EMU and the financial sector
Inaugural lecture to the Leerstoel Generale Bankby Dr. Willem F. Duisenberg, President of the EMI,at the Katholieke Universiteit van Leuvenon 5 February 1998
Ladies and gentleman, I am very honoured to be asked to deliver the inaugural lecture of the Generale Bank chair. I would like to take this opportunity to discuss with you the current trends affecting the European financial sector and in particular the effects of European Economic and Monetary Union (EMU).
The advent of EMU represents new opportunities and challenges for financial institutions and markets. EMU may create a new environment for the production of financial services and become a catalyst for change, providing a "critical mass" which will allow progress to be made in financial integration. Nevertheless, Monetary Union will, in many respects, only accelerate current trends. This is the reason why I should like to describe, first, where the European financial sector stands now, before considering the effects of EMU on financial markets and institutions.
1. Current trends in the European financial sector
As I just indicated, I would like to set the stage by describing the current trends affecting the European financial sector. It is useful indeed to summarise briefly the most significant developments in the European financial system in order to give some flavour of the context in which EMU is going to take place. In my view, the European financial sector has been experiencing three major trends: (i) a general movement of deregulation and internationalisation; (ii) significant growth of financial markets, with effects on disintermediation, and (iii) rapid technological changes. Let me review them successively.
1.1 Deregulation and internationalisation
First, in comparison with the very regulated financial systems in Europe inherited from the post-war period, most European countries have been liberalising their financial services industry, beginning in the mid to late 1960s, then more significantly in the 1980s and 1990s. A marked trend towards the privatisation and, in some cases, the demutualisation of financial institutions has also been observable in all countries.
At the same time, European countries have progressively opened up their financial markets and institutions to foreign competition. This was partly the consequence of independent national legislation, but also resulted from the dynamics set in train by the Treaty of Rome, which received a new impetus with the Single Market programme. The most significant restrictions on capital movements in the EU were lifted by the mid-1990s. The Second Banking Co-ordination Directive, implemented by 1 January 1993, introduced the single banking licence, which allows credit institutions to establish branches or supply cross-border services to all European Economic Area countries without prior authorisation from the authorities of the particular country. One should also mention the harmonisation in the securities industry under the Investment Services Directive, implemented by 1 January 1996. Earlier, harmonised rules applying to some investment funds were introduced with the UCITS Directive, implemented by 1 October 1989.
One indicator of such an evolution is the progressive internationalisation of banking networks. Effectively, the share of foreign branches in banks’ total assets has increased continuously, to reach around 10% of the market for the majority of EU countries. In particular, the opening of banking markets in southern Europe was a major consequence of the Single Market programme. However, if one excludes the particular role of financial centres in countries like Ireland, Luxembourg and the United Kingdom, the level of internationalisation remains currently lower than in the United States, where foreign penetration is around 30%.
1.2 Growth of securities markets and disintermediation
The second major trend affecting the financial sector is the growth of securities markets. During the last 15 years, in Europe, intermediation between savers and investors has come to rely more on marketable instruments. The ratio of equities, bonds, certificates of deposit and commercial paper outstanding to GDP has increased significantly in most EU countries both absolutely and relative to traditional loans and deposits since the mid-1980s. Another feature of this pattern is the more active role of institutional investors in conjunction with population ageing, which increases the demand for fully funded pension schemes in many EU countries, as well as leading to increased precautionary savings for old age (e.g. via life assurance policies) even when there is a comprehensive social security pension system available. As a consequence, one can observe a trend towards disintermediation - a shift of services or functions away from the traditional loans and services offered by the banking system - even if banks still offer the most important instruments of intermediation in many countries.
1.3 Technological developments
Third, technological innovation is leading to rapid changes in the financial sector, from the point of view of both financial "processes" and "products". I just want to mention a few examples of progress made in that area which have had effects on competition and performance. Firstly, in organised exchanges, new electronic continuous auction markets have been introduced since the early 1990s, particularly CAC in Paris, IBIS and, recently, XETRA in Frankfurt. Also, in derivatives markets, the Deutsche Termin Börse (DTB) now runs a fully electronic order-driven system with almost one-third of its members trading from workstations outside Germany. MATIF and LIFFE, traditionally specialised in open outcry systems, are currently also developing electronic trading systems. Secondly, in the banking area, the use of the Internet, as well as the development of electronic money are starting to affect the traditional distribution channels. Finally, computer-driven credit scoring systems challenge traditional bank-client relationships by reducing the information advantage of banks. Jointly with securitisation, these advances in information technology have been leading to the "unbundling" of banking activities (see Rajan, 1996), in the sense that activities formerly operated by a single bank are now processed by separate financial institutions. This paves the way for the entry into the industry of new players, in particular non-banks. One of the most recent examples is the growth of "supermarket banking" (where food retailers offer competitive deposit facilities and an increasing array of other financial services in-house) in the United Kingdom.
All these trends are bringing about substantial change in the financial sector, leading to the narrowing of intermediation margins and a reduction in profitability. In such a context, EMU represents new challenges and opportunities that I want now to discuss, considering financial markets and institutions successively.
2. Effects of EMU on financial markets
The Single Currency will have significant effects on financial markets. The most immediate changes will affect the foreign exchange markets. Cross-trades between the currencies participating in Monetary Union, which currently represent about 10% of total transactions, will disappear. Demand for foreign exchange hedging transactions will also experience further reductions, although the bulk of such transactions usually involve the US dollar and should not be affected by EMU. New activities may also emerge, in particular those associated with the use of the euro as a reserve currency, but this will only develop as the euro becomes established. More predictable, though, are the likely effects of EMU on money and securities markets, on which I wish now to focus.
2.1 Money markets
EMU will have very significant effects on the money markets. The single monetary policy will create a new environment, to which the current money markets will have to adapt.
2.1.1 The single monetary policy framework will create a new environment...
The new framework for the implementation of the single monetary policy will create the necessary conditions for the integration of European money markets.
First, the technical infrastructure to support a large European money market will be provided by the interlinking of real-time gross settlement (RTGS) systems through TARGET. Large cross-border payments denominated in euro will therefore be processed as smoothly as if they were domestic payments. Initially designed to carry out the single monetary policy, TARGET might also be available for other kinds of transfers as an alternative to private netting systems (such as the ECU Clearing), mainly at the wholesale level, and should therefore contribute substantially to reducing the kind of systemic dangers to which netting systems are exposed.
Second, the ESCB will rely on monetary policy instruments designed to create a deep and liquid money market at the EU level. As indicated in the "Framework Report" published in January 1997 by the EMI, and explained in more detail in the so-called "General Documentation" published in September 1997, the ESCB will rely on open market operations as well as on standing facilities. The interest rate corridor between the latter (the deposit and the lending facilities) is expected to be relatively wide, although it may depend on the exact parameters chosen by the ESCB. Since these two rates are designed to bound overnight market rates, the likely width of the range means that significant leeway will be left to banks to manage their interest exposure, therefore encouraging market development. The ESCB will also rely on a broad range of counterparties. In addition, the ECB Governing Council might decide to make use of reserve requirements, and the averaging provisions mechanism might be viewed as contributing to increasing the volume of the interbank market. Compared with alternative ways of controlling volatility in the interbank market, reserves with averaging facilities will have the advantage of assigning a central role to market forces and of not requiring the central bank to be frequently in the market. Equal treatment of counterparties and the reliance on market-based policy instruments are consistent with the requirement, enshrined in the Maastricht Treaty, that the ESCB "shall act in accordance with the principles of an open market economy with free competition".
One might anticipate that not only the harmonisation effect of the single monetary policy, but also the greater level of competition will progressively reduce arbitrage opportunities linked to liquidity differentials. However, the US case shows that it has not hindered the development of large money markets. In particular, the decision that the ECB will use reverse transactions as the main instrument for implementing monetary policy might provide a strong incentive for the development of an EMU-wide private repo market, where financial and non-financial entities may engage in short-term collateralised refinancing operations for conducting day-to-day treasury management (see Schinasi and Prati (1997)).
2.1.2 ...which will require member countries to adapt
The single monetary policy will, however, require market participants to adapt to the new environment.
First, the harmonisation of Monetary Policy Instruments and Procedures (MPIPs) at the start of Stage Three will have an impact on banks’ refinancing. New facilities will be introduced, requiring further adjustment of techniques towards greater use of interventions at market rates in some countries. Of course, some countries have already made some adjustment (such as the use of repos by the Bank of England, development of the short-term money market in Germany) and changes realised in the past did not prove to be too difficult to implement for many countries. For a few other countries, however, the adjustment will be more significant.
Second, in order to accommodate differences in financial structures across countries, two tiers of eligible collateral are to be allowed for monetary policy operations: the first one includes instruments that are common to all countries, while the second comprises marketable and non-marketable financial obligations as well as, in some cases, equities traded on a regulated market. In the case of Tier 2, the assets and eligibility criteria are established by each NCB, under ECB guidelines and with its approval. This would, for example, allow the inclusion of a large volume of trade bills and bank loans in Germany and France.
It should finally be noted that very significant progress has already been achieved in the direction of the integration of European money markets, as is evidenced by the convergence of monetary policy intervention rates, as well as the nearly identical money market and swap yield curves over the past two years for the Belgian franc, the Deutsche Mark, the Dutch guilder and the French franc regarding maturities from one week to two years.
2.2 Securities markets
EMU will also have an impact on securities markets. First, EMU creates the potential for the emergence of deeper and more liquid financial markets. Second, it will have effects on the nature of products offered.
Regarding the size of financial markets, EMU will offer EU countries the opportunity to compete in size with the United States and Japan. The capitalisation of existing (domestic and international) debt securities and equities in the EU-15 area amounted to 12,500 billions dollars at the end of 1995, as compared to 27,000 billions dollars for the US and Japanese markets taken together, on account of the large size of the EU domestic bond markets. The greater depth and liquidity of EU markets after the introduction of the Single Currency, as well as the strength and the stability of the euro, may also attract additional investors from outside the euro area.
Regarding the nature of products offered on EU securities markets, EMU may have significant effects.
First, one can expect that the disappearance of foreign exchange risk means that credit risk will become more important in relative terms, which may lead to the emergence of a "credit risk culture" in the management of debt instruments. While this will be favoured, in particular by the implementation of the "no bail-out" clause - which will have an impact on the rating of public debt, in the sense that domestic issues are likely to receive ratings similar to those currently attributed to foreign issues (see BIS (1996)) - fiscal discipline and the strict application of the Stability and Growth Pact should per se reduce credit differentials to a minimum. Of course, a "credit risk culture" would also depend on the existence of a system of rating agencies really adapted to the needs of European investors. In countries where banks hold a significant proportion of government bonds (France, Germany, Belgium and Luxembourg), banks will have to adjust their portfolios in the light of perceived variations in this credit risk. At the same time, the zero credit risk weighting for zone A government debt (which includes all EU countries’ government debt) in the solvency ratio regimes will provide a strong incentive to invest in government bonds. Investors will also pay more attention to the liquidity characteristics of financial markets.
Second, one could witness in the very near future the creation of a unified European capital market for prime borrowers. This would include the emergence of a single reference bond yield curve, as well as a European equity market for blue-chip stocks. Such markets would, however, not cover the whole spectrum of issuers, since securities from small and medium-sized companies would probably remain national. The latter compartment of the market will probably remain, to a large extent, separated, since investors’ home bias is likely to remain important, because of asymmetric information, tax differences, or attempts by national centres to protect their market shares.
Third, other markets may also develop. The Stability and Growth Pact will, by constraining fiscal policy and imposing limits on government deficits, reduce governments’ recourse to the capital market, hence creating room for other issuers. In addition to population ageing, it will put additional pressures on pay-as-you-go pension systems in favour of funded ones. Non-government bond and equity markets should therefore grow, accelerating the general movement towards disintermediation. In addition, to the extent that the operational framework for monetary policy increases the demand for private paper, it will have an effect on financial market structures, by creating the "critical mass" which will allow new products to be sufficiently competitive to expand significantly. This will increase the scope for securitisation; it might even lead to the emergence of a low-grade bond market in addition to the market for prime borrowers. One qualification, however, is that, if securities markets are to expand and become more diversified to compete on an equal basis with the United States, securities settlement systems will have to further improve and develop significantly.
Fourth, EMU will also have an impact on derivatives markets. Products linked with short-term interest rates will suffer falls in trading volumes, since the single monetary policy in Stage Three implies that there will be only room for one leading short-term contract. This may have consequences for the 16 European futures or options markets (including Switzerland). As far as long-term contracts are concerned, the coexistence of more than one reference bond market will not be a durable feature, so that one can anticipate either a single contract - although this may imply co-operation between financial centres, as it is currently the case between DTB and MATIF - or several identical ones with similar characteristics (margins, opening hours).
3. Effects oF EMU ON Financial institutions
Financial institutions constitute the backbone of the financial sector. In addition, given the progressive institutionalisation of financial markets, they are the ultimate participants. They will naturally be at the forefront of the changes ushered in by EMU. Following the standard (albeit sometimes criticised) paradigm in industrial economics, namely the Structure-Conduct-Performance approach, I wish to consider now how EMU will affect the nature of financial institutions’ activities and their competitive environment. Then I shall deal with the effects of EMU on the performance of financial institutions.
3.1 EMU changes the nature of financial institutions’ activities and their competitive environment
The single currency as well as the development of deeper financial markets create two challenges for financial institutions. First, it may reinforce securitisation in the "narrow sense" as well as in the "broad sense" of a growing use of instruments tradable in financial markets. Second, it will intensify competition.
EMU is likely to increase the size of securities markets so that securitisation in the "narrow sense" - i.e. the transformation of banking assets into tradable securities through financial engineering - will make further progress, offering banks more flexibility in terms of asset/liability management. At the same time, with securitisation in the "broad sense," the competitive disadvantage of traditional bank intermediation vis-à-vis financial markets and non-banks is likely to increase, with differential effects on deposit collection and credit activities.
On the deposit side, banks are likely to increasingly face competition from institutional investors. Following the disappearance of foreign exchange risk, limits on portfolio diversification by institutional investors, like the "currency matching rules", are likely to be applied only outside the euro area. This will boost the cross-border investment activity of institutional investors. As a consequence of the changing nature of demand, with the greater use of mutual funds, the maturity of banks’ deposit-taking may become shorter and deposit collection more costly. On the asset side, greater competition in the securities business will coexist with the persistence of asymmetric information in lending activities. In the latter case, the need to have a direct link with borrowers means that traditional financial intermediation is likely to remain substantial, in particular lending to small and medium-sized enterprises, for whom access to the securities markets is more difficult. Therefore, EMU represents both challenges and new opportunities, since, in this new environment, institutions currently involved in fee-generating activities, or offering services linked to financial markets, will have a competitive advantage in the faster growing segments of the financial sector.
On the other hand, EMU will increase competition among financial institutions. Note that national banking markets are today relatively concentrated, more significantly so in the smaller countries. Against this background, EMU will, by removing the last obstacle to the circulation of financial services across European countries, induce, at least in the first years, a significant increase in competition. Using data provided by IBCA, a rating agency, one can compute an upper bound for the level of concentration of assets, loans and deposits, as measured by the share of the five largest EU credit institutions. Concentration ratios might be between 10 and 11% (between 13 and 14% for universal banks), as compared to 18% in the United States in 1993 (OECD, 1995). This reveals that there may exist some scope for further consolidation in Europe, in continuation of the trend observed in the late 1980s and early 1990s.
To assess the overall effect of EMU, it is however useful to distinguish between wholesale and retail markets.
Wholesale markets are already significantly internationalised and competitive, but competition in these markets will nevertheless evolve over time. The single currency will imply a further redistribution of banking activities to the extent that competitive advantages, partly based on the existence of national currencies, will disappear. In particular, the "anchoring principle" imposed by some central banks and requiring domestic financial institutions to lead manage bond issues will, if maintained, be enlarged to a wider zone, or even disappear. In addition, the main currency-based competitive factor, namely the expertise in the domestic monetary environment will, according to Dermine (1996), disappear. However, other competitive factors are likely to be unaffected by the single currency in the short run. These include the existence of a distribution network of customers, as well as access to information on supply/demand flows, which help to assess the direction of price movements. Regarding mergers and acquisitions, the knowledge of the accounting, legal and fiscal environment also remains an important determinant. However, all these competitive advantages are not irreversible and may be progressively eroded by EMU. In addition, the importance of the size factor (i.e. the cumulative advantage of controlling a large market share, hence the ability to operate on a larger scale) indicates that current positions may be progressively overturned by European or even by other global players.
In retail banking markets, EMU will induce further progress in payment systems, both directly and via interaction with technological innovation, the major driving force behind changes in payment systems. For instance, technological innovation may itself be fostered by the transition to the single currency. In particular, the liberalisation of telecommunications, favoured by the Single Market that EMU is due to complete, may lead to a more widespread use of phone, PC and Internet banking. Network-based e-money payments may also benefit from a global and highly competitive market.
Changes in competition may therefore be expected to be more pronounced on the liabilities than on the assets side. In particular, remote access to banks in other Member States will become very easy in the context of a single currency and branches may lose their relevance as distribution centres of deposit products. Regarding the assets side, Monetary Union will enable operations in any national market to be financed through deposits obtained in the home country, hence also facilitating the remote supply of financial services. Consequently, competition in some segments of the market is likely to increase. This is the case of activities which are relatively homogeneous and closely related to the deposit function, like consumer credit and standard mortgage loans, as opposed to small-scale commercial loans and specialised consumer loans which require more direct contact with customers. On the other hand, there still exist legal, fiscal and institutional obstacles to full integration that will limit the effects of competition. However, being more visible in the single currency area, they may trigger further pressure, leading to their progressive disappearance.
3.2 EMU may have a significant impact on the performance of the banking industry
The move to EMU offers challenges for financial institutions. While the changeover process imposes constraints in the short run, the medium-term effects on the performance of these institutions will, in my view, certainly be positive.
3.2.1 EMU implies one-off costs associated with the changeover...
One should not deny that the changeover to the euro is a major undertaking which is costly for financial institutions. The changeover scenario agreed in Madrid in December 1995 is designed to minimise costs by adopting a decentralised approach. It is the principle of "no compulsion, no prohibition", which allows institutions to choose the most appropriate way and the pace at which they upgrade their operational systems.
Costs vary across institutions depending on their activities. While being apparently low for firms active in securities business, costs would be higher for institutions specialised at the retail level, given their role of intermediaries, during Stage Three A (1999-2002), between agents and institutions proceeding at different paces regarding the introduction of the euro. Conversely, securities firms already operate in a multi-currency environment. It is interesting to note that various estimates tend to show that smaller and/or more specialised institutions may not always be disadvantaged, although their lower cost of organisation may in some cases be more than offset by limited expertise. Adequate planning and timing of the changeover seems to make a difference, since some changes are due to be made independently of the advent of EMU, in particular regarding preparations for the year 2000.
3.2.2 ...but the competitiveness of EU financial institutions should increase in the medium run
In the medium run, however, I see the costs of the changeover as a profitable investment for financial institutions.
First, in a few instances, the move to Stage Three may help reveal organisational deficiencies at the level of institutions, the solution of which will, in the end, prove decisive in improving the competitiveness of successful European institutions. Similarly, the time-consuming process of the harmonisation of market conventions and codes of practices (day counts, business days, reference rates...) will not only ensure the continuity of operations when moving to Stage Three of EMU and the smooth functioning of the area-wide money market based on the euro, it will also promote the fungibility of instruments across countries, a necessary condition for the creation of deeper financial markets (see the Giovannini Report).
Second, institutions will probably gain from returns to scale associated with activities extended to the EU area level, leading to the constitution of global players able to compete with non-euro institutions. One should, however, acknowledge that the economic literature does not provide clear evidence in favour of very significant returns to scale in banking. Similarly, regarding the existence of economies of scope that may justify the existence of large universal banks, the literature is, again, inconclusive. There is, at most, evidence of small gains of joint production for liquidity management, treasury and dealing activities, risk management and payment systems. There is also only anecdotal evidence that returns to scale in money market operations may also imply the concentration of other activities. However, although it is quite speculative to predict how banks will exploit possible returns to scale and react to potential competition, one possible scenario is that EMU will lead to the coexistence of a few Europe-based global players, alongside smaller institutions specialised either in given product groups or in specific regions. It is also difficult to predict which strategy will be preferred by banks after EMU - (1) specialising in specific "niches" involving particular skills; (2) building new strategic alliances among universal banks; or (3) accelerating the movement of concentration through mergers and acquisition.
Third, from a more macroeconomic point of view, the priority given to price stability in Stage Three should provide an enhanced environment for the production of financial services. Less volatile inflation and interest rates are good for banks’ customers, and hence for banks. They will also benefit from higher expected economic growth via lower interest rates supported by a strong euro. Thus, EMU may increase the competitiveness of the whole European banking industry, and in particular of the international banking groups.
EMU will certainly have a major impact on the European financial sector. Of course, all trends currently apparent should not be exclusively explained by the "EMU factor". However, the single monetary policy will generate new activities, in particular in connection with the emergence of larger and deeper financial markets. In addition, competition is likely to increase significantly with the single currency, as one of the major obstacles to financial integration will disappear, although retail banking markets will keep, at least at the beginning of EMU, many of their "local" features, in particular those due to tax differences. Other speakers in this Lecture Series will come back later to this issue of tax convergence.
Let me finish by indicating that the objective of the EMI is to ensure that the move to Stage Three takes place as smoothly as possible. Work to establish the infrastructural support for the conduct of the single monetary policy in areas like payment systems and statistics is broadly complete. The operational framework for monetary policy has been set out in detail. The ECB Governing Council will make the last few necessary adjustments in good time. Market participants are adapting their accounting and operational systems and can now define their strategies. Provided that the supply of financial services is adequately priced ex ante (this would require that all banks do not decide to invest in the same sectors and do not lend imprudently to new customers), I am convinced that financial institutions will soon reap the benefits of EMU.
Bank for International Settlements (1996) International banking and financial market developments, August.
Davis, E. P. (1995), Pension funds, retirement income and capital markets, an international perspective Oxford University Press.
Davis, E. P. (1997) "The role of institutional investors in the evolution of financial structure and behaviour" LSE, FMG Working Paper.
Dermine, J. (1996) "European banking with a Single Currency" Paper presented at Wharton Financial Institutions Seminar, Philadelphia.
Giovannini Report (1997), "The impact of the introduction of the euro on capital markets", European Commission.
Mc Caughley, R. and W. R. White (1997) "The Euro and European Financial markets", Bank for International Settlements.
Rajan, R. (1996) "Why banks have a future, an economic rationale", Temi di Discussione, Banca d’Italia.
Schinasi, G.J. and A. Prati (1997) "European Monetary Union and International capital markets: structural implications and risks" IMF Working Paper.
 See in particular Davis (1997).
 See in particular Davis (1997).
 Differences in rating across Canadian states may be taken as evidence of the likelihood of such an effect, although the effective bankruptcy of a European government would only occur after running through the alternative assistance mechanisms, including those from the IMF.
 Currency matching rules require insurance companies, for example, not to hold more than 20% of their assets in foreign currencies, unless they are matched by liabilities denominated in the same currency. The Single Market and the constitution of international groups of institutional investors have already limited the relevance of such rules.