What can the U.S. banking system learn from Germany?
Contrary to the United States, Germany has not witnessed any catastrophic financial contagion event with smaller banks. In the U.S., smaller banks play a pivotal role in lending to small and medium-sized enterprises (SMEs), which are closely intertwined and vulnerable to systemic risk.
The downfall of such banks, accounting for approximately 50% of SME lending, can cause a domino effect throughout the financial system, as observed in examples like Silvergate Bank, Silicon Valley Bank, Signature Bank, and possibly First Republic Bank.
Adding fuel to the fire, many small U.S. banks have invested heavily in securities known as HTM" rather than deposits, making themselves more susceptible to market fluctuations, particularly in a high-interest-rate environment with an inverted yield curve.
These securities offer banks a predictable cash flow and fulfill their liquidity requirements.
However, the existing accounting methodology for HTM investments is based on their original cost rather than their current market value, resulting in overvalued bank assets and underestimation of risk exposure.
On the other hand, the German banking system follows a more decentralised and community-driven strategy with its cooperative and Sparkassen systems.
Smaller banks like Sparkassen and Volksbanken prioritise the interests of local communities and businesses, are owned by their members and customers, and make decisions based on the best interests of their locale, thereby reducing their vulnerability to market fluctuations and protecting deposits.
This decentralised structure mitigates systemic risk since each bank operates independently, serving its local community. In the event of one bank encountering financial difficulties, other institutions are unlikely to be affected since they are not connected via complex financial instruments and interbank lending, thereby preserving the overall stability of the banking system.
Hence, it is evident that small banks in the U.S., the primary lenders to SMEs, are highly contagious due to the interconnected nature of the U.S. banking system. Moreover, their risky investments make them vulnerable to systemic risk.
In contrast, the German banking system's decentralised and community-focused approach promotes stability and resilience in the face of economic shocks.
Similar to the German banking system, there is an emerging new technology revolutionising the banking system globally.
Institutional DeFi is an emerging sector that can address contagion and trust issues in traditional finance. By leveraging decentralised technologies, Institutional DeFi can provide greater transparency, security, and resilience to financial systems.
For instance, DeFi protocols can offer a more secure and transparent way of managing financial transactions, removing intermediaries, and reducing the risks associated with traditional financial systems. Additionally, the decentralised nature of DeFi means there is no central point of failure, and each institution can operate independently, serving its community.
This decentralisation can help mitigate systemic risks and prevent the spread of contagion in the event of a financial shock, leading to a more stable and resilient financial system.