RBA Annual Conference – 1991 European Financial Deregulation: The Pressures for Change and the Costs of Achievement Joseph Bisignano[1]

1. Introduction

To begin this paper on financial deregulation in Europe, I would like to shift the geographical focus a bit and start with a reference to Australia. In a recent speech, Reserve Bank Governor Fraser stated:

“With deregulation, it was recognised that the banks would be running greater risks, thereby increasing the importance of adequate capital and liquidity, and effective management controls. To this end, a supervisory framework has been developed which embraces minimum capital requirements, liquidity management, large credit exposures, associations with non-bank financial institutions, and the ownership of banks. In developing and implementing this framework, the Bank has been mindful of the trade-off that must be struck between maintaining community confidence in the banking system on the one hand, and acknowledging the essential role of risk in dynamic financial markets on the other”.[2] (Emphasis ours)

The allusion to the existence of a “trade-off” between maintaining confidence in the banking system and recognising the important role of risk in financial and real economic markets forces us to face up to a normative judgment: is there a trade-off between “stability” and “efficiency” in financial systems? This question is fundamental to all market organisations where governments believe they have a role to play in safeguarding the public and at the same time promoting aggregate economic activity.

The predominant view in all countries is that the industry we call “banking” ought to be regulated, and universally it is. In fact, it has been one of the most heavily regulated industries. Regulation usually takes the form of simply limiting competition. Of course, there are costs associated with restraints on competition, paid for by the purchasers of financial services and by suppliers of funds to banks. But the presumed benefit, “stability”, was thought to be worth the costs. With reasons varying by country and with the peculiarities of individual experience, the costs of some banking regulations are now recognised to outweigh the benefits.

Promoting financial stability by restricting banking competition in some cases was reinforced by insuring deposits with a government-operated deposit insurance programme. Some private insurance schemes exist, but are modest compared with public schemes. This too reflects the view that the private market cannot structure an insurance scheme – a private “safety net” – which would be credible enough to prevent bank runs or be large and efficient enough to satisfy deposit claims in the event of major runs. After more than fifty years of experience with a government deposit insurance system, the US Government is realising that the true “lender of last resort” is turning out to be the US taxpayer. It is now searching for a new financial structure, a better “trade-off” between stability and efficiency in the provision of banking services. The sub-title to the US Treasury's 1991 fiscal reform package, “Recommendations for Safer, More Competitive Banks”, implies that banks were not safe enough or competitive enough.[3]

The confrontation between safety and competitiveness in banking is now facing Europe. Unlike the US experience, however, it is not taking place, at least in the large countries, in an environment of multiple bank failures and an upheaval in corporate balance sheets. Yet the appearance of relative stability in some countries may exist only because in earlier times they have chosen a different financial stability/efficiency trade-off: the observed stability may in fact mask serious inefficiencies. The adjustment problems in moving to a less regulated banking world will also be different from the US experience because of the greater role of government ownership and control of financial and non-financial firms in Europe and, importantly, the different structure of relationships between financial intermediaries, equity holders and companies.

At the outset, it is best to warn the reader not to expect to emerge from this essay some common European view of financial deregulation. There is a great deal of diversity among European experiences, depending on where the optimal stability/efficiency trade-off point was thought to exist and how it was obtained. Likewise, the origins and consequences of financial liberalisation display some similarities but also contain considerable differences.

The paper is organised as follows. Section 2 will review the general macro-economic and structural financial background in Europe, with some emphasis on the historical roots of current European banking structure. Section 3 will consider some of the domestic and external pressures for financial deregulation. Next, we will take up the issue of the European Community's Second Banking Directive and the “1992” initiative. The topic of Section 5 is the securement of financial stability. The sixth section considers the potential sources of efficiency gains in the financial services industry resulting from deregulation. Finally, Section 7 concludes with a discussion of the limits of “acceptable instability” in the financial services industry.

2. Some Historical and Structural Background

Studies of financial deregulation often take as their starting point a review of previous and existing restraints on the quantities, prices and types of financial services offered by financial intermediaries and then detail the background which led to the relaxation or removal of these restraints or activities' prohibitions. Examples of such restraints include credit and interest rate ceilings, restrictions on capital flows and the segmentation of the financial services industry. Rather than begin with such an approach, I would like to start with what might be termed the “philosophical” differences in financial structure between countries, factors which have contributed to the historically greater intermediated and, in part, segmented financial systems in continental Europe compared to those in Anglo-Saxon countries. These differences are dependent on what I term “the philosophy of finance”. It is this philosophy, reflecting financial, cultural and historical experience, which has helped determine national financial structures. The components of this philosophy include:

  1. the content and the perceived merits of public disclosure of information on performance, ownership and control of enterprises;
  2. the strength of belief in the allocative efficiency of open financial markets versus possibly less transparent financial institutions;
  3. the desired structure of and market for the ownership and control of financial institutions and non-financial companies; and
  4. perceptions of the existence and ability of public policy to exploit any trade-off between financial stability in the allocation of capital.

The extension of credit requires a transfer of information from borrower to lender and a monitoring of the credit quality of the borrower. The transfer of information, the “information trade”, may take place directly between borrower and lender, or between the borrower and an intermediary, who accumulates a variety of loan contracts and finances them with own capital and borrowed resources. Both borrower and lender have an incentive to develop a close “information-sharing” and, possibly, a “risk-sharing” relationship. Information which is valuable to the firm will be closely held and not made widely known when it can be used to the detriment of the firm. Hence, the loan contract is an information-sharing agreement, as well as a contractual relationship defining the transfer of funds and the creditor's rights. To effect the transfer of funds, the lender often obtains valuable “inside” information on the status of the borrower. The firm/borrower also has the incentive not to reveal information or actions which would worsen its loan bargaining position with the lender. It may then hide information from its creditors. A bank may have the incentive to take a longer-term view of the borrower, seeing him over difficult periods, if it is to extract a return from its monitoring and surveillance role as lender. In addition, the “firm”, in the form of its managers, has an incentive to seek contractual relations with creditors and owners, and even with the government in some cases, which would protect it from takeover. Thus, the contractual relationship between borrower and lender is not only one entailing the securement of finance but also involves fundamental issues of the stability of the firm and “corporate governance”. Debt and equity are hence sources of finance and alternative and complementary ways of “managing” the firm by the suppliers of capital.

If we look back at the 19th Century, we can gain some appreciation for the current differences in financial structure between Germany, the United Kingdom and France. Up to the 1870s, most of the shares of German firms were unquoted on stock exchanges, unlike the equity market in London at the time. German banks were active in promoting and placing securities, and their dominance greatly reduced the need for equity markets to raise capital.[4] This close relationship between German firms and banks continues to exist today. German banks hold sizeable shares in industry, exercise large proxy voting rights and sit on numerous boards of directors of major firms. This continued close relationship can be better understood if we recall that, unlike the United Kingdom and France, in 1815 Germany was composed of thirty-eight independent states. Banks aided in not only the financing of industry but indirectly in the removal of trade barriers and in the concentration and cartelisation of German industry.

In the 19th Century, British banks were more involved in the financing of trade than long-term industrial development. The capital raising in industry took place much more through markets than through institutions, with some major exceptions in the north of England. During the Second Empire in France, the Pereire brothers pushed the notion that banks ought to engage in industrial banking. The opening of the Crédit Mobilier in 1852 was, some believe, the origin of the close ties between banking and industry in continental Europe.[5] The origins of the differences between the current structure of continental European and Anglo-Saxon banking hence lie to some extent on 19th Century industrial development. The major role of banks in continental Europe, as opposed to securities markets, has been argued to be related to its later process of industrialisation, compared with England, and where industrialisation was even slower to the use of government finance.[6] (Recall that in France and Italy the government still owns a sizeable portion of the financial industry.)

These brief historical reminders are useful in understanding five general points about continental European financial structure:

  1. although financial markets have grown rapidly during the 1980s, continental Europe remains a largely intermediated financial system;
  2. the dominant role of government financing in some countries has significantly crowded-out private marketable debt instruments;
  3. the preference of many non-financial companies to seek close, long-term relationships with reliable domestic creditors, at the expense of equity issuance and a fragmentation of debt claims in capital markets, arose as a means of protection against takeover and to minimise the information problems between lenders and borrowers, hampering the growth of capital markets;
  4. inflation in Europe often discouraged the holding of long-term fixed interest rate and marketable financial assets; and
  5. the financial system often has been a direct source of finance for governments, both in the placement of funds and as a source of direct and indirect tax revenue.

It should not be a surprise then to observe that the European Community is still struggling to reach agreement on its 13th Company Law Directive dealing with takeovers. The issue in dispute is whether all shares should have the same voting rights, with a number of continental countries against and, not surprisingly, the British in favour. These preliminary remarks also help to understand the major differences, for example, in corporate takeover activity between the United Kingdom and Germany. In Germany, there have been few full acquisition takeovers and very few, if any, hostile takeovers.[7] The experience is quite the opposite in the United Kingdom.

The industrial development which was spurred by close ties between industry and banks in some cases also laid the groundwork for later restrictions on bank-industry ties. The Banca d'Italia's strong opposition to commercial ownership of banks and bank ownership of industrial shares partly stems from the banking crisis of 1907. Italian industrial growth from 1896 to 1907 was fostered both by heavy lending by “banks of ordinary credit”, some of which were completely speculative investments, and by industrial banks (“mixed banks”), which provided equity capital to private industrial firms. The absence of a private capital market and Italy's heavy dependence on foreign capital, much of which was placed in Italian bank deposits, caused the 1907 New York stock market crisis to lead to a cut-off of foreign investment in Italian industry.[8] The collapse of several Italian banks during this period, in particular the Società Bancaria Italiana, is partly the origin of later constraints on Italian bank investments and restraints on banking competition.

These few examples illustrate how the competitive structure of European banking was determined by the iterative process of finding some sort of “equilibrium” in the trade-off between financial stability and efficiency. The experience of banking crises, periods of speculative activity and the felt need to protect domestic firms from foreign takeover or “excessive competition” caused some European governments to compartmentalise the financial system, selecting particular intermediaries as suppliers of credit to particular economic sectors and, in a manner, “maturity matching” the assets and liabilities of intermediaries as a means of ensuring balance-sheet stability. For example, the French Banking Act of December 1945 established three types of banks, deposit banks (banques de dépôts), investment banks (banques d'affaires) and long and medium-term credit banks (banques de crédit à long et moyen terme) which differed by types of deposits offered and maturity of credits extended. Investment banks, as might be expected, were able to take equity positions in industry. This banking structure existed in France until January 1984, when all banks were classed as “établissements de crédit”, removing the distinction between the previous three bank classes. Although these institutions might be thought of as having a “universal bank” character, some maturity constraints on deposits still persist.

In addition to a history of financial intermediation dominance, government ownership of financial intermediaries in some countries, a segmented financial structure and generally underdeveloped capital markets, particularly equity markets, continental European financial structure might also be described as having had more of an “implicit” than “explicit” safety net system. Because of the need to ensure confidence in the banking system and the fiduciary relationship governments have had with respect to depository institutions, deposit insurance in Europe usually has been more of an implicit government commitment than a formal contract. It was also implicit in some countries for the simple reason that the government had a large hand in bank ownership. This has been true not only at the national level but at the local and state level, as for example with Switzerland's cantonal banks and Germany's municipal and Lander savings banks.

With this quick historical sketch, let me now turn to the elements which were argued to comprise the “philosophy of finance”. Until recently, I would argue that continental European financial structure attempted to secure stability, both of financial and non-financial industries by:

  1. limiting public disclosure of business information;
  2. promoting close business ties between industry and financial institutions and government;
  3. providing domestic industries with equity/debt structures and financial/government links which would shield them from foreign competition and takeover; and
  4. limiting competition in certain strategic industries, especially in banking and certain non-banking financial institutions, by explicit restraints on activities which would lead to “excessive competition” and by permitting the formation of formal and informal cartel arrangements.

Lastly, in some cases, financial stability and monetary/credit control were also secured, or so it was thought, by explicitly restricting capital flows. To be sure, few countries can be described as having had all of these characteristics. Yet, as a group, continental European countries achieved modern growth by encouraging one or several of these characteristics of financial structure and restraints on competition in finance.

3. Sources of Pressures for Financial Deregulation

To focus very broadly on the sources of pressure for financial deregulation in Europe in recent years, it may help to think of a two-by-two “deregulation pressure matrix”: domestic versus foreign and market versus institutional pressures. To begin, consider two examples, those of the United Kingdom and France.

The 1986, deregulation of British capital markets, the so-called “Big Bang”, occurred because of both domestic and foreign pressures and for both market and institutional reasons. Domestically, the threat of prosecution of the stock exchange under the UK's Restrictive Practices Act was the institutional reason for the elimination of minimum commissions. This resulted in the removal of restraints on stock market membership and the functional separation between agents (brokers) and market makers (jobbers). The international and market-related pressures on UK capital markets were the elimination of capital controls in 1979. This opened the domestic market to increased foreign competition, particularly from New York capital markets, which had been deregulated in 1975. With the rapid entry of foreign firms into the London market and the enhancement of technology to handle dual capacity (agency and market-making) activities came a major re-organisation of capital market supervision.[9]

During the mid 1970s, the French Government was aware of the dominance of banks in the financing of the economy and the very modest use of financial markets. In 1976, only 15 per cent of the French economy's financial needs were satisfied in financial markets, compared with almost 50 per cent in the United States. The institutional framework of finance was one of enormous segmentation and heterogeneity. In addition, French finance was littered with a variety of selective and preferential credit programmes. In 1981, the Banque de France estimated that there were seventy different regimes of financing at preferential rates, accounting for 44 per cent of credits to the economy.[10] The central bank and Ministry of Finance argued that the French financial system was hampered by inefficiencies reflected in modest competition and negative real interest rates. The pressures for reform in the French case were both domestic and institutional. It was simply realised that interest rates in the French economy were neither playing their role in the allocation of resources nor as an instrument of monetary policy.

Given this simple framework for looking at the sources of pressure for deregulation (domestic-foreign, market-institutional), one should also have in mind some general objectives of deregulation. Broadly speaking, there appear to be three:

  1. increasing competition in finance;
  2. expanding the role of open financial markets in order to improve the efficiency of the determination of interest rates and in the allocation of credit; and
  3. providing a system for securing the stability of the financial system without inadvertently encouraging excessive risk-taking.

As was stated earlier, many of the pressures for financial deregulation in continental Europe came from the underdevelopment of domestic capital markets and hence the relative absence in some cases of market-determined financial prices. These deficiencies meant that the financial price “signals” which did exist could at times lead to a serious misallocation of resources. Governments in some cases attempted to fill the gap left by an inefficient financial pricing system by direct credit allocation through special credit institutions, while at the same time preventing these institutions from competing with one another, plus limiting the attractiveness or availability of competing foreign assets with the use of exchange restrictions and prohibitions on the purchase of foreign financial assets. Recall that Italy and France have only recently eliminated restrictions on private financial investment abroad.

An example of how government institutions attempt to substitute for open capital markets can be seen in the case of Belgium. In place of the capital market facilitating “direct finance” between borrowers and lenders, the National Industrial Credit Company issues bonds to households and financial institutions, then lends these funds to industrial companies. The Belgium Municipal Credit Institution performs a similar exercise, using the funds raised to finance the investments of local authorities. The rates set on the tap issues of these two institutions are a function of the rates on government securities, determined by the Treasury in conjunction with bank members of the securities consortium. The absence of a market-determined interest rate has at times led to “contradictory” policy objectives.[11] For the purpose of minimising government costs of finance, the rate was desired to be kept as low as possible, yet too low a rate would make foreign securities attractive. It is not surprising then to see that for many years Belgium had a dual exchange rate system. Recently, plans were undertaken to restructure the six public credit institutions in Belgium into two groups, with the objective of improving their competitiveness in light of the 1992 initiative to increase competition in financial services in Europe. Belgium is another example where the pressures for financial deregulation had both a domestic and foreign source.

It is obvious that the strong regulation of financial systems, especially banking, has had as an objective more than the maintenance of security in the financial system. Governments often regulated the financial industry firstly because they needed to finance themselves and secondly because they desired to direct the flow of credit to particular borrowers, often determined by government industrial development priorities. To accomplish this, we have seen in Europe, as in other countries, considerable restrictions on competition in banking, for example, limitations on branching and constraints on foreign entry, as well as the informal government sponsorship of financial cartels. In most cases, these regulations led to considerable stability in financial structure, at least on the surface, and in some cases well-known inefficiencies. Not surprisingly, the constraints on competition in banking and the government protection of the industry sometimes led to excess capacity. For example, in the past, Spanish banks were restricted in their ability to compete by price; deposit rates were formally administered by the government. To compensate, banks competed by branching widely, leading to overcapacity. Only infrequently have European banking reforms been related to widespread bank failures, as has occurred in the United States over the last several years.

An exception to this statement is the example of Spain. The heavily-protected and regulated Spanish banking system weakened significantly between 1978 and 1985, stemming in part from the oil price related decline in industrial output. Banks had lent heavily to industry and were also large holders of industrial shares.[12] The 1973–74 oil price rise had been essentially accommodated by Spanish monetary policy, resulting in a short-term rise in real wages and a decline in industry profits. The relaxation of monetary policy was subsequently followed by a tightening and sharp rise in interest rates. Real growth turned negative in 1979 and 1981. Average real growth fell to only 0.7 per cent between 1978 and 1982, compared with an average 4.6 per cent over the previous eight years. As a result of banking lending and particularly due to the large bank equity investment in industry, there were widespread bank failures.[13]

Although the weakness in the Spanish banking system was not directly related to deregulation, as it recently has been, for example, in Norway and Sweden, it certainly had the effect of revealing the vulnerability of the Spanish banking system. One consequence of the banking difficulties between 1978 and 1985 was the increased recognition of the need for consolidation in the industry, given the appearance of a number of inefficient, overprotected institutions, and for an expansion in the financial safety net. Since that experience, the Spanish Government has played a major role in encouraging bank mergers. In addition, a deposit insurance system was put in place in 1980.

As should be clear from these illustrations, how financial deregulation came about in Europe largely depended on where the “financial shoe fit tightest”. In some cases, the deregulatory process was rather well planned and gradual, beginning with the domestic side of the economy (e.g. deposit rate deregulation, relaxation of constraints on bank lending) and ending with the opening-up of the external side, with the removal of exchange controls and increased tolerance for foreign competition in domestic markets. In some ways, France fits this mould. As far back as 1978, the French, under Prime Minister Raymond Barre, started to revive the French bond and equity markets, for example, by providing tax incentives for personal shareholding (the “Monory Law”). The 1982 Dautresme Report led to the “Delors Law” in 1983, which relaxed conditions for non-voting share issuance, improved tax benefits for personal investment in French shares and provided a legal framework permitting the introduction of a number of new financial instruments, such as floating rate bonds, convertible bonds, bonds with warrants, investment certificates and participating shares.[14]

The development of money and capital markets in France then provided the central bank with an improved market-oriented package of instruments with which to conduct monetary policy. By 1990, France was able to eliminate exchange controls without serious difficulties for financial flows, monetary policy or interest rates.

In some other cases, the external side was opened up first and domestic financial deregulation followed later. This to some degree was the British model. Exchange controls were eliminated in 1979. However, deregulation came about in response to competitive pressures and not, as in the French case, from a long-term plan for structural change in the financial system. Because the United Kingdom for some time has promoted the development of London as an international financial centre, foreign penetration of the UK banking and securities markets increased the pressure for structural reform and weakened the strength of the domestic bank cartel. The British/French comparison is useful in providing us with another angle with which to view the financial deregulatory process: domestic versus foreign and exogenous (government planned) versus endogenous (competitive) forces for change. No doubt these characterisations can be stretched too far and are only partially accurate. Yet they force us to recognise the multiple sources for structural change in European financial systems and to examine both the anticipated and unanticipated results of these developments.

With regard to the unexpected changes which financial deregulation can bring, we can pick no better European example than Sweden. In the middle of the process of significant financial deregulation during the 1980s, which proceeded from permitting banks to issue certificates of deposit in 1980, to the elimination of statutory interest rate regulations in 1983, and finally to the abolition of exchange controls in 1989, Swedish economist Lars Jonung stated, “The idea of a run on a bank or a bank collapse is out of the question”.[15] The Swedish deregulatory process was in some ways like the French, proceeding from domestic financial liberalisation, where for years the financial structure was very heavily regulated and capital markets dormant, to ultimately external liberalisation, permitting all domestic residents to diversify funding and investment decisions.[16] The strong statement regarding the unlikelihood of a bank run or collapse derives from the near “zero trade-off” between stability and financial market efficiency that had been the hallmark of the Swedish banking system. Instead of any chance of “excess competition” in banking leading to weakness, before deregulation Swedish banks were characterised as having “a type of over-regulation motivated by the desire to avoid bank collapses”.[17] Aside from multiple regulations hampering banking efficiencies, the prohibitions on entry near guaranteed at some point the need for bank reform. Between 1945 and 1983, no charter was granted for the establishment of a new private bank. Thus, from a pre-Second World War financial system which was largely open to international competition and without interest rate and credit flow regulations, Sweden piled regulations on regulations, first justified by war-time financial requirements and later promoted by governments which were largely opposed to competition in finance. The system which was structured to help finance the government by artificially holding down long-term interest rates and directed at providing privileged finance to the housing sector, ultimately ended up retarding the growth and health of its banking industry.

The over-regulation of the Swedish banking industry up until the 1980s gave impetus to a non-regulated financial sector. The constrained intermediated (indirect finance) sector spurred the development of a non-intermediated (direct finance) sector: companies began issuing their own paper, so-called company investment certificates. In addition, finance houses appeared to side-step lending regulations and became major lenders to small and medium-sized firms, over-reaching their original purview of leasing and factoring.[18] The Swedish example illustrates how tight control and regulation of the banking sector can give birth to a competitive non-regulated (or at least less-regulated) non-bank intermediation sector, which further weakens the banking system, in the end giving rise to major deregulation. (This stylised model of the deregulatory process can also be used, for example, to explain US experience.) The problems of the beleaguered Swedish banking system were compounded by several increases in bank “liquidity ratios”, eventually reaching 50 per cent. The banking system by 1983, when liquidity ratios were finally abandoned, was heavily weighed down with public sector bonds and hampered in competing with a rapidly growing non-bank financial competitor. As bank portfolios of public sector bonds rose, bank loans fell in tandem, declining from around two-thirds of total bank assets in 1970 to around 50 per cent by 1985.[19]

Confidence in the stability of the Swedish financial system, which appeared so strong in the mid 1980s, was revised downward by the end of the decade. The growth in non-bank financial institutions, the “less-regulated” financial sector, saw the greatest adjustment difficulties. Several of the largest non-bank finance companies had substantial loans outstanding collateralised with mortgaged property. Highly-leveraged mortgage lending, in some cases equivalent to the full current market value of the property, met with difficulty when property prices failed to continue rising as anticipated. This led to a “crisis” in the finance company industry in the autumn of 1990. Between 1988 and October 1990, the number of finance companies declined by almost 50 per cent. The inefficiencies in the banking industry were partly corrected by a series of mergers and acquisitions, somewhat like the structural adjustments which took place in Spain. Some large banks also entered into share agreements with insurance firms.[20]

The Swedish example shows how the search for an “equilibrium” trade-off between stability and efficiency in the financial system can arise from both ends of the “regulatory spectrum”. At one end a country can be slow to permit competition in financial intermediation, saddling the primary intermediary sector with regulations and constraints which eventually lead to inefficiencies, giving rise to less-regulated non-bank financial intermediaries. This sort of “reform procrastination” model of financial structure helps to explain the enormous adjustment problems we have seen in some countries.

At times we have also observed “crisis deregulation”. The United States is probably the best example of this stylised model. Its financial history is one strongly influenced by populist sentiment which has feared – not completely without good reason – the accumulation of centralised financial strength. Looking back to the early 19th Century, we see the US Congress refusing to renew the charter of the First Bank of the United States in 1811, and then in 1836 President Andrew Jackson vetoing the charter of the Second Bank of the United States. The integral of this populist sentiment together with the experience of the Great Depression continued to delay major bank reform until, without too much exaggeration, by the 1980s the system exploded. The Garn-St. Germain Depository Institutions Act of 1982 attempted to correct some of the competitive difficulties which plagued thrift institutions (savings banks) but with unanticipated costly consequences. By 1991, the experience of numerous bank failures was threatening to deplete the commercial banks' deposit insurance fund, after the thrift industry's insurance fund had earlier collapsed. The US Treasury proposed a sweeping reform of banking in February 1991. But by May 1991, it appeared that the US Congress, stunned by the costly experience of thrift industry deregulation, was concentrating its attention primarily on deposit insurance reform and the replenishing of the deposit insurance fund, leaving major banking reform waiting. This procrastination, to be sympathetic, may not be all to the negative, given the difficulty of finding a desired “equilibrium” between stability and efficiency in the financial sector. The search for the “optimal” financial structure in the United States has been made more difficult due to the substantial competition domestic banks have met from capital markets and foreign banks. At the end of the 1980s, US banks provided a significantly smaller share of the financing of the non-financial corporate sector than they had only a half-dozen years earlier.

At the other end of the regulatory spectrum is the argument for a quick and complete dismantling of financial regulations. A priori there is little way of knowing whether this approach will more quickly find a “stable equilibrium” between stability and efficiency than a gradualist approach. An example of this approach for which we will have a test case in a few years is the European Community's “1992” initiative, which will open up European competition in a variety of financial areas, all under the direction of a single financial umbrella firm, similar to so-called “universal banks”. This revolutionary programme of deregulation is discussed in Section 4 below. At this point, it is worth simply keeping in mind the contrast between American and European financial deregulatory movements. The US experience is being spurred by widespread bank failures, a major threat to the government's financial safety net (the deposit insurance fund) and by a need for consolidation in an arguably over-regulated and overprotected industry. European financial deregulation under the EC's Second Banking Directive is promoted by recognised inefficiencies in some areas of the industry, overprotection in some countries and, like the United States, a history of segmented markets and in several cases an absence of serious competition.[21] Yet we do not find the widespread bank failures that we see in the United States. Why?

This is not an easy question to answer, yet it at least deserves a directional attempt. Consider the following statement by Kenneth J. Arrow in an essay on “moral hazard”, which in a financial context deals with the risk that arises from the ability of a borrower to hide actions and information from the lender which would be of use to the latter in pricing and structuring a loan contract.

“The price system is intrinsically limited in scope by our inability to make factual distinctions needed for optimal pricing under uncertainty. Non-market controls, whether internalised as moral principles or externally imposed, are to some extent essential for efficiency”.[22]

This statement refers to the use of the price system in achieving “efficiency”. I would argue, with some admitted reluctance in doing so, that “stability” in financial systems may not be achieved simply by an appeal to the efficiency of the financial price system.[23] This position is awkward to argue for an economist because it implies that in certain markets non-price factors are needed to permit the price system to achieve both efficiency and stability. Let me try to make more concrete what I mean here. It is not simply happenstance that much of the weaknesses we are observing in banking markets are occurring in Anglo-Saxon countries. This is possibly an overstatement but still an element rings true. These same countries are those pointed to as having well-developed capital markets. In certain ways, some of the weaknesses in banking are coming from the competition from capital markets. The formal and informal relationships between borrowers and lenders may be significantly different in Anglo-Saxon countries than in continental European countries and Japan. The difference in these relationships may be central to the differences in financial stability between countries.

There appear to be major differences between Anglo-Saxon and continental European financial relations between enterprise managers, shareholders and creditors. These differences relate to what we defined above as the “philosophy of finance”. Consider the OECD's “philosophy of finance” in a recent discussion of financial market efficiency.

“Company directors and managers represent shareholders' interests and have a duty to look after these interests by maximising the value (discounted total profitability) of the firm. In dealing with creditors, they must maintain the firm's credibility and solvency, which are dependent on the profitability of the enterprise. Although professional managers are responsible for most of the economic activities in OECD countries, they frequently do not behave in line with the above-mentioned pattern, as regards both shareholder control and creditors. Control is nonetheless exercised. It is exercised most efficiently when financial markets operate openly and competitively, information circulates freely and financial investors behave rationally.”[24] (Emphasis ours)

The above statement can be argued to be a predominantly Anglo-Saxon view of financial market efficiency. What might appear as innocuous praise for financial markets operating “openly and competitively”, information circulating “freely” and investors behaving “rationally” are in fact contentious issues. For example, the availability of information on the behaviour of enterprises in continental Europe is considerably less than that available from most Anglo-Saxon countries. We can see this in the OECD's latest survey of business information disclosure by multi-national firms.[25] Generally, there is greater compliance with the OECD disclosure guidelines from Anglo-Saxon countries than from continental European or Japanese firms. One reason may be that the “corporate governance” or control relationship between firms, creditors and shareholders is much different between Anglo-Saxon and non-Anglo-Saxon countries. The dominance of bank financing in the financial structure of non-financial corporations in continental European countries and the close relationship between banks and enterprises, a sort of symbiotic relationship, has contributed in certain cases to strong long-term relationships between creditors and business borrowers. And where the relationships are strongest, we have seen considerable strength in the financial system and a reluctance of financial authorities to promote financial innovation and certain types of deregulation. The European country which is being alluded to here is obviously Germany.

The reference to Germany is made to provide an example of a European country where the demand for financial deregulation and innovation has been modest compared with its neighbours. But before examples are drawn, it should be recalled that the efficiency of the German banking system, which dominates the financing of the non-financial corporate sector, has benefited from earlier liberalisation of interest rate controls. These liberalising efforts took place mostly in the 1960s, much before similar efforts in France, Spain and Sweden for example. On the other hand, Germany has not gone out of its way to promote the development of its money and bond markets. While it is difficult to find a specific reference to a clear policy choice for a dominant bank-intermediated financial system over a more market-oriented financial system, we can find indirect references. For example, Deutsche Bundesbank President, Karl Otto Pöhl, recently stated, “Although quite a number of ‘financial market innovations’, …, have not been introduced in the Federal Republic, or have only been introduced more hesitantly than elsewhere, we can, in my view, be quite satisfied with the development of our financial markets in the last few years.”[26] The German example is the clearest European illustration of the desired “trade-off” between stability and efficiency implying an underdevelopment, at least from an Anglo-Saxon viewpoint, of capital markets.

The early deregulation of German interest rates and the universal nature of German banks is part of the reason we have not seen the rise of competitive, unregulated non-bank financial intermediaries and the turbulence in the banking system caused by “disintermediation”. The relatively modest supply of marketable securities issued by firms thus cemented the position of banks both on the deposit side and on the lending side. For example, if we look at the portfolio composition of the private non-financial sector in the mid 1980s, we see that institutional investment in Germany represented only 12 per cent of gross financial assets. However, in the United States and the United Kingdom, the percentage of gross financial assets of the private non-financial sector represented by institutional investment in 1985 was 25 per cent and 30 per cent, respectively.[27]

The German illustration of a predominantly intermediated financial structure is also useful in characterising the nature of the trade-off between stability and efficiency in financial structure. This issue has to do, firstly, with the benefits and costs related to having claims on the non-financial enterprise sector tradeable in secondary markets and, secondly, with the “control” of firms, or what some academics refer to as the “corporate governance” role of holders of financial assets. Both issues are related to the stability of financial markets and institutions and central to the stability of both the non-financial and financial business sectors. These issues have to do with the subject of the efficiency of business information “transfer” in financial markets and financial institutions.

Deregulation which promotes the development of non-bank financial institutions and marketable securities may have two undesirable effects. First, it may promote unexpected volatility or “distortions” in the prices of financial assets which undermine both the stability of the institution which holds them and of the institution on which they are held. The volatility in equity and corporate bond markets during the 1980s has raised questions over the ability of financial markets to “accurately” assess the present value of future returns to enterprises. This volatility has probably created more “price risk” than was anticipated by proponents of deregulation. The volatility of financial markets seen in recent years raises the question of whether “total risk”, price risk plus credit risk, has risen with the greater securitisation of finance.

Secondly, an important issue for financial stability is the role that institutional holders of marketable securities play in monitoring the behaviour of non-financial enterprise borrowers and the influence they can legally exercise on the decision-making of firms. In the case where most of enterprise borrowing comes from banks, as in Germany and Japan, and where banks and enterprises have long-term interdependent information and risk-sharing relationships, “stability” may be achieved but at the risk of serious conflicts of interest. On the other hand, where claims on enterprises represent more of an “arm's length” relationship and where business law restricts the influence that financial institutions may have on business borrowers, the stability may be undermined by an absence or weakness of the monitors (i.e. creditors) of enterprise behaviour. The separation of corporate ownership from control that we see in some countries, due to the lack of “active” equity investors, may give rise to even greater stability difficulties. The managers of firms may undertake investment in activities which are not in the interest of investors in the firm, but in the interests of protecting their privileged information and control position. This can lead to the managers themselves recognising their control advantage, taking the firm private by retiring equity with debt obtained by exploiting the market undervaluation of the firm. Thus, the issue of “financial stability” and the potential gains from financial deregulation are closely related to the debate over the desired corporate governance relationships between financial intermediaries and non-financial enterprises. Financial deregulation may, by encouraging the growth of capital markets, in some instances reduce the financing and corporate governance role that banks play with respect to the non-financial corporate sector. It also may improve the efficiency of the financial system and reduce potential conflicts of interest dilemmas for banks. But the move to develop competitive capital markets through deregulation brings with it its own set of stability problems.[28] A particular one on the minds of many Europeans is the extent to which European Community inspired financial deregulation will increase competition in the financial services industry and in the competition for the ownership and control of major firms.

(a) A Short Digression: Norway

It may seem incongruous to bring examples of financial reform in lilliputian Norway to a country the size of Australia, but an important lesson can be gained by doing so: micro-economic reform of the financial system can have an enormous impact on the efficacy of macro-economic policy.

The short story of Norway is that financial liberalisation, specifically the removal of regulations on bank lending, took place during the period in which marginal tax rates were high, interest payments were deductible from gross income for tax purposes, the economy was growing strongly and politicians would not accept the need for a rise in nominal interest rates. The result was not difficult to forecast. After a long period of direct credit regulation, foreign exchange controls and selective monetary policy instruments, the relaxation of bank lending restraints led to an explosion in domestic credit, which, given a nominal interest rate objective for the central bank, meant a classic central bank induced credit expansion during the mid 1980s. As a result, the Norwegian krone was devalued by 10 per cent in May 1986 and monetary policy had to be tightened.[29]

The 1984 abolition of direct bank lending regulation in the environment just described meant that banks were both unfamiliar with the new competitive environment and underestimated the risks they were incurring. Operating profits “after actual losses” for all banks fell from 1 per cent of average total assets in 1986 to 0.01 per cent in 1987 and −0.23 per cent in 1988. They remained feeble in 1989. An earlier policy of encouraging a build-up of autonomous regional banks backfired due to the geographical concentration of risk. As a result of this experience and the EC's push to create a “single market”, Norwegian banking policy changed dramatically; the second and third largest commercial banks merged and the largest saving bank merged with a number of regional savings banks. And, in the pattern of domestic liberalisation followed by an opening-up to foreign competition, Norway eliminated exchange controls in July 1990.

While small on an international scale, Norway's experience with deregulation and its financial upheaval was as large and significant to its national economy as anywhere else. Indeed, there are a number of similarities with the deregulation of building societies and the explosion in private credit growth in the United Kingdom. Financial deregulation in an environment of flawed intermediate monetary targets, politically-constrained monetary policy and large incentives for the private sector to take on debt were ingredients common to a number of countries during the 1980s. The reduction from 322 to 150 in the number of Norwegian saving banks and from 320 to 180 Swedish finance companies during the 1980s are examples of how inappropriate macro-economic policies can greatly aggravate the transitional adjustment costs in going from a tightly-regulated financial system to one with competitive institutions.

4. The EC's Second Banking Directive and the “1992” Initiative

Twenty-three years separate the European Community's November 1966 “Segre Report” on the development of European capital markets and the passage in December 1989 of the EC's so-called “Second Banking Directive”.[30] The first report looked at the reasons for the weaknesses of European capital markets, which, in a review of the report by Kindleberger, included “monopoly, structural deformation and high liquidity preferences”.[31] The second document can be viewed as a furtherance of the objectives of the original EEC treaty: broadly defined, the freedom of economic movement (capital, goods, workers), the freedom of economic establishment and the freedom of the provision of services within the borders of the EEC. The objectives of the “1992” financial services initiative are a paraphrase of the objectives just cited – freedom to establish anywhere in the Community, freedom to provide throughout the Community financial services which are permitted to be offered in the home country, and the freedom of capital movements.

To see how far Europe has come between the publication of the two reports, and to get a glimpse of how far Europe has yet to go at becoming “one financial market”, consider the following two examples. In March 1964, Germany announced the imposition of a 25 per cent “Kuponsteuer”, a tax on the interest received by both domestic and foreign investors in Germany. Some argued that because of limited international competition in financial markets at the time, the tax was the reason for the rise in interest rates from 6 per cent to 8 per cent.[32] The coupon tax remained in effect for a number of years. In contrast, in the autumn of 1987 Germany once again announced the introduction of a withholding tax on domestic interest income. Partly in response to the coupon tax, and developments in international interest rates and exchange rates, non-resident purchases of German long-term financial assets fell by DM30 billion in 1988, to less than DM10 billion.[33] The Deutsche Bundesbank did not conceal its displeasure with the new tax in its 1988 Annual Report, arguing that an earlier abolition of coupon taxation had increased the demand for German securities and contributed to reducing interest rates. Nor did it hide its pleasure in subsequent publications following the removal of the coupon tax.

The second illustration concerns the European Community's establishment of solvency rules for banks and investment firms. Here the German central bank argued in April 1990 that “It would not be consistent with the principles of a single European financial market, however, if in this context different solvency rules for banks and investment firms were to be introduced”.[34] The Bundesbank argued that different solvency rules for banks and investment houses would produce a “regulatory bias in favour of pure investment firms”. Because of Germany's universal banking system, such investment houses are practically non-existent in the Federal Republic. The direction this debate takes is that concerning the form of conglomerate financial institutions which will emerge as a result of the EC's Second Banking Directive.

These two illustrations show, firstly, that since the 1966 Segre Report there has been a very significant integration of capital markets in Europe, such that small differentials in interest rates and tax structures can have major impacts on capital flows. Secondly, there is now a competition in financial institution “structure”. The typically segmented institutional structure in European finance is gradually giving way to a broadening and homogenisation of financial services and of the institutions which provide them. The movement has been aided by the passage in December 1989 of the EC's Second Banking Directive.

The objectives of the Second Banking Co-ordination Directive are clearly spelled out in the explanatory memorandum accompanying the early draft of the articles of the Directive:

“Main Objectives of the Proposal

  1. The proposal for a Second Banking Co-ordination Directive is the centre-piece of Commission proposals for the banking sector in the context of the completion of the Internal Market by 1992. Along with the liberalisation of capital movements and other accompanying Community instruments in the Banking sector (on own funds, large exposures, harmonised solvency ratio, deposit guarantee system), it is intended to:

    remove the remaining barriers to freedom of establishment in the banking sector;

    provide for full freedom of services.

  2. The approach in the Directive is firmly based on the White Paper concepts of harmonisation of essentials, mutual recognition and home country control. The aim is that there should be a single banking license valid for both establishment and freedom of service no later than the end of 1992.”[35] (Emphasis ours)

Table 1 lists the “banking services” covered in the Second Banking Directive, services which are to be traded across borders of EEC member states and to which the principle of “mutual recognition” is to apply. The single banking license for EEC banks and the list of permissible activities effectively “has been drawn up on a liberal universal banking model”.[36]

Table 1 Second Banking Co-ordination Directive Commission of the European Communities
List of Activities Subject to Mutual Recognition
  1. Acceptance of deposits and other repayable funds from the public
  2. Lending*
  3. Financial leasing
  4. Money transmission services
  5. Issuing and administering means of payment (e.g. credit cards, travellers' cheques and bankers' drafts)
  6. Guarantees and commitments
  7. Trading for own account or for account of customers in:
    1. Money market instruments (cheques, bills, CDs, etc.)
    2. Foreign exchange
    3. Financial futures and options
    4. Exchange and interest rate instruments
    5. Transferable securities
  8. Participation in share issues and the provision of services related to such issues
  9. Advice to undertakings on capital structure, industrial strategy and related questions and advice and services relating to mergers and the purchase of undertakings
  10. Money broking
  11. Portfolio management and advice
  12. Safekeeping and administration of securities
  13. Credit reference services
  14. Safe custody services

*Including inter alia: – consumer credit
– mortgage lending
– factoring, with or without recourse
– financing of commercial transactions (including for feiting)

Source: Proposal for a Second Council Directive on the Co-ordination of Laws, Regulations and Administrative Provisions Relating to the Taking-up and Pursuit of the Business of Credit Institutions and Amending Directive 77/780/EEC, Annex, December 1989.

The Second Banking Directive is, without exaggeration, an enormous change in the competitive environment in European banking. Banking systems in Europe have been, and in certain areas remain, very segmented, and kept that way by differences in legal, economic, political and monetary systems in the European Community.[37] The move to allow banks to enter into “unhindered competition” based on the principle of “mutual recognition” of each others' laws and regulations, and along the lines of a universal bank is indeed a major structural change in European banking. It is a particularly large step when we recognise that most countries in Europe have chosen to limit competition through a variety of means in order to bring stability to the banking industry. This new competitive initiative will encompass “credit institutions” (“undertakings whose business it is to receive deposits and other repayable funds from the public and to grant credits for their own account”) and “financial institutions” (“undertakings, not being credit institutions, whose principal activity is to grant credit facilities (including guarantees), to acquire participations or to make investments”).[38] The Second Banking Directive thus covers a broad spectrum of financial institutions, both deposit and non-deposit-taking.

The variety of activities permitted an institution under the Second Banking Directive reduces to almost meaningless any traditionally restricted definition of a “bank”. Moreover, the Second Banking Directive authorises a single banking license, in which a bank authorised to operate in its home market is immediately eligible to operate in any EC member state, subject to the rules of its home country.

Three questions are raised by the new competitive “banking” environment in Europe:

  1. will “universal banks” be the standard organisational form for deposit-taking institutions in Europe?;
  2. what areas will be first subject to new competition and entry?; and
  3. in what areas of finance are consolidation and weakness likely to occur?

With respect to the first question, it should be recalled that most studies of economies of scale in banking find that they set in at a relatively modest bank size. There is little evidence of increasing returns to size in banking for large institutions. Some believe that there may be potential gains from so-called “economies of scope”, the gains from the combination of different but related activities within the same economic structure.

Those who have looked carefully at the issue suggest that neither advantages – size or scope – are obviously large. It is also suggested that universal banking, similar to that of the major three German banks, will not be a common European phenomenon.[39] While banks may be permitted to engage in a variety of financial activities, it is questionable how many institutions will truly be “universal” in scope and depth of services offered.

Some of the initial enthusiasm for a single market in financial services in Europe was aided by the Price Waterhouse study for the Commission of the European Communities, published in 1988.[40] This study concluded that the gains to consumers (“increase in consumer surplus and economic welfare”) derived from the integration of financial services and markets in Europe would be approximately ecu 11 to 33 billion; they called it “prudent” to use ecu 22 billion as the “upper limit of the potential welfare gains”. We can only guess whether the gains in consumer welfare are worth the “implicit costs” (e.g. negative externalities created by the potential for increased financial instability) involved in securing them. One area which has been identified as having exploitable gains was insurance. Insurance remains a very protected industry in Europe, for which there are wide differences in cost. For example, the premiums were calculated for 20-year term insurance using British and Belgian mortality rates. The result displayed a difference of 227 per cent, only one-twenty-fifth of which was attributable to the interest rate differential.[41]

Even before the actual introduction of the 1992 initiative, Europe is seeing a flurry of link-ups between banks and insurance companies and the start-up of new insurance firms by banks.[42] One of the most notable was the creation of Deutsche Lebensversicherung in 1989, a life insurance firm, by Deutsche Bank in Germany. The existing German insurance giant, Allianz, and Dresdner Bank have hooked up to take advantage of each other's marketing networks. What has been called “Allfinanz” in German goes by the name of “bancassurance” in France. France's largest bank, Crédit Agricole, also began its own life insurance company in 1985 with Prédica, and only a few years later was ranked second in France with respect to premium income. The contributions of insurance premium income to bank revenues, particularly in the United Kingdom, have even caused some commentators to ask whether some large institutions should even be called “banks”.[43]

The entry of banks into insurance and the creation of a number of product/distribution alliances, while not unexpected, has nonetheless disappointed expectations of the development of major cross-border financial mergers and acquisitions which were prominent a couple of years ago.[44] One well-known disappointment with a cross-border merger was the unsuccessful Dutch-Belgian combination of Amro Bank and Generale Bank. Instead, what has resulted is a number of national mergers. One of the best known, the Spanish Banco Bilbao Vizcaya merger, was encouraged by the Spanish Government, which has been well aware of the need to consolidate the Spanish banking industry. In some other European banking mergers, such as those in Denmark and the Netherlands, we have seen consolidations of banks in markets which are already characterised by considerable concentration.

It is difficult to make any generalisations regarding the future structure of European banking markets without serious analysis. The only study known to the author, that of 300 “deals” analysed by Salomon Brothers, concluded that one general characteristic appears to be the combination of a “sophisticated product provider from northern Europe and a distribution network in the south”.[45] Another observation is that although the 1992 initiative is based on a “universal banking” principle, to date there has not been a major move in this direction. Some argue that the weakness of some European banks may have been a blessing which prevented them from rushing into hasty expansions.[46]

While the 1992 EC efforts to improve competition in financial services in Europe are in the long run likely to have far-reaching implications, they should not be exaggerated. A number of countries have been well aware of the archaic structure of their financial institutions and markets and have undertaken efforts to improve them. Taking a broad look, we can identify three factors unrelated to the EC's “Single Market” program which have helped to change the competitive environment in European banking: firstly, the significant decline since 1980 in the number of countries having interest rate controls/regulations or interest rate cartel agreements; secondly, the development and improvement in money, bond and equity markets; and, thirdly, the deregulation of fees and commissions on financial services. The 1992 initiative may have speeded along some of these changes but certainly cannot be credited with the broad push in deregulation. Italy, for example, has made great strides in augmenting the competitiveness of its banking and capital markets, including the elimination of ceilings on bank lending, improvements in its money market and, most recently, legislation which would permit public banks to become joint stock companies. Probably the greatest transformation in financial structure in Europe during the 1980s has been that in France, which has improved the scope and sophistication of its money, capital and financial derivatives markets. Only recently, France introduced the first non-US zero coupon bond market. The future ability of European banks to establish and compete throughout the Community on the basis of the permissible activities in their home country will no doubt further increase structural change in banking and financial markets. But the catalyst for reform is not of recent birth.

If competition in finance is to increase in Europe as a result of “1992” and on-going structural reform, how will existing institutions protect themselves? As we have already mentioned, mergers, shared marketing arrangements and major economising efforts are taking place. What will be interesting to observe is how banks and firms combine efforts for “protective” and “risk-sharing” reasons. In addition to the anticipated increase in banking competition is the incentive for corporate structural change provided by the increased threat of takeover, made easier by the decline in European takeover barriers.

While it is too early to put forward opinions on this subject without qualification, it does appear that some European institutions are heading for greater information and risk-sharing arrangements, similar to those seen in Germany and Japan. For example, Dresdner Bank of Germany and Banque Nationale de Paris have been discussing a 7 per cent cross-shareholding arrangement, with the purpose, according to press reports, of “spreading the risks and costs of expansion by joint ventures with other banks or insurance companies”. A similar arrangement has been in discussion between Commerzbank (Germany) and Crédit Lyonnais (France). The search for closer ties between banks and industrial firms in Europe may be directly related to attempts to protect firms from takeover. Some analysts suggest that private French banks would like to build strong banking-industry ties somewhat like relationships which have existed for some time in Germany.[47] And it may indeed have been with the Japanese “keiretsu” (informal corporate groupings) risk and information-sharing relationships in mind that Mme Christiane Scrivener, a member of the EC Commission, recently encouraged heads of EC firms to communicate and co-operate more with one another.[48]

Europe, in short, is getting braced for increased competition from the formation of an “internal market” as laid out in the EC Commission's “Single European Act”. “The internal market shall comprise an area without internal frontiers in which the free movement of goods, persons, services and capital is ensured in accordance with the provisions of this Treaty.” (Article 8A, Single European Act, 1986.) In response, European countries, including some which are not members of the European Community, are not only removing barriers between countries but also within national borders. France's relaxation of restrictions on private investment in nationally-owned companies and Italy's Amato Law, permitting private capital placements into state banks, are, if not a direct result of the Single European Act, certainly considerably encouraged by it.

5. The Securement of Financial Stability

With the Second Banking Directive designed to foster increased competition in an area of economic activity which has been traditionally heavily regulated, Europe confronts the question of what areas of finance it wishes to stabilise and secure from disruption and how to obtain this stability. Given the broad definition of “credit institutions” the European Community has adopted, the additional problem is raised of potentially having the existing “safety net” implicitly extended to “non-banking” activities.

The issue we are encroaching on is a broad and complex one. It is broad because the Second Banking Directive has taken a “universal” banking approach to the definition of a bank, combining traditional bank lending and securities activities. It is complex because of the difficulties of “isolating” the financial activities desired to be protected without removing some of the synergies and “returns to scope” which are derived from combining various financial services under the same institutional umbrella.

Consider the two examples of capital requirements and deposit insurance. Should “investment houses” be subject to the same capital requirements as “banks”? Placing a higher capital requirement on banks could be argued to put banks at a competitive disadvantage vis-à-vis investment houses in the conduct of securities business. However, the higher prudential standards for banks are presumably based on the desire to protect some banking functions which, in the event of failure, would have very large and difficult to compensate externalities. One particular service identified as in need of protection is the provision of “payments services”. On the other hand, it can also be argued that because securities firms are not covered by a government safety net and are more subject to volatile market risk than “banks”, they ought to have higher capital standards than banks. The issue of the appropriate capital standards for universal-type banks and securities houses is still a very lively and as yet unresolved issue in Europe. The issue is a topical one for the simple reason that although there is a trend towards conglomerate financial institutions, specialised securities firms are still quite an important force in some countries, in particular, the United Kingdom.

Deposit insurance can be both implicit and explicit. Where banks are partly in government hands, as a number are in France and Italy, insurance can be largely considered implicit, although Italy established an Interbank Deposit Protection Fund in 1987. And even though Germany has a private deposit protection system for commercial banks, the advertising of deposit insurance is said to be prohibited.[49] What is interesting in Europe is the move towards a more explicit system of depositor protection under the aegis of the European Community at a time when “banks” are greatly expanding their range of activities, as, for example, into insurance.

Both capital requirements, deposit insurance and some forms of regulation are capable of “insulating” to some degree depository institutions from financial “shocks”. Yet the fundamental stability of financial institutions cannot be said to be primarily derived from regulation or government “safety net” systems. No doubt deregulation in countries which had previously been tightly regulated at times has been followed by serious adjustment problems. In some cases, this has resulted in the failure of institutions and in a necessary consolidation of the financial industry. Yet the source of the underlying weakness in many cases stemmed at least in part from earlier regulations which had constrained the ability of financial institutions to adapt to changing market conditions and demands for financial services; example, the demand for housing credit in the United Kingdom. One of the reasons for the absence of major financial deregulatory problems in Germany has been the fact that interest rate regulations on retail and large deposits were eliminated in the 1960s. Moreover, it cannot be easily argued that the German universal banking model by itself was the major determinant of banking stability. The stability seems to stem more from the relationships that banks have developed with enterprises, which have helped to reduce problems of “moral hazard” (i.e. hidden information and actions of borrowers) that typically exist in financial relationships.

The informational and control relationship that financial intermediaries, in particular banks, have with company borrowers is now a common theme in the financial theory literature. Without burdening ourselves with the technical scaffolding, it suffices to note that both business information disclosure and company control relationships are much different in continental European than they are in Anglo-Saxon countries. There is more public disclosure of company information in Anglo-Saxon countries than in continental European. At the same time, there are generally closer and longer-term relationships between banks and companies in continental Europe. The reasons are obvious enough. There is a much greater emphasis in Anglo-Saxon countries on “market contracting”. The question is whether it makes any difference to the underlying health of financial institutions.

At the same time it appears curious that even with a greater public availability of information on firms in Anglo-Saxon countries it is here that the banking systems seem to have incurred considerable deterioration. The argument is sometimes made that banking regulation results from the fact that borrowers have information which they can hide from banks. Their hidden information and actions then make banks subject to information uncertainties regarding the quality of their credits. And, given their short-term deposits and illiquid loan portfolios, banks are subject to the risk of deposit “runs”.[50]

How then can “moral hazard” problems be reduced in banking? In a European context, the debate may be characterised by defining two bank-industry “relationship poles”. One side of the debate would promote closer bank-industry ties by permitting bank ownership of equity shares in industry and, as in the German model, permitting bank managers to take a significant role in the direction of industrial groups. This would promote greater information and risk-sharing and longer-term relationships between banks and industry. These types of arrangements appear to imply greater reliance on “implicit contracting” between banks and firms which cement long-term relationships. The potential problems they create are those of conflicts of interest and, through bank ownership of shares, equity market risk for banks.[51]

Alternatively, a solution may be sought by distancing the inter-relationships between banks and industry by prohibiting bank ownership of shares and at the same time requiring greater public disclosure of company information. This type of arrangement often has in mind protecting the “payments system” associated with banking from disturbances in industry and in minimising potential conflicts of interest when bank-industry ties are close. It was for some of these reasons that twenty-five years ago the EC's “Segré Report” (“The Development of a European Capital Market”, 1966) sought to promote greater use of capital markets in Europe. To quote from the Report:

“These problems spring mainly from the conflicts of interest a bank may face in exercising its various functions – distributing credit, taking controlling interests in enterprises, running a share portfolio, participating in issue syndicates, managing open-end investment funds and, finally, acting as an adviser to its customers or as manager of investment portfolios.” (Page 213)

The debate is quite clear – attempt to remove barriers to close information and risk-sharing and quasi-joint control relationships between banking and industry or discourage banks from industry relationships which could create conflict of interest dilemmas and risk implicitly extending the “safety umbrella” to sectors of the economy which are not desired to be “protected”. Note that both arrangements involve their own type of “moral hazard” difficulty. In the first, the dependency of the bank on an industrial relationship could cause the bank to try to “leverage” the implicit or explicit “insurance” the government extends to it, taking greater risks related to its ties with industry. Here the “asymmetrical information” problem results because the insurer, the government, is not totally aware of the actions of the insured, the bank. In the second case, where there are not close ownership relationships between banks and industry, the bank may be less informed about the activities of company borrowers and also have few direct means of influencing firm behaviour. The incentive for the borrower firm to conceal bad information and exhibit only “good news” then creates a moral hazard for the bank intermediary.

Which type of bank-industry relationship is “optimal” depends on normative judgments on how best to make available information on company behaviour to claimants on the firm and what sort of control or influence on firm behaviour should be exercised by financial intermediaries. The point to emphasise is that the so-called moral hazard/information-related risks will always exist in borrower-lender relationships. The organisational question is how best to minimise and distribute these risks over the parties to financial relationships: intermediaries, bond holders, shareholders, company managers and the government.

Europeans are currently attempting to solve problems of “information asymmetry” and “moral hazard” in financial arrangements in different ways. These efforts all involve attempts to utilise and manage business information more efficiently. While difficult to arrive at any accurate categorisation, one might define these attempts as Anglo-Saxon “market-oriented” and continental European/Japanese “non-market-oriented”. For example, in the United Kingdom, the Accounting Standards Board has proposed a very radical change in company accounting rules which appears to bring them closer to US GAAP standards.[52] The nature of the resolution of information problems is to provide clearer and more accurate company data. On the continent, however, we are seeing greater efforts to form informal information-sharing arrangements. These continental moves to promote closer information ties within industry and between financial intermediaries and industry can be seen as attempts to exploit the gains often associated with Japanese “keiretsu” corporate groupings: information and risk-sharing and a structure of informal relationships which minimise costly contract and competitive disputes.

It is quite clear that there are sharp differences of opinion in Europe regarding how moral hazard-information asymmetry problems in financial intermediation are best resolved. One might argue that some continental European and Japanese banking-industry relations, with emphasis on long-term implicit contracting, solve some information/moral hazard problems through greater non-contractual, informal relationships. Because long-term explicit contracts are difficult to define and enforce under conditions of uncertainty (e.g. it is difficult to anticipate all contingencies and costs of altering contracts based on contingent events), we observe in some countries strong implicit contracting between intermediaries and industrial firms. This may be one of the reasons that bank financing continues to dominate non-financial company balance sheets in the Federal Republic of Germany and why only modest equity and bond financing is observed. In contrast, in Anglo-Saxon countries, which rely more on “classical contract law” (emphasis on “legal rules, formal documents and self-liquidating transactions”) and less on “relational contracting”, we find less close long-term relations between financial intermediaries and non-financial companies, less sharing of risks and information and much more emphasis on “arm's length” transactions. It can be conjectured that for these reasons problems of moral hazard and informational asymmetries may be greater in Anglo-Saxon countries than in continental European countries and Japan, but risks of conflict of interest greater in the latter than in the former countries. While these are debatable conjectures, they help to put in perspective the difficulties of ensuring financial stability based solely on formal regulations.

A brief mention should also be made of another sharp difference among Anglo-Saxon and continental European financial behaviour and a topic of recent concern in Europe: takeovers. Based on long-standing differences in company organisational structure, company financing and business law among these countries, it should not be surprising to see the greatest support for the relaxation of restrictions on takeover activity coming from British and not continental European economists.[53] The issues here basically involve different views of how corporate control should be exercised. These issues are removed from debates over how to directly ensure financial stability by regulation and governmental “safety nets” but just as fundamental. Financial stability is interdependent with the issue of corporate control and risk-information-sharing between financial intermediaries and non-financial companies.

6. Sources of Potential Efficiency Gains in the Financial Services Industry

We now consider briefly the source of efficiency gains which are expected to result from financial deregulation and ask critically whether such gains carry with them unanticipated costs.

A convenient categorisation of financial market efficiencies is that recently described by the OECD.[54]

  1. Allocative efficiency: whereby the removal of regulations and price distortions permits savings to be directed into highest-yielding (risk-adjusted) forms of investment;
  2. Operational efficiency: whereby increased competition reduces costs of financial intermediation and other services; and
  3. Dynamic efficiency: whereby deregulation and increased competition help to generate an improved range of financial products and services through innovations, permitting capital markets to adapt to changing customer needs in a flexible way.”

This convenient categorisation permits us to identify where gains from deregulation may or may not result. Without providing any analysis here, we conjecture that gains from operational and dynamic efficiencies have been experienced by a number of European countries. Nonetheless, the OECD study argues that gains from improved operational efficiency present “a very mixed picture between countries, with little apparent progress in some that have taken substantial steps in the direction of deregulation”.[55]

The efficiency area we believe can most be questioned is that of “allocative efficiency”. The OECD states that among the potential indicators of allocative efficiency are: “measures of the extent to which financial resources fund productive investment within the domestic economy and permit it to be allocated through the price mechanism to areas of high productivity” (emphasis ours). We question whether financial deregulation in Europe has yet improved allocative efficiency on the basis of the following technical definition of efficiency developed by Tobin.[56] According to Tobin, “a market in a financial asset is efficient if its valuations reflect accurately the future payments to which the asset gives title – to use currently fashionable jargon, if the price of the asset is based on ‘rational expectations’ of those payments”. Tobin terms this concept “fundamental-valuation efficiency”.

It is difficult to make a straightforward case that financial deregulation during the 1980s has unambiguously improved allocative efficiency. The absence – even if difficult to prove technically – of “fundamental-valuation efficiency” in several major financial and real assets in the second half of the 1980s has tempered the enthusiasm of market efficiency advocates. Two markets have especially drawn considerable public attention: equities and real estate. We are still searching for a reasonable explanation of the major international equity market crash of 1987. But, in some ways even more surprising, even if smaller in magnitude, was the US equity market “mini-crash” of 1989, which was supposedly triggered by little more than an unsuccessful attempt to complete a leveraged buy-out. A third example of difficult-to-explain equity market behaviour was the response to the rise in oil prices associated with disturbances in the Middle East from August 1990 to early 1991.[57] Generally, during the previous two major rises in oil prices, 1974 and 1979, the reaction in countries' equities markets were roughly proportionate to their dependence on energy imports at the time of the rise in oil prices. However, even though the size of the oil price increase, particularly in real terms, was less than earlier shocks, equity price declines were considerably greater than might have been expected given the reduced dependence on oil among the major industrial economies.

Arguably as difficult to explain has been the widespread experience of major appreciation in real estate values and the associated failures and weaknesses of financial institutions arising from their subsequent declines. The two countries often singled out for illustration are the United States and Japan.[58] Both countries have experienced weaknesses in financial institutions due to over-investment in real estate. While it is debatable whether there is a worldwide shortfall in saving needed to finance world investment, it seems less arguable that there have been major inefficiencies in the allocation of capital, resulting in excessive investment in assets whose “valuations did not reflect accurately the future payments to which the asset gives title”. The open question is whether the real estate boom of the 1980s was directly associated with financial deregulation.

With respect to the relationship between financial liberalisation and the prices of homes, certainly the relaxation of credit rationing restraints increased the availability of mortgage credit in some European countries and contributed to the rise in real estate lending. Yet it is difficult to separate out the effects of financial liberalisation from other important factors, such as the treatment of mortgage interest for tax purposes, demographics and income growth during the 1980s.[59] Nonetheless, it is tempting to associate high saving rates in some countries, such as Japan and Italy, with the limited availability of personal housing finance. The Bank of England reports that in 1989 the level of mortgage debt as a percentage of GDP in the United Kingdom was more than twice that of Japan and about eight times that of Italy.[60] Personal credit availability is said to exist “to a limited extent” in both of the latter two countries. It is also clear that the removal of constraints on UK bank balance sheets (the “corset”) in the mid 1980s, the break-up of the building societies cartel and the Building Societies Act (1986) all contributed to a greater general availability of personal finance in the United Kingdom, much of which was funnelled into housing investment.[61] Certainly some of what appears as asset price inflation in UK housing is a reflection of the longstanding pent-up demand for housing finance. The British private sector likely experienced appreciable gains in financial allocative efficiency, notwithstanding problems associated with the increase in consumer debt levels.

What is much less clear is whether financial liberalisation led to allocative efficiency in the investment in non-residential real estate during the 1980s. Here we are involved in a semantic problem. That is, is the allocation of real resources “efficient” even if it turns out to have been in good part unproductive or loss-creating? The occurrence of failed or weakened financial institutions in some countries, with the United States the most notable example, lends sympathy to Tobin's concern over the absence of “fundamental-valuation efficiency”. It is difficult to respond to this argument with the proposition that greater regulation would have produced more “efficient” results. The answer again depends on how one defines the “optimal” trade-off between financial stability and efficiency in the market allocation of capital.

7. Conclusion: What are the Limits of “Acceptable Instability” in the Financial Services Industry?

Because of the diversity in European banking systems, financial regulatory structures and stages of development in capital markets, it is difficult to attempt any generalisation concerning how governments are attempting to redefine an optimal trade-off between stability and efficiency in the institutions which allocate financial capital. This final section, nonetheless, will try to broadly outline some areas where some “convergence” may occur.

One of the critical areas to watch in Europe is the “exit policy” in the banking and non-banking financial sectors. Bank failure, at least explicit bank failure, is rare in Europe and, as in most countries, a highly politically charged issue. How then will the weaker institutions “exit” in the face of increased competition: through mergers with domestic banking institutions; takeover by foreign institutions; de facto government nationalisation; takeover by industrial or non-bank financial institutions; or outright failure?[62]

How “exit policy” in the banking industry will change in the future is anyone's guess. We might conjecture that the relaxation of constraints on alternative exit avenues will be roughly proportional to the current “restrictiveness” of banking regulation.[63] One way to get a feel for how restrictive participants feel about European banking regulation is to look at survey evidence. Here we rely on a recent survey of senior management opinions of European banking regulation. The survey by Price Waterhouse, for example, on the overall regulatory environment for credit institutions in Europe found it the “most balanced” in the United Kingdom, France, Ireland and Luxembourg. Bank officers in Italy, Germany, Spain, Portugal and Greece, on the other hand, thought regulations in these countries were rather restrictive. It is, of course, inappropriate to apply a broad view of the restrictiveness of bank regulation to a specific banking issue like “exit”. Nonetheless, it is interesting to observe that Italy, Spain and Greece are often identified as having a number of inefficiencies in the banking industry, derived from previous policies of restricting competition. At the same time the structural difficulties in some highly-regulated banking markets have prompted more liberal government policies. This was true in Spain where the banking crisis in the early 1980s led to a greater ability of foreign banks to purchase weak Spanish banks and eventually contributed to a greater government commitment to liberalising the financial system.[64]

Another issue which needs to be confronted in Europe is the issue of government ownership of financial institutions. In countries where a good portion of the financial system is still publicly owned, governments are rethinking their position as 1992 comes closer. The Amato Law in Italy, for example, which became effective in July 1990, will permit “public law banks” to become joint stock institutions, albeit with 51 per cent of the voting power of the joint stock institution still in government hands. This is a major achievement for Italy where approximately 80 per cent of the banking system is public.

An additional question in Italy regarding bank ownership is the question of the source of additional capital for the banking industry. Specifically, should industrial concerns be allowed to acquire banks? The separation of banking and commerce in Italy extends in both directions: industrial/commercial firms cannot currently acquire banks nor can banks hold shares in non-financial enterprises. At present some argue that if the nationalised banks are to be privatised they will need large amounts of private capital. As the equity market in Italy is still somewhat narrow, some argue that the only way, outside of foreign investment, to inject large amounts of capital into Italian banking will be to permit industrial ownership of banks. To date this has been strongly resisted by the Banca d'Italia. In lieu of this, public policy appears to be directed at increasing the concentration in the banking industry through mergers, particularly of smaller banks and saving institutions.

It is also helpful to compare the problems created in Sweden by the rapid growth and risk-taking of modestly regulated non-bank financial institutions with the recent major overhaul of the Italian central bank's supervisory functions. The Banca d'Italia will now begin to supervise a wide variety of non-bank financial operations and, importantly, will attempt to pool information in forming opinion on banks' overall performance, rather than segment supervisory responsibility and information flows.[65]

While not specifically aimed at the banking industry as in Italy, we also have seen a relaxation of privatisation policy in France. The new French policy will now permit minority investments by domestic or foreign firms in state-controlled enterprises. Some argue that the push behind this liberalising measure reflects that government's own capital constraint in funding state enterprises.

In addition to the expected European competitive pressures associated with “1992”, another reason why we are observing a widespread concern with the need for consolidation in European banking is the question of “size”. The “daunting size of the large Japanese banks”, to quote the former Chairman of Midland Bank, and the recognition of the inability to continue to secure stability by isolating regional banks from both domestic and foreign competition are fostering mergers, consolidation and rationalisation.[66]

The ultimate question facing European bankers is how they will respond to the increased competition most assume will occur when 1993 arrives. This question is of interest in light of three factors:

  1. the EC move to more explicitly define the financial system's safety net;
  2. the institution of common bank adequacy requirements; and
  3. the increase in the efficiency and size of European capital markets.

Will increased competition, capital requirements, deregulation and the growth of securities markets cause European banks to attempt to “exploit the safety net”, as is argued to have occurred in the United States? Federal Reserve Chairman Alan Greenspan has an interesting observation on this question:

“A major implication of the current safety net is that some banks with relatively low capital ratios have been willing and able to fund riskier assets at a lower cost, and on a much larger scale, than would have otherwise been possible. The exploitation of this moral hazard has been encouraged by the increasing ability of many banks' prime corporate customers to tap the capital market directly. As such customers have migrated away from banks, and the traditional valued-added from intermediation of such credits has eroded, some banks have sought to boost returns on equity by, in part, reaching for ever more risky credit positions. The result has been a misallocation of our nation's scarce resources toward riskier activities funded by deposits whose costs have been limited by the safety net, and an increase in the probability of failure of many of our banks”.[67]

With greater European banking competition on the horizon, Chairman Greenspan's concerns today may be those of Europe tomorrow.


Assistant Manager, Monetary and Economic Department, Bank for International Settlements, Basle. [1]

Talk by the Governor of the Reserve Bank of Australia, B.W. Fraser, to the International Union of Housing Finance Institutions. [2]

US Department of the Treasury (1991). [3]

See Richard Tilly (1967). [4]

A review of the rise of banking in 19th Century Europe is available in Charles P. Kindleberger (1984). The close ties between banking and industry in the first half of the 19th Century were in part related to the economic philosophy of Claude Henri de Rouvroy, Comte de Saint-Simon. See Rondo E. Cameron (1961). [5]

This is the well-known “theory of economic backwardness” of Alexander Gerschenkron (1962). [6]

See Julian Franks and Colin Mayer (1990). [7]

See Kindleberger (1984) and Franco Bonelli (1971). [8]

For a review of the “City Revolution” in London, see Margaret Reid (1988). [9]

See Petit (1991). [10]

See Jacques Baudewyns and Geert Maes (1987). [11]

See Xavier Vives (1990). [12]

An excellent review of the structure of real and financial markets in Spain is José Viñals et al. (1990). Viñals et al. report that in September 1988 Spanish banks held in shares approximately 10 per cent of the total stock market capitalisation. [13]

For a concise overview, see Jacques Melitz (1990). A comparison of banking systems in the European Community is available in Joseph Bisignano (1991). [14]

Lars Jonung (1986). [15]

See Sveriges Riksbank (1989). [16]

Jonung, op. cit., page 117. [17]

This history is drawn largely from Jonung (1986), cited above. [18]

Peter Englund (1990). [19]

See Marianne Bilyer and Per Anneström (1990). [20]

See Commission of the European Communities (1988b) for an analysis of competition and efficiency in European finance. [21]

K.J. Arrow (1984). [22]

For a discussion on how “market solutions” may not be “Pareto efficient”, see Joseph E. Stiglitz (1991). [23]

Organisation for Economic Co-operation and Development (1987). [24]

Organisation for Economic Co-operation and Development (1990). [25]

Speech by the President of the Deutsche Bundesbank, Herr Karl Otto Pöhl, at the Frankfurt Stock Exchange, Frankfurt am Main, 21 March 1991. [26]

Organisation for Economic Co-operation and Development (1987). [27]

Philippe Ducos (1987), for example, argues that securitisation in France will increase bank funding costs, while at the same time acting as a substitute for the elimination of restrictions on interest-bearing deposits. [28]

See Jon A. Solheim (1990). [29]

See Commission of the European Communities (1966) and (1989). [30]

Charles P. Kindleberger (1981). [31]

Kindleberger, ibid. [32]

See Deutsche Bundesbank (1988). [33]

Deutsche Bundesbank (1989). [34]

Commission of the European Communities (1988a), page 1 of Explanatory Memorandum. [35]

Ibid., Explanatory Memorandum, page 2. [36]

See Richard Cordero (1990). [37]

Ibid., page 108. [38]

See Alfred Steinherr and Christian Haveneers (1990). [39]

Commission of the European Communities (1988b). [40]

Ibid., page 18. [41]

See Thomas H. Hanley et al. (1990). [42]

See King (1991). [43]

For an early review, see Hanley et al. (1989) and Hanley et al., op. cit. [44]

Hanley et al. (1990), page 7. [45]

Jack Revell (1991). [46]

See Federico Rampini (1990). [47]

Christiane Scrivener (1991). [48]

A brief review of comparative deposit insurance systems is available in US General Accounting Office (1991). [49]

A broad review of this literature is available in John Chant (1987). [50]

Contrast, for example, the recent rapid expansion in industrial investment of Crédit Lyonnais with that of other French banks. See Humphreys (1991). [51]

See Financial Times (1991). [52]

See, for example, Mervyn King and Ailsa Roell (1988). [53]

See Blundell-Wignall and Ishida (1990). [54]

Ibid., page 105. [55]

James Tobin (1984). [56]

For a further discussion, see Bank for International Settlements (1991). [57]

See, for example, Bank of Japan (1990). [58]

See Bank of England (1991). [59]

Ibid., page 63. [60]

See Callen and Lomax (1990). [61]

Some have argued that the reason for the neglect of the study of the efficiency in the European banking industry is the low number of bank failures. See Ernst Baltensperger and Jean Dermine (1987). [62]

“Banking and Securities Regulation in Europe: A Survey of Senior Management Views”, Price Waterhouse. [63]

See Beatriz Sanz Medrano (1990). [64]

See Financial Times (1990). [65]

See Sir Kit McMahon (1989). [66]

Remarks by Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System, before the 27th Annual Conference on Bank Structure and Competition at the Federal Reserve Bank of Chicago, 3 May 1991. [67]


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