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The deregulation and integration of financial services is an
important element of the 1992 programme. Regulatory structures and
banking development differ widely among EC members, and until recently,
some countries also imposed legal obstacles to the establishment of
foreign bank subsidiaries and to the acquisition of firms by foreign
banks. 1992 will increase competition in European banking, Xavier
Vives told a 14 February lunchtime meeting organized jointly by CEPR
and by the UK office of the Commission of the European Communities. But
important features of retail banking mean that competition will still be
limited and the gains to consumers not so great as previously suggested. The Commission's Second Banking Directive established the legal framework intended to foster greater integration of the banking sector. Authorization for a financial institution to operate in any one EC country automatically gives the right to operate throughout the Community. The central issue, Vives argued, is how liberalization will affect competition. The Price Waterhouse study for the European Commission on `the cost of non-Europe' in financial markets concluded that important welfare gains would be achieved because integration would stimulate competition. Because of banks' role in providing liquidity insurance and opportunities for risk sharing, Vives argued, regulation has taken the form of deposit insurance schemes and controls on the interest rates offered to depositors and borrowers. These regulations have had side-effects, notably regulatory capture and moral hazard (witness the experience of the US savings and loans), providing a focus for restrictive practices and collusion. European banking has therefore been characterized by a lack of competition, keeping prices above competitive levels. One consequence is that banks have shifted the focus of competition to service quality, for example in the proliferation of branches and the provision of ancillary services. The environment of heavy regulation will be shattered by the principle of mutual recognition enshrined in the Second Banking Directive, and as a result competition among banks in Europe will increase. The Price Waterhouse report argued that the prices of financial services would fall across Europe to the lowest existing levels in the EC, because banks that fail to match the lowest price will be driven out of their markets by more aggressive competitors. This prediction is too extreme, according to Vives. In banking, and particularly retail banking, a number of important economic barriers to entry will remain even after deregulation, making such `hit and run' entry infeasible. These barriers include the need to compete with existing firms who have accumulated networks of branches and automated teller machines, the costs to consumers of switching banks, and the importance of reputation. These factors will place an upper limit on the likely gains from integration, which will fall short of the levels associated with fully competitive outcomes. This view is supported by the structure of European banking today, Vives argued. Freedom of capital movement already exists in several countries and almost all legal obstacles to the establishment of banking subsidiaries have been removed (with the temporary exception of Spain). But trade in banking services is still limited, and foreign banks' market shares vary substantially in different European countries. Unless hidden restrictions persist, there must be important economic barriers to entry. These conclusions also suggest that the banking market will remain segmented, according to Vives, with different degrees of competition coexisting and an uneven distribution of the benefits of integration. Large-scale corporate banking is already subject to strong international competition. There will be significant increases in competition in retail banking for wealthy individuals and in corporate banking for medium-sized firms, where barriers to entry are less significant. Mass retail banking will see the smallest increase in competition, because here branch networks and high switching costs for consumers are of the most significance. Low-income depositors will probably experience welfare losses as a result of increased price competition, since banks will no longer tend to cross-subsidize some activities, in particular cheque accounts, where charges to consumers have not reflected costs. 1992 will also bring an increase in mergers and acquisitions, Vives predicted. Banks have opened a proliferation of branches in order to locate near their customers. When they are free to compete on interest rates, they will be left with overextended networks, which may only be rationalized by mergers. Concentration in local markets will therefore increase, as occurred in the United States after deregulation there. The role of branch networks as a barrier to entry also means that the only way to enter a market may be to acquire an existing bank. Finally, Vives warned that the EC Directives on financial regulation may have undesirable consequences. As many observers have noted, the ground is laid for a `deregulatory competition' among national regulators. National authorities will face strong incentives to be very liberal in setting standards, so as to give their home banks a competitive edge abroad. The home regulator will know that should a disaster befall an overseas subsidiary, the cost will be borne by foreign taxpayers; the result will be `too little' regulation. The EC Directives call for minimum standards but, Vives argued, they give national regulators insufficient incentive to internalize costs. |
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