Xavier Vives

Integration of European Banking - The Way Forward:

Corporate Finance

Paolo Fulghieri Colin Mayer

Pedro Pita Barros Erik Berglöf Jordi Gual Xavier Vives

Xavier Vives

Background: Regulatory history

• Creation of single market – Maastricht 1992• Introduction of euro• Financial Services Action Plan (FSAP):

objectives to create broad and deep capital markets through financial integration

• 2000 Lisbon European Council set 2005 as year by which Action Plan should be fully implemented

Xavier Vives

Background: History of economic thought

• "Banking Competition and European Integration", in European Financial Integration, A. Giovanini and C. Mayer, editors, Cambridge University Press, 1991.

• "Regulatory Reform in European Banking", European Economic Review, 1991.

• Monitoring European Integration: The Making of Monetary Union, (joint with D. Begg, P-A. Chiappori, F. Giavazzi, C. Mayer, D. Neven, L. Spaventa, and C. Wyplosz), CEPR, 1991.

• "The Supervisory Function of the European System of Central Banks", Giornale degli Economisti e Annali di Economia, October-December 1992, 51 (9-12), 523-532.

• Monitoring European Integration: The Future of European Banking, (with J-P Danthine, F. Giavazzi and E-L von Thadden), CEPR 1999.

• “Central Banks and Supervision with Application to the EMU” in Challenges for Modern Central Banking, A. Santomero, S. Viotti and A. Vredin (eds), Kluwer Academic Publishers (USA), 2001, 95-113.

• “Restructuring Financial Regulation in the European Monetary Union”, Journal of Financial Services Research, 2001.

Xavier Vives

"Banking Competition and European Integration“ (1991)

• Expectations in Cecchini Report (1988) of convergence to lowest prices in financial services in Europe as a result of SMP of seamless market where law of one price woudl prevail ill founded because banking is imperfectly competitive and not contestable– Switching costs, asymmetric information and

reputation, institutional barriers to entry,…• However, Single Market Programme represents

a credible commitment to the liberalization of the banking and financial sector in Europe

Xavier Vives

Main theses (BC & EI,1991)

• The main effect of integration will be to change the focal point of the strategies of banks from collusion and regulatory capture to competition.

• Nevertheless, competition will be imperfect owing to the presence of important economic barriers to entry, yielding an upper bound for the integration benefits lower than the competitive benchmark.

• The banking market will remain segmented, with different degrees of competition, and the benefits of integration will be unevenly distributed.

• Mergers, acquisitions and cross-participation agreements will tend to soften competition.

Xavier Vives

MEI 1991Giornale degli Economisti (1992)

• Regulatory arrangements in Europe do not guarantee efficient integration of banking and financial markets and the stability of the system

• Supervisory arrangements should be consistent with potential externalities across markets

Xavier Vives

MEI 1999• European Union (EU) financial markets are

fundamentally segmented‘On the supply side – savings behaviour – is the “home

bias” of European households. On the demand side the behaviour of firms – one needs to understand why European corporations stay clear of the bond market and typically borrow from banks’

• There is room for an increase in competition in banking even tough there has been some increase during the 1990s

• Domestic mergers: There are limited benefits for banks to diversification in the EU

• EMU confronts potential increase in risk without a clear strategy in regulation and supervision

Xavier Vives

JFSR (2001)

• The impact of the euro– The most important effect of the single currency will

be the deepening and expansion of financial markets– Market solutions will become more attractive than

intermediated solutions– Reduce segmentation in retail banking but will not

eliminate it (degree of cross border penetration is small because of barriers in retail, differences in preferences and culture between countries, and regulatory restrictions)

– The euro will accelerate the restructuring of the sector

Xavier Vives

JFSR (2001)

• Present financial regulatory arrangements within EMU are not adequate either to preserve stability or to foster financial integration. Reform of financial regulation should concentrate on:

• Establishing clear procedures for crisis lending and management with the European Central Bank at the centre.

• Preparing the ground for more centralised supervisory arrangements in banking, insurance and securities.

• Establishing and consolidating an active domestic and EU wide competition policy which limits local market power and national champions which are too big to fail.

Xavier Vives

Some European highlights• Political obstacles to cross-border banking

mergers: problems of BBVA in Italy with Unicredito, BSCH in

Portugal with Champalimaud, or protectionist attitude of the French authorities in the triangular battle BNP-SG-Paribas.

• Emergence of pan-European stock exchanges has been retarded because of regulatory hurdles and lack of harmonization in supervisory procedures, settlements systems, disclosure and enforcement:– Failure of iX (international exchanges) joint venture of

the London Stock Exchange and Deutsche Börse– Current problems in consolidation

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Eppur si muove

• SCH buys Abbey in the UK• Fazio authorizes bids of ABN Amro for

Antoveneta and BBVA for BNL, resp.• French banks may pay interest on the accounts• Consolidation moves of exchanges continue• May 14 2005: EU (Ecofin) agrees a financial

crisis plan– MoU between central banks, banking supervisors and

finance ministries of the EU in financial crisis situations

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Outline

• Globalization and competition

• Measuring financial integration

• Does ownership matter?

• Cross border mergers

• Key results – Retail– Corporate– Accession countries

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General tendencies From regulation, intervention, and stability

to liberalization and greater instability Information technology and demographic

change Result: increase in competition,

disintermediation (but banking not in decline), market integration (SMP, euro), and financial innovation

Transformation of banking sector: Move from taking deposits and granting loans to

provision of services to investors and firms Consolidation

Xavier Vives

Banking is multiproduct industry

• Different segments have different levels of competition

• Local/geographical dimension for – retail (reputation, branch network as entry barriers

and switching costs) and – SME market (established relationships and

asymmetric information)

• Global for wholesale/investment banking (providing services -underwriting, trading, brokerage, rating, M&A- to multinational corp. & medium-sized firms with international operations)

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Size and concentration

• Size important again: – from investment in bricks to investment in IT,

specialized human capital and financial engineering

– diversification

• Natural oligopoly in global segments (like wholesale/investment banking)?

• Electronic banking does not make banking contestable:– not widespread yet, subject to exogenous and

endogenous switching costs, – more impact on deposits than loans?

Xavier Vives

How much integration?

• Integration is not an end it itself: – key objective is improved access to financial

services, and that may lead to uneven degrees of integration

– Adaptation to local preferences may imply efficient discrimination

• Naive integration goal could lead to unwarranted harmonization

Xavier Vives

Measuring integration• Integration is driven by information technology

improvements and globalization as well as common currency, SMP and FSAP measures. – The impact is different across Member States– Disentangling effects not easy

• How do we assess the extent of integration?– Qualitatively: obstacles to cross-border transactions– Quantitatively

• Prices of financial services across countries• Magnitude of cross-border transactions • Wholesale versus retail cross-border activities and the importance of

domestic competition

• What is the proper benchmark for market integration?– Discriminatory versus non-discriminatory regulation that hampers

cross-border trade (removal of artificial barriers to entry and trade)

– The type of banking services under examination: transactions-based versus relationship-based banking

Xavier Vives

Barriers to Entry• Regulatory

– Restrictions (e.g. limitations on the proportion of overseas securities that pension funds allowed to hold)

– Regulatory hurdles to opening foreign branches and subsidiaries; takeovers

– Discrimination against foreign providers– Non-discriminatory but different

• Non-regulatory barriers relating to patterns of savings and borrowings,

proximity of savers to borrowers, brand loyalty

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Evaluating Integration

• Qualitative studies – legal and institutional obstacles

• Prices – compare prices and co-movements of prices

of similar products in different member states

• Cross-border activity – deposits, loans, branching, takeovers

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Does ownership matter?• Is free trade in financial services any different from free

trade in any other good? What is the impact of foreign ownership on– domestic liquidity:

• Will the foreign (home) supervisory authority take into account the liquidity effects in the host country?

– the financing of domestic economic activity (in relationship banking, particularly lending to SMEs)?

• Proximity matters for long term commitments• And this may explain how difficult is to enter SMEs lending markets

• Foreign ownership may reduce the commitment of domestic banks to domestic borrowers because a distant HQ – may use hard information and rigid protocols instead of soft

information;– may not internalize the welfare of local stakeholders

• Domestic regulator is not blind to national origin because it responds to local constituencies

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Integration and ownership

• Above caveats do not justify in general protectionism in relationship banking since close relationships, may – lead to high cost of finance (“lock-in”)– delay the closure of non-viable firms – lead to collusive arrangements that prevent entry– eliminate healthy competition and innovation from

foreign institutions

• Furthermore, the alternative to foreign bank ownership may be semi-public banks, vulnerable to political influence and a soft budget constraints

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Cross-border mergers in Europe

• What has held them back: information or regulatory barriers?

• Obstacles to cross-border mergers in Europe (which are not present in the US):– more limited economies of international

diversification, – labor market rigidities, – differences in language, regulation, corporate

culture, and – political interference (fostering of national

champions).

Xavier Vives

Cross-border mergers in Europe

• Domestic mergers have predominated to cut costs reducing branching overlap, increase or maintain market power, prevent a hostile takeover or form a financial conglomerate

• Banks from some countries (US) seem to have efficiency advantage when entering foreign markets – If source of US advantage is regulatory/supervisory

conditions instead of deep financial markets then lowering those barriers in Europe will increase cross-border activity

Xavier Vives

Market integration, diversification and risk taking

• Diversification need not produce superior performance and/or greater safety, however – for low risk banks geographical diversification

improves risk-return tradeoff (Italy)– some kinds of cross-border consolidations do

improve risk-return trade-off (US)– low or negative correlation of bank return on equity in

different European countries suggests benefits of cross-border consolidation

Xavier Vives

The time has come for cross border mergers?

• “Cross border mergers may develop in a second phase to acquire local expertise, access high margin deposits or diversify, at the same time that size is gained to compete in the global market segments” (JFSR 1991)

• Intermediate step: Cross border regional mergers– Scandinavian countries and Benelux (late 90s)

• More recently:– SCH takes over Abbey– ABN Amro and BBVA try, respectively, with

Antonveneta and BNL

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Questions• How is it that SCH from inefficient Mediterranean

South takes over Abbey from efficient Anglo-Saxon North?– Because the UK does not have a protectionist attitude– Because Spanish banks have become efficient in an

increasingly competitive domestic market they have been able to expand internationally (e.g. Latin America)

– SCH diversifies portfolio (Brazil concentration) in a stable non-euro country; challenge to integrate IT platforms and derive synergies

• Why major British banks did not bid?– For fear of antitrust intervention (after Lloyds TSB was

not allowed to take over Abbey in 2001)

Xavier Vives

Morale

• Role of national competition authority crucial in blocking anticompetitive domestic mergers

• Hands-off policy of national regulator

• Role of European competition authority to expose and dismantle artificial obstacles to cross border mergers

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MED Banking (2005)Assessment

• A variable level of integration in banking:– High in wholesale banking and in certain areas of corporate finance, – modest in relationship aspects of banking, – low in retail banking, and – patchy and heavily dependent on foreign financial institutions in the

accession countries. • For the most part, integration has been greatest where economic

theory predicts it to be so. • Care therefore needs to be taken not to attempt to correct perceived

low levels of integration through excessive harmonization of regulation in areas in which only modest amounts of integration can be expected.

• However, the report rejects the use of arguments about ownership and relationship banking to justify the retention of artificial barriers to integration.

Xavier Vives

Main results for retail markets

• Retail banking remains regional, since proximity to clients, access to information and long term relationships are key competitive drivers

• Integration remains very modest, but deregulation has had indirect effects: market structures converge, through domestic consolidation and expansion beyond commercial banking (e.g. insurance)

• Cross border bank transactions increase (particularly after the euro); more branches opened abroad but subsidiary form remains important

• Cross-border mergers and de novo entry remain marginal

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Corporate Finance in Banking

• To what extent has there been integration in the corporate finance aspects of banking?

• How does this vary across different areas of corporate finance?

• What explains differences in degrees of integration?

• Is the US dominance in investment banking worrisome?

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Corporate Finance Areas

• Bond markets

• Bank lending to SMEs

• Syndicated bank lending

• Public equity markets

• Private equity

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Theoretical Predictions I

• Information problems more serious in equity than in debt finance as a consequence of the greater information sensitivity of equity finance

• The participation of a large number of investors requires information to be more widely available in public securities than in private capital markets

Expect more integration in:• Finance for large than small firms• Market sources than intermediated finance• Public than private transactions• Debt than equity

Xavier Vives

Theoretical Predictions II

• Should anticipate that in a ranking of financial integration it would be most in evidence in public debt markets, least in private equity markets and somewhere in between in private debt and public equity markets.

• However, what is observed is a high level of cross-border flows in private equity and only modest integration of syndicated bank lending (primarily to large corporations)

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Results• Degree of integration highly variable• Most pronounced in public corporate bond

issuance• Significant integration in public equity

market activity• In both more integration at the large end of

the market• Also significant in private equity• Only modest in syndicated bank lending• Largely absent from bank lending to SMEs

Xavier Vives

Measures of Integration in Corporate Finance

• Size and growth of markets

• Spreads and fees – change in levels over time and cross-country variation

• Nationality of banks - proportion of business organized by domestic, euro area, other Europe and non-Europe banks

Xavier Vives

Corporate Bond Markets:Size and Growth

• European corporate bond market grew by 280% over 5 years 1998 to 2003

• Before 1998 virtually no lower grade bonds

• By 2003, more than 25% BBB or below• In 1998, 85% of issuance associated with

financial institutions• By 2003, industrials had increased share

from 7% to 38%

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Corporate Bond Markets:Fees and Spreads

• Sharp drop in fees charged by bookrunners on underwriting issues in euros since 1994. Larger drop than on dollar denominated underwriting fees

• Regression of spreads on euro area corporate bond issues shows that most explained by bond’s coupon, liquidity, maturity, ratings and sector. Country proxies do not account for much

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Corporate Bonds:Nationality of Issuing Banks

• Substantial growth in presence of US banks – pre-EMU US banks underwrote 3.6% of issues; post-EMU underwrote 25%

• Sharp drop in the proportion of bookrunners coming from same country as issuer, slight increase in proportion from elsewhere in Europe, and large increase from outside Europe (particularly for large issues)

• US banks account for 4 of top ten places in ranking of shares of euromarket issues

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Summary

• The rapidly expanding European corporate bond market has witnessed a high degree of cross-border integration with particularly significant penetration by US banks

• The marked reduction in underwriting fees in the euro area, associated with greater contestability of the investment banking business, suggests that the ability to place issues into large markets is of more significance in gaining competitive advantage than relationships arising from geographical proximity.

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Lending to SMEs: Rates

• Some convergence in lending rates - standard deviation of rates 3.5% in 1998/9 and

1.3% in 2001/2

• Mainly convergence in medium and long-term rates.

• But primarily due to market rates of interest not spreads– Standard deviation of spreads only declined

from 1.7% to 1.3%

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Lending to SMEs:Nationality of Banks

• Do firms employ host or home banks as they expand internationally?

• Home banks are knowledgeable about the firms; host banks of local markets

• Firms that use host banks more likely to use local banks; those that use home banks more likely to use global banks

• But 2/3 of firms choose a bank headquartered in the host nation

• Thus local knowledge of host banks important

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Syndicated Bank Lending

• Fees – some decline in largest transactions since 1995 but increase in average sized transactions

• Nationality – little penetration by overseas banks and decline in smaller transaction

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Summary

• There is a marked distinction between the bond and bank lending market:– a high degree of integration in the European bond

markets as reflected both in terms of pricing behavior and the presence of foreign banks.

– only modest convergence of interest rates, fees and margins in bank lending and little penetration by foreign banks.

• The distinction appears to have more to do with the nature of intermediation than with the size of borrowers:– Syndicated bank lending to large companies shows

markedly less signs of convergence and integration than bond finance.

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Public Equity Markets

• Underwriting fees – fallen from 2.8% in euro area in 1995 to 2.4% in

2000 for top quintile transactions

• Nationality of underwriting banks – continuing domination of domestic banks,

particularly for small firms – penetration by US banks

• increased market share from 10.8% in 1995 to 36.6% in 2001

• Takeovers – particularly strong presence of US banks, occupying e.g.

three of top five positions in first half of 2004

Xavier Vives

TOP FINANCIAL ADVISERS IN EUROPEAN TAKEOVERS

(All completed European targets)

1/1/04-30/6/04

Value ($M) Deals Share

Goldman Sachs 52600.2 25 13.4%

Morgan Stanley 42635.0 29 10.9%

Lazard 37733.4 35 9.6%

JP Morgan Chase 35970.5 49 9.2%

Rothschild 34575.7 72 8.8%

Deutsche Bank 28080.0 38 7.2%

BNP Paribas 22867.8 23 5.8%

Merril Lynch 22263.4 23 5.7%

UBS 20443.6 34 5.2%

Citigroup 20306.0 27 5.2%

HSBC Holdings 18280.6 9 4.7%

ABN Amro 15884.1 28 4.0%

CSFB 13942.5 38 3.6%

Societe Generale 13771.5 21 3.5%

Cazenove 13301.7 7 3.4%

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Summary

• Equity markets have displayed a significant degree of integration, though not on the scale of that observed in bond markets.

• Cross-border activity has been particularly in evidence in large firm transactions with US banks capturing a substantial fraction of the market.

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Private Equity

• Private equity (including LBOs) increased from .08% of GNP in 1995 to .16% in 1999

• The gap between Europe and the US has grown, and particularly for early/development finance

• Rate of growth of venture capital uneven in the EU

• Pension funds main source in US (50%) as against banks in Europe (28%)

Xavier Vives

Xavier Vives

Integration

• European market for venture capital has been integrating at a rapid pace during the 1990s, with a progressive increase in the cross border flows of venture capital finance

• Between fund raising and investing, finance may cross national borders twice: 1. from the country of origin to the country of

management and then 2. from the country of management to the country of

destination. • Cross-border flows in both funds and

management

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Fraction of funds managed by domestic venture capital funds originated from another European country (IMPORT), and fraction of funds managed by domestic venture capital funds employed to finance firms located in another European country (EXPORT).

EXPORT 2001

United Kingdom

Switzerland

Sweden

Spain

Portugal

Norway

Netherlands

Italy

Ireland

Iceland

Greece

Germany

France

Finland

Denmark

Belgium

Austria

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

0.00% 10.00% 20.00% 30.00% 40.00% 50.00%IMPORT

Xavier Vives

EuropeEU

United Kingdom

Germany

FranceNetherlands

Italy

Finland

Belgium

Switzerland

Sweden

Spain

Norway

Denmark

Ireland

Austria

Greece

Portugal

Iceland

0%

50%

100%

150%

200%

250%

300%

350%

400%

0% 20% 40% 60% 80% 100% 120% 140% 160% 180%

Country of management / country of destination

Country o

f destination / c

ountry o

f origin

Ratio of funds of venture capital funds managed domestically with respect to funds invested domestically (horizontal axis), and ratio of funds invested domestically with respect to funds originating domestically (Vertical axis).

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Summary

• While early stage financing in Europe is modest in comparison with that in the US, the European venture capital industry displays a remarkable degree of integration and cross-border activity

• Flows are large both between suppliers of finance and management firms and between the managers and the ultimate users of capital

• Some countries are net exporters of finance and some of fund management; others are importers are one or both of these.

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Conclusions (1)

• Integration greatest in public bond markets• Less in equity markets and still less in bank

lending where information problems more acute • In relation to bond and equity issuance,

integration has been most pronounced at the large end of the market.

• But in bank lending, to date there has been only modest integration of syndicated bank lending to relatively large firms.

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Conclusions (2)• High degree of integration in private equity• Flows reflect institutional separation between sources of

finance and management• Matching of firms with both sources of finance and

managerial expertise is particularly beneficial where there is significant variation in firm characteristics and investors bear high proportion of risks

• Implication: The financing of firms in their early stages of development may require access to particular sources of finance and managerial expertise that may be available at lower cost internationally than domestically

• Cause for concern: limited growth in European private equity markets and their focus on later stage finance and management buy-outs

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Main results for accession countries

• Real integration has outpaced financial integration, which remains uneven and partial

• Most of the progress in banking and Baltic area• Integration has been achieved through

ownership of West European banks• Equity and bond markets remain weak and

illiquid• Access of SMEs to capital markets may be

facilitated by a modern banking sector, but bringing down overall risk levels remains a key policy priority

Xavier Vives

General policy implications (1)• Integration occurring where comparative benefits are

greatest• Failure to achieve integration in certain areas (retail

banking) reflects inherent impediments– Main deficiency in relation to SME may not be failure to integrate

bank lending but to develop capabilities to manage early stage equity finance

• The development of a vibrant SME sector in Europe, and in particular a high tech one, may be more dependent on stimulating the provision of private equity to firms in their early stages of development than the integration of bank lending. – The key bottleneck is limited managerial expertise and not lack

of funds• There is risk of excessive harmonization, particularly in

relation to corporate finance

Xavier Vives

General policy implications (2)

• In investment banking, integration has occurred largely on the back of penetration of European markets by US banks, which have injected a greater degree of competition and efficiency in the new issue process to the benefit of European corporations

• Ownership -and location of headquarters- does matter for relationship banking (as opposed to transaction-based activities to large corporations)– This may present a concern for accession countries

but not for Western Europe and therefore no protectionism should be allowed

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Policy conclusions• New institutional arrangements are required to

implement the FSAP (“Lamfalussy process”). From peer pressure to– greater powers to central organization;– fostering enhanced cooperation of inner club

• Financial integration rests critically on the principles of mutual recognition and home country rule and the avoidance of host country regulation– An European SEC for conduct of business rules and consumer

protection?• Lead regulators should be established to coordinate the

regulation of cross-border activities• Competition policy to play a key role at both domestic

and EU level (particularly for cross border mergers)• Lender of last resort and systemic risk: increased need

for coordination