The New Way of Continental European Universal Banking

TABLE OF CONTENT

1. Introduction

2. Consolidation trend in the European Banking Industry

3. New structure of the European Banking Environment

5. Review of recent Financial Intermediation Theory

6. Implications for the Monetary policy in the European Union

7. Summary

8. Outlook

9. References

“ The New Way of Continental European Universal Banking ”

Keywords: Europe, Banking, Financial Intermediation, Efficiency

JEL-Classification

G00 - FINANCIAL ECONOMICS

O 40 - ECONOMIC GROWTH, GENERAL

G2 - FINANCIAL INSTITUTIONS AND SERVICES

L1 - MARKET STRUCTURE, FIRM STRATEGY AND MARKET PERFORMANCE

ACCEPTED PAPER FOR THE 17th AUSTRIAN WORKING GROUP ON BANKING AND FINANCE WORKSHOP AT KARL-FRANZENS-UNIVERSITÄT GRAZ

Submitted by

Johann Sebastian Kann* *

* The author is PhD student at Vienna University of Economics and Business Administration

“ The root of the current predicament for the Continental European Universal Banking System lies in their failure to respond to the changes that have taken place in their external environment over the past decade: the globalization of capital, the growing sophistication of issuers (such as governments and corporations) and investors (such as insurers and mutual funds), and the central role of the dollar in global investment flows. ” N.N

Abstract

The goal of this paper is to investigate how the European Banking environment has changed dramatically over the past years.

Based on new studies the author will present the Modern Financial Intermediation Theory from Allen and Santomero (2001) and Recent Banking Efficiency Studies from Van Dijcke (2000) and Ali/ Gstaach (2000), in order to be able to derive new conclusions for the Continental European Universal Banking System.

The paper presents a possible new structure of the European Banking System, which will show 3 major segments of local, national and international Banks.

Finally the author will draw conclusions of such changes on the Monetary policy of the European Union.

1. Introduction

There is broad agreement that the environment of financial services in Continental Europe has changed and will change fundamentally.

There are three major reasons for that:

- the traditional characteristic features of Banking in Continental Europe have changed due to deregulation and liberalisation in the European Union,
- further financial integration in Europe and
- technical progress.

There has been a very fundamental change of view in the financial theory ¹ :

- As economic literature in the past has shown, the specific role performed by banks in the economic system is not to intermediate savings, but rather to certify the quality of borrowers, monetizing liabilities which otherwise would fail to find purchasers in the markets (Fama 1985)².
- Banks are essential for economic development in that they are a crucial device for the selection of entrepreneurs and the allocation of financial and real resources (Diamond 1984)³.
- Allen and Santomero said in 1998 that the traditional theory of financial intermediation was focusing too heavily on the functions of financial institutions that are no longer crucial in mature financial systems.

Certainly the largest advances in the near future in Continental European Banking will occur by:

- further product innovation (“Securitization”, “Riskmanagement”),
- better distribution channels (“e-banking”),
- continuing restructuring on the cost and revenue side (“focus on the core business”) and
- a deeper focus on information technology (“outsourcing”), which will result in increasing competition between the banks.

In this context the question arises whether universal banks in Europe are suited to cope with the current transformation process or not. The answer to this question seems to be simple:

- Universal Banks in Continental Europe have established themselves as successful players on international markets over the past (see Germany, Italy, France, Belgium, Netherlands, Spain in international Rankings)
- Nevertheless they have to become more flexible in adapting to new European needs for the future.

There is no doubt about the fact that higher competition will lead to further consolidation in the banking industry, which theoretically should benefit their clients in the long run. (see next chapter)

Today they are both highly internationalised markets for certain products and markets that still have strong domestic focus.

Retail activities are still confined very much to national territories and internationalisation is making progress. Cross-border transactions between financial intermediaries are bound to open up new and attractive markets and allow for better risk diversification.

Austria’s major banks for instance have been very successful in establishing business contacts in the European Union, opening local subsidies and acquiring local banks in the Central and Eastern European countries. This illustrates the trend of closer cooperation and increasing integration in the Continental European Banking industry.

2. Consolidation trend in the European Banking Industry

It is difficult to predict the extent of development and/or the forms of future consolidation in the Continental European Banking Industry.

Nevertheless past efficiency studies in the EMU have shown that there is a need for paying more attention than in the past to cost containment (finding cost saving potential), to option to leave certain markets or to enter them (restructuring businesses), to form alliances or look for potential M&A targets in form of national and/or cross-border activities.

One should not forget that Investment Banking and Wholesale Banking have already been much more international than Retail Banking and the trend toward consolidation in Investment Banking is already more pronounced than in other fields. So what is going to happen in the next couple of years is economic in nature: the reduction of “over banked” and “over branched” institutions?

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Table: European Banking Statistics

Source: German Banking Union, 2002 (*Monetary Institutions= Financial Institutions, Central bank, Monetary Funds)

The author believes that in banking size matters, because it makes it easier for a bank to attract staff and to establish reputation. Although crossborder mergers in Europe have cultural and political impediments one can see that in the fact integrating staff and the operations of two different national identities will be more than difficult.

The organizational culture of almost all banks still reflects the important differences between general economic, political, cultural and social norms and patterns of different European countries.

Certainly there is no doubt that with stronger competition and a growing importance of capital markets (Allen/Santomero 2001) universal banking has become a general model in Europe: They will provide a comprehensive set of services to specific groups of clients.

However European banks have historically found it difficult to create a culture that demands initiative and requires accountability to the highest standards.

It seems that European Universal banks in particular have been afflicted by the difficulties of moving people and capital rapidly between organizational units. Too often, fiefdoms emerge around product lines or countries that make rapid change in response to market opportunities difficult to execute. These political empires can no longer be tolerated in today’s environment.

Especially in Austria Universal banks have struggled to attract top quality people outside their home markets, in part because of a reputation that young, talented individuals — particularly foreigners — would not be given sufficient opportunity. This must certainly change in order to stay competitive.

As mentioned earlier, the next couple of years will be a defining period for European Universal Banking. Many of upcoming strategic moves will be irreversible and will alter the competitive landscape for all players.

European players must aggressively define their own role, or it will be defined for them. The current downturn and industry restructuring are indeed painful, but they also present a unique opportunity for European players to chart a new course.

3. New structure of the European Banking Environment

In the following table the author shows how the largest 100 banks in Europe are structured and how profitability differ. (see table 1)

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Table 1: Top 100 European Banks Statistics, 2000 Source: BIS

By putting the top 100 European Banks into Clusters (Source: BIS), ordered according to their total assets and analysed by performance, efficiency, income, liquidity, balance structure and asset quality can be analysed, but at the same time general assumptions for the Banking industry can not be easily made. (see Table 1)

Therefore the author takes a closer look at the political or structural impediments to better understand the European Banking Industry.

1) Political Impediments: The introduction of the single currency in a EMU has strengthened the role of financial markets, lowered transaction costs, increased opportunity of diversification and made the European financial system more competitive and robust. Nevertheless this goes at the expense of banks in their role as intermediaries. Lower margins for Cluster 1 and Cluster 2 banks.
2) Structural impediments: The complex structure of European Banking can be shown at the highly diversified revenue streams and operating fields. Smaller banks such as Cluster 6 seem to be most profitable although they are medium to small sized.

The author sees it appropriate to differentiate today’s European and Global Banking from a European Perspective between three groups or types of banks.

- The first group comprises a selection of big universal banks which already have a strong position in Investment Banking, Commercial Banking, Private Banking, Asset Management and Retail Banking. (European and Global Wholesale Bank - PREMIUM SEGMENT)
- The second group is that of nation wide operating banks which do not have a protected market niche. Banks in this group are a fairly endangered species. (Regional Retail Distributor - LOW SEGMENT)
- The third group comprises smaller and more locally oriented banks in particular banks which are affiliated to a regional focus such as savings banks and the cooperative banks. These banks are not affected in a negative way because of their legal structure and their small market share compared to big international universal banks. (Pan European Product Specialist - MIDDLE SEGMENT)⁴

4. Review of recent banking efficiency analysis

Efficiency Analysis became a popular tool for process improvement and organisational change in the early 1990’s. Over 600 studies have been made since then world wide in the field of Banking alone.

The author argues that they were a useful and widely used tool in the Banking industry.

- In order to help better structuring and transforming the traditional Banking system.
- Most of them were viewed as a learning experience that allowed banks to compare their processes and performance outcomes with others.

The reason why most of the implications from the efficiency studies could not be implemented were because the types of methodologies used to conduct efficiency studies in Banking also produced widely varying results. On the other hand many organisations have found that high level statistical comparisons and even industry specific surveys have not delivered the dramatic improvements desired. They inevitably left bankers the “….so what are we going to do about it ?” question unanswered.

In the following we will see 3 brief examples of how diverse assumptions for efficiency studies, their methodologies (approach) and their use have been, which special focus of the implications on Austria:

Looking at the results of efficiency studies from Berger (1994-1999)⁵ Ingo Walter published a paper about Financial Services Strategies in the Euro Zone in the European Management Journal in 1999 discussing the new challenges for European banks after the introduction of the Euro in 2000 for the 21st century.⁶ Substantial overcapacity and inefficiencies were the major problems of the financial services industry in Europe at that time. Since then a process of massive restructuring and consolidation took place, searching for operating economies and revenue synergies. Increased profit margins, lower prices (“no pain, no gain”) and increased average size of firms (“bigger is better”) as proposed by Walter have taken place, but have shown no significant change in the revenue stream of the financial services industry.

Van Dijcke has concentrated his attention on the rationale of looking at the cost to income ratio and its growing use as a proxy for bank (in)efficiency in 2000. In his empirical analysis between 1995 and 1998 Van Dijcke was looking at the change of the composition of the bank income (while remaining in his regression model all other elements remain equal). Van Dijcke found out that changing scale and scope had limited impact on the cost to income ratio. By using the available inputs efficiently in order to generate a higher (or given) output level the direct impact on the ratio was much larger. His regression model showed further more that when looking at efficiency, it was necessary to benchmark the cost of income residuals of a sample of banks then compare linear cost to income ratios. Useful and valuable benchmark information is available when the CIR is set against the bank’s main competitors and similar banks.⁷

In 2000 Ali/ Gstaach analysed the relative efficiency of Austrian banks with a Data Envelopment Analysis. Austria's legal framework for banking changed substantially during 1990-1997, due, mainly, to the country's entry into the European Union in 1995. Ali/ Gstaach investigated in 2000 the relative performance of Austrian banks during this period and thereby test the hypothesis of increased competitiveness. Their study revealed that commercial banks consistently improved productivity over the period, Savings & Loans and Volksbanken exhibited a turnaround in productivity in 1997, and Rural Credit Unions experienced consistent productivity decline. Overall, Austrian banks experienced a decline in average efficiency and productivity until 1996 with slight improvements in 1997. The study reveals evidence of product diversification rather than increased price competition; A decrease in the spread of prices payed for inputs indicates increased competitiveness over the period, which can be attributed to deregulation brought about by EU-membership.⁸

5. Review of recent Financial Intermediation Theory

“Progess in finance seems largely to coincide with a lesser role of traditional Banking in the financial intermediation business” said Allen/Santomero in 2001)⁹ This key sentence implied a major change in the history of financial intermediation theory in 2001.

Transaction costs and information asymmetries were being so dramatically reduced in modern financial systems that what was once special about issuing liquid liabilities and financing illiquid assets is hardly special today (Bossone 2001).¹⁰

Diamond (1984) found a special feature in banks acting as delegated monitors of borrowers, on behalf of the ultimate lenders, in the presence of costly monitoring. Essentially, banks produce a net social benefit by exploiting scale economies in processing the information involved in monitoring and enforcing contracts with borrowers.¹¹ Banks reduce the delegation costs through a sufficient diversification of their loan portfolio (Bossone 2001).

The provision of liquidity services pre-eminently characterized banks on the classical contribution by Diamond and Dybvig (1983).¹²

Instead of placing their endowments in an illiquid production technology, individuals deposit them with banks in exchange for claims entitling them to withdraw the deposits to finance future, unanticipated consumption needs. By that depositors gain consumption flexibility. The specialness of banks in the Diamond and Dybvig modell (1983) is that banks must be able to transform liquidity into optimal illiquidity in the agent portfolios, by efficiently exploiting at the margin the depositor’s preferred trade off between consumption flexibility and intertemporal consumption.

Fama (1995) points to the specialness of banks as deriving from integrating credit and liquidity provision functions. His model gives banks a special role as information providers to capital market participants, who incorporate the information embedded in banks’ lending decisions into their own investment evaluations.¹³

Calomiris and Kahn (1991) investigated the specific liability issued by banks in the form of demandable debt to finance illiquid assets. They show that ,under costly and asymmetric information, demandable debt provides an incentive-compatible solution to the potential conflict of interest between bankers and bank depositors.¹⁴

Allen and Santomero said in 1998 that the traditional theory of financial intermediation was focusing too heavily on the functions of financial institutions that are no longer crucial in mature financial systems. They suggest that the emphasis on the role of intermediaries as reducing the frictions of transaction costs and asymmetric information is too strong. They therefore suggested a view that financial intermediaries are the facilitators of risk transfer who deal with an increasingly complex maze of financial instruments and markets. The key area of intermediary has become riskmanagement. Financial intermediaries reduce according to their theory participation costs, the costs of learning about effectively using markets as well as participating in them on a day to day basis, which plays an important role in understanding the changes that have taken place.¹⁵

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¹ followed by new implications in recent efficiency studies in Banking.

² Fama, E. (1985): What ’ s different about banks?, in Lewis,-Mervyn-K., International Library of Critical Writings in Economics, vol. 43. Financial intermediaries. Aldershot, 1985; 455-65.

³ Diamond, D. (1984): Financial intermediation and delegated monitoring, Review of Economic Studies 51, 393-414.

⁴ These initial remarks were designed to put the development of the Banking sector in Continental Europe into the perspective of recent implications of effciency studies in the Banking sector.

⁵ Further implications can be reviewed in:: Berger, A.N. (1993): Distribution-free estimates of efficiency in the U.S. banking industry and tests of the standard distributional assumptions. J. Productivity Anal. 4 (3), 61-92. Berger, A.N. (1995): The profit-relationship in banking - tests of market-power and efficient-structure hypotheses. J. Money Credit Banking 27 (2), 405-431. Berger, A.N. (1998): “ The efficiency effects of bank mergers and acquisitions : A preliminary look at the 1999s data ” . Bank mergers and acquisitions (Kluwer Academic Publishers), pp. 79-111. Berger, A.N. and Humphrey, D.B. (1997): “ Efficiency of financial institutions : International survey and directions for future research ” . European Journal of Operational Research, 98, pp. 175-212. Berger, A.N. and Mester, L.J. (1997): “ Inside the black box : What explains differences in the efficiencies of financial institutions ? ” Journal of Banking and Finance, 21, pp. 895-947. Berger, A.N. and Mester, L.J. (1999): “ What explains the Dramatic Changes in Cost and Profit Performance of the U.S. Banking Industry ” . February. Berger, A.N., Demsetz, R.S. and Strahan, P. (1999): “ The Consolidation of the Financial Services Industry : Causes, Consequences and Implications for the Future ” . Forthcoming Journal of Banking and Finance, Volume 23. Berger, A.N., Humphrey, D.B. (1991): The dominance of inefficiencies over scale and product mix economies in banking. J. Monetary Econ. 28, 117-148. Berger, A.N., Humphrey, D.B. (1997), Efficiency of financial institutions: International survey and directions for future research, European Journal of Operational Research, vol. 98, S. 175-212. Berger,-Allen-N.; Demsetz,-Rebecca-S.; Strahan,-Philip-E. (1999): The Consolidation of the Financial Services Industry: Causes, Consequences, and Implications for the Future, Journal-of-Banking-and-Finance; 23(2-4), February 1999, pages 135-94.

⁶ Walter, Ingo (1999): Financial Services Strategies in the Euro-Zone. In: European Management Journal, 17. Jg., H. 5, S. 447-465.

⁷ Van Dijcke,P.(2000): Impact of globalisation on efficiency in the European banking industry:What can we learn from the CIR?, paper for the 22 nd SUERF Colloquium in Vienna, 27-29 April 2000.

⁸ Ali,-Agha-Iqbal; Gstach,-Dieter (2000): The Impact of Deregulation during 1990-1997 on Banking in Austria, Empirica; 27(3), 2000, pages 265-81.

⁹ Allen,-Franklin; Santomero,-Anthony-M. (2001): What Do Financial Intermediaries Do?, Journal-of-Banking-and-Finance; 25(2), February 2001, pages 271-94.

¹⁰ Bossone,-Biagio (2001): Do Banks Have a Future? A Study on Banking and Finance as We Move into the Third Millennium, Journal-of-Banking-and-Finance; 25(12), December 2001, pages 2239-76.

¹¹ Diamond, D. (1984): Financial intermediation and delegated monitoring, Review of Economic Studies 51, 393-414.

¹² Diamond, D, Dybvig, P.H (1983): Bank run, deposit insurance and liquidity, Journal of Political Economy 91 (3), 401-414.

¹³ Fama, E. (1995): Banking in the Theory of Finance, in Lewis,-Mervyn-K., International Library of Critical Writings in Economics, vol. 43. Financial intermediaries. Aldershot, 1995; 592-610.

¹⁴ Calomiris, W., Kahn, C. (1991): The role of demandable debt in structuring optimal banking arrangements, The American Economic Review 81, 497-513.

¹⁵ Allen, Franklin; Santomero, Anthony M.(1998): The theory of financial intermediation. In: Journal of Banking & Finance, 21. Jg., S. 1461-1485.