European Monetary Union and International Capital Markets
Structural Implications and Risks
Author:
Mr. Garry J. Schinasi
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Mr. Alessandro Prati
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Contributor Notes

Author’s E-Mail Address: GSchinasi@imf.org; APrati@imf.org
Publication Date:
01 May 1997
eISBN:
9781451848250
Language:
English
Keywords:
WP; U.S. dollar; treasury bill; institutional investor; interbank market; monetary policy; reserve currency; EMU member country; EU currency
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This paper analyzes the structural implications of EMU for international capital markets. It discusses the potential size of euro capital markets and the existing roles of European currencies in international capital markets. The paper also examines the euro’s impact on international securities markets, including the role of the ECB, the evolution of EMU securities markets, and aspects of systemic risk management. The implications for wholesale and retail banking markets are also discussed, as are the broader implications of the introduction of the euro for changes in international capital flows, international portfolios, and by implication exchange rates.

Abstract

This paper analyzes the structural implications of EMU for international capital markets. It discusses the potential size of euro capital markets and the existing roles of European currencies in international capital markets. The paper also examines the euro’s impact on international securities markets, including the role of the ECB, the evolution of EMU securities markets, and aspects of systemic risk management. The implications for wholesale and retail banking markets are also discussed, as are the broader implications of the introduction of the euro for changes in international capital flows, international portfolios, and by implication exchange rates.

I. Introduction

If the process of European monetary integration remains on schedule, January 1, 1999 will see the beginning of the creation of the union of currencies of economically and financially diverse European countries. Regardless of the precise number of countries that initially join, a European Monetary Union (EMU) of any size will pose challenges, opportunities, and risks for both private and official participants in European and international financial markets. Although the introduction of the euro is a significant step toward European financial integration, it is by itself only one step in a long process. Previous steps have included: in the area of monetary and exchange rate policy, the creation of the European Monetary System (EMS) with the Exchange Rate Mechanism (ERM), and the Basle/Nyborg agreement; and in the area of financial integration, the adoption and still ongoing implementation of the European Union (EU) Second Banking, Capital Adequacy, Investment Services, and other financial directives.

Even with these important initiatives, European financial markets have tended to remain segmented, with banks retaining their strongholds in providing retail banking services, and with markets for debt and equity securities retaining distinctly national orientations. Hence, the achievement of the full potential financial market benefits of EMU is not assured. Much remains to be accomplished by market participants, by national authorities, and at the EU level to capture the efficiency gains of the envisioned single European financial market. Whether the introduction of the euro becomes a catalyst for change and finally creates the “critical mass” necessary to begin the completion of the financial integration process remains to be seen. What is clear, is that the establishment of EMU provides the opportunity to dismantle the barriers between the now segmented European markets for bank deposits and loans, securities, and payments and other financial services, and the opportunity for creating capital markets that rival the size, efficiency, and international importance of the U.S. markets.

The purpose of this paper is to survey the potential structural implications of EMU for European and international capital markets and to identify unresolved issues. Much is still unknown about key decisions and how market participants will react to them, and so the paper is necessarily conjectural. However, it attempts to identify outcomes conditional on the changes in incentives brought about by the introduction of the euro and EMU. Because the paper covers many areas, it might be useful to summarize its main themes and observations.

Regarding financial intermediation, the introduction of the euro is likely to encourage the further securitization of European finance, and it opens up possibilities for increased market integration, greater uniformity in market practices, and more transparency in pricing. How far these processes will evolve depends on the degree of cross-border competition and, perhaps more importantly, on EMU financial policies. Particularly important will be the evolving design and implementation of monetary policy operating procedures and whether they will be used to encourage or discourage the development of deep and liquid euro EMU-wide securities markets.

In European banking systems, although restructuring through consolidation has occurred at the wholesale level, where global competition reigns, there is room for significant further consolidation at the retail level, where competitive pressures have been resisted. The main problem is that Europe is over banked with relatively inefficient local financial intermediaries. The euro is likely to enhance cross-border competition and encourage greater operational efficiency, and thereby provide additional pressures for consolidation. Although there are private mechanisms through which consolidation can occur, important barriers might prevent the necessary adjustments from occurring and create the need for public support of inefficient retail banking systems.

In the international monetary system, the euro is likely to surpass existing EU currencies combined as both a reserve currency and a currency of denomination for international financial transactions. As markets sort out this new currency, there is likely to be a rebalancing of official and private portfolios and shifts in the pattern of international capital flows. This rebalancing is likely to have a noticeable impact in global foreign exchange markets and in the major domestic financial markets worldwide. Changes in private portfolios and capital flows will reflect changing assessments by international institutional investors seeking various risk-return profiles in an unfamiliar tripolar global financial market. Whether this implies a weak or a strong euro will depend on perceptions about the ability of European authorities to achieve fiscal consolidation and structural reforms (including in capital markets and retail banking systems), and the effectiveness and credibility of EMU monetary and exchange rate policies.

The paper is structured as follows. Before analyzing the main issues, Section I of the paper examines the potential size of the domestic euro capital markets and the role of existing European currencies in international capital markets. Section II analyzes the structural implications for European and international securities markets, including the role of the European Central Bank (ECB) and its potential impact on securitization, the possible evolution of EMU markets for repurchase agreements (repo), interbank funds, bonds, equities and derivatives, and two aspects of systemic risk management. Section III looks at the implications for wholesale and retail banking markets. Section IV examines the broader implications of the introduction of the euro for changes in capital flows and international portfolios. Section V summarizes the paper.

II. Potential Size of the Euro Markets

In absolute terms, and compared to any reasonable benchmark, the introduction of the euro has the potential for creating the largest domestic financial market in the world. At end-1995, the market value of bonds, equities, and bank assets issued in EU countries amounted to more than $27 trillion (Table 1), roughly the same order of magnitude as world GDP (94 percent of world GDP). By comparison, the market value of assets in North America—with roughly the same population and GDP as the EU—amounted to about $25 trillion ($23 trillion in the United States). Were the initial union to include only the “core” countries (Austria, Belgium, France, Germany, Luxembourg, the Netherlands), the domestic euro market would equal the size of Japan’s domestic market ($16 trillion); and were the union to include in addition Ireland, Italy, Finland, Portugal, and Spain (EU11), it would roughly equal the size of the U.S. domestic market. An interesting aside is that the value of bonds, equities, and bank assets is roughly three times the respective GDPs in the EU, the United States, and Japan (about 320 percent in the EU and Japan and about 307 percent in the United States).

Table 1.

European Union (EU), Japan, and North America: Selected Indicators on the Size of the Capital Markets, 1995

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Sources: Bank for International Settlements; Bank of England, Quarterly Bulletin (November 1995); Bank of Japan, Economic Statistics Monthly (May 1996); Central Bank of Ireland, Quarterly Bulletin (Winter 1995); International Finance Corporation, Emerging Stock Markets Factbook 1996; Organization for Economic Cooperation and Development, Bank Profitability: Financial Statements of Banks, 1985-1994; and International Monetary Fund, International Financial Statistics and World Economic Outlook databases.

Domestic and international debt securities shown by the nationality of the issuer.

The 1994 data are shown for all banks except for the following: commercial banks plus savings banks for Denmark; commercial banks for Canada (consolidated worldwide), Greece, Luxembourg, and Mexico; domestically licensed banks for Japan (excluding trust accounts); commercial banks plus savings banks plus cooperative banks for Sweden; and commercial banks plus savings banks plus savings and loan associations for the United States.

Sum of the stock market capitalization, debt securities, and bank assets.

Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom.

Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.

Austria, Belgium, Finland, France, Germany, Ireland, Luxembourg, and the Netherlands.

EU private entities overwhelmingly have tended to finance their activities through bank loans rather than through bond and equity financing, and U.S. entities have relied more heavily on bond and equity financing. In the EU11, bank loans comprised 57 percent of all outstanding financial assets at end-1995. By contrast, U.S. bank loans accounted for only 22 percent of total assets outstanding.

In contrast to government securities markets, European private debt securities markets are segmented, with all but the largest firms borrowing solely from a domestic investor base. In the EU11, for each dollar of bank borrowing, private firms borrowed, on average, only 50 cents through private securities issues. By contrast, in the United States, for each dollar of borrowing from banks, U.S firms borrowed slightly more than two dollars through debt securities issues. Japanese private entities were much closer to their EU, than to their U.S., counterparts.

Although the amount of EU private bonds outstanding appears to be sizable enough to suggest a reasonably large market for corporate bonds (roughly three-fourths the size of the U.S. market), the bulk of these bonds were issued by European financial institutions. Looking at this from the side of corporate balance sheets, as of end-1994, bonds accounted for a relatively small share of the total liabilities of nonfinancial firms in France (5.7 percent) and in Germany (less than one percent); by contrast, they accounted for 18.8 percent of the total liabilities of U.S. nonfinancial firms.1 The low share of debt financing by European companies extends to the short end of the maturity spectrum as well, because European companies tend to rely on bank financing for short-term funds. U.S. corporate entities tend to rely more heavily on short-term financing because of their access to the very liquid and highly developed commercial paper market, which accounts for more than half of the world’s outstanding commercial paper. These observations about the use of debt securities underscore the greater historical reliance by firms in the United States on direct intermediation through the corporate debt securities markets, and the heavy reliance in Europe on bank financing, and the relatively undeveloped European corporate securities markets (with the exception of U.K. markets).

Another way of assessing the potential importance of the euro from a purely quantitative perspective is to examine the use of existing European currencies as currencies of denomination in international financial transactions. In international bond markets, 35 percent of the outstanding stock of international debt securities were denominated in EU currencies at end-September 1996 (Table 2). Although this is a substantial share of international issues outstanding, and is a close second to the amount of dollar international issues outstanding, EU countries themselves issued more than 45 percent of all international bonds outstanding. In addition, in the five year period ending in December 1995, only a minor share of developing country debt was issued internationally in EU currencies.

Table 2.

Amounts Outstanding of International Debt Securities by Currency and Country of Nationality, September 1996 1/

(In billions of U.S. dollars)

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Source: Bank for International Settlements, International Banking and Financial Market Developments (Basle: Bank for International Settlements, November 1996).

Euronotes and international bonds.

Currencies of Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom; plus ECU.

Currencies of Australia, Canada, Hong Kong, New Zealand, Norway, and Switzerland; plus other currencies.

Still another way to gauge the potential role of the euro is to examine daily turnover in the global foreign exchange markets. According to the most recent Bank for International Settlements (BIS) survey, as of April 1995 the dollar was involved in at least one side of a transaction about 42 percent of the time, the deutsche mark 18.5 percent, the yen 12 percent, and the pound sterling 5 percent. EMS currencies combined were involved in at least one side of a transaction about 35 percent of the time, including European cross-currency trading (Table 3). In related derivative markets, the dollar, EU currencies, and the yen, accounted for shares of trading that are roughly equivalent to the relative sizes of their economies (in terms of GDP), but most of this activity actually involved U.S. and U.K. financial institutions. Transactions involving currency swaps were clearly tilted toward the dollar, reflecting its now dominant position in international finance and as a reserve currency (Table 4).

Table 3.

Use of Selected Currencies on One Side of the Transaction, April 1989, April 1992, and April 1995 1/

(As percentage of global gross foreign exchange market turnover)

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Source: Bank for International Settlements, Central Bank Survey of Foreign Exchange and Derivatives Market Activity 1995 (Basle: Bank for International Settlements, May 1996).

Number of reporting countries are 21 in 1989 and 26 in 1992 and 1995. Data for 1989 and data for Finland in 1992 include options and futures. Data for 1989 cover local currency trading only, except for the U.S. dollar, deutsche mark, Japanese yen, pound sterling, Swiss franc, and ECU. The figures relate to gross turnover because comparable data on a “net-gross” or “net-net” basis are not available for 1989.

Data for April 1989 exclude domestic trading involving the deutsche mark in Germany.

Table 4.

Notional Principal Value of Outstanding and New Interest Rate and Currency Swaps, 1995

(In billions of U.S. dollars)

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Source: Bank for International Settlements, International Banking and Financial Market Developments (Basle: Bank for International Settlements, November 1996).

Includes the currencies of Belgium, Denmark, France, Germany, Italy, the Netherlands, Spain, Sweden, and the United Kingdom; plus ECU.

Not adjusted for reporting on both sides.

In summary, although the EU currencies command a significant share of activity in international financial markets, they do not now command shares in line with either the size of the EU economy or the relative size of their domestic financial markets.

III. Structural Implications for European and International Capital Markets

A. Incentives for Further Market Integration and Development

Driven by financial deregulation, changing opportunities for investment, and bank disintermediation, European securities markets have become more highly integrated and liquid. These changes have been associated with the placement of large sovereign debt issues, which provided strong incentives to develop liquid and efficient secondary bond markets, and the accumulation of large stocks of public debt, which raised yields on government securities thereby making them an attractive alternative to bank deposits. Facilitated by the recent convergence of macroeconomic policies, greater capital mobility has contributed to market integration by linking national securities markets, reducing bond spreads, and increasing co-movements in bond and equity returns across EU countries.2

Against the background of these ongoing structural changes, the introduction of the euro will alter incentives in such a way so as to encourage the further securitization3 of European finance, greater uniformity in market practices, more transparency of pricing, and increased market integration.4 First, by eliminating currencies, the introduction of the euro reduces the direct cost of spot transactions and eliminates a relatively volatile element of market risk—foreign exchange risk—in longer dated real and financial contracts between entities in EMU member countries. While foreign exchange risk between some ERM currencies may have diminished recently (as measured by implied volatilities, for example), the costs incurred by market participants—including central banks—during the violent disruptions in the ERM crisis in 1992-93 will long be remembered as will the frequent realignments, often preceded by speculative attacks, in the early years of the EMS and in the less formal exchange rate arrangements before the EMS.

Second, the elimination of currency risk increases the relative importance of other elements of risk, including credit, liquidity, settlement, legal, and event risks. Credit risk is likely to be the most important component of securities pricing within EMU, with the implication that the “relative value” of underlying credits will drive securities prices rather than judgements about the stability and volatility of currency values.

Increased attention will be paid to other elements of risk. Bond issues of two otherwise identical credit risks—say a German and a French company producing the same goods and having similar balance sheets—may be priced differently if issuing techniques, clearing and settlement procedures, and legal procedures are different in the respective countries. The impact of these remaining and less volatile components of risk on the cost of raising funds will provide incentives to suppliers of securities to narrow further their interest rate spreads by increasing transparency and by improving issuing techniques and financial infrastructures in order to attract investors. This competitive process, if allowed to run its course, could lead to the harmonization of market practices within the euro zone far enough to eliminate the existing advantages a particular geographical market may now have. In this way, the elimination of currency risk could lead to greater uniformity and transparency of market practices, with the benefits of more uniform pricing and a breakdown of market segments within Europe.

The elimination of currency risk, the convergence of credit spreads, and more uniformity in market practices together can be expected to increase the depth and liquidity of European securities markets. In short-term markets (money, swap, and short-term Treasury bill markets, for example), contracts denominated in individual currencies will be denominated in euro and could be traded across national markets, even if small credit spreads remain. For securities with multiple exchange listings, competition among exchanges could lead to a consolidation of trading in a single location. Even in markets that remain somewhat segmented (because of higher credit spreads or restrictions), lower transaction costs (elimination of commissions on foreign exchange transactions and costs of hedging exchange rate risk) and the elimination of trading restrictions (for example on institutional investors) will add liquidity. Moreover, competition among issuers—no longer based on the strength of the currency—will encourage sovereigns to introduce market reforms.

Third, the euro will reduce directly the number of existing barriers to cross-border investment and eliminate some restrictions on currency exposures of various pools of capital (pension funds, insurance companies, other asset managers). To begin with, all intra-EMU foreign exchange restrictions on the investments of pension funds will become irrelevant within the EMU area. The EU matching rule (liabilities in a foreign currency must be 80 percent matched by assets in that same currency) for insurance companies—which has been extended to pension funds in some countries—will also no longer be binding within EMU, as insurance companies will be able to invest their assets in any country of the euro area, as long as their liabilities are denominated in euros. The size and country diversification of assets managed by institutional investors in the EU, say mutual funds—still far smaller than in the United States—could rapidly increase together with their share of foreign investments (Table 5). Finally, the “anchoring” principle, restricting lead managers of issues to full subsidiaries domiciled in the issuing country, will become irrelevant and will thereby increase the potential for intra-EMU market penetration.

Table 5.

Mutual Funds, June 1996

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Source: Investment Company Institute.

Does not include Ireland and the Netherlands for the equity and bond funds.

Does not include Austria, Denmark, Ireland, and the Netherlands for the money market funds.

The equity funds also include balanced funds and “other” funds.

Fourth, the possibilities for portfolio diversification will change. The advantages of currency diversification will be lost to the extent that business cycles have been asynchronous and shocks asymmetric. This will encourage investors and financial institutions to search for, and find, new opportunities for portfolio diversification within EMU repo, government securities, and corporate securities markets, but it may also encourage them to seek diversification outside the euro area as well.

European securities markets will also be shaped by other important factors. Technological progress will soon make fully integrated EU-wide securities and derivative markets unavoidable, by making the location of trading, clearing, and settlement largely irrelevant. Continued fiscal consolidation and privatization—as part of the Stability and Growth Pact—is likely to reduce the volume of new government bond issues, providing room for private entities to issue new equity shares and debt securities. Finally, as the role of the unfunded social security system diminishes, the role of institutional investors, like insurance companies and private pension funds, will increase the demand for public and private paper of various maturities and types, perhaps including corporate bonds.

Overall, the introduction of the euro could become an important catalyst in the development of securities markets because it may enhance the impact of EU financial directives, increase transparency in credit evaluation, accelerate the processes of financial market integration, and further expand Europe’s institutional investor base.

B. EMU-Wide Repo and Interbank Markets

Monetary policy operating procedures and securitization

Whether or not these incentives lead to the development of deep and liquid short-term securities markets will depend, in part, on demand and supply factors and the extent of cross-border competition between financial intermediaries, both within and outside EMU. Also important are the financial policy choices by EMU member countries, as there are remaining legislative, regulatory, and tax impediments to cross-border investment and, therefore, to the development of EMU-wide markets. Potentially greater in importance are the institutional arrangements for the implementation of monetary policy, and more generally financial policy.

Historically, the nature and development of private money markets has had an important bearing on the development of domestic securities markets.5 In the highly liquid and securitized markets in the United States, for example, the central bank traditionally has played an active role in the markets by intervening daily. The objectives of this active participation are to smooth out fluctuations in liquidity during the day and to provide stability to the pattern of interest rates on overnight funds. Financial institutions have come to expect this active participation, and the structure of financial activities and balance sheets reflects this mode of central bank operations. This active participation has fostered the development of efficient money and securities markets in the United States.6

The European models for conducting monetary and financial policies, and in particular the German model, rely extensively on minimum reserve requirements, reserve averaging, and infrequent (bi-weekly) market interventions to smooth liquidity in the banking system and to provide stability to the pattern of interest rates. The reliance on reserve requirements, the preference for infrequent market interventions, and the “narrow” concept7 of central banking adopted by some European central banks has tended to discourage the development of private securities markets and to foster the predominance of bank-intermediated finance.

At this point in the process of establishing the institutional structure of the European System of Central Banks (ESCB), it is uncertain which paradigm will prevail over the next few years. According to Article 105 (1) of the Maastricht Treaty, “the primary objective of the ESCB shall be to maintain price stability,” and the Treaty does not explicitly envisage an active role for the ECB in ensuring the smooth functioning of the financial system.8 Although final decisions have not been made, the current plan for monetary policy operating procedures is to rely on a system of minimum reserve requirements, with reserve averaging, and to have infrequent (bi-weekly) and decentralized repo operations, and decentralized fine-tuning operations. The national central banks (NCBs) will collect repo bids from local markets, send them to a central computer in Frankfurt, and allocate the repo transactions according to instructions from the ECB once all the bids are collected and the market price determined.9 Although the ECB has the authority to intervene more frequently and to issue its own paper, it remains to be seen how it will adapt to market pressure that will require more frequent interventions.

Two related policy uncertainties—involving the Target payments system and supervisory and lender-of-last-resort functions—will be discussed in subsection F following the discussion of the potential impact of the euro on European repo, money, bond, equity, and derivative markets, to which the paper now turns.

Repurchase agreements and money markets

The decision that the ECB will use repurchase agreements as the main instrument for implementing monetary policy could prove to be a strong, and decisive, incentive for the development of an EMU-wide market for repurchase agreements (repo market). Although private repo markets currently exist in some countries, except for a few exceptions they are not highly developed and lack the liquidity and depth of the repo markets in the United States.

In the United States, repo markets are an important alternative money market instrument. By providing ready access to secured borrowing, and by enhancing liquidity in the securities markets, repos facilitate portfolio financing and the ability to short the market. Banks also can use repurchase agreements for extending credits to securities dealers collateralized by a zero-risk-weighted central government bond. In Europe, only France has a transparent and liquid repo market, with 20 primary dealers being required to post prices on Reuters. The United Kingdom recently introduced a gilt repo market, while other countries, notably Germany, have discouraged them by subjecting repo transactions with nonbanks to reserve requirements, with the result that a large share of the German repo business migrated to London. In Italy, legal, taxation, and settlement obstacles have prevented the development of a liquid repo market.

An open question is whether the different market structures characterizing the interbank markets in each member country will survive or whether market pressures—acting through price differentials—will lead to a single EMU-wide interbank market. Integration has already increased somewhat, with growing shares of foreign interbank deposits and smaller discrepancies between interest rates on euro and domestic markets (Table 6). On short maturity transactions, especially shorter than one month, interest-rate arbitrage is still imperfect, in part because of differences in taxation and regulation. With the euro, the elimination of European cross-currency risk, the establishment of ECB repo operations, and the provision of intraday liquidity for settlement purposes, there would be few, if any, impediments preventing first-, second-, and third-tier European banks from dealing directly with each other for supplying or accessing overnight funds. This overnight borrowing and lending could quickly lead to the creation of an efficient EMU-wide interbank market with total volumes at least equal to the sum of those of current domestic interbank markets. In this scenario, domestic interbank rates would be harmonized across EMU with residual differences reflecting only different credit standings of second or third tier banks.

Table 6.

European Union: Cross-Border Interbank Assets, 1992-96

(In percent of GDP)

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Sources: Bank for International Settlements; and International Monetary Fund, World Economic Outlook.

It is a possible next step, although by no means certain, for a private repo market to develop in all EMU countries, in which a private yield curve will offer instruments ranging in maturity from overnight to long-term contracts. In such a market, financial and nonfinancial entities alike can engage in short-term collateralized refinancing operations for conducting day-to-day treasury operations in supporting their real economic activities. Many European multinationals now conduct such refinancing in New York, London, Tokyo, and other international financial centers.

With the development of an EMU repo market, collateralized borrowing and lending will enable financial institutions to refinance their operations at interest rates below those in the interbank market. The development of this European-wide market could help set the tone for the development of other capital markets in Europe. It would also open up opportunities for large global financial institutions to participate more fully and actively in short-term EMU markets for liquidity management, in much the same way they participate in the markets in New York and London. The benefits for European capital markets from the participation of these large global players would be significant in terms of adding depth, liquidity, and efficiency to European capital markets.

Possible remaining impediments to the establishment of EMU-wide repo markets would be reserve requirements on repo operations—remunerated at below market interest—other longstanding legal and settlement obstacles, and elements of tax systems. In addition, interest rates in the repo market might not become fully uniform across Europe if different margins (“haircuts”) are applied to Tier 1 and Tier 2 collateral for repurchase transactions with the ECB. Alternatively, if the ECB does not discriminate between the quality of collateral, the distinction between issuers at the short-end of the curve may become blurred and lead to a “race to the bottom” in quality in providing collateral.

C. EMU Bond Markets: New Focus on Credit Risk

Government bond market

By eliminating currency risk on European cross-country transactions, and by directly reducing transactions costs, the introduction of the euro reduces the cost of issuing and investing in government securities. The increased transparency of costs and benefits is likely to influence both demand and supply and to provide strong incentives for the harmonization of market practices—auctioning techniques, issue calendars, maturity spectrum—toward the most transparent and cost-effective practices for both issuers and investors. As investors and issuers become familiar with these transactions, it is reasonable to expect market segmentation to diminish, as investors search throughout EMU sovereign markets for their preferred risk-return profiles among the sovereign issuers in the union. For this reason, EMU member governments can no longer take for granted their “home-currency” market, and will try to appeal to a broader investor base. Whether or not this harmonization of market practices and market desegmentation occurs in full, market participants who in the past focused on the relatively volatile currency risk will now focus attention on the other less volatile risks, including credit (sovereign), liquidity, settlement, legal, and event risks.

The refocus on credit risk by both issuers and investors is likely to increase cross-border competition between financial intermediaries for bringing new issues to market, for “rating” new credits, and for allocating investment funds across the national markets. Competition is likely to involve non-European as well as European financial institutions and asset managers. Financial intermediaries from the United States—where both investment houses and institutional investors have respectively specialized on the issuer and investor sides of these markets for decades—would appear to have a comparative and competitive advantage in supplying many of these services against all but the largest European financial intermediaries. Thus, the establishment of EMU is likely to contribute to the restructuring of the global business of investment banking and universal banking.

How far market desegmentation will go, and how liquid the European sovereign debt market becomes will depend on how credit risks are priced. Several potential EMU member countries enjoy top ratings on debt denominated in domestic currencies and lower ratings on debt denominated in foreign currency (Table 7). There are several reasons for these differences. First, foreign currency debt cannot be repaid by printing domestic money and it has, therefore, higher default probabilities associated with it. Second, debt issued in domestic currency is mostly locally held so that governments, for political reasons, are more likely to continue to service domestic debt. Third, governments may find it easier to raise taxes or cut expenditures to repay domestic debt than to repay foreign investors. If these considerations are valid for euro-denominated debt issued by future EMU members, then interest rate spreads, and in particular credit spreads, could change to be more in line with those currently observed on the foreign currency denominated debt of these countries. This could amount to a downgrading of asset quality for those countries.10 In this scenario the share of foreign currency debt would increase from current levels to 100 percent (Table 8). Spreads could increase above those observed on the relatively small stocks of foreign currency debt presently outstanding.11 Counteracting some of this pressure for spreads to rise would be the improved fiscal positions of several countries to meet the Maastricht criteria and the stability pact.

Table 7.

Ratings of Foreign and Local Currency Debt of Sovereign Governments, April 21, 1997

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Sources: Bloomberg Financial markets; The IBCA Ltd.; Moody’s Investors Service; and Standard and Poor’s.
Table 8.

European Union Countries, North America, and Japan: Foreign Currency Debt, 1996

(In percent of total government debt)

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Source: Country desks.

The years for which the latest data are available.

Preliminary data.

Data as of October 1996.

Data as of September 30, 1996.

Data as of March 31, 1996.

There are other factors that would influence credit spreads. Although the “no-bailout” clause in the Maastricht Treaty rules out the possibility of direct EU assistance to individual EMU member countries, it is unlikely that market participants will price sovereign debt as if it were corporate debt.12 The mere size of public debt outstanding in any potential EMU member country relative to any single corporate issuer would imply significant systemic implications of an involuntary restructuring or an outright default by an EMU member country. This would increase the pressure to find alternative solutions. One possible mechanism for dealing with fiscal problems when they arise is to provide EU financial assistance conditional on implementation of a macroeconomic stabilization plan. In addition, strict enforcement of the stability pact would reduce the “free-rider” problem of governments running fiscally irresponsible policies from time to time.

Pricing credit risk

From a pricing perspective, credit risk will become the most important risk and will make up the largest part of the remaining interest rate spreads among EMU issuers after the introduction of the euro. Unfortunately, there is no unambiguous guide to the likely levels or dispersion of sovereign credit spreads in EMU. One way of estimating credit spreads is to compare interest rates on sovereign debt issues that trade in a common currency. Among the potential EMU member countries that have issued dollar denominated debt, as of end-1996, spreads between ten-year dollar issues trading in domestic markets and comparable U.S. Treasury issues ranged from a low of 24 basis points for Austria to a high of 34 basis points for Italy (Table 9)13 Spreads on five-year issues ranged between a low of 10 basis points for Austria and a high of 22 basis points for Italy. Although it is difficult to assess whether these spreads are “high” or “low,” it would appear that they are probably reflecting a good deal of market optimism about the prospects for a successful EMU and over the adjustments made in some countries.

Table 9.

Estimates of Credit Spreads for European Union Sovereigns, September 11, 1996

(In basis points)

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Source: Paribas Capital Markets, EMU Countdown (September 9, 1996), Table 5.

Another rough benchmark on credit spreads is the pricing of debt issued by the separate legal entities making up the separate states of the United States of America and of the provinces of Canada. In the case of the United States, a sample of municipal bond traders collected over the period 1973-1990 indicates that the largest spread during the 28 year period was 146 basis points, and the mean of the spread was 32.4 basis points with a standard deviation of 24.8 basis points.14 The sample also reveals that in December 1989, the last date of the sample, the maximum difference in spreads on 20 year general obligations issues of 41 U.S. states was 84 basis points. Regarding the Canadian provinces, a much more limited sample suggests that spreads over Canadian federal issues of ranged from 35 basis points for Saskatchewan to 78 basis points for Quebec (Table 10).15

Table 10.

Interest Rate Spreads of Canadian Provinces

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Sources: Goldman Sachs, Fixed Income Research: Corporate Bond Monthly (February 1977), p. 47; and SBC Warburg, EMU: Opportunity or Threat (December 1996), p. 62.

Yet a third indication would be the pricing of European corporate debt. If EMU member countries maintain their sovereign ratings of triple-A, it is reasonable to expect that credit spreads between EMU member country issuers would be in the range of Standard and Poor’s Triple-A rated corporate issuers. As of a few weeks ago, spreads for five triple-A rated corporate issues were in the range of between 10 and 45 basis points above their respective domestic benchmarks.16

Overall, it should be expected that there would be a convergence of interest rates on sovereign debt issued—and outstanding—by EMU member countries. Whether or not all of these issues trade at identical spreads will be determined by the market. To the extent that spreads remain, market segments will be identifiable. How much of an impact this will have on market liquidity remains to be seen.

Possibilities for desegmentation: yield-curve benchmarks and currency redenomination

The plan to introduce the euro has reopened the competition among European sovereign issuers for providing EMU with the benchmark yield curve for pricing other sovereign issues and private debt issues. This renewed competition is likely to increase the potential for further desegmentation of national debt markets. From an investor’s point of view, the benchmark issue offers the highest return possible on what is deemed to be a “safe” investment. Such issues are usually high in volume, extremely liquid, and associated with various hedging instruments, with the added advantage of low bid-ask spreads. Benchmark issues also are used widely in repo markets, and are typically usable as collateral for a wide range of other financial contracts. From the issuers point of view, the key advantage is that the yield is the lowest possible for that particular market segment; the added liquidity also provides easy access to a wide investor base for issuance. Thus, the importance of benchmark status is that it provides access to the lowest cost financing in a liquid market.

The main candidates for benchmark status are German and French instruments, and it would appear that France possesses several technical advantages (Figure l).17 First, the French sovereign market is widely seen to be very liquid because relatively larger issues are more evenly distributed across the maturity spectrum to generate a smooth yield curve. Second, French markets are supported by a transparent and liquid market for repurchase agreements; the bulk of DM repo trading is located offshore, mainly in London, mostly as a result of reserve requirements. These requirements are likely to be lifted and so this French advantage will be eliminated soon. Third, France has already developed a strip market—which can be used to recalculate the exact value of each security on issue. Fourth, the French auction schedule has been for some time very regular and predictable with the Treasury announcing its plans at the beginning of the year. Finally, the French government has already announced its intentions to redenominate in euros the outstanding stock of debt on January 1, 1999. Although French paper is well placed to provide the benchmark yield curve for euro markets, all these advantages could be matched by other markets if measures are taken by other countries, and in particular by Germany, before the euro is introduced. If this process of competition continues, existing segments will be reduced and market size, liquidity, and efficiency will most likely increase.

Figure 1.
Figure 1.
Figure 1.

The Euro Benchmark–Yield Curve: Germany vs. France

Citation: IMF Working Papers 1997, 062; 10.5089/9781451848250.001.A001

Source: Paribas.

The “critical mass” approach requires that starting in 1999, all new issues of government bonds and bills (at least those traded on the secondary market and expiring after the end of phase B) will have to be denominated in euros.18 Countries have the option to redenominate their outstanding stock of debt in euro as of January 1, 1999. The coexistence of new euro-denominated bonds and old national-currency bonds issued by the same government could segment the newly created euro market for government securities and reduce its relative liquidity. In addition to France, Belgium has also announced its intention to redenominate debt on January 1, 1999. Germany is in the process of deciding, in part because the existence of a deep and liquid secondary market for German sovereign issues could be the decisive factor in providing the euro benchmark yield curve.19

Prospects for a European corporate bond market

EU financial market legislation and the rapid development of the fund management industry has begun to chip away at longstanding regulatory and tax impediments to the development of European corporate debt markets. These markets have remained relatively small, however. Although outstanding debt securities issued by EU private entities totaled about $4 trillion (about 87 percent the size of the U.S. corporate debt market), about 25 percent of this total was issued in international markets, of which about $268 billion were issued by nonfinancial entities. Domestic issuance in 1995 was also low compared to other more highly developed markets: German firms issued only $0.142 billion and French firms only $6.4 billion, whereas U.K. firms issued $20.7 billion, Japanese firms $77.2 billion, and U.S. firms $154.3 billion (Table 11).20

Table 11.

Funds Raised in Capital Markets by Non-Financial Enterprises in Selected Industrial Countries, 1990-95

(In percent of total)

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Source: Organization for Economic Cooperation and Development, OECD Financial Statistics Part 3: Non-Financial Enterprises Financial Statements (Paris: Organization for Economic Cooperation and Development, 1995).

Data for short-term bonds are not available for Italy, the Netherlands, and Japan.

Residual including bank financing.

The introduction of the euro is likely to accelerate the development of corporate bond markets, especially if the increased focus on credit risk in the EMU sovereign markets leads to the development of a credit-risk culture, as now exists in the United States and the United Kingdom. First, as noted earlier, a single currency provides incentives for the creation of a much larger effective European institutional investor base. The increasingly yield-conscious behavior of European investors, and the coincident growth in fund management in Europe, has expanded the investor base for corporate debt securities—EU mutual funds now manage close to $1.4 trillion (see Table 5). Although the credit-risk culture has yet to take off in Europe the way it has in the United States, even a moderate shift will have a significant impact on international capital markets. For example, if the degree of disintermediation in EU countries was to close the securitization gap (adjusted for economic size) with the United States by 25 percent, this would unleash capital flows equal to roughly $2 trillion into international capital markets. This is roughly about half as large as the entire market capitalization of EU or Japanese equity markets.

Second, EU firms have begun to show an increased desire to tap debt securities markets. An important factor spurring firms to issue debt securities is the increasingly sophisticated, value-maximizing corporate financial policies that European firms are beginning to adopt. However, the underdevelopment of domestic corporate debt securities markets has presented an obstacle to firms wishing to issue debt securities. Although this obstacle has been circumvented to some degree by tapping the international securities markets, there are significant additional obstacles to accessing the international markets for all but the largest, “brand-name” firms.

While there are reasons for optimism about the development of a European-wide corporate debt market, it will most likely not occur quickly. The remaining impediments to the development of these markets fall into two categories: excessive regulation and the narrow institutional investor base. Excessive regulatory burdens have simply prevented these markets from developing in some countries. For example, tax policy and issuance requirements prevented the development of commercial paper and bond markets in Germany until very recently. More generally, regulators in virtually all EU countries have stifled corporate debt securities markets by discouraging issuance of lower-grade corporate debt securities. Regarding institutional investors, corporate debt securities are often highly heterogeneous across issuers as well as across issues (by the same issuer), and thus the costs involved in evaluating their currency risk, credit risk, and legal risk—contract terms, such as covenants—effectively means that these markets will be successful only if there is a large institutional investor base. Smaller issuers, small issues, as well as firms in smaller countries—in which currency risk figures more prominently for foreign investors—therefore may face a limited investor base.21 22

D. Equity Markets

The introduction of the euro is likely to accelerate the processes of competition, consolidation, and technological innovation that has characterized equity markets in recent years. In the second half of the 1980s, the London Stock Exchange attracted an increasing share of turnover in continental equities by creating a screen-based dealer market for non-UK stocks called SEAQ International (SEAQ-I) separate from the London dealer market. During this period, competition among the European exchanges was fierce. Since the early 1990s, continental exchanges have recouped a substantial share of trading with new electronic continuous auction markets, particularly CAC in Paris and IBIS in Frankfurt, and SEAQ-I has declined in importance as an organized exchange. Nevertheless, London dealers are still the primary source of liquidity for large block transactions and for ‘program-trading’ in a significant number of continental stocks, even though they engage in considerably less customer dealing in continental equities, and considerably more brokering through the continental bourses.23 Thus, since the introduction of continuous electronic trading on the continent, London dealers have taken a smaller proportion of orders on their own books and have worked orders mostly through the continental markets. As such, the activity of London dealers is reinforcing the liquidity of auction markets, and the London-based dealer market and the continental-based auction markets are simultaneously competing and interdependent. Currently, London is by far the dominant equity market in Europe in terms of companies listed, market capitalization, and turnover (Table 12). On the continent, Frankfurt and Paris have the largest exchanges with a similar number of listed companies and capitalization. All other exchanges are significantly smaller.

Table 12.

European Union (EU) Countries, United States, and Japan: Equity Markets, 1996

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Sources: Federation of European Stock Exchanges; Federation of International Stock Exchanges; Nasdaq; New York Stock Exchange; and Tokyo Stock Exchange.

Together with ongoing pressures from computerization and the implementation of ISD, the introduction of the euro will provide strong incentives for concentration among the European exchanges.24 The euro will eliminate differences in the continental electronic trading systems and make them virtually identical. The most likely development is that a European-wide equity market for blue-chip stocks will emerge into a single electronic exchange with a screen-based automated order-driven trading system, like IBIS. This will be possible only if the trading costs of this system will remain competitive vis-a-vis those of proprietary trading systems. National bourses may survive by specializing in trading low-capitalization companies: while there are incentives for this kind of trading to concentrate in a pan-European electronic trading platform, local custody, settlement, and tax systems may allow for local trading to continue. Overall, EMU is likely to further increase cross-border equity trading, and enhance both the integration of national markets and overall market liquidity.

Also uncertain is EMU’s impact on competition between auction and dealer systems. If EMU enhances market efficiency and reduces equilibrium equity prices and spurious price volatility, then execution risk will diminish and immediacy will become less important. This implies that dealer markets, where investors pay a premium for immediacy in terms of higher bid-ask spreads, will experience competitive pressures from auction-agency markets, where increased liquidity will reduce execution risk. In addition, to the extent that EMU will increase cross-border asset holding and trading, counterparty risk could increase or become more difficult to assess. This will also put dealer markets at a disadvantage, because dealers would have to raise bid-ask spreads to compensate for the higher counterparty risk. By contrast, auction-agency markets usually pool this risk.25

There are remaining impediments that could slow down consolidation. Some provisions of the ISD—the concentration provision and the concept of “regulated market”—leave scope for “protectionism” on behalf of national stock exchanges. Differences in accounting can also prevent institutional investors from purchasing stocks of certain countries. Finally, clearance and settlement procedures can affect equity trading by increasing transaction costs, which could be reduced through centralization of clearance and settlement services in a single European central securities depository (CSD), the so-called “Euro-hub”.26

E. Derivative Markets

The euro will affect derivatives markets in two ways: several contracts will disappear or consolidate into a single contract; and a smaller number of contracts will increase the competition among European derivatives exchanges. With the establishment of EMU and only euro interest rates, nearly 200 contracts involving 13 different currencies are likely to disappear. An open question is how will the associated reduction in diversity affect the 16 European futures and options exchanges? Initiatives are likely to emerge among the smaller exchanges to establish technical linkages and common settlement procedures. This will confine the race for post-EMU supremacy in derivative contracts to Europe’s big three exchanges: the London International Financial Futures Exchange (LIFFE), Europe’s biggest derivatives exchange, followed by the Deutsche Terminbörse (DTB) and Marché à Terme International de France (MATIF).27 In light of their specialization in interest rate contracts, LIFFE and MATIF are likely to be most affected by EMU. Competition among the exchanges will also be affected by the development of electronic trading. DTB will be able to capitalize on its technological prominence with a fully electronic order-driven system with almost one-third of its members trading from workstations outside Germany. Both LIFFE and MATIF have maintained an open outcry structure. While LIFFE already has an electronic capability, MATIF is likely to be seriously handicapped by the failure in the summer of 1996 to finalize a link with DTB.

Other factors could also play a role. LIFFE’s leading position may be damaged if the United Kingdom is not included in EMU and if access to Target and intraday liquidity is limited. DTB might gain a competitive edge from being located in Frankfurt. MATIF could benefit from the fact that the French government has been actively issuing ECU-denominated debt since 1989 and is the leading sovereign borrower in ECU. Experience in the ECU bond market suggests that where the active cash market resides, the futures business is likely to follow. In addition, some consider MATIF the best placed exchange to trade the future euro benchmarks, since a smooth transition from the French franc to euro could be ensured by enhancing the liquidity of existing contracts. Smaller exchanges in core euro countries (Belgium and the Netherlands) will be the first to see business decline, followed by the exchanges in peripheral countries (Italy and Spain). The likely outcome is that these exchanges will offer a smaller range of equity-based local contracts.

The most direct impact of EMU on the structure of derivatives contracts will be the elimination of currency derivatives between the currencies of countries joining EMU. If EMU begins with core ERM countries, the negative impact on trading volumes will be muted, because trading in intra-core currency derivatives is relatively limited. Higher volume contracts between core and noncore currencies will simply change into contracts between the euro and noncore currencies; DM-lira contracts will simply become euro-lira contracts. The high volume contracts between dollars, yen, and DM-block currencies will be little affected with the euro substituting for European currencies. If EMU enhances trading within, and capital flows to, the euro-area, the demand for currency derivatives could increase. Activity in the European derivative markets may also increase during 1997-98 and 1999-2002 as foreign exchange and interest rate options are used to hedge risk in the transitional periods.

With the creation of EMU, the market for interest rate swaps will become larger and more liquid, as contracts of participating currencies become perfectly fungible. Enhanced liquidity is also likely to increase the use of swaps outside the banking sector. EMU will also boost the demand for options contracts on interest rate spreads and allow investors to hedge credit-risk spreads between bonds of high-debt countries and the euro benchmark. Interest-rate-spread based contracts may also develop for private debt securities.

For bond market futures, it is difficult to know whether the market will demand a futures contract for each national bond, or whether a generic contract will emerge. This will depend on the volatility of credit spreads between the various national issues. If the spreads are stable, the low basis risk could lead the market to develop a single liquid 10-year futures contract similar to the U.S. Treasury bond future. Otherwise, there could be a range of futures contracts one for each national benchmark issue. The selection of deliverable bonds will also be crucial. If two or more national bonds are deliverable for a generic bond futures contract, the contract could favor the cheapest bond to deliver and create liquidity of that bond at the expense of higher quality bonds. Basket-type euro futures contracts are unlikely to emerge, because derivatives exchanges would like to avoid repeating the experience of LIFFE with 10-year ECU futures contracts between 1990 and 1991. At that time, LIFFE’s basket of deliverable bonds included Ecu OATS, European Investment Bank bonds, U.K. gilts, and Italian government bonds. While all bonds, in principle, had the same rating, there was, in practice, always one that was cheaper to deliver. In effect, LIFFE’s contract turned out to be an inadequate hedging tool.

F. Systemic Risk Management in EMU

This section examines two remaining institutional challenges. The degree of securitization and the liquidity of financial markets rests on the ability to quickly and efficiently settle payments and to move cash. A wholesale payments system capable of safely processing a large volume of intraday payment orders is necessary to support the large turnover in securities markets needed for liquidity, the rapidly changing dealer positions financed with repurchase agreements, and margin requirements arising from futures and options markets. The first challenge involves reaping the full benefits from the Target payments system. Who has access, and on what terms, could have important implications for systemic risk management and for fully capturing the potential risk reductions of real-time gross settlement (RTGS). The second challenge involves linking supervisory and lender-of-last-resort functions to the center of the payments system for effective systemic crisis prevention and management.

Reaping the rewards of RTGS across Europe

The main systemic problem in payments systems is the very low probability but very high cost (payments gridlock) of settlement failures. RTGS systems are being implemented in EU countries to improve payments efficiency and to reduce the potential for settlement problems. Because the euro will increase integration across national markets, cross-border transactions are likely to increase significantly, even for European countries not included in EMU. In order to implement an EMU monetary policy, to improve payments efficiency, and to reduce the potential for payments system problems, the EU will implement a new Target payments systems that links the separate national RTGS payments systems. To the extent that European (EU and non-EU) countries that have significant volumes of transactions with the euro zone are not part of EMU, the full benefits of RTGS systems will not be internalized within EMU. This is a rationale for making Target a pan-European payments system.

By not including all European countries in the Target system, alternative settlement systems for euro transactions will be developed, some of them private, and this could reduce the number of transactions across Target. Most private systems are end-of-day settlement systems in which participants in the system accumulate large gross exposures, net them at various well-defined times throughout the day, and then reach payment finality through a national RTGS system at the end of the day. If the legality of netting arrangements is tested, this could create the potential for serious liquidity problems in the unlikely event that a major institution would fail to settle. The unwinding of positions would have very high-cost consequences for third parties, with knock on effects throughout the netting system. In Out countries where netting arrangements are likely to be used to settle a significant share of these daily euro transactions, the systemic risk reductions that can be achieved in RTGS systems will not be realized. To the extent that Target participants in EMU have as counterparties participants in non-EMU EU countries that are subject to the risks of netting arrangements, Target members will not be fully be insulated from the kind of systemic risk that RTGS systems are specifically designed to eliminate.

Another remaining issue in the design of target is access to intraday and over night borrowing facilities. Some EU countries view access to Target intraday credit by non-EMU countries as having monetary policy implications. This view can be seen as recognizing the importance of measuring the impact of payment-system intraday liquidity on the ability to achieve monetary objectives, and of determining the optimal interval over which to measure this impact: a day, a week, a month, the middle of the trading day, the end of the trading day. A longstanding working assumption is that intraday liquidity for smoothing payments flows has no impact on the achievement of monetary policy objectives. There is, however, little analytical work that examines the relationship between payments system design and the impact of intraday liquidity on the ability to achieve monetary objectives.

Managing systemic risks in target

Another aspect of the Target payments system that has not been clarified yet is the allocation of responsibility for safeguarding the European-wide payments system during a financial crisis and against liquidity problems that may arise in the course of payments settlement. Safeguards would normally include mechanisms for determining when and if a problem exists, whether or not a particular institution is having difficulties during settlement because it is liquidity constrained or insolvent, and how to resolve the problem either by providing access to lender-of-last-resort (LOLR) facilities or by denying access to the payments system. The challenge is one of creating clearly understood and easily implemented crisis management mechanisms for very low probability events that impose costs on the payments system and its participants.

A potential risk is the lack of clarity about the mechanism for assessing and resolving a financial crisis involving cross-border payment flows between financial institutions within Target. At this stage, LOLR responsibility has not yet been assigned. Because the ECB is at the center of the Target payments system and has sole responsibility for monetary policy, it would be inappropriate to assign this responsibility to the NCBs even though they are responsible for the smooth functioning of their national RTGS systems. In addition, the Maastricht Treaty neither mandates nor denies ECB authority for supervising European financial intermediaries, whether they are ECB counterparties or not. The national authorities, only in some cases the NCBs, will continue to be responsible for banking supervision, and for enforcing EU directives on capital adequacy, accounting standards, disclosure requirements, and other important aspects of financial supervision and regulation and financial market surveillance.

The history of financial crisis suggests that during a fast breaking crisis, it is important for central banks to have sufficient information for making decisions about whether to provide support during a temporary liquidity problem. In many situations, problems could be addressed by the relevant national supervisory authorities, but there may arise situations where the ECB will have to act decisively and quickly. For example, the Bank of New York (BONY), a major clearing bank in the U.S. payments system, experienced a computer breakdown on November 21, 1985. Because the U.S. Federal Reserve System had recently completed a routine inspection of the bank, it was able to assess quickly the solvency of BONY and to decide that the bank was experiencing a severe liquidity problem. Because of its roles as supervisor and lender of last resort, the Federal Reserve System was able to avert a major systemic crisis by extending an overnight loan of $22.6 billion from the discount window, collateralized by $36 billion in securities. If European capital markets become more highly securitized, this feature of systemic risk management will need to be addressed.

There is also the potential problem of incompatible incentives: there may arise situations where national supervisory authorities would have information about the solvency of an institution but for practical reasons it is not willing or able to quickly or adequately inform the ECB. It would increase transparency of the supervisory framework and the surveillance over EU payments systems if a mechanism was designed to deal with these and related problems. Even though “constructive ambiguity” about the conditions under which lender-of-last resort facilities will be available is a necessary element in preventing moral hazard, there should be no ambiguity among policy makers about the mechanisms that will be called upon to manage crisis situations.

III. Structural Implications for European and International Banking: Further Disintermediation, Competition, and Consolidation

The existence of larger and more liquid capital markets in Europe and the unavoidable reforms of European health, pension, and social security systems will create a large private pool of investable funds and most likely expand the role of institutional investors and the demand for specialized asset management. This could open up each national market to cross-border competition. Continental banks will respond to this challenge by stepping up their current efforts to acquire, or merge with, specialized firms, and additionally to diversify their businesses against the risk of disintermediation by forming groups with institutional investors.

The creation of more liquid European capital markets—if not a European-wide capital market—is likely to encourage small- and medium-size corporations to access securities markets. Direct access to securities markets will in turn affect the competitive position of banks and could accelerate the gradual process of disintermediation that has been taking place in European banking markets. In this scenario, credit evaluation and local market underwriting skills will become extremely valuable. Thus, by creating incentives for the creation of broad, deep, and liquid private securities markets in Europe, the introduction of the euro and the establishment of EMU creates an environment of competition for shares of markets traditionally closely held and maintained by domestic universal banking institutions, both at the wholesale and retail level.

A. Wholesale Banking

At the wholesale level, with the removal of currencies and foreign exchange risk for intra-EMU cross-border transactions, there will be few remaining barriers to entry for the large global institutions. The commoditization of wholesale services and the cost of supplying them will determine customer relations. Competition in wholesale banking is driven by price, access to distribution networks, and geographical reach. Only a limited number of large-sized financial institutions have the capital, resources, and geographical reach to compete globally in providing services to the top tier of multinational corporations and large- and medium-sized companies with international operations.28

It is possible to identify several aspects of this competition and consolidation at the wholesale level that are related to the introduction of the euro. As noted earlier, the euro directly eliminates the “anchoring principle,” advocated by many European central banks, and requiring domestic financial institutions to lead-manage bond issues, creating cross-border competition for providing this investment banking service. This new competition could lead to consolidation and greater concentration through cross-border mergers and acquisitions. The euro also eliminates the 80 percent matching rule on foreign currency exposures of insurance companies and pension funds within Europe. Under existing rules, an EU insurance companies, for example, cannot hold more than 20 percent of its assets in foreign currencies unless they are matched by liabilities denominated in the same currencies. The lifting of this restriction is likely to increase cross-border investment flows, and will open up this pool of investment funds to investment banks in EMU for providing underwriting, trading, brokerage, rating, and merger and acquisition advisory services. Banks strong in the above areas, with good placement power, are likely to see their franchises increase in value, and banks weak in these areas could be in the market for acquisitions of merchant banks and asset managers by continental European banks. Universal banks with strong investment banking franchises are also likely to benefit from EMU.

The euro is also likely to have a number of indirect effects all pointing in the direction of further consolidation in wholesale banking in Europe: lower profit margins through its general impact on competition; rationalization of foreign exchange and corporate and industrial treasury functions, which would reduce the demand for cash-management services provided by wholesale and investment banks; and reduction in the number of providers of regional and global payments processing services. This consolidation can only be hastened by the elimination of European currencies.

Competition is also likely to increase in correspondent banking as non-EMU banks reduce the number of correspondents they need inside the euro bloc. Consortia of banks providing basic electronic banking services, including payments to each others’ customers in Europe, are also likely to emerge. The Target system will handle only large-value euro payments for central banks, large private banks, and very large companies, and smaller companies will have to go through banks’ own payments systems and correspondent networks for low-value payments in euro. Competition in the market for wholesale money transmission services will also increase. As companies increase their cross-border activities, introduce more sophisticated treasury management, and concentrate their euro business with fewer banks, traditional home-currency correspondent banks may be unable to compete with the global banks which assure cost-effective and efficient payment services around the world through their own networks.

B. Retail Banking

At the retail level, there is a greater need for restructuring and consolidation. The key problem is that Europe is over banked at the retail and local levels (Table 13 and 14). The most glaring consequence of this over banking is that potential EMU countries—France, Italy, Belgium, the Netherlands, Austria—have banking systems that are over staffed, and these staffs are underemployed, relative to banks operating in more efficient banking systems (the United States, for example) (Chart l).29 European banks are also known to provide services at noncompetitive prices. This leaves the least well capitalized and inefficient banking systems, and the banks within them, vulnerable to competitive pressures.

Chart 1.
Chart 1.

Labor Costs and Productivity in Banking, 1994

Citation: IMF Working Papers 1997, 062; 10.5089/9781451848250.001.A001

Source: Organization for Economic Cooperation and Development, Bank Profitability: Financial Statements of Banks 1985-1995 (Paris: Organization for Economic Cooperation and Development, 1996).
Table 13.

Banks’ Restructuring: Number of Institutions and Size Concentration, 1980, 1990, and 1995 1/

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Sources: British Bankers’ Association; Building Societies Association; national data; and Organization for Economic Cooperation and Development.

Deposit-taking institutions, generally including commercial, savings and various types of mutual and cooperative banks; for Japan, excluding various types of credit cooperatives; and for Canada, excluding trust and loan companies (in 1994, 83 institutions).

Figures shown in parentheses are for top ten institutions.

For Finland, 1985; Canada and France, 1984; Spain, 1981; and the United Kingdom, 1983.

For Finland, Japan, and Sweden, 1994.

For Finland and the Netherlands, 1985; France, 1986; Italy, 1983; and Switzerland, 1987.

For Belgium, Japan, Switzerland, and the United Kingdom, 1994; and Finland, 1993.

From peak to most recent observation where applicable.

For number of institutions, western Germany only. Data for the whole of Germany: 1995, 3,784; percentage change, -30 percent.

Concentration data for commercial and savings banks only.

Excluding credit unions: 1995, 12,067; percentage change, -36 percent.

Table 14.

European Union Countries, North America, and Japan: Population per Bank Branch, 1985, 1992, and 1994

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Source: Organization for Economic Cooperation and Development (OECD), Bank Profitability: Financial Statements of Banks 1985-1994 (Paris: OECD, 1996).

Despite these longstanding problems, consolidation has not occurred in Europe to the extent that it has in the United States. There have been a significantly smaller number of mergers and acquisitions, and they have tended to be smaller in size (Table 15). The absence of significant consolidation is difficult to explain against the background of strong competitive pressures and incentives for change. In recent years, local banking markets in Europe have experienced competitive pressures associated with deregulation, the abolition of capital controls, and single market initiatives. These competitive pressures have lowered net interest margins (Table 16) and reduced bank profits (Table 17).30 Some banking systems have also had to increase provisions for non-performing loans as real estate and property related sectors weakened in the presence of declining or soft real estate prices. In most cases, European banks have been unable to counteract these trends with cost reductions and increased revenues in other areas of financial services. The resistance to consolidation might be attributable to factors such as home currency advantage, legal and regulatory restrictions, ownership structures that inhibit entry and exit, extensive branch networks, and strong traditional and cultural relationships.

Table 15.

Mergers and Acquisition Activity in Banking, 1989-96 1/

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Source: Securities Data Company.

Classified by the industry of the target; completed or pending deals; announcement date volumes.

As of April 4, 1996.

Table 16.

Net Interest Margins, 1989-95 1/

(In percent of average earning assets)

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Source: The IBCA Ltd.

The shaded numbers indicate the highest net interest margin for the 1989-95 period for each county.