In academic discussions of the efficiency and desirability of corporate monitoring through institutional investors within the United States, the German system receives much attention because its financial institutions, especially its banks, are the major shareholders and monitors of industrial and commercial corporations.(1) One empirical study concludes that the German system of bank monitoring is not only highly effective, but also correlates with improved profitability.(2) It reduces the agency and information costs that result from separation of ownership and control in the U.S. system, thus minimizing costs and maximizing profits.(3)
Recently, however, the role of German banks in corporate governance appears to be changing. Bank control of German corporations has been weakened by developments in the German capital market. For example, the internationalization of the German capital market, resulting primarily from the European Community's financial market integration and company law harmonization program,(4) has reduced the gains realized by the banks' monitoring efforts.(5)
This Article describes recent developments in the German system in terms of the relationship between markets, financial institutions, and corporate governance. U.S. observers might benefit from the following discussion because of the similarities and differences between the German system and the current U.S. system. The German experience provides insight into the operation of the U.S. system of corporate governance and a blueprint for potential reforms.(6) The German experience is also relevant to the debate over the appropriate role of institutional investors in improving corporate governance.(7)
Part I provides necessary background for understanding the German system, illustrating the powerful role of German banks in corporate governance and the underdeveloped state of the German capital market. Part II demonstrates how difficult it would be for Germany to develop an efficient market for corporate control, describing various factors that would render the German system unfavorable to shifts in corporate control. Part III briefly compares corporate governance problems in the United States with those in Germany. Part IV describes recent developments in the German capital market and their implications for corporate governance. In particular, it analyzes the potential impacts of the recent European Community directives on German corporate governance. Part V discusses possible alternative mechanisms to address corporate governance problems that may be arising in Germany.
I. Major Attributes of the German System
A. Banks as Central Players
1. The Banks' Influence
Banks are the most important institutional investors in Germany. Pension funds, investment funds, and insurance companies, which constitute the major institutional investors in the United States,(8) so far have had little importance in Germany. One reason for this is that investment funds in Germany are quite limited in number and are dominated by banks.(9) The thirty-one domestic public investment funds, which manage 132 public funds with globally diversified portfolios, hold only DM 16.6 billion in fund capital. In addition, German retirement funding is very different from U.S. pension funding. Unlike the United States, in Germany, corporate retirement plan reserves are not primarily used to finance the corporation. Also, the government retirement system is funded through employee contributions rather than a capital cover procedure.(11) Furthermore, German insurance companies are subject to strict limitations with regard to investment in equity; they may invest only five percent of their capital.(12) In addition, the separation between the banking and insurance industries is slowly evaporating in Germany, thus making the banks more important. Deutsche Bank, for example, holds ten percent of Allianz and Munchener Ruckversicherung, the two largest insurance companies in Germany. …