The Future of European Banking

Will EMU be the 'last straw' that breaks the back of the traditional European banking industry? This is the question addressed by a Report published by CEPR entitled The Future of European Banking, the ninth in the influential Monitoring European Integration series. The Report’s authors, Jean-Pierre Danthine, Francesco Giavazzi, Xavier Vives and Ernst-Ludwig von Thadden, ask where the European banking industry is heading and what risks lie ahead.

There seems little doubt that inside EMU the practice of banking and the process of financial intermediation will become more uniform, but at what speed and on which model will they converge? What are the implications for competition within the European market and for the competitiveness of European banks? And how should governments manage regulation and bank supervision? These are some of the key questions addressed in this Report.

Banking in Europe is likely to remain quite different from banking in the US. … and this is not good news.

While the European banking industry will certainly undergo major changes, it is likely to remain quite different from its US counterpart.  Despite the massive consolidation of the financial industry, in the US concentration at the level of local banking markets has, if anything, decreased. In Europe, on the contrary, mergers among commercial banks have so far been mostly within national markets.

It is clear why a European bank's first bids for growth by acquisitions would naturally be made nationally, where mergers are easier in terms of culture and regulation, and they may also bring local market power. But there will be losers from such increases in market power, notably small businesses, which will not be big enough to access the new euro financial markets directly, and consumers, at least until direct banking becomes more widespread.

Because national banking market structures and lending practices differ across Europe, the same change in ECB-set interest rates will affect EU economies differently. This could be a serious hindrance to the operation of a single monetary policy. One reason why transmission mechanisms differ across EMU states is the heterogeneous structure of the European financial industry.

Asset management and investment banking involve economies of scale that are likely to become more important with the introduction of the single currency which will induce two types of mergers: acquisitions aimed at enlarging the stock of assets under management and acquisitions aimed at buying human capital (teams) and technology. The first kind of merger need not be cross-border: domestic acquisitions are good enough to build up volume. But the second type of acquisition will be cross-border, though mostly directed towards US and UK-based investment banks.

Few European banks will make it to the status of universal banks. But those that do will try to exploit the economies of scale across EMU, fighting the battle with US universal banks and specialized investment banks. The outcome is uncertain. European universal banks will be boosted by the advantage of incumbency in most of the areas in which they are active. The difficulty of integrating investment and commercial banking cultures is the strongest point in favour of US specialized institutions – and the biggest challenge for the new European universal banks.

An agenda for policy: With the recent financial crises in Asia and Latin America, the popularity of restrictions on the activity of financial intermediaries is growing. At a time of uncertainty and turbulence, the word 'control' is used increasingly. But a better approach would minimize interference with the market and use market mechanisms to improve regulation. The right word is 'regulation', not 'control'. But it is vital to get regulation right. 

On competition, the days in which banking was off-limits for competition policy are gone and should not return. The tendency towards national consolidation is a challenge for European competition authorities since it is likely to reinforce local monopoly power. The main players will be the national competition authorities: if domestic consolidation of the banking industry beyond a certain degree of concentration is made impossible by local competition authorities or by the European Commission, national banks will learn to go against their natural tendencies and start consolidating internationally. At the same time, the role of European competition policy will remain important, particularly in checking that state-aids do not derail the necessary restructuring of inefficient banks that are regarded as national champions. 

Supervision traditionally focused on the assessment of the quality of a bank's balance sheet at a specific point in time, and on whether it complies with capital requirements and restrictions on portfolio composition. This approach is no longer adequate where banks are active players in the capital market and where trading losses can drive them into insolvency extremely rapidly. In EMU, as banks take on more market risk, their ability to withstand sudden fluctuations in market prices also depends on the readiness of the central bank to provide liquidity to the financial system, and to banks in particular. The ECB is a very different institution from the Fed – more concerned with and more constrained by the risks it may take onto its own books, and thus likely to be less ready to provide liquidity to banks. Ex-ante regulation and supervision are correspondingly more important in EMU than they are in the United States.

European banking supervision should be centralized: There are a number of risks associated with the current decentralized supervisory system for European banking. The advent of cross-border banking, the likely emergence of pan-European universal banks, and, more generally, the new competitive climate of European banking, confront national supervisors with delicate coordination issues. In the face of these challenges, it is unlikely that the simple coordination among independent national authorities – as provided for by the Second Banking Directive – will be a safe arrangement.

Past European experience with national supervision has not always been satisfactory, with domestic supervisors sometimes being too close to the institutions they regulate, thus risking being captured. The natural distance that a supra-national regulator keeps would thus appear to be particularly healthy. But it is ironic that while the international financial community is studying the possibility of setting up a 'world financial regulator', petty national jealousies appear to be preventing this from happening at the European level, putting the stability of European financial markets at risk. 

Building a centralized supervisory body is a possibility already foreseen in the Maastricht Treaty, but it appears only to allow centralization of supervisory responsibilities inside the ECB. While a clear improvement on decentralized supervision, this may not be the optimal arrangement as the ECB is already being perceived as accumulating too much power, and issues of accountability have been raised. An independent European-wide regulatory agency, distinct from the ECB, may generate less concerns in this respect while at the same time facilitating accountability.

As universal banking makes it increasingly difficult to distinguish between market risk and the risk of individual banks, the argument for combining the two functions of bank and market supervision in a supra-national EU independent agency seems overwhelming.

Notes for Editors:

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The Authors:

Jean-Pierre Danthine is Professor of Economics at Université de Lausanne, director of the International Center for Asset Management and Financial Engineering (FAME), Geneva, and a Research Fellow in CEPR's Financial Economics and International Macroeconomics programme. 

Francesco Giavazzi is Professor of Economics at Università Bocconi and a Research Fellow in CEPR’s International Macroeconomics programme. 

Xavier Vives is Professor of Economics at Institut d'Anàlisi Econòmica and a Research Fellow in CEPR’s Financial Economics and Industrialrgilbert@cepr.org Organization programmes.

Ernst-Ludwig von Thadden is Professor of Economics at Université de Lausanne and currently visiting Professor at Stanford University. 

We are also extremely grateful for underlying research support received from Fundación ICO. 

The Instituto de Crédito Oficial (ICO) is the State Financial Agency and also acts as a Specialised Credit Institution. ICO's objectives are to support and promote those economic activities that will contribute to growth and to a more equitable distribution of the nation's wealth and, especially, those which, because of their social, cultural, innovative or ecological significance are particularly worth developing. Within this context the objectives of the Fundación ICO are the promotion and development of research and studies related to economic, scientific, technological, environmental, sociological, cultural and humanitarian fields. The Fundación ICO is particularly interested in the promotion, either directly or indirectly, of studies, research and projects related to the economic field. The Fundación ICO also runs and manages the Museo Colecciones ICO, which holds three different modern art collections: Spanish Sculpture and Drawings, Contemporary Spanish Painting, and an edition of Pablo Picasso's Suite Vollard.