1

European Banking Integration: where do we stand?

By

Xavier Freixas

Deutsche Bank Lecture to be presented on Thursday, 5 June, in the Saïd Business School.

Fifteen years ago the Cecchini report was published. It was an ambitious document. With a

total lack of academic rigor and an excessive confidence it ventured to put forward precise

forecasts regarding the effect economic integration could have on the price of financial

services.

1 Source ECB and Datastream Mortgage rates for The Netherlands, average of Mortgage, consumer and corporate lending rates for all other countries, 1996-2003

The discrepancy between the Cecchini report forecast and the actual decrease in the prices

of financial services illustrates how easily barriers to entry foreign markets in Europe are

understated. Barriers to entry are still today's most relevant challenge of European financial

integration. Because Europe is a bank dominated economy, with a ratio of bank loans to

GDP equal to 100.4% in 1999 (contrasting with 48.4% in the US), this lecture focuses on

BELGIUM GERMANY SPAIN FRANCE ITALY NETHERLANDS

UK

Cecchini Report 23% 25% 34% 24% 29% 9% 13%

Actual -3,78% 1,89% 9,18% 28,45% 4,21% 23,08% -9,50%

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European banking integration. barriers to entry have diminished and that in spite of some

drawbacks European financial integration is under way since 1999.

The building of an integrated European banking industry started with the first Banking

Directive in 1977. Yet neither the first nor the second Directive, with the establishment

in1988 of the common European passport for banks, had a significant impact on European

integration. To our knowledge, there is no clear explanation of why attempts to achieve

financial integration have been often unsuccessful and when successful have had their

implementation in each country member legislation long delayed. Still, as stated by

Kroszner (1998), p. 1 "The positive analysis of how regulatory change has evolved can

ultimately provide normative guidance for those who wish to implement lasting policy

reforms", so that the analysis of why integration has been hampered is crucial if we want to

build a competitive efficient banking system.

In order to assess the state of European integration, there is a basic implicit assumption of

the Cecchini report that we have to address. The Checchini report assumed that integration

would lead to competition and margins on financial products and services would adjust to

the level of the lowest ones. This has proven to be only partially correct. It is true, for

instance, that reserve requirement have converged, since otherwise banks in countries with

a reserve requirement of 17% like Spain would have never been able to stay aflot. Yet,

there are differences that, in the absence of active European legislation, could not be

expected to converge, thus justifying cross-country differences in loans and deposits

margins. The simplest one is consumer protection legal regime1. Cultural ones matter as

well: it would be quite difficult to convince French borrowers to accept a variable rate on a

mortgage: banks have already tried and failed during times of high inflation.

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The main error in the Cecchini report was to take for granted that convergence of margins

on financial services would converge. Macroeconomists have faced a similar issue in their

analysis of the convergence of per capita GDP and have defined two different notions of

convergence: ß-convergence occurs when prices of financial services decrease more in

those countries with higher initial prices; s -convergence occurs when the standard

deviation of interest rates across economies declines over time. The Cecchini report took

for granted that ß-convergence would occur so that prices would adjust to the level of those

in the most efficient European countries. Today, researchers in that area have agreed that

there are specific differences among countries that prevent the “law of one price” to apply.

These inequalities of interest rates are common even within countries: within Italy range

from 6.2% in Northern Italy to 8.4% in the South.

If we take this into account, we may consider s -convergence as a more realistic integration

test for a European market for banking services where some barriers to integration remain

in place. Nevertheless, integration means also lower level of product differentiation and a

larger number of participants competing for a larger market share. So, in spite of some

insuperable country specific differences, we still expect margins to decrease in some

countries and observe ß-convergence.

Empirical research on European financial integration has provided a number of relevant

results that, together, provide a new perspective on the future of the European banking

industry. We will examine these results in a first section where we review some evidence

on the segmentation of the banking industry, then proceed to examine, in section 2, how, in

1 See the Distance Marketing of Financial Services Directive of September 2002

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the last four years integration has increased before concluding, in section 3, by considering

the future of the European banking industry.

1. A segmented retail banking industry

The idea of a fully integrated banking industry is contradicted by (at least) four types of

empirical findings. First, the literature on cost efficiency has repeatedly established that

European levels of cost efficiency differ across country. Second, the same type of analysis

performed at the level of profit efficiency has also shown differences in profit efficiency.

Third, the expected wave of cross-country mergers supposedly triggered by European

integration did not take place. These three empirical observations are in fact at the heart of

the process of banking integration and of the existence of regulatory barriers to entry.

Cost efficiency in Europe

Recent empirical research has established the potential gains in efficiency a more

competitive structure could provide. This is an interesting issue since, at the same time it

provides a straightforward prediction of the chances of success of one country to

successfully enter another country’s market. As a consequence, it is also an indirect test of

the degree of integration and barriers to cross-country entry in Europe.

The empirical methodology has its origins in the work of Farrell(1957) and on DEA or data

envelopment analysis. Using data on inputs and outputs an efficient frontier of cost

minimizing inputs is derived. Firms that have chosen input combinations which are not on

the efficient frontier are then, theoretically, able to obtain efficiency gains.

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The empirical literature can be quite helpful here provided the tabling of the question we

want to address is sufficiently precise. A question such as : « is the German or the Italian

banking industry efficient ? » is too ambiguous. It is necessary to define efficiency in a

more precise way in order to survey the different answers the literature has provided.

The simplest way to consider cost efficiency is to assume perfect integration. In this case,

the inputs necessary to produce one unit of loan or deposit are the same in every country

and there is a unique efficient European production technique (or frontier). This is the

approach that is most commonly developed, as it allow us to compare the efficiency levels

of different countries.

Using this methodology, Altunbas et al. (2001) measure the efficiency of the European

banking industry during the period 1989-1997. They show that cost inefficiencies usually

range from 15% to 30%. Their country by country analysis shows that some leading

countries like Italy, Germany, Sweden, Austria and Denmark control better their costs and

reach efficiency levels higher than 80%, while at

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Average-X efficiency levels of bank in the E.U. 1989-1997 1989 1997 Austria 0.791 0.819 Belgium 0.631 0.678 Denmark 0.778 0.809 Finland 0.807 0.704 France 0.712 0.756 Germany 0.782 0.865 Greece 0.720 0.762 Ireland 0.834 0.677 Italy 0.783 0.874 Luxembourg 0.766 0.670 Netherlands 0.787 0.762 Portugal 0.665 0.711 Spain 0.766 0.763 Sweden 0.806 0.835 UK 0.702 0.702 All 0.755 0.821 Source: Altunbas et al (2001), Table 3, p. 1944

the other end of the spectrum, countries like Belgium, Ireland, UK, Finland and Portugal

lag behind with a level of efficiency lower than 70%.

These results have to be interpreted with caution. To some extent different efficiency across

countries could simply reflect different business mix or strategies, in which case the

difference in efficiency between Luxembourg and Spain will simply reflect a completely

different type of business.

Although this may occur for some countries, Fernandez de Guevara and Maudos (2002)

show that it is the exception rather than the rule, and conclude that "on the cost side, the

country effect is also more important than the type of institution and specialization in

explaining the inequalities of efficiency between groups".

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Maudos et al. (2002) complement their analysis of cost-efficiency by studying the variables

affecting cost efficiency. Their results are quite consistent with the predictions of

theoretical models. To be cost efficient a bank 1) has to have a medium size (MEDBANK),

that is, between 10 and 100 billion $, 2) has to have a high proportion of loans in their

asset, 3) has to invest in low risk projects and 4) has to have a small network of branches.

Surprisingly the institutional form, commercial banks and all types of non-for profit

organizations has no effect. Regarding the environmental variables, the result obtained is

that cost efficiency increases 1) in a competitive environment and 2) in a low growth

context, which is quite consistent with the standard microeconomic predictions: market

power lowers the incentives to control costs and a high rate of growth implies a higher

marginal cost for a given capacity.

The following table reproduces the impact of these factors, where S stands for the

institutional form dummy, L/A represents the ratio of loans to assets, DEVROA is the

standard deviation of return on assets and CR stands for concentration ratios

Regression analysis of the potential correlates of efficiency Cost efficiency Variable Coefficient t-statistic SMALLBANK -0.005 -0.715 MEDBANK 0.916 39.961 LARGEBANK -0.021 -1.031 S1 0.083 1.784 S2 0.004 0.226 S3 -0.009 -0.515 S4 0.033 1.234 S5 0.015 0.649 S6 0.026 0.898 S7 0.024 1.313 S8 0.025 1.596 L/A -0.021 -1.438 DEVROA -3.382 -3.717 CR 0.290 1.844 GDPGROWTH -3.439 -5.324 BRANCH -1.7E-04 -2.638 Adjusted R2 0.095 Source: Maudos et al. (2002)

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These observations have interesting implications for competition. Still, they also have

important methodological implications. Indeed it becomes then crucial to identify

environment variables and compute banks efficiency in an alternative way, taking into

account the environment variables.

This approach is developed by Lozano-Vivas et al. (2002) who identify a series of variables

that will affect the efficiency of banking activity (namely, Income per capita, Salary per

capita, Population density, Deposit density, Income per branch, Deposit per branch, Branch

per 10000 inhabitant, Branch density, Equity over total assets and Return over Equity). The

introduction of these environment variables make the efficiency score increase

significantly, reflecting the fact that a lack of efficiency could be actually reflecting a poor

banking environment.

Once these variables are taken into account the ranking changes completely, as illustrated

in next table.

Table. Efficiency scores: Complete model (Common frontier. Banking and four environmental variables).

Average Std. Belgium 79.32 25.50 Denmark 75.45 15.79 France 40.98 27.85 Germany 57.87 24.11 Italy 33.10 22.20 Luxembourg 62.30 23.58 Netherlands 51.75 27.35 Portugal 79.87 21.99 Spain 82.14 14.93 U.K. 58.65 30.15 Source Lozano-Vivas et al (2002), Table 6, p. 70

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An interesting effect of computing the environment-connected cost efficiency is that it

allows to compute the cost efficiency of the efficient banks in each country. The following

table computes this score. Its implication are straightforward: except for Italy and the

Netherlands, European banks are as efficient as their environment permits. But this, of

course, does not mean that the European banking market is competitive, since competing

for the best environment, like reducing the number of branches, is also expected from banks

in a competitive environment.

Whether we have to use the original efficiency ranking or the environment corrected one in

order to assess the extent of European integration depends on the type of foreign expansion

strategy we consider: direct cross-country selling is related to overall efficiency, in which

Table. Average behavior of the efficient banks of each country. Basic Model Complete Model Belgium 66.61 100.00 Denmark 48.83 100.00 France 87.53 100.00 Germany 63.53 100.00 Italy 43.15 53.72 Luxembourg 90.48 100.00 Netherlands 60.57 73.01 Portugal 23.16 100.00 Spain 35.74 100.00 U.K. 43.23 100.00 Source Lozano-Vivas et al (2002), Table 7, p. 71

case, salary levels, deposit density or the banks capital ratio become irrelevant. If, instead

foreign expansion implies creating a new branch network abroad, it is the environment

corrected measure we have to consider.

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Consequently, according to these results, one way or another, integration is incomplete.

Regarding the expansion of bank branches, the empirical results show that we should

observe larger foreign entry in Italy and the Netherlands ; concerning direct cross-country

we should observe higher development of distance selling to high branch network

countries, like Spain or Belgium.

Profit efficiency in Europe

Cost minimization is obviously a necessary condition for profit maximization, but not a

sufficient one. In a competitive world where banks produce a homogeneous product, cost

efficiency is equivalent to profit efficiency. In fact, banks offer a wide range of financial

services, and heterogeneous customers value these services differently (horizontal

differentiation). A bank may therefore misprice its outputs or offer the wrong output

combination. This can be tested and, surprisingly enough, the limited evidence available

suggests that the levels of inefficiency are higher for profits than for costs. A study by

Berger and Mester(1997) establishes that there is no positive correlation between cost

efficiency and profit efficiency. This suggests that higher costs may be the price a financial

institution has to pay in order to achieve higher specialization and market power or a

different output combination. It is therefore interesting to complement the previous analysis

by considering the differences in profit efficiencies in Europe. The results of Maudos et

al.(2002), illustrated in the following table, are particularly relevant.

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Profit efficiency Cost efficiency Germany 0.547 0.900 Austria 0.489 0.907 Belgium 0.352 0.856 Spain 0.539 0.862 Finland 0.270 0.732 France 0.446 0.782 Italy 0.540 0.764 Luxembourg 0.626 0.764 Portugal 0.525 0.822 United Kingdom 0.428 0.796

Source: Maudos et al.

The ranking in profits is in sharp contract with the cost-efficiency one. Portugal ranks

among the most profit-efficient countries, while Belgium appears as the less efficient one.

Luxembourg and Italy that rank among the low cost-efficient countries are in fact among

the high efficient ones. The analysis by factors provide additional information on the profit

generating strategies. Unsurprisingly, profits are higher for large banks, that invest in risky

projects and enjoy market power (as measured by the concentration ratio) in a high growth

environment (Maudos et al. 2002).

Thus the analysis of profits establishes that there is a distinct pattern in marketing products

that could be bank and country specific. A loan could be produced anywhere in Europe and

sold, with the additional cost of operational risk capital, cross-border. Yet it is not clear that

it could be sold without the use of the host country marketing techniques. As a

consequence, cross-country differences in the level of profit efficiency incentive strategic

alliances, mergers and acquisitions which allow to combine the optimal location for the

production of a financial service with its optimal marketing.

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Mergers and Acquisitions

The creation of the EMU led most economist to predict a wave of cross-country mergers.

The argument stated that a unique currency meant a larger market where financial products

could be produced in a central place and distributed to the different countries by using the

host country specific distribution network. Cross-border mergers were thus a way to avoid

redundancies in the production of a financial product (cost efficiency) while retaining the

country specific characteristics of distribution. This proved to be completely wrong, as the

wave of mergers was mainly domestic, with the majority of cross-border in Europe

involving a non-European partner.

Several contributions have addressed this puzzle. The impact of a merger can be studied

from two complementary points of view: first, as an event study, the impact can be

measured in terms of the abnormal returns for the firms undergoing a merger. Second, the

alternative way is to compare cost and profit efficiency before and after a merger.

Using the first event study approach, Beitel and Schiereck(2001) show that acquiring banks

have experienced significant negative cumulative abnormal returns since 1998, and, in

particular, cross-border transactions of European banks seem to be value destroying.

The second approach is used by Vennet(2002), who finds support for the hypothesis of

efficiency driven cross border mergers in the sense that, in most cases, the merger concerns

a poorly managed bank taken over by an efficient one. Nevertheless, Vennet shows that the

merger increases profit efficiency but not cost efficiency.

The results are consistent with Buch and DeLong(2001) conclusions on the relative absence

of cross-border bank mergers. They show that bank mergers are hampered by regulator

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barriers and information costs related to distance and cultural factors. This is quite

consistent with casual observation (as in the case of the creation of Merita). Buch and

DeLong also establish that banks operating in a more regulated environment are less likely

to become a target, thus suggesting the possibility of political interference.

The role of regulation

It has been repeatedly argued that the tension between economic integration and retaining

national political control is one of the reasons for regulatory fragmentation. In the case of

banking regulation, the failure to quickly implement an integrated regulatory framework is

also related to the basic mandate of regulatory agencies.

The main responsibility of banking regulatory agencies is to preserve financial stability of

the domestic banking industry. For this reason, they will not represent the interest of the

average bank but rather would tend to weight more fragile banks losses than competitive

banks profits.

The evidence on political obstacles to cross-border acquisitions is overwhelming, as

suggested by BBVA’s attemps to take over Unicredito in Italy or BSCH in acquiring the

Champalimaud group, by the auction of Banesto and Crédit Lyonnais after their distress, an

auction that was restricted to domestic bidders or by the resolution of the battle of BNP-

SG-Paribas which was in any case to leave the control of the group within France.

2 European Integration since 1999

The issue of European integration can be considered from different perspectives. Interbank

markets in the EMU are fully integrated since 1999. The difference in overnight rates

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across countries seldom reaches 3 bp, and when it reaches this amount it is only on the 23rd

of the month, because of minimum reserves computation period. The share of transactions

with a foreign Euro-zone counterpart has increased from 21% in 1998 to 42% in 2001 in

the unsecured segment (see Cabral et al. 2002). Over the same three years, the share of

domestic transaction has dropped from 68% to 31%, with the rest of the transactions being

explained by a more active role of the rest of the world (which includes UK, Sweden and

Denmark). Thus the European interbank market appears to be fully integrated.

Two main events As we have seen in the previous section, the market for retail banking is still segmented.

Nevertheless, two events have shaped a new framework for European financial markets.

The first one is the creation of a monetary union, which has suppressed currency risk and

has made all Euro-based financial services become highly substitutable products. The

second event is the implementation of the Financial Services Action Plan (FSAP) that has

allowed to adopt a fast-track reform process based on the Lamfalussy 'Wise Men's report'.

The FSAP proposes more than 40 different measures for adoption by 2005 of which many

have already been adopted by the European Parliament and the Council.

The effect of the Euro are widely recognized: the degree of differentiation among Euro-area

financial products has diminished overnight. Competition should therefore increase.

The reasons why FSAP should be considered as a major qualitative change are not so

obvious. In particular, since FSAP procedures uses consultation intensively, capture theory

would suggest that the output would be a set of regulatory measures that would increase the

banking industry market power. This would be a rather naïve perspective.

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In fact, two major characteristics of FASP should be emphasized. First, regulatory reform

under FSAP concerns a full range of regulatory measures. Second it is based on ample

consultation with the market main players. The first implication of this is that the regulatory

process is credible, reinforced even by the deadline of 2005, and, therefore, lobbying by an

individual bank to veto or to delay all new regulatory rules is less effective.

The main implication of consultation is illustrated in the following diagram. When

regulation is designed by domestic regulators, these will tend to weight more financial

stability than competition and efficiency.. As a consequence, the gains some banks would

obtain from more open markets could be silenced in the design of new regulation. This may

explain the failure of the pre-FSAP regulatory process, illustrated by the case of the

Takeover Directive, that did not receive the European Parliament approval after twelve

years of negotiations. Instead, under consultation, banks that would gain from financial

integration have their saying2. The figure ignores some additional important features of

FSAP that will go in the same direction increasing its efficient production of regulation.

Thus, for instance, changes in the regulatory framework have to be approved by several

principals: the Council of Ministers, European Commission, the European Parliament. This

is better done through a preliminary consultation process where the basic guidelines are set

than as a sequential decision to adopt a given legislation.

2 As of now, the analysis of this change in the structure of regulatory design has not been the object of a theoretical model. Still, the model of Pagano and Volpin (2002) could be adapted and this would clarify the difference in the resulting political economy equilibrium between the different stake holders: banks, domestic regulators and borrowers.

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Figure 1

The evolution of margins in Europe

If our theoretical argument is correct, and indeed the pace of financial integration has

accelerated since 1999, recent estimations should show signs of convergence in the margins

as predicted.

Two caveats are in order. First, it could be argued that competitive pressure may be

countered here by the effect of the wave of domestic mergers. Yet this need not be the case.

If the efficient size of banks is large and competition is preserved, higher concentration

would be associated with lower margins. In order to answer this question, Corvoisier and

Gropp(2000) test the two alternative hypothesis and find out that higher concentration is

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associated with higher margins. As a consequence, recent domestic mergers should result in

increased banks margins or at least in a lower tendency to decrease. Notice that they result

is quite consistent with the one obtained by Vennet: both reject the efficiency hypothesis

and accept the market power one

Second, as the theory of banking has emphasized, the banks role, which differentiate them

from financial markets, is to monitor their clients. As a consequence, we expect banks to

create long term relationships with their clients in which case competition is limited by the

existence of switching costs and concerns mainly attracting new clients.

The empirical evidence on the effect of financial integration can be obtained either from the

analysis of banks' margins on loans and deposits or else from the evolution of cost

efficiency. We will develop successively these two complementary perspectives.

To begin with consider the evolution of banks margins. Cabral et al.(2002) study the

evolution of margins over a two years period after the introduction of the Euro and obtain

already some evidence of a decrease in margins, that is evidence of ß-convergence, which

we reproduce in the next table.

They report the evolution of the margins on three interest rates, household lending,

corporate lending and deposits, by computing the difference with respect to the interbank

market rate, with the corresponding sign. Although it is well known that banks set their

interest rates with some delay to changes in interbank interest rates (sticky interest rates),

the average on a two year period, before and after EMU should not be sensitive to this

effect.

Considering these three interest rates, it is clear that deposit rates and corporate lending

rates could be sheltered from competition, as the bank-client relationship is more important

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and the financial service provided is less homogeneous. If so, we will observe more

competition in the household lending segment.

The results of Cabral et al. can be summarized as follows:

• The decrease affects mainly household lending rates. With the exception of Belgium

the rates have decreased in every country. The average decrease is of 1%, and this is

not due to the decrease in Euro rates since in half of the countries the rates have

increased.

• Corporate rates also show the same pattern, but, first, the decrease is smaller, only

30 basic points on average, second, margins increase in four countries and third, the

extreme dispersion of margins from 0.49% to 4.81% indicates that the nature of

corporate risks could be quite different.

• Deposit rates have increased in every country except Greece with an average

increase of 30 basic points.

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Lending retail interest rates and margins (%-points Household lending rates Corporate lending rates

Average (May 98-May 99)

Average (May 01-May 02)

Average (May 98-May 99)

Average (May 01-May 02)

Rate Lending margin

Rate Lending margin

Rate Lending Margin

Rate Lending margin

Austria 6.33 2.35 6.42 1.70 6.11 2.69 6.07 2.21 Belgium 5.36 1.38 6.37 1.65 4.98 1.57 5.64 1.78 Germany 6.25 2.27 6.74 2.03 6.23 2.83 7.05 3.19 Finland 5.24 1.25 5.24 0.53 4.31 0.89 4.71 0.85 France 7.16 3.18 7.23 2.52 4.52 1.12 5.31 1.45 Greece 12.561 6.551 7.65 2.94 16.44 5.61 8.09 4.23 Ireland 7.49 3.43 6.84 2.12 8.68 5.28 8.67 4.81 Italy 6.71 2.67 6.31 1.60 6.13 2.50 5.64 1.77 Luxembourg 5.18 1.19 5.12 0.40 N.A. N.A. N.A. N.A. The Netherlands 5.29 1.31 5.81 1.09 3.67 0.29 4.35 0.49 Portugal 6.36 2.34 6.09 1.38 6.36 2.83 5.51 1.65 Spain 5.85 1.83 5.78 1.06 6.06 2.53 6.20 2.34

Euro area 6.65 2.48 6.30 1.58 6.68 2.56 6.11 2.25 Std. Dev. 2.01 1.48 0.76 0.76 3.50 1.67 1.34 1.34

Source:Cabral et al. 2002

(%-points) Average (May 2001-May 2002) Rate Deposit

margin Rate Deposit

margin

Austria 2.18 1.24 2.17 1.69 Belgium 2.31 1.10 2.37 1.49 Germany 2.46 0.94 2.49 1.37 Finland 1.20 2.21 1.59 2.27 France 2.65 0.75 2.68 1.18 Greece 8.48 2.35 2.06 1.80 Italy 2.26 1.37 1.72 2.14 Luxembourg 2.50 0.91 2.54 1.32 The Netherlands 2.33 1.06 2.32 1.55 Portugal 2.44 1.08 2.45 1.41 Spain 2.08 1.46 2.32 1.54

Euro area 2.81 1.32 2.25 1.61

Std. Dev. 1.92 0.52 0.34 0.34

Source: Cabral et al. 2002

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The analysis of Kleimeier and Sander(2002) also emphasizes the importance of the

introduction of the Euro, although from a different perspective. Since they acknowledge the

impossibility for the law of one price to work in the banking environment, they point out

that integration will imply that changes in interbank rates will be passed through to retail

interest rates. Therefore they test for co- integration of the different rates and find that

although previous regulatory changes, like the Second Directive, had not much effect on

interest rate, there is evidence of a structural break after January 1st, 1999 in corporate

lending rates. The evidence on mortgage rates is more difficult to interpret since they obtain

co-integration in real terms but not in nominal rates.

Our own calculations lead to conclusion similar to the one obtained by Cabral et al. (2002).

Using more recent data tha t covers until February 03, we find the surprising result that

during the last year mortgage margins have increased. Still, the main result remains: except

for the UK, the margins on mortgages have decrease over the last four years in every

country of our sample. On average the decrease is of 63 basic point, but the decrease

appears as a robust result.

Regarding consumer loans to household the decrease is even larger, with an average

decrease of 1.33% a, a decrease that has occurred in each and every country of our sample

with different deepness.

There is no evidence of a decrease in the margins either on short term lending to enterprises

or on deposit rates.

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(%-points) Mortgage Lending

Margin Consumer loans

Margin

Short term CorporateMargin

Time deposits Margin

01/ 95-

12/ 98 01/99-12/02

01/ 95- 12/ 98

01/99-12/02

01/ 95- 12/ 98

01/99-12/02

01/ 95- 12/ 98

01/99-12/02

Austria 2.84 1.80 4.50 3.11 3.26 2.20 0.75 1.32 Belgium 2.21 2.11 4.40 3.25 3.47 3.79 0.88 0.94 Germany 2.47 1.80 7.75 6.63 4.19 4.41 0.73 0.75 Finland 2.09 1.25 3.32 2.42 N.A. N.A. -0.31 0.50 France 3.78 2.49 6.07 4.57 2.13 1.10 0.09 0.15 Greece N.A. N.A. N.A. N.A. 5.94 4.54 1.92 1.07 Ireland 1.48 1.18 N.A. N.A. 4.34 5.12 N.A. N.A. Italy 3.60 2.21 N.A. N.A. 0.03 -0.20 1.14 0.76 The Netherlands 2.67 1.97 N.A. N.A. -0.08 0.42 -0.75 -0.03 Spain 1.80 1.41 5.08 4.14 0.85 0.82 1.23 1.04 Sweden 1.19 0.70 N.A. N.A. 1.65 0.84 2.57 2.49 UK 0.29 0.52 15.37 13.00 N.A. N.A. 1.91 1.78

diagram shows that short term loans to enterprises have become fully synchronized since

January 1st 1999, but differentials appear as quite stable. In fact, apart from the issue of

relationship lending we have mentioned, there is an obvious bias as some countries, like

Italy are financing mainly small and medium firms while others, like the Netherlands, may

be granting loans to larger and safer corporations.

• Regarding the tendency to stable cross-country spreads that the measure of s -

convergence would reflect, we obtain only s -convergence in deposit margins

The evolution of cost efficieny

An alternative way to study convergence is by analyzing cost efficiency. Even if, as we

have stated previously the differences among country persist, higher competition may exert

a pressure towards increased cost-efficiency. The results of Altunbas et al. (2001) and their

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year by year estimation allow us to obtain a crucial piece of information: there has been a

clear trend towards increased efficiency during this period in Europe? The answer is

affirmative. Efficiency has increased, even if it has not increased in all countries. As we

illustrated in Figure 1, the average efficiency level has increased

Of course it is impossible to state whether this is the result of European Integration,

increased competition from US banks or increased competition from mutual funds.

The future of European banking The changing environment of the banking industry is not specific to Europe. The structure

of the banking business is changing and will continue to evolve. Increased competition

from securities markets has lead banks to focus on client relationship, financial services and

fee-based products creating a new framework for banking competition.

Among the different changes in the environment two are particularly meaningful for the

future of the European banking integration: internet banking and Basel II. They will both

Source Altunbas et al. (2001), Table 3, page 1944

0.750

0.760

0.770

0.780

0.790

0.800

0.810

0.820

0.830

1988 1990 1992 1994 1996 1998

X-efficiency score

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have an effect on competition even if their effect might be limited in the short run by the

development of banking in Central and Eastern European Countries.

The reason why internet banking is and will become an increasingly important factor of

banks competitiveness has been repeatedly asserted. Internet creates a different structure of

fixed/variable costs that will increase the optimal size of banks and benefit larger banks. In

spite of the dominant “multi-channel” strategy, the fraction of customers that are able to

access internet is already a key element in delivering financial products in a cost-efficient

way, and will become even more so in the future. Thus, cross-country differences regarding

the average market penetration of internet will become crucial in shaping the future map of

European banking. The scarce data available on internet access indicate a wide gap

between the different European countries. The average penetration in Europe is set at about

5% (15% in the US). Nevertheless, the Scandinavian countries lead with 50% in Finland

and 20% in Sweden, while the southern European countries lag clearly behind.

In 1999 direct cross-border credit accounted for a mere 2.8% of all credits to private non-

banks. Still, the rate of growth of cross-border credit reached 23.5% while it was only 9.2%

for domestic credit. This spectacular rate of growth was obtained in spite of the fact that

any cross-border marketing operation had to satisfy fifteen different sets of rules as the

conduct of business regulation is the responsibility of the host country. If the Distance

Marketing Directive is successful when implemented in 2004, internet selling will lead to a

completely different market structure for the banking industry, possibly with an advantage

not only for cost-efficient countries but also for “internet efficient“ ones.

Basel II will also affect the banks environment. After three iterations, the regulation has

been calibrated in such a way that in the majority of countries the average capital required

should be the same as under Basel I. Still, not only in some countries banks will require

24

additional regulatory capital, but also some banks will be confronted with a shortage of

capital, while others will hold capital in excess. As a consequence, the simple use of

standard corporate finance models allows us to predict a substantial wave of mergers across

Europe. If this occurs once the cross-country acquisition Directive is implemented, it will

be an opportunity for an efficient restructuring of the European banking industry.

25

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