Germany's distinctive, bank-based system of investment finance is believed to have played a key role in Germany's postwar economic success, by providing external finance for investment at low cost and by ensuring sound corporate governance. Jeremy Edwards and Klaus Fischer find little evidence to support this view in their detailed comparison of banks, finance and investment in Germany and the United Kingdom.

Economic theory suggests that the German system might have two important advantages: it might provide finance for investment more readily and at lower cost; and it might ensure better monitoring of managements on behalf of shareholders. German banks might be able to provide loan finance at low cost for two reasons: their representation on supervisory boards gives them access to better information about the firms to which they lend; and such representation might enable banks to reduce the costs of financial distress, by preventing managers of failing firms from taking actions which harm the suppliers of debt finance. The German system might also be better at providing equity finance: because they know more about the firms, banks might be able to screen new issues more effectively on behalf of potential shareholders. Investors would therefore be more willing to take up new issues which have been screened by the banks, and firms would gain improved access to equity finance.

Corporate governance might be better in Germany as well. It is often argued, for example, that in companies with widely dispersed share ownership, an individual shareholder has little incentive to monitor managers closely. Banks' proxy voting power and supervisory board representation _might_ enable them to monitor more effectively managerial performance and so avoid the need to use hostile takeovers to discipline managers.

The theoretical case for a German-style system seems compelling. Edwards and Fischer's detailed analysis reveals, however, that the system does not seem to operate as the theory suggests. Over the period 1970-89, for example, their calculations (based on flow of funds data) reveal that UK non-financial enterprises financed a higher proportion of their gross capital formation by loans from financial institutions than did German non-financial enterprises. Related research by CEPR Research Fellows Jenny Corbett and Tim Jenkinson confirms this finding: their comparison of investment finance in Germany, Japan, the United Kingdom and the United States reveals that if there is an outlier, it is Japan, not Germany.

Does representation on supervisory boards lead German banks to provide a greater volume of loan finance? Edwards and Fischer find little empirical evidence to support this claim. Most German firms do not possess supervisory boards: only AGs and large GmbHs are legally required to have them. AGs actually financed a smaller proportion of their investment by bank loans than did other types of firms in Germany. AGs also financed a smaller proportion of their investment by bank borrowing than did comparable public limited companies in the UK.

Edwards and Fischer also find that German banks supply very little external equity finance to firms: equity represents only about 3% of the value of bank loans made to German non-bank firms. Neither do German banks play an important role as underwriters of new issues. Until the early 1980s, German companies made very fewinitial public offerings of shares: this method of raising finance was insignificant.

Are German banks, by virtue of their positions on supervisory boards, able to limit the costs of financial distress and ensure smooth reorganizations of troubled firms? The evidence presented by Edwards and Fischer casts doubt on this claim as well. Because German bank loans to firms are typically secured by collateral, the losses banks suffer from a firm going bankrupt are small on average, and hence banks' incentives to reorganize rather than liquidate are limited. The evidence also shows a tremendous variation among German banks in their ability to detect problem loans at an early stage and to reorganize firms in distress.

There is also little evidence that German banks play a key role in controlling managements on behalf of shareholders. Steven Kaplan's study of management and supervisory boards in Germany reveals that turnover on these boards does increase with poor share performance, but that the turnover-performance relationship does not vary with measures of bank voting power. In addition, if banks did play an important rolein corporate governance, then profits should be higher in firms where banks have stronger control: the empirical evidence available for Germany suggests this is not the case, according to Edwards and Fischer.

It may be that German banks don't need to monitor managers closely: in the United Kingdom share holdings are typically widely dispersed, but in Germany most large listed AGs have at least one shareholder whose holdings are large enough to provide them with a strong incentive to monitor management. Edwards and Fischer argue that if large German firms do suffer less from managerial failure than do their UK counterparts, the reason may not be that German banks are especially good at controlling managers, but that the structure of share ownership in Germany provides shareholders with stronger incentives to monitor managers themselves.

Banks, Finance and Investment in Germany, by Jeremey Edwards and Klaus Fischer, was published by Cambridge University Press earlier this month.

Edwards is aUniversity Lecturer in the Faculty of Economics and Politics at Cambridge University and a Research Fellow in the Financial Economics programme at CEPR.