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European
Banking The European banking industry is
in turmoil. Along with other financial-sector activities, formerly protected
domestic banking markets are being opened to competition. As a result, banks
throughout Europe are undergoing the most far-reaching process of consolidation
and restructuring of the post-war period. The pace of mergers and acquisitions
has accelerated and banks that have long been in trouble are disappearing more
rapidly. This European phenomenon carries echoes of wider international trends.
Following an unprecedented wave of cross-border mergers and acquisitions, a
handful of huge global institutions seem prepared to dominate the scene. At the
same time, the Asian crisis and its aftermath have left deep wounds. Banks –
and European banks in particular – appear to be vulnerable to economic
accidents like Asia and Russia; in some respects, banks have been shown to be
more fragile than ever before, as the consequences of the recent near-collapse
of Long Term Capital Management illustrate. Not only the industry but also
the bank as an institution is changing. Advances in information and financial
technologies are transforming banking practices at the same time as regulatory
changes have transformed banking markets. This has been true in the United
States, with the Riegle-Neal Act of 1994 and the gradual repeal of the 1933
Glass-Steagall Act. It applies even more so in Europe, where the EU has been
attempting to create a more level playing field in banking, as in other
financial markets. But Europe’s financial markets
are now also being hit by two additional shocks: first, the transition to a
common currency under EMU; and second, the transition from pay-as-you-go to
funded social security systems. Either shock on its own would cause an upheaval
in European portfolios, as European households shift from holding bank deposits
towards securities, especially equities, and towards more
internationally-diversified portfolios. Their combined force is likely to
further transform the European financial landscape. For banks, there are likely
to be profound changes in their relationships with their clients, in both the
household and corporate sectors. These developments raise
questions of fundamental importance for the European banking industry. What
forces are driving this accelerated transition? Where is the industry heading?
What risks lie ahead in the transition? At what speed, and towards which model,
will the practice of banking and the process of financial intermediation in
Europe converge? Will European banks come to resemble their US counterparts and
competitors? What are the implications for competition within the European
market and for the competitiveness of European banks? And how should
governments manage regulation and bank supervision? These are some of the key
questions addressed in a new CEPR Report, entitled ‘The Future of European
Banking’, the ninth in the influential annual series, Monitoring European Integration. Published in February 1999, the
Report was written by Jean-Pierre
Danthine (Université de Lausanne, International Center for Asset Management
and Financial Engineering (FAME), Geneva, and CEPR), Francesco Giavazzi (Università Bocconi, Milano, and CEPR), Xavier Vives (Institut d’Anàlisi
Econòmica, CSIC, Barcelona, and CEPR) and Ernst-Ludwig
von Thadden (Université de Lausanne and CEPR). The authors discuss the
contemporary nature of the bank as an institution; describe the recent
transformation of the US banking industry; assess the current condition of
European banking markets; and explain the differences between the European and
US commercial-banking sectors (and why these differences might be a source of
concern). Then, focusing on the impact of EMU, they explain why the euro will
transform the asset-management and investment-banking sectors; examine the
policy issues facing Europe’s regulatory and competition authorities at both
the national and supranational levels; look forward to the nature of European
banking in the 21st century; and, finally, offer an agenda for policy. Will the European banking
industry end up just like its US counterpart? The Report’s authors note that,
on purely objective grounds, the post-Riegle-Neal Act United States and
post-EMU European banking sectors will be very similar, suggesting that the two
may converge on a single model. But the transformations of the US and European
banking industries differ in two important respects. First, the deregulation
process in the United States is more advanced – not only because the currency
segmentation of European markets has only now been removed (and only among 11
countries), but also because to date the EU’s Single Market Directives,
although substantial on paper, have not been as effective in practice. Second,
despite the massive consolidation of the financial industry in the United
States, concentration at the level of local banking markets has, if anything,
decreased. In Europe, by contrast, mergers among commercial banks so far have
been mostly within national markets. Moreover, although the European banking industry will certainly undergo major changes, it is likely to remain quite different from its US counterpart because of three fundamental factors: (1) EMU countries are not US states: although seemingly counter-intuitive, the diversification of macroeconomic risk – which has been the driving force behind the wave of interstate mergers in the United States – in fact requires less cross-border consolidation in Europe, where regional diversity within national boundaries still provides adequate insurance; (2) the weight of different European cultures and languages will not disappear, at least at the retail, consumer-market level; and (3) the European financial framework – including law, taxation and, more importantly, regulatory and supervisory institutions – is still far from harmonized. Finally, history matters: in the
restructuring process, European banks will benefit from the advantage of
incumbency in European markets. Conversely, in the United States, the
incumbency advantage of US investment banks and asset managers is likely to
compensate more than enough for their inability to exploit existing economies
of scope with commercial banking activities. The convergence of banking models
in Europe and the United States will thus be conditioned by their histories of
universal and specialized banking respectively. Turning to the prospects for
competition and consolidation among European banks, the Report argues that the
limited evidence available suggests there is room for further intensification
of competition, even though the industry appears already to have gone through a
significant increase in competitive pressures. In part because of the current
lack of regulatory harmonization, but also owing to past heritage, competitive
conditions so far have provided only a limited impetus for change. The
existence of different currencies has been an important factor in European
market segmentation, playing in some sense the role of interstate banking
restrictions in the United States. The advent of the euro will undermine this
effect but will not be enough in itself to create a true single European
financial market. Non-regulatory barriers – taxation and corporate law in
particular – are also likely to remain important for the foreseeable future as
a source of continuing segmentation. Again, the fact that
diversification and consolidation possibilities in Europe are almost as good
within countries as they are across countries is relevant here. A European
bank’s first bids for growth by acquisitions would more naturally be made
nationally, where mergers are easier in terms of culture and regulation, and
where they may also bring local market power – a welcome relief from increasing
competitive pressures. But there will also be losers from such increases in
market power, notably small businesses – which will not be big enough to access
the new euro financial markets directly – and consumers, at least until direct
banking becomes more widespread. Competition is not the only
argument why this tendency for national consolidation is unhealthy. Because
national banking-market structures and lending practices differ across Europe,
the same change in ECB-set interest rates will affect EU economies differently.
This could be a serious hindrance to the operation of a single monetary policy.
One reason transmission mechanisms differ across EMU states is precisely the
heterogeneous structure of the European financial industry. The creation of new
cross-border suppliers of financial services, at a time when European consumers
and firms are likely to become more similar, would plausibly result in a
homogenization of financial practices across EMU. The Report’s authors believe that
the areas of European banking that will be most affected by the euro are asset
management and investment banking. Both activities involve economies of scale
that are likely to become more important with the introduction of the single
currency. These scale economies will induce two types of mergers: first,
acquisitions with the simple purpose of enlarging the stock of assets under
management; and second, acquisitions with the purpose of buying human capital
(teams) and technology. The first kind of merger need not be cross-border:
domestic acquisitions may be good enough to build up volume. But acquisitions
designed to build expertise in the technology and process of asset management
will be cross-border, though mostly directed towards US and UK-based investment
banks. Economies of scope between
investment and commercial banking provide an organizational advantage to
universal banks. So, despite the fact that early attempts at integrating
commercial and investment banking cultures have not been successful, the
incentives of commercial banks will change. Relying on the experience of past
failures at building universal banks may not be a good way to think about
future developments. That said, few European banks
will make it to the status of universal banks. But those that do will try to
exploit the economies of scale across EMU, fighting the battle with US
universal banks and specialized investment banks. The outcome is uncertain.
European universal banks will be boosted by the advantage of incumbency in most
of the areas in which they are active. The difficulty of integrating investment
and favourable commercial banking cultures are the main advantages of the US
specialized institutions – and the biggest challenges for the new European
universal banks. But regulation, provoked by the desire to stop commercial
banks taking on too much off-balance-sheet risk, could slow down the emergence
of European universal banks. If consolidation of the banking
industries within individual European countries is undesirable for reasons of
competition, it may prove popular nevertheless for other reasons. In
particular, chauvinistic support for ‘national champions’ often hides behind
the fear that local consumers and firms may be neglected by large institutions
with headquarters located far away. Only domestic banks, so it is argued,
preferably small and with a strong local presence, can understand and service
local clients appropriately. This argument, however, is not
well-founded. Analysis of the effects of consolidation in the United States –
where local competitive conditions have been preserved by authorities – on the
availability of bank credit to small US firms, reveals no evidence that local
consumers and firms are neglected. The bottom line, therefore, is
that cross-border consolidation should be encouraged by removing the barriers
(legal, fiscal, regulatory and political) to such mergers. Cross-border mergers
permit the emergence of efficient producers without prejudice to competitive
conditions. They also help homogenize banking practices, promoting the
desirable convergence of the mechanisms by which a single monetary policy will
be transmitted to the real side of European economies. It is time, argues the
Report, to favour the emergence of European competitors rather than national
champions. In this endeavour, the main
players will be the national competition authorities. If domestic consolidation
of the banking industry beyond a certain degree of concentration is made
impossible by local competition authorities or by the European Commission,
national banks will learn to go against their natural tendencies and start
consolidating internationally. At the same time, the role of European
competition policy will remain important, particularly in checking that state
aids do not derail the necessary restructuring of inefficient banks that are
regarded as national champions. What impact will these changes
have on European citizens? The transformation of the European banking industry
is of no trivial consequence for the welfare of European citizens. An efficient
system of intermediation should encourage savings by offering consumers a large
choice of high-performance savings instruments, and promote investment by
providing adequate and low-cost financing to all projects likely to feed
economic growth. attempt to defend their turf by
obstructing the rapid growth of such a market; and second, governments –
inspired by national chauvinism – may act to foster and protect their ‘national
champions’. In either case, European citizens will bear a high cost. What do the Report’s conclusions
imply for the policy agenda? Given the present uncertainty and turbulence in
world financial markets, is there a case for the financial authorities to
exercise greater control over the markets? Certainly, the recent financial
crises in Asia and Latin America have increased the salience of calls for more
restrictions on the activities of financial intermediaries. The Report’s view is that a
better approach would be to minimize interference with the market and use
market mechanisms to improve regulation. The right word is therefore
‘regulation’, not ‘control’. It is vital, however, to get regulation right. The
authors consider that banking should be subject to two types of constraints
only: those derived from a concern for the stability of the financial system;
and those derived from the need to check market power. On competition, the days in which
banking was off-limits for competition policy are gone, and should not be
permitted to return. The tendency towards national consolidation is a challenge
for European competition authorities since it is likely to reinforce local
monopoly power. This is particularly important for small-firm lending, as large
firms will access the euro capital markets directly, and consumers will have
the option of turning to specialized asset managers and direct banking. Banking
supervision is a particularly delicate and urgent issue in EMU. Traditionally,
supervision has focused on the assessment of the quality of a bank’s balance
sheet at a specific point in time, and on whether it complies with capital
requirements and restrictions on portfolio composition. The Report considers
that this approach is no longer adequate in a world in which banks are active
players in the capital market and, because of trading losses, can be driven
into insolvency extremely rapidly. As banks take on more market
risk, their ability to withstand sudden fluctuations in market prices also
depends on the readiness of the central bank to provide liquidity to the
financial system and to banks in particular. In this respect, the ECB is a very
different institution from the Fed – more concerned with, and more constrained
by, the risks it may take onto its own books, and thus less likely to be ready
to provide liquidity to banks. The implication is that ex ante regulation and supervision are correspondingly more
important in EMU than they are in the United States. An associated issue is whether
bank supervision should be centralized. The Report concludes that there are a
number of risks associated with the current decentralized supervisory system
for European banking. The advent of cross-border banking, the likely emergence
of pan-European universal banks and, more generally, the new competitive
climate of European banking, confront national supervisors with delicate
coordination issues. In the face of these challenges, it is unlikely that
simple coordination among independent national authorities – as provided for by
the Second Banking Directive – will be a safe arrangement. Past European experience with
national supervision has not always been satisfactory, with domestic
supervisors sometimes being too close to the institutions they regulate, thus
risking being ‘captured’. The natural distance that a supranational regulator
keeps would thus appear to be particularly healthy. It is ironic, however, that
while the international financial community is studying the possibility of
setting up a ‘world financial regulator’, petty national jealousies appear to
be preventing this from happening at the European level. This situation puts at
risk the stability of European financial markets. Building a centralized supervisory
body was a possibility foreseen in the Maastricht Treaty, but it appears only
to allow centralization of supervisory responsibilities inside the ECB.
Although a clear improvement on decentralized supervision, this may not be the
optimal arrangement, since the ECB is already being perceived as
accumulating too much power, and issues of accountability have been raised. An
independent European-wide regulatory agency, distinct from the ECB, may
generate fewer concerns in this respect, while at the same time facilitating
accountability. Thinking about a new European
agency would also allow fresh consideration of the desirability of combining
the supervision of banks and markets. As universal banking makes it
increasingly difficult to distinguish between market risk and the risk of
individual banks, the argument for combining the two functions of bank and
market supervision in an independent supranational EU agency seems
overwhelming. Finally, the Report draws
attention to the fact that, important as it may be for the growth of European
firms, an efficient euro corporate bond market will not spring up in a vacuum.
Banks could see in such a market a strong competitor, and use their incumbency
advantage to hamper its development. The authorities cannot guarantee that
Europe-wide securities markets will thrive but – as in the case of cross-border
consolidation – they can certainly ensure, through inappropriate regulation and
taxation, that efforts to build them fail. As importantly, a liquid corporate bond market will only blossom if the central bank is prepared to provide liquidity to the system whenever necessary. Although there is no direct mention of this task in the statutes of the ECB, the Board of the Bank should carefully consider the role that the Fed has played in fostering liquid markets in the United States. The Future of European Banking Order
from CEPR ISBN: 1 8981 28 38 3 Price: £15/$24/ €24 |