the Palermo meeting of G7 finance ministers and central bank governors.

First, a new pension reform passed the Bundestag, the lower chamber of parliament, in January. Its aim is to stabilize the state pension system and supplement it with a new privately funded pension system that will strengthen German capital markets.

Second, on January 25, Eichel's ministry shocked the financial world by unveiling a bold financial regulatory reform plan that it had drafted in secrecy. It would establish a single agency to supervise banking, securities, and insurance. At the same time, the Berlin government put forward a reform concept to streamline the Bundesbank, a once powerful institution that still has a staff of sixteen thousand but has lost its main task of setting monetary policy to the European Central Bank (ECB).

Third, the government is helping public sector banks--in particular Landesbanken and Sparkassen--to reach a compromise solution with the EU on the thorny issue of state guaranties in the form of statutory guaranty obligation (Gewahrtragerhaftung) and maintenance obligation (Anstaltslast). According to the private banks, this type of state support constitutes an illegal subsidy in violation of the EU Treaty. This will require a far-reaching restructuring of Landesbanken and the savings bank sector and put the sector on the road to at least partial privatization. The state guaranties for Landesbanken and Savings Banks--so reads the complaint of the competing private banks--give public banks significant financial advantages when it comes to raising debt and equity.

By proposing a new centralized institution--a Federal Agency for Financial Market Supervision located in Bonn and Frankfurt--the German finance minister regained the reform momentum he appeared to have lost and dealt a stunning blow to the Bundesbank's aspirations to get the Bundesaufsichtsamt fur das Kreditwesen (BAKred) under its roof. By proposing a central management structure for the Bundesbank, Eichel wants to enhance Germany's role in ECB decision-making. Eichel's reform concept is very clear: Strengthen the Bundesbank's position in the ECB but let a separate agency supervise the financial markets.

For the last eighteen months, the Bundesbank's leaders have been waging a fierce public battle to become the sole banking supervisor in the country. They argue that the Bundesbank already is heavily engaged in bank supervision. Another argument was that the once mighty Bundesbank would lose influence in the European System of Central Banks (ESCB), many of whose members are in charge of bank supervision in their countries. Having given up its monetary policy function, the Bundesbank would gain new self-esteem by becoming Germany's single bank supervisor. This line of reasoning was supported by a commission of experts led by former Bubba President Karl Otto Pohl.

Ernst Welteke, the current president of the Bundesbank, and Edgar Meister, the member of the Directorium responsible for bank supervision, were already openly giving details about how they would integrate the bank supervision agency BAKred with its 650-member staff into a department of the Bundesbank. Since Welteke and Meister had close political and personal ties to Eichel, a deal in favor of the Bundesbank seemed a foregone conclusion. The man most affected, BAKred President Jochen Sanio, could not speak out publicly. He had proposed a consolidated financial market supervision concept to the new German government two years ago.

The aggressive Bundesbank campaign had backed Eichel into a corner. Financial observers expected him to eventually yield to the pressure. After all, only Germany's private banks, a few journalists, and some constitutional law professors dared publicly to oppose the Bundesbank's take-over move. With strong backing from its members, the Bundesverband deutscher Banken (BdB) hit back. The association's top managers, Manfred Weber (a Bundesbank veteran who served as an aide to former Bubba President Schlesinger) and Wolfgang Arnold led the opposition against the Bundesbank move to take over BAKred, the bank supervisory agency that had just moved from Berlin to Bonn. Meanwhile, the public sector banks, savings banks, and co-operatives went into hiding.

Weber and Arnold warned that the specter of reforming Germany's banking supervision along the lines of politically powerful regional interests could seriously damage Europe's largest financial market. A take-over of BAKred by the Bundesbank would cause a lot of regional interference in bank supervision from the politically linked LZB branches. At a time of dazzling globalization, they warned that unified bank supervision principles could not be assured. Unless Eichel and his reformers produced a modern financial market supervision concept, the reaction of a hostile Anglo-Saxon press could severely damage Germany's reputation.

As it turned out, the Bundesbank leadership made some strategic blunders. By pushing for a small management board to centralize authority within the Bundesbank, Welteke upset the Lander governments that were eager to place some LZB presidents in the Bundesbank management. For this reason, he failed to secure broad support from the Lander for his ambitious plan to bring the BAKred under the roof of the Bundesbank.

Soon it became apparent that some of the Lander governments preferred to negotiate separate deals with the Federal Government in the next legislative process. Bavaria's finance minister, Kurt Faltlhauser, made this point very clear: "We want to make sure that no jobs are cut at the LZB in Bavaria and that our LZB stays engaged in bank supervision. What happens to Bundesbank headquarters, for us, is secondary."

When the Bundesbank leadership missed its chance to form a solid front with the Lander, Eichel had an opening to push his bold single financial supervisor proposal. Eichel and his key strategists, Koch-Weser and Axel Nawrath, a top finance ministry official, borrowed from financial supervision models in Great Britain, Japan, and Sweden, where financial supervision is handled outside of the central bank.

Before its summer recess, the government plans to introduce two bills--one to consolidate BAKred, the Bundesaufsichtsamt fur den Wertpapierhandel (BAWe) and the Bundesaufsichtsamt fur das Versicherungswesen, and the other to restructure the Bundesbank. With these initiatives, the government "is making an important contribution to stabilize our financial system, to strengthen Finanzplatz Deutschland and to improve the protection of investors and consumers" Eichel said. "The new concept of consolidating financial market supervision could lead the way in Europe."

The new Bundesanstalt fur Finanzmarktaufsicht would deal with such issues as e-commerce, asset management, derivatives, insider trading, compliance, money laundering, and consumer and investor protection. As in other countries, Germany's banks, securities houses, and insurance companies are competing for the same clients by offering a full range of financial products and marketing channels.

There have always been strong links between banks and securities houses. But now the barriers between banks and insurance companies are breaking down. The emergence of financial conglomerates poses new challenges to government regulators. As a single European market develops, Eichel believes Germany could be the leader in market regulation with a single supervisory agency. These German moves come at a time when an EU committee chaired by Baron Alexandre Lamfalussy is about to put forward its recommendation for improving the regulatory framework for financial markets in the European Union.

As for restructuring the Bundesbank, Eichel wants a six-member Vorstand (management board) to replace the current fifteen-member central bank council, where the main branches (LZB) are represented. The Vorstand would be composed of a president, vice-president, and four members. Eichel believes this structure would strengthen Germany's role in the European System of Central Banks because there would be no intervention by regional central bankers.

There is growing frustration in the Berlin government and in the Bundesbank leadership that some regional LZB-presidents continue to make statements on interest rates as if European Monetary Union had not taken place and they still have a say on monetary policy. Keeping the LZB-heads out of the Bundesbank's decision making will help in the transfer of power over monetary policy from the Bundesbank to the (ECB).

Under Eichel's reform plan, the Bundesbank president would still be appointed by the federal president at the recommendation of the German government. The other four members of the managing board would be appointed by the German government at the recommendation of the president of the Bundesbank. The German government would keep nine Landeszentralbanken in operation. The presidents of the LZBs would be appointed by the Federal President at the recommendation of the Bundesrat (Federal Council), the upper chamber of the German parliament, where the Bundeslander are represented. The LZB presidents would not be represented in the new Vorstand but would consult with the management on a regular basis. Germany's commercial banks and the public sector banks have welcomed the proposed reform plan. Not surprisingly, LZB presidents and some of the Lander governments are strongly opposed.

Will Eichel's plans for a single financial market supervisor and streamlined Bundesbank fail because he cannot get the needed support from the Lander in the upper chamber? Eichel's aides are confident that the Lander won't be able to block the single supervisor concept anymore. In their view, the Lander governments have one overriding concern: making sure that the nine regional Bundesbank branches continue to play a role in bank supervision and won't have to face massive personnel cuts. They also are under heavy pressure to guarantee that the LZB president will have a say within a slimmed down Bundesbank. The Bundeslander, some governed by the opposition Christian Democrats (CDU) and Christian Social Union (CSU), are jealously guarding their stake in the once powerful Bundesbank structure.

For the past year and a half, the finance ministers of four Lander--Kurt Faltlhauser of Bavaria, Pear Steinbruck of Northrhine-Westfalia, Georg Milbradt of Sachsen (who recently stepped down), and Heinrich Aller of Niedersachsen--have represented all the LZBs in negotiations with Eichel on restructuring the Bundesbank and financial supervision. Last December 6, the "Gang of Four" came up with a reform package of their own. Under their bill, bank supervision would be kept under the roof of the Bundesbank. The regional branches would supervise smaller banks that do not pose risks to the banking system. The Bundesbank would be run by an eleven-member managing board--five members appointed by the German government and six LZB-presidents appointed by the Lander governments. Since only six of the nine LZB presidents could vote at one time, seats would rotate among all the regional heads. Meanwhile, the Lander finance ministers are asking the Bundesbank to cut 30 percent of its staff, mainly at Frankfurt headquarters. "The Lander plan turns out to be very favorable for the Landeszentralbanken and very unfriendly to the Bundesbank headquarters" says Arnold of the private bank association.

Eichel has some strong cards to play in his negotiations with the Lander finance ministers. By adding some LZB presidents to the managing board of a restructured Bundesbank on a rotating basis, as does the Federal Reserve's Federal Open Market Committee, he could win the support in the upper chamber for his single supervisor plan.

Eichel also has powerful financial trends on his side. A more efficient central bank and consolidated banking supervision are just the latest moves in Germany toward financial regulation reform and more efficient capital markets.

Over the past decade, Germany has amended its financial regulations four times. It has abolished taxes on stock turnover, drafts and bills, and corporate capital injections; expanded the ability of investment funds to engage in options and futures trading; improved investor protections and transparency; liberalized derivatives trading, and introduced new types of investment funds, such as pension funds and venture capital funds.

"Regulatory reform, technical progress, and the international environment have combined to deepen and raise the efficiency of German capital markets" argues Goldman Sachs analyst Thomas Mayer in his study, Germany's Economic Revival: The Role of Capital Markets. "European Monetary Union has been leading to the integration of German markets into European markets with characteristics similar to those in the United States, albeit slightly smaller in size."

Enactment of Eichel's twin reforms will help ensure that Germany's role as a player in the global financial marketplace keeps growing.

Klaus C. Engelen is the international correspondent for Handelsblatt in Dusseldorf, Germany.