Until recently, European banking was characterized by heavily regulated national oligopolies. 'Concerted pricing' and collusive agreements maintained the prices of financial services above their competitive levels, so interbank competition focused on non-price factors. Most legal obstacles to freedom of capital movement and to freedom of establishment within the community have now been removed. Market access should be further improved by the 'single banking license', whereby a financial institution authorized to operate in one member country may freely supply banking and financial services elsewhere. Such institutions are subject to home-country regulation in relation to solvency and large exposures, minimum harmonization across countries on prudential supervision and consumer protection, and a host-country regulation in relation to monetary policy issues including deposit insurance.

European financial integration will shift banks' strategies from collusion and regulatory capture to competition. Once regulation is harmonized and restricted to its prudential role, opportunities for regulatory capture will diminish and incentives to break collusive agreements will increase, as sanctions against defecting banks disappear. Nevertheless, competition will not be perfect, since remaining economic barriers to entry will continue to give incumbent banks advantages in terms of cost or product differentiation.

Recent US experience has demonstrated that the danger of destabilizing competition arises from inadequate measures in supervision, prudential and consumer protection, so deregulation should be accompanied by improvements in supervisory standards rather than the imposition of 'revised' restrictions on competition and entry. The implicit insurance provided in Europe by the 'lender of last resort' encourages risk-taking. The present combination of 'home' and 'host' country principles exacerbates the problem, since national authorities may be too liberal in setting standards in order to give their own banks a competitive edge - leaving foreign taxpayers to foot the bill if disaster happens. Despite its emphasis on minimum standards and harmonization, the present system provides national authorities with inappropriate incentives to internalize the costs of their decisions.

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