Consolidation of the payment systems industry: the Eurosystem's perspective
Keynote address given by Mr. Tommaso Padoa-Schioppa during the International Payment Systems Week 2001 London, 2 April 2001
I would first like to thank you for giving me the opportunity to present the Eurosystem's view on one of the most notable changes in the financial landscape in recent years, namely the significant acceleration of the consolidation process.
Financial sector consolidation is of interest to the Eurosystem and other public authorities in various respects. Today, I would like to focus on its effects on payment systems and, more specifically, on the effects of certain developments in the correspondent banking business on euro payment systems.
A major study has recently been conducted at the G10 level in order to enhance official and public understanding of the main trends in the field of consolidation, including their causes and consequences. As a result of this work, a Report on Consolidation in the Financial Sector was published in January 2001, which was prepared by a Working Party chaired by Roger W. Ferguson, Jr, Vice-Chairman of the Board of Governors of the Federal Reserve System. This report analyses the issue of consolidation in a very comprehensive manner and includes a separate chapter on the effects of consolidation on payment and settlement systems.
Moreover, at the Eurosystem level, a survey was conducted between July and September 2000 - in co-operation with the Bank of England and other non-participating EU central banks - with the aim of identifying the main impact of Monetary Union on correspondent banking and other settlement arrangements in euro. The national central banks involved may well be presenting the results of this survey to the national banking community in their respective country in the course of this month.
In the following discourse, I will first briefly describe the main trends in and the causes of consolidation. I will then explain why the Eurosystem is keen to pursue these developments and what the main policy conclusions are from our perspective.
The main trends in consolidation
In a payment systems context, consolidation includes various developments in the financial sector whose common element is that they result in a higher degree of concentration of payment flows. In this sense, consolidation relates not only to institutional aspects (mergers and acquisitions), but also to reorganisational measures within individual financial institutions, specialisation and outsourcing processes and, not least, the market infrastructure.
The high level of merger and acquisition (M&A) activity in recent years has relevant implications from a payment systems perspective. With a declining number of financial institutions, interbank transactions are increasingly becoming intrabank transactions ("on-us" items). This may have positive effects on efficiency since these transactions do not involve external exchanges of payment messages via a traditional payment system. This point also raises certain concerns that I will come back to. Another implication is that M&As are usually followed by a rationalisation of the payment activities of the banks concerned. In addition, the global players emerging as a result of international M&As often have more demanding business needs towards the providers of payment and settlement systems.
A second trend, which may be called internal consolidation, is the concentration by large international banks of a considerable proportion of their worldwide payment and cash management activities in one or a few operating centres. The establishment of CLS Bank is likely to bolster this trend.
As a third trend, a process of specialisation and outsourcing can be identified. At the domestic level, this is not new in the savings and co-operative banking sector, where central institutions provide payment and back office services to smaller banks, usually from the same sector. More recently, so-called transaction banks have emerged which specialise in the provision of payment and back office services to other banks. Whether these initiatives will be successful depends, inter alia, on how future payments processing will be organised in the e-world. If open network structures in interbank connections were to enable banks to exchange certain kinds of payment transactions directly without an intermediary, the role of central "processing factories" could be heavily affected.
Going beyond national boundaries, a concentration process has become evident in international correspondent banking. This includes a reduction in both the numbers of correspondent banking accounts and market players. In turn, as the aforementioned ECB survey on developments in the EU has shown, the size of the correspondent banking business of a single credit institution can reach nearly EUR 40 billion per day. This is far more than the turnover of the smallest large-value euro payment system and almost half the daily turnover in 2000 of the third largest non-RTGS large-value euro payment system.
The emergence of cross-border payment systems such as TARGET, Euro 1, STEP 1 (and, soon, CLS Bank) is on the one hand eroding the traditional "bridging" function of international correspondents. On the other hand, it is reshaping the services supply, as it enables correspondent banks to provide a broader range of services (e.g. by offering smaller banks a kind of indirect access to such systems) while, at the same time, covering a wider geographic area.
Allow me here to digress briefly on the meaning of "international" and "cross-border" in the context of a single currency zone. All payments in euro within Euroland are to be considered "domestic" payments. This will be all the more so from 2002 thanks to the introduction of euro banknotes and coins: for payments in central bank money, the distinction between domestic and cross-border payments will disappear once and for all. Alas, this will not be entirely true for cross-border payments in commercial bank money, but today I do not want to deal with this issue, which is, as you know, one of the concerns of the Eurosystem. In Euroland, the term "cross-border" payments is just a convention to refer to payments across national boundaries. However, this term should by no means be taken as a synonym for "international payments", i.e. payments between two countries that have different currencies. Thus, a euro payment between London and Lisbon is an "international" payment, while a payment between Lisbon and Athens is a "domestic" payment that just happens to cross the borders of two euro area countries.
Coming back to consolidation, the last type of consolidation to be considered here concerns the market infrastructure for making payments. The number of large-value payment systems in euro has decreased to five. However, this multiplicity of large-value payment systems in euro remains exceptional compared with that of other currency areas where both market forces and policy-makers have resulted in the creation of a single system (in the case of the United Kingdom) or two systems (as in the United States). In fact, a further consolidation has already been announced with the merger of the two German systems - EAF and ELS - into RTGS Plus, which will happen in September 2001.
The causes of consolidation
Let me now say a few words on the main causes of consolidation. It is clear that, in a market economy, consolidation processes are ultimately aimed at reducing costs and/or increasing the revenue of the financial institutions concerned. While the profit motive is the main driving force, the form and pace of consolidation are determined by several environmental factors. Of course, there are also factors discouraging consolidation. However, I will leave them aside today.
In general, the benefits of size and, hence, the incentive to make large investments basically arise from developments in information technology and from the internationalisation of the interbank and capital markets. The latter has been made possible by a general trend towards a deregulation and liberalisation of financial markets and is connected with sharply increasing cost-cutting pressures, inter alia, in the field of payment processing.
Huge IT investments are usually needed to set up the required infrastructure or to maintain and improve the existing one. Therefore, only the institutions that have or can reach a "critical mass" in terms of the number of payments processed are able to write off these costs. Alternatively, they may, at the domestic level, outsource payment activities to transaction banks benefiting from economies of scale or, at the international level, leave this business to specialised correspondent banks acting on a global basis.
At the European level, the introduction of the euro has - together with increased legal harmonisation - played a special role. The euro has eliminated the segmentation of local markets caused by the multiplicity of national currencies, thereby creating a bigger market in one single currency. Consequently, consolidation has been stimulated, as it widens the economies of scale and scope inherent in the clearing and settlement business.
In fact, with regard to correspondent banking business, the ECB survey (confirming the findings of an earlier survey conducted in 1999) shows that the impact of Economic and Monetary Union (EMU) on correspondent banking was substantial. The majority of banks now have just one correspondent account per euro area country, plus an additional account for back-up purposes.
A further step towards higher concentration is expected in 2002 when the legacy currencies (which are still used for a large part of the commercial payments processed via correspondent banks) will cease to exist. Undoubtedly, the cash changeover in 2002 will be another milestone in the evolution of correspondent banking business in Europe.
With regard to the payment systems infrastructure, the introduction of the euro has resulted in the inter-linking of the RTGS systems in the euro area and the establishment of TARGET. This was a requirement of the single monetary policy, and has proven to be a key factor in the unification of the euro money market.
In the field of market infrastructure, the consolidation process is, however, to a large extent driven by major players located in countries both within and outside the euro area. These institutions normally participate in several systems and thus tend to request a greater harmonisation of these systems or even an amalgamation of infrastructures across borders in order to save the costs of the numerous interfaces they would otherwise need to maintain.
I would now like to turn to the policy-related part of my presentation: why do central banks closely follow these developments? What conclusions does the Eurosystem draw from its analysis, in particular of the developments in correspondent banking?
One of the basic tasks of the Eurosystem is to ensure the smooth functioning of the payment system. Like any central bank, the Eurosystem performs this task in two ways: by offering safe and sound payment and settlement services (TARGET) and by overseeing privately run payment systems to ensure that they comply with agreed standards. Of course, since substantial payment flows occur outside the "official" payment systems, looking solely at the soundness and efficiency of such systems would only provide a partial picture. This is why the Eurosystem considers that fulfilling its statutory task means looking at developments in the payments business as a whole, and not only overseeing payment systems.
This is all the more relevant since, with developments in correspondent banking and the introduction of innovative payment arrangements (i.e. EuroSIC, the BACEE Payment and Clearing System (BNS)), the nature of correspondent banking business is changing in Europe. Indeed, correspondent banking networks tend to acquire features that resemble those of payment systems. Both advanced correspondent banking and innovative payment arrangements combine features of "traditional" correspondent banking and of "true" payment systems. Like the former, they allow the users to forward payments to third parties who do not participate in the same scheme and provide a point of entry to one or more payment systems. At the same time, like the latter, such arrangements allow users to exchange payments among themselves and thus generate network externalities that are typical of payment systems: positive externalities, as the value of the arrangement increases the wider the participation; and negative externalities, as systemic risk may increase. In some ways, therefore, such arrangements "do more" than payment systems. Hence the interest of the Eurosystem.
As I mentioned earlier, the concentration of correspondent banking business has reached a level where the size of the payment turnover of a single credit institution is sometimes comparable with that of a large-value payment system subject to Eurosystem oversight. Thus, since the soundness of systemically important payment systems is at the heart of central banks' responsibilities in the field of payment systems, as pointed out in the recent Report on Core Principles for Systemically Important Payment Systems produced by the Committee on Payment and Settlement Systems (CPSS), it goes without saying that the Eurosystem also pays close attention to the soundness of payment arrangements of comparable size. In addition, it is worth remembering that the consolidation of payment and settlement activities on a small number of major market players, all of whom participate in several payment systems, has an impact on the distribution of operational, financial and systemic risk (a higher risk of contagion). These are all risks that central banks typically aim to reduce via their payment systems policy.
Central banks are also interested in the efficiency gains that consolidation and concentration of the payments business allow. Correspondent banking services are increasingly technology-intensive, and the choice of correspondents is clearly influenced by the quality of what is offered in terms of efficient and highly automated services. On the one hand, since huge IT investments are usually necessary, only big players can afford the large investments required to provide front-line services and to achieve economies of scale. On the other hand, further developments in e-technology and its low-cost availability to smaller banks may change this trend. Thus, while the end-result is not yet clear, efficiency considerations may push many smaller institutions to reconsider their positioning both in correspondent banking business and in terms of access to payment systems. Indeed, indirect participation comes closer to an "enhanced" correspondent banking service provided by direct participants. Of course, the Eurosystem is eager to understand the driving forces that may lead to a substantial change in the structure of access to euro payment systems.
The geographical positioning of payment arrangements is another relevant aspect being looked at by the Eurosystem. Some large correspondent banks have always had "typical" geographical orientations catering for the needs of specific banking communities abroad. This is not entirely new, in the sense that internationally operating banks have traditionally played this role, especially in countries whose currencies had a prominent role in the foreign exchange market before the introduction of the euro. However, the emergence of innovative payment arrangements in euro - like EuroSIC - have introduced new aspects in this respect. Such arrangements are also relevant from a policy perspective because they enable a non-EU banking community to access the euro payment system. On average in 2000, EuroSic processed nearly EUR 1.5 billion a day, with the larger share of payments in terms of value sent to counterparties who were not participating in the system but who could be reached via the connection to EAF and TARGET. While, for the time being, the limited turnover does not raise concerns, the Eurosystem wants to follow the development of such arrangements closely.
Another aspect with policy relevance is the governance structure, as one of the duties of a central bank is to guarantee fair and open access to payment infrastructures. Privately run payment systems often have a co-operative structure that favours the internalisation of positive externalities and ensures that decisions are in the interests of participants. Clearly, the degree of openness of the club, and of its decision-making bodies, is crucial in this respect. Arrangements evolving from correspondent banking business are typically owned by a single private entity, and thus tend to be less open and transparent; there may not only be discriminatory problems in the definition and application of access criteria, but also problems in terms of the selection of operational features, the adoption of new technologies and standards, pricing policies, etc. From this point of view, there is a role for central banks in fostering fair and open access to all kinds of schemes.
Last but not the least, consolidation in correspondent banking has an impact on the use of central bank money. The use of central bank money as a settlement medium for certain kinds of transactions, in particular large-value payments, has always been a major part of central banks' risk reduction policies. This has been particularly true in the EU since 1993, when the Committee of Governors (the predecessor of the EMI Council and the ECB Governing Council) took the decision to foster the use of RTGS systems provided by the central bank as a key risk-reduction measure. This trend culminated in the introduction of TARGET, whereby nearly 70% (in terms of value) of the large-value payments in euro in the last two years were settled in central bank money. The recent developments in correspondent banking and the emergence of innovative payment arrangements that settle in the books of a commercial bank might affect the share of payments settled in central bank money and reverse this trend. Again, with reference to the Core Principle report, the importance of settlement in central bank money increases with the increase in the systemic importance of the arrangements. In any case, central banks have an interest in ensuring that the settlement agent, in whose books settlement is made, is sound, so that the commercial bank money used as the settlement asset carries very little financial risk.
On the basis of the aforementioned considerations, the Eurosystem concluded that the policy relevance of advanced correspondent banking and innovative payment arrangements is not inferior to that of traditional payment systems. Consequently, the Eurosystem will continue to monitor their systemic importance and development closely. In this respect, a structured collection of statistics may be the necessary basis for further analysis. The second half of 2002 could be an appropriate point in time to undertake a new fully-fledged survey. At that time, the impact of the final changeover to the euro will have fostered a new wave of changes in correspondent banking relationships and will have further increased the level of concentration in the field.
In the meantime, the Eurosystem will develop a policy line, including an oversight framework, for such schemes. The starting point for the elaboration of such a framework is the consideration that correspondent banking and innovative payment arrangements play a role very similar to that of traditional payment systems, without being subject to the specific risk management measures that apply to payment systems, which are requested to comply with agreed safety standards. In order to achieve a comprehensive and equitable regulatory framework in the payments area, the Eurosystem intends to consider all schemes whose function is comparable to that of a payment system. In this vein, it may consider whether agreed standards for payment systems might also be applicable to such schemes. The Core Principles - which were included in the set of oversight principles of the Eurosystem in January 2001 - can serve as a good starting point for further reflection in this matter.
The Eurosystem shares the conclusions of the Report on Consolidation in the Financial Sector which highlights the benefits of close co-operation between banking supervisors and payment systems overseers in this area. The analysis of developments in correspondent banking and of the effects of consolidation in this field may be complemented by an exchange of information between oversight and supervisory authorities, so that the synergies that exist between the two perspectives are usefully exploited. The recently adopted "Memorandum of Understanding between Payment Systems Overseers and Banking Supervisors in Stage Three of EMU" could serve as a basis for exchanging information in this area as well.