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Efficiency in financial institutions

Speech by Professor Otmar Issing, Member of the Executive Board of the European Central Bank, at the World Congress of Savings Banks, Madrid, 23 May 2003.

Ladies and gentlemen,

This session of the conference is devoted to the issue of efficiency in financial institutions. The very first question which springs to mind in this context is whether banks are efficient institutions and whether they are carrying out functions which in today's world might be considered obsolete. Over a year ago, the Annual Meeting of the American Economic Association, one of the most prestigious economic conferences held every year, discussed the issue of whether banks would still exist in 2020. I do not think that this is a question which would have arisen quite so prominently at the European level. Banks have played a much more important role in Europe over the past 50 years than they have in the United States, and while the world is obviously a place of change, there is little reason to expect that banks will disappear by 2020 in Europe. I should add that most of the participants at this conference did not expect that to happen in the United States either, but the general consensus was that the nature of banking would definitely be subject to change.

In a rapidly changing environment, banks as institutions have been around for an incredibly long time. There are any number of different conjectures about the origins of banks, and there is a whole host of economic theories on the rationale for having them. Some of these theories centre on banks being trustworthy enough to provide customers with liquidity and a safe investment haven. Others focus on the expertise of banks in monitoring credit developments. Maintaining that trustworthiness and being at the leading edge in terms of assessing and monitoring risks are to my mind two key competencies that apply to banks and most other sectors of the financial system.

I will come back to the role of banks and the issue of trust after discussing some of the more general features of the lending relationship and current trends in the European financial system.

The importance of banks and relationship lending

Despite the amalgamation of institutions, the financial system is composed of a number of financial markets, instruments and institutions. Although the view among leading economists is not unanimous, several economic studies suggest the existence of a link between the sophistication of the financial system and economic growth. As Ross Levine claims "[...] the weight of evidence suggests that financial systems are a fundamental feature of the process of economic development and that a satisfactory understanding of the factors underlying economic growth requires a greater understanding of the evolution and structure of financial systems (R. Levine, "Financial Development and Economic Growth: Views and Agenda", Journal of Economic Literature, June 1997, Vol. 35, No. 2.)". There is a long-standing debate in academic and policy-maker circles on the relative merits and drawbacks of bank versus market financing of economic activity. Whilst in periods of financial market turbulence, there is no doubt that the role played by banks in terms of acquiring expertise on the creditworthiness of their customers and developing close links with firms' management most certainly has its advantages with regard to maintaining financial stability, I do subscribe to the commonly held view that a financial system with a broad range of products and suppliers of services is the best way of meeting the diverse needs of the customers.

Relationship lending is the term used to describe special agreements made between banks and their customers with regard to credit availability. (Professor O. Issing, "Relationship lending in the euro area", speech delivered at the second ECB Central Banking Conference, October 2002.) Banks have the opportunity to closely monitor the customers' creditworthiness, which normally means that liquidity is provided more readily, as relationship lending overcomes some of the information asymmetries. At the microeconomic level, relationship lending tends to insulate firms from financial shocks, as they can rely on previously arranged credit agreements, and the adjustment of retail rates to monetary policy changes is not normally instantaneous. The macroeconomic implication is that relationship lending contributes to smoother business cycle fluctuations. Indeed, those fluctuations have been historically more pronounced in the United States and the United Kingdom, where relationship lending is less widespread than in continental Europe.

Relationship lending is not always the best financing choice for firms at any given point in time. When assessing a firm's borrowing needs, the bank will need to consider not only the firm's current liquidity supply, but also its long-term ability to repay. It will also take into account a number of non-contractual levers the bank could use to extract repayment (R. Rajan and L. Zingales, "Banks and markets: the changing character of European finance", paper presented at the second ECB Central Banking Conference, October 2002.). The interest rate charged is normally renegotiated over time and may not fully reflect the intrinsic risk of the investment. In a direct, market-financed lending relationship, firms have access to a wider circle of potential lenders. The interest rate is a competitive one compensating the lender for the risk associated with that particular loan. Because it is based on the dissemination of more widespread information, direct financing via the market implies more fixed costs. Thus it is likely that larger firms will take advantage of this form of financing more than smaller firms, and that firms in general drift towards capital markets during more prosperous cycles.

Innovative firms embarking on new areas of technology have a better chance of obtaining financial assistance in a system based on the broad availability of public information. At the moment, the absence of a well-developed stock market is a disadvantage to any type of economy. Equity, as a means of financing, is essential for the emergence and growth of innovative firms, as banks may be reluctant to provide these firms with loans.

Overall, I believe that economies characterised by both a well-established banking sector and capital markets have a distinct advantage. Furthermore, in times of crises in either of these sectors, the other sector can be used as a prop to counterbalance any negative effects, acting as the "spare tyre" if you like.

Characteristics of the European financial system

Let me turn briefly to the most prominent characteristics of the euro area financial system.

Relationship lending plays a prominent role in Europe, particularly in financing small and medium-sized enterprises (SMEs). Given that euro area economies are widely dominated by such enterprises, a decline in the availability of relationship lending would likely have a significant impact on the euro area economy.

A wave of consolidation has taken place in the euro area banking sector over the past few years (ECB (2002), "Report on financial structures"). The number of credit institutions has declined, primarily as a result of mergers between smaller institutions at both regional and national levels. At the same time, these mergers have often given rise to bigger non-specialised universal banks. Partly as a result of this wave of consolidation in recent years, the number of branches and employees working in credit institutions in the euro area has dropped significantly in some countries and in some specific categories, e.g. savings banks. The integration of cross-border banking services, in particular at the retail level, remains limited and restricted to a few countries in the euro area. The handful of larger institutions that provide their services throughout the euro area mainly serves larger corporate customers. This is quite natural as information asymmetries are more pronounced with regard to retail customers, and it is in this field that domestic players continue to play an important role.

The euro area financial system has been subject to change over the past few years even outside the banking sector. Traditional deposit-taking activities have been challenged by the emergence of asset management companies and predominantly mutual and pension funds. Households and corporations have directed savings and surplus funds in the economy increasingly towards these new players. This suggests that the intermediation process in the euro area is undergoing significant change. It should be noted, however, that life insurance companies and investment funds are often located within banking conglomerates, suggesting that new developments are also taking place in the banking business.

The origin of savings banks

The idea of trust has been at the core of the business of savings banks since the very beginning. Mutual savings banks, which originated in the United Kingdom in the first part of the nineteenth century and progressively spread throughout the United States, were conceived as philanthropic institutions designed to relieve pauperism by "inducing habits of economy" in the working classes. The first mutual savings banks were associated with charitable organisations managed by wealthy philanthropists endeavouring on such projects in their spare time. Similar institutions soon began to develop in continental Europe. The German Sparkassen, for example, which began to spread after the Napoleonic wars, were private institutions or entities owned and controlled by the government.

An important feature of these banks was that liability for these deposits was either assumed by the owners (in the case of private institutions) or by the government (in the case of government-owned entities - T. W. Guinnane, "Delegated Monitors, Large and Small: Germany's Banking System, 1800-1914", Journal of Economic Literature, March 2002, Vol. 40, No. 1). The safety of deposit was crucial to their mission as savings banks. Only firm assurance that their savings were safe would encourage the poor to entrust them to a financial intermediary. Furthermore, in order to limit potential liabilities, savings banks were usually limited in the type of assets they could hold.

Research on savings banks has always been somewhat limited, as their role has never been considered terribly important for industrial lending and, ultimately, for economic growth. By contrast, universal banks — defined as institutions offering a full range of financial services under one corporate roof — are generally attributed with a leading role in the development of industry. However, savings banks did in fact play a very important role in the development of industry. In Germany, for example, they financed many public infrastructure projects and facilitated the large urban agglomeration resulting from industrialisation. The transformation of savings banks from small specialised financial intermediaries into large institutions offering a broad range of services is perhaps one of the most striking innovations of the twentieth century.

Banks and trust

Let me now turn to two aspects, which are fundamental for sound money and credit, and they are credibility and trust.

One of the main characteristics of banks has always been their role as a trustworthy provider of liquidity and safe investment. In the early days of banking, there were plenty of examples of governments' lack of respect for the private property of its citizens, not least bank deposits. In 1345, a number of bankers in Barcelona were actually executed by the municipal authorities, in spite of the fact that their failures primarily resulted from forced loans to the city. Executing these bankers was a convenient way of avoiding repayment of these loans and for improving public finances (R. Rajan, "The Past and Future of Commercial Banking Viewed Through an Incomplete Contact Lens", Journal of Money, Credit, and Banking, 1998, Vol. 30, No. 3).

Some even claim that converting the cash originating from deposits to loans was a convenient way of limiting the scope for the government to confiscate banks' assets. Thus banks reacted to the fear of the government abusing its power by creating the dual characteristics of banks as we define them today, as takers of deposits and lenders.

Central banks have also had a turbulent relationship with governments. Many central banks were founded by governments who wanted to enjoy the financial advantages they felt could be obtained from such banks. Some government-sponsored central banks were established to restore the value of the national currency, usually after the government had already destroyed its value as a result of over-issuance during wartimes. Often the financing of governments led to excess printing of money and subsequent inflation, which eroded the value of money. For the private citizen, inflation was yet another way of confiscating its property.

People who have been cheated tend to learn. If deposits are confiscated or the value of money is destroyed, people stop holding deposits and money. Instead they search for other assets that have some of the same properties. This in itself tends to push up inflation and invalidate the intermediation process of the financial system, which is crucial for financing investments and creating growth. Furthermore, these other assets are in many ways inferior in terms of their value as a means of transaction, store of value and unit of account. In addition, they are not normally easily accessible to the ordinary man on the street.

Some may say that these issues were relevant many years ago, but not today. But, if we look at recent events in one particular Spanish speaking country, we see at least one example of how a government, through excessive recourse to financing from its banking system, has destroyed the confidence of its citizens, resulting in the disintegration of the economy and a sharp rise in poverty.

It does not take much to lose credibility, but it takes decades to rebuild it. When the ECB was established in 1998, this was clearly a central issue, although to some extent we were able to draw on the credibility established by our predecessors, i.e. the NCBs. However, the founding fathers of European Economic and Monetary Union wisely included provisions in the Treaty which would help to create confidence in the ECB. A clear mandate with priority given to maintaining price stability and independence in its decisions are fundamental elements of the statute. The Stability and Growth Pact should also be regarded as a factor contributing to trust and credibility.

History shows us that we should be very careful about treating such issues lightly. Short-term gains can easily end up being futile against the efforts needed to re-establish the lost confidence of the general public. As argued in another speech some time ago "Ultimately, trust must be earned, it is granted temporarily, it must be checked and it must be backed up by hard evidence, not be based purely on faith or belief (Professor O. Issing, "Should we have faith in central banks", speech delivered on the occasion of the Millenium Year Lecture at St. Edmund's College, Cambridge, October 2000)."

Concluding remarks

Sound central banking, but also banking in general and the business of savings banks in particular, must be based on long-term objectives. In this context, the monetary policy strategy of the European Central Bank, with a clear commitment to price stability, helps to reduce uncertainty and thus makes it easier for people to make long-term decisions. While we may all be tempted, at one point or another, to settle for short-term gains, we must not forget that we all rely heavily on the general public's trust in us and given the focus of the business you are in, you have a particular interest in us maintaining confidence in the long-term stability of the euro.

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