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Schriftenreihe des Europa Institutes Budapest, Band 10:93–102.


Structural Changes in European Financial Markets*


There can be little doubt that the introduction of the euro has sharply accelerated the process of structural change in European financial markets. These changes, however, have been under way for a few years as a result of financial globalisation which continues to exert its own influence. It is not easy to assess the precise direction of these structural shifts, nor indeed to forecast their pace, and certainly not their final outcome. However, events are speeding up – look at the monumental banking battle involving three large French banks, which would have been unthinkable only a year ago – and we are beginning to see some of the major issues that are likely to arise for market participants, public authorities and, indeed, public interest. These are challenges for the European Union as a whole, for the euro area and, sooner or later, for Hungary, too. I should like to share some thoughts with you on these topics.


A reminder of some key facts

Let me start by drawing your attention to some of the main characteristics of European financial markets in general, and of banking in particular, as they appeared in the second half of the 1990s – and comparing them with the situation prevailing in the United States.

The most striking fact is the dominant influence of banks in the European (and even more fundamentally in the continental European) financial system. As with all statistics, a lot can be distorted by definitions (which institutions can be classified under the heading, «banks»?). However, in this particular case, there can be no doubt about the validity of this assertion. In the European Union, at the end of 1996 banks’ total assets amounted to close to 200% of GDP. The figure for the United States was around 80%. Or, to make another significant comparison, the share of bank assets in the total assets of all financial intermediaries fell, in most European countries, within the range of 70 to 80%. It was as low as 26% in the United States. This means, incidentally, that there was no highly significant difference between the two areas in terms of the total financial assets/GDP ratio.

Second, note the relative weakness of equity markets in Europe (with the notable exception of the United Kingdom and the Netherlands). Stock market capitalisation in relation to GDP barely reached 33% in continental Europe. It stood at more than 100% in the United States. This is, in fact, a mirror image of the previous characteristic: non-bank financial intermediaries (mutual funds, investment companies, pension funds) are substantial holders of equity investments in the United States. Their importance is more limited in Europe and, on top of this, they are more biased in favour of fixed income securities.

The third fact is that European households are big savers. In 1996 net lending from European household savings was 6% of GDP, while it was close to zero in the United States. Moreover, European households channelled most of their (gross) financial savings towards the banking system or purchases of debt – mostly government debt. By contrast, American households became major holders of equity portfolios – either directly, or via mutual and pension funds.

Finally, securitisation has had a major impact on US banking but, so far at least, a much smaller impact on the way European banks operate. For banks, securitisation means that securities holdings acquire a growing importance among their assets, that bank assets become more and more marketable, that such assets move from the balance sheet to off-balance sheet liabilities (thereby allowing a relative shrinking of the balance sheet without affecting total profits) and, more generally, that the lender – borrower relationship loses both its transparency and stability.

At the risk of oversimplifying matters, all these observations can be captured in one major proposition: namely, that the European financial structures have remained «bank-oriented», while the United States has moved towards a «market-oriented» system. For a few years, the importance of securities’ markets in relation to traditional banking intermediation has, of course, progressed in Europe – but that happened in the United States, too. The contrast has so far remained striking.


The euro and the single banking and financial markets in Europe

It is against this background that we have to consider the potential impact of the euro on Europe’s financial structures.

Where do we stand now – in the late summer of 1999 – with the euro?

European households will not experience the full reality of the single European currency until the early days of 2002. It is at that time that national currency units will have to be converted into euro and that all national administrations will start operating their accounting and payment systems in euro.

However, even today the euro is a reality both from a legal point of view and in terms of the practical life of financial market participants. Legally, the euro is the currency of the euro area member countries: on 1 January this year, national currency units became simply non-decimal components of the euro, in the same way as a pfennig is just one hundredth of a Deutsche Mark. (This does not prevent the national banknotes from remaining legal tender until their withdrawal at the beginning of 2002). The legally enforceable conversion ratios between the euro and the national currencies have been established by a monetary law and are therefore observed by courts all over the world.

With regard to banking and financial markets, the euro is also a very practical reality. The European System of Central Banks (ESCB) operates with banks through euro-denominated assets and liabilities. As a result – not by decree but for practical reasons – the interbank and foreign exchange markets operate in euro. New government bond issues are effected in euro and the outstanding stock of government debt has been converted into euros. Last but not least, trading on organised exchanges – such as stock markets – takes place in euro.

The widespread use of the euro in these operations represents a significant – I should probably say, decisive – step towards the implementation of the single financial and banking market in Europe, since it removes one of the major non-tariff barriers distorting the functioning of this market. All capital account transactions have now been unrestricted for some time and together with the possibility of setting up branches or subsidiaries in other countries. Admittedly, the lack of full harmonisation of regulatory practices and of taxation still represents a substantial impediment to free competition, but these impediments can and will be dismantled gradually. The replacement of the national currencies by the euro in financial transactions is not a matter of gradual change, rather there has been a sudden, radical shift. Let me give you two examples which show why this is going to give a decisive push to the implementation of a genuinely single banking and financial market.

The first relates to banking. The existence of foreign exchange risk, however small, does represent an impediment to cross-border banking competition. This risk can, of course, be eliminated or reduced by the use of appropriate hedging techniques. But hedging involves costs and therefore banks operating in their home market, with full access to funding in domestic currency, have a competitive edge over banks lending from abroad. Once the intra-euro area are foreign exchange risk is eliminated, this kind of competitive edge will disappear.

The second example concerns the government debt market. The redenomination of all outstanding government debt in euro opened up the possibility of developing a large, liquid and efficient secondary market in government securities. Trading costs are reduced for the benefit of issuers and purchasers of government debt, but this amounts to a sharp reduction in the profits of traders. This, however, is not a zero sum game. The disappearance of the foreign exchange risk enhances transparency. A yield differential between, say, 10-year Italian government bonds and their German counterparts no longer reflects a foreign exchange risk, but basically a credit risk or some other remaining market imperfections.

Both examples show that the introduction of the euro enhances competition, which is precisely what the single market in banking and financial services is expected to achieve. Competition is surely a good thing for the users of financial services, be they borrowers or investors, who will benefit from better service, a wider range of products and, last but not least, from innovation. But competition does not make life easier, to put it mildly, for financial intermediaries which have to cope with constant pressure on their profit margins. Even more importantly, when there is a sudden change in market conditions – and that is what the introduction of the euro amounts to – the pressure on profits will not be constant, gentle, or gradual, but potentially sudden and severe. It is the reality or the anticipation of this sudden impact which induces fast and deep structural changes. These changes are at the heart of the competitive process, which Schumpeter so eloquently described as the process of «creative destruction». I shall touch upon the implications of this for systemic stability towards the end of my presentation. The key issue is that «destruction» in banking or financial markets can have far wider systemic consequences than in, say, manufacturing industry. Banks, even in a «securitised» or «market-oriented» system, remain at the heart of credit distribution, liquidity creation and, perhaps most importantly, the payment and settlement system.


Financial globalisation

A very major difficulty encountered when trying to assess the direction and speed of the structural changes induced by the euro derives from the fact that our financial systems are also affected by the more general, worldwide process of financial globalisation.

«Globalisation» is one of those inventive catchphrases in American English which convey a lot to the reader without attempting to be very precise. For the purposes of this presentation I shall use it in a very wide sense.

First and foremost, I take it to mean financial integration in the geographical sense: to be part of the word-wide global financial «village». This means that capital is free to flow between countries belonging to the globalised part of the world, and that it does indeed flow. Controls on capital account transactions have on the whole been lifted; and current account transactions are naturally free.

But globalisation also means that these same countries have substantially liberalised or deregulated their domestic financial systems. This does not imply that a financial intermediary will buy or sell any financial product of its liking, but it does mean that there are few administrative restrictions in this respect. Deregulation also means that the authorities do not interfere with pricing decisions, nor do they set quantitative limits on specific lending, investment or funding decisions. Specialisation still exists, more by tradition and by free choice than as a result of regulation. But at the margin at least there is intense competition among institutions belonging to different groups of intermediaries.

The general trend towards lifting controls on capital account transactions (internationally) and deregulating financial markets (domestically) has coincided with revolutionary changes in communications and information systems technology. These changes are very much part and parcel of financial globalisation today. It is to a very large extent because of these changes, which have allowed the creation of highly complex new financial products and operating techniques as well as the instantaneous transmission of information that our global financial world today is so much different from the unrestricted banking and financial markets which existed before World War I.

To sum up in a couple of sentences the most striking outcome of these developments, one could say: (a) that they have resulted in an enhanced threefold financial interdependence – in the geographical sense (i. e. between countries of the globalised world), between markets (for instance between debt and equity markets) and between the various segments of the financial industry: and (b) that by the same token they have led to the creation of a highly competitive environment with competition across borders, between individual financial intermediaries and between groups of intermediaries.


The avenues of structural change

In what follows, I shall comment on (or, rather, think loud about) some of the main directions which structural changes in Europe’s financial system are likely to take as a result of the dual impact of the euro and globalisation.

1. In banking the first, most visible change is towards concentration through mergers and acquisitions. This is a world-wide trend in which globalisation is playing the major role, with the euro adding strong momentum to it. The striking fact is that until now mergers and acquisitions have tended to regroup banks within national borders. Cross-border mergers have been very rare; cross-border acquisitions (or minority participations) somewhat more frequent, but still insignificant in number and size. Several factors may have contributed to this outcome. National banking «cultures» or traditions are still strong: it is easier to merge with (or acquire control of) institutions which share such traditions. At the same time in a number of countries regulatory authorities have displayed a bias in favour of national rather than cross-border concentrations. Be that as it may, I am convinced that what we have seen so far is just the first stage of regrouping. Cross-border initiatives will be the next step. They are likely to involve both mergers between institutions of comparable size or acquisitions of smaller banks.

2. What about the nature of these regroupings? Will they be friendly or hostile? Until recent events in French banking, I was of the view that friendly initiatives would prevail. This is what has happened in the United States so far, and also in the United Kingdom. One reason is, I thought, that success in banking and, even more, the successful management of banking mergers crucially depend on people – not only on top management, but on a much wider group of people. A hostile takeover is likely to lead to a massive loss of talent: a targeted company is an ideal hunting ground for head-hunters. Another reason for friendly mergers may have been that regulatory authorities favoured them – partly because they kept a watchful eye on systemic risk, but often also because they feared that the acceptance of hostile bids at the domestic level would increase the chances of «foreign» invasion. It remains to be seen whether the French example will be followed by others, or will be regarded as an exception.

3. Assuming that cross-border regroupings become a reality, what sort of size configuration will European banking acquire? My guess is that the size structure will not be a simple one. A handful of Europe-wide megabanks are likely to emerge, some of which will aim to become «global» on a world-wide scale as well. But even not all of these banks will want to cover retail banking throughout Europe. At the other end of the spectrum, the number of small local banks will surely diminish, but I do not think that this species will become extinct. Customer proximity – either for households, or for small enterprises – will still count (I shall say more about this later, in connection with remote banking). The intriguing question concerns medium-sized «regional» banks. Many of these will be swallowed up by the megabanks, but some of them may well survive, especially if they add to their geographical franchise the advantage of being efficient «niche» players.

4. The most difficult configuration to foresee concerns specialisation. The megabanks will do everything to encompass the full range of financial services, including investment banking. Will they succeed? The US evidence is not conclusive in this respect, since, despite recent successful inroads into investment banking by a couple of large «traditional» banks, the scene is still dominated by a few «genuine» investment banks. European megabanks will have to compete, both in Europe and elsewhere, precisely with these «first league» US investment banks, which have on their side not only tradition and accumulated expertise, but also the support of their US equity market base. Finally, the most open issue, on which I hold no views, concerns the links between insurance and banking. There is no doubt that potential synergies exist between banking and insurance in the area of asset management and in retail sales of banking and (some) insurance products. What is questionable, however, is whether the exploitation of such synergies is best dealt with through mergers or could be handled by inter-company agreements.

5. Let me now consider the impact on banking of one of the key components of globalisation, namely IT (information technology) developments.

The traditional channel through which IT developments have been, and will continue to affect banks’ operations is through cost reductions which occur in the management of information – typically, in the collection, storage, processing and transmission of information. Automated processes replace highly labour-intensive work methods and a lot of paperwork. After a very long waiting period (IT was used as early as the late 1950s!) the cost reductions and improvements in efficiency achieved in this way are now becoming substantial. Note, however, that IT has improved the quality of management – for instance, in terms of management control – for a much longer time. The influence on banking structures of these «traditional» IT developments has not been unambiguous. There is evidence that major investments in this field are subject to the rule of economies of scale and that they substantially enhance the ability of management to control efficiently large-scale and diversified companies. But these investments do not pay off quickly; they are frontloaded in terms of costs while the benefits are associated with long time-lags. When banks with different IT systems (which have to be replaced or «harmonised» try to merge, the heavy initial cost implications and the prospect of delayed returns act as a deterrent to concentration.

The second, more recent channel through which IT developments may affect banking relates to the implementation of customers’ access to banking services through «remote banking». There is no doubt that this development has the potential to radically change the operation (and therefore the structure) of retail banking in Europe. Europe is dominated by branch banking, with signs of overbanking and excess capacities in the majority of the European Union member countries. Remote banking is going to lead to the radical reduction of the number of branches, a change in the employment pattern of banks (shift towards marketing and sophisticated value-added services), interbank agreements on common standards, and increased competition from non-banks such as supermarkets, and so on. But I would caution against believing that all this will happen everywhere and at a very fast pace. My guess is that the rate of change will vary between geographical areas according to differences in the age pyramid, wealth, education and social structures, all of which have a bearing on the willingness and ability of retail customers to adjust to new habits. The winners will be those banks which are able to detect the time-scale of these new developments. If a bank were to implement prematurely radical changes in its organisation with the intention of switching over to generalised remote banking, the mistake could be very costly; if it were to do so too late, its market share would suffer heavily.

6. Structural changes in markets are likely to be as profound as, and probably faster than, those in banking – perhaps because in this field the introduction of the euro and technological progress interact swiftly and very powerfully. Electronic trading will dominate, I am quite sure, in all major secondary markets within a couple of years. This forecast is based on observations of what has already been happening. On the first pan-European wholesale secondary market for euro-denominated government securities (which started operating in April this year), the daily turnover in benchmark German, Italian and French securities has been around 30 billion euro, i.e. about 15 to 20 % of total trading. The trading is now being extended to the benchmark securities of other euro area countries as well as to the very large market in repos. At the same time new, competitive initiatives have been announced. As for the European equity markets, they will see the surge of online (Internet) trading, in the same way as has happened in the United States, as investors gradually recognise the speed, convenience and relatively low costs of trading on the Internet.

Such developments will lead over time to the gradual withering away of national financial centres – or, to be more precise, to their reduction to the kind of core activities on which developments in information and communications technology have a limited impact. Advisory services for mergers and acquisitions are a prime example of activities where interpersonal contacts (and therefore location) count. Location will become far less important for market-related activities, especially as regards secondary markets.

7. Will these developments (together with many others, on which I have no time to comment) steer Europe towards increasingly «market-oriented» financial structures – along the lines of the US model? Very probably, yes. But the pace of this change remains largely unpredictable.

Challenges to European supervisory and regulatory authorities

The organisation of banking and financial services, supervision and regulation within the euro area is, at present, more or less as it was a few years ago. I view this situation with some concern, because I fear that the current pattern of organisation will have difficulties in responding to the challenges raised by the potentially revolutionary changes affecting European banking and financial structures. Let me spell out briefly the reasons for my concern.

The basic responsibility for supervision and regulation lies, at present, with national authorities. Some of these are part of (or closely tied to) the national central banks, while others are separate agencies – mostly, but not always, under some sort of government control. The heterogeneity is enhanced by the fact that while in some countries many segments of the financial industry are regulated by one authority, in others the responsibility is shared among different institutions. Admittedly, all these authorities are co-operating between themselves under the auspices of the European Commission, while the European Central Bank is expected to «contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system» (Article 105 (5) of the Maastricht Treaty). But will this be sufficient?

I do not rule out the possibility that this loose co-operative framework may enable such a large, heterogeneous group of participants to harmonise the national rules and practices so as to lift the remaining non-tariff barriers to the development of an efficient single banking and financial market. This is conceivable, although not very likely. I would make the same remark with regard to the chances of reaching a consensus view on what kind of financial structures will reconcile efficiency and stability. Given the pace at which market structures – for instance, the degree of concentration or the emergence of financial services giants – are likely to evolve, there is a genuine risk that regulators will be overtaken by events. This risk is even greater when is comes to the crisis handling ability of the authorities – especially in a truly «market-oriented» system. The LTCM experience in the United States is worth keeping in mind. Successful crisis-handling in our globalised world requires clout, speed and agreement on who is responsible for what initiative – precisely because the rules of crisis handling cannot, and should not be laid down in advance. It is not obvious, to put it mildly, that the current arrangements meet these requirements.


Concluding remarks on Hungary

What could, or will be the implications of all these developments for the Hungarian financial system? There is good news and bad news.

First, the good news. As regards financial markets and institutions in general, and banking in particular, Hungary has achieved an enviable position among the countries of Central and Eastern Europe. The road leading to this relatively satisfactory situation has been bumpy. The restructuring of banks has been costly, as successive governments have exhausted the full range of policy errors, while bank managements made their own contributions. But this happened in all other former communist countries as well, without their being able to achieve what Hungary has now achieved, namely a banking system that has real owners, efficient operational methods, and with an, on the whole, sound balance sheet structure. But banking is not alone in this respect. The stock exchange is by far the most liquid among the area’s stock exchanges; the reporting obligations and practices of the listed corporations ensure accurate information and a high degree of transparency; the reform of the pension system – a good thing in itself, even if allowance is made for its teething problems – contributes to the development of strong institutional investors; the payment, settlement and clearing system functions smoothly; and last but surely not least, the National Bank of Hungary has a sophisticated set of policy tools. I do not claim that this is perfect (it is just less imperfect than what you can see in some other countries), nor that (with the benefit of hindsight) it would not have been possible to achieve the same results at a lower cost to the Hungarian taxpayer, but the fact is that in the area of banking and finance, Hungary has successfully approached western standards. And that is no mean feat.

But what, then, is the trouble? Well, the bad news is that these «western standards», as I have tried to show you today, are a moving, indeed a very fast moving target. The Hungarian banking industry cannot avoid a wave of mergers of regroupings – if only because some of the key western shareholders in Hungarian banks will have merged among themselves. «Remote banking» raises a strategic question for many Hungarian banks: should they expand their branch network – in terms of branches, Hungary still has a shortage of banks, and banking services to the crucial small and medium-sized enterprises are still unsatisfactory – given that in the none-too-distant future branches may become redundant? How will the Hungarian securities industry respond to the challenge of online Internet trading of equities? More generally: which banking and financial services will continue to require customer proximity? I trust that their inventiveness and entrepreneurship will enable Hungarian financial market participants to respond to these challenges, for the greater benefit of Hungarian savers, investors and borrowers (as well as for their own benefit). But the road ahead will not be an easy one. This, indeed, it the general challenge facing the whole of the Hungarian economy: to integrate itself into European economy which has entered, in terms of all its components and in every aspect of its modus operandi, a period of radical structural change.


Selected bibliography

Publications of the European Central Bank:

«Possible effects of EMU on the EU banking system in the medium to long term», February 1999.

«Banking in the euro area: structural features and trend», April 1999.

«The effects of technology on the EU banking systems», July 1999.

While, William R., «The coming transformation of continental European banking?» Bank for International Settlements, Working Papers No. 54, June 1998.

Danthine, J. P. Giavazzi F., Vives X., von Thadden, E. L., «The Future of European Banking», Centre for Economic Policy Research (CEPR), London, 1999.

Bäckström, U., «The future of the European financial system», Bank for International Settlements, BIS Review, 23 June 1999.


* English version of an address by A. Lamfalussy to the Hungarian Academy of Sciences in Budapest, on 16 September 1999.