Regulation, Competition and Integration in EU banking: What Drives Performance? - Revisiting Freiburg -
Speech by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECB
Albert-Ludwigs University of Freiburg,
Faculty of Economics and Behavioural Sciences,
Opening of the Integrated Master Programmes of the academic year 2005/2006,
Freiburg, 21 October 2005
Ladies and Gentlemen,
It was with great pleasure that I accepted the invitation to come to the University of Freiburg – an institution with more than five centuries of tradition and which is home to remarkable academics, whose work has contributed to important debates, in particular in the fields of Economics, Law and Political Science. And I see that, in a recent nation-wide assessment, the Economics at Freiburg has once again been ranked very highly - both in terms of research and also student satisfaction. Congratulations.
“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” This quote from John Maynard Keynes is a strong reminder of the power of economic ideas and the relevance of education.
My economic education was very much influenced by a man who spent his formative years as a professor in Freiburg during the 1960s. His name is Erich W. Streissler. He taught us to critically analyse all theories. We followed his advice: we tried to understand Keynes, only briefly touched upon Hayek and enjoyed reading Schumpeter. Only later did I understand the great impact that Eucken has had on shaping post-war German economic policy.
In the first part of my speech today, I want to revisit three of these economic thinkers:
Walter Eucken (1891-1950), who was a Professor here at the Freiburg University and founded what has become known as the “Freiburger Schule” of economics.
The Nobel Laureate Friedrich August von Hayek (1899-1992) who – after a distinguished academic career in Vienna, London and Chicago – came to Freiburg and took up Eucken’s chair.
Joseph Schumpeter (1883-1950) who, like Hayek, came from Austria and moved – via Bonn – to the States, where he taught at Harvard. Although he is not directly part of the Freiburg tradition, I include him in the list because his views on competition and performance are compatible in an interesting way with those of the other two economists.
What would these thinkers tell us if they could observe today’s world? I believe they would welcome the process of opening up and integrating national markets in Europe and would call for a clear and consistent framework of rules that allows for competition and facilitates innovation. In trying to convince you of this point, I will, in the second part of my speech, present in application of these principles to an important case, an assessment of current developments in the European financial sector. In particular, I will focus on how regulation, competition and integration currently determine the performance of European banks.
I – Economic thinkers
I must say that I do not dare to propose new interpretations of the work of the three thinkers in a speech here at Freiburg University, which was formerly home to Hayek and Eucken and where researchers continue to study and to be inspired by their ideas. Moreover, it is not immediately self-evident that the work of these three great thinkers can be linked to the ongoing debate on financial integration in Europe. In fact, one could almost call Hayek, the great foe of constructivist approaches, an eurosceptic since he showed serious doubts on the viability of economic union in Europe.
That said, let me start with Eucken. He developed – in his posthumonously published Grundsätze der Wirtschaftspolitik – a blueprint for a competitive order which is at the heart of modern economic constitutions in democratic societies. Following his ordo-liberal thinking, a pure laissez-faire system had a tendency to concentration, monopolization or cartelization, hence: to self-destruct. What was needed, instead, following Eucken’s prescription was a strong – and at the same time: low-interventionist – state which created and underwrote “a performing price-system with perfect competition”. Such a free interplay of market forces would be most adequate to ensure an optimal coordination of supply and demand. Thus, to emphasize, he would not see the market economy as a product of nature but as something that should develop within a clear and consistent framework of rules devised by the State. Having experienced the breakdown of the pre-1914 order and the economic crises of the interwar period, Eucken stressed the relevance of institutions for the functioning of the market. This key message is currently regaining relevance. Following the waves of deregulation in the 1980s, we now realise that a well-functioning market has to be sensibly regulated in order to ensure competition. While Eucken favoured free trade, his perspective – maybe not surprising at that time - was mainly focused on the national dimension, i.e. the nation state and national competition policy. In applying Eucken’s theories nowadays, in my view, it is important to reinterpret his arguments as a plea for a clear and consistent regulatory framework at the European Union (EU) level.
In contrast to Hayek, Eucken is much more constructivist in the sense that, in his opinion, the state had ultimately the responsibility to create the appropriate conditions for the development of a market economy which prevent an accumulation of market power that would distort the functioning of the price mechanism – what he calls “Ordnungspolitik”. In his comments on Hayek’s book “The Road to Serfdom”, Eucken made clear his concern by writing: “Today, following a decade of disastrous economic policy, the process of concentration has progressed as in most industrialised countries, and a laissez-faire approach would lead to unsustainable market power, monopolistic, quasi-monopolistic or oligopolistic market forms, unbalanced markets and social conflict … it is indeed a third, new way which is the right one.” Although Eucken’s critique of monopolisation tendencies inherent in an unregulated market is very important, it seems to me that his animosity towards large companies, especially their size resulted from consolidation, was slightly naïve and built on a rather romantic vision of an economy formed exclusively by small and medium-sized enterprises. It disregarded to some extent the efficiency gains that larger units can generate – the issue of minimum efficient size and the resulting economies of scale – and the global competition that enterprises face. In the European context we therefore see that concentration is, from a welfare economic point of view, to be welcomed in those sectors where excess capacity exists, for example, in banking, and that size, rather than undermining the competitive environment, often strengthens it.
With this remark I am not advocating non-intervention policy in the way that Hayek would. Being more in line with Eucken’s approach, EU competition policy is playing a crucial role in limiting the emergence of pockets of excessive market power, to a large extend substituting most effectively for national rules. In my view, it is paramount to provide an environment in which cross-border restructuring of the industry takes place, but in which markets that are at the same time sufficiently contestable to allow new players to enter potentially. European integration needs to allow for consolidation yet still create an environment conducive for innovations. Often innovations originate in smaller enterprises and I will return to this point later.
On the issue of competition, I must refer to Hayek’s lecture “Competition as a Discovery Process”, which reveals one of the most interesting views put forward by Hayek, being in fact enormously influential up to today in the economics of information. The market – which Hayek later calls “catallaxy” – is presented as the major instrument for the creation, transmission and destruction of information as a result of relative price movements. In this setting, “the price mechanism tells individuals that what they are doing, or can do, has for some reason, for which they are not responsible, become less or more demanded”. The market then brings about a mutual adjustment of individual plans and ensures that whatever is being produced is produced in an efficient way. The results of the discovery procedure – with a minimum of required knowledge at the level of the individual participants - though are, however, totally unpredictable at any stage of the process.
At a conceptual level, this view contrasts strongly with the accepted economic theory in which competition produces an equilibrium, neglecting the dynamic nature of competition. Hayek prefers the concept of “order” – or “spontaneous order” – to that of equilibrium, since an order can be approached to various degrees and can be preserved throughout a process of change.
On the policy side, authorities should in no way intervene or help in the discovery process – maybe this is why Hayek never aspired to advisory positions and public office – because they have deficient and incomplete knowledge (“pretence of knowledge”). According to Hayek, the relevant knowledge is dispersed across all the separate individuals and simply cannot be concentrated in and communicated to one agency. However, a prerequisite for the development of spontaneous order is that all parties involved accept the framework implemented for the market coordination mechanism. On this point, I should say that, at least with regard to financial markets, Hayek would not be too disappointed with the behaviour of the EU authorities, as they have been increasingly concerned with assisting the development of the spontaneous order rather than imposing rules. In the banking sector, for example, we can say that reciprocity and the mutual recognition of standards in the supervisory field have been key drivers of financial integration in Europe, offering a much quicker and effective vehicle for integration than a time-consuming harmonisation of laws and regulations. In addition, while recognising that a minimum level of regulatory harmonisation is needed for an integrated financial market to emerge, increasing importance has been given to the role of market participants.
To a great extent, as stressed by Hayek, market forces have been the crucial contributors to financial integration since they are motivated by the benefits of realising efficiency gains, diversifying risk and exploiting economies of scale and scope. The market initiative has been responsible for the emergence of rules, practices and standards common to all market players. We can say that the EU authorities are increasingly accompanying a market-led integration process. In this new approach, EU authorities are mostly alert to potential coordination failures where market forces alone may not be able to achieve a positive outcome. Together with industrial associations, public institutions are therefore playing an important role as catalysts, helping the industry to overcome such coordination problems. A good example from the banking world is the establishment of the Single Euro Payments Area (SEPA), where there is some evidence for a substantial “first mover disadvantage” – first movers bear high costs by complying with specific standards, but do not necessarily reap the highest rewards.
Along the same lines, following Hayek’s idea that “habits are law”, we have been observing some significant changes in the way in which financial markets and financial institutions are regulated, namely that self-imposed standards, as opposed to law-based regulations, but still with a nurturing role of the public sector, have proven to be an adequate tool for exercising discipline in this market. Self-imposed standards as an informal mode of governance are generally formulated under a consensus principle by those to whom they are addressed and compliance with them is voluntary. The International Swaps and Derivatives Association, for example, has developed the international contractual model for swaps, and is also working on best practices for derivatives markets; similar initiatives have been taken in the field of securities trading and settlement. A more resounding example is perhaps the implementation of international accounting standards which harmonise reporting requirements at the global level.
A related issue that mostly concerns financial institutions is that of process-oriented – as opposed to rules-based – regulation. By the rules-based approach I mean the case in which regulatory requirements are based on simple formulas applied in a uniform manner to the market players, while the process-oriented approach rejects ‘one-size-fits-all’ rules and relies on the self-assessments by financial institutions. The new capital rules for banks, i.e. the widely discussed Basel II approach, is a good example of process-oriented regulation. Industry standards and process-oriented regulation are increasingly emerging as flexible, market-friendly forms of governance that are able to follow market developments and adjust to them with far more flexibility than law-based requirements. In both cases, the emphasis is placed on the self-disciplining mechanisms of the financial industry.
Turning now to the unpredictable feature of the Hayekian discovery process, I find that his views on competition as a generator of information and innovation with an unpredictable outcome offer a valuable description of economic processes. Integration of financial markets is enlarging the remit for competition that, for some financial markets, is reaching the global level (e.g. bond and equity market) and which for others (e.g. banking, in particular the retail segment) is gradually moving from the domestic to the EU cross-border level.
Going back to the banking industry, ongoing consolidation has shown that there are significant efficiency gains to be made. This could mean that in a “better” or “superior” order – to use Hayek’s terminology – the active players should mostly be large banks. However, the size of a bank does not say much about its relative profitability. Rather, profits appear to be driven by the competitive strategy chosen by the banks. Clearly, the strategy of an international bank with a huge balance-sheet is unlikely to be similar to that of a community-based savings bank, but size may be a poor proxy for strategy. In relation to size, there may be some concerns regarding the increasingly important role of US banks, namely in the European wholesale market – and I will return to this point later when talking about performance. Hayek tells us that, in order to be able to stay in the market, European banks must escape from exclusive price competition by innovating, thus creating a stimulus for technological progress and growth. Therefore, it is truly an open question as to what type of relevant players will be in a “better” or “more robust” spontaneous order.
I would not like to end my detour into the academic world without mentioning Schumpeter, who was, like Hayek, a member of the Austrian School and whose creative power and intellectual influence has contributed to the development of almost all fields in Economics. Hayek and Schumpeter developed along very different, if not orthogonal paths in their scientific work. While Schumpeter was convinced of the importance of mathematics and exactitude in developing economic theory, a belief which was already present in his first articles as a doctoral student, Hayek did not believe in calculus for solving economic problems due to dispersed knowledge among economic agents (irrationality).
No matter how diverse their lines of reasoning are, the famous Schumpeterian process of creative destruction somehow backs up Hayek’s reluctance to accept the concept of static equilibrium. Schumpeter’s innovations incessantly revolutionise the economic structure from within: an essential feature of capitalism. According to Schumpeter, innovation – or to use his terminology, “a new combination” – covers a broad range of meanings. Besides the introduction of new products and methods of production, marketing efforts and changes in market structures are regarded as carrying out new combinations. Economic development is therefore continuously – and for prosperity generating reasons – disequilibrated by the innovations, the constant search for new combinations.
I see the financial sector and the banking industry as good examples of the process of creative destruction. The traditional loan-deposit activity of banks has been shaken by at least five major “new combinations” in the Schumpeterian sense:
securitisation – the shift away from the dominance of non-marketable instruments (bank loans and deposits) to marketable securities;
institutionalisation of investment – preserving the role of bank and non-bank financial intermediaries despite the increased role of securities markets;
growth in complex financial instruments – designed to un-bundle, trade and transfer risks;
conglomeration – the conduct within one financial institution of at least two of the three traditionally distinct activities of banking, securities and insurance; and
consolidation – the outcome of mergers and acquisitions both within and across sectors of the financial system.
These major transformations in the financial landscape could correspond to middle-length cycles in Schumpeter’s fundamental work on business cycles. While Schumpeter himself sees the three different simultaneous cycles – long (of about 60 years), medium and short cycles (of about 40 months) – as a theoretical construction, his conception of the wave-like character of economic processes as they are pushed forward by innovation and imitation looks very appealing to me in order to understand current trends in the financial sector.
Interestingly, many years later, the development of new innovative economics and evolutionary economics – building on the concept of heterogeneity of economic agents, for example, with strong roots in the Schumpeterian legacy – may to some extent have conciliated Hayek’s and Schumpeter’s ideas on rationality, allowing for less-than-perfect rationality and foresight on the part of actors, as well as trial-and-error behaviour.
What have I found when revisiting these economists? That:
free markets need strong institutions and clear regulation;
the opening-up of protected national markets will intensify competition;
competition generates information and triggers innovation with an unpredictable outcome; and
‘creative destruction’ is the necessary condition for replacing old structures with new, more efficient ones.
II – Regulation, competition and integration
With these ideas in mind, let me now turn to the second part of my talk centred on the driving forces of performance in the European banking industry. In line with the notion of economics as – Staatswissenschaften or Political Economics in the old rendering, practicing and practical economists – ever since Adam Smith – have focused on the behaviour of the individual market participants. For an entrepreneur, we speak about his or her “performance” on the market. In addition to the individual strategy of the entrepreneur, regulation, competition and economic integration are important factors that influence performance of firms, and banks in particular.
I would like to provide you with a visual map that presents the links between the different concepts that I will assess in the following. Regulation, which is the starting point of my analysis, impacts on performance either directly or indirectly via its effect on the market structure. It takes the form of efficiency regulation, safety or stability regulation and what I would call territorial regulation. This last form of regulation concerns the political and judicial territories whose borders limit the applicability of regulation. This is particularly important when there are different political levels that adopt regulation, namely from the local to the international level. Integration and competition are the two key aspects of the market structure. They are clearly interlinked and directly impact on performance. While I do believe that regulation, competition and integration constitute the major determinants of what ultimately decides on performance, there are also additional sources of influence which I would group under other factors.
Before going into these issues, let me briefly recall the objectives of the European Central Bank and the Eurosystem that justify the interest of central banks in these topics. First of all, in relation to the prime objective of price stability, the smooth and effective transmission of monetary policy impulses throughout the euro area is enhanced through integrated and efficient financial markets. Integration is also important for the smooth functioning of payment and clearing systems, the main channels through which liquidity flows and, furthermore, it is relevant for the ECB’s task of safeguarding financial stability – a second ECB objective. Deeper financial integration implies a higher capacity to absorb economic shocks and can offer more possibilities for financial institutions to better manage and diversify risks. While competition contributes to the efficiency of financial markets, good performance and profitability tends to contribute to the robustness of financial institutions and their ability to withstand shocks – essential for the stability of the financial system.
I will focus on the banking sector for three main reasons that relate to the objectives I have just mentioned. First of all, because banks form the core of the monetary system and are the main transmission channel for central bank’s monetary policy. Secondly, because of the need to monitor the banking industry from the financial stability angle, given the links established through the payment system and the interbank markets in which financial distress of one institution can rapidly spread out to the whole banking system –so-called systemic risk. Finally because, when comparing degrees of integration across the financial sector, the banking industry appears to be somewhat lagging behind the degree of integration in other financial markets – such as the money market or bond and equity markets – thus raising the question as to what could be done to foster integration in the banking sector.
Over the past decades a number of major structural developments occurred in the EU banking environment, which are intrinsically related to the key words regulation, competition and integration. Economic developments have required an increasingly more advanced financial system. Technological developments have produced considerable changes in the efficiency of banks, also triggering financial innovations. Financial developments have been characterised by the more important role of financial markets and private initiative fostering deregulation and financial liberalisation. Last but not least, the Single Market and the Economic and Monetary Union led to enormous changes contributing to a more efficient landscape and growing competition in the EU banking sector.
Let me start with the issue of EU regulation and the question of whether it is appropriately addressing these changes in the financial sector. In order to assess whether banking regulation is optimally designed two basic questions have to be asked: does the regulation achieve its ultimate objective, i.e. is it effective, and is this objective achieved at the lowest cost, i.e. is the regulation efficient?
Effectiveness and efficiency considerations have to be carefully balanced. Indeed, effectiveness can be achieved at the expense of efficiency. In the interest of financial stability, it could be desirable to limit competition in banking, so that by increasing bank profitability institutions would count on larger financial buffers to absorb adverse shocks. However, this lower risk of instability would most plausibly represent too high a cost charged to customers therefore reducing economic efficiency. Similarly, with the aim of promoting economic efficiency, authorities could aim at pursuing rapid deregulation running the risk that market participants would prove to be insufficiently prepared for it therefore destabilising the financial system. In this case, the aim of increased efficiency could come at the expense of effectiveness. The Scandinavian banking crisis of the 1990s would be a case in point, which painfully demonstrated that neither banks nor supervisors were actually capable of adequately evaluating risks in a quickly deregulated financial system.
In the context of the EU, it rapidly became clear in the late 1990s that the effectiveness–efficiency balance of financial regulation, and banking regulation in particular, had to be reassessed to work towards a “better” type of rulemaking especially given the pace at which developments are evolving in the financial sphere and the changes that monetary union has induced.
At present, EU financial markets have matured and rule-making has to proceed at a quicker pace and in a more flexible way to keep up with market developments. To give you an example, it took about nine years to finalise one of the preliminary versions of the Prospectus Directive, and four and a half years were needed to finalise the Investment Services Directive. In a time of quickly evolving markets, such large time-lags are no longer acceptable. To speedup the EU legislative process, a new framework was put forward by the Group of Wise Men chaired by Alexandre Lamfalussy that some of you may have heard about. Within this framework, the politically sensitive principles would be adopted by the Council and the European Parliament via the “co-decision” procedure, while technical implementation measures could be more quickly enacted by the Commission through the so-called “comitology” procedure. The Lamfalussy approach, initially adopted for the securities sector and later extended to all financial sectors, has already brought tangible benefits. For example, the Directive on Markets in Financial Instruments was adopted in 18 months and the Prospectus Directive in just 15 months.
The beneficial effect of a more speedy adoption of Community legislation can however be eroded by a slow national implementation process, and here further efforts are still needed. This issue is addressed to a certain extent by another way of implementing a more efficient rulemaking process which consists of eliminating intermediate layers of rules. In this respect, efforts are underway to produce a single EU rule book as mentioned by the European Commission in its Green Paper on Financial Services Policy for the coming five years. I see such an EU rule book as a bridge between the harmonisation of key aspects of banking regulation and supervisory convergence achieved through the new Lamfalussy committees. National rule books would then accommodate necessary local diversity and be restricted in a prudent fashion to those rules that have not been harmonised at the EU-25 level.
Thinking of Hayek, I see here some scope for competition between national regulations without the introduction of fully-harmonised EU regulation. Convergence of national rules may also occur gradually through the competition among regulatory regimes in the context of a minimum harmonisation level already ensured in the EU. One example is the legal way in which banks decide to enter a foreign market – through branches (supervised by the home authorities) or subsidiaries that are supervised by the host authorities. In contrast to harmonisation, competition between regulatory regimes has an additional advantage in that the coexistence of various rule-making authorities might introduce regulatory innovations that, once proven successful, can be copied by other authorities.
Another way to avoid excessive regulation and to remain adaptable to changing conditions is to put more emphasis on adequate governance structures and banks’ own risk-management systems, rather than detailed prescriptive rules – what I called process-oriented regulation in the first part of my talk. The New Basel Capital Framework is, in that respect, a good illustration. This framework allows banks to use their own internal models to calculate capital requirements for credit risk and operational risk, provided that some requirements are met.
The new regulatory design reflects the increased need for dialogue, transparency and accountability of policy makers and provides considerable scope for self-regulation and the development of standards by market participants, who have the greatest technical knowledge and who are often the best placed to find the most appropriate methods by which to conduct business within an industrial framework.
However, regulatory competition and self-regulation do face limits. There are cases where EU regulation is needed and a decentralised or spontaneous approach faces insurmountable organisational and industrial self-interests of the key players involved.
Competition & integration
Turning now to the issues of competition and integration I would like to recall that, while closely related, these are quite different concepts. Take the European context as an example; competition can be strong at the national level but weak in the cross–border dimension if the various national markets are not integrated. In other words, competitive though non-integrated national markets can co-exist. However, highly integrated markets are likely to lead to more competition not least due to the increased number of players. In the European reality, given the efforts towards further integration in financial markets, the two concepts are strongly aligned, and integration is fostering competition.
Coming back to the banking industry, the public policy response to the question of whether competition among banks is good or bad has changed profoundly during the nineties. In fact, competition among banks is viewed as positive – something that Hayek always had defended – only since the mid-1970s. Before that date, mostly as a response to the banking and financial crises of the 1930s, the idea that competition had to be constrained in order to preserve the stability of the banking and financial industry dominated. The argument roughly being that in an oligopolistic environment individual banks could absorb losses more easily and the banking industry would always have sufficient funds to rescue an ailing institution.
The late twentieth century witnessed periods of significant regulatory and structural change in the United States and the EU rendering the banking industry significantly more competitive on both sides of the Atlantic. There are, however, limits to regarding banking as moving towards the textbook or the Freiburg ideal of perfect competition and they derive from peculiar characteristics of the banking system. First of all, banks form the core of the monetary system and there is a natural element of cooperation among banks – that is why we call it a system – channelling liquidity to the other participants of the financial system and managing the payments traffic in the economy. These core transactions can only take place within a set of stable and respected institutions. Moreover, banks are still regarded as crucial for financial stability and the performance of the economy and thus enjoy the kind of public protection which is not extended to other industries – that do not form a system.
As I have already mentioned, financial integration is perceived to be a key factor in the development and modernisation of the financial system which, in turn, leads to greater productivity and competitiveness, a more efficient allocation of capital and, therefore, increased potential for economic growth. For the banking industry in particular, enhanced financial integration results in the widening of business opportunities for individual institutions and efficiency gains so that the more efficient institutions gain market share at the expense of the less productive banks as well as benefiting from risk diversification and economies of scale and scope. Besides contributing to economic growth, some studies show that a more integrated and efficient banking sector also appears to play an important role in fostering a Schumpeterian process of “creative destruction” among firms.
A significant level of integration has already been reached in the EU banking market. The total number of credit institutions in the euro area declined from around 9,500 in 1995 to 6,400 in 2004, which means that almost one-third of the credit institutions active ten years ago have since disappeared. Banking consolidation in the euro area has mainly taken place at the domestic level; however, the euro has been acting as a catalyst for cross-border mergers and acquisitions since its launch. Merger activity witnessed peaks in the late 1990s when around 80% of the value of M&A deals in the EU banking sector involved domestic banks only. Between 1999 and 2002 in particular, cross-border banking consolidation within the euro area was high in both absolute and relative terms. In 2004, whilst all kinds of banking M&As experienced a slowdown, cross-border M&As were particularly affected. For example, the number of cross-border mergers stood at 20, down from 41 in 2001. IT synergies as well as capital diversification benefits arising from the new capital rules for banks – Basel II – are likely to provide further incentives for large cross-border transactions.
But consolidating activities is only one indicator for assessing integration in the banking industry. At the moment, more than 40 EU banking groups develop significant cross-border activities participating in up to 17 foreign banking markets. In addition, the market share of foreign branches and subsidiaries in the EU as a whole stood at 36% of total assets at the end of 2004. Furthermore, there was progress in euro area cross-border activity in the wholesale and inter-bank markets. At present, for example, close to one half of the securities held by euro area banks are issued by non-banks resident in other EU countries and cross-border interbank loans account for more than 40 % of all interbank loans, up from 25% in 1998. At the retail level however, EU banking markets still remain rather fragmented.
Figures are however modest when contrasted with those of the US – a natural benchmark for assessing banking integration in the EU – where an unprecedented number of mergers and market exits have taken place since the mid-1980s. The number of commercial banks declined from over 13,000 in 1988 to less than 8,000 in 2002, a drop of 40%. The share of US interstate mergers in total mergers jumped dramatically from below five percent prior to the Riegle-Neal Act to 30% on average in the 1997-2002 period. Moreover, the share of interstate mergers in large mergers was particularly high. One remarkable feature of merger activity was that, much like in Europe, institutions expanded primarily within their geographic home region. While the consolidation process continues unabated, we should bear in mind that there are regulatory limits to further consolidation, as, according to the Riegle-Neal Act, a single bank holding company may not control more than 10% of nation-wide deposits or more than 30% of deposits in one state. Interstate expansion in the US occurred, apart from cross-border acquisitions as detailed above, via interstate branching as well. US banks (savings and commercial banks) have made extensive use of the scope for interstate branching. The number of multi-state (as opposed to single-state) organisations rose from less than 200 in 1988 to 493 in 2002, and their share of total assets doubled to 75%. The number of interstate branches run by commercial banks increased massively from 30 at the start of 1994 to more than 21,400 in 2002. As a result, while the share of interstate branches in total branches surpassed 15% in only about half (27) of the fifty US states in 1998, almost four-fifths (37) of the US states showed this ratio by 2002. However, it needs to be pointed out that the total of 493 multi-state organisations means only 5% of US banks operate in more than one state. No US institution has major retail operations in all regions of the US and even in broader regions there are huge gaps. Hence, the results is that, like in the EU, intrastate consolidation has been prevalent in the US, even though the regulatory, cultural and linguistic differences which are often said to lie behind the dominance of national mergers in the EU are not present – at least not to such degree – in the US.
III – Performance
The assessment of the performance of the financial system should be a functional one, namely based on how well the financial system performs its main functions. These are: to trade, hedge, diversify and pool risk; to allocate resources; to generate information on investment possibilities; to monitor investments and to mobilise savings. The better financial systems perform these functions, the more they contribute to economic growth. The enormous economic and societal difficulties that, for example, some countries in Latin America face, which do not have a well-functioning financial and banking sector, illustrate this point vividly. In order to play its vital role, the banking sector has to reach a certain degree of profitability.
The indicator of profitability of a firm that is used most often is probably return on equity, “ROE” to use the jargon. It is a summary measure of a firm’s performance over a certain period and indicates the return shareholders are getting for putting their money at risk. It includes both the firm’s revenue-generating capacity and the costs it incurs to produce this income. Adequate profitability is a buffer available to banks – and to firms in general – to weather financial difficulties and is an important source of self-funding, a crucial dimension of an institution’s longer-term financial robustness.
Mainly for this reason, those who take a financial stability view, such as central bankers and banking supervisors, have a natural interest in seeing a profitable financial sector – it provides for a larger “buffer” should the system be hit by a shock. What is perhaps less straightforward is that both a too low and a too high profitability may indicate that the financial sector is not doing well. Too low a profitability may mean that banks are being inefficient in conducting their business or that they face strong competition from more loosely regulated entities. But too high a profitability may also spell problems. It might indicate that pressure from competition is low and that banks are earning rents at the expense of their customers, resulting in economic inefficiencies. A recent report by the consultancy firm Capgemini, for example, showed that for the same set of core retail banking services the price between different EU countries differs with a factor of 1 to 4. Linking this with the debate on integration, domestic banks could be in a position to overcharge their customers because they do not fear the entry of more efficient foreign competitors as a result of low financial integration in the retail sector, for example.
Various issues should be taken into account when comparing profitability indicators across countries. For example, comparisons across different types of banks, say public, state, cooperative, mutual and private banks – all significantly present in the EU banking industry with frequently substantially different business models, is not very appropriate. It should also be remembered that good performance of the economy is generally also reflected in banking (and other industries’) profitability. Hence, countries exhibiting strong growth are more likely to show good profitability in the banking industry. Over periods of time characterised by intense merger activity it should be noted that the performance of banks may also be reflecting the on-going consolidation.
Nevertheless, from a comparison across EU countries and with the US, it can be seen that there is probably “excess capacity” in the European banking industry (in that there are many small banks that do not benefit from economies of scale), disproportionate banking infrastructure (e.g. the branch network) and diversified settlement systems. The data seem to suggest that US banks are more profitable. This represents a challenge to the EU banking sector since US banks are direct competitors of European banks and increasingly active in the European market. In this respect, Europe faces, however, a dilemma in bank competition, namely with the United States. The largest American banks still have comparatively small market shares within the US and hence competition issues do not arise to anywhere near the extent they would if banks of such size existed in Europe. However, if these large banking institutions would operate and compete on a pan-European level, this development might enhance for competition and consumer choice. Bringing Hayek and Schumpeter again into the picture, I would stress that the key to profitability may lie more with innovation, with regarding business profiles, and with new products, more closely tailored to the needs of savers and investors that enable banks to escape from exclusive price competition, than with the size of a bank’s balance-sheet. I am convinced that there will be room for middle and regional players as well.
IV – Conclusions
Concluding my speech now, I would like to thank you again for having invited me to Freiburg and motivating me to revisit parts of the work of some great economists with strong roots in this university.
What can we learn from Eucken, Hayek and Schumpeter?
Institutions matter, information is important, and innovation and ‘creative destruction’ are key ingredients of a dynamic economic system. We need to analyse interaction among market participants and the impact of regulation, competition and integration in order to understand economic performance in general and in the financial realm in particular. Although they largely predate with their most important work European integration, I think the three thinkers also provide advice for the EU: European Integration has to be a market-led process facilitated by a clear and consistent framework of rules. We need capable public authorities that provide such a framework; the onus is then on the market to exploit the opportunities that economic integration provides.
I hope to have convinced you that the ideas of these thinkers are in no way outdated or obsolete. Somehow ironically, economic thinking is often not relevant in its contemporary context – some ideas gain political relevance only years later. I also hope that my presentation, by insisting and stressing the merit of these concepts today, inspires your studies and future research work in economics and social sciences, in particular in the Integrated Master Programmes here at the University of Freiburg. Most of you, as I understand from Professor Gehrig, have very much applied and practical aspirations. And what appears to be here in the Freiburg air will be, I have no doubt, useful indeed when you leave the university to work in the private or the public sector all over the world.
 This is well illustrated by the current corporate governance debate (see, for example, Raghuram Rajan and Luigi Zingales’ book published in 2003 entitled “Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity”).
 Eucken’s colleague Wilhelm Röpke campaigned explicitly against European integration, seeing it as a danger to free trade at a global level and as a vehicle for creating a centralised “Leviathan” in Brussels. Needless to say, I do not concur with such a view. Actual developments reveal Europe in many of our nations as an instrument to open-up markets, to liberalize access and to generally enable competition, e.g. in sectors like energy, telecommunications – and even banking.
 Hayek, F. A., “The Road to Serfdom”, 2000, London: Routledge; (first published in 1944).
 Hayek, F. A., “New Studies in Philosophy, Politics, Economics and the History of Ideas”, 1978, Routledge & Kegan Paul, London and Henley.
 Padoa-Schioppa, T., “Self vs. Public Discipline in Regulating Finance”, 2004, Oxford University Press.
 DeYoung, R. and T. Rice, “How do banks make money? A variety of business strategies”, 2004, Federal Reserve Bank of Chicago Economic Perspectives, Q4.
 There is, of course, also a reverse nexus between regulation and market structure/development in that the former is adapted to the latter but this is not in the remit of this talk.
 European Commission (2005), “Green paper on financial services policy (2005-2010)”.
 Padoa-Schioppa, T.“Competition in Banking” in Regulating Finance, 2004, Oxford University Press.
 See, for example, Thesmar, D., et al, “Banking deregulation and industry structure: evidence from the French banking reforms of 1985”, paper presented at the ECB-CFS research conference on 23-24 May 2005.