This paper analyses the process of disintermediation, the progress in consolidation, the impact of new technologies, and the role of ownership and control structures for the euro area banking sector. The impact of these trends on competition policy, "too big to fail" concerns, and financial stability is investigated. In this setting, the paper endorses stronger cross-border coordination among supervisory authorities but notes that more formal cross-border arrangements through supranational agencies seem, at this stage, premature. However, an increased capacity to perform centralized market surveillance, building on domestic supervisory information, is needed to ensure the efficiency and stability of euro-area financial markets.


This paper analyses the process of disintermediation, the progress in consolidation, the impact of new technologies, and the role of ownership and control structures for the euro area banking sector. The impact of these trends on competition policy, "too big to fail" concerns, and financial stability is investigated. In this setting, the paper endorses stronger cross-border coordination among supervisory authorities but notes that more formal cross-border arrangements through supranational agencies seem, at this stage, premature. However, an increased capacity to perform centralized market surveillance, building on domestic supervisory information, is needed to ensure the efficiency and stability of euro-area financial markets.

I. Introduction

1. Euro area banking systems are in flux. Faced with the combined pressures of globalization, disintermediation, new technologies, and increased competition from nonbank financial intermediaries, banks are devising strategies to thrive in this new environment. These trends, while global, have recently affected the euro area with particular intensity. The structural change brought about by the adoption of a common currency and a common monetary policy is exerting a profound impact on the area’s financial sector. Money markets have been integrated; trading, quoting and settlement operations are already denominated in euros; and competition for banking services—at the wholesale level through global providers and at the retail level through internet banking—is intensifying. Further, multiple European currency trading desks are extinct and are being replaced by bond and equity trading and issuance. For these reasons, this paper focuses on the euro area to examine the challenges facing banks, their response, and that of their supervisors in this new environment. Both banks and those individuals that influence public policy will need to continue to be proactive in developing appropriate strategies to facilitate adaptation to the new euro area environment.

2. This paper is divided into two parts. Section II gives an overview of the euro-area2 banking system, identifying common trends in bank performance and balance sheet structure, and outlines some recent capital market developments. This provides the background for the discussion, in Section III, of the issues arising from these trends and developments. In particular, the following points are examined in detail.

  • Financial disintermediation has increased in the wake of Stage III of European Economic and Monetary Union (EMU). Is such a trend a threat to the profitability of euro-area universal banks? Or, being universal banks, do they have the flexibility to adjust to the changing environment?

  • The ongoing process of consolidation has been rationalized on the basis of the benefits of the economies of scale and scope it can generate, which can vary across lines of business. Are the conditions for realizing these benefits—free access to new markets and flexibility in the use of inputs, including labor—satisfied in the euro area?

  • Consolidation, especially at the retail level, has predominantly prevailed within a national context rather than across borders. Could this hurt competition? To what extent could it hamper the benefits of technological advances such as the Internet?

  • An outstanding feature of banking systems in the euro area is the large share of financial institutions whose ownership structures mean that they are “not for sale.” How could this feature affect the reshaping of the financial system in the region? Should these institutions be incorporated?

  • Considering that the “optimal” size of banks may have grown, do existing impediments to cross-border consolidation promote the creation of “too big to fail” institutions from a national perspective?

  • What are the implications of market integration, consolidation across markets and products, and creation of very large firms, for financial stability and the soundness of the banking system? Has the risk of cross-border contagion increased? The advent of Stage III of EMU implies that the domains of monetary policy and banking supervision no longer coincide. How does this impact the arrangements for the prevention and management of liquidity and solvency crises?

  • Is the current supervisory structure appropriate for this quickly changing environment, in particular as regards the development of very large, complex institutions and the growing regional integration of financial markets, foreshadowed by the rapid expansion of interbank credit following monetary union? Would a centralized supervisory architecture be more appropriate?

The answers to these questions are not straightforward, and in many cases depend crucially on whether a national or euro-area view is taken. The presence of cross-border interrelationships and linkages in an integrated economic area suggests that a euro-area view may be preferable. But even from a euro-area perspective, different views regarding the speed and desired amount of integration of political institutions will yield different answers. Overall, the paper takes the view that, to preserve the stability of financial markets and increase their efficiency, the changing euro-area banking environment requires policy makers to examine financial sector policies increasingly from a euro-area perspective, complementing the domestic one. On perhaps the most difficult question facing policy makers—the appropriate venue for financial oversight—the paper discusses the costs and benefits of various arrangements, noting that such discussions are already taking place in other fora (as evidenced by the Brouwer Report). More specifically, the paper concludes that a centralized euro-area supervisory organization, although perhaps desirable in principle, would be premature at this stage in practice. However, the increased integration of financial markets calls for more centralized market surveillance that builds on domestic supervisory information. This, together with enhanced cooperation of national supervisors, is key to the efficiency and stability of euro-area financial markets.

II. Structure and Performance of the Euro Area Banking Sector

A. Market Structure and Institutions

3. Although it is difficult to characterize the euro-area banking sector using just one or two phrases, it is clear that the euro area’s financial system continues to be bank dominated.3 The proportion of financial assets controlled by the banking systems of the euro area countries remains high (Table 1). Bank loans to euro-area residents amount to about 100 percent of the area’s GDP, twice the ratio in the United States, whereas equity and bond market capitalization as a percent of GDP are substantially smaller than in the United States. Compared to Japan, euro-area bank loans as a percent of GDP are similar, though Japanese banks rely more heavily on deposits. Like the United States, debt and equity markets play a larger role in the financial structure of Japan than in the euro area. While euro-area banks continue to play a dominant role in intermediating savings through the traditional means of collecting deposits and extending loans, the use of investment funds as well as pension and insurance products as savings vehicles is growing. For instance, assets in investment funds have increased at double-digit rates in the recent years in almost all countries. Loan growth to euro-area residents has risen at lower, albeit still brisk rates, on average about 7 percent in 1998-99. Contrary to the United States, where commercial banks have only recently been able to issue mutual funds and sell insurance products, the growth in new savings vehicles is replacing traditional revenue of euro-area universal banks: revenues are not necessarily lost to other financial intermediaries.4 This section identifies common features and trends, while pointing out some distinct differences, among EU-11 countries’ banking sectors. Subsection C will discuss recent performance and balance sheet trends in the sectors.

Table 1.

Financial Structure in the Euro Area, the United States and Japan

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Sources: (From ECB Monthly Bulletin, January 2000) BIS (domestic debt securities); ECB (bank deposits and MFIs loans for the euro area); IMF (bank deposits and GDP forecasts in Japan and the United States); Eurostat (GDP forecast for the euro area, stock market capitalization); Federal Reserve (bank loans for the United States); and Bank of Japan (bank loans for Japan).

For the euro area, data cover demand deposits, deposits with an agreed maturity and deposits redeemable at notice of MFIs other than NCBs and the ECB. For the United States, data include demand, time and savings deposits from all banking institutions, while for Japan, data include demand and time deposits from deposit money banks. For Japan, other banking institutions which offer close substitutes to deposits are not included.

For the euro area, data cover loans to euro area residents from the consolidated balance sheet of euro area MFIs. For the United States, data cover total loans at commercial banks, saving institutions and credit unions (from the Flow of Funds accounts of the United States from the Federal Reserve), while for Japan data cover total lending at deposit money banks from the monetary survey from the Bank of Japan.

Owing to the use of different reporting rules and calculation methods, data are not entirely comparable.


4. Unlike other developed countries, virtually all euro-area countries continue to maintain savings banks, and mutual and/or cooperative banks that wield considerable weight in the local market, particularly at the retail level (Table 2). Although in most EU-11 countries the largest institutions in the banking sector are private commercial banks, other types of banks with different ownership structures continue to play a substantial role in the banking sector. The definitions differ slightly from country to country, but these institutions can generally be characterized along the following lines: commercial (private-stock companies), savings banks, cooperative or mutually owned banks, public banks, and a mixture of other types of banks, usually with special purposes (Box 1). In several cases, the savings banks are publicly owned, most often by local or municipal authorities, and there are still cases of state and central government ownership of big banking institutions.

Table 2.

Market Shares per Type of Institution in Selected Euro-Area Countries

(End-1998, in percent)

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Source: Central Bank bulletins.

5. Germany has the largest banking system in terms of number of credit institutions and Ireland the smallest. Germany has by far the biggest number of credit institutions—over 3,000—due to its large population and the diverse nature of its banking system (Annex I, Table 2). France has fewer than half that many, followed by Austria and Italy (with each containing slightly fewer than 1,000). Spain ranks sixth after the Netherlands. Each of the remaining countries contains fewer institutions by far.

Types of Euro Area Banking Institutions and their Roles

Private commercial banks: Commercial or private banks are owned by their shareholders. Such private-stock companies usually offer equity to the public, but may be owned by private equity holders. They can distribute profits to their shareholders, typically in the form of dividends. These owners generally have limited liability and exercise control through various mechanisms, often through boards of directors or supervisory bodies. Voting rights, though, may be separable from share ownership.

Savings banks: Savings banks often supply credit to local or regional areas. In many cases, their original purpose was to provide credit to farmers, artisans, or other underprivileged groups who were unable to obtain credit elsewhere. Even when not required to do so, savings banks often focus on individuals and small- and medium-sized businesses. And even when shareholder-owned, there may be restrictions on the source of deposits, choice of assets, or distribution of profits. When partly or entirely owned by state or local governments or municipalities, these institutions are usually required to allocate part of their operating surplus to a “social fund” for use in the local community and the remaining profit can be either retained or distributed to the government owner. Further, in many cases, government officials acting on behalf of the bank are involved in lending policies and day-to-day operations to assure that the bank is fulfilling its stated public purpose. The institution may also receive either subsidized capital, loan guarantees, or the ability to provide preferential interest rates to depositors (higher than market rates) or to borrowers (lower than market rates). Governance structures vary considerably, particularly when the savings institutions is partly or fully owned by the public sector.

Cooperative/mutual banks: These banks are typically owned by their depositors or creditors and the services of these banks may be restricted to those who own them, although recent liberalization has permitted many of these institutions to offer their services to others. Ownership shares can be restricted to ensure broad ownership. In some countries, profits are distributed as dividends to the mutual owners, sometimes in the form of higher interest rates on deposits. In other countries, profits are retained, adding to reserves and the equity base. Governance is often implemented through boards of directors selected from among the members of the cooperative or mutual institution.

Public banks: Public financial institutions are now less prevalent in Europe and are typically outside the banking system. However, the most common type of public banks remaining in Europe are savings banks, owned or controlled in part by local or municipal authorities. Germany and Austria, with 35 percent and 14 percent of assets in banks either owned or governed by the public sector, respectively, constitute the largest public banking sectors of this type.

Other types of banks: Often countries have some specialized lending institutions. For instance, many EU countries contain mortgage banks, Germany has the largest such sector, whose assets are predominately mortgages and their liabilities come from either household deposits or the issuance of mortgage-backed securities. In some countries, there are agricultural lending banks, postal savings banks, and other special banks servicing specific sectors of the economy.

Distribution channels and employees

6. Although the number of banks can be a useful starting point, perhaps a better measure of the availability of banking services to customers is the number of branches per 1,000 inhabitants (Table 3). By this measure, Spain has the highest branch “coverage” with nearly one branch for every 1,000 inhabitants compared with an average of 0.57 branches per 1,000 across all euro-area countries. The smaller populations of Luxembourg and Belgium also have a considerable number of branches per 1,000 inhabitants—0.92 and 0.70 branches respectively. Germany, despite its overwhelming number of banks, has 0.55 branches for every 1,000 inhabitants, ranking fifth of all euro-area countries’ banking sectors.

Table 3.

Number of Bank Branches per 1,000 Capita

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Sources: National central banks; national bankers’ associations; European Central Bank: “Payment Systems in the EU,” 2000; FDIC; and IFS.Notes: Includes foreign bank branches; excludes branch bureaus in other banks. Excludes post office branches, central bank branches, Treasury branches. Ireland and UK figures include branches of building societies.

Data in 1990 is for 1991.

Figures in 1998 exclude branches of foreign banks.

Table 4.

Employees per Branch

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Sources: National central banks; National Bankers’ Association; BIS; and ECB “Payment Systems in the EU,” 2000.

Post offices are not included.

7. While in most countries the number of credit institutions has been shrinking over the last 15 years (the exceptions are Ireland and Luxembourg, where the increased number is attributable to foreign banks engaged in cross-border activities), the number of branches per capita started its decline somewhat later. In fact, in 4 of the 11 euro-area countries, this measure of banking density continues to increase (Table 3). Both Spain and Italy are among the countries for which branches per capita have continued to expand—often through the split of large branches—even while the number of banks has continued to decline.5 Finland stands out as a euro country in which the branch network per capita has shrunk dramatically since 1985, though this is likely the result of the Nordic banking crisis in the early 1990s, which encouraged a dramatic restructuring in the Finnish banking system.

8. Taking the place of traditional brick and mortar branches are new distribution channels. The number of ATMs per 1,000 inhabitants has grown substantially in all EU countries, with Spain leading the pack (Table 5). The smaller countries that have experienced branch closings have seen some of the greatest usage of ATMs. More recently, telephone and Internet banking options have been introduced. For instance, up to 25 percent of Finland’s Merita bank customers already use Internet banking.6

Table 5.

Number of ATMs per 1,000 Capita

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Sources: National central banks; National Bankers’ Association; ECB, “Payment Systems in the EU,” 2000; and IFS.

9. Given the trends noted above, a declining number of bank employees as a proportion of the population would be expected, but only recently has such a trend been evident. The last several years have seen only marginal changes in the number of bank employees in most countries (Table 6). Moreover, even in cases where the number of employees has declined, labor costs have remained stubbornly high.7 This is probably due to the type of individuals now being employed (higher skilled) and high nonwage costs (pension and social insurance contributions, separation costs, etc.).

Table 6.

Number of Employees

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Sources: National central banks; National Bankers’ Associations. Figures differ according to sources: data from central bank publications are reported when available.

Post office employees are not included.


10. To date, consolidation in the euro area has taken mostly two forms, (1) mergers among relatively large private, commercial banks and among bank and nonbank financial institutions; and (2) mergers within the savings and cooperative banks, respectively. Consolidation has been essentially limited, sometimes with implicit government guidance, to within national borders and within their own types (see subsection B below). Some commentators have interpreted the governments’ guidance as an apparent desire to limit foreign ownership of some influential institutions and to create a few “national champions” in each country to compete in the European or global marketplace (Table 7).

Table 7.

Recent Mergers and Acquisitions Among Large Banking Groups

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Sources: Various company reports and financial press releases.

11. Consolidation has accelerated recently at the top: more than half of the 30 biggest euro-area banks are the result of recent mergers and the average size of the top five has doubled since 1995 (Table 8). Bank of International Settlements (BIS) data show that some 500 mergers and acquisitions (M&As) took place in 1991-92, valued at $17.5 billion, whereas in 1997-99 only 200 M&As took place, at a value of about $100 billion—fewer M&As but of a much larger scale.

Table 8.

The Top 30 Euro Area Banking Groups

(In terms of total assets, in million of U.S. dollars)

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Source: The Banker.

Banking groups that are the result of recent mergers.

12. The degree of concentration at the top is particularly striking in the smaller euro-area countries, where now just a handful of banks dominate these banking sectors. EU-11 countries’ banking systems are characterized by relatively few large banks, some of which are considered global players, and an array of medium-sized and small institutions. In almost all of the smaller countries, the top five banks hold more than 50 percent of the banking system whether measured by total assets, total loans, or total deposits (Table 9). In a few countries, the concentration is now even more pronounced. For example, in the Netherlands and Belgium, two large banking groups have more than half of banking sector assets, respectively. The four biggest countries have less concentrated banking sectors, although in France, the top five banking groups take in nearly 90 percent of all deposits. Notably, Germany has the lowest level of concentration in the euro area almost regardless of how it is measured. France and Spain are relatively more concentrated.

Table 9.

Concentration Indicators in 1998 1/

(In percent of total)

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Sources: IBCA; and national central banks.

C5: share of the five largest banking groups. C2: share of the two largest banking groups.

13. Mergers among smaller banks and savings institutions, though perhaps less visible, have been continuing for a number of years. For instance, in Germany, most of the recent merger activity has been among savings banks (Sparkassen), whose number has declined by some 5 percent, and credit cooperatives, dropping 13 percent over the last five years. In Italy, banking law changes in the early 1990’s have brought about consolidation in the segments of the banking system that were previously partly owned by the public sector (see subsection B below). Spain, too, has seen slow, but steady, consolidation in its savings bank sector, the cajas. For France, the consolidation of the mutual, cooperative and savings banks occurred earlier, but has proceeded further, with almost all of these institutions becoming a member of one of five large groups.8 What is notable about these mergers is that not only are they within-border mergers, but they also occurred within their own type. Some of the “unevenness” in the consolidation process, therefore, comes from the fact that, in contrast to the United States or United Kingdom, many of the EU-11 institutions are not available for acquisition outside their type owing to their unique ownership structures.

14. Because negotiating mergers and acquisitions (M&A), particularly cross-border ones, can sometimes become problematic, cross-border alliances have started to appear. For example, BSCH (Spain) has share exchange agreements with several European banks (Table 7). However, there are conflicting opinions as to whether all these alliances will eventually lead to fully-fledged cross-border merger operations. To date, there are only a few examples of large, cross-border M&A deals, which have a predominantly regional nature:

Dexia,9 Fortis, and ING in the Benelux countries; and Merita-Nordbanken-Unidanmark in the Nordic region. HSBC’s (Hong Kong/United Kingdom) proposed friendly bid for Credit Commercial de France (CCF) is pending as the first nonregional bank merger.

Share of foreign banks

15. Although individual euro-area countries’ banking systems are becoming more concentrated through mergers of large institutions, the concentration remains in domestic hands. Foreign bank shares within domestic markets are low within the four largest euro-area economies (Table 10). Of the four, market shares of foreign branches and subsidiaries as a share of total domestic assets range from around 12 percent in Spain to about 4 percent for Germany. At the opposite extreme is Luxembourg, where foreign banks dominate the banking scene: foreign branches and subsidiaries hold almost 100 percent of the domestic asset base. Ireland, too, has a large proportion of foreign branches or majority foreign-owned banks in its banking sector—over 50 percent. For the most part, the foreign institutions present in these international banking centers have been encouraged to locate there by various tax and other benefits and, for the most part, they do not participate in domestic credit creation, acting mostly as wholesale banks or locations to book assets in a favorable business environment.10

Table 10.

Share of Foreign Banks 1/

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Source: European Central Bank, “Possible Effects of EMU on the EU Banking Systems in the Medium to Long Term”, February 1999.

Market share of branches and subsidiaries of foreign credit institutions as a percentage of the total assets of domestic credit institutions, end-1997.

1996 figures.

B. History and Industrial Policy Shaped the Current Structure

16. The present structure of the euro-area banking system is the outcome of historical development beginning in the nineteenth century. As in many banking systems around the world, a long history of government intervention and regulation of the banking system has left traces that are still pervasive today. In the euro area, two main features of its history can be highlighted: (1) policies directed at providing universal access to savings instruments, and the provision of credit to targeted segments of the economy, often accompanied by special privileges granted to specific institutions; and (2) the nationalization and subsequent privatization of large portions of national banking sectors.

Unique role of savings institutions

17. Although there is a rich history of banking in Europe, the development of present-day savings institutions is normally attributed to policies that attempted to encourage the provision of financial services to sectors or parts of society that had been left outside the main channels of economic development. At the turn of the nineteenth century, savings banks were envisioned as instruments for the channeling of households’ savings to the industrial sector, whereas mutual and cooperative banks were the providers of credit and liquidity management services for nonindustrial sectors of activity, such as artisans or farmers.

18. The regulation and organizational structure of these institutions vary across countries, but most of them share the feature that their first priority is not to make profits but to accomplish some well-specified public goal. In France and the Netherlands, savings and/or mutual banks are concentrated in a few groups with a pyramidal structure.11 In Germany and Italy, by contrast, the savings and cooperative sector consists of hundreds of small independent entities, which have contributed to the highly diverse nature of their banking sectors. Spain lies in between in terms of concentration, as the cajas have undergone a steady process of consolidation among themselves, mainly at the regional level. In all of these cases, special ownership structures provide these institutions with the opportunity to pursue other goals besides generating profits. Though profitability is gaining increased importance even to this class of institutions, to the extent that they choose not to maximize profits, this gives them a competitive edge relative to commercial banks, which feel the pressures of their shareholders.

Public ownership

19. The heavy weight of the public sector at some point in history is another common characteristic of Europe’s banking sectors. This feature has decisively shaped the banking market, either through the subsequent privatization or through the influence exerted by the public institutions on the types of products and their prices (Box 2). Although most EU-11 central governments no longer own or control large segments of the banking sector, in some countries, notably Germany and Austria, state and local municipalities continue to do so. The Landesbanken and Sparkassen capture over one-third of total assets in Germany, and similar institutions hold about 14 percent of total assets in Austria.

Special privileges

20. An important auxiliary component of public policy in the banking sector has been the granting of special privileges to some of these institutions to facilitate the fulfillment of their role in directing credit to particular areas and in providing savings vehicles for some segments of the population. These privileges have taken several forms.12 In France, the savings banks enjoy the monopoly distribution of the most popular tax-exempted saving account, the Livret A, and some of the mutual networks had, until recently, the monopoly for the distribution of subsidized loans to some sectors of activity. In Germany, the Landesbanken receive two formal government support mechanisms that influence their credit rating and help to lower their funding costs. Implicit guarantees are also present in other countries, as evidenced by lower bank ratings when banks are considered on a “stand alone” basis (i.e. without such guarantees or implicit government support), such as in Moody’s financial strength ratings (Table 11).

Table 11.

Banks’ Financial Strength Ratings

(Proportion of banks in each rating)

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Source: Moody’s.

Privatization of Financial Institutions in Major European Countries

Privatization has been uneven in Europe. The privatization of banks in major European countries started in the mid-1980s (e.g., with the sale of Société Générale), but acquired momentum only in the 1990s, with the sale of banks such as BNP and Crédit Lyonnais in France, Argentaria in Spain, and several major banks in Italy. As well, many Italian savings banks changed their ownership structure from exclusively “foundation-owned” to more open, shareholder-based, entities.

The transformation of the Italian banking sector has in some ways proceeded the farthest. Public sector ownership of the banking sector in Italy fell from 72 percent of total assets in 1993 to 16 percent in 1999, when the share controlled by the Treasury represented less than 1 percent of banks’ capital. The share of “foundations” has also declined substantially, with their stake in large banks being cut by two-thirds and in savings banks by half. Despite this impressive progress, the government continues to encourage foundations to divest and relinquish their control over banks through a set of fiscal incentives and sanctions.

Privatization in France has also been significant, although it leaves room for entrenchment by the public sector. On the one hand, the privatization of the three major commercial banks resulted in a ownership structure with significant participation of international institutional investors and banks that has imparted some market discipline to the sector. On the other hand, several of the financial institutions sold by the state in the late 1990s were acquired by mutual banks (CIC by Crédit Mutuel) or publicly controlled institutions (Crédit Foncier by the Caisses d’Epargne). This outcome was attributable in large part to the stronger capitalization of mutual banks and to their more accommodative approach to labor redundancies, which helped the government disregard foreign bids. In addition, the recent reform of the Caisses d’Epargne fell short of fully privatizing their operations: they were mutualized, and are now under the control of depositors, local governments, and the state-owned Caisse de Dépôts et Consignations (CDC).

Change in Germany has been slow and limited. This stability has in part been attributed to the demands created by German Unification, which renewed the mission of public banks to promote regional development, as well as to a conservative German populace with respect to their local savings banks. Recent decisions by the European Commission may, however, help catalyze changes, at least for the Landesbanken who will likely be required to pay market rates for their funding.

Finally, the share of the public sector in Spanish banking has increased, rather than decreased, in the last 15 years. This has not been the outcome of nationalization: the Spanish authorities quickly auctioned off the banks in which they had intervened during the financial crisis of 1978-83, sold Banesto within ten months of its intervention in 1992, and sold off, under the umbrella of Argentaria the traditionally state-owned specialized banks. Rather, the increasing importance of the public sector is the result of the growing weight of savings banks. Although technically private institutions, local and regional government officials sit on the governing boards of the cajas and influence policy. Although they were not considered as part of the Spanish banking system until the 1970s, they were subsequently allowed to carry out universal banking activities (1977) and expand their operations beyond their original regions (1988). Today, some of them have become major players: the two largest, Caja Madrid and La Caixa, have nation-wide operations and rank among the top five Spanish banks.

21. There has been growing recognition that the private sector may be better situated to meet regional or local development goals and provide universally-available savings vehicles. In the past, some governments believed that credit would not be allocated to satisfy various public development goals, particularly following World War II, and that small investors would not have access to savings vehicles necessary for their retirement. Most euro-area governments now take the view that, while directed lending and savings incentives may still play a role in some selected circumstances, most of the intermediation process should be free from government intervention.

C. Recent Performance and Changes in Balance Sheet Structure

22. Despite the persistence of relatively high labor costs and fierce competition for traditional banking business, the performance of EU-11 banks improved in the second half of the 1990s. Financial liberalization, globalization, and technological changes over the past years have challenged banks to strengthen their competitiveness, and many of them have reacted proactively to the new environment. Facing strong competitive pressures on their traditional income-generating activities, many banks reacted by diversifying their income sources both across products and countries. The structure of banks’ balance sheets reflects these changes: on the liabilities side, traditional deposits have shrunk to the benefit of money market mutual funds and other liabilities, while on the assets side, banks have developed trading activities and securitization operations. Banks’ capitalization has also shown signs of improvement and—in those countries where this important, but sensitive, statistic is disclosed—the share of bad loans in total assets has declined, often following the strengthening of the economy. On balance, despite high operating costs, profitability measures of the banking sector generally improved. Performance, however, differed across types of banking institutions. In France and Spain, savings and cooperative banks increased their share of the sector’s profits, while their share declined in Germany and Italy. This section reviews these developments and highlights some trends that have emerged in the region in the business of banking.

23. The data for this section come predominantly from annual reports of individual banks reporting to FitchIBCA, which harmonizes bank accounting definitions across countries. Although the set of banks covered is not comprehensive, use of the FitchIBCA data base has two main advantages.13 First, FitchIBCA uses the domestic accounting-based source data and adds or subtracts the appropriate categories to provide cross-country consistency (termed “global” variables). This makes comparisons possible—for instance, national sources provide capital ratios that are not comparable across countries because definitions of capital differ across countries. Second, the FitchIBCA database contains many more variables that have been made comparable than other sources (there is only a limited number of them in, for example, the OECD Bank Profitability statistics). This makes it possible to extend the analysis to cover other information such as off-balance sheet items.

Expanding business focus

24. Deregulation of the financial services industry in the euro area over the last 15 years has considerably increased competition in the banking sector and reduced the role of traditional intermediation activities as a source of income for banks. Between 1992 and 1998, net interest margins (NIM)—the difference between banks’ revenues from lending and the remuneration of deposits—have declined from 2 to 1.5 percent of banks’ assets (Table 12). Even though net interest margins have also declined in the United States, they are now lower in all euro-area countries (with the exception of Italy, Spain and Portugal) than in the United States. The steepest drops were recorded in small countries such as Ireland and Portugal, where margins were quite high to start with and for which the path toward EMU accession was associated with falling inflation and domestic interest rates. A similar, albeit more moderate, process also occurred in Italy.

Table 12.

Performance Indicators for Banking Systems

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Sources: FitchIBCA Inc; and Fund staff calculations.Notes: Performance indicators are defined as follows: NIM denotes net interest margins; ROA, or return on assets, is the ratio of pre-tax profits to average assets; ROE, or return on equity, is the ratio of pre-tax profits to average equity; earning power is the ratio of pre-provisioning profits to average assets. The first year reported for the USA is 1993 since the sample of banks reporting in the database is not representative.

Ratio of operating costs to operating income. Our definition of operating costs differs from the traditional one in mat it excludes provisions, which are too year- and bank-specific.

25. Other sources of income, notably commissions from asset management and other services, have come to represent a significant share of banks’ revenues. The new environment created strong incentives for banks to look for new sources of income. On the liabilities side, they began diversifying into businesses with which synergies could be found, such as the management of investment and pension funds. In several EU countries, most of the institutional investors are now included in banking groups and operate with the same corporate strategy. As a result, one-fourth of banks’ operating income in three of the four largest euro area countries came from commissions remunerating this activity in 1998, up from a sixth in 1992. In a significant banking center such as Luxembourg, asset management now provides almost a third of banks’ income.

26. The expansion of commission income has been principally based on the impressive growth of mutual funds, a line of business in which banks in most euro area countries have secured a prominent role. Among the four largest countries, Italy and Spain experienced the strongest growth in managed assets in the second half of the 1990s. The stock of assets held by mutual funds in Italy has multiplied by five since 1995, while it has more than doubled in Spain. The growth of mutual funds in France in recent years has not been as strong as elsewhere, but the French mutual fund industry is mature relative to other European countries: with more than euro 600 billion in assets, it is the biggest in Europe (Table 13). By contrast, mutual funds play a secondary role as savings vehicle in Germany, as time and savings deposits are still the preferred financial instrument of most individual investors.14 The growth of mutual funds has benefited banks in France, Italy and Spain because banks in these countries have been in the forefront of the industry. Indeed, assets held by mutual funds affiliated with banks account for more than two-thirds of the total assets of the industry.15 Many large banks have also taken advantage of their distribution networks—as well as the asset management capabilities they had developed in support to mutual funds—to carve out a comfortable position in the insurance market as well.

Table 13.

Managed Savings in Europe

(1999Q3, in billions of euros)

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Source: European Federation of Investment Funds and Companies (FEFSI).

27. Of course, the counterpart to the growth in managed savings has been the decline in customers’ deposits in banks’ balance sheets, and banks have developed other sources of funding. The expansion of mutual funds has been associated with a decline in the share of deposits in banks’ liabilities, by one-sixth in Ireland and around 10 percent in four other EU-11 countries between 1995 and 1998 (Table 14). Banks have however partially offset this decline in one of their sources of funding by channeling some of the short-term mutual fund investments toward the purchase of certificates of deposit (CDs) or banks’ debentures—a practice relatively common in France for many years.

Table 14.

Main Components of Banks’ Balance Sheets, 1998

(In billions of U.S. dollars and percentage of total assets)

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Sources: FitchIBCA Inc; and Fund staff calculations.

28. To sustain their profitability, banks have also developed their presence on the stock market, and income from trading securities on banks’ own account has become an important, albeit uneven, source of revenue. On the asset side, banks have diversified their sources of income by offering their services for security trading and underwriting for the accounts of their customers. Anecdotal evidence also suggests that, with the advent of EMU, fee income from the issuance of securities by euro area companies and the income earned on advising mergers and acquisitions have been a fast-growing source of revenue for banks. In 1998, securities trading operations provided about one-fifth of banks’ operating income in France, increasing from the level in the beginning of the 1990s. In other EMU countries, however, this type of activity even if expanding contributes relatively little, and generally less than in the United States, to banks’ operating income. Of course these revenues vary substantially from year to year, reflecting their sensitivity to market developments.

29. Despite a disintermediation of finance, EU banks’ asset structure reflects the rapid increase of lending since the run-up to, and advent of, EMU. Perhaps surprisingly, the share of loans in banks’ balance sheet assets has increased in some countries, even though lending spreads have generally declined. This process started before the introduction of the euro, reflecting growing demand for credit owing to the downward path of interest rate levels and an increase in the degree of competition in the bank loan market. Mortgage lending has grown substantially in a number of euro area countries and the process of securitizing these loans, while still at an early stage in some countries, is also progressing at a brisk clip. After the euro was introduced, lending growth was amplified by the growth in “leveraged” loans (e.g., to finance mergers and acquisitions as European corporations restructured), which overshadowed the also substantial increase in issuance of corporate bonds.16 More generally, the increase in the share of loans in banks’ balance sheet may reflect the slow take-off of securitization of standard loans, as opposed to that of mortgages, owing partially to remaining ambiguities in some countries’ legal framework covering such instruments. However, demand factors, such as the growth of institutional investors in the euro area, and supply factors—such as the desire of smaller banks to diversify their assets and the generally favorable regulatory treatment of securitized assets—are however likely to sharply increase the use of loan securitization in coming years.17 Lastly, the decline in non-loan assets represented by the reduction in government securities outstanding in the run-up to the euro, also acts to increase loan shares.

30. The growth of bank lending also results from banks’ expansion into foreign markets, as evidenced by the substantial rise in international claims that they hold. The ratio of foreign assets to domestic private sector claims in banks’ assets increased in almost all EU-11 countries in 1995-98 (Table 15), in part prompted by the low interest rates prevailing in Europe in the period. In 1999, this ratio was larger than 1 in three countries (Belgium, Luxembourg, and Ireland), and above 0.75 in another four countries. It declined only in Portugal and Spain, owing to the unusual increase in domestic lending that accompanied the strong economic performance in these two countries.18 Expansion into emerging markets has tended to reflect old economic links. Foreign exposures of Spanish and Portuguese banks, for instance, have been concentrated in Latin American countries, while German and Austrian banks have accumulated significant claims against eastern Europe.

Table 15.

Foreign Asset Exposures

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Sources: IFS (Panel A); BIS; and Fund staff calculations (Panel B).

Data for France, Germany, Belgium, and Luxembourg refer to 1997.

“Reporting” countries are the EU-11 excluding Portugal, plus Canada, Denmark, Japan, Norway, Sweden, the United Kingdom and the United States.

Operating costs

31. Operating costs, despite some decrease, remain high and absorb at least three-fourths of banks’ operating income in Germany, France, Italy and Spain. The development of non-interest-earning activities does not seem to have resulted in a significant reduction of banks’ operating costs. The development of asset management activities, for example, requires increased fees to be paid to financial advisors and the development of some fee-generating activities may entail higher information technology (IT) and personnel costs. Indeed, although the ratio of labor costs to operating income declined, to a different extent in almost all euro-area countries, it remains higher than in the United States (except in Luxembourg, Finland, and Portugal). Personnel costs remains the largest component of operating costs, with the average euro-area bank spending over half of its operating expenseson wages and salaries in 1998, despite the rise in expenditures associated with the conversion to the euro.

Asset quality

32. The assessment of banks’ asset quality is made difficult by the lack of uniformity in the treatment of nonperforming loans across euro-area countries, but it appears to indicate an improvement in most countries, notably those more advanced in the economic cycle (Box 3). Excluding Germany, Austria, Luxembourg, and the Netherlands that do not publish figures on the level of nonperforming loans (NPL), EU-11 countries can be divided in two groups with respect to the share of bad loans in total loans (Table 16).19 In the first group, including Finland, Ireland, Portugal, and Spain, NPL account for less than 3 percent of total loans. In the second, accounting for Belgium France, and Italy, NPL range from 3 percent to 9 percent of total loans. Remarkably, the share of bad loans in Finland, Portugal, and Spain has dropped sharply to between 2 percent and 3 percent since the mid-1990s, in contrast to a more subdued reduction in France and a very modest decline in Italy.20 The pace at which bad loans have been written off in different countries has been related to the stage of these countries in the economic cycle, but it has also reflected individual country policies. Those countries in which supervisors can have a say on the amount of provisions that are tax deductible (e.g., Portugal and Spain) have typically witnessed a faster pace of write-offs than those countries in which deductibility is more inflexible (e.g., Italy).

Table 16.

Measures of Liquidity and Solvency

(In percent; 1998 unless otherwise marked)

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Sources: FitchIBCA Inc; National Central Banks; and The Banker.Note: The term “n.a.” implies an absence of an aggregate representing the banking sector as a whole. The number of banks reporting these data to FitchIBCA voluntarily is small and thus these data have not been reported as their representativeness is not certain.