By Patricia Kowsmann 

FRANKFURT -- Ten years ago, David Zimmer quit his management job to build his own fiber-optic network company in Germany. With EUR4 million ($4.9 million) in hand, he knocked at the door of about 20 banks for a EUR4 million loan.

Private banks including heavyweights Deutsche Bank and Commerzbank didn't even reply to requests for a meeting, Mr. Zimmer says. In the end, his company, Inexio, got funding from two small local lenders -- a state-owned savings bank and a cooperative bank.

"If it weren't for the savings and cooperative banks, we wouldn't be here," said Mr. Zimmer, whose company now employs 300 people and has EUR65 million in annual revenue. "And I suspect that is true for many SMEs [small and medium-size enterprises] in Germany."

Germany may be the worst place in Europe to be a bank. With more than 1,600 banks, more than in the U.K., France, Italy and Spain combined, the sector is crowded and margins are low. Yet to many Germans, the copious credit this galaxy of banks makes available to businesses is a factor of their economy's success.

That has put German banks at the center of a continentwide question: What should European lenders look like?

Since the financial crisis that revealed bad lending practices and profitability troubles at many European banks, regulators have promoted consolidation. In Portugal, the European Central Bank supported takeovers by Spanish banks. In Italy, a law was passed to ease takeovers of small cooperative banks. And the EU has pressed Berlin to cut down the number of lenders.

But Germans argue that their fragmented system turned out to be a boon during the financial crisis. State savings banks and cooperatives, which didn't hold risky securities, kept lending while commercial banks seized up. The model has since caught the attention of Ireland, where lawmakers are mulling the creation of state-owned local savings banks.

"There is no question the fragmented nature and diversity of the German banking system is part of the success of the country's economy," said Patrick Rioual, head of German financial institutions ratings at Fitch. "It fosters small companies' reliable and cheap access to credit, which supports their development."

Germany's "three-pillar" banking system is split into about 200 commercial banks, 400 state-owned local savings banks, including six larger regional lenders, and 970 cooperative banks owned by their 18 million account holders -- one in four Germans.

This is a highly fragmented, and moderately lucrative, market. Commercial banks hold just one-third of loans and deposits, according to Citigroup, while the top five banks have a 30% market share, against a 60% average in Europe. Pretax profit margins at listed German banks were 16% of revenue in 2016, compared with 23% in France and 42% in the Netherlands.

"I learned in economics that a high level of competition is a good thing, " said Sven Giegold, a German Green Party EU lawmaker based in Brussels, where Germans are fiercely lobbying to keep their system intact.

But competition in the German market doesn't extend everywhere. While the cooperative and savings banks compete with one another and with the commercial players, they enjoy exclusivity on their respective territorial patches -- there is no competition within the system's state-owned and cooperative pillars.

And while they are run for profit, they stress their public-service role of serving the local economy.

"We still refuse to accept government aid, we don't chase after any stock-market trends, and always ask ourselves 'what do people need,'" says a character dressed in 19th-century garb in a promotional video produced by the cooperative banking association.

There's some truth to the high-minded claim. While commercial banks froze lending during the financial crises of the past decade, cooperative and savings banks increased their exposure to German companies, according to central bank figures. SME surveys show German companies were the least affected by a credit crunch that hit Europe in 2012.

In Baden-Baden, a spa town in Germany's wealthy southwest, the local savings bank has a 40% market share and half its outstanding loans are to businesses, from automotive suppliers to health providers and hotels.

"We are happy to take on customers who initially require relatively small loans," said Lothar Volle, the local lender's chief executive. "The idea is to help them grow."

To be sure, Germany's banking model has had its share of trouble. The larger regional lenders made risky bets ahead of the 2007 crisis and some collapsed or had to be rescued as a result. The country's largest institution, Deutsche Bank, overextended itself and was caught in scandals. Overcrowding means many lenders are struggling to survive in a low-interest-rate environment.

But in a country where 99.6% of all companies are small-to-medium size and businesses are scattered across the map, small local lenders play an outsized role.

Far away in Ireland's capital, which was hard hit by a banking crisis in 2010, lawmakers are interested in the model.

"In a small country like Ireland, the demand is for smaller units that are engaged and understanding of the local communities," said John McGuinness, head of parliament's finance committee. "That's why we want our Sparkassen."

Write to Patricia Kowsmann at patricia.kowsmann@wsj.com

(END) Dow Jones Newswires

January 22, 2018 05:44 ET (10:44 GMT)