european financial sector

saravnasFile Attachment2000ebe7coverv05b.jpg

Competition and Profitability inEuropean Financial Services

Financial services firms play a key role in the European economy. The efficiencyand profitability of these firms and the competition among them have an impacton allocation of savings, financing of investment, economic growth, the stabilityof the financial system and the transmission of monetary policy.

Competition and Profitability in European Financial Services is a collection ofresearch contributions which includes evaluations of trends in the Europeanfinancial services industry and examines the driving forces of efficiency,competition and profitability of financial firms and institutions in Europe. Thepapers have been written by leading academics and researchers in the field whospecialise in strategic, systematic and policy issues related to the Europeanfinancial services industry.

This edited collection will be essential reading for students and academics andwill also be of interest to financial practitioners and government officialsinterested in acquiring a deeper understanding of this complex issue.

Morten Balling is Professor of Finance at the Aarhus School of Business, Denmark.

Frank Lierman is Chief Economist at Dexia Bank, Belgium.

Andy Mullineux is Professor of Global Finance at the University ofBirmingham, United Kingdom.

1 Private Banking in EuropeLynn Bicker

2 Bank Deregulation andMonetary OrderGeorge Selgin

3 Money in IslamA study in Islamic political economyMasudul Alam Choudhury

4 The Future of EuropeanFinancial CentresKirsten Bindemann

5 Payment Systems in GlobalPerspectiveMaxwell J. Fry, Isaak Kilato,Sandra Roger, KrzysztofSenderowicz, David Sheppard,Francisco Solis and John Trundle

6 What Is Money?John Smithin

7 FinanceA characteristics approachEdited by David Blake

8 Organisational Change andRetail FinanceAn ethnographic perspectiveRichard Harper, Dave Randalland Mark Rouncefield

9 The History of the BundesbankLessons for the European Central BankJakob de Haan

10 The EuroA challenge and opportunity for financial marketsPublished on behalf of Socit Universitaire Europenne de RecherchesFinancires (SUERF)Edited by Michael Artis, Axel Weber and Elizabeth Hennessy

11 Central Banking in EasternEuropeEdited by Nigel Healey and Barry Harrison

12 Money, Credit and PricesStabilityPaul Dalziel

13 Monetary Policy, Capital Flows and Exchange RatesEssays in memory of Maxwell FryEdited by William Allen andDavid Dickinson

Routledge International Studies in Money and Banking

14 Adapting to FinancialGlobalisationPublished on behalf of SocitUniversitaire Europenne deRecherches Financires (SUERF)Edited by Morten Balling,Eduard H. Hochreiter andElizabeth Hennessy

15 Monetary MacroeconomicsA new approachAlvaro Cencini

16 Monetary Stability in EuropeStefan Collignon

17 Technology and FinanceChallenges for financial markets, business strategies and policy makersPublished on behalf of SocitUniversitaire Europenne deRecherches Financires (SUERF)Edited by Morten Balling, Frank Lierman, and AndyMullineux

18 Monetary UnionsTheory, history, public choiceEdited by Forrest H. Capie andGeoffrey E. Wood

19 HRM and Occupational Healthof SafetyCarol Boyd

20 Central Banking SystemsComparedThe ECB, the pre-euroBundesbank and the FederalReserve SystemEmmanuel Apel

21 A History of Monetary UnionsJohn Chown

22 DollarizationLessons from Europe and theAmericasEdited by Louis-Philippe Rochonand Mario Seccareccia

23 Islamic Economics andFinance: A Glossary, 2ndEditionMuhammad Akram Khan

24 Financial Market RiskMeasurement and analysisCornelis A. Los

25 Financial GeographyA bankers viewRisto Laulajainen

26 Money DoctorsThe experience of internationalfinancial advising 18502000Edited by Marc Flandreau

27 Exchange Rate DynamicsA new open economy macroeconomics perspectiveEdited by Jean-Oliver Hairault and Thepthida Sopraseuth

28 Fixing Financial Crises in the21st CenturyEdited by Andrew G. Haldane

29 Monetary Policy andUnemploymentThe US, Euro-area and JapanEdited by Willi Semmler

30 Exchange Rates, Capital Flowsand PolicyEdited by Peter Sinclair, Rebecca Driver and ChristophThoenissen

31 Great Architects of InternationalFinanceThe Bretton Woods eraAnthony M. Endres

32 The Means to ProsperityFiscal policy reconsideredEdited by Per Gunnar Berglundand Matias Vernengo

33 Competition and Profitability in European Financial ServicesStrategic, systemic and policy issuesEdited by Morten Balling, Frank Lierman and Andy Mullineux

Competition and Profitabilityin European Financial ServicesStrategic, systemic and policy issues

Edited by Morten Balling,Frank Lierman and Andy Mullineux

First published 2006 by Routledge2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN

Simultaneously published in the USA and Canadaby Routledge270 Madison Ave, New York, NY 10016

Routledge is an imprint of the Taylor & Francis Group

2006 SUERF

All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers.

British Library Cataloguing in Publication DataA catalogue record for this book is available from the British Library

Library of Congress Cataloging in Publication DataA catalog record for this book has been requested

ISBN 041538494X

This edition published in the Taylor & Francis e-Library, 2006.

To purchase your own copy of this or any of Taylor & Francis or Routledgescollection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.

(Print Edition)

Contents

List of figures ixList of tables xiList of contributors xvAcknowledgements xviiList of abbreviations xix

Introduction 1MORTEN BALLING

1 Strategic and organizational challenges in European banking 8JORDI CANALS

2 Regulatory capital requirements and financial stability 22JAIME CARUANA

3 Markets and institutions: managing the evolving financial risk 35MALCOLM D. KNIGHT

4 Macroeconomic consequences of financial regulation 44JOSEF CHRISTL

5 The changing pattern of payments in the United States 51ANTHONY M. SANTOMERO

6 The EastWest efficiency gap in European banking 63MARKO KOMAK AND PETER ZAJC

7 Foreign acquisitions and industry wealth effects of privatization: evidence from the Polish banking industry 80MARTIN T. BOHL, OLENA HAVRYLCHYK AND DIRK SCHIERECK

8 Electronic payments and ATMs: changing technology and cost efficiency in banking 96SANTIAGO CARB VALVERDE, DAVID B. HUMPHREY AND

RAFAEL LOPEZ DEL PASO

9 Pricing strategies in European banking: specialization,technology and intertemporal smoothing 114SANTIAGO CARB VALVERDE AND FRANCISCO

RODRGUEZ FERNNDEZ

10 The magnitude of distortions when measuring bank efficiency with misspecified input prices 142MICHAEL KOETTER

11 Competition in a highly concentrated banking sector:theoretical, empirical and practical considerations for the Netherlands 183WIM BOONSTRA AND JOHANNES M. GROENEVELD

12 Strategic management in banking, in medio virtus 204JEAN DERMINE

13 European primarily Internet banks: the profitability outlook 222JAVIER DELGADO, IGNACIO HERNANDO AND MARA J. NIETO

14 Bank risks and the business cycle 230LIEVEN BAELE, OLIVIER DE JONGHE AND

RUDI VANDER VENNET

15 House prices and consumer lending 257JOHN P. CALVERLEY

16 Capital markets and financial integration in Europe 281PHILIPP HARTMANN, SIMONE MANGANELLI AND

CYRIL MONNET

Index 307

viii Contents

Figures

1.1 Return on equity 167.1 Cumulative abnormal returns for target and other banks

(201 days event window) 877.2 Cumulative abnormal returns for target and other banks

(41 days event window) 938.1 Predicted unit operating cost by log of asset value:

19922000 in euros 1038.2 Predicted unit operating cost by log of asset value: three separate

years 1992, 1996, 2000 in euros 1038.3 Predicted delivery cost to asset ratio by ATM/branch ratio:

19922000 1048.4 Predicted unit payment costs by year: 19922000 in euros and

predicted unit payment costs by payment volume 1058.5 Approximate check, card and giro average cost in euros 1068.6 Predicted unit operating cost by log of asset value: three

separate years 1992, 1996, 2000 in euros 1079.1 EU Banks income structure as a percentage of total income

(December 2002) 1179.2 Mark-up of loans and deposits in the European banking sectors

(19942001) 13311.1 Hypothesized relationships in the SCP and efficiency hypothesis 18511.2 Sales of mortgages via banks and brokers 19311.3 Structure of the market for mortgage loans 19311.4 Banks customer contacts 19411.5 Customer satisfaction regarding banks 19811.6 Relationship between CR5 and average price of core

banking products 19811.7 Number of relationships with providers of financial services 19912.1 Share price of Lloyds and Barclays (relative to index) 20812.2 Lloyds TSB share price and volume, 19932003 20913.1 Internet banks: size and efficiency 22615.1 Household debt growth vs. house price growth, 19952003 26115.2 UK: house prices/average earnings 262

15.3 US: house price ratios 26716.1 Cross-sectional standard deviation of interest rates on

short-term and medium- and long-term loans to enterprises 28516.2 Cross-sectional standard deviation of interest rates on

consumer and mortgage loans and time deposits 28516.3 Cross-border loans (as a percent of domestic loans) 28616.4 First principal component of euro-area government yield

differentials and the spread between the 10-year fixed interest rate on swaps and US government bond yield 290

16.5 The relative importance of country and industry effects in global asset growth 297

16.6 Monthly ratio of foreign to domestic volume in the five years after cross-listing, median values 298

16.7 Rolling window parameter estimates of the effects of a change in the United States money market rate on the German money market rate 299

x Figures

Tables

1.1 Banks profitability as a percentage of total average assets (net interest margin) 9

1.2 Banks profitability as a percentage of total average assets (pre-tax profits) 10

1.3 Top 20 world banks cost/income ratio 101.4 Top 20 world banks market capitalization 111.5 Market concentration 111.6 Top 20 world banks total assets 126.1 Input and output variables 706.2 Descriptive statistics of dependent variables, inputs and

outputs for cost 716.3 Number of banks across sub-regions 726.4 Selected estimation results for the translog cost function

specification 736.5 Average efficiency scores for the entire sample of banks,

EU-4 countries 746.6 Average efficiency scores and statistics for individual countries 756.7 Time dynamics of banking efficiency in the entire sample and

three sub-regions within the EU for the 19962003 period 767.1 Summary statistics of the Polish banking structure 847.2 Summary of cross-border M&A transactions 857.3 Estimation results on cumulative abnormal returns (41 days

event window) 887.4 CARs for transactions announced before 1998 and after 1998 907.5 Estimation results on cumulative abnormal returns

(201 days event window) 917.6 Summary of the regression results 928.1 Service delivery, payment and operating cost in

Euroland UK (19921999) 989.1 Relative importance of credit institutions, mutual fund

and insurance companies in the EU-15 (1997, 2000, 2002) as a ratio of GDP 116

9.2 Sample composition by country and year 125

9.3a Summary statistics: means of the posited variables over time 1289.3b Summary statistics: means of the posited variables

by country 1299.4 Determinants of the loan to deposits rate spread in the

European banking sectors 1309.5 Determinants of the Lerner index in the European

banking sectors 1329.6 Determinants of the loan to interbank market rate

spread in the European banking sectors 1359B.1 Determinants of the loan to deposits rate spread in the

European banking sectors (excluding Germany) 1379B.2 Determinants of the Lerner index in the European

banking sectors (excluding Germany) 13810.1 Illustration of input price calculation 15110.2 Comparison of alternative input prices 15310.3 Descriptive statistics between 1994 and 2001 15510.4 Mean bank size and input prices per state 15610.5 Input prices across models 15710.6 Cost frontier estimates between 1994 and 2001 16010.7 Mean cost efficiency estimates, 19942001 16210.8 Spearmans for CE relative to model 1.1 16310.9 Mean CE over time 164

10.10 Mean CE across states 16510.11 Cost efficiency differences 16510.12 Alternative profit frontier estimates between 1994 and 2001 16810.13 Alternative profit efficiency estimates, 19942001 17010.14 Mean profit efficiency over time 17110.15 Mean profit efficiency across states 17210.16 Alternative profit efficiency East versus West 17310.17 Alternative profit efficiency of large versus small banks 17310.18 Correlation between CE and alternative PE 17511.1 PR model results in empirical studies 18911.2 Capital of euro area banks owned by foreign residents 19011.3 Ranking major banking institutions and concentration

ratios in the Netherlands 19211.4 Competition: profile of Dutch banks 20012.1 Lloyds TSB strategy, 19832004 20712.2 Lloyds TSB ROE, 19932003 20812.3 Intermediation margin, 19802000 21112.4 International diversification of credit risk,

a simulation exercise 21412.5 Profitability of Barclays, NatWest and Lloyds in 1992 21513.1 Impact (p.p.) of an increase in asset size by 50 per cent 22814.1 Summary statistics 24114.2 Value/return/risk of banks: countries 244

xii Tables

14.3 Value/return/risk of banks: types of banks according to their institutional type 245

14.4 Value/return/risk of European banks: types 24814.5 Bank sensitivity to market and interest rate risk 25015.1 Residential property price gains, 19952003 25915.2 Household debt trends, 19952003 26015.3 Checklist: typical characteristics of a bubble 26515.4 Monetary policy dilemmas with two targets 27016.1 Average yield spread for 10-year government bonds

relative to Germany 28916.2 Average fees by nationality of borrower and currency of

denomination, 19942001 29116.3 Cost scale elasticities for a single instruction in

securities settlement 29316.4 Fund level survey data: European VC industry is

highly captive 29516.5 Robust regression-dependent variable sales growth rate 295

Tables xiii

Contributors

Lieven Baele is a Lecturer in the Faculty of Economics and BusinessAdministration at Tilburg University, The Netherlands.

Morten Balling is a Professor in the Department of Accounting, Finance andLogistics at the Aarhus School of Business, Denmark, a member of theSUERF Council of Management and Chairman of the SUERF EditorialBoard.

Martin T. Bohl is the Chairman of the Department of Finance and CapitalMarket Theory at the Europa University Viadrina in Frankfurt an der Oder,Germany.

Wim Boonstra is Chief Economist at the Rabobank Group, Amsterdam, TheNetherlands, and an Observer on the SUERF Council of Management.

John P. Calverley is Chief Economist and Strategist at the American ExpressBank, London, United Kingdom.

Jordi Canals is the Dean of IESE Business School and Professor of Economicsand General Management in Madrid, Spain.

Santiago Carb Valverde is the Director of the Department of EconomicTheory and History, University of Granada, Spain, and Director of the FinancialAnalysis Department of the Fundacin de las Cajas de Ahorros (FUNCAS).

Jaime Caruana has been the Governor of the Banco de Espaa since 2000 andis also Chairman of the Basel Committee on Banking Supervision.

Josef Christl is the Executive Director of the Oesterreichische Nationalbank,having previously been Chief Economic Advisor to the Austrian Minister ofFinance and Chief Economist of Creditanstalt.

Olivier De Jonghe is a Research Assistant of the Fund for Scientific ResearchFlanders at the University of Ghent, Belgium.

Javier Delgado, Banco de Espaa, Madrid.

Jean Dermine is Professor of Banking and Finance at INSEAD, Fontainebleau,France.

xvi Contributors

Johannes M. Groeneveld is Senior Vice President of Corporate Strategy to theExecutive Board and Deputy Chief Economist at the Rabobank Group,Amsterdam, The Netherlands.

Philipp Hartmann is Head of the Financial Research Division at the EuropeanCentral Bank, Frankfurt am Main, Germany.

Olena Havrylchyk is a member of the Department of Economics at the EuropaUniversity Viadrina in Frankfurt an der Oder, Germany.

Ignacio Hernando, Banco de Espaa, Madrid.

David B. Humphrey is Professor of Finance at the Department of Finance,Florida State University, Tallahassee, USA.

Malcolm D. Knight has been General Manager of the Bank for InternationalSettlements since 1 April 2003. From 1999 to 2003 he was Senior DeputyGovernor of the Bank of Canada.

Michael Koetter is a Postgraduate at the Utrecht School of Economics, TheNetherlands.

Marko Komak is an Assistant Professor at the Faculty of Economics at theUniversity of Ljubljana, Slovenia.

Frank Lierman is Chief Economist at Dexia Bank, Belgium, and a member ofthe SUERF Council of Management.

Rafael Lopez del Paso is Professor in the Department of Economic Theory andHistory, University of Granada, Spain.

Simone Manganelli, Financial Research Division at the European Central Bank,Frankfurt am Main, Germany.

Cyril Monnet, Financial Research Division at the European Central Bank,Frankfurt am Main, Germany.

Andy Mullineux is Professor of Global Finance at the University ofBirmingham, United Kingdom.

Mara J. Nieto is an Advisor at the Banco de Espaa, Madrid.

Francisco Rodrguez Fernndez is the Assistant Director of the Department ofEconomic Theory and History, University of Granada, Spain.

Anthony M. Santomero is the President of the Federal Reserve Bank ofPhiladelphia. Previously he was the Richard K. Mellon Professor of Finance atthe University of Pennsylvanias Wharton School.

Dirk Schiereck is Professor in the Department of Finance at the EuropeanBusiness School, Oestrich-Winkel, Germany.

Rudi Vander Vennet is Professor of Financial Economics at the University ofGhent, Belgium.

Peter Zajc is an Assistant Professor at the Faculty of Economics at the Universityof Ljubljana, Slovenia.

Acknowledgements

The editors would like to gratefully acknowledge the excellent support theyhave received in producing this book from the SUERF Secretariat based atthe Oesterreichische Nationalbank in Vienna, particularly Michael Bailey andBeatrix Krones, and from Gabrielle Kelly, Andy Mullineuxs secretary of theDepartment of Accounting and Finance in the Birmingham Business School atthe University of Birmingham.

Abbreviations

ACH Automated Clearing HouseAIG Accord Implementation GroupANZ Australia and New Zealand Banking Group LimitedARC Accounts Receivable CheckATM Automatic Teller MachineBGC Bankgiro CentraleBIS Bank for International SettlementsBR Bank BranchesCAPM Capital Asset Pricing ModelCARs Cumulative Abnormal ReturnsCDO Collateralised Debt ObligationCE Cost EfficiencyCEE Central and Eastern EuropeCFS Centre for Financial StudiesC&G Cheltenham and GloucesterCGFS Committee on the Global Financial SystemCI ratio CostIncome ratioCPI Consumer Price IndexCSD Central Securities DepositoriesCV Coefficient of VariationDEA Data Envelopment AnalysisDFA Distribution-Free ApproachEAD Exposure at DefaultECB European Central BankECB-CFS ECB-Centre for Financial StudiesECU European Currency UnitEFTPOS Electronic Funds Transfer at Point of SaleEMU European Monetary UnionEP Economic ProfitEPS Earnings Per ShareESCB European System of Central BanksEUR EuroFA Fixed Assets

xx Abbreviations

FDH Free Disposable HullFSAP Financial Sector Assessment Programs/Financial Services

Action PlanGDP Gross Domestic ProductGLS-RE Generalized Least Squares Random EffectsGMM Generalized Method of MomentsHHI HerfindahlHirschman IndexHKMA Hong Kong Market AuthorityHSBC Hong Kong and Shanghai Banking CorporationHVB HypoVereinsbankICT Information and Communications TechnologyIESE Institute for Experimental Software Engineeringi.i.d. Independently Identical DistributionIMF International Monetary FundING ING GroupINTMG Interest MarginsIO Industrial OrganizationIOSCO International Organization of Securities CommissionsIPO Initial Public OfferingIRB Internal Ratings BasedIT Information TechnologyLDC Lesser Developed CountriesLGD Loss Given DefaultLMSPR Loan Market Rate SpreadLTA Loan-to-Asset RatioLTCM Long Term Capital ManagementLTV Loan-to-Value RatiosM&A Mergers and AcquisitionsMADC Mean Average Deviations for CountryMADI Mean Average Deviations for IndustryMEW Mortgage Equity WithdrawalMTS MTS (European Bond Market)NEIO New Empirical Industrial OrganizationOBS Off-Balance Sheet ActivitiesOC Operating CostsOECD Organisation for Economic Co-operation and DevelopmentOFHEO Office of Federal Housing Enterprise OversightOLS Ordinary Least SquaresPD Probability of DefaultPE PriceEarnings ratio/Profit EfficiencyPIN Personal Identification NumberP&L Profit and LossPOP Per PersonPR Panzar and Rosse ModelRAROC Risk-Adjusted Return on Capital

Abbreviations xxi

ROA Return on AssetsROE Return on EquitySBC Swiss Bank CorporationSCP StructureConductPerformanceSD Standard DeviationSFA Stochastic Frontier Analyses/ApproachSMEs Small and Medium-Sized EnterprisesTA Total AssetsTARGET 2 TARGET 2 systemTFA Thick Frontier ApproachTOC Total Operating CostTSB Trustees Savings BankUBS Union Bank of SwitzerlandUSD US DollarsVAT Value Added TaxVC Venture CapitalWIG Warsaw Stock Exchange Share Index

The chapters in this volume are papers that were presented at a Colloquiumorganized in Madrid, Spain 1416 October 2004 by the Societ UniversitaireEuropenne de Recherches Financires (SUERF) in cooperation with IESEBusiness School and in association with Banco de Espaa. The theme of theColloquium was Competition and Profitability in European Financial Services:Strategic, Systemic and Policy Issues. The first four chapters are keynotespeeches that cover strategic and organizational issues, financial stability issues,regulatory capital requirements and macroeconomic perspectives. Chapter 5 isthe 2004 Marjolin Lecture concerning patterns of payments in the United Statescompared with Europe.

The remaining eleven chapters are papers presented in one of the threeCommissions of the Colloquium. They deal with banking efficiency, economiesof scale and scope in financial institutions, privatization of banks, changingtechnology, pricing strategies, competition, the impact of internet banking and theconnection between business cycles, asset price fluctuations, monetary policy andbanking risks.

In Chapter 1, Jordi Canals, IESE Business School, looks at the strategic andorganizational challenges that must be faced by banks in Europe. He considersthe task of European bankers to be very demanding. The implementation ofthe European single market in financial services is still far from being complete.American banks are on average more efficient and profitable. Economicprospects in Europe look gloomy. Banks in Europe are in a transformationprocess, but the process is slow. Financial margins have been declining between1999 and 2003. Banks are diversifying from traditional intermediation andinterest-based transactions to fee-based financial transactions. Universal banksseem to show some advantages over more focused banks but they are complexorganizations from a managerial perspective. According to the author, Europeanbanks have to tackle the challenge of closing the performance gap in relation toUS banks if they want to make sure that they have the control of their own destinyin their hands. They must renew their strategies. Organic growth requires innovation,marketing capabilities and customer service, qualities that many European banksdo not excel at. European banks must also rethink their international strategy andmodernize their organizational design. Control systems and risk management,

Introduction

Morten Balling

conflicts of interest within universal banks and other governance issues must bedealt with.

Chapter 2 is the keynote speech given by Jaime Caruana, Governor of Bancode Espaa and Chairman of the Basel Committee on Banking Supervision.According to the governor, there is broad consensus among economists thatfinancial systems have become more vulnerable to financial instability in recentyears. This is due to the increased sophistication and complexity of businessstructures and of the products offered, the greater degree of internationalizationand a strong increase in competition. In its work on Basel II, the Committee hastaken into consideration the need of a broad approach to foster financial stability.Implementation of appropriate macroeconomic policies is important. So is anappropriate institutional framework including a solid legal structure. The CorePrinciples for Effective Banking Supervision (1997) establishes a sound foundationof supervisory, legal and accounting systems. Commercial banks carry responsi-bility for the development of measures linking the risks they face with the appro-priate level of capital they should maintain. Supervisors should design andimplement incentives-based systems to promote sound and prudent management.Basel II is a major step forward. Traditional banking supervision must becomplemented by a more risk-focused analysis. Risk management must be basedon a strong foundation of corporate governance. Capital and provisioning policiesshould be set with an appropriate time horizon that allows at least a full businesscycle to be considered. Counter-cyclical elements should be introduced. Banksshould be advised to build up capital and provisions during good times in orderto be well prepared to face times of difficulty. Basel II provides an appropriatecomprehensive framework for managing financial stability.

The keynote speech by Malcolm Knight, General Manager of the Bank forInternational Settlements (BIS) is presented in Chapter 3. The author arguesthat the fundamental transformation of the financial industry over the pastthree decades has driven a significant transformation in the nature of financialrisk. The financial industry has gained enormously in richness, depth and variety.Financial activity now represents a much larger share of aggregate economicactivity than it did twenty or thirty years ago. At the same time, financial marketshave become much more tightly interconnected. Consequently, the managementof financial risk has become a more important aspect of economic activity. Thenew financial instruments have enhanced our ability to dissect a complex risk intoits simpler components. Risks can be transferred easily among the marketparticipants. The roles of financial markets and financial institutions havebecome more complementary. The endogenous component of risk has becomemore prominent. Firms should therefore develop techniques that uncovervulnerabilities which emerge from the endogeneity of risk. Supervisory authori-ties should aim at more consistency in their treatment of financial risk acrosssectors. Macroprudential analysis should supplement the more traditionalmicroprudential focus. Authorities should support the application of a commonset of reporting standards focused not only on the profitability of firms but alsoon their risk profiles.

2 Morten Balling

Chapter 4 is the keynote speech by Josef Christl, Executive Director of theOesterreichische Nationalbank. The author looks at financial regulation in thespirit of regulatory skepticism. One cannot assume from the outset that financialstability is something that can be delivered by just switching the right regulatorybuttons. It should be made clear what financial regulation is trying to achieve.The nature of market failures should be clearly understood. Since financial criseshave often been caused by macroeconomic shocks, macroeconomic aspectsshould be given more consideration. Imbalances that may trigger a crisis maybuild up under booming economic conditions. Risks may therefore to a largeextent be endogenous. Regulators should monitor the build up of imbalances.Capital adequacy rules can limit excessive risk taking by banks and act as a bufferagainst insolvency crises. Financial stability reviews published by central bankscan contribute to a coordination of expectations. Correlated bank exposures andcredit interlinkages lie at the heart of systemic risk. Quantitative models of riskassessment should be adapted to the financial system as a whole.

Chapter 5 is the 2004 Marjolin Lecture, given by Anthony M. Santomero,President of the Federal Reserve Bank of Philadelphia. The author describes thedifferences in the origins and evolution of payment structures between the UnitedStates and Europe. Europeans use cash roughly twice as much as do Americans.In Europe, half of all non-cash retail payments are made through a Giro systemand only about 15 per cent by check. In the United States, it is almost exactly thereverse. Payment cards account for the remainder of retail payments. Europeancentral banks encouraged the use of Giro systems. In the early 1970s, the Fedintroduced the Automated Clearing House (ACH), but unlike the European Giro,ACH has not developed into the dominant form of electronic payment. It was thecredit card that proved most instrumental in moving US payments from paper toelectronics. The author expects retail payments in the United States to continuemoving away from paper cheques towards electronic instruments, including creditcards, debit cards, ACH and emerging vehicles such as prepaid cards. TheAmerican Central Bank is committed to working to improve the reliability andefficiency of the current generation of payment vehicles. At the same time, itworks to foster innovation and to support the next generation of payment vehicles.There seems to be an emerging trend for the US and the European Union (EU)payment systems to converge. The United States and Europe will look more alike,although the two continents will get there from very different starting points.

In Chapter 6, Marko Komak and Peter Zajc (University of Ljubljana) estimatethe East/West banking efficiency gap and its dynamics in the 19962003 period.They compare the cost efficiency of banks in the 10 new EU member countriesand 5 old EU member countries. The authors apply a stochastic cost frontierapproach. Data is drawn from the financial statements of individual banksprovided by the FITCH/IBCA BankScope Database. In their model, bank pro-duction depends on labour, funds and physical capital as inputs. Banking servicesprovided are proxied by total loans, other earning assets and total deposits.Results are presented as average efficiency scores for individual countries andgroups of countries that form sub-regions within the EU. It turns out that the

Introduction 3

average efficiency score is the highest for Cyprus and Malta and the lowestfor Central and Eastern Europe (CEE) and the Baltic countries. The dynamic partof the analysis shows that the East/West efficiency gap has been graduallynarrowing.

In Chapter 7, Martin T. Bohl and Olena Havrylchyk (European UniversityViadrina Frankfurt an der Oder) together with Dirk Schiereck (European BusinessSchool, Oestrich-Winkel, Germany) look at the wealth effects of fifty-one Polishbank acquisitions by foreign investors between 1996 and 2002. In 1998, a new acton banking came into force that removed all restrictions for the entry of foreignbanks. The following transformation of the ownership of Polish banks has beendramatic. At the end of 2002, 14 out of 15 banks listed on the Warsaw StockExchange had foreign majority shareholders. The authors apply ThomsonFinancial SDC Mergers and Acquisitions Database for an event study. They findthat the shareholders of target banks experienced positive abnormal returns overthe event window. Also shareholders of non/participating banks experiencedsome positive returns.

In Chapter 8, David B. Humphrey (Florida State University) and SantiagoCarb Valverde and Rafael Lopez del Paso (University of Granada) study theimpact of the increasing use of electronic payments and automatic teller machines(ATMs) on cost efficiency in banking. They demonstrate that the shift to newtechnology has been associated with significant reductions in operating cost as aper cent of bank asset value during the 1990s. The share of non-cash transactionsthat are electronic rose from 1992 to 2000 and the number of bank employees per10,000 inhabitants declined in most of the European countries. They perform anempirical analysis of the operating costs at Spanish savings and commercialbanks over the period 19922000. The new technology has significantlycontributed to a reduction of operating costs in the Spanish banking system.

In Chapter 9, Santiago Carb Valverde and Francisco Rodrguez Fernndez(University of Granada and FUNCAS) analyse the effects of changes in bankspecialization and diversification on pricing strategies and the evolution of bankmargins. They study a sample of 19,322 European banks during 19942001.Financial innovation and changes in financial intermediation activities havealtered the income structure of European banks significantly. Interest marginshave declined while the importance of fees has increased. The authors apply amulti-product framework to study the determinants of bank margins. Theyincorporate the effects of specialization-diversification options beyond lendingand deposit taking. The authors find that both market power and risk parametersalter bank margins when introducing financial innovations. Specialization andbank margins are significantly related. Output diversification permits banks toincrease their revenues and obtain higher market power. Fee income may com-pensate, somehow, lower interest margins that result from stronger competition intraditional markets.

Chapter 10 by Michael Koetter (Utrecht School of Economics) on bankefficiency and mis-specified input prices was awarded the 2004 Marjolin Prizefor the best contribution to the Colloquium by an author below the age of forty.

4 Morten Balling

The author applies stochastic frontier analysis and compares the effects ofalternative input price specifications on the measurement of bank efficiency. Inhis models, banks produce loans, securities and off/balance sheet activities bymeans of borrowed funds, labour and fixed assets. Banks are assumed to minimizecosts when producing a given output bundle conditional on available equity.The empirical analysis is based on data concerning German banks. Numbers areobtained from the FITCH/IBCD BankScope Database. He estimates cost andprofit efficiency with several different model specifications. It is shown thatefficiency estimates are affected by alternative input price specifications. Theinfluence is higher on cost efficiency than on profit efficiency. A certain East-effect is documented. There are significant efficiency differences between banksin East and West Germany but the differences are declining through time.Regional information is, however, still important.

In Chapter 11, Wim Boonstra and Johannes M. Groeneveld (Rabobank) studythe competitive conditions in the highly concentrated Dutch banking sector.Analyses based on the so-called StructureConductPerformance (SCP) paradigmtry to establish a link between market structure, behaviour of banks andprofitability. Concentration is seen as a market situation that makes superior bankperformance possible. In contrast, the efficiency hypothesis postulates thatefficient banks are able to increase their market share due to their higher prof-itability. As a consequence of superior performance, the degree of concentrationincreases. The authors find existing studies on competition and concentration inEuropean banking typically based on concentration figures at the macro levelunsatisfactory. Instead, they look at C5-ratios and HerfindahlHirschman indices(HHI) in individual sub-markets and argue that competition may be more intensethan the macro figures suggest. One should also include the competitive implica-tions of structural developments in the distribution of financial services, entranceof new independent intermediaries and new technology. Due to improved internetaccess, bank customers are increasingly shopping for the best bargains for eachproduct and service. Increasing transparency makes it difficult for banks to cross-subsidize individual products. They conclude that the degree of concentration ina specific banking market is not a reliable proxy for the intensity of competition.The key issue in banking has little to do with too big to fail but with too smallto survive instead.

In Chapter 12, Jean Dermine (INSEAD) argues for a balanced view in thesense that strategic management in banking should define both short-term andlong-term financial goals and ensure an acceptable degree of diversification.Value-based management should achieve the maximization of both short-termand long-term economic profits. The difficulty of finding a delicate balance isillustrated by the Lloyds TSB (Trustees Savings Bank) case. In the years after1983, Lloyds TSB demonstrated brilliant performance. After 1999, a moredifficult environment and an increasing focus on cost cutting contributed to ashare price decline as the market seemed to be questioning the sources of futuregrowth. The companys diversification policy seemed to work well in the early1990s. Nordea AB is also analysed in the chapter as an interesting example of a

Introduction 5

cross-border merger in which the management plan to move to a single corporatestructure as a European Company. At the end of the chapter, the author returnsto the trade-off between short- and long-term corporate objectives and betweenfocus versus diversification. In both respects, the in medio virtus is to be highlyrecommended.

Chapter 13 is a paper by Javier Delgado, Ignacio Hernando and Maria J. Nieto(Banco de Espaa). The authors analyse what they call primarily internet bankscompared to traditional banks. Most banks use a combination of branches and theinternet for delivery of services to their customers. The number of bank cus-tomers using online facilities is increasing worldwide. The authors attempt toidentify and estimate the magnitude of technology based scale and learningeffects of banks that heavily rely on new technology in their business model.Primarily Internet banks show significant technology based scale economiesarising from their ability to control operational expenses more efficiently than thenew traditional banks. Internet banking penetration varies across countries. TheScandinavian countries have the highest levels of Internet banking use. The prof-itability of European Internet banks was negative on average over the period19942002 due to high costs of website development and promotion. The authorsapply data from BankScope. In the empirical analysis they distinguish betweenprimarily Internet banks, small established traditional banks and newly charteredbanks. The profitability of primarily Internet banks is so far significantly lowerthan that of newly chartered traditional banks. Primarily Internet banks show,however, significant scale economies in terms of Return on Assets (ROA) andReturn on Equity (ROE).

In Chapter 14, Rudi Vander Vennet and Olivier De Jonghe (Ghent University)and Lieven Baele (Tilburg University) look at the relationship between businesscycles and bank risks. They investigate how bank health is related to the economicconditions in which they operate. After a review of theories concerning asymmetricinformation, agency costs, changing incentives and monetary policy transmissionchannels, the authors carry out an empirical study based on a sample of 280 listedEuropean banks. Together, the banks in the sample account for more than 80 percent of the total assets in the European banking industry. Accounting data isretrieved from the BankScope database maintained by FITCH/IBCA/Bureau VanDijk. Capital adequacy, degree of diversification, type of institution and othercharacteristics are used to reveal specific strengths or weaknesses of banks whenthey are confronted with an economic slowdown. The authors find that bank returnsand risks differ considerably across countries, that commercial banks and financialconglomerates fare less well in the economic downturn (20002003) than tradi-tional intermediaries such as savings banks. Market-based return and risk measuressupport the conjecture that diversified banks were hit much harder in the economicslowdown than their more specialized peers. The stock market does not viewdiversification as universally better than focused banking. Capital adequacy, on theother hand, clearly has a positive effect on the risk profile of banks.

Chapter 15 is a paper by John P. Calverley (American Express Bank). Theauthor explores the implications of housing bubbles and high household debt for

6 Morten Balling

monetary policy and for bank profitability. It is documented that rapid rises inhouse prices are a widespread phenomenon among the industrial countries.Analysis based on 19742002 data suggests that house prices have becomeunusually high compared with historical levels, in relation to both earnings andrents. Alongside the rise in house prices there has been a rise in household debt.The household debt-income ratio has risen. The rise in household debt burdenssuggests that consumers may be more sensitive to higher interest rates than in thepast. The sensitivity depends, however, on the relative importance of respectivelyfloating rate mortgages (the rule in the United Kingdom) and fixed rate mortgages(the rule in the United States). The author discusses imposition of loan-to-valueratios, property exposure limits on bank lending and counter-cyclical provisioningrules as alternatives to monetary policy. All in all, he expects that handling ofhousing pricing problems will play a major role in monetary policy and the courseof the economy in the years to come.

In Chapter 16, Philipp Hartmann, Simone Manganelli and Cyril Monnet(European Central Bank (ECB)) report on the scope, the findings and initiativesof the ECB-CFS (Centre for Financial Studies) Research Network on CapitalMarkets and Financial Integration in Europe. The Network aims at measuringand monitoring the degree of European integration in each financial market andat stimulating policy-relevant research concerning the current and future structureand integration of the financial system in Europe and its international linkageswith the United States and Japan. High priority topics are bank competition andthe geographical scope of banking, international portfolio choices and assetmarket linkages between Europe, the United States and Japan, European bondmarkets and securities settlement systems. A crucial research theme is the effectsof the implementation of the Financial Services Action Plan from 1999 on thedevelopment and integration of financial markets. Other important topics onthe research agenda of the Network are the enlargement of the EU and the impactthat financial integration and financial system development may have onfinancial stability and economic growth.

Introduction 7

In the early 1990s, European banks seemed to be in big trouble. The creation ofthe European Single Market in 1992, the collapse of the European MonetarySystem, the economic slowdown, the deregulation in financial markets and theemergence of new competitors were factors that created a sense of uncertainty in some cases, even panic among many European banks. However, most bankshave survived, banking restructuring has been implemented in several countriesand most banks are in a stronger position than in the early 1990s.

Many European banks have reinvented themselves by redefining their strategy,designing new organizational forms, launching innovative services and enteringinto new businesses. We have also seen in Europe the emergence of new universalbanks, with a strong diversification strategy away from traditional retail banking,like Deutsche Bank or HSBC, and the creation of stronger regional banks, likeBarclays, BBVA or Santander Group.

Nevertheless, the future of European banking looks uncertain. The implemen-tation of the European single market in financial services is still far from beingcompleted, which means that, in some segments of the financial services industry,national markets are still isolated, fragmented and somehow protected fromexternal competitors.

Although the competitive positioning of many European banks has improvedover the past few years, their comparison with the financial performance of USbanks does not look particularly good. US banks, on average, are more efficientand profitable in using capital than European banks. On top of this, their marketvalue is not only bigger, but also priceearning ratios are higher in US banking.One may argue that because European banks are not very profitable, US bankswill not want to increase their business or acquire banks in Europe. But the rightargument may be the opposite: precisely because many European banksunderperform US banks, there is room for efficiency gains in this industry ifbetter managed and financially stronger banks in this case, US banks take overless efficient ones.

The banking system depends very heavily on the state of the economy. With eco-nomic prospects in Europe so gloomy and no perspectives of acceleration in thegrowth rate, banks may have a hard time in generating revenue growth over the nextfew years. Moreover, Japanese banks seem to be back and we will see in the near

1 Strategic and organizationalchallenges in Europeanbanking

Jordi Canals

future the emergence of banking giants in China. Certainly, scale is not the key factorfor long-term survival in banking, but many European banks may be in the brink ofbeing absorbed, unless they think about consolidation and, more important, changethe way of running the business which today has become somehow obsolete.

Retail banking in several European countries is still organized the old way(Belaisch et al., 2001), with a heavy cost structure, not very intense price compe-tition, slow innovation and poor customer service. In many ways, European bankingdoes have the same competitive shape as some other European industries aboutten years ago. The difference is that the pace of change in banking has beenslower than in other industries. Regulation mixed up with political interferenceand the slow process of implementing the European single market are importantexplanations for the slow transformation of banking in Europe. But many USand a few European banks have been changing very quickly (see Canals, 2003),showing a possible way out. It seems clear that efficiency will drive the worstperformers out of the market.

This paper discusses some strategic and organizational challenges thatEuropean banks are facing today. It is structured as follows: we will offer first anoverview of some features of the European banking industry; next, we willanalyse some major challenges that European banks will face in the next fewyears: closing the performance gap with US banks, fostering strategic renewal,managing organizational complexity and improving corporate governance.

1.1 Banking: the European landscape

1.1.1 Profitability

Table 1.1 offers an overview of the evolution of net interest margins between 1999and 2003 for the United States, Japan and some key European countries.Financial margins have fallen since 1999 in all the countries considered. The USbanking system still outperforms the rest of countries by far. In Europe, onlySpain gets close to the US banking system. France and Germany are left behindand seem unable to offer products innovative enough to maintain the financialmargin.

Strategic and organizational challenges 9

Table 1.1 Banks profitability as a percentage of total average assets (net interest margin %)

1999 2000 2001 2002 2003

United States 3.34 3.22 3.11 3.11 2.99Japan 1.14 1.07 1.01 1.00 0.55UK 2.30 2.21 2.04 1.96 1.82Germany 0.95 0.82 0.90 0.82 0.79France 1.14 0.94 0.65 0.75 0.91Spain 2.62 2.63 2.92 2.72 2.38

Source: Bank for International Settlements.

The profitability measured on average assets has also declined in all countriesexcept in Spain, as shown in Table 1.2. Nevertheless, the US banking systemshows a return on assets far above any other country. Spain and the UnitedKingdom, the next countries after the United States, show a return on assets 40%smaller than US banks. The case of German and Japanese banks is really bad,although Japanese banks seem to be slowly recovering.

The efficiency ratio or costincome ratio (CI) is another way of looking atthe efficiency of the banking industry. Table 1.3 shows the change in this ratiobetween 2003 and 1998 for the top twenty banks in terms of market capitalizationat the end of 2003. US banks are the most efficient ones, with ratios of about 50%or less. The superior performance of US banks has to do not only with their cost

10 Jordi Canals

Table 1.2 Banksprofitability as a percentage of total average assets (pre-tax profits %)

1999 2000 2001 2002 2003

United States 2.17 1.79 1.52 1.71 2.04Japan 0.42 0.37 0.69 0.45 0.07UK 1.43 1.53 1.24 1.08 1.22Germany 0.43 0.55 0.14 0.05 0.20France 0.69 0.83 0.67 0.46 0.58Spain 1.21 1.33 1.20 1.05 1.27


Table 1.3 Top 20 world banks cost/income ratio (%)

1998 2003

1 Citigroup 76.79 52.502 Bank of America 67.36 53.133 HSBC Holdings 54.87 47.934 Wells Fargo & Co. 70.04 60.165 Royal Bank of Scotland 50.65 55.076 UBS 78.43 75.437 JP Morgan Chase & Co. 80.98 68.038 Wachovia 55.78 66.419 Barclays 65.47 58.44

10 Mitsubishi Tokyo Financial Group 102.14 72.4411 Bank One 67.86 60.3112 BNP Paribas 68.14 62.9013 US Bancorp 53.78 44.7714 Banco Santander Central Hispano 69.58 63.1015 Mizuho Financial Group 129.48 64.0216 HBOS 40.40 45.6917 Deutsche Bank 78.10 81.8118 Banco Bilbao Vizcaya Argentaria 62.44 56.7719 Lloyds TSB 46.32 52.2120 Credit Suisse 72.89 70.46

Source: The Banker.

efficiency, but also with their ability to generate higher absolute revenue, strongerthan the ability of European banks.

Market valuation highlights how different US and European banks perform andthe gap in scale that is dividing banks on both sides of the Atlantic. Table 1.4shows the top twenty banks in the world in terms of market capitalization(December 2003), with Citigroup far away from the rest of banks and only oneEuropean bank, HSBC, getting close to the second US bank, Bank of America.


Table 1.4 Top 20 world banks market capitalization(December 2003, $M)

2003

1 Citigroup 243,4732 Bank of America 170,5863 HSBC Holdings 163,6674 Wells Fargo & Co. 98,5705 Royal Bank of Scotland 95,7596 UBS 86,6637 JP Morgan Chase & Co. 77,7168 Wachovia 61,6949 Barclays 57,471

10 Mitsubishi Tokyo Financial Group 57,22511 Bank One 54,88912 BNP Paribas 54,56213 US Bancorp 52,88014 Banco Santander Central Hispano 51,36215 Mizuho Financial Group 50,49616 HBOS 50,35117 Deutsche Bank 46,21718 Banco Bilbao Vizcaya Argentaria 45,58319 Lloyds TSB 45,01320 Credit Suisse 42,194

Source: The Banker.

Table 1.5 Market concentration (%)a

1997 2003

United states 21 24Japan 39 42Germany 17 22France 38 45United Kingdom 47 41Italy 25 27Spain 47 55


Notea Top five banks assets as a percentage of all banks

assets.

Moreover, the potential for market concentration in the United States is stillhigh, which means that the average scale of top banks in the United States canbecome bigger. Table 1.5 shows the market concentration index for seven coun-tries in 1997 and 2003. The increase in the concentration levels is generalized.But Germany, the United States and Italy are the laggards. It is more difficult tosee more European banks buying US banks than US banks entering more aggres-sively into Europe. Both trends further consolidation in the United Statesand the opening up of European banking to the rest of the world are good oppor-tunities for US banks and a threat for European banks.

1.1.2 Growth and diversification

The average scale of banks has substantially increased over the past years in Europeand the United States (see Berger et al., 1999). Table 1.6 shows the top twenty banksin terms of total assets in 2003 and their size in 1999. This increase is remarkable.Banking growth has been driven mainly by mergers and acquisitions (M&As), andthe diversification process of banks away from retail activities to corporate banking,asset management, capital markets transactions and advisory services.

The increasing importance of financial markets in the Western world hasattracted many retail banks to capital markets, setting up new advisory, investmentbanking, trading and research units or acquiring other firms. The anecdotalevidence of this trend is clear. Deustche Bank acquired Bankers Trust; Dresdner

12 Jordi Canals

Table 1.6 Top 20 world banks total assets ($M)

1999 2003

1 Citigroup 716,937 1,264,0322 Crdit Agricole Groupe 441,524 1,105,3783 HSBC Holdings 569,139 1,034,2164 Bank of America Corp 632,574 736,4455 JP Morgan Chase & Co 406,105 770,9126 Mizuho Financial Group 428,804 1,285,4717 Mitsubishi Tokyo Financial Group 678,244 974,9508 Royal Bank of Scotland 146,307 806,2079 Sumitomo Mitsui Financial Group 507,959 950,448

10 BNP Paribas 701,853 988,98211 HBOS 222,795 650,72112 Deutsche Bank 843,761 1,014,84513 Barclays Bank 398,825 791,29214 Wells Fargo & Co 218,102 387,79815 Rabobank Group 282,514 509,35216 Bank One Corp 269,425 326,56317 ING Bank 351,211 684,00418 UBS 613,637 1,120,54319 Wachovia Corporation 67,353 401,03220 ABN AMRO Bank 459,994 667,636

Source: The Banker.

Bank acquired Kleinwort Bentson; Citigroup acquired Schroders; ING acquiredBarings; Crdit Suisse acquired Donaldson Lufkin and Jenrette; UBS and SBCmerged; Chase Manhattan acquired JP Morgan. The evolution of non-interestincome as a percentage of gross income in the European Union (EU) is clear. Inthe 1980s, this ratio was less than 25% in most EU countries; in 2000, it wasabout 40% in the Eurozone countries (Canals, 2003). This ratio is not the onlyindicator of diversification, but shows in a simple way how much banks are goingaway from traditional intermediation and interest-based transactions to fees-basedfinancial transactions. This means that banks are not only changing the nature oftheir activities as financial intermediaries, but also the type of capability theyneed to develop to bolster their competitive advantage.

Moreover, this diversification process of many European banks is not only areaction against low revenue growth in some traditional banking activities, butalso the belief that the universal banking model, with a holding company andseveral business units competing in different segments of the financial servicesindustry, is the pathway to the future.

Universal banks seem to show some advantages over more focused banks (seeSaunders and Walter, 1994; Canals, 1997). The first is the potential to exploitlinkages among the banks business units and, in particular, the advantage ofcross-selling of financial services. The opportunities for cross-selling seem tobe important in retail banking, asset management, investment funds and insur-ance. Nevertheless, the volume of cross-selling does not increase as quickly assome banks would wish, for a variety of reasons. First, a bank may not offer thebest set of financial services and its competitive advantage in cross-selling maybe weak. Second, rivalry in each segment makes competition very tough foruniversal banks, and specialists may be more efficient. Third, the universal banksinternal organization does not always create an efficient coordination between thebusiness units selling different types of financial services from the clients pointof view. Fourth, the distribution system of universal banks has become increasinglyspecialized and segmented; the creation of special branches for high-incomeindividuals or special networks for serving the corporate market reflect this trend.This means that fragmentation of distribution channels may play against theintegration of financial services that cross selling requires.

The second potential advantage for universal banks is the diversification of thesources of earnings and the prevention of the risk of substitution. This riskconsists of the threat of innovation that comes from new financial services oralternative distribution channels. The emergence of new products such as invest-ment funds or new distribution channels, such as Internet banking, makes thisthreat evident. Some banks senior managers also argue that the diversification ofearnings may increase earnings stability. This may be true only in those activitiesin which earnings tend to be stable themselves for example, they come fromrecurrent activities but not in the cases of those activities like capital markets which are not. However, from a strategic point of view, what really reduces therisk of substitution is innovation. In this respect, universal banks do not have infact a clear advantage over specialized banks.


Universal banks may enjoy another advantage: the offer of a one-stop shop bybecoming exclusive providers of a wide range of financial services to individu-als, families and firms. Firms may be edging towards dealing with a smaller numberof banks. However, it is less obvious that a single bank can be superior to othersin providing all of the financial services that companies might require. In Europe,some universal banks with a strong corporate banking presence have a leadingrole in lending. However, it is more difficult for them to compete with US invest-ment banks in advisory functions, mergers or acquisitions. Their problem lies notso much in the size of the market, as in the fact that US banks have an extensiveexperience and developed unique capabilities in deal-making.

However appealing the advantages of universal banks might be, the problemsand challenges that they involve are also relevant. These are extremely complexorganizations from a managerial perspective, with specific coordination andcompensations problems stemming from the fact that they are the umbrella underwhich sometimes very different business units operate. Universal banks alsogenerate conflicts of interests, with different business units investment banking,lending, advisory services, etc. fighting for their sources of revenue.

From a profitability viewpoint, there is no evidence that universal banks diversified financial services firms are more profitable than focused banks. Onthe contrary, profitable banks may be big and small ones, depending also on theindustry conditions in each country and, eventually, on the quality of managementof each bank.

Nevertheless, even if the evidence does not fully support the vision of universalbanks, there is no doubt that they are shaping financial institutions today in theEuropean landscape.

1.2 European banks: main challenges and risks

Taking into account the competitive and financial position of European banks inthe beginning of the 1990s, their evolution over the past ten years has been areasonable success for many of them. Nevertheless, this industry is clouded byinternal challenges and competitive threats. It is difficult to predict which specificpathway its evolution will follow, but it is true that this industry has not gonethrough a strong restructuring process as other European industries, and the roomfor efficiency improvement is still significant.

In this section, we will discuss four major challenges that European banks willhave to tackle over the next few years, because their survival depends very muchon their success in overcoming more intense competition for clients and markets:closing the performance gap with US banks, fostering strategic renewal,managing organization complexity and improving corporate governance.

1.2.1 Closing the performance gap

As seen in the previous section, European banks profitability has declined overthe past few years see Tables 1.1 and 1.2 with some notable exceptions. And US

14 Jordi Canals

banks are, by far, still more profitable than European banks. This generates aperformance gap, an asymmetry between banks on both sides of the Atlantic ashighlighted earlier. European banks have to tackle the challenge of closing this gapas they want to make sure that they have control of their destiny in their hands.

A deeper explanation for financial performance in European banking is thelack of economic growth and the low potential for growth revenue in manyareas of financial services. Slow growth plays into the hands of cost cutting,which becomes the undisputable tool to improve performance in Europe,since European banking has still higher fixed costs and CI ratios. However impor-tant it may be, cost cutting is neither a guarantee of long-term survival andsuccess, nor a signal of revitalizing banks strategies which is what many banksactually need.

Investment in technology has declined over the past three years, but it willcome back in banking and will give those banks that invest smartly in technologya more effective weapon to lower operational costs. Unfortunately, many bankshave turned their back on technology after the bubble burst in 20012002, butthere are many successful examples of how technology can help manage bankingoperations more efficiently.

A direct outcome of the lower banking profitability in Europe is that theEuropean banks market value is smaller than that of US banks. This lowervaluation, in combination with the sheer size of some US banks, transforms theminto potential and powerful bidders in European banking. European banks will notbe in control of their future unless they can reduce this performance gap.

What are the generic options for European banks in order to close this gap?Three generic approaches have been followed. The first is looking for moreefficiency through cost restructuring (Berger and Mester, 1997). The second isdownsizing and assets sell-off of those units, which the current managementcannot run well and that absorb too much capital in an inefficient way. Finally, arestructuring of the portfolio that include both asset disposal and investment innew business.

These generic approaches could be useful in some instances, but do not resolvethe underlying problems of European banks. The reason is simple. The return onassets of any company is the difference between revenue and expenses, over totalassets. The problem with the three approaches described previously is that theymay be good at cutting costs and refocusing banks away from marginal business,but not good enough for the real challenge that banks have to go through in orderto improve long-term performance.

Figure 1.1 shows the arguments. Banks can reduce expenses and improve theirreturn on equity; or sell assets, in order to improve their rate of return on assets.Nevertheless, these are not sustainable policies in the long term, since there is alimit to cutting expenses or how far a bank can proceed with asset disposal.Unless banks make an effort to boost revenue growth in the long term and usecapital more efficiently, it will be impossible to close the performance gap thatseparates US banks from European banks. The growth challenge is the next issueto be discussed.


1.2.2 Strategic renewal

Concern about banks market value has focused the attention of senior managersinside and outside the banking industry. Nevertheless, this approach is essentiallyflawed, since the share price should be the outcome, not the driver, of a goodbusiness strategy. There is a sense of despair about the market value of someEuropean banks, with a significant asset size, in particular, when they comparetheir valuation vis--vis US banks valuations. However, this uneasiness is uselessbecause there is not the same sense of urgency about rethinking bankingstrategies, or considering the deeper, underlying factors that drive market value inthe long term. Rediscovering the meaning of strategy in banking is critical ifbanks want to focus on long-term growth.

And the banking landscape for growth will become more difficult in thefollowing years. Revenues in some traditional business segments are flat. Rivalrywill become more intense, with savings banks and other financial services firmsdifferent from banks offering new, innovative savings products and advisoryservices. Many indicators seem to suggest that customers in banking are notparticularly loyal to their banks and switching costs are more of an unwantedchain around customers than the outcome of excellent bank service. Finally, inEurope economic growth has been disappointing over the past decade and, unfor-tunately, it does not seem that its prospects may change in the near future. In thislandscape, financial services will not grow dramatically unless banks offer someinnovative services.

Strategic renewal in banking includes several dimensions. The first is the con-viction about the importance of generating organic growth as opposed to acquisi-tions. The reason is that acquisitions generate instant growth, but not necessarilysustainable growth. Moreover, acquisitions absorb the focus of top managers fortoo long, at the expense of customer service and product innovation (Houstonet al., 2001). And organic growth requires innovation, marketing capabilities andcustomer service, qualities that many European banks do not excel at. Moreover,they have very rarely been the first priority among senior managers of banks.

The second dimension is commercial execution. Banks are not the bestcustomer-friendly firms. The levels of customer retention are not extremely high inbanking. At a time when all types of companies in a variety of industries including

16 Jordi Canals

ROE = Revenue Expenses

Revenue Expenses

Equity

Assets

AssetsEquity

Figure 1.1 Return on equity (ROE).

retailing or airlines are fighting for customer loyalty in different ways, manybanks seem to be way behind this effort to captivate the minds, hearts and walletsof their customers.

The third dimension for strategy renewal in banking is rethinking internationalstrategy. Banking in Europe, with some exceptions, is still a national industry.Even banks that have a strong presence outside the home country do not have aclear international strategy. Many banks have been opportunistic in internationalstrategy in the sense of capturing good opportunities, rather than thinking whatinternational strategy could make sense for them in the long term. The questionabout which countries a bank should operate in to improve its positioning andguarantee long-term success has been replaced by whether a target could fit intothe banks current portfolio of business. There is nothing wrong in using oppor-tunities well. The wrong approach consists of focusing only on opportunities anddisdaining strategic thinking. Some questions like the countries where a bank cancompete in, which competitive advantages it should have in each country or howto transfer resources or capabilities from the centre to the national subsidiaries arekey questions to be answered by a solid international strategy.

Another key strategic issue for banks is how much diversification they canafford to achieve. In the past few years, the trend towards diversification in bankinghas been inexorable, driven by the slow growth in some traditional areas and theattractiveness of bigger growth potential in others. Nevertheless, there is a limitto what a bank can efficiently accomplish in its diversification process.

The lack of focus in a diversified bank is real and the risk of losing or dilutingits competitive advantage over too many activities if a bank does not have theright managerial capabilities may be too high. Herding behaviour is not onlya driving factor in financial markets, but also in business strategy, and thebanking industry has shown many examples of cloned strategies. The trendtowards diversification in banking has been very strong, but the performance ofsome diversified banks has also been disappointing. And it is far from clear thatdiversified banks are more profitable than focused, specialized banks.

1.2.3 Organizational complexity

Many industries have gone through dramatic changes in their organizationaldesign over the past decades. The automobile industry has adopted the leanmanufacturing system first developed by Toyota, a new revolutionary approach toassembling cars. Retailing has also experienced a dramatic change, with newformats and outlets emerging and old ones decaying. Is the organizational changein banking over the past few years enough to cope with future challenges?

The answer is no. Many European banks are still organized as they were ten ortwenty years ago, while their business has changed dramatically and they havealso been trying to change their strategy. However, a new strategy should besupported by a new organizational design. Otherwise, the new strategy will fail.

There are four basic reasons to foster thinking on how banks have to approachtheir organizational design in the next few years. The first is that there is not yet


an integrated European market for financial services at the retail level. Bankshave to deal with customers who have different needs, show different patterns ofbehaviour and different financial cultures regarding payments systems or specificproducts. And regulation in Europe is still a national affair. The need to have localstrategies for each country is more demanding than in other industries. And, at thesame time, banks need to have an international strategy. Moreover, they have toprofit from international strategies, by developing synergies, sharing someresources, deploying some capabilities and capturing new learning opportunities.Organizing banks around this diversity of dimensions is particularly complex, andfew banks are pleased with what they have in place today.

The second reason is that even those banks with clear international strategieshave an organizational design that does not reflect their international scope.International activities are not integrated in the banks structure and systems in acoherent way. Still, many banks display organizational charts showing the differentbusiness units retail, corporate, advisory services, etc. and the internationaldivision. The latter also reproduces many of the domestic business units.Coordination problems between different areas arise systematically.

The third reason is that banks are diversified organizations with different businessunits. Each unit has different competitive dynamics, requires different professionalprofiles, involves different performance assessment processes and needs differentresources. The return on investment is also different, which creates problems interms of resource allocation, performance assessment and compensation systems.

The fourth reason is outsourcing. The integration of new countries into theworld economy, with a highly educated population and lower salaries, will openup new possibilities for the relocation of certain activities from Europe to LatinAmerica and Asia. This is a trend that manufacturing firms have been trying toshape and adapt to, but is still a recent challenge for European banks. Onlytechnology and back office work have been outsourced over the past few years.Nevertheless, we will see a more intense shift of activities, towards emergingcountries with sophisticated professional skills in the next few years, includingactivities such as financial analysis, research and advisory services.

There are no simple solutions to those challenges. Nevertheless, it is clear thatbanks are today multi-business firms and they need to adopt a corporate strategywhich is consistent with this reality. Business strategy deals with how a firmcompetes in an industry. Corporate strategy deals with how a diversified firmwith several business units creates advantages for each unit, allocates and sharesresources among units, coordinates policies and activities and develops synergies.In a nutshell, corporate strategy must show unequivocally that diversified banksmake sense and have a higher value than the mere sum of their parts.

In general, European banks have been good at developing new business strate-gies, but they have to face the transformation into multi-business firms and developan integrated, coherent corporate strategy. This includes the design of policies thatcould enhance revenues across units by sharing resources, best practices or people,or become more efficient by using joint resources better. And it requires thedefinition of the role of the corporate centre in managing the diversified bank.

18 Jordi Canals

1.2.4 Governance challenges

Change in banks management requires boards of directors that are ready to exerta leadership role in steering banks towards the future and making their long-termsurvival possible. Banks boards face today some of the same challenges asboards in other industries. But banking presents some specific issues that maketheir governance particular.

The first is control systems and risk management. Any company can beafflicted by bad risk management. In the case of banking, this is a particularlyserious threat, since risk is not only at the heart of the long-term survival of banks,but is also a basic pillar of financial stability for a country.

The discussion on risk management highlights the complexity of managing inan industry with a strong regulatory framework that, at the same time, no longerenjoys the protection of regulated prices or limited competition. On the contrary,the strong and cold winds of rivalry are blowing in the banking industry andcreating new threats to established banks. The pressure to generate revenuegrowth may push some banks over the border of prudent lending operations,hence making risk management more complex (see Canals, 2003). In this contextdelineated by clear regulatory rules and stronger rivalry, boards of directors neednew competencies to understand the technical issues about regulation and, at thesame time, to manage innovation in a prudent way, but also need to get ahead ofcompetitors.

The second specific governance issue is conflicts of interest within universalbanks. Some universal banks have an advantage over investment banks becausethey can advise customers on some operations such as mergers, acquisitions,alliances or initial public offerings (IPOs), and lend them money as well. However,there is a conflict of interest for any universal bank: how much risk in lendingmoney to a customer should be taken up with the prospect of a lucrative fee-basedincome from advisory services offered to the same customer. Even if universalbanks may not be covering corporate lending losses through their investmentbanking operations, it is certainly a situation where a conflict of interest may arise.

Banks boards need to be not only prudent but also very transparent about therelationship between advisory services and lending. This means dismantlingone of the strong arguments in support of the cross-selling hypothesis. Otherwise,customers, investors and regulators may view this strategy suspiciously.

The third governance area for banks boards of directors is the relationshipbetween the board and the executive committee. A superficial approach wouldsuggest that this is not a special case in banking, since other companies in otherindustries face the same challenge. Nevertheless, in industries more intensive inknowledge and sophisticated concepts and techniques and banking is one ofthem, particularly in capital markets and risk management operations boardsrun the risk of being overshadowed by executive committees that not only knowmore about the firm and its specific technical issues, but also know how to handlefinancial tools, concepts and valuation techniques really difficult to grasp by non-experts. As banks become more sophisticated financial institutions, developing


more specialized and complex financial instruments and products, boards ofdirectors should have the technical knowledge and competence to be able to usethose concepts properly and provide a contrasting view to the proposals of theexecutive committee. In a nutshell, the board should supervise those operations inan efficient way, but it will not be up to this challenge unless its members do havethe right technical background to exert supervision in a competent way.

A final governance issue is that banks are becoming more international, withoperations in different countries and continents. But it seems that many boards inEuropean banks are still dominated by members from the same country of originas the bank. This observation leads to two implications. The first is that boards ofdirectors should increasingly reflect international diversity if they want to beready to provide a useful supervisory role and help project the bank into thefuture. The second dimension is that regulation in Europe is still a national affair.This explains why banks need to have board members with a deep knowledge offinancial services, but also aware of the specific dimensions of the business andregulation in the different countries where banks operate.

As we pointed out earlier, European banks are more international than ever.Their international strategy may be a sound way to face the challenge of increasedcompetition at home. Nevertheless, it should be supported by an organizationaldesign that takes into account the role of each national subsidiary and thecorporate centre, and how they complement each other by sharing resources andtransferring competencies. And a solid international strategy should be super-vised by a board that understands and can make a good judgement about complexfinancial operations and the specific risk attached to those operations in someparticular countries.

1.3 Some final reflections

European banks today are in much better shape than they were ten years ago.Their transformation has been remarkable, not only adapting to the new realitiesof the European single market, but also transforming themselves into moresophisticated firms, with better management and the aspiration to operate indifferent countries outside the home market.

Nevertheless, European banks face a serious threat: their financial perfor-mance is poorer than US banks performance, their scale is smaller and theEuropean single market for financial services is still plagued with many barriersthat make the goal of pan-European banking a distant objective. This threat getsmore intense because it operates simultaneously with two other important forces:the emergence of new Asian financial giants and the gloomy state of the Europeaneconomy which does not expect spectacular growth over the next few years. Inthis complex context, European banks run the risk of being overtaken by USbanks or becoming less attractive to investors in the financial services industry.It is true that European banking has a few very strong performers, like RoyalBank of Scotland, BBVA, Santander or HSBC. Nevertheless, the laggardsoutnumber them.

20 Jordi Canals

Banks long-term survival in Europe requires that their boards of directorsand top managers tackle, simultaneously, four basic challenges: closing theperformance gap with US banks, developing strategies that foster revenue growth,designing organizations that make sense amid the increasing complexity ofbanking operations in particularly, international operations and, finally, puttingin place boards of directors with the knowledge, wisdom and experience tounderstand the complexities of banking operations and the specific realities ofbanking in the different countries and regions where the banks operate.

None of the previous challenges is specific to the banking industry. But it istrue that banking has become more complex and the combination of increasingfinancial innovation in sophisticated products, geographical diversity and tougherregulatory contexts makes the job of board members and senior managers moredemanding. There are several European banks that are already tackling andapparently, successfully those challenges. Europe needs a strong bankingindustry and it is in the interest of Europe to have solid banks that are able to staveoff the competitive, financial and organizational risks that banking faces inthe twenty-first century.

References

The Banker, London: Financial Times Group.Belaisch, A, Kodres, L., Levy, J. and Ubide, A. (2001). Euro-Area banking at the cross-

roads, Working Paper 01/28, IMF.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, 21,895947.

Berger, A. N., Demsetz, R. S. and Straman, P. E. (1999). The consolidation of thefinancial services industry: causes, consequences and implications for the future,Journal of Banking and Finance, 23, 135194.

Canals, J. (1997). Universal Banking, Oxford: Oxford University Press.Canals, J. (2003). Financial institutions and financial markets: the emergence of a new

class of universal banks, in P. C. Padoan, P. A. Breton and G. Boyd, The StructuralFoundations of International Finance, Cheltenham: Edward Elgar.

Houston, J. F., James, C. M. and Ryngaert, M. D. (2001). Where do merger gains comefrom? Bank mergers from the perspective of insiders and outsiders, Journal ofFinancial Economics, 60, 285331.

Saunders, A. and Walter, I. (1994). Universal Banking in the United States, New York:Oxford University Press.


2.1 Introduction

It is a pleasure for me to be here with you today. The Bank of Spain is also proudto participate in this 25th SUERF Colloquium and to support the IESE BusinessSchool in its organization.

One of the main missions of SUERF is to fhoster an appropriate climate for theanalysis and study of monetary and financial issues. At its twenty-fifth gathering,the SUERF Colloquium will once again contribute to this. The success of thismeeting is largely ensured thanks to the participation of top academics andresearchers from various universities, central banks and other institutions fromaround the world.

A look at the proposed programme shows that the studies to be submittedto the three working Commissions will be of great interest, and the fact thatthese have been pre-selected and reviewed guarantees their high quality. The areason which the Commissions will focus are very important for the banking indus-try. Perhaps more in line with the subject of the third area (macro-policy andfinancial stability), I will be setting out my views on the role that capitalregulation and, more broadly, prudential regulation play in promoting financialstability.

As you all know, The Basel Committee on Banking Supervision publishedthe text of Basel II in June 2004. The text is the result of the Committeeswork over the past six years, during which time it has benefited greatly fromthe support of industry, supervisors, central banks and academics from aroundthe globe.

The driver of this effort has been the well-documented changes in the environmentin which banks, particularly the most sophisticated ones, now operate. Thesechanges have meant that the 1988 Accord is no longer fully satisfactory. Underthe leadership of my predecessor as Chairman of the Committee, BillMcDonough, we initiated a process of change which goes beyond the mere refor-mulation of a rule to maintain a specific level of capital. As a result, together withleading institutions worldwide, supervisors began exploring ways to incorporatemore sensitive measures of risk into the capital framework, the final objectivebeing to promote financial stability.

2 Regulatory capitalrequirements and financialstability

Jaime Caruana

In the presentation of the new capital framework, in June 2004, Jean-ClaudeTrichet, Chairman of the G10 group of central bank governors and President ofthe European Central Bank (ECB), stressed this objective when he underlinedthat Basel II will enhance banks safety and soundness, strengthen the stabilityof the financial system as a whole, and improve the financial sectors ability toserve as a source for sustainable growth for the broader economy.

Questions that naturally arise from this statement are how will Basel II fosterfinancial stability? In what way is Basel II different? My intention today is tooffer you an answer to these questions.

In a nutshell, I think that the new capital framework represents a significantstep towards achieving a more comprehensive and risk sensitive supervisoryapproach.

Basel II is much more than just setting better minimum quantitative capitalrequirements. It is about establishing incentive-based approaches to risk andcapital adequacy management, within a comprehensive framework of threemutually supporting pillars. In my view, the combination of better risk management,a stronger capital structure and improved transparency standards in the bankingsystem can significantly improve financial stability.

From a different perspective, Basel II represents the recognition of the progressmade by banks in recent times to develop and improve their risk management andmeasurement systems. It is also an encouragement to continue this work. Itrepresents an unparalleled opportunity for banks to improve their capital strate-gies and risk management systems. Likewise, it offers supervisors an opportunityto enhance co-operation and implementation consistency, to align supervisionmore closely with sound current industry practices and to foster the dialogue withthe industry.

I would like to develop and organize these ideas around ten points. Throughthem I will summarize some of the elements that are incorporated into Basel II.Thanks to these elements, Basel II will be a more efficient regulation than itspredecessor, the 1988 Accord, and will contribute to bringing about a stronger andmore stable financial system. Nevertheless, I would like to begin my reflectionsby sharing with you a prior consideration, that is the need to think about financialstability in a broad sense.

2.2 Prior consideration, financial stability:a broad concept

In recent years, central banks, supervisors, international agencies and academicsfrom all over the world have paid particular attention to financial stability.Increasingly, policymakers are recognizing that financial stability is a public goodmuch like price stability. All of us have long understood the benefits of pricestability and the need for sound monetary policy in the pursuit of sustainedeconomic growth.

Even if we do not have as comprehensive a framework for financial stability aswe do for price stability, in recent years, we have learned more about the concurrent

Capital requirements and financial stability 23

need for a stable financial system. That includes the need for businesses andconsumers to have access to credit on fair and reasonable terms through all stagesof the business cycle so that they can build and grow. We need an efficient andresilient payments system to maintain the flow of funds through the economyat all times. We need financial markets that remain active, liquid and trustedregardless of events in the economy.

Given the unique positions of banks at the

european financial sector

Documents

financial marketspublished

financial system

financial practitioners

morten balling

policy makerspublished

policy issues

efficiencyand profitability

european central bankjakob