"Banks and Markets: The changing character of European finance"
Second ECB Central Banking Conference, 24 and 25 October 2002, Frankfurt am Main
The transformation of the European financial system
Press summary - Second session
Raghuram Rajan and Luigi Zingales, University of Chicago
Raghu Rajan and Luigi Zingales identify a significant shift in the European financial system over the last two decades: from one mainly based on close relationships between banks and their clients to one which is more arm's-length and competitive, with larger and more developed securities markets. This shift is marked by a sharp increase in the ratio of stock market capitalisation to GDP, the introduction of many "new equity" markets, an "explosion" of financial derivatives, and the growing importance of corporate debt issuance. The reasons for this development can be found in the creation of a common market for goods and services, the exposure of domestic financial institutions to foreign competition as a consequence of Economic and Monetary Union, the favourable effects of the elimination of currency risks on corporate bond markets and the transfer of powers from national governments to the European Commission. The authors' analysis leads them to welcome this transition and to recommend that it should continue in the future. They express concern, however, about the uneven distribution of its benefits within Europe. To function well, markets require a well-designed legal and regulatory infrastructure. While northern European countries seem to have developed it, southern Europe still lags far behind. These distributional effects as well as other political factors may slow down the development of markets in the near future, or even reverse it.
Rajan and Zingales put forward a number of strong proposals to help avoid such a "great reversal". First, the European Union should promote structural reforms, especially in southern European countries, in order to develop an effective arm's-length market-based system and to cushion the distributional effects. Second, the authors think that the European Union should focus on enlargement rather than on accelerating political union, as enlargement would increase economic competition. The introduction of new divergent interests would make co-ordination of particular interests and lobbying more difficult, thus reducing the political threats to markets. Third, the European Union should favour a division of power between local and central authorities over centralisation, so as to prevent a reduction in political competition. In particular, supervisory functions should not be centralised within the European Central Bank, because this would make the ECB too powerful and thus more vulnerable to political pressure, which could lead to regulations unfavourable to financial markets.
This assessment is based on the authors' research on the historical development of financial systems. Their fundamental thesis is that relatively closed economies in which political power is more centralised exhibit significantly less financial development, in particular regarding the advance of arm's-length market-based financing. The main reason is that closed economies with centralised political powers provide favourable conditions for local interest groups to lobby for measures that protect incumbent financial firms against outside competition. This ensures the continuation of relationship-based financing practices even when arm's-length markets would be more efficient.
Kaiserstrasse 29, D-60311 Frankfurt am Main
Tel.: +49 69 13 44 74 55, Fax: +49 69 13 44 74 04
Internet: http://www.ecb.europa.eu
Reproduction is permitted provided that the source is acknowledged