Banking Competition
Financial Intermediation

Financial intermediation is currently an active subject of research on both sides of the Atlantic, and its direct policy relevance is also increasing. The integration of Europe's financial markets raises questions concerning the risks to the banking system of increased competition, the appropriate forms of regulation for banks and other financial intermediaries, and the relative merits of Anglo-American vis-à-vis European types of financial markets. The choice of financial system best suited to promote economic growth and the design of reform packages to establish such systems are also central to Eastern Europe's economic transformation. These issues were discussed at a joint CEPR conference with the Fundación Banco Bilbao Vizcaya (BBV) on `Financial Intermediation in the Construction of Europe', held in San Sebastián on 27/28 March, which brought together some 40 leading academics from Europe and North America. The conference was organized by Colin Mayer, Price Waterhouse Professor of Corporate Finance at the City University Business School, London, and Xavier Vives, Research Professor at the Institut d'Anàlisi Econòmica (CSIC), Universitat Autònoma de Barcelona, Co-Directors of CEPR's Applied Microeconomics programme.

Competition in Banking

Anjan Thakor (Indiana University) presented his joint paper with David Besanko, `Relationship Banking, Deposit Insurance and Bank Portfolio Choice', which showed how borrowers may benefit from imperfect competition in banking. Relationship banking entails the accumulation of proprietary, borrower-specific information and the consequent creation of informational rents by banks, which they share to some extent with borrowers. Relationship banking also increases the value of a bank's charter; this may mitigate the problem of moral hazard that arises if deposit insurance encourages socially wasteful risk-taking by banks. As banking becomes more competitive (or faces increased competition from capital markets), however, the value of such long-term relationships diminishes, which enhances the attractiveness of riskier loans. Thakor concluded that increased competition among banks may therefore make all borrowers worse off.

Richard Gilbert (University of California at Berkeley) maintained that interest rates should be made endogenous in the model. Carmen Matutes (Universitat Autònoma de Barcelona and CEPR) argued that Thakor's model was unnecessarily complicated; she suggested how the proposed equilibrium strategies need not be optimal and challenged the role of deposit insurance in the model.

In `Competition and Bank Performance: A Theoretical Perspective', Michael Riordan (Boston University) considered the effects of the increased competitiveness in banking that is expected to characterize Europe's future. Banks insure lenders against the risk of default they would face by lending bilaterally to borrowers and screen investment projects through their process of approving loans and setting terms. Lenders are imperfectly informed about the quality of their investments; such markets are typically characterized by a `winner's curse', which increased competition exacerbates, thereby inducing tighter screening by individual lenders. This may also reduce welfare if the information banks use to make their lending decisions tells them less about the quality of loans.

Anthony Santomero (University of Pennsylvania) suggested that this model described a bank-lending problem rather than an investment problem. He noted that the homogeneous investors considered in this model had no special abilities to generate signals so there was no real communication. David Pyle (University of California at Berkeley) suggested incorporating comparative advantage in the collection of information: competition may help good banks to attract the best projects.

Financial Instruments and Markets

In his paper, `Seniority and Maturity Structure of Bank Loans and Publicly Traded Debt', Douglas Diamond (University of Chicago) developed a model to describe how highly-levered borrowers in financial distress with private information about their credit prospects choose the seniority and maturity of their debt. Borrowers face a trade-off: long-term debt protects managers' `control rents' (the future returns to the project that accrue to borrowers but which cannot be assigned to lenders in the event of the firm's liquidation), while short-term debt increases the sensitivity of the financing cost to new information, which will benefit a borrower who expects its credit rating to improve. If control rents are large, however, even these `good' firms will prefer to protect them by giving away some of the benefits of such enhanced information. Also, making short-term debt senior to long-term debt and writing contracts for junior long-term debt to allow additional debt senior to it can increase the sensitivity of the financing cost to new information for a given level of managerial control. Diamond maintained in conclusion that his model's predictions were consistent with data on the structure of many leveraged buy-outs in the mid- and late 1980s.

Patrick Bolton (Université Libre de Bruxelles and CEPR) pointed out that long-term debt plays no role so long as renegotiation is allowed and that Diamond's model took no account of the type of renegotiation. Martin Hellwig (Universität Basel and CEPR) argued that Diamond's approach restricted the set of possible contracts to a specific, non-optimal type.

Gary Gorton (University of Pennsylvania) then presented the paper, `Stock Markets and Resource Allocation', by Franklin Allen, which assessed the relative weights European countries should place on stock markets vis-à-vis banks for raising funds in the design of their financial systems. Banks perform better in economizing on information gathering and stock markets do better in providing diverse views about the likely future performance of an investment. Most analyses assume that the production technology is well known and that problems of resource allocation are essentially static. In fact, managers' views about the relationship between actions and value vary, and multiple draws on stock markets provide incentives to gather information. Stock markets may therefore perform better in checking that managers' views of their firms' production functions are sensible in cases where there is no clear consensus on how firms should be run. This is likely to apply to industries that are relatively uncompetitive or characterized by long periods before the results of their actions become apparent or by rapid technological change. Banks, in contrast, are better suited to screening and monitoring of firms that use well-established production techniques.

Anjan Thakor noted that rapidly changing conditions enhance the importance of renegotiation, in which case firms normally prefer to raise finance from banks. Sudipto Bhattacharya (University of Delhi) suggested focusing on spillovers of proprietary versus private information to gain a sharper understanding of the relative performance of stock markets and banks in disseminating information. Martin Hellwig questioned Allen's emphasis on external finance, since internal finance has been predominant in practice.

Regulation

In their paper, `Financial Intermediation, Regulation and Reputation: Theory and Policy Implications', Arnoud Boot and Stuart Greenbaum (Northwestern University) argued that increased competition in banking in particular the erosion of monopoly rents has enhanced the importance of reputation- building incentives to financial institutions. Reputation allows banks to reduce their market-determined funding costs on the uninsured parts of their funds, which gives them incentives to increase their monitoring to avoid risk. This creates funding- related reputational benefits, which can substitute for rents, since both encourage monitoring. In contrast, deposit insurance fixes banks' future funding costs and therefore destroys funding- related reputational benefits; this can have detrimental effects on banks' behaviour. Boot and Greenbaum concluded by endorsing recent `narrow bank' proposals for financial sector reform, which separate banks' monetary and non-monetary functions and restrict their use of insured deposits to the funding of safe assets, while allowing them full discretion in the use of uninsured deposits.

Pierre-André Chiappori (Département et Laboratoire d'Economie Théorique et Appliquée, Paris, and CEPR) pointed out that bank owners still take risks whether depositors are insured or not, due to limited liability, so the main issue is the observability of their risk-taking behaviour. Gary Gorton noted that the model assumes that customers are much better informed than they actually are: if they can observe banks, then monitors can observe firms, so there may be no need for banks.

In his paper, `Banking: Private Governance and Regulation', written jointly with Mathias Dewatripont, Jean Tirole (Université des Sciences Sociales, Toulouse, and CEPR) considered moral hazard at the levels of the bank and its monitors. He first considered banks as ordinary firms and focused on their governance structure rather than defining them in terms of their specific activities. Dispersed and uninformed small depositors hold most of banks' debt, which seriously limits the intensity with which their managements are monitored. Tirole applied earlier models of the optimal financial structure of the firm to the optimal control of banks' management, with profits as `hard' information and the (non-verifiable) riskiness of loans as `soft' information. This indicated that both shareholders and creditors can discipline bank management: in good times control goes to equity, while in bad times control shifts to debt. Tirole then extended this model to the case where the regulator acts on behalf of the depositors, by encouraging banks to recapitalize when the value of their assets is reduced.

Ailsa Röell (LSE and CEPR) suggested describing some more real- world applications of the model, especially concerning renegotiation. Also, if applying this model developed for firms to banks indicates that government intervention works, similar intervention should benefit firms outside the financial sector. Martin Hellwig pointed out that this paper, like much of the theoretical literature, neglected the systemic risk that had provided the historical motivation for banking regulation: things may go badly for many banks simultaneously.
Eastern Europe

In her paper, `Creditor Passivity and Bankruptcy: Implications for Economic Reform', Janet Mitchell (Cornell University) assessed Hungary's recent experience with bankruptcy. She described how creditor passivity in seeking the satisfaction of claims against default is increasing in Eastern Europe, hindering the implementation of bankruptcy laws, and potentially subverting efforts towards economic reform. In the Hungarian case, state agencies and banks have remained passive, and only trade creditors have initiated bankruptcy proceedings. Mitchell suggested three broad explanations of this passivity. First, creditors may believe the value of their claims to be too close to zero to warrant the effort of collecting them, or that their debtors' prospects and hence the value of their own claims will improve. Second, they may be reluctant to signal the extent of their non-performing claims, which would reduce their own reported profit levels or worse. Third, creditors have an incentive to remain passive as long as they believe that others will remain passive: if such `implicit collusion' leads to a collusive equilibrium with self-fulfilling beliefs, the government faces a credibility problem, since it cannot force everyone into bankruptcy.

David Newbery (Department of Applied Economics, Cambridge, and CEPR) distinguished firms with a positive cash flow, which could survive by not repaying their debts and could in principle be restructured, from those with a negative cash flow, which should be liquidated. Difficulties would then arise from the need to complete restructuring before privatization, as the German case has shown, which seems impracticable for most East European countries today. Also, privatizing banks would strengthen their hand in negotiations with firms. Anthony Santomero questioned why banks do not liquidate firms when both are owned by the government: the `unique body' explanation does not apply, since governments are collections of individuals with different interests.

In their joint paper, `Enterprise Debt, Bank Credit and Monetary Policy', David Begg (Birkbeck College, London, and CEPR) and Richard Portes (CEPR and Birkbeck College, London) maintained that the widespread failure of East European firms to meet promised payments to banks (and other firms) is threatening their survival and undermining the price system's ability to reallocate resources efficiently. These economies exhibit excessive levels of rolled-over loans, which absorb credit needed to finance new firm entry. Early privatization of banks is important, but it will not be sufficient for the reasons given by Mitchell. Moreover, banks like other firms are insolvent now and must become solvent before privatization. To achieve this, Begg and Portes favoured recapitalizing banks directly over recapitalizing their customers: this should improve banks' behaviour and allow foreign competition in banking. In a second stage, enterprise debts should be cancelled in the process of privatization.
Rafael Repullo (Banco de España and CEPR) suggested that an interest rate policy may be more effective than credit control, which requires high skill levels and generates inefficiencies. He also argued that rolling over per se need not lead to higher borrowing from the central bank. Ramon Caminal (Universitat Autònoma de Barcelona) stressed the need for a clearer description of the rules of the game. To tackle the credibility problem, the government must define new rules to deal with firms' bad debts; but the authors' proposal for a once-and- for-all write-off may be no more credible than other alternatives: debtor firms may simply accept this rule now and refuse to pay the debt they incur in the future.

Finance and the Real Economy

In the final presentation, Robert King (Rochester University) discussed `Financial Indicators and Economic Growth in a Cross Section of Countries', a joint paper with Ross Levine. They presented existing and new measures of the evolution of markets, specially financial markets, to document the effects of the financial system on long-term growth in a cross-section of countries during 1960-89, operating through investment and allocative efficiency. Their analysis suggested the importance of identifying and separating the financial intermediaries involved (central and deposit money banks) and establishing to whom the financial system is allocating credit. These results contrast markedly with the use of overall size of the financial system in past studies.
Mark Gertler (New York University) questioned the authors' assumption that the financial system accounted for growth, since causality can work in both directions; also their pooling of developed and developing countries together could be a source of possible biases. Nouriel Roubini (Yale University and CEPR) shared Gertler's concerns about the direction of causality. While welcoming the paper's contributions in data collection and the construction of financial measures beyond the existing literature, he also suggested a further separation of different intermediators including stock and bond markets and a greater emphasis on the role of savings.

Round Table Discussion

The conference also included a round table discussion on `Financial Integration in Europe: East and West'. Pierre-André Chiappori opened the discussion by arguing that the future European Central Bank (ECB) should play a more active role in coordinating national central banks' supervision of the financial sector than is currently proposed. Convergence should not be restricted to monetary indicators and will affect both institutions and fiscal policy. He also proposed that the ECB deal with liquidity issues, while a separate body takes charge of deposit insurances and insolvency crises.

José Pérez (Banco de España) called for gradual convergence rather than a shock therapy approach towards monetary union. The desirable integration of Europe's financial markets can only be achieved by a strong ECB with powers to perform monitoring and supervision functions. Pérez argued that convergence will be achieved and the discussion should shift to minimizing its costs.

Paulina Beato (Banco Español de Credito) focused on the fiscal aspects of the Maastricht agreement. The taxation of capital gains can be based on the recipient's residence or on the source location. Beato favoured taxation based on residence, despite its higher requirements in terms of administrative complexity and the collection of information.

In his description of economic reforms in Eastern Europe, Colin Mayer (City University Business School, London, and CEPR) described three different approaches: intervention by the state before privatization; delegation of this intervention to existing financial institutions; and delegation from institutions to management. Only Germany had successfully combined all three approaches. Banks had played a critical role, but less as providers of funds than as means of facilitating contacts and creating networks with Western German firms. Mayer argued that all three steps were required to achieve a successful and gradual restructuring and devolution of control to managers in Eastern Europe. He concluded by noting the minimal role of stock markets in the process.


The papers presented at this conference will be published early next year, in a volume to be edited by Colin Mayer and Xavier Vives.