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29. Volkswirtschaftliche Tagung 2001

Der einheitliche Finanzmarkt –Eine Zwischenbilanz

nach zwei Jahren WWU

Klaus LiebscherOpening and Introductory Remarks 4

Willem F. DuisenbergThe Role of Financial Markets for Economic Growth 10

Konvergenz der FinanzsystemeSir Edward GeorgeComparing Financial Systems: How Much Convergence? 20

Franklin AllenComments on Sir Edward George, ÒComparing Financial Systems: How Much Convergence?Ó 28

Ernst-Ludwig von ThaddenThe Single Financial Market: An Assessment and an Outlook for the Future 32

Helmut ReisenWill Basel II Contribute to Convergence in International Capital Flows? 48

Esa JokivuolleComments on Helmut Reisen ÒWill Basel II Contribute to Convergence in International Capital Flows?Ó 64

Dirk SchoenmakerLuncheon Speech: The Skill Profile of Central Bankers and Supervisors 70

Die optimale Gestaltung von Finanzmarktregulierung und Finanzaufsicht:Die Herausforderung der wachsenden Internationalisierung der FinanzindustrieGertrude Tumpel-GugerellEinleitungsstatement 78

Ernst WeltekeDas Design eines Aufsichtssystems aus dem Blickwinkel der Deutschen Bundesbank 82

Walter RothensteinerDie Gestaltung des Bankenaufsichtssystems aus Sicht der Gescha¬ftsbanken 92

David T. LlewellynA Regulatory Regime for Financial Stability 98

Jean-Claude The« baultFinancial Supervision: The EU Approach 122

Arturo EstrellaComments on David T. Llewellyn, ÒA Regulatory Regime for Financial StabilityÓ 134

Norbert WalterComments on David T. Llewellyn, ÒA Regulatory Regime for Financial StabilityÓ 142

Karl-Heinz GrasserDinner Speech: Aktuelle Themen der Budgetpolitik 152

Inhalt

2 Volkswirtschaftliche Tagung 2001×

vowi-tagung_2001 - Seite 2 - 6. 11. 2001, 16:12 - schwarz - rot

Wolfgang Schu¬ sselKamingespra¬ch: Aktuelle Themen der Wirtschaftspolitik 160

Langfristige Perspektiven fu¬r neue Technologien, Finanzma¬rkte und FinanzmarktaufsichtHermann-Josef LambertiNew Technologies and Financial Markets in the Long Term 170

Christophe BisiereThe Internet and Financial Markets: Island versus Nasdaq 180

Clive BriaultComments on Hermann-Josef Lamberti, ÒNew Technologies and Financial Markets in the Long TermÓand Christophe Bisiere, Bruno Biais and Chester Spatt,ÒThe Internet and Financial Markets: Island versus NasdaqÓ 192

Gert WehingerComments on Hermann-Josef Lamberti, ÒNew Technologies and Financial Markets in the Long TermÓand Christophe Bisiere, Bruno Biais and Chester Spatt,ÒThe Internet and Financial Markets: Island versus NasdaqÓ 200

Erich W. StreisslerFinancial Institutions and Technological Progress: An Historical Perspective 208

Gianni TonioloA Tale of Two Financial Market Integrations Ð Comments on Erich W. Streissler,ÒFinancial Institutions and Technological Progress: An Historical PerspectiveÓ 218

Bankwesen und Finanzdienstleistungen, PodiumsdiskussionGertrude Tumpel-Gugerell, ModerationEinleitungsstatement 226Graham BishopComments for the Panel Discussion on the Banking Industry and Financial Services 231Alessandro ProfumoThe Banking Industry and Financial Services 240Urs Philipp RothThe Single Financial Market: A Swiss Perspective 243Reinhard H. SchmidtThe Banking Industry and Financial Services 247

Franco BruniSummary Statement 254

Gertrude Tumpel-GugerellClosing Remarks 260

Franz-Weninger-Stipendien 264

Die Vortragenden 266

Inhalt

Volkswirtschaftliche Tagung 2001 3×


Klaus Liebscher

1


Opening

and Introductory

Remarks

It is a great pleasure for me to wel-come you all to the 29th conferencein economics hosted by the Oester-reichische Nationalbank. We arehonored that so many of you areattending this conference to sharewith us your views as well as yourexpertise. I would like to extend aspecial welcome to the keynotespeaker of this conference, Mr.Duisenberg, President of the ECB.

This yearÕs topic ÒThe SingleFinancial Market: Two Years into EMUÓfits very well into the tradition ofthis conference. It has always beenour aim Ð and our ambition Ð to dis-cuss current issues which are ofmajor interest to both practitionersand academics. I believe that it is fairto claim that the single Europeanfinancial market is one of theseissues.

European Monetary Union(EMU) has certainly been the mostimportant event for European andindeed for international financialmarkets since the breakdown of the

Klaus LiebscherGovernor,

Oesterreichische Nationalbank


Bretton-Woods system. With thesingle currency an important neces-sary condition is met to achieve theambitious goal of creating a singlefinancial market in Europe. Thesingle currency itself, however, cannot establish this market automati-cally. Many other conditions have tobe fulfilled and new challenges haveto be met. It is our hope that thisconference will provide a forum toaddress these important issues andwill allow us to take stock of whatwe have achieved so far.

The financial sys-tem fulfills severalessential functions forthe performance of thereal economy. It playsa crucial role in theallocation of resourcesby channeling fundsfrom households toenterprises, it provides

risk-sharing opportunities for house-holds and firms, and it helps agentsto economize on transaction andinformation costs.

An economic environment inwhich these functions can be fulfilledsmoothly and efficiently is thereforeessential for the welfare of an eco-nomy.

For a long time European finan-cial markets had to cope with variousobstacles created by national bounda-ries and different legislation. As aconsequence, the financial system inall the different countries could notfulfill its essential functions as effi-ciently as it might have. However,the picture has changed dramaticallyduring the last decade. With anaccelerating process of Europeanintegration and the historic projectof the EMU the conditions to

establish a truly harmonized financialmarket in Europe have become veryfavorable. They have been fosteredby the impressive success of the euro.Together with the U.S. dollar theeuro has established itself as the sec-ond most important reserve cur-rency. By the end of 1999, 13% ofthe worldÕs foreign reserves wereheld in euro.1) It also immediatelygained an important rank as a cur-rency of denomination in the bondmarket. It served as liability cur-rency for 76% of corporate sectordebt issued by euro area residentsin 1999.2) But also as an issue cur-rency for international bonds in theprivate sector the euro topped theU.S. dollar in the same year.3) Inaddition soon after the introductionof the euro more than 50 countriesalready use it as an anchor currency.

In the numerous outlooks issuedprior to EMU it was argued that thesingle currency will enhance thedepth and liquidity of European cap-ital markets. It was predicted thattransaction costs will decrease sub-stantially, that opportunities fordiversification of income risks willbe strengthened and that the Euro-pean financial system will becomemore competitive at an internationalscale. How shall we judge theseexpectations ex post, after the expe-rience of more than two years ofEMU? The papers in session 1 willtake up these issues in depth.

I think that looking back we seethat these hopes and predictions havenot been empty. Already in the run-up to the single currency consider-able structural changes have takenplace in European financial markets.This process of change has gainedmomentum by the introduction of

1 See IMF (2000), Appendix I, table 1.2.2 See BIS (2000a), p. 128. This number is to be compared with an average of 50% in the predecessor currencies

between 1990 and 1998.3 See BIS (2000b), p. 17.

Klaus Liebscher



the euro and there are good reasonsto believe that we are only at the verybeginning of this process. The evi-dence for the direct changes broughtabout by the single currency isrelatively easily seen and thereforeusually uncontroversial.

These direct effects such as thestandardization and transparency insecurity pricing, the elimination ofcurrency risk, as well as the homog-enization of the public bond marketand the refinancing procedures forthe banking system arise almostautomatically as a consequence ofthe currency union and the establish-ment of the Eurosystem. They arequantitatively important althoughthey are not always easy to assessempirically.

Much more difficult to assess arethe indirect effects. These effectsentail the impacts on the depth andthe liquidity of European capitalmarkets, on opportunities to diver-sify income risks of households andfirms, the institutional changes, andthe way in which these changes willshape the future of the Europeanfinancial system. They are morelikely to materialize gradually overtime and might not yet be visible intheir entire consequences. Some ofthe long-run perspectives will beaddressed in session 3 at the end ofthe conference in detail. But evenhard boiled sceptics have to acknowl-edge that, in the meantime, some ofthese effects have become visible inan impressive way.

Take the capital market as anexample. Expectations with regard

to this important part of the financialsystem have been particularly high.In the capital markets the changesin the corporate bond market haveperhaps been most pronounced.Not only has total volume increasedremarkably, also the size of individualissues has increased by a substantialamount. By itÕs size and itÕs opennessthe bond market in the euro area isnow able to absorb very large issues.It is able to do so at a larger scalethan the individual bond markets ofthe predecessor currencies of theeuro. The evidenceavailable so far1) there-fore supports verymuch the view that theEuropean private bondmarket has substantiallyincreased in liquidityand breadth.

We can also ob-serve a clear trend to-ward an increase in equity financing.The listing of new companies hasincreased considerably during thelast three years. Circumstantial fac-tors notwithstanding, this increasealso reflects an increased attractive-ness of stock market listings in theeuro area.2)

It is not unwarranted to assumethat this is only the beginning of adevelopment reaching much further.With the convergence of fundamen-tals across the euro area, countryspecific investment strategies willbecome less attractive and the valueof trans-European asset managementwill presumably increase.3) Thisdevelopment will contribute to more

1 A widely cited study documenting this evidence is for instance Danthine, Giavazzi, von Thadden (2000).2 Evidence based on the data from the International Federation of Stock Exchanges (FIBV) reported in a speech by

the Vice President of the ECB Christian Noyer shows that in the course of 1999 approximately 900 companieswere newly listed in the euro area. Compared with 1998 this amounts to an increase of 40%. See Noyer (2000).

3 As evidence to support this as a reasonable conjecture one could take the Goldman-Sachs/Watson-Wyatt survey offund managers. The survey has found for 1998 that 70% of fund managers intended to change their asset allo-cation after the introduction of the euro. 64% said that the new allocation will be based on sector considerationsrather than countries. See Goldman Sachs, Watson Wyatt (1998).

Klaus Liebscher



efficient information flows and willultimately lead to a major reorgan-ization of the European asset man-agement industry, which has alreadybegun. Once this development fullymaterializes, the trend toward anincreasing importance of pan-Euro-pean equity markets will be rein-forced.

Evidence could also be takenfrom other segments of the financialsystem to support the view that euroarea financial markets have alreadyseen a remarkable development both

in quantity and quality.Take for instance thelarge size and highliquidity of the unse-cured money market,the rapid developmentof an overnight interestrate swap market basedon euro money marketrates and the futures

markets based on government bondssuch as the bund future, which hasgained a references status for thewhole euro area.

The development of Europeanfinancial markets is of course alsoshaped by global economic trendsand technological developments. Itis therefore not always easy to disen-tangle the impacts of the single cur-rency from impacts of other factorsthat are conductive to the develop-ment of the single financial market.We also have to be aware that furtherdevelopments are needed to create atruly homogeneous single financialmarket in Europe and variousobstacles still remain. The develop-ments I have sketched before, how-ever, give good reasons to be opti-mistic about the future.

The structural changes that wecan already see in financial marketswill also affect the future of financialinstitutions, in particular Europeanbanks. Our conference will addressthis important issue in a panel discus-

sion including panelists from thebanking industry and from academia.Not only do they play a dominantrole in the European financial sys-tem, they are also among the mostimportant players on Europeanfinancial markets.

While the changes in the capitalmarkets which I have outlined beforehave a negative impact on the tradi-tional deposit and lending business,banks can take advantage of benefitscreated by the increasing role of assetmanagement and investment bankingactivities, where they have specialexpertise due to the European tradi-tion of universal banking. Thus, thedevelopment toward a more marketbased financial system does not implythat banks will be unimportant.Quite to the contrary, their rolemight be even strengthened by thesedevelopments. However, to benefitfully from these new opportunitiesthey will have to go through a signifi-cant process of restructuring andinnovation.

Investment banking and assetmanagement activities are mostaffected by the single currency.These banking activities are charac-terized by strong economies of scale.Due to these technological featuresthere are incentives for merger activ-ities both domestic as well as cross-border and we have already seenthese incentives at work. From thepresent perspective it is not yetvisible, what will be the ultimateoutcome of this process. However,as already seen in the capital market,it seems that EMU has been a deci-sive push toward a more integratedand more competitive Europeanbanking industry.

Structural change in financialmarkets is not only a challenge formarket participants and financialinstitutions. Since financial marketsare dependent on a well-functioningcomplementary legal, regulatory,

Klaus Liebscher


2


and supervisory infrastructure, regu-lators are particularly challenged tokeep up with the pace of changeand to find suitable answers to thenew reality of financial markets. Ses-sion 3 of our conference is thereforeentirely devoted to the discussionand analysis of this important topic.

Indeed we have been observingvarious proposals to reorganize andrestructure financial markets super-vision and to create a new institu-tional framework to safeguard finan-cial stability throughout the Euro-pean Union. Some member stateshave already taken steps of majorinstitutional reforms.

In the course of this debate theactive involvement and the key roleof central banks in supervising thebanking system has been repeatedlychallenged. Models of new nationalinstitutions in charge of supervisingbanks, financial markets, and theinsurance industry under one roofof a general financial service author-ity have gained some popularityamong politicians.

The merger of various super-visory fields into one single institu-tion is highly ambitious and will haveto be assessed in the light of practicalexperience. Whatever reorganiza-tion design is under debate, it is ofcrucial importance to take a clearposition about the role of the centralbank. Regarding the role of thenational central banks in this con-text, I would like to refer to Presi-dent DuisenbergÕs keynote speech,who will devote part of his presenta-tion to this issue.

The project of creating a Euro-pean single financial market has beensupported by global economic trendsand the process of European integra-tion, but it has also received a major

impulse by the establishment ofEMU. It has already induced animpressive process of structuralchange and it has created new chal-lenges for market participants, finan-cial institutions, and regulators. Tomeet these challenges the open dis-cussion of issues, the contributionof individual and institutional exper-tise, and the serious efforts of all ofus to find sound answers and goodsolutions to new problems is decisiveto turn this ambitious project to theultimate benefit for European citi-

zens. It is my hope that our confer-ence can contribute to these efforts.

Thank you very much for yourattention. §

References

BIS (2000). 70th Annual Report. Basel.

BIS (2000b). Quarterly Review. Basel.

Danthine, J. P., Giavazzi, F., von Thad-den, E. L. (2000). European Financial

Markets after EMU: A first Assessment.

Mimeo.

Goldman Sachs, Watson Wyatt (1998).The Goldman Sachs/Watson Wyatt EMU

Survey Ð Summary of Results. Goldman

Sachs Equity Derivatives Research, June.

IMF (2000). Annual Report 2000. Washing-

ton D. C.

Noyer, C. (2000). The development of

Financial Markets in the Euro Area, speech

delivered by the Vice President of the

ECB at the Royal Institute of International

Affairs. London. June 26, 2000.

Klaus Liebscher



Willem F. Duisenberg


The Role

of Financial Markets

for Economic Growth

It is a great pleasure and honour forme to join the OesterreichischeNationalbank for its 2001 EconomicsConference on ÒThe Single FinancialMarket: Two Years into EMUÓ. I wouldlike to take the opportunity to talkabout the role of financial marketsfor economic growth. I shall firstconsider whether the design of thefinancial system matters for eco-nomic growth. Second, I shall say afew words about where the euro areafinancial system is heading, two yearsafter the introduction of the euro.After this I shall discuss the role ofmonetary policy in the interplaybetween financial markets and eco-nomic growth. Towards the end, Ishall address, as just mentioned byGovernor Liebscher, the role of cen-tral banks in prudential supervision.

Does the financial systemmatter for economicgrowth?

In the financial system funds flowfrom those who have surplus fundsto those who have a shortage offunds, either by direct, market-basedfinancing or by indirect, bank-based

Willem F. DuisenbergPresident,

European Central Bank


finance. The former British PrimeMinister William Gladstone ex-pressed the importance of financefor the economy in 1858 as follows:ÒFinance is, as it were, the stomachof the country, from which all theother organs take their tone.Ó

The financial system comprisesall financial markets, instrumentsand institutions. The question ofwhether the design of the financialsystem matters for economic growthin my view has to be answered withÒyesÓ. According to cross-country

comparisons, individualcountry studies as wellas industry and firmlevel analyses, a positivelink exists betweenthe sophistication ofthe financial systemand economic growth.While some gaps re-main, I would say that

the financial system is vitally linkedto economic performance. Never-theless, economists still hold con-flicting views regarding the underly-ing mechanisms that explain the pos-itive relation between the degree ofdevelopment of the financial systemand economic development.

Some economists just do notbelieve that the finance-growth rela-tionship is important. For instance,Robert Lucas asserted in 1988 thateconomists badly over-stress the roleof financial factors in economicgrowth. Moreover, Joan Robertsondeclared in 1952 that Òwhere enter-prise leads, finance followsÓ.According to this view, economicdevelopment creates demands forparticular types of financial arrange-ments, and the financial system auto-matically responds to these demands.

Other economists stronglybelieve in the importance of thefinancial system for economicgrowth. They address the issue ofwhat the optimal financial system

should look like. Overall, the notionseems to develop that the optimalfinancial system, in combinationwith a well-developed legal system,should incorporate elements of bothdirect, market-based and indirect,bank-based finance. A well-devel-oped financial system shouldimprove the efficiency of financingdecisions, favouring a better alloca-tion of resources and thereby eco-nomic growth.

Both market and bank-basedfinancial systems have their owncomparative advantages. For someindustries at certain times of theirdevelopment market-based financingis advantageous. For example,financing through stock markets isoptimal for industries where thereare continuous technological advan-ces and where there is little consen-sus on how firms should be managed.The stock market checks whetherthe managerÕs view of the firmÕs pro-duction is a sensible one. For otherindustries, bank-based financing ispreferable. This holds in particularfor industries which face stronginformation asymmetries. Financingthrough financial intermediaries isan effective solution to adverse selec-tion and moral-hazard problems thatexist between lenders and bor-rowers. Banks in particular havedeveloped expertise to distinguishbetween good and bad borrowers.Economies that have both well-developed banking sectors and capi-tal markets thus have an advantage.Furthermore, in times of crisis ineither system, the other system canperform the function of the famousspare wheel.

The financial system is also par-ticularly important in reallocatingcapital and thus providing the basisfor the continuous restructuring ofthe economy that is needed to sup-port growth. In countries with ahighly developed financial system,



3


we observe that a greater share ofinvestment is allocated to sectors ofrelatively high growth. When welook back more than one centuryago, during the Industrial Revolu-tion, we see that the financial systemof England did a better job in identi-fying and funding profitable venturesthan other countries in the mid-1800s. This helped England enjoycomparatively greater economic suc-cess. Walter Bagehot, banker andformer editor of The Economist,expressed this in 1873 as follows:ÒIn England, however, É capitalruns as surely and instantly where itis most wanted, and where there ismost to be made of it, as water runsto find its levelÓ.

Nowadays, the lack of a well-developed stock market would be aparticularly serious disadvantage forany economy. Equity is essential forthe emergence and growth of inno-vative firms. TodayÕs young innova-tive high-technology firms will bethe main drivers of future structuralchange essential for maintaining acountryÕs long-term growth poten-tial. The contribution of financialmarkets in this area is a necessityfor maintaining the competitivenessof an economy today given thestrongly increased internationalcompetition, rapid technologicalprogress and the increased role ofinnovation for growth performance.

In recent years, Ònew marketsÓ,for stocks of young and growingcompanies, have become a growingmarket segment in the euro area.Equity financing is particularlyadvantageous for these companiesand their investors given the uncer-tainties of the economic return. Asthe term ÒsharesÓ suggests, withequity financing you get your shareof the outcome, whether it is posi-tive or negative. Banks, on the otherhand, may be reluctant to provideloans owing to the risk profile of

these firms and the greater exposureto a negative result in a loan con-tract.

Total market capitalisation of thenew markets in five euro area coun-tries grew from EUR 7 billion at thebeginning of 1998 to EUR 167 bil-lion in December 2000. While someof this increase can be attributed tothe overall rise in share prices duringthis period, it is important to notethat the number of listed companiescontinued to increase almost everymonth. The total number of compa-nies listed on these newmarkets in the euroarea increased from 63at the beginning of Jan-uary 1998 to 564 at theend of 2000. Develop-ments over the last yearhave admittedly beendismal. However, it isthe nature of new mar-kets, given the uncertainties attachedto future developments of the com-panies listed on these markets, toexhibit more volatility than estab-lished markets.

Bank-based finance has a specialrole to play for many companies inneed of funds, and thus helps toensure a well-balanced growth proc-ess. The economic literature onÒrelationship bankingÓ has demon-strated that banks can contribute toalleviating the impact of sudden eco-nomic shocks on their clients. Banksstand ready to provide many custom-ers with funds even in adverse cir-cumstances, e.g. when the liquidityof financial markets dries up.

The banking sector also has anessential role to play with respectto the allocation of funds to the mostprofitable investment opportunities.Banks are, as mentioned before,financial intermediaries that bynature add cost to the allocation ofcapital. Thus, in order for banks tosurvive in a market economy they




need to provide added benefits. It isdifficult to compete with the debtsecurities market if a bank loan isof a size where the fixed costs ofaccessing debt markets become neg-ligible. However, securities marketsare not always sufficiently liquidand some, especially small andmedium-sized enterprises cannotcover their liquidity needs via secur-ities markets owing to significantfixed costs of access. An additionalbenefit of bank-based finance relatesto the intrinsic nature of the bankingbusiness: some projects cannot befinanced directly by the market onaccount of significant informationasymmetries between the borrowersand potential lenders. Banks canbridge this gap thanks to their com-parative advantages in the assessmentand monitoring of investment pro-jects, which contributes to overcom-ing information asymmetries.

The financial systemof the euro area aftertwo years with the euro

Let me now turn to the majorchanges of the financial system inthe euro area after two years withthe euro.

Financial market integrationThe launch of the euro on 1 January1999 was a historic event. Elevennational currencies were convertedinto one single currency overnight.Greece became the twelfth EUMember State to adopt the singlecurrency on 1 January 2001. Thenewly created currency area of thetwelve participating EU MemberStates has a considerable weight inthe world economy. It accounts foraround 20% of the worldÕs GDPand of world exports. The successfullaunch of the euro, which is a keyelement in the creation of a stableand prosperous Europe, has boostedthe integration of financial markets

in the euro area. This process ofintegration in European financialmarkets coincided with the trendstowards globalisation and securitisa-tion. Other factors, among a widerange which shape the financialsystem are historically determinedcharacteristics, technological inno-vation, monetary and fiscal policiesand specific legal and accountingsystems that differ from country tocountry.

Evidence of integration can befound, to varying degrees, in allparts of the financial system. Theeuro area money market is amongthe most integrated parts of thefinancial system. The conduct ofone common monetary policy inthe euro area brought about immedi-ate integration of the unsecuredsegments of the money market,mainly the interbank market andthe short-term derivatives market.The secured segments of the moneymarket, that is the repo market andthe markets for short-term secur-ities, are also increasingly integrated,but they still suffer from underlyingproblems with the management ofcollateral. Nonetheless, the outlookis promising. The euro area bondmarket has also developed rapidly.Notably, the private segments ofthe euro area bond market haveflourished since the introduction ofthe euro. The amount outstandingof long-term debt securities issuedby the private sector was 22% higherat the end of 2000 compared withthe end of 1998. Probably the mostsignificant development has beenthe rapid growth in the euro-denominated corporate bond mar-ket, which has increased several-foldin size since the launch of the euroand is now characterised by issuesof above EUR 1 billion. EMU hasalso stimulated integration in thestock markets in the euro area,where structural developments have




been dominated by a series of high-profile mergers and attemptedmergers.

Regulatory frameworkThe rapid growth achieved by Euro-pean securities markets has takenplace notwithstanding remainingregulatory obstacles to their integra-tion. The European authorities arefully aware of the need to address thisproblem. Several obstacles have beenidentified in the recent Report of theCommittee of Wise Men, chaired byAlexandre Lamfalussy. The Commit-tee proposes to speed up the removalof impediments through the institu-tionalisation of two new regulatorycommittees for securities markets,which should allow for an increasedharmonisation of securities regula-tion and less burdensome proceduresfor adapting Community rules torapidly changing financial markets.

Another essential Europeaninitiative was the adoption by theCommission, in May 1999, of aprogramme for the completion ofthe Single Market for financial ser-vices. This programme, the FinancialServices Action Plan, lists a series ofmeasures with indicative prioritiesand timetables. The project consid-ered as a whole and its inherentphilosophy are capable of enhancingeconomic growth. In this perspec-tive, a handful of specific initiativesdeserve a particular mention. A firstinitiative is the adoption of the Euro-pean Company Statutes, which isessential to enhance the level playingfield between European firms andto provide a suitable legal frame-work for transnational conglomer-ates. A second important aspect isthe Risk Capital Action Plan, whichwould help redirect financial flowstowards high-growth small andmedium-sized enterprises. Let mealso mention the last four initiatives,namely the e-commerce policy for

financial services, the harmonisationof rules on the accounting require-ments for European companies, thetakeover bids directive, and finallythe removal of accounting, legaland fiscal discrepancies hinderingthe cross-border use of collateral.A European directive on this subjectshould be adopted in 2003.

Many of these initiatives mayappear to be unimportant and some-what ÒesotericÓ regulatory changes.However, they can provide a realboost to the smooth operation ofmarkets and, therefore,to economic growth.For example, obstaclesto the cross-border useof collateral preventthe further cross-bor-der integration andconsolidation of clear-ing and settlementinfrastructures, thushindering the integration of Euro-pean money, bond and equitymarkets. A smooth electronic inte-gration of trading, clearing andsettlement operations would helpreduce transaction costs substan-tially. The gradual dismantling ofregulatory obstacles to the remainingmarket integration in Europe willcontribute to enhancing their depthand efficiency, in turn contributingto an improved allocation of fundsto the most profitable investmentopportunities, and thus supportingeconomic growth.

What is the roleof monetary policyand central banks?

Price stabilityThe interaction between financialmarkets, economic growth and mon-etary policy is by no means a newissue for central bankers. However,financial market developments havebrought the question to the forefrontof the policy debate. The continued




integration and deepening of finan-cial markets is a significant issue forpolicymakers, and particularly forcentral bankers, since smoothlyfunctioning and efficient financialmarkets are crucial in ensuring asmooth transmission of monetaryimpulses.

The best contribution that mon-etary policy can make to the smoothfunctioning and integration of Euro-pean financial markets and to eco-nomic growth is to maintain a steadymedium-term price stability orienta-tion. Such a policy will be beneficial,as it will minimise the adverse effectsof inflation and high inflation uncer-tainty. As we all know, price stabilityis beneficial in numerous ways. Notonly does it create a climate forhigher economic activity over themedium term, but it also reducesthe economic and social inequalitiescaused by the asymmetric distribu-tion of the costs of inflation amongthe various economic agents. In addi-tion, in an environment of low infla-tionary expectations, inflation riskpremia become relatively less impor-tant as a determinant of financialprices. As a result, other factors suchas credit risk can play a larger rolein the price formation mechanism.Ultimately, this results in a moreefficient allocation of financialresources.

The approach of focusing onprice stability is by now the conven-tional wisdom in industrialised coun-tries. In the case of Europe, this con-sensus on the contribution of pricestability in the medium term to pro-moting long-term growth is explic-itly enshrined in the Statute of theEuropean System of Central Banks(ESCB), which states unambiguouslythat Òthe primary objective of theESCB shall be to maintain pricestability in the medium termÓ. TheECB is convinced that by rigorouslyfulfilling this mandate monetary

policy is making its most effectivecontribution to the realisation ofstrong output growth and satis-factory employment prospects.

Financial stabilityand the role of central banksin banking supervisionAlso the design of prudential regula-tion plays an important role from agrowth perspective. Supervision isthe guardian of financial stability,which in turn crucially determinesthe capability of the financial systemto allocate resources efficiently andabsorb liquidity shocks. Financial cri-ses can have a deep and protractedimpact on economic growth, as illus-trated by several episodes of financialinstability that occurred in manycountries. The contribution of pru-dential supervision to economicgrowth proceeds along two dimen-sions. From a preventive perspective,supervision has to ensure a continu-ous and comprehensive monitoringof all the potential threats to financialstability. The role of supervision isalso crucial after the emergence ofa crisis, in order to provide for aswift and ordered resolution. Super-visors can only be effective in thesetwo respects if they are able to paysufficient attention to systemicissues, namely the risk of contagioneffects. In order to address this issuein an effective way, they should beable to bridge the gap between infor-mation of a micro-prudential nature,namely information on the safety andsoundness of individual institutions,and macro-prudential analysis, whichencompasses all activities aimed atmonitoring the exposure to systemicrisk and at identifying potentialthreats to financial stability arisingfrom macroeconomic or financialdevelopments.

This line of argument would sup-port a large role for central banks insupervision, since they have tradi-



4


tionally played a large role in macro-prudential analysis and the preserva-tion of financial stability and theyhave acquired a strong expertise inthis field. Furthermore, smoothaccess of central banks to micro-pru-dential information would also beprofitable from the perspective ofanother traditional central bankingtask, namely the oversight of pay-ment systems.

In spite of these argumentssupporting a large role of centralbanks in supervision, the debatehas remained broadlyinconclusive in the eco-nomic literature so far,owing to the existenceof opposite considera-tions. The first impor-tant argument against alarge role for centralbanks is the so-calledÒconglomeration argu-mentÓ, which crucially relies on theidea of a blurring of distinctionbetween banking, insurance andsecurities firms. In order to preservethe level playing-field, all segmentsof the financial industry would haveto be supervised under the aegis ofa common supervisor. According tothis line of reasoning, this ÒumbrellaÓcould not be the central bank, sincethe latter is traditionally in chargeof supervising monetary organisa-tions. I will not embark upon a thor-ough analysis of this issue now. Letme just say that I am convinced thatthis argument has lost relevance inthe current context characterisedby a more market-based conduct ofsupervision Ð which alleviates thelevel playing-field concern Ð and byan increased relevance of systemicrisk issues.

The second major argumentagainst a large involvement of centralbanks in supervision is the allegedconflict of interest between mone-tary policy and prudential super-

vision. Many authors have arguedthat the institution in charge ofmonetary policy cannot be entrustedwith supervision, because the mone-tary policy stance would be Òconta-minatedÓ by supervisory issues, forinstance the need to safeguard theliquidity of individual banks.

The advent of the euro, however,has shifted the balance of argumentsdecisively in favour of a large involve-ment of national central banks(NCBs) in supervision, for two mainreasons. First, the argument of a

conflict of interest between mone-tary policy and prudential super-vision becomes irrelevant withinthe euro area, where supervisoryresponsibilities are at the nationallevel. Since the geographical jurisdic-tions of monetary policy and pruden-tial supervision no longer coincide,NCBs in charge of prudential super-vision are shielded from the tradi-tional conflict of interest.

The second key factor is theincreased relevance of systemic risksince the advent of the euro. Thenature and scope of systemic riskhave changed in a decisive way. Afirst decisive evolution is the growingintegration of European financialmarkets in the euro area. As I havealready mentioned, the interbankmarket, especially the unsecuredsegment, is already fully unifiedacross the area owing to the dis-appearance of the currency risk andthe connection of national real-time gross settlement systems viaTARGET, the large-value cross-




border payment system of the Euro-system. A second key evolution fromthe perspective of systemic risk is thegrowing merger and acquisitionactivity and the trend towards theemergence of financial conglomer-ates in Europe, which has, forinstance, been identified in a recentG10 report on consolidation in thefinancial sector. In this new environ-ment, financial institutions areincreasingly involved in intricatenetworks of counterparties in theinterbank market and via payment

and settlement systems,and the impact anunwinding of theirpositions could haveon asset prices becomeseven more ambiguous.These interrelationshave a more interna-tional character thanbefore the advent of

the euro, which implies that super-vision has to pay much more atten-tion to euro area-wide develop-ments. The national central banksof the euro area have a comparativeadvantage in this field owing to theirresponsibilities over payment andsettlement systems, their traditionalfocus on systemic risk, and their roleas components of the Eurosystem.

My conclusion is that the suc-cessful pursuance of financial stabil-ity in Europe, which is a prerequisitefor economic growth, could benefitconsiderably if NCBs maintain andeven reinforce their role in pruden-tial supervision. The debate on theorganisation of banking supervisionseems to be taking a different coursefor the moment at least in a few euroarea countries. Institutional arrange-ments based on a single supervisoryauthority for the financial systemsas a whole seem to have gainedmomentum over the past months insome euro area countries like Ireland

and Finland, and also in your coun-try, Austria, where a single super-visor for banking, insurance, secur-ities and pension funds should beestablished early 2002 according tothe recent draft Financial MarketSupervisory Authority Act (Finanz-marktaufsichtsgesetz).

At first sight, this evolution runscounter to the need for a largerinvolvement of NCBs in prudentialsupervision. However, in this fieldimplementation details are crucial.In particular, it is crucial that effec-tive provisions for a close co-opera-tion and a smooth exchange of infor-mation between the separate super-visory authority and the NCB are laiddown. NCBs should in any case beentrusted with the task of safeguard-ing financial stability of the system asa whole and endowed with theinstruments needed to pursue suchan objective effectively. In thisrespect, an extensive operationalinvolvement of NCBs in the conductof prudential supervision is a keyfactor.

Conclusions

In concluding, I believe it is fair tosay that EMU has already had a pro-found impact on the process of EUfinancial integration. The impact ofthe introduction of the euro as a sin-gle currency of twelve MemberStates has created the potential forlarge, deep and liquid euro-denomi-nated financial markets, whichshould help to deliver high rates ofoutput and employment growth inthe euro area economy. This trans-formation in the financial and eco-nomic landscape entails certainpotential risks, but it will providemany opportunities for enhancedefficiency and growth in the financialmarkets and economies in the euroarea. I am convinced that the latterwill prevail. §





Sir Edward George

5


Comparing Financial Systems:

How Much Convergence?

The theme of this session is conver-gence of financial systems, withinthe context of the overall conferencetheme of ÒThe Single Financial MarketÐ Two Years into EMU.Ó What I proposeto do this morning is to ask, first,what are we Ð or should we be Ðlooking for in our financial systems;then to ask, second, what are themajor driving forces that have been,and are, affecting our financial sys-tems Ð including but not confinedto EMU; and, finally, to offer somethoughts on how those systems mightcontinue to evolve.

So let me begin by asking whatshould we look for in our financialsystems. In answering that question,I could give you a long list of partic-ular payments and savings services aswell as credit, investment and insur-ance services, provided to individu-als, to private organisations and busi-nesses of all kinds, and to variouslevels of government. But that wouldbe simply a description of our finan-cial systems which do still differ inmany respects as a result of historyand tradition, of particular localneeds, and of the state of evolutionin individual countries. We are moreinterested in the essential purpose ofour financial systems. And at the

Sir Edward GeorgeGovernor,

Bank of England


very heart of that is their capacity tobring together financial resourcesnot currently needed by their ownersfor expenditure on consumption orphysical investment, and to channelthose resources to wherever theycan be most productively used Ðalways allowing for risk.

The free movement of capital,like free trade in goods and services,is an immensely powerful means ofpromoting efficient resource alloca-tion nationally, regionally and glob-ally, and as such it can make a major

contribution to improving economicwelfare Ð reducing poverty and rais-ing living standards Ð which is, ofcourse, what we all want to see. Cer-tainly, the free movement of capital,like free trade, needs to be governedby rules designed to minimise distor-tions and unfairness, and to reducethe risks of intermediaries beingunable to honour their commitmentsor of broader, systemic, instability.I do not pretend for a moment thatit works perfectly in practice: wecould all well do without the well-publicised institutional failures ofrecent years, for example, or thevolatility which characterised theAsian financial crisis or the morerecent Òtech stockÓ bubble. But it iscertainly the most effective meansof financial resource allocation thatwe have so far discovered. The chal-lenge is to make it work more effec-tively Ð more efficiently, both interms of intermediation costs, andcrucially in terms of the directionof the flow of resources Ð but also

more reliably and securely for bothsavers and borrowers. This is largelydown to financial markets them-selves. But it is a challenge, too, forthe financial authorities who needto balance the need for market com-petition with the maintenance ofminimum prudential and businessbehavioural standards by individualfinancial institutions, and the needto preserve overall macro-levelfinancial stability. How far we aresucceeding in meeting this challengeis, to my mind, the essential crite-rion against which we should seekto assess the development of ourfinancial systems.

Against that background let menow try to identify some of the maindrivers of change that have been, andare, affecting all our financial systemsto varying degrees.

The first is financial deregula-tion, that is to say the relaxation ofcontrols designed to override marketforces in either an overall macro-economic or a directional sense. Inthe case of the UK, this extends backvery importantly to the abolition ofexchange controls and direct con-trols over bank lending over twentyyears ago, to enabling buildingsocieties (our principal mortgageproviders) to extend their range offinancial services activities, to theopening up of membership of theStock Exchange and broader capitalmarket intermediation and so on.

Deregulation in this sense wasboth encouraged by, and in turncontributed to, increasingly intensecompetition within the financialservices industry, including a blur-ring of traditional distinctionsbetween different types of financialinstitutions. They were accompaniedby what I think of as Òre-regulationÓthat is to say more formal and struc-tured regulation of both the pruden-tial behaviour and standards of con-duct of virtually all financial services

Sir Edward George



activity targeted more specifically atboth institutional stability and con-sumer protection but, subject tothat, leaving the market to do itsjob. Such regulation in the UK hasnow been consolidated in a single,over-arching, financial services regu-lator, the Financial Services Author-ity (FSA). The Bank of Englandremains responsible for macro-prudential oversight, that is to saythe stability of the financial systemas a whole, including oversight ofpayments systems. But we are nolonger responsible for prudentialbanking supervision at the micro-level.

The re-regulation process, ofcourse, conforms with the accessprovisions of the WTO and withinternationally-agreed standards set-tled within the IMF. It incorporatesthe minimum standards of bankingsupervision agreed (and now subjectto revision) under the Basel CapitalAccord. It incorporates, too, thosemeasures that have so far been agreedat the regional, European, levelrelating to a wider range of financialservices activity in the context ofprogress towards the single financialmarket.

Whether or not these initiativeslead over time towards greater Òcon-vergenceÓ of our financial systems insome structural sense Ð as they mayÐ taken together with national dere-gulation they should at least contrib-ute to greater competition, includingcross-border competition, and helpto improve the effectiveness of ourfinancial systems in terms of thekey criterion which I suggested ear-lier in my remarks.

That is particularly true, at leastpotentially, of the steps proposed toadvance the European single financialmarket, as set out in the Commis-sionÕs Financial Services Action Plan,because of its broad scope. Butprogress has so far been painfully

slow. In that context I welcome therecent emphasis on closer and moreactive co-operation between financialregulators within Europe, regardlessof national regulatory structures.And I particularly welcome theproposals put forward by AlexandreLamfalussy and his ÒWise MenÓfor accelerating progress on meas-ures that would encourage greaterefficiency in EuropeÕs securitiesmarkets. But there is clearly a greatdeal more that we can do in thiswhole area.

Such changes in national financialservices regulation and related inter-national and regional actions, takentogether with increasing awarenessin many parts of the world of thepotential advantages of opening na-tional financial markets to interna-tional competition, provide anencouraging environment for a sec-ond main driver of change in ourfinancial systems Ð globalisation. Itis a process we are particularly con-scious of in London where majorfinancial institutions from all overthe world, including, of course, fromelsewhere in Europe, have long beenpredominant players, especially ininternational wholesale market activ-ity. But international ownership ofbanks (including newly privatisedbanks) and other financial institu-tions has increasingly become a com-mon characteristic of financial sys-tems in a wide range of other coun-tries. I will not comment furtheron globalisation, which is certainlyvery familiar to you, except perhaps

Sir Edward George



to say that I have often been teased bypeople who talk about the Wimble-donisation of the City of London Ðmeaning that we provide the tourna-ment venue but the prizes are mostlycarried off by competitors fromoverseas. I think that many of thosepeople now increasingly understandthat it is activity rather than national-ity of ownership which creates acompetitive market place and in turnprovides employment and incomeand tax revenue, which are the thingsthat really contribute to the macro-

economy. As a broad generalisationthe wider the range of participantsthe more efficient the market place.

A third major driver of change inour financial systems Ð as elsewherein our economies Ð is, of course,information technology. This hasclearly transformed transactionsprocessing, putting a premium onthroughput, and encouraging someforms of specialisation and consolida-tion. It has made possible entirelynew Ð and typically much cheaper Ðmeans of delivering financial servicesmaking it easier for new entrants tocontest existing franchises. It hasfacilitated the development of newfinancial instruments and investmentstrategies, and it has radicallychanged trading mechanisms. Itshould also have made it easier forboth financial institutions and theirregulators to measure, monitor andmanage risk. But the electronic rev-olution, as it applies to our financialsystems, has clearly had a very posi-tive impact on the efficiency of all

our financial markets and no doubtstill has a long way to go.

Other major drivers include: theeffects of rising living standards, theassociated increase in financial wealthand the consequences of ageing pop-ulations in many of our countrieswith a related emphasis on privatepension provision. They include alsothe impact of fiscal policies which arenow typically directed to limitingbudget deficits and reducing publicsector debt and of monetary policiesdirected at consistently low inflation

as a necessary conditionfor sustainable eco-nomic growth. Manyof these trends seemlikely to encourage acontinuing relative shiftin savings and invest-ment patterns towardsprivate sector capitalmarket intermediation,

although such intermediation willoften be carried out by banks orwithin banking groups. I have nodoubt that you can all think of otherimportant drivers of change in ourfinancial systems. And all of thisbefore we even come to EMU!

Now, let me be clear, I agreewith those who argue that the singlecurrency Ð by eliminating exchangerisk within the participating coun-tries Ð can make a significant contri-bution to increasing the depth andliquidity of financial markets andreducing transactions costs withinthe euro area. And indeed it alreadyhas had that effect, particularly inmoney and bond markets, especiallythe corporate bond market. It has nodoubt also been a factor encouragingthe tendency to, mostly national,consolidation as financial institutionsprepare for greater competitionfrom other euro-based institutionsin their national markets. All of thisis very positive for the competitiveefficiency of euro area financial

Sir Edward George


6


systems both nationally and withinthe euro area as a whole. It is in factone of the two main potential eco-nomic benefits of the single cur-rency, the other, of course, beingthe positive effect of nominalexchange rate certainty within theeuro area on trade flows of goodsand other, nonfinancial, services andits impact in more efficient resourceallocation. It is also the field in whichthe UK, through London, has beenable to make a positive contributionto the development of the euro evenfrom outside the euro area.

So I do not at all underestimatethe contribution that the euro hasmade, and is making, to improvingthe efficiency of the euro area finan-cial systems. But the point I havetried to emphasise this morning isthat it is just one important factoramong a number of others affectingour financial systems, so that oneshould not perhaps expect that itwould have had a dramatic overallimpact Ð certainly not in so short aperiod of time. And my message isthat there are many other thingsbeyond the introduction of the singlecurrency that we can and should do,whether from inside or outside theeuro area, to improve the function-ing of our financial systems.

Nationally, certainly within theUK, apart from continuing to tryto find the right balance generallybetween competition and necessaryregulation, we need also Ð throughthe authorities and the financial mar-kets working together Ð to continueworking to ensure that the financialsystem reaches those parts of theeconomy that are traditionally mostdifficult to get at, including particu-larly the encouragement of smallerand medium-sized businesses andnew enterprises as well as commun-ity development and regeneration.

Regionally, within Europe, as Isaid earlier, we need to work away

at developing the single financialmarket, pressing on with the Finan-cial Services Action Plan. Mostimmediately, in line with the Lamfa-lussy recommendations, we need toaddress some of the regulatoryobstacles to greater integration ofsecurities markets. And we need toencourage the markets to find moreefficient solutions to trading, clear-ing and settlement systems, particu-larly in securities markets, but alsomore generally.

The main driver in this last con-text, certainly from thepoint of view of thosewho use these systems,is the wish to reducecosts. It is often pointedout that there are thirtyplus exchanges inEurope and probablyat least as many settle-ment systems Ð whichare linked to a greater, but often toa lesser, degree, which operate underdifferent legal and regulatoryregimes and which all incur theirown running and development costs.The fragmentation also means thatmarket participants incur indirectcosts because it is harder for themto manage their liquidity and collat-eral efficiently. So the general mes-sage, which commands wide sup-port, is that some serious consolida-tion would be in order. The questionhowever is how to bring this about.

I will not go into the technicaldebate about horizontal versus verti-cal integration, nor into the distinc-tions Ð which are neverthelessimportant Ð between trading, clear-ing and settlement. And there areother, less technical, influences too,including perceptions of nationalinterest. But whatever the reasons,it is proving difficult for the marketsto make real progress in these areas.In the face of this, there are thosewho argue for some outside party

Sir Edward George



to intervene and enforce consolida-tion. The outside party some seemto have in mind is the authorities inone guise or another. I have to saythat I have doubts about the wisdomof such an approach. There is littlereason to suppose that the authoritiesare likely to be any better than theprivate sector at finding the way for-ward. Nor is it obvious that nationalauthorities have the locus or leverageto insist on a particular model.Much the same reservations wouldapply to any European level inter-vention. That said, what the publicsector can contribute, in this areaas in financial markets more gener-ally, is a removal of barriers tocompetition, requirements on theprovision of information and theeasing of constraints on the effectivefunctioning of the market. If consol-idation does indeed take place, thepublic authorities may also have arole in ensuring that heavily concen-trated market infrastructure pro-

viders do not exploit their position.But at a European level we are atpresent still some way from thissituation.

And internationally we need towork together, within the WTOand the IMF, as well as within thevarious international regulatory andprofessional bodies, to promote theglobal free movement of capital,because in this context Ð as in thecase of free trade Ð the potentialbenefits are not confined to nationalor even regional boundaries butincrease within wider internationalparticipation.

We have come a long way inimproving the effectiveness of ourfinancial systems, and there arepowerful forces at work pushing usin the right direction Ð including,within Europe, the introduction ofthe euro. But we still have a very longway to go. I have no doubt thatthe effort will prove to be worth-while. §

Sir Edward George




Franklin Allen

7


Comments on

Sir Edward George,

ÒComparing Financial Systems:

How Much Convergence?Ó

Sir Edward George has given a verygood summary of the role of thefinancial system. I would not dis-agree with anything he has said.Clearly, European Monetary Union(EMU) is one among a number offactors in determining the effective-ness of financial systems.

I would emphasize things some-what differently, however. His com-ments on EMU were concerned pri-marily with positive aspects:Ð first, with providing a more

competitive market for financialservices and,

Ð second, with increased efficiencydue to the absence of exchangerate uncertainty.An important issue obviously is

what, if any, are the negative aspectsof EMU?

As somebody who lives in theUnited States, one of the things thathas surprised me most about EMU is

Franklin AllenProfessor,

University of Pennsylvania


the lack of an academic debate at atheoretical level on this issue. Thedecision to create a European mone-tary union is clearly one that is sus-ceptible to economic analysis. Thetheoretical papers that are quotedare often from many years ago. Mun-dell (1961), for example, comes tomind.

So what are the potential nega-tive aspects of EMU?Ð Inflation is one issue that is often

focused on. Given that the Euro-pean Central Bank is modeled on

the Bundesbank, I do not thinkthat this is much of a concern.

Ð A more important issue is that offinancial stability.Today, I think, many regard the

primary role of central banks as pre-venting inflation with a secondaryemphasis on maintaining economicgrowth. This has not always beenso. When the Bank of England wasfounded in 1694 its primary purposewas to raise money to fight theFrench. Some historians have arguedthat it was the superior financingability of the British that allowedthem to continually defeat theFrench throughout the 18th centurydespite the fact that the populationof France was three times that ofBritain.

By the 19th century the focus ofcentral banks shifted more to finan-cial stability and their role increas-ingly came to be to eliminate crises.The Bank of England was particularlyimportant in this respect. The lasttrue systemic crisis in the U.K. was

the Overend and Gurney crisis of1866. Skilful manipulation of the dis-count rate allowed avoidance ofmany severe crises. For example, inMay of 1873 there was a severe stockmarket crash in Vienna that triggereda major international crisis. It spreadto many countries, but the U.K.avoided the worst of it. The techni-ques the Bank of England developedspread to other European countries,and crises became relatively rare inEurope.

The experience of the U.S. atthis stage was quite different. In areport on the Second Bank of theUnited States, John Quincy Adamswrote: ÒPower for good is powerfor evil even in the hands of omnip-otence.Ó (Studenski and Krooss,1963, p. 254). This quotation sumsup the American distrust of central-ized power of any kind. From 1836until 1914 the U.S. did not have acentral bank. It had many financialcrises. On average, about every tenyears there was a crisis.

In 1907 there was a particularlysevere one that originated in theU.S. and then spread to many othercountries. A French banker isreported to have commented: ÒTheU.S. is a great financial nuisance.Ó(Timberlake, 1978, p. 39).

The undertone is, of course, thatÒWe sophisticated Europeans havesolved the problem of crises. If onlyyou unsophisticated Americans couldget your act together we would all bemuch better off.Ó The severity of the1907 crisis reignited the debate onwhether the U.S. should have a cen-tral bank. The outcome of thisdebate was the foundation of theFederal Reserve System (Fed).

The distrust of centralized powerthat John Quincy AdamsÕ statementillustrates persisted and as a resultthe Federal Reserve System was verydecentralized. This together with alack of experience meant that the

Franklin Allen



Fed was unable to prevent the bank-ing crises of the early 1930s. Manyeconomists argue that it was theFedÕs failure that led to the severityof the Great Depression. TheBanking Crisis of 1933 resulted in asignificant reform of the FederalReserve System and power becamemuch more centralized. Since thenthere have been no systemic crisesin the U.S.

The U.S. experience with theFed early in its history raises theimportant issue of whether the divi-sion of responsibility between theregulatory authorities, the nationalcentral banks and the European Cen-tral Bank is the correct one. I donÕtthink we will be able to judge thesuccess of EMU until this importantaspect has been tested during adownturn. My own view is that amore centralized structure is desir-able. The speed with which manycrises develop is such that coordina-tion between different entitiesbecomes difficult. This could makedealing with the crisis problematic.Taking a long run perspective, therole of central banks in preventingcrises is their most important job.It is, for example, much more

important than whether the inflationrate is 1% or 3%.

The other major issue facingEMU that Sir Edward was only ableto hint at is the question of whetherthe U.K. should join. My own viewis that it should. I think the positiveaspects of EMU that Sir Edwardemphasized outweigh the negativeaspects in the long run.

For the U.K. there is a particu-larly important additional factor.This is the contribution that thefinancial services industry and in par-ticular the City of London makes tothe U.K. economy. In the short runit is difficult to believe that Londonwill cease to be a major financialcenter. In the long run, if the U.K.does not join EMU, it is quitepossible. §

References

Mundell, R. (1961). A Theory of Optimum

Currency Areas. In: American Economic

Review. September, pp. 657Ð665.

Studenski, P. and Krooss, H. (1963).Financial History of the United States.

2nd edition, New York.

Timberlake, R. (1978). The Origins of

Central Banking in the United States.

Cambridge.

Franklin Allen



Ernst-Ludwig von Thadden

8


The Single Financial Market:

An Assessment and an Outlook

for the Future

1 IntroductionIn the first two years of its existence,the European Monetary Union(EMU) has been followed and dis-cussed intensely by the public andoften received mixed reviews. To alarge extent these reviews have con-centrated on the performance of theexternal value of the euro and have,quite superficially, equated theappreciation of the U.S. dollar dur-ing much of that period with a weak-ness of EMU. In this paper, I shalldiscuss another, and certainly moreimportant side of EMU: that of anagent of change of European financialmarkets.

The paper reviews some earlyevidence on the performance andpossible developments of Europeancapital markets, after two years ofEMU. Despite the euroÕs widelydocumented slide on the foreignexchange market, the assessment ofthis evidence is very favorable. Onalmost all counts EMU has eitherchanged the European financial land-scape already drastically or has thepotential to do so in the future.

Ernst-Ludwig von ThaddenProfessor,

Universite« de Lausanne


Whether this potential will be real-ized, however, depends on how thefinancial industry and politics adjustto the new situation. There havebeen astonishing positive develop-ments, but also a number of disap-pointments. EMU has magnified theimpact of the former and exposedthe scope of the latter.

Although short-term influenceshave played a role, such as the catch-ing-up effect after the double crisisof the Russian sovereign default andLong-Term Capital Management

(LTCM) in the fall of 1998, or theone-off positioning effect of newsecurities issues in the euro market,it is difficult not to see the euro asthe major factor behind the remark-able transformation of Europeancapital markets between 1998 and2000. A corporate euro bond markethas emerged whose issuing activityis beginning to challenge the previ-ously dominant role of the U.S. dol-lar market. Primary issues in Euro-pean equity have reached recordhighs in 1999, with whole new mar-kets becoming prominent interna-tionally, such as the Neue Markt inFrankfurt or ItalyÕs Nuovo Mercato(the stock market breakdown of2000 has been another, less welcomesign of EuropeÕs catching up with theU.S.). Europe-wide indices havebeen established. Portfolios are nowpredominantly allocated along pan-European sectoral lines rather thanon a country basis. Not only hasEurex, the German-Swiss exchangefounded in 1998, caught up with

other large exchanges, but by theend of 1999 it had overtaken theChicago Board of Trade by a clearmargin to become the worldÕs largestderivative exchange. In 2000, it evenexpanded its lead. TARGET, thepan-European settlement system,has been a success, and even duringthe difficult first months of EMU,liquidity has flown relativelysmoothly across EMU member coun-tries. Banks all over Europe havemerged or formed alliances on anunprecedented scale, drasticallychanging the national banking envi-ronments and beginning to createinternational firms and networks.Cross-border mergers in all indus-tries have increased strongly, givingrise to record volumes in theEuropean merger and acquisitionindustry.

This paper argues that part ofthis development could have beenexpected as the consequence of whatI call the direct effects of the euro.The less immediate potential conse-quences of the euro, some of whichare discussed below, could not havebeen counted on, however. Theyoccurred because market partici-pants took the creation of the singlecurrency as a signal for change inthe European financial market andcoordinated their expectationsaccordingly. Policymakers, regula-tors, and supervisors will have tobe careful not to disappoint theseexpectations and to push ahead withthe reform of European capital mar-kets. European political leadersseemed to have understood thiswhen they adopted the EuropeanCommissionÕs Financial ServicesAction Plan at the Lisbon summitin March 2000. But while the Finan-cial Services Action Plan has stillbeen relatively broad and sometimesvague, a relatively focused reportwas produced by the LamfalussyCommittee of Wise Men in February




2001 and adopted at the EuropeanCouncil meeting in Stockholm inMarch 2001. This report maps aclear path to reform in some impor-tant areas of European capitalmarkets and is likely to either elimi-nate or to clearly expose some ofthe last remaining obstacles to fullintegration of European financialmarkets. If national politics wantsto, the successful evolution ofEMUÕs first two years is likely tocontinue.

2 Global Financial Marketsbefore EMU

As a benchmark some data on globalfinancial markets prior to EMU areuseful. For 1995, table 1 shows thatthe combined value of equities,bonds, and bank assets outstandingin the 11 EMU countries in 1995was USD 21,084 billion, almostequaling the USD 22,865 billion inthe U.S. The reason for the highEuropean value are bank assets; thesize of the U.S. bond marketexceeded the European one by57%, and the U.S. stock market itsEuropean (EU 11) counterparts by224%. On the other hand, the Euro-pean bond market was larger thanthe Japanese (by 31%), and the Japa-nese stock market significantly largerthan the EU 11 one (by 73%).

Consistent with the relative sizeof the U.S. stock market, turnover

on U.S. stock exchanges was muchlarger than in Europe. In 1996, turn-over on the New York StockExchange alone was 134% higherthan that of all stock exchanges ofEU 11 countries taken together,and still 40% higher than that of allstock exchanges in the EU (includingLondon). Similarly, the worldÕs larg-est derivative exchanges were inChicago (CME, CBT).

In 1997, USD 456 billion ofinternational bank lending weredone in U.S. dollars and approxi-mately USD 251 billion in euro leg-acy currencies. In the same year,USD 329 billion of all internationaldebt securities issues were in U.S.dollar, and USD 135 billion in euroarea currencies, with total issuingactivity in the U.S. standing at USD175 billion.

These and other indicators showthat in the mid-1990s, in the aggre-gate and with the exception of bankassets, U.S. capital markets were sig-nificantly larger than European ones,and the U.S. dollar the dominantinternational currency.

3 Direct Effects of EMU

The direct effects of European Mon-etary Union can be classified into fivecategories. These effects are similarto those put forward in the famousreport by the European Commission(1990) on ÒOne Market, One

Table 1

Comparison of International Capital Markets in the Year 1995

GDP Stock marketcapitalization

Bank assets Debt securities Total assets1)

Private Public Total

USD billion

EU 11 6,804 2,119 11,972 3,084 3,910 6,993 21,084Denmark 173 56 156 188 142 330 542Sweden 229 178 203 186 233 419 800U.K. 1,106 1,408 2,424 396 430 826 4,658U.S. 7,254 6,858 5,000 4,295 6,712 11,008 22,865Canada 566 366 516 93 589 682 1,565Japan 5,114 3,667 7,382 1,876 3,450 5,326 16,375

Source: IMF.1) Total assets = stock market capitalization + bank assets + debt securities.




Money.Ó Some of them are relativelystraightforward to estimate, othersare more elusive, as the CecciniReport makes clear.Ð Standardization and transparency in

pricing. The direct gains consistmostly of the time saved compar-ing or posting prices in severalcurrencies and the value lost insuboptimal transactions byimperfectly informed partici-pants.

Ð The elimination of intra-Europeancurrency risk. Although the antici-pation of EMU had reducedexchange rate volatility among afew EMU member states in thesecond half of the 1990s to verylow levels, exchange rate riskhad been an important compo-nent of intra-European marketrisk even in the 1990s. This riskdeclined over the decade and wasquantitatively much smaller thannon-EMU currency risk (in par-ticular the risk associated withthe U.S. dollar).

Ð The elimination of currency-relatedinvestment regulations. Despitethe European CommissionÕs sec-ond banking and investmentservices directives, there existstill a number of obstacles tointra-European capital flows.EMU has de facto eliminated animportant obstacle, the restric-tion on foreign currency-denominated asset holdings ofpension funds and life insurancecompanies, at least for EMUmember states. Yet, the availableevidence shows that, in the early1990s, the so-called 80% rulewas usually not a binding restric-tion, which suggests that theintroduction of the euro did notautomatically trigger a realloca-tion of institutional investment.

Ð The unification of bank refinancingopportunities across EMU memberstates. As of January 1999, the

different national bank refinanc-ing systems were replaced byone single mechanism. Liquiditynow is provided EMU-wide bythe European Central Bank onthe basis of weekly reverse trans-actions, executed by the nationalcentral banks through standardtenders.

Ð The shrinking of the foreign ex-change market. Average dailyforeign exchange transactionsbetween EMU legacy currencieswere worth approximately USD125 billion in 1998, around6.3% of total global transactions.This trading volume simply dis-appeared between December31, 1998, and January 1, 1999.Yet, already between 1995 and1998 intra-EMU currency trans-actions fell from USD 201 billionto USD 125 billion, presumablybecause the euro eliminatedspeculative or hedging motives.However, as also U.S. dollarvehicle trades between Europeancurrencies have disappeared, thedirect loss of currency tradingis probably considerably higherthan these USD 201 billion or13% of all global transactions.While for banks this fall in trad-ing volume has caused a corre-sponding decrease in revenues,it represents, of course, an over-all economic gain.

4 Indirect Effects of EMU

Theory predicts that the directeffects of the single currency dis-cussed above typically induce addi-tional indirect effects, which maybe quantitatively more important,but also more difficult to assess. Iwill briefly review five differentgroups of indirect effects: the costof cross-country transactions withinthe EMU area, the availability ofliquidity to financial institutionsacross the euro area, the depth of



9


European financial markets, thebreadth of these markets, and thechanges in the banking sector thathave been stimulated by EMU.

4.1 Retail Transaction CostsIn addition to the direct reductionsin transaction costs throughimproved transparency, the singlecurrency has had little impact onthe costs of transacting inside theeuro area. Yet, it has made the exist-ing obstacles and inefficiencies fortrade across EMU member frontiersmore visible, for market participantsand policymakers alike. It hasbecome blatantly clear that withinEurope, cross-border payments andsecurities settlement are moreexpensive, lengthier, riskier, and lessstandardized than domestic ones.

For instance, a study by theEuropean Central Bank in 1999found that fees charged to customersfor domestic credit transfer rarelyexceeded EUR 0.10 to 0.15, whilefor cross-border transactions insidethe euro area these fees variedbetween EUR 3.5 and 26 for smallamounts and between EUR 31 and400 for higher amounts, wherebanks in some countries even addedadditional charges, such as for bal-ance of payments reporting. Cross-

border payments needed more thandouble the time to reach their desti-nation than domestic payments, withsubstantial variation between coun-tries. Furthermore, the euro areahas 18 large-value systems (theU.S. has two), 23 securities settle-ment systems (three in the U.S.),and 13 retail payments systems(three in the U.S.). Differences intaxation, legislation, and accountingstandards create further well-knownobstacles.

EMU has provided new urgencyto policymakers to address theseproblems. The establishment ofTARGET and Euro 1, the settlementsystems for large transactions of theEuropean System of Central Banksand the European Banking Associa-tion, respectively, and the imple-mentation (in August 1999) of theEU Directive 97/5/EC of January1997 on cross-border credit trans-fers are some of the most visiblesteps taken in that direction. Theproposal in early 2000 by the Euro-pean Committee for Banking Stand-ards for a common standard of pay-ment definition and routings was afurther useful step.

Yet, the private sector has takenmore time to address the problemsin cross-border payment systems

Table 2

International Composition of Euro Area Bank Balance Sheets1)

End-1997 End-1998 End-1999 Growth1997 to 1999

Total interbank claims (EUR billion) 4,673 4,964 5,366of whichdomestic (%) 63.2 64.5 64.5 17.2within euro area (%) 14.7 16.3 17.6 37.5

Total loans (EUR billion) 9,758 10,350 11,070of whichdomestic (%) 79.2 79.8 79.8 14.3within euro area (%) 7.4 8.1 8.7 33.4

Total deposits (EUR billion) 9,147 9,780 10,510of whichdomestic (%) 75.4 74.4 72.8 10.9within euro area (%) 9.6 10.2 10.3 23.3

Source: ECB.1) Sample comprises all resident banking institutions in the euro area, defined as ÒMonetary Financial Institutions other than central

banksÓ by the ECB. ÒDomesticÓ and Òwithin euro areaÓ do not add up to 100, because business with the rest of the world is omitted.




than many observers had wished. Inparticular, the hope, expressed bythe European Central Bank, thatthe industry Òmake a considerableimprovement in this field [cross-bor-der payment systems] very soonÓ(Monthly Bulletin, June 1999) hasbeen repeatedly disappointed, alsobecause of the coordination probleminherent in competing paymentstandards. Yet, perhaps because ofincreasing public pressure, despitethe long delay, there has been prog-ress. In November 2000, memberbanks of the European Banking Asso-ciation launched STEP 1, a proces-sing facility for retail payments onthe Euro 1 clearing platform, thatis to cut processing times for interna-tional transfers significantly. And inMay 2001, the European BankingAssociation announced that its mem-bers had agreed to a system of signif-icantly reduced flat fees for cross-border payments.

4.2 Liquidity Distributionand Interbank Marketsin the Euro Area

The unification of central bank refi-nancing possibilities for banks afterEMU should help, as an indirecteffect, to provide a level playing fieldfor financial institutions and toequalize their costs of capital acrossEurope. In practice, however, accessto refinancing facilities has remaineduneven and liquidity redistributionthrough secondary markets imper-fect. This issue is important becausethe distribution of liquidity throughthe auctions of the European Systemof Central Banks is necessarilyimperfect, an imperfection that isexacerbated by the decentralizedoperational procedure of the systemthat is based on the old national mon-etary infrastructures.

Although overnight interbankbid-ask spreads in 1999 tended tobe higher than in 1998 in most

EMU countries (for reasons thatare not entirely clear), the unsecuredmoney market seems to have workedrelatively well from the start of EMUon (also because of the relative suc-cess of TARGET). EURIBOR, thenew Frankfurt based short-terminterbank rate, was accepted as thereference rate within weeks by themarket, and, driven by this standard,overnight interest rates have con-verged completely.

Any difficulties in the distribu-tion of liquidity across Europe seemrather due to imperfections in thecross-border repo market. On theone hand, overnight repo rates inthe euro area have almost fully con-verged during the course of 1999,suggesting that the system is workingwell enough to arbitrage away pricedifferentials. On the other hand,the European interbank market evenin 2000 was still seriously frag-mented along national lines, duemostly to difficulties with nationaldifferences in the treatment of collat-eral. Fortunately, there were fewchallenges to the system in 1999and 2000 that would have requiredlarge movements of secured fundsacross borders. Hence, the mainproblem of EMU repo markets, theabsence of an efficient system of linksbetween national securities settle-ment mechanisms, still requires theattention of policymakers and mar-ket participants. As in other areas,the Lamfalussy Report, with its rec-ommendation of the principle ofmutual recognition for wholesalemarkets, has shown how to addressthese problems.

The EurosystemÕs pragmatictemporary solution to the problem,the Correspondent Central BankingModel (CCBM), is not likely to beeasily upgradeable, because it is nei-ther automated nor real-time, nordirect. On the other hand, the emer-gence of competing centralized




systems or the upgrading of linksbetween partial systems may giverise to similar coordination problemsas those mentioned above for pay-ment systems.

4.3 Capital Market DepthThe problem of remaining transac-tion costs notwithstanding, by elimi-nating currency risk EMU has puttraders in foreign euro-denominatedassets on an equal risk base withdomestic traders. Together with theincrease in transparency resultingfrom the single currency, this hasgreatly reduced the barriers to trad-ing such assets. In this sense, EMUhas improved the demand side ofthe market for each asset traded inthe euro area, i.e. it deepened themarket. To the extent that deepermarkets indeed give rise to increasedtrading, the single currency there-fore has reduced liquidity risk.

However, an important theoreti-cal feature of markets with transac-tion costs and liquidity risk is thepossibility of multiple equilibria. Insuch markets depth is endogenous,and Òvirtuous circlesÓ of high tradingactivity and low liquidity risk are asmuch possible as Òvicious circlesÓ oflow trading and high liquidity risk.When assessing the impact of theeuro on liquidity it is, therefore,important not only to add up the dif-ferent pre-euro domestic markets,but also to evaluate the relationshipbetween market prices, trading vol-ume, the number and size of partic-ipants, and transaction costs in themarket after EMU.

This analysis is beyond the scopeof the present paper. But the experi-ence of the past two years has shownthat markets have indeed deepenedconsiderably, although there is stillscope for further integration of thepublic bond market. Private bondand primary equity markets haveintegrated and expanded at a speed

and to a point where it is possibleto speak of an equilibrium switch.Secondary equity markets have bene-fited from the historical upswing ofequity markets that lasted until2000, but have been hamperedmainly by the institutional difficultiesof integrating stock exchanges orsettlement systems across borders.

A look at the bond market pro-vides an example of the successesand limitations of market deepeningunder EMU. Public bond marketsin the euro area cannot expand muchin the foreseeablefuture because of thelimitations on govern-ment debt imposedby the 1996 Stabilityand Growth Pact. Yet,an important indirecteffect of EMU has beenthe significant degree ofhomogenization of pub-lic debt markets achieved in its wake.Following the obvious decision byEMU member states to issue allnew public debt in euro as of January1999 (which would not have createda market big enough to rival the U.S.or Japanese markets), the mostimportant decisions in this respectwere the redenomination of out-standing fungible public debt andthe homogenization of bond conven-tions (such as day count).

Yet, issuing practices have notbeen fully harmonized, so that thepublic bond market is not perfectlyintegrated. In fact, although theyield curves have converged consid-erably, euro area government bondsare still not perfect substitutes, asis evidenced in the evolution ofgovernment bond yields given intable 3.

Presumably, part of the yielddifferentials shown in table 3 aredue to the differences in fundamentalrisk. But table 3 shows that, evenwithin the group of top-rated coun-




tries, some yield differentials existand even fluctuate differently acrossthe yield curve. The most importantexplanation for these differentials areliquidity considerations. In fact,markets have traditionally attacheda higher liquidity risk to non-German public bonds than to Ger-man ones, with the exception ofsome shorter maturities, whereFrench and sometimes Italian issueshave had a traditionally liquid mar-ket. Partly this has been due to thelarge issuing volumes and partly tothe liquidity of the futures contractsfor German long-term debt. Given

the elimination of currency risk,the identical fundamental risk forthe top issuers, and the fact thatthe German ten-year futures con-tract now seems to serve long-termbonds across Europe, the marketpresently seems to exhibit the typeof equilibrium behavior discussedearlier: Since yields across differentsovereigns are different, the marketsfor these issues are, by definition,segmented, which implies that theliquidity risk in the smaller segmentsis higher, which translates into differ-entiated yields, closing the viciouscircle.

Table 3

Government Bond Benchmark Yields 1998 to 1999, Selected Countries

Two-year bonds

August 1,1998

October 1,1998

December 1,1998

February 1,1999

April 1,1999

June 1,1999

August 1,1999

October 1,1999

December 1,1999

February 1,2000

April 1,2000

%

Germany 3.8871) 3.2971) 3.2571) 2.8861) 2.8451) 2.841 3.479 3.765 3.986 4.368 4.441Austria 4.077 3.483 3.4792) 3.0412) 2.957 2.984 3.675 3.737 4.3002) 4.570 4.6062)Belgium 4.017 3.436 3.351 2.955 2.944 2.851 3.4081) 3.607 3.9471) 4.6062) 4.564France 3.997 3.405 3.306 2.934 2.857 2.928 3.466 3.747 4.113 4.376 4.363Ireland 4.5082) 3.563 3.355 2.959 2.884 3.0092) 3.520 3.911 3.979 4.3241) 4.3501)Italy 4.342 3.7532) 3.463 3.011 3.0072) 2.971 3.7112) 3.9132) 4.127 4.458 4.597Netherlands 3.970 3.477 3.370 2.950 2.951 2.925 3.483 3.904 4.192 4.472 4.477Spain 4.127 3.525 3.304 2.899 2.860 2.8061) 3.364 3.5071) 4.200 4.565 4.599Max-min3) 0.621 0.456 0.222 0.155 0.162 0.178 0.347 0.406 0.353 0.282 0.256Max-min4) 0.190 0.186 0.222 0.155 0.112 0.143 0.109 0.167 0.314 0.202 0.243

U.K. 6.697 5.442 5.213 4.784 4.807 5.191 5.786 6.227 6.219 6.444 6.330U.S. 5.464 4.146 4.429 4.642 4.988 5.514 5.605 5.705 6.018 6.566 6.427

Ten-year bonds

August 1,1998

October 1,1998

December 1,1998

February 1,1999

April 1,1999

June 1,1999

August 1,1999

October 1,1999

December 1,1999

February 1,2000

April 1,2000

%

Germany 4.6171) 3.7911) 3.9401) 3.6441) 3.9821) 4.1731) 4.939 5.1401) 5.1361) 5.5051) 5.2191)Austria 4.768 4.088 4.154 3.826 4.147 4.355 5.144 5.357 5.351 5.746 5.486Belgium 4.831 4.096 4.191 3.900 4.228 4.462 5.2122) 5.4532) 5.389 5.7742) 5.481France 4.724 3.968 4.000 3.747 4.101 4.333 4.8641) 5.225 5.304 5.677 5.368Ireland 4.862 4.100 4.122 3.844 4.053 4.284 4.986 5.388 5.269 5.627 5.353Italy 4.9272) 4.3042) 4.180 3.901 4.235 4.5052) 5.187 5.408 5.351 5.756 5.5032)Netherlands 4.704 3.942 4.022 3.785 4.118 4.375 5.020 5.316 5.245 5.592 5.339Spain 4.892 4.246 4.2122) 3.9112) 4.2872) 4.478 5.175 5.371 5.3552) 5.741 5.441Max-min3) 0.310 0.513 0.272 0.267 0.305 0.332 0.348 0.313 0.253 0.269 0.262Max-min4) 0.151 0.297 0.214 0.182 0.165 0.202 0.280 0.217 0.215 0.241 0.262

U.K. 5.700 4.623 4.640 4.184 4.522 4.895 5.271 5.741 5.227 5.586 5.195U.S. 5.447 4.299 4.661 4.746 5.281 5.764 5.909 5.988 6.205 6.431 5.829

Source: Datastream.1) Minimum.2) Maximum.3) Percentage point difference between highest and lowest yield.4) Percentage point difference between highest and lowest yield when comparison is restricted to AAA-rated countries (Germany, Austria, France and the Netherlands).



10


In view of this reasoning it ispossible that the public bond marketsof Germany, France, the Nether-lands, Austria, and Luxembourg willin future, without much policyaction needed, shift from one equili-brium to another to become onefully integrated single market, simplybecause of changing market percep-tions. In fact, if the recent trend byinstitutional investors continues,which is to disregard fundamentalrisk and segment the market fullyalong traditional liquidity lines (withGermany in a first tier, then Franceand Italy, and then the other coun-tries), then already little furthercoordination of EMU public debtmanagement may be sufficient tocreate a fully integrated and highlyliquid EMU public debt market.Interestingly, the Giovannini Reportof November 2000 found little needfor a large coordination effort inpublic bond issuing practices insideEMU, arguing that the expectedcosts would probably more than out-weigh the expected reductions inyield spreads. However, in the multi-ple-equilibrium perspective dis-cussed above, small advances in thecoordination of public debt markets

may be enough to bring about largeconsequences in consolidating thesemarkets.

For the private bond market, thedata point to more than high poten-tial, they indicate a fundamentalswitch of market behavior. Althoughthe euro-denominated corporatebond market slacked off slightly in2000, it has quadrupled in sizebetween 1998 and 2000. While until1998 bond distribution in the euroarea for all but the very few largestfirms was almost exclusively domes-tic, the larger bond issues since 1999were sold on a truly European scale,which even surprised most marketparticipants. Furthermore, and dif-ferently from the public bond mar-ket, the European private bond mar-ket has become more liquid alsobecause of pure growth on the supplyside. Here, the boom in mergers andacquisitions in Europe, fueled by theliberalization of several importantindustries in different countries, hasplayed an important role.

Table 4 provides a global view ofthe evolution of bond issues. Itshows, in particular, that global netissuing activity in euro in 1999exceeded the U.S. dollar volume by

Table 4

Net Issuance of International Debt Securities

by Currency and Region1)

1998 1999 2000

USD billion

Europe U.S. dollar 68.6 54.9 176.6Euro 156.5 488.5 378.5Total 254.0 627.3 686.2

North America U.S. dollar 257.2 435.5 320.5Euro 24.8 45.6 47.7Total 296.9 494.9 398.8

Others U.S. dollar 83.7 54.5 45.7Euro 39.9 36.9 14.8Total 127.6 92.8 53.2

Total U.S. dollar 409.4 545.0 542.7Euro 221.3 571.0 441.0All currencies 678.5 1,215.1 1,138.3

Source: BIS.1) Flow data for international bonds; for money market instruments and notes, changes in amount outstanding.




11%, after it had been only 54% ofthe U.S. dollar total in 1998 and sig-nificantly less before. This explosionof euro issues (compared to the eurolegacy currencies) was mostly due tothe spectacular increase in issuingactivity in Europe between 1997and 2000. However, table 4 alsoshows that the 1999 figures reflecta certain catching-up effect afterthe autumn 1998 crisis and short-term positioning activity in early1999, as the U.S. dollar has over-taken the euro again in 2000. Yet,even when only viewed between1998 and 2000, the data point toan enormous change in bond marketbehavior following the introductionof the euro: the U.S. dollarÕs shareof global bond issues fell from 60%in 1998 to 48% in 2000, while theeuroÕs share rose from 33% to 40%.

4.4 DiversificationThe second main benefit of increasedmarket size resides in better diversi-fication possibilities. In theory, thereduction of costs and risks ofcross-border transactions allowsinvestors to better spread the funda-mental risk of their asset holdingsand to rebalance portfolios towardassets that previously were too costlyin terms of the risk-return tradeoffof standard portfolio theory, typi-cally toward foreign ones. The prob-lem with this theoretical argument isthat it is known to be flawed. Asdocumented repeatedly in the1980s and early 1990s, the share ofinternational equity in total equityholdings by domestic investors hastraditionally been too small to becompatible with the standard portfo-lio model (the so-called home-biaspuzzle).

It is tempting and probably moreplausible to argue instead that thehistorical equity home bias is betterexplained by informational problemsfaced by domestic investors when

valuing foreign securities. In thisview, the lack of transparency andtrading opportunities in continentalEuropean firms as well as the weaklydeveloped equity culture of Euro-pean investors explain the paucityof equity flows into and out ofEurope until the 1990s, while thechange in both these features in thecourse of the 1990s explain theobserved increases of equity flows.EMU then fosters market integra-tion, not by eliminating foreignexchange risk, but by improvinginformation flows and by reorientingtraditional international asset alloca-tion methods from a country basisto a pan-European industry basis.According to this theory, if interna-tional transaction costs are high, onlyfew firms will find it profitable tochange their portfolio strategies,but if these costs come down, amajor shift in intra-European portfo-lio allocation can occur.

This is exactly what has beenobserved between 1998 and 2000.While according to surveys in 1997only 20% of European equity manag-ers believed that a portfolio alloca-tion based on sectoral criteria wassuperior to a country-based alloca-tion, at the end of 2000 75% pre-ferred the sectoral approach to Euro-pean equity investment. In parallel,pan-European benchmarks such asthe Stoxx or FTSE Eurotop indices,have developed and supported thebroadening of the European equitymarkets reflected in the record turn-over on European primary and sec-ondary equity markets in 1999 and2000.

A necessary prerequisite for afurther broadening of capital marketsin the euro area is institutional inte-gration, in particular with respectto back-office operations and settle-ment procedures. For stockexchanges, the existing overcapacityof exchanges and the incompatibil-




ities among them, on regulatory,technical, and personal grounds,have posed bigger problems in thepast few years than expected. EMUhas exposed these problems veryclearly and accelerated efforts inthe markets to overcome them.Examples such as the creation ofEuronext or the plan of the Euro-pean Securities Forum in October2000 to create a single counterpartand netting facility for all Europeanequities are encouraging, but thefailed merger between the Londonand Frankfurt stock exchanges showsthat the obstacles to integration inthis area are still high. On the otherhand, in the area of bonds and deriv-atives, there has been some remark-able progress: Euro MTS, the trad-ing platform for public bonds, and,Eurex, the derivatives exchange cre-ated by the merger of the GermanDTB and the Swiss Soffex, have sur-passed all expectations.

4.5 BankingThe main players in the Europeancapital markets, banks, have beenaffected by EMU in different ways.In particular, while the changes incapital market activity tend to hurtthe traditional deposit and lending

business of commercial banks (byproducing a Òshift from banks tomarketsÓ), they benefit the moremarket-based asset management andinvestment banking activities. In fact,by securitizing assets, banks at thesame time contribute to the develop-ment of new sectors of the capitalmarket and profit from it. As figure1 shows, after its early success inthe 1980s and early 1990s, mostlybased on mortgages and auto loans,securitization has continued to growstrongly in the second half of the1990s in the U.S. and seems to gainimportance in Europe.

In the same vein, the tendencyto replace bank loans by traded debtin the financing of large firms, asevidenced in the evolution of theprivate bond market outlined insection 4.3, will not make banksredundant. To the contrary, eventraditional commercial banking stillplays an important role in thischanged environment, not onlybecause of the increasing importanceof syndicated loans, but also by theprovision of liquidity through linesof credit.

However, in order to realize thepotentials of the Single EuropeanMarket and EMU, banks have had

0.1

USD billion

Global Securitization Issuance

Figure 1

500

400

300

200

100

0

Source: Moody�s Investors Service.1) Estimated.

North AmericaEurope

Asia/AustraliaLatin America

146 155

234

313

454

526

5 9 30 46 47 62

0.3 5 18 2043

3 6 14 6 10 10

1994 1995 1996 1997 1998 19991)




to adjust significantly in the pastfew years and will probably have toadjust even more in the future. Thisadjustment involves refocusing,cost-cutting, and technological andorganizational innovation and hasbeen sometimes painful and oftenslow. The available evidence indicatesthat there is considerable variation incost efficiency of European banks,with little evidence for size ineffi-ciencies among commercial banks,but for large average managerial in-efficiencies (deviations from industrybest practice), which have been,however, declining between 1993and 1997. Furthermore, large bankstend to benefit most from scaleeconomies and technological prog-ress, and universal banks are at leastnot less efficient than specializedones. In fact, the available data sug-gest that the recent trend towardde-specialization and size in Euro-pean banking tends to increase effi-ciency.

One of the indicators of industrychange is the evolution of bankmergers in Europe during the1990s (see table 5). While therehas been a steady stream of mergersin European banking throughoutthe 1990s, declining from a peakin absolute numbers in the early1990s, the value of transactions hasgrown by over 500% in 1997 and1998 compared to the previousperiods. The merger wave has meantfirst and foremost the creation oflarger banks, and second a beginningcross-border expansion. Comparedto other sectors, bank mergersthroughout the 1990s have beenlargely domestic; still in 1997 and1998, 70% of all bank mergers inthe European community weredomestic, compared to 51% for allmergers. Yet, the number for 1997and 1998 is down from 78% overthe period from 1989 to 1995, andthe data for 1999 confirm thisdownward trend. It seems that the

Table 5

Mergers and Acquisitions in the Banking Sector1)

Number of transactions Value of transactions

1991 to1992

1993 to1994

1995 to1996

1997 to19983)

1991 to1992

1993 to1994

1995 to1996

1997 to1998

1991 to1992

1993 to1994

1995 to1996

1997 to1998

Number USD billion % of all sectors2)

U.S.A. 1,354 1,477 1,803 1,052 56.8 55.3 114.9 362.4 18.7 9.0 10.6 18.2Japan 22 8 14 28 0.0 2.2 34 1.1 0.3 18.8 21.6 4.1

Euro area4) 495 350 241 203 17.5 14.6 19.1 100.4 8.3 9.3 11.2 27.1Belgium 22 18 20 21 1.0 0.6 0.5 32.5 14.1 7.0 4.9 34.8Finland 51 16 7 7 0.9 1.0 1.2 4.3 22.3 21.7 7.4 77.5France 133 71 50 36 2.4 0.5 6.5 4.0 4.3 1.0 9.8 4.1Germany 71 83 36 45 3.5 1.9 1.0 23.2 6.5 7.6 3.7 45.5Italy 122 105 93 55 5.3 6.1 5.3 30.1 15.6 17.7 24.9 63.3Netherlands 20 13 8 9 0.1 0.1 2.2 0.4 0.2 0.5 17.5 0.8Spain 76 44 27 30 4.3 4.5 2.3 5.9 13.5 21.5 14.1 26.6

Sweden 38 23 8 8 1.1 0.4 0.1 2.1 3.8 2.0 0.3 7.1Switzerland 47 59 28 22 0.4 3.9 1.0 24.3 9.5 43.4 2.4 78.3U.K. 71 40 25 17 7.5 3.3 22.6 11.0 6.5 3.4 10.4 4.0

Total banks 2,098 2,032 2,162 1,360 84.7 83.2 200.8 534.2 11.7 8.5 11.0 18.9Memo item:Total nonbanksfinancial 2,723 3,267 3,973 5,156 63.7 122.2 189.9 534.2 8.8 12.5 10.4 19.4

Source: BIS.1) Classified by the industry of the target; only completed or pending deals; announcement date volumes.2) Of mergers and acquisitions in all industries.3) As of October 30, 1998.4) Excluding Austria, Ireland, Luxembourg and Portugal.



11


recent evolution of bank mergersshows a kind of Òpecking order,Óin which banks first merge nation-ally, then across borders insiderestricted geographic regions (suchas the Benelux, the Scandinavian,or the Mediterranean countries),and finally reach out across all ofEurope. Whereas this last step stillseems to be a thing of the future,the failure of the merger betweenDeutsche Bank and Dresdner Bankin April 2000 may, in fact, indicatethat even in the large national mar-kets the time of domestic mergersbegins to run out.

5 Outlook

This paper has argued that with EMUthe European capital market haschanged drastically. Yet, this changeis not irreversible. In fact, what Ihave called the indirect effects ofEMU are largely based on a changein market expectations about thefunctioning of the market, and suchexpectations can easily change again.It is, therefore, highly important forpolicymakers, regulators and theEuropean System of Central Banksalike, to live up to these expectationsand provide the necessary clarity andfirmness for the management andcontinued reform of European finan-cial markets.

Many areas for such activityexist, some of which I have touchedupon in the previous sections. Inthe area of banking consolidation,for instance, national governmentshave no active pro-European stance,old-fashioned national rhetoric stilldominates when it comes to take-overs of large domestic banks by for-eigners. In the area of cross-borderpayment and security settlement sys-tems, the European market lacks thenecessary unified infrastructure thatwould allow a truly unified marketto function efficiently. Implicit orexplicit discrimination against for-

eign investors in tax or accountingstandards still exists. Deficienciesand incompatibilities of the data col-lected and provided by nationalauthorities make the goals andactions of financial regulation andmonetary policy less transparentthan in the U.S.

Most of these shortcomings anddangers have finally been recognizedby regulators and legislators andtheir academic assessment is fairlyuncontroversial. There are, however,several areas where the academic

debate still has not yet reached a con-sensus. Most important among themis the question of banking super-vision in the euro area. It is wellrecognized that the dispersion offinancial market regulation andsupervision across a multitude ofnational and transnational institu-tions reduces transparency, increasesuncertainty, and may present a realdanger in case of a crisis. Yet, con-centration of supervision is not apanacea, as financial supervision is amulti-dimensional problem. In par-ticular, there is a case to be madein favor of concentrating the super-vision of all financial services underone roof, an approach pioneered bythe United Kingdom with its Finan-cial Services Authority. However,concentrating financial supervisionacross all branches of the financialservices industry and all countriesis likely to create a regulatory mon-ster with little effectiveness. There-fore, the costs and benefits of bun-dling supervisory functions along




different dimensions still needs to beclarified further.

On the political front, the Euro-pean CommissionÕs Financial Serv-ices Action Plan and the LamfalussyReport of February 2001 list mostof the shortcomings discussed abovefairly clearly. Yet, the real difficultylies in bringing about the necessarychanges politically. Here, the Euro-pean Union has a less than satisfac-tory track record, judging from thedifficulties in adopting and imple-menting the important EU directivesof the 1990s. The takeover directive,after 12 years of debate between

national law makers, industry, andthe Commission voted down by theEuropean Parliament in June 2001,is an alarming case in point. For thisreason, the institutional side of theLamfalussy Report, with its proposalfor a concrete Òfast-track approachÓto decision-making and implementa-tion, is most innovative, and maywell turn out to be the most impor-tant piece of financial reform in theEuropean Union for years. But notunexpectedly, opposition to pre-cisely this aspect of the report isalready mounting. §





Helmut Reisen

12


Will Basel II

Contribute to Convergence

in International

Capital Flows?1)

1 IntroductionOn 16 January 2001, the BaselCommittee on Banking Supervision(Committee, 2001) released the sec-ond consultative package on the NewBasel Capital Accord (Basel II). Theproposal modifies and expands a pro-posal issued for comment in June1999 (see Committee, 1999;Reisen, 2000) and describes themethods by which banks can deter-mine their minimum capital require-ments. Comments were due on theproposal by 31 May 2001.2)

1 The author wishes to thank Richard Cantor (MoodyÕsInvestors Service) and Peter Conroy (Deutsche Bank)for helpful discussions and Martin Grandes for effi-cient assistance. The author alone is responsible forthe opinions expressed in this paper and, obviously,for any errors.

2 The Basel Committee originally intended to finalisethe Accord by year-end 2001, but has meanwhileextended the time schedule. Anyway, as implementa-tion of Basel II is not expected until at least 2004,near-term reaction on capital cost and capital flowsdiscussed in this paper will be limited.

Helmut ReisenHead of Division I,

OECD Development Centre


Such comments are, above all,solicited from a supervisory perspec-tive, in particular on whether theproposal will result in capital chargesthat are better aligned with underly-ing credit risk. This paper, however,is focused on a different concern. Itinvestigates the potential consequen-ces of Basel II on international bankcredit flows, namely the impact(a) on capital cost and (b) the volatil-ity of credit supply across the riskspectrum of borrowers. Alas, thefindings suggest that Basel II, if

implemented in its cur-rent form, would leadto more divergence,rather than conver-gence, in the cost andcyclicality of bankcredit flows betweeninvestment-grade bor-rowers, mostly at homein industrial countries,

and sub-investment-grade bor-rowers, mostly placed in emergingand developing countries.

The next section presents themajor elements of Basel II in its2001 version for the first pillar ofthe new Accord, the minimum regu-latory capital charge. The focus is onPillar 1 as the risk weights applied tobank assets and other risk positionsare of primary importance for bankcredit and, indirectly, bond pricing.Section 3 investigates the potentialimpact of changing the risk weight-ing on particular categories of debtby comparing the risk-adjustedreturn on bank capital under the cur-rent Accord against the spreadimpact under Basel II. Section 4explores the potential impact of thelast proposal on the cyclicality ofdebt flow supply to emerging anddeveloping countries. Section 5 con-cludes. While this paper does neitherquestion the need for bank capital

regulation1) nor provide alternativesuggestions for modifying the sophis-ticated framework elaborated bythe Committee, it intends to stresssome of its, possibly unintended,negative implications on specula-tive-grade borrowers from thedeveloping world. The concern isthat the new Basel Accord woulddeepen the regulatory divide inglobal finance.

2 Features of the newBasel Capital Accord(second consultativepaper)

The capital framework proposed inthe new Basel Accord consists ofthree pillars: minimum capitalrequirements (covering credit riskand operational risk), the super-visory review process, and marketdiscipline. Under the draft pro-posals, the rigid (total) capital ratioof 8% introduced in the 1988 BaselAccord will be maintained; new ishow the risk weights to the capitalratio would be determined. This isthe focus of the present paper, as riskweights determine the banksÕ loansupply and funding costs, becausebanks have to acquire a correspond-ing amount of capital relative to theirrisk-weighted assets.

It is widely agreed that cross-border lending has faced regulatorydistortions through the 1988 BaselAccord. Most importantly, short-term bank lending to the emergingmarkets has been encouraged by arelatively low 20% risk weight, whilebank credit to non-OECD bankswith a residual maturity of over oneyear has been discouraged by a100% risk weight. This has stimu-lated cross-border interbank lending,which has been described as theÒAchillesÕ heelÓ of the internationalfinancial system. And, OECD-based

1 For a review of the literature see Santos (2000).

Helmut Reisen



banks and governments havereceived a more lenient treatment,even if they constitute sovereign risksequivalent or inferior to non-OECDemerging markets (see table 1).

The Committee is now propos-ing two main approaches to thecalculation of risk weights: a Òstand-ardisedÓ and an Òinternal ratings-basedÓ (IRB) approach. One of themain changes from the CommitteeÕs1999 Consultative Paper (Commit-tee, 1999) is the clear intention thatleading banks will be able to use theIRB approach to set risk weights.The major change compared to the1988 Basel Accord is that for sover-eign exposures, membership in the

OECD will no longer provide thebenchmark for risk weights.

Table 2 summarises the proposalsfor risk weights under the standar-dised approach. The proposed riskweights will substitute credit ratingsby Òeligible external credit assess-ment institutionsÓ, not just ratingagencies as under the 1999 proposalbut also export credit agencies(ECA)1), for a split between OECDand non-OECD as the main determi-nant. Risk weights will continue tobe determined by the category ofthe borrower Ð sovereign, bank orcorporate Ð but within each of thosecategories, changes have been made.Under the proposal, a sovereign with

Table 1

The current Basel Capital Accord:

risk weights by selected category of on-balance-sheet assets

Risk weight Category

%

0 Ð Claims on governments dominated and funded in national currencyÐ Other claims on OECD-based central governments and central banks

20 Ð Claims on banks incorporated in the OECDÐ Claims on banks outside the OECD with a residual maturity of up to one year

100 Ð Claims on banks outside the OECD with a residual maturity of over one yearÐ Claims on corporatesÐ Claims on governments outside the OECD

Source: Basel Committee on Banking Supervision (1999).

Table 2

The new Basel Capital Accord

risk weight under the standardised approach

Agency rating AAA to AAÐ A+ to AÐ BBB+to BBBÐ

BB+to BBÐ

B+ to BÐ Below BÐ

Sovereign ECA risk score 1 2 3 4Ð6 4Ð6 7

Sovereigns 0 20 50 100 100 150Banks Ð option 11) 20 50 100 100 100 150Banks Ð option 22) 20 503) 503) 1003) 100 150Corporates 20 50 100 100 150 150

Source: Basel Committee on Banking Supervision (2001).1) Risk weighting based on risk weighting of sovereign in which the bank is incorporated. The rating shown thus refers to the sovereign

rating.2) Risk weighting based on the rating of the individual bank.3) Claims on banks with an original maturity of less than three months would receive a weighting one category more favourable than the

risk weighting shown above subject to a floor of 20%.

1 See Griffith-Jones and Spratt (2001) for a discussion on the use of export credit agencies in regulating bankcapital and the potential impact on developing countries.

Helmut Reisen



a AAA rating (or 1 ECA risk scoreunder the OECD 1999 methodol-ogy) would receive a 0% risk weight;lower ratings translate into a jump inrisk weights via 20, 50, 100 to 150%for sovereigns weighted below BÐ(or ECA risk score 7). For the treat-ment of claims on banks, there aretwo options. The first optionrequires that banks be assigned a riskweight that is one category lessfavourable than that assigned to thesovereign of incorporation. Nationalsupervisors in low-rated developingcountries may opt for the secondoption which bases the risk weighton the external assessment of thebank. For claims on corporates, amore risk-sensitive framework isnow proposed by moving away fromthe uniform 100% risk weight for allcorporate credits under the 1988Accord.

The internal ratings-based (IRB)approach suggested in the recentCommittee proposal represents afundamental shift in the treatmentof regulatory bank capital. It buildson internal risk rating practices ofleading banks to estimate the amountof capital they believe necessary tosupport their credit and operationalrisks. The IRB approach is nowexpected to be used by the majorityof globally active banks once thenew Accord is implemented (Deut-sche Bank, 2001), and thereforeshould be the prime determinant ofrisk weights (and hence debt capitalcost to borrowers).

The IRB approach is based onmapping risk measures derived fromprobability of default (PD), lossgiven default (LGD) and, under theÒadvancedÓ approach, maturity (M),into risk weight buckets.1) Banksare required to provide PD. WhileLGD and maturity are provided by

supervisors in the ÒfoundationÓapproach, all elements are expectedto be provided by the banks in theadvanced approach, if they meet anelaborate set of minimum require-ments with respect to in-house riskmanagement systems. For eachexposure, the risk weight is a func-tion of PD, LGD, and (where appli-cable) M. Where there is no explicitmaturity dimension in the Òfounda-tionsÓ approach, the average matur-ity of exposures will be assumed tobe three years. The Committee thensuggests the following formula tocalculate risk weights (RW):

RW � �LGD=50� �BRW�PD�or 12:50� LGD;

whichever is smaller.BRW (PD) denotes the bench-

mark risk weight with a given PDand LGD. Where there is an explicitmaturity dimension, the Committeesuggests to multiply the benchmarkrisk weight BRW (PD) with a multi-plicative scaling factor, linear in M,

�1� b�PD� � �M ÿ 3��;

where the maturity adjustmentfactor b(PD) also is a function ofPD. The suggestion, obviously,implies higher risk weights for lon-ger maturities.

Representative values for bench-mark risk weights (BRW) as a func-tion of the default probability forcorporate exposures are provided intable 3. The table also adds informa-tion on the corresponding ratinglevels. Note the important fact thatthe Committee does not suggest alinear, but a strongly exponential riseof risk weightings along the spec-trum of higher probability of default.As will be shown in section 4, this

1 The process is complicated by new recommendations regarding Òcredit risk mitigation techniquesÓ under which it ispossible to obtain partial capital relief by taking into account guarantees, collateral, netting or credit derivatives.

Helmut Reisen


13


suggestion would have fatal conse-quences on the terms at which spec-ulative-grade borrowers could incurbank debt in the future under thesuggested IRB approach.

Based on the history of corporatedefault rates per rating notch pro-vided by MoodyÕs Inverstors Service(1999) and calibrating the dataprovided by the Committee as givenin table 3, the regression estimated

below in figure 1 obtains. This func-tion can then be used to interpolatefor each rating notch the probabilityof default and the corresponding riskweight.

Although the features presentedhere do not do justice to the com-plexity and sophistication of the sec-ond consultative paper issued by theCommittee, they provide sufficientdetail for the subsequent calculations

Table 3

Proposed IRB risk weights for hypothetical corporate exposure

with loss-given-default equal to 50%

Agency rating Probability of default,3-year maturity, %1)

Theoreticalrisk weight2)

Investment grade AAA 0 0AA+ 0 0AA 0.07 7AAÐ 0.21 20.8A+ 0.37 36.2A 0.16 15.9AÐ 0.28 27.6BBB+ 0.59 56.9BBB 0.41 40.0BBBÐ 1.28 118.1

Speculative grade BB+ 3.77 293.9BB 5.46 378.7BBÐ 11.76 529.9B+ 15.03 559.9B 19.85 630.3BÐ 27.79 1,063.5CCC and below 31.38 1,493.1

Source: Basel Committee on Banking Supervision (2001); MoodyÕs Investors Service (1999).1) Average historical probability of default for the period from 1980 to 1998 of corporate borrowers, cumulative for three-year maturities.2) Based on the regression displayed in figure 1, which in turn is derived from calibrating IRB risk weights provided by the Committee in the

technical support document cited above.

BRWc

Regression of probability of default

and proposed IRB risk weights

Figure 1

600

500

400

300

200

100

0

Source: Own calculation.

0PD

5 10 15 20

y = 0.1538x3 � 6.5063x2 + 100.3xR2 = 0.9869

Helmut Reisen



on the implications for credit spreadsand capital cost in industrial anddeveloping countries.

3 Implicationsfor credit spreads

It has been shown for sovereignexposures (Reisen, 2000) thatchanges in risk weights have a directimpact on credit spreads. Under thecurrent 1988 Basel Accord, lowerfunding cost that arose for privatebank lending to new OECD mem-bers as a result of lower risk weightsdid indeed translate into lower inter-est cost on new loan commit-ments.1) The benefit of lower inter-est cost (after correcting for worldinterest rate developments) material-ised despite higher loan demand bynew OECD countries. Credit costmight therefore also strongly reactfor categories of debt in which therisk weighting is moved significantlyunder the new Basel II proposals.

Extending calculations in Deut-sche Bank (2001), the calibrationsbelow compare the risk-adjustedreturn on capital using current riskweightings and credit spreads underBasel I with risk weightings andspreads that could result from thestandardised and IRB approach underBasel II. It is assumed that banks fundthemselves at LIBOR, and the spreadin excess of LIBOR is expressed as apercentage of capital required, whichin turn translates the minimum Baselcapital ratio requirement (total capi-tal/weighted risks) of 8% into a cap-ital amount. This allows to deter-mine the amount of breakevenspread change needed to maintainthe banksÕ risk-adjusted return oncapital achieved under the 1988Basel Accord.

Figure 2 shows that ratings (andhence underlying default probabil-ities) differ significantly betweenborrowers located in OECD coun-

1 In particular, upgrades to investment grade open up a much wider investor base to emerging and developing coun-tries. As they become eligible for inclusion in benchmark investment-grade indices, portfolio managers would haveto consciously justify a countryÕs exclusion rather than start from the presumption that the country will not beincluded in investment-grade portfolios. Such portfolios are particularly held by long-term contractual institu-tions, such as pension funds and insurance companies. An upgrade to investment grade will therefore result inhigher and more stable demand for a developing-country bond, as the demand for countryÕs bonds will not belimited to unconstrained investors, such as high-yield managers and hedge funds, that are able to trade oppor-tunistically in and out of speculative-grade bonds.

Number of sovereigns

Standard and Poor's sovereign ratings

Figure 2

10

8

6

4

2

0

Source: Standard and Poor�s.

AAARating

Emerging marketsDeveloped countries

AA+ AA AA� A+ A A� BBB+ BBB BBB� BB+ BB BB� B+ B B� CCC+to D

Helmut Reisen



tries and those in non-OECD coun-tries. The median sovereign ratingfor OECD countries in early 2001was AA, while the median sovereignrating in non-OECD countries wasBB (although with a much widerstandard deviation among non-OECD borrowers than amongOECD borrowers). These differen-ces would translate into a dramaticdivergence in risk weights and debtcost between the two countrygroups, if the internal ratings-basedapproach (IRB) suggested by theCommittee was applied. Differencesbetween categories of borrowers Ðsovereigns, banks (short-term expo-sures), corporates Ð are not system-atically significant within these coun-try groups, according to inquirieswith rating agency economists andrecent research (Durbin and Ng,1999); they will therefore beignored in the calculations givenbelow. Table 4 provides some illus-

trations of the potential impact ofchanging risk weights, one for dou-ble-A rated OECD-based borrowers,and three for non-OECD borrowerswith triple-B, double-B and single-Bratings. Loss given default rates(LGD) are generally assumed to be50%, in line with findings inMoodyÕs Investors Service (1999),and the remaining maturity of under-lying assets at three years.

The results displayed in table 4indicate that the potential impact ofchanging risk weights in Basel IIcan be dramatic, although such num-bers cannot be exact science. Dou-ble-A rated sovereigns (such as Italy)would only face a slight uptick incredit spreads under the IRBapproach as the implied defaultprobability for double-A rated bor-rowers is 0.07% (on three-yearmaturities), which translates intotheoretical risk weight of 6.99%.This implies that the lending bank

Table 4

Potential impact of change in risk weightings implied by Basel II

Basel regulation Sovereigns Break-evenspreadchange,bp3)

Banks, option 2 Break-evenspreadchange,bp3)

Corporates

As-sumedLIBORspread

Riskweight1)

CapitalrequiredperUSD100

Risk-adjustedreturn,%2)

As-sumedLIBORspread

Riskweight1)



As-sumedLIBORspread

Riskweight1)



Break-evenspreadchange,bp3)

Double-A (OECD-based)Current 5 0 0.0 . . 10 20 1.6 6.3 20 100 8.0 2.5Standardised 0 0.0 . . Ð 20 1.6 6.3 Ð 20 1.6 12.5 Ð 16IRB approach 7 0.6 8.3 + 3 7 0.6 16.7 Ð 6 7 0.6 33.3 Ð 18

Triple-B (non-OECD)Current 100 100 8.0 12.5 100 100 8.0 12.5 100 100 8.0 12.5Standardised 50 4.0 25.0 Ð 50 50 4.0 25.0 Ð 50 100 8.0 12.5 ÐIRB approach 40 3.2 31.3 Ð 60 40 3.2 31.3 Ð 60 40 3.2 31.3 Ð 60

Double-B (non-OECD)Current 400 100 8.0 50.0 400 100 8.0 50.0 400 100 8.0 50.0Standardised 100 8.0 50.0 Ð 100 8.0 50.0 Ð 100 8.0 50.0 ÐIRB approach 379 30.3 13.2 +1,115 379 30.3 13.2 +1,115 379 30.3 13.2 +1,115

Single-B (non-OECD)Current 700 100 8.0 87.5 700 100 8.0 87.5 700 100 8.0 87.5Standardised 100 8.0 87.5 Ð 100 8.0 87.5 Ð 150 12.0 58.3 + 350IRB approach 630 50.4 13.9 +3,709 630 50.4 13.9 +3,709 630 50.4 13.9 +3,709

Source: Own calculation as described in the text based on the procedure developed in Deutsche Bank (2001).1) For the IRB approach obtained from the cubic regression estimate given in figure 1.2) Assumes LIBOR flat funding. Risk-adjusted return on capital is 100/regulatory capital required per USD 100 times spread over LIBOR; quoted as return in excess over LIBOR.3) Indicates the amount of spread movement needed (in basis points) to produce the risk-adjusted return achieved under the current Basel I environment.

Breakeven spread change is difference in risk-adjusted return between ÒcurrentÓ and ÒstandardisedÓ, resp. ÒIRBÓ approach times capital required per USD 100 in ÒstandardisedÓ, resp. ÒIRBÓapproach.

Helmut Reisen



has to acquire USD 0.56 per USD100 under the IRB approach, com-pared to the 0 risk weight underBasel I and under the standardisedapproach suggested now for BaselII. The argument is reversed for dou-ble-A rated corporates, where therisk weighting would drop from100% under Basel I to 20% in bothscenarios of Basel II. This results inan increase of the risk-adjustedreturn on capital for the lendingbank. Assuming a spread of 20 basispoints over LIBOR for double-Arated corporates, the risk-adjustedreturn rises from 2.5% (100/8 x0.2) to 12.5% (100/1.6 x 0.2)under the standardised approach.This would produce a drop in thebreakeven spread of 16 basis points([12.5 Ð 2.5] x 1.6). As for lendingto sovereigns and banks, lending todouble-A rated corporates wouldrequire a risk weight of only 7%.This translates into a capital require-ment of USD 0.56 per USD 100 lent(0.08 x 0.07), and hence a risk-adjusted return of 35.7% (100/0.56 x 0.2). The correspondingbreakeven spread would be ([2.5 Ð35.7] x 0.56) = 18.6 basis points.

As displayed in figure 2, 22 outof 53 rated non-OECD sovereignscurrently enjoy investment-graderatings (BBBÐ and higher). The mostassigned rating category for thisgroup of countries is BBB. Table 4shows that the suggestions of thenew Basel Accord, regardless ofwhether under the standardised orthe IRB approach, would benefittriple-B rated non-OECD borrowersthrough sizeable reductions in riskweights, regulatory capital require-ments, and consequently debt costsas breakeven spreads drop by 50 to60 basis points.

In strong contrast to the favour-able impact for investment-gradeborrowers, the adoption of the IRBapproach suggested by the Commit-

tee would effectively close specula-tive-grade borrowers from interna-tional bank lending. This would hitthe majority of developing countriesas 31 out of the 53 rated non-OECDsovereigns have speculative-graderatings. While the standardisedapproach would leave risk weights,regulatory capital, risk-adjustedreturns and hence breakeven spreadsunchanged (except for corporateborrowers rated B and below andother borrowers rated C and below),the suggested IRB approach seems toimply extraordinarily heavy riskweights. Ignoring any distinctionbetween categories of borrowers,bank lending to double-B rated bor-rowers would require a risk weightof 379%, translating to regulatorycapital needs of USD 30.3 per everyUSD 100 lent. Assuming that dou-ble-B borrowers are quoted 400 basispoints in excess of the LIBOR rate,this would diminish the risk-adjustedreturn for bank creditor from 50.0%in both the current and the standar-dised approach to 13.2% under thesuggested IRB approach. To keepthe creditor bankÕs profit level even,the drop in the risk-adjusted rate ofreturn on capital would translate intoa rise of the breakeven spread in theorder of 1,115 basis points. Forsingle-B rated borrowers, table 4indicates an even more dramatic risein the breakeven spread as a result ofprohibitive risk weights.

In fact, market spreads areunlikely to react as dramatically assuggested by table 4, for several rea-sons. The data above refer to netexposures; the strong yield differen-ces indicated in the table might leadto significant arbitrage trades.Importantly, nonbank investors suchas asset management firms, insur-ance companies and pension fundsindifferent to risk weightings wouldprobably arbitrage based on bankregulatory requirements. Moreover,

Helmut Reisen


14


the second Consultative Paper sug-gests regulatory capital relief forcredit risk mitigation, for examplethrough credit derivatives, collateraland guarantees. Finally, it is not clearto what extent banks base their lend-ing decisions on calculations of risk-adjusted returns (as provided in table4), not least because the capitalrequirements relate to the bankingbook, but not to the banksÕ tradingbooks to which exposures might beplaced.

In any case, it seems clear thatcredit spreads will more closelyreflect credit ratings as a proxy ofdefault probabilities. While this isexactly what supervisors are aimingat, the calculations provided hereindicate that the chasm betweeninvestment-grade borrowers, mostlybased in OECD and in some of themore successful emerging markets,and speculative-grade borrowers,mostly from the developing world,will deepen. This outcome wouldclearly run against endeavours ofthe global development communityto broaden the range of developingcountries that benefit from privatecapital inflows. Not only does BaselII risk to raise capital cost for specu-lative-grade developing countries,but it may also increase the volatilityof bank credit supply to this group ofcountries.

4 Systemic implications

The concern that Basel II will raisethe volatility of private capital flowsto speculative-grade developingcountries, and hence their vulner-ability to currency crises, is basedon four aspects of the new Accord:(a) the rigidity of the 8% minimumcapital ratio; (b) the lateness andthe cyclical determination of agencyratings, which define regulatory

capital needs under the Òstandar-disedÓ approach; (c) the cyclicalnature of the probability of defaultand of yield spreads, which deter-mine regulatory capital needs anddebt costs under the Òinternal rat-ings-basedÓ approach; and (d) theongoing incentives for short-termrather than long-term interbanklending embedded in the BaselAccord.

First, theory suggests that linkingbank lending to regulatory capitalthrough a rigid minimum capitalratio acts to amplifymacroeconomic fluctu-ations in a non-Modi-gliani-Miller world,where investmentdemand depends onthe ability of firms toretain earnings or toobtain bank loans(Blum and Hellwig,1995). If negative shocks to aggre-gate demand reduce the ability ofdebtors to service their debts tobanks, such reduction in debt servicelowers bank equity, which in turnreduces bank lending and investmentbecause of capital adequacy require-ments. With a binding bank capitalrequirement c, an additional USD 1of bank profits induces 1/USD addi-tional units of bank lending. Linkingbank lending to bank equity thus actsas an automatic amplifier for macro-economic fluctuations: Banks lendmore when times are good, and lesswhen times are bad; rigid, or evenpro-cyclical capital requirementsreinforce that habit.

Second, under the ÒstandardisedÓapproach, risk weights will be deter-mined above all by agency ratings.However, empirical evidence sug-gests that sovereign ratings lag ratherthan lead the markets.1) It seems that

1 See Reisen and von Maltzan (1999). Reinhart (2001) has recently shown that the lagged nature of ratings, inparticular in the context of banking-cum-currency crises, has not changed since the Asian 1997/98 crisis.

Helmut Reisen



there is little scope to improve onthat performance, as the nature ofsovereign risk and the public avail-ability of sovereign default determi-nants make it difficult for ratingagencies to acquire an informationlead over financial markets. More-over, current income growth hasbeen repeatedly identified to influ-ence ratings positively (see, amongothers, Cantor and Packer, 1996;Kaminsky and Schmukler, 2001).This means that during boom timesratings will improve, while theydecline during bust periods.

Thus, assigning fixed minimumcapital to bank assets whose riskweights are in turn determined bymarket-lagging ratings will reinforcethe tendency of the capital ratio towork in a pro-cyclical way. TheIMF (1999) has also found that rat-ings on developing-country bor-rowers are characterised at times bya low degree of durability, indicatinga low prediction value. The Basel IIproposals reinforce pro-cyclical ten-dencies further as a strong disconti-nuity between risk weights on differ-ently rated assets will make banksÕloan portfolio more liquidity-hungry,hence raising the vulnerability of thefinancial system to liquidity risk. Tothe extent that a high share of banksÕloan portfolio is invested in triple-Brated sovereign and corporates (with

a 50% risk weight, recall table 2),downgrades on such assets (implyinga 100% risk weight according to theÒstandardisedÓ approach) will forcebanks to reserve more liquidity orto cut back lending to the down-graded borrowers. The financial sys-tem would become more vulnerableto a liquidity crisis.

Third, under the Òinternal rat-ings-basedÓ approach, risk weightsassigned to the different categoriesof borrowers will be governed byunderlying default probabilities.However, MoodyÕs Investors Service(1999) has shown that default ratevolatility increases with lower ratingnotches, though not as strongly asaverage default risk. Moreover,another recent investigation by Moo-dyÕs Investors Service (2001) showsthat macroeconomic shocks, notidiosyncratic risk, explain most ofthe volatility in default rates. Duringthe period from 1970 to 1999, one-year default rates for speculative-grade issuers in MoodyÕs GlobalDatabase oscillated between roughly1% in tranquil times and 10% in cri-sis years. Under the IRB approachsuggested in the new Basel Accord,these fluctuations in default probabil-ity would translate into correspond-ing pro-cyclical shifts in risk weights.The proposed IRB risk weights forcorporate exposure with Loss-

Index

EMBI+ price index

Figure 3

200

150

100

50

0

Source: Fernandez-Arias and Hausmann (2000).

LatamNon Latam

1994 1995 1996 1997 1998 1999

Helmut Reisen



given-default equal to 50% rise fromroughly 100% for a 1% probability ofdefault to 500% for a 10% probabil-ity of default.

Figure 3 shows a remarkable cor-relation for the evolution of emerg-ing-market bond prices during thelast decade. This phenomenon,termed financial contagion, is espe-cially worrisome at the time of largenegative shocks triggered by exoge-nous events, when average spreadson emerging-market bonds can easilyrise from, say, 250 to 750 basispoints. The corresponding jump inrisk spreads would be exacerbatedby the new Basel Accord as banksare discouraged by a corresponding,pro-cyclical, rise in risk weights toarbitrage such pricing gaps. Follow-ing the calculation procedure oftable 4, a corresponding rise inspreads from 250 to 750 basis pointsand a rise in underlying risk weightsfrom 100% to 500% of the 8%

bank capital ratio would produce ajump in the bankÕs required break-even spread of 500 basis points.

Fourth, the new Basel Accordstill discourages long-term interbanklending to emerging and developingcountries. For speculative-gradedeveloping countries, the regulatoryincentives for short-term interbanklending thus tilt the structure of theircapital imports towards short-termdebt. Short-term foreign debt, inrelation to official foreign exchangereserves, has been identified as thesingle most important precursor offinancial crises triggered by capital-flow reversals (Rodrik and Velasco,1999).

Table 5 displays the potentialimpact of risk weights for short-term(below three months) bank-to-banklending, in addition to the calcula-tions shown already in table 4 withregard to long-term (three-yearmaturity) lending. Let us first have

Table 5

Regulatory incentives for short-term interbank lending

Basel regulation Long-term, option 2 Short-term, option 2

AssumedLIBOR spread

Risk weight1) Capitalrequiredper USD 100

Risk-adjustedReturn, %2)

Breakevenspreadchange, bp3)

AssumedLIBOR spread

Risk weight1) Capitalrequiredper USD 100

Risk-adjustedReturn, %2)

Breakevenspreadchange, bp3)

Double-A (OECD-based)Current 10 20 1.6 6.3 10 20 1.6 6.3Standardised 20 1.6 6.3 ÿ 20 1.6 6.3 ÿIRB approach 7 0.6 16.7 ÿ 6 0 0.0 . . . .

Triple-B (non-OECD)Current 100 100 8.0 12.5 100 20 1.6 62.5Standardised 50 4.0 25.0 ÿ 50 20 1.6 62.5 ÿIRB approach 40 3.2 31.3 ÿ 60 10 0.8 125.0 ÿ 50

Double-B (non-OECD)Current 400 100 8.0 50.0 400 20 1.6 250.0Standardised 100 8.0 50.0 ÿ 50 4.0 100.0 � 600IRB approach 379 30.3 13.2 �1,115 60 4.8 83.3 � 800

Single-B (non-OECD)Current 700 100 8.0 87.5 700 20 1.6 437.5Standardised 100 8.0 87.5 100 8.0 87.5 � 2,800IRB approach 630 50.4 13.9 �3,709 400 32.0 21.9 �13,300

Source: Own calculation as described in the text based on the procedure developed in Deutsche Bank (2001).1) For the IRB approach, long-term (three years) risk weights are obtained from the cubic regression estimate given in figure 1. The underlying default rates for short-term exposures were

obtained from MoodyÕs; they are 0% for double-A, 0.1% for triple-B, 0.6% for double-B, and 6.8% for single-B borrowers (MoodyÕs, 2001; exhibit 16). For the standardised approach, claimson banks rated between A+ and BBÐ with an original maturity of less than three months would receive a rating one category more favourable than the risk weight on longer maturities.

2) Assumes LIBOR flat funding. Risk-adjusted return on capital is 100/regulatory capital required per USD 100 times spread over LIBOR; quoted as return in excess over LIBOR.3) Indicates the amount of spread movement needed (in basis points) to produce the risk-adjusted return achieved under the current Basel I environment. Breakeven spread change is

difference in risk adjusted return between ÒcurrentÓ and ÒstandardisedÓ, resp. IRB approach times capital required per USD 100 in ÒstandardisedÓ, resp. IRB approach.

Helmut Reisen



a look how the current (1988) BaselAccord has discouraged long-termbank lending for banks from devel-oping countries, as opposed to theneutral incentives provided forlending to OECD-based banks. Therisk-adjusted return for lendingto triple-B rated non-OECD banksis calculated as 12.5% for long,but 62.5% for short maturities;the respective numbers are 50%versus 250% for double-B ratedbanks, and 87.5% versus 437% forsingle-B rated banks.

The standardisedapproach suggested inBasel II attenuates thebias towards short-term lending to triple-B and double-B ratedborrowers, but doesnot entirely deletethem. By contrast,bank-to-bank lending

to single-B rated borrowers wouldnot any longer be distortedby higher risk-adjusted returns onshort-term lending under the Òstand-ardisedÓ approach.

Strong incentives, by contrast,continue to be provided under theÒinternal ratings-basedÓ approachfor short-term bank lending, inparticular to triple-B rated banks.The required breakeven spreadchange is minus 50 basis points onshort-term lending under the IRBapproach compared to the currentBasel requirements, as the corre-sponding risk weight drops to 10%,assuming a 0.1% probability ofdefault on short-term exposureaccording to the evidence providedin MoodyÕs Investors Service(2001). Therefore, while for expo-sures with a residual maturity ofthree years the corresponding proba-bility of default (0.41%) translatesinto a risk weight of 40% and arisk-adjusted return of 31.3% (foran assumed spread over LIBOR of

100 basis points), the equivalentrisk-adjusted return is much higher,125%, for short-term exposures totriple-B rated banks.

While higher risk-adjustedreturns for short-term exposuresthan for long-term exposures canalso be calculated with respect todouble-B and single-B banks (seetable 4), this is likely to be less rele-vant for the structure of future banklending. As discussed before (seetable 4), the required breakevenspread change is extremely high forspeculative-grade borrowers, if theIRB approach is compared to thecurrent Basel regulations; this holdsessentially for short-term lending aswell, except perhaps for lending todouble-B rated banks.

5 Conclusions

The Basel Committee on BankingSupervision has recently released asecond Consultative Paper proposinga new Basel Capital Accord. TheConsultative Paper is highly com-plex, sophisticated and ambitious,aiming at better risk sensitivity ofregulatory capital charges, improvedincentive compatibility to enhancerisk management and safer banks.However, it may lead, if imple-mented as is, to deepen the dividebetween investment-grade and spec-ulative-grade borrowers in theirability to tap world financial marketsat sustainable debt cost and in theirexposure to volatile capital supply.

This paper has argued that spec-ulative-grade borrowers, the bulkof emerging and developing coun-tries, will suffer from a dramatic risein debt costs and heightened cyclical-ity of global bank credit as a result ofBasel II if the IRB approach suggestednow prevails. Calculations providedhere underpin the concern that therise in risk weights required by theIRB approach, itself being a funda-mental shift in the treatment of

Helmut Reisen


15


regulatory bank capital, would effec-tively close speculative-grade frominternational bank lending. By con-trast, the ÒstandardisedÓ approach,which links risk weights to ratingsby eligible external credit assessmentinstitutions, would leave banksÕ reg-ulatory capital charges, risk-adjustedreturns and hence required spreadslargely unchanged (except for thevery lowest rating notches) to mostdeveloping-country borrowers.

The concern that Basel II willraise the volatility of private capitalflows to speculative-grade develop-ing countries, and hence their vul-nerability to currency crises, has alsobeen addressed in this paper. It isbased on four aspects of the newAccord: the rigidity of the 8% mini-mum capital ratio; the lateness andthe cyclical determination of agencyratings, which define regulatory cap-ital needs under the ÒstandardisedÓapproach; the cyclical nature ofthe probability of default and ofyield spreads, which determine reg-ulatory capital needs and debt costsunder the IRB approach; and theongoing incentives for short-termrather than long-term interbanklending embedded in the BaselAccord.

Supervisors are mainly con-cerned with the safety of the financialinstitutions under their responsibil-ity; development and systemic con-cerns do not seem to get the atten-tion that the important regulatoryimpact on private capital flowswould deserve. Akin to the much-discussed ÒdigitalÓ devide in the areaof education, innovation and growth,Basel II risks to deepen the Òregula-toryÓ devide between investment-grade and speculative-grade bor-rowers in the area of global finance.The 21st century is expected to seea growing share of global outputmove from the rapidly ageing OECDeconomies to the younger develop-

ing world, where all the worldÕslabour force growth will take place,promising higher capital returnsthere. This promise is reinforcedby the observation that poor coun-tries have a higher potential to growthan rich countries. These expecta-tions, though, will not materialisewithout substantial capital flowsfrom capital-rich and ageing coun-tries to labour-rich economies. BaselII, as it stands, will not be of helpto widen the range of countries likelyto benefit from private capitalinflows. §

References

Basel Committee on Banking Super-vision (1999). A New Capital Adequacy

Framework. Bank for International Settle-

ments, Basel.

Basel Committee on Banking Super-vision (2001). The New Basel Capital

Accord. Bank for International Settlements,

Basel, January.

Blum, J. and Hellwig, M. (1995). The

Macroeconomic Implications of Capital

Adequacy Requirements for Banks. In:

European Economic Review, vol. 39, no. 3.

Cantor, R. and Packer, F. (1996). Deter-

minants and Impact of Sovereign Credit

Ratings. Federal Reserve Bank of New York.

Economic Policy Review, vol. 20, no. 2.

Deutsche Bank (2001). New Basel Capital

Accord. In: DB Global Markets Research,

January.

Durbin, E. and Ng, D. (1999). Uncovering

Country Risk in Emerging Market Bond

Prices. Board of Governors of the Federal

Reserve System (US). Finance and Eco-

nomics Discussion Series no. 639.

Fernandez-Arias, E. and Hausmann, R.(2000). WhatÕs Wrong with International

Financial Markets? In: Hausmann, R. and

Hiemenz, U. (eds.). Global Finance from a

Latin American Viewpoint. Inter-American

Development Bank and OECD Develop-

ment Centre.

Griffith-Jones, S. and Spratt, S. (2001).Selected Issues Arising from the New Basel

Capital Accord and their Potential Impact

Helmut Reisen



on Developing Countries, preliminary.

Mimeo, IDS at Sussex University.

IMF (1999). Capital Markets Report. Sep-

tember.

Kaminsky, G. and Schmukler, S. (2001).Emerging Markets Instability: Do Sovereign

Ratings Affect Country Risk and Stock

Returns? Paper presented at the confer-

ence ÒThe Role of Credit Reporting

Systems in the International EconomyÓ,

World Bank.

MoodyÕs Investors Service (1999).Historical Default Rates of Corporate

Bond Issuers, 1920Ð1998. New York,

January.

MoodyÕs Investors Service (2001). Test-

ing for Rating Consistency in Annual

Default Rates. New York, February.

Reinhart, C. (2001). Sovereign Credit Rat-

ings Before and After Financial Crises. Paper

presented at the conference ÒThe Role of

Credit Reporting Systems in the Interna-

tional EconomyÓ, World Bank.

Reisen, H. (2000). Revisions to the Basel

Accord and Sovereign Ratings. In: Haus-

mann, R. and Hiemenz, U. (eds.). Global

Finance from a Latin American Viewpoint.

Inter-American Development Bank and

OECD Development Centre.

Reisen, H. and von Maltzan, J. (1999).Boom and Bust and Sovereign Ratigs.

OECD Development Centre Technical

Paper no. 148. In: International Finance,

vol. 2, no. 2, July.

Rodrik, D. and Velasco, A. (1999). Short-

Term Capital Flows. NBER Working Paper

no. 7364. NBER, Cambridge.

Santos, J. (2000). Bank Capital Regulation in

Contemporary Banking Theory: A Review

of the Literature. BIS Working Papers

no. 90. Bank for International Settlements,

September.

Helmut Reisen




Esa Jokivuolle

16


Comments on

Helmut Reisen,

ÒWill Basel II

Contribute to Convergence

in International Capital Flows?Ó

IntroductionIt is a great pleasure to have theopportunity to comment on HelmutReisenÕs paper. It is an interestingand highly topical study as the secondconsultation round for Basel as wellas EU proposals for the new capitaladequacy framework ends Ð infact Ð today. I personally find thepaper particularly interestingbecause I have long been concernedwith the question of the relationshipbetween the regulatory capitalrequirements of banks and the pric-ing of debt, both as a former riskmanager and as a researcher.

As an ever worried centralbanker I feel that I can only agreewith the paperÕs main conclusions

Esa JokivuolleProject Supervisor,

Bank of Finland


and predictions. Yes, after Basel II, amuch greater division in the cost ofdebt between low-risk and high-riskborrowers, both internationally anddomestically, seems inevitable. Andyes, this could severely tighten theterms of international credit formany countries. The volatility ofthe flow of funds to high-risk sover-eign borrowers would also seem toincrease. We should therefore beconcerned about these prospectsand think of ways to alleviate theproblems brought by the new CapitalAccord.

Nonetheless, there seem to besome puzzles in the relationshipbetween the regulatory capital ofbanks and the pricing of debt. I oftenask myself this: It is all fine in prac-tice, but how does it work in theory?In the following I will try to saysomething on this problem.

Minimum Capital Require-ments, Economic Capital,and the Pricing of Debt

Reisen presents calculations indi-cating that particularly the use ofthe internal ratings-based approach(IRBA) of Basel II could dramaticallyincrease the cost of debt to the low-est-grade borrowers. This is due tothe fact that the approach wouldstrongly increase the capital require-ments of banks for such exposures.On the other hand, the cost of debtto the highest quality borrowers islikely to diminish. Reisen makes hispoint in the context of internationalfinance, but the same effects shouldreadily apply in any lending context.

What should, however, be moreimportant for the pricing of debt:the regulatory capital requirementor the so-called economic capital ofbanks? Probably both matter, but ifI had to pick only one, I would saythe economic capital. Economic cap-ital is reserved against banksÕ trueportfolio risk. Within a bank, it is

further allocated to each creditexposure according to their contri-bution to the portfolioÕs overall risk.These risk contributions would thenbe used to assign the minimumspread requirement to each expo-sure, that is, to determine the mini-mum acceptable interest rate on aloan. Economic capital, rather thanregulatory capital, would hence bethe primary capital constraint a bankmanagement should consider inlending decisions in order to maxi-mize shareholder value.

One of the outspoken goals ofBasel II, particularly that of IRBA,is to bring regulatory capital closerto the economic capital. If this isthe case, and if banks were alreadypricing their loans according to theeconomic capital allocations, whyshould there be much change in pric-ing after Basel II? For instance,expecting a dramatic broadening ofthe credit spread on speculative-grade debt after the new CapitalAccord would seem to imply thatthese debts have earlier been seri-ously underpriced.

In practice it seems that theminimum capital requirements ofbanks, nonetheless, affect the pric-ing of debt more strongly than thebasic theory above would suggest.A snapshot comparison from Octo-ber 1999 of the corporate bondmarket spreads and the correspond-ing theoretically acceptable mini-mum spreads, called Òrock-bottomspreads,Ó across rating classes indi-cates that the actual credit spreadcurve has been much flatter thanwhat would seem to be justified byeconomic risk considerations. Whilehigh-grade bonds have earned sizableliquidity spreads, the lowest-gradebonds have not even earned therock-bottom spread. The reason forthis might be distorted incentiveeffects of the current minimum cap-ital requirements, or simply imper-

Esa Jokivuolle



fect pricing practices. However, con-siderable parameter uncertainty inpricing might affect the credibilityof these results.

My conclusion so far is that, atleast in theory, the economic capitalcalculations of banks should alreadybe driving the pricing of debt now.Therefore, as particularly the IRBAis merely to take regulatory capitalrequirements closer to economiccapital, I do not necessarily expectdramatic changes in pricing. None-theless, available empirical evidencesuggests that reality may not followthe basic theory in that there seemto have been remarkable deviationsfrom economic-capital-based valua-tions in the market. Why this isso remains at least partly puzzlingto me.

Calibrationof Basel II Risk Weights

The above argumentation has mainlyfocused on the relative pricing ofdebt across rating classes. Anotherimportant issue for banks and theirdebtors is the level of debt pricing,which could be affected by the over-all stringency of the capital require-ments. Although not much discussedso far, it is known that the currentlevel of the internal ratings-basedrisk weights have been derived bycalibrating them to 1.5 times theeconomic capital of a representativecredit portfolio used in the calibra-tion. In other words, the IRBA capi-tal requirements are currently likelyto be well above the correspondingeconomic capital levels.

In addition to this, another argu-ment may raise the capital held bybanks even further. A recent studyargues that banks hold capital inexcess of the minimum requirementin order to fulfil the minimumrequirement also in possible eco-nomic downturns within their capitalplanning horizon (see Jokivuolle and

Peura, 2001). The need for such cap-ital cushions may even be increasedby the increasing volatility of thenew capital requirements, resultingfrom the rating sensitivity of the riskweights. These cushions togetherwith the new minimum require-ments that already appear to be wellabove the economic capital levelsshould be given due considerationwhen Basel is carrying out the finalcalibration of the risk weights. Thiswould be important in order toachieve the targeted overall capitallevel in the banking sec-tor, and not to imposeunnecessary pressureson the pricing of debt.

Precautionary cush-ions of banks may alsoplay another role, andnow I briefly come toReisenÕs second pointof increasing cyclicalityof emerging market finance. If thereis anything like Òrelationship lendingÓin the case of emerging markets,then banks that lend to these coun-tries might have incentives to reservein advance capital cushions wellabove their minimum capitalrequirements in order to be able tocontinue lending through bad times.This might work to alleviate theproblem of cyclicality, even thoughthe original build-up of such cush-ions in response to the new CapitalAccord could depress lending. Any-how, it would be all the more impor-tant to calibrate the final risk weightsin such a way that the cushions ofbanks are not forced to detrimentallyhigh levels.

Conclusions

To conclude I would say that, consid-ering the available empirical evi-dence, we should be concernedabout the effects of Basel II on theavailability and pricing of especiallyspeculative-grade debt, as Reisen

Esa Jokivuolle



suggests. In my comments I havepointed out, however, that we maystill be faced with an incompleteunderstanding of how the interplayof the regulatory capital require-ments and economic capital calcula-tions of banks affects debt markets.I also emphasized factors that Baselmight have to consider carefullywhen implementing the final calibra-tion of the new risk weights.

One consequence of Basel IIcould be that banks using the stand-ardized approach, which imposesless stringent capital requirementson speculative-grade debt, wouldstart specializing on speculative-

grade lending. Banks adopting theIRBA would in turn specialize onthe better end of the rating scale.This might be a rather absurd out-come as less sophisticated banksare particularly likely to hold tothe standardized approach. That is,banks with less sophisticated riskmanagement methods might endup lending to the riskiestcustomers. §

References

Jokivuolle, E. and Peura, S. (2001).Regulatory Capital Volatility. In: Risk

Magazine, May.

Esa Jokivuolle


17



Dirk Schoenmaker


Luncheon Speech:

The Skill Profile

of Central Bankers

and Supervisors

1 IntroductionIn an earlier paper (Goodhart andSchoenmaker, 1995), we observeda trend towards separation betweenmonetary policy and supervisoryagencies. A major reason for this isthat if taxpayers were seen to bepotentially liable during a crisis,there would be a demand for moredirect political control over super-vision. Subsequently, some centralbanks have lost their supervisorypowers, notably the Bank of Eng-land. A key question in the ongoingdebate on separation (e.g. Peek,Rosengren and Tootell, 1999) iswhich institutional structure willdeliver better results. It is difficultto answer this question by inspectingthe historical record (i.e. evidence ofoutputs). This is partly becausefinancial crises, though regrettablymore frequent in recent decades,remain rare events and are often trig-

Dirk SchoenmakerHead of the Financial Stability Division,

Dutch Ministry of Finance

Charles GoodhartLondon School of Economics

and Paolo DasguptaLondon School of Economics


gered by factors quite independentof the organisational structure ofsupervision. In this paper, we inspectwhat staffing and expertise institu-tions employ (i.e. evidence of inputs)in an attempt to shed more light onthe question of which structuremay do better.

The study involves a quantitativeevaluation of the academic and pro-fessional skills of the supervisorystaff at central banks and supervisoryagencies. In particular, we seek toexplore what kind of perspective

supervisors in differentinstitutional settingsmay adopt: a macro-oriented perspectiveor a more micro-approach? The answerto this question is rele-vant, as there is evi-dence that many finan-cial crises have been

macro-induced (e.g. Hellwig, 1995;Lindgren, Garcia and Saal, 1996;Kaminsky and Reinhart, 1999).Examples are the US Savings andLoans debacle (interest rate shock),the Scandinavian banking crisis(recession) and the UK secondarybanking crisis (property prices).These macro-related causes are oftenintertwined with micro-related fac-tors. The banking problems in Scan-dinavia, for example, may have beentriggered by a recession in the late1980s/early 1990s, but liberalisationof the financial sector in the mid-1980s, in the absence of proper riskmeasurement and control mecha-nisms at banks, as well as lack of riskawareness at supervisory agencies,may have contributed to anunchecked boom in lending.

This cross-country survey of theskill profile of supervisory staffshould help to provide an insight intotwo additional issues. First, are thereeconomies of scale in financial super-vision? One would expect that coun-

tries with larger or more financialinstitutions would not employ pro-portionally more supervisors thancountries with smaller financial sys-tems. Second, is there any impactof the design of the financial systemand the stage of financial develop-ment (e.g. Levine and Zervos,1998; Rajan and Zingales, 1998) onthe number and type of financialsupervisors employed? Would acountry with a well-developed stockmarket employ more, or a differenttype of, supervisors than a countrywith a financial system that is mainlybank-intermediated?

2 Empirical study

This new area of research is based ona unique data set on the numbers andnature and level of expertise of thestaff employed by supervisory agen-cies. It is a first effort to collectdetailed information on the composi-tion of the staff at supervisory agen-cies. Usable data were obtained from91 agencies covering some 57 sepa-rate countries. This includes centralbanks, bank, securities and insurancesupervisors, irrespective of whetherthe countries have opted for a unifiedÒmega-supervisorÓ structure or,alternatively, a number of jointsupervisors. The study involves aquantitative evaluation of the aca-demic and professional skills of thoseemployed by these bodies, gatheredfrom the responses to a question-naire. The data refer to the super-visory departments of these bodies.Staff employed in the monetary wingof central banks is thus excluded.Data on staff in the supervisory andfinancial stability sections of centralbanks are difficult to separate. More-over, these sections tend to use eachother in practice. Supervisors would,for example, make use of a macro-economic outlook for the financialsystem prepared by the financialstability people.

Dirk Schoenmaker


18


The first part of the question-naire was intended to discover thesupervisory tasks for which eachinstitution has been responsible (i.e.whether systemic stability, pruden-tial supervision and/or conduct ofbusiness) and the areas of the finan-cial sector each institution has tosupervise (i.e. whether it regulatesbanks, securities firms, insurancehouses, markets, etc.). The latterinformation determines whetherthe agency is a Òmega-supervisorÓ(i.e. a sole supervisor), a joint super-visor, or has no supervisory missionat all. The second part enquiredmore specifically about the academicand professional qualifications of thestaff employed by the regulatorybodies. The agencies were asked toquantify the number of staff special-ising in the different professions(lawyers, accountants, economists,financial experts, others), and howmany have had some commercialexperience (i.e. how many hadworked in the private sector before-hand). The final question, concern-ing staff qualifications, tried to estab-lish the number of experts workingat the agency. Experts are definedas staff with the equivalent of a uni-versity MasterÕs degree or above.

In order to obtain a picture ofthe economic position and stage offinancial development of those coun-tries whose agencies responded, a setof 12 variables was obtained fromsecondary sources. Inter alia, these

data include variables such as GNP,M2 as a measure of broad money,stock exchange capitalisation as wellas the number of regulated banks ofeach country.

The basic data series are turnedinto a set of ratios, where the numer-ator is derived from the survey, andthe denominator is M2 or anothersurvey variable. The use of deflatorssuch as M2 is necessary to makecomparisons between the institutionsmore consistent, as it is evident thatsupervisory agencies belonging tosmaller countries are likely toemploy fewer qualified staff thanlarger countries in absolute terms.This provides us with a set of eightratios, as presented in table 1. Thefirst three ratios relate to the numberof regulators in supervisory agenciesand the number of experts amongthem. The fourth ratio presents thenumber of regulators with commer-cial experience. The final four ratiosshed light on the composition ofexperts. Most supervisory agencieshave provided usable data on law-yers, economists and financialexperts. However, too few agenciesactually specify the number ofaccountants working for them.

We next divide our sample intoseveral categories, i.e. whether therespondent was a central bank ornot, in the OECD or not, and whattype of supervision it was responsiblefor, i.e. systemic, prudential and/orconduct of business. What we want

Table 1

Set of ratios for supervisory skills

Ratio Variable

1. Total Number of Regulators/M2 Regs/M22. Total Professional Experts/M2 Experts/M23. Total Professional Experts/Total Number of Regulators Experts/Regs4. Commercial Experience/Total Number of Regulators Commercial/Regs5. Lawyers/Total Number of Regulators L/Regs6. Lawyers/Total Professional Experts L/Experts7. (Economists + Financial Experts)/Total Number of Regulators (E + F)/Regs8. (Economists + Financial Experts)/Total Professional Experts (E + F)/Experts

Source: Goodhart, Schoenmaker and Dasgupta (2001).

Dirk Schoenmaker



to discover in this exercise is whatare the main factors, besides puresize Ð which we hope is controlledby the deflator Ð, which influencethe input of professional skills intothe supervisory process. Oneobvious factor is the institutionalstatus; we seek to quantify this in avariety of ways. The variables listedbelow are used as dummies, reflect-ing the institutional functions of theregulatory bodies. The agenciesanalysed are classified according towhether:Ð they are a central bank or not

(Central Bank);Ð they are a sole supervisor (Sole),

joint supervisor (Joint), or not asupervisor at all (Not Super-visor);

Ð they are responsible for systemicstability (Systemic), prudentialsupervision (Prudential), con-duct of business (Conduct) or acombination of these.To give an overview of the data,

table 2 presents the average ratio

for each category. Data are providedfor four ratios: total number of reg-ulators deflated by M2, regulatorswith commercial experience to totalnumber of regulators, lawyers tototal experts and economists andfinance experts to total experts.The number of regulators deflatedby M2 seem to be higher in non-OECD countries. To pick up anystructural differences, a dummy forOECD is incorporated in the regres-sion analysis (see table 2). The aver-age ratio of regulators with commer-cial experience is higher at multipleagencies, suggesting that these spe-cialist agencies mainly hire employ-ees with private sector experience.The average ratio of laywers toexperts is lower in central banks thanin separate supervisory agencies,while the number of economistsand finance experts is higher.

The first stage of the empiricaltest was to run regressions with theeight ratios as dependent variablesand a set of institutional variables as

Table 2

Average ratios for various categories of agencies

Category Average Ratio1)

Regs/M2 Commercial/Regs

L/Experts (E + F)/Experts

1. OECD CBs, Sole Supervisor 0.0014(n = 9)

0.2635(n = 5)

0.1775(n = 8)

0.6291(n = 8)

2. Non-OECD CBs, Sole Supervisors 0.0314(n = 25)

0.3935(n = 22)

0.1085(n = 12)

0.5751(n = 26)

3. OECD CBs, Joint Supervisors 0.0017(n = 7)

0.3620(n = 4)

0.0878(n = 5)

0.7044(n = 6)

4. Non-OECD CBs, Joint Supervisors Ð(n = 0)

Ð(n = 0)

0.0350(n = 1)

0.5035(n = 1)

5. OECD CBs, No Supervisory Role 0.0039(n = 10)

0.4174(n = 6)

0.1108(n = 4)

0.7723(n = 7)

6. Non-OECD CBs, No Supervisory Role 0.0100(n = 1)

0.3250(n = 1)

0.2174(n = 1)

0.3043(n = 1)

7. OECD Non-CBs, Mega-Supervisors 0.0074(n = 6)

0.1675(n = 2)

0.4298(n = 4)

0.2514(n = 3)

8. Non-OECD Non-CBs, Mega-Supervisors Ð(n = 0)

Ð(n = 0)

Ð(n = 0)

Ð(n = 0)

9. OECD Non-CBs, Multiple Agencies 0.0005(n = 29)

0.7275(n = 15)

0.2961(n = 25)

0.4461(n = 22)

10. Non-OECD Non-CBs, Multiple Agencies 0.0004(n = 1)

1.0000(n = 1)

0.2623(n = 1)

0.1721(n = 1)

Overall average 0.010(n = 88)

0.473(n = 56)

0.217(n = 61)

0.549(n = 75)

Source: Goodhart, Schoenmaker and Dasgupta (2001).1) Average ratios are shown with the number of agencies within brackets. The total number of respondents per ratio can be lower as not all

of the 91 respondents completed all questions in the survey.

Dirk Schoenmaker



explanatory variables. The full setof institutional variables comprisesboth the supervisory role of eachagency (sole supervisor, joint super-visor or not supervisor at all) andthe duty (systemic stability, pruden-tial supervision and/or conduct ofbusiness). In the second round, aset of economic variables (e.g.GNP, M1, M2, number of banks,stock exchange capitalisation) wasadded as explanatory variables. Thesetup of the regressions and thedetailed results are reported inGoodhart, Schoenmaker and Das-gupta (2001). It should be noted thatthe results are affected by the differ-ent ways in which supervisory agen-cies answered the survey questionsand should therefore be interpretedcautiously.

3 Resultsand implications

It is found that central banks hiremore supervisors than non-centralbank supervisory agencies. In partic-ular, central banks employ moreeconomists and fewer lawyers intheir supervisory/financial stabilitywing than non-central banks. Theempirical literature on financial cri-ses has found that both microeco-nomic and macroeconomic factorshave figured in past financial crises(e.g. Hellwig, 1995; Caprio andKlingebiel, 1997). This would sug-gest that prudential supervisionshould not only be aimed at themicro-level (examining individualfinancial institutions) but also at themacro-level (examining macro-shocks affecting the financial systemas a whole). The result that centralbanks hire relatively more econo-mists would indicate that an institu-tional setting with central bankinvolvement is more likely to pro-duce such a macro-approach than asetting without central bank involve-ment.

In an earlier paper (Goodhartand Schoenmaker, 1995), however,we have argued that there would bea demand for more direct politicalcontrol over supervision as taxpayersare seen to be potentially liable dur-ing a crisis. This would, in turn,imply a trend towards separationbetween supervisory and monetarypolicy agencies, as it is difficult toreconcile political control over thesupervisory wing of a central bankwith independence for the monetarywing. The case for independence for

monetary policy is well established(e.g. Cukierman, 1992; Alesina andSummers, 1993).

Another argument against directcentral bank involvement in super-vision is a potential creep of the cen-tral bank safety net (Goodhart,2000). The ongoing integration andconcentration in the financial sectorleads to a blurring of dividing linesbetween different financial sectors.This used to be only the case inEurope where universal banks andfinancial conglomerates have existedfor some time. More recently, withthe adoption of the Gramm-Leach-Bliley Act (e.g. Barth, Brumbaughand Wilcox, 2000), financial con-glomerates are also allowed in theUS. This integration trend would callfor a cross-sector approach in super-vision to maintain effectiveness aswell as to prevent inefficient overlap.For reasons of time inconsistency, itwould be difficult for central banksto deny credibly the availability ofthe lender of last resort function out-

Dirk Schoenmaker



side the narrowly defined bankingsystem, while being responsiblefor supervising the wider financialsystem.

Where do these conflicting argu-ments about central bank involve-ment in supervision leave us? A pos-sible model is an institutional settingwhere the central bank and thesupervisory agency are put togetherphysically with mixing of staff, butseparate boards. Putting the twoclose to each other would allow fora blending of the necessary skills

(the ÒhardwareÓ) as wellas the ethos and culture(the ÒsoftwareÓ). How-ever, as both agencieswould keep their ownboard, decision-makingand accountability areseparated. The super-visory part can thus besubject to greater polit-

ical control, while the monetary partcan (more) credibly restrict itslender of last resort function to thecore banking system. An exampleof this model can be found inFinland, though not fully. After thesevere financial crisis in the late1980s/early 1990s, the supervisoryagency responsible for banking andsecurities supervision was put nextto the central bank, but kept itsown board. The stated aim of thisexercise was to get more economicskills (as well as more financialresources) into the supervisoryagency, which was until then domi-nated by lawyers.

Next, the empirical results inthis paper indicate that there are sig-nificant economies of scale in finan-cial supervision, though this can bemeasured by several alternative vari-ables (e.g. the scale of bank interme-diation, GNP per capita). Not sur-prisingly, agencies with sole super-visory responsibility will have moreregulators than those with either

joint or no supervisory responsibil-ities. An issue for further researchis whether further economies ofscale could be observed in countrieswith a mega-supervisor compared tocountries with several joint super-visors. However, our database cannotproduce the aggregate number ofregulators in each country, as notall supervisory agencies in the coun-tries under investigation replied tothe questionnaire.

Finally, the design of financialsystem has a significant impact onthe number and type of supervisorsemployed. A larger banking systemwill lead to relatively fewer regula-tors being hired, strongly indicatingeconomies of scale. A higher stockmarket capitalisation, however, willlead to more regulators. There donot appear to be any economies ofscope in financial supervision. More-over, a higher stock market capital-isation raises the relative number ofregulators with commercial experi-ence as well as the relative numberof lawyers. These results suggestthat a more developed and complexfinancial system would need bothmore supervisors as well as moreskilled ones. The positive effect ofstock markets on economic growth(Levine and Zervos, 1998) seemsto come at a price, albeit a smallone. §

References

Alesina, A. and Summers, L. (1993).Central Bank Independence and Macro-

economic Performance: Some Compara-

tive Evidence. In: Journal of Money, Credit

and Banking 25, pp. 151Ð162.

Barth, J., Brumbaugh, D. and Wilcox, J.(2000). Glass-Steagall Repealed: Market

Forces Compel a New Bank Legal Struc-

ture. In: Journal of Economic Perspectives

14, pp. 191Ð204.

Caprio, G. and Klingebiel, D. (1997).Bank Insolvency: Bad Luck, Bad Policy, or

Bad Banking? In: Bruno, M. and Pleskovic,

Dirk Schoenmaker


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B. (eds.). Annual World Bank Conference

on Development Economics 1996. World

Bank, Washington DC, pp. 79Ð104.

Cukierman, A. (1992). Central Bank Strat-

egy, Credibility, and Independence: Theory

and Evidence. Cambridge, MA.

Goodhart, C. (2000). The Organisational

Structure of Banking Supervision. Special

Paper, no. 127, LSE Financial Markets

Group, London.

Goodhart, C. and Schoenmaker, D.(1995). Should the Functions of Monetary

Policy and Banking Supervision be Sepa-

rated? In: Oxford Economic Papers 47,

pp. 539Ð560.

Goodhart, C., Schoenmaker, D. andDasgupta, P. (2001). The Skill Profile of

Central Bankers and Supervisors. Discus-

sion Paper, no. 377, LSE Financial Markets

Group, London.

Hellwig, M. (1995). Systemic Aspects of

Riskmanagement in Banking and Finance.

In: Schweizerische Zeitschrift fu¬r Volks-

wirtschaft und Statistik 13, pp. 723Ð737.

Kaminsky, G. and Reinhart, C. (1999).The Twin Crises: The Causes of Banking

and Balance-of-Payments Problems. In:

American Economic Review 89, pp.

473Ð500.

Levine, R. and Zervos, S. (1998). Stock

Markets, Banks and Economic Growth.

In: American Economic Review 88, pp.

537Ð558.

Lindgren, C.-J., Garcia, G. and Saal, M.(1996). Bank Soundness and Macroeco-

nomic Policy. International Monetary Fund,

Washington DC.

Peek, J., Rosengren, E. and Tootell, G.(1999). Is Bank Supervision Central to

Central Banking? In: Quarterly Journal of

Economics 114, pp. 629Ð653.

Rajan, R. and Zingales, L. (1998). Finan-

cial Dependence and Growth. In: American

Economic Review 88, pp. 559Ð586.

Dirk Schoenmaker



Gertrude Tumpel-Gugerell


Die optimale Gestaltung

von Finanzmarktregulierung

und Finanzaufsicht:

Die Herausforderung

der wachsenden Internationalisierung

der Finanzindustrie

Einleitungsstatement

Gertrude Tumpel-GugerellVize-Gouverneurin,



Je weiter die Globalisierung derFinanzindustrie voranschreitet, umsomehr muss uns bewusst sein, dassauch Bemu¬hungen zur Wahrung derStabilita¬t des Finanzsektors nur ineinem globalen Kontext erfolgreichsein ko¬nnen. Systemische Finanz-krisen lassen sich nur dann ver-hindern, wenn nationale Aufsichts-beho¬rden u¬ber internationaleKommunikationsnetze in sta¬ndigerVerbindung miteinander stehen.Eine wirksame Risikobegrenzungdurch Regulierung und eine effektive

Finanzmarktaufsicht stellen eineGrundvoraussetzung fu¬r das Funktio-nieren und die Stabilita¬t der Finanz-ma¬rkte dar.

Die Aufsichtsbeho¬rden sindgefordert, von der reinen U¬ berpru¬-fung der Umsetzung von Vorschrif-ten abzugehen und versta¬rkt auf einequalitative Aufsicht zu setzen. DieRisikosteuerung steht im Mittel-punkt des Interesses. Dafu¬r sindAufseher mit umfassender Erfah-rung und Qualifikation erforderlich.O¬ sterreich muss mehr in die Finanz-marktaufsicht investieren. Nur dannwerden wir mit den internationa-len Entwicklungen Schritt haltenko¬nnen.

Wir sind mit zwei grundsa¬tz-lichen Fragen konfrontiert. Erstens:Wie soll Finanzmarktaufsicht organi-siert sein, damit Stabilita¬t und Funk-tionsfa¬higkeit der Finanzma¬rkte ambesten gewa¬hrleistet sind? Und zwei-tens: Welche Rolle sollten die Zen-tralbanken bei der Finanzmarktauf-sicht spielen?

Die Vielfalt der bestehenden undangestrebten Lo¬sungen la¬sst daraufschlie§en, dass es eigentlich keinideales Modell gibt.

In diesem Zusammenhangmo¬chte ich gerne David Llewellynzitieren: ãObwohl das institutionelleGefu¬ge an sich wichtig ist, ist es perse noch keine Garantie fu¬r eineschlagkra¬ftige und effiziente Regulie-rung und Aufsicht, und es wa¬re fatalzu glauben, dass lediglich eine neueAufsichtsstruktur ein Allheilmittelsei.Ò (Llewellyn, 2000)

Der IWF hat vor kurzem in einerStudie festgestellt, dass das pas-sendste institutionelle Gefu¬ge fu¬rdie Finanzaufsicht jene Lo¬sung ist,die die Struktur des lokalen Marktesam besten widerspiegelt.

Damit mo¬chte ich zur Frageu¬bergehen, wie stark Zentralbankenin die Finanzaufsicht eingebundensein sollten.

Die Oesterreichische National-bank ist der festen U¬ berzeugung Ðund Gouverneur Liebscher hat dasin seinem Einleitungsstatementheute morgen klar zum Ausdruckgebracht Ð dass Zentralbanken eineSchlu¬sselrolle bei der Bankenaufsichtspielen sollten. Der Grund dafu¬rist sehr simpel: Die Wahrung derStabilita¬t des Finanzsektors za¬hlt zuden Hauptaufgaben einer Zentral-bank. Nur in einem stabilen finan-ziellen Umfeld ist eine ada¬quateUmsetzung der Geldpolitik u¬ber-haupt mo¬glich.

Durch eine enge Einbindung derZentralbanken in die Bankenaufsichtlassen sich zahlreiche Synergieeffekteerzielen:Ð Finanzdaten aus dem statisti-

schen Meldewesen lassen sichsowohl fu¬r Zwecke der geldpoli-tischen Analyse als auch fu¬r dieFinanzaufsicht verwenden.

Ð Die Zentralbank kann ihrer Ver-antwortung fu¬r die Stabilita¬tdes Finanzsystems am besten



20


nachkommen, wenn sie auch indie Bankenaufsicht und die Vor-Ort-Pru¬fungen unmittelbar ein-gebunden ist.

Ð Angesichts der Unabha¬ngigkeitder Zentralbanken kann der For-derung der Basler Grundsa¬tzenach einer mo¬glichst hohenUnabha¬ngigkeit der Aufsichts-beho¬rde am besten entsprochenwerden, wenn die Beho¬rde inder Zentralbank direkt oder inihrer unmittelbaren Na¬he ange-siedelt ist.

Ð Nationale Zentralbanken arbei-ten auf internationaler Ebenesehr eng zusammen. Wie schoneingangs erwa¬hnt, ist es sehrwichtig, dass die Aufsichtsbeho¬r-den zum Meinungsaustausch aufein gut funktionierendes Netz-werk zuru¬ckgreifen ko¬nnen, umso ihren Beitrag zur grenzu¬ber-schreitenden Finanzmarktstabili-ta¬t zu leisten.

Ð Und schlie§lich der Punkt, derwohl am schwersten wiegt: KeineFinanzkrise kann ohne enge Ein-bindung der Zentralbanken gelo¬stwerden. Aus diesem Grund mussdie Zentralbank umfassendeKenntnisse u¬ber alle Finanzinsti-tute haben Ð ein Ziel, das sichnur durch die enge Einbindungder Zentralbanken in die Banken-aufsicht erreichen la¬sst.Mit dieser Position hat die

Oesterreichische Nationalbank auchVersta¬ndnis beim Bundesministerfu¬r Finanzen gefunden. Der Kerndieser Argumente findet sich heutebereits weitgehend im Gesetzes-entwurf fu¬r die Finanzmarktaufsichtin O¬ sterreich wieder. §

Literatur

David Llewellyn (2000). The Institutional

structure of Regulatory agencies. In: How

Countries Supervise their Banks, Insurers

and Securities Markets. CBP, London.




Ernst Welteke


Das Design eines Aufsichtssystems

aus dem Blickwinkel

der Deutschen Bundesbank

Die Debatte u¬ber das bestmo¬glicheDesign fu¬r ein effizientes Aufsichts-system hat sowohl in O¬ sterreich alsauch in Deutschland durch die Vor-sto¬§e der jeweiligen Regierungenneue Ansto¬§e bekommen. Gernenehme ich die Gelegenheit wahr,hier auf der 29. Volkswirtschaft-lichen Konferenz der Oesterreichi-schen Nationalbank einige grund-sa¬tzliche U¬ berlegungen aus Sichtder Deutschen Bundesbank zupra¬sentieren.

1 Ziele und Bausteineder Bankenaufsicht

Fragen der Bankenaufsicht sind vonvitaler Bedeutung fu¬r eine Volkswirt-schaft. Denn ein stabiles Finanz-system stellt das Herzstu¬ck einermodernen Volkswirtschaft dar. Esversorgt die wirtschaftlichen Akteu-re mit Kredit und u¬bertra¬gt die geld-politischen Impulse in die realeSpha¬re der Volkswirtschaft.

Die internationale Aktivita¬t vonFinanzinstituten und das Revival derAllfinanzidee stellen neue Anforde-rungen an die Bankenaufsicht. Wie

Ernst WeltekePra¬ sident,

Deutsche Bundesbank


hat ein effizientes und effektives Auf-sichtssystem heute auszusehen?

ãForm follows functionÒ, derLeitgedanke des Bauhauses gilt auchin diesem so ganz anderen Kontext.Die Ziele der Finanzaufsicht bestim-men das Vorgehen und damit auchden institutionellen Rahmen. DieZiele in der Finanzaufsicht unter-scheiden sich jedoch in den einzel-nen Sparten des Finanzsektors ganzerheblich.

Die Bankenaufsicht im engerenSinne stellt auf die finanzielle Stabili-

ta¬t des einzelnen Institutes und denGla¬ubigerschutz ab. Die Finanzmarkt-aufsicht soll die Integrita¬t der Ma¬rktebewahren. Die Versicherungsaufsichthat in erster Linie den Schutzdes Versicherungskunden im Visier.Ganz unterschiedliche Ansatzpunktemithin. Eines ist jedoch klar: U¬ berallem steht die Stabilita¬t des Finanz-systems.

Als Notenbanker ist fu¬r mich dieBankenaufsicht von noch gro¬§ererBedeutung als die Regulierung undU¬ berwachung der anderen Finanz-sparten. Ich werde mich daherzuna¬chst auf den Regelungsrahmenfu¬r den Bankensektor konzentrieren.Was braucht man fu¬r ein effizientesSystem der Bankenaufsicht?1. Einer der wichtigsten Bausteine

im Aufsichtsgeba¬ude sind sach-gerechte Regeln. Regeln fu¬r dieMa¬rkte und Regeln fu¬r dieMarktteilnehmer, mo¬glichstwenig belastend, aber doch ihreFunktion erfu¬llend. Sie schaffenVerbindlichkeit und sorgen

gleichzeitig fu¬r Transparenz. Sieschu¬tzen die Stabilita¬t desFinanzsystems. Die Regeln derBankenaufsicht sind in Europa Ðnach dem Grundsatz der Min-destharmonisierung Ð heute biszu einem gewissen Grad ange-glichen.

2. Diese Regeln mu¬ssen in Aufsichts-praktiken mit Leben gefu¬llt wer-den. Die Praxis der Banken-aufsicht unterscheidet sich heutein den europa¬ischen La¬ndernzum Teil noch recht deutlich.Manche Aufsichtsbeho¬rden stu¬t-zen sich bisher vorwiegend aufMeldungen und Berichte derKreditinstitute. In anderen La¬n-dern stehen Pru¬fungen vor Ortsta¬rker im Vordergrund. Mitdem neuen AufsichtskonzeptãBasel IIÒ wird hier in gewissemUmfang eine Konvergenz derAufsichtspraktiken in Richtungvermehrter Pru¬fungen vor Ortstattfinden, um die Risiken derInstitute besser einscha¬tzen zuko¬nnen.

3. Das Aufsichtsgeba¬ude muss mitMenschen gefu¬llt werden. Nureine hinreichende Zahl gut quali-fizierter Experten kann sicherstel-len, dass das Ziel der Finanz-marktstabilita¬t mit klugenRegeln und einer sachgerechtenAufsichtspraxis erreichbar ist.

4. Und schlie§lich mu¬ssen dieExperten einen institutionellenU¬ berbau bekommen. Der organi-satorische Rahmen der Finanz-aufsicht sollte die Marktstrukturspiegeln, nicht aber ihr voraus-eilen. Denn die Aufsichtsstruk-tur hat eine dienende Funktionmit Blick auf das Stabilita¬tsziel.Sie kann bzw. soll Marktstruktu-ren nicht beeinflussen. Organisa-torische Fragen haben in denletzten Wochen die gro¬§te Auf-merksamkeit erfahren, obwohlihnen doch unter allen Bau-

Ernst Welteke


21


steinen materiell nicht diegro¬§te Bedeutung fu¬r die Stabili-ta¬t des Finanzsystems zukommt.Wie sieht Bankenaufsicht in der

Praxis aus? Die Bankenaufsicht u¬bereinzelne Kreditinstitute liegt innationaler Kompetenz. Der Maas-trichter Vertrag und das Statut desEuropa¬ischen Systems der Zentral-banken (ESZB) legen dies fu¬r Europaso fest. Der nationale Gesetzgeberverpflichtet die Kreditinstitute,den Aufsichtsbeho¬rden u¬ber ihreGescha¬fte zu berichten. In Deutsch-land stellen die Kreditinstitute mitbankstatistischen Meldungen, Bilan-zen sowie den Berichten externerWirtschaftspru¬fer den Bankenaufse-hern eine Fu¬lle von wichtigen Infor-mationen bereit.

Die Aufsichtsexperten u¬ber-pru¬fen anhand dieser Unterlagenlaufend, ob die Banken sich regel-konform verhalten und ob besondereRisiken bestehen. Hinzu kommt derperso¬nliche Kontakt zwischen Ban-kern und Aufsehern, z. B. in Gespra¬-chen mit der Gescha¬ftsleitung. DieAufsicht vor Ort gewinnt internatio-nal an Bedeutung.

Wenn die Experten der Auf-sichtsbeho¬rde bei ihren Pru¬fungenzu der Einsicht gelangen, dassRegeln verletzt werden, suchen siezuna¬chst das Gespra¬ch mit derGescha¬ftsleitung. Zur Abwehr un-mittelbar drohender Gefahren fu¬rdie Stabilita¬t eines Institutes oderdes Systems steht ihnen eine ganzeReihe abgestufter Ma§nahmen zurVerfu¬gung.

International beruht die Banken-aufsichtspraxis auf enger Zusammen-arbeit der nationalen Aufsichtsbeho¬r-den von Heimat- und Gastla¬ndern.Der vertragliche Rahmen fu¬r dieseKooperation wird in bilateralenMemoranda of Understanding be-schrieben. Zusa¬tzlich kommunizie-ren und kooperieren die Bankenauf-seher multilateral in internationalen

Gremien, z. B. dem Banking Super-vision Committee des ESZB.

Das Konzept ãHeimatland-aufsicht plus internationale Zusam-menarbeitÒ nutzt den u¬berragendenVorteil der dezentralen Aufsicht:die Na¬he zu Ma¬rkten und Instituten.Gleichzeitig werden grenzu¬ber-schreitende Aktivita¬ten der Bankenund ihre Auswirkungen auf Instituts-und Systemstabilita¬t aufmerksambeobachtet.

2 Rolle der Notenbankenin der Aufsicht

ãForm follows function.Ò WelcherFunktion folgt die Einbindung derNotenbanken in die Finanzaufsicht?

Die Geldpolitik bedient sich derFinanzma¬rkte zur U¬ bertragung ihrerImpulse in die reale Spha¬re derVolkswirtschaft. Finanzma¬rkte leitendie zins- und liquidita¬tspolitischenSignale der Notenbank weiter. Wirddiese Transmission gesto¬rt, kann dieZentralbank ihren Auftrag zur Wah-rung der Preisstabilita¬t nicht erfu¬l-len. Der von allen gewu¬nschteErfolg der Geldpolitik ha¬ngt mithinauch an dem reibungslosen Funktio-nieren der Finanzma¬rkte im jeweili-gen Wa¬hrungsgebiet.

Folgerichtig weist der EG-Ver-trag dem Europa¬ischen System derZentralbanken in Artikel 105 Ðdem Kapitel u¬ber die Wa¬hrungspoli-tik Ð eine Mitverantwortung fu¬r dieStabilita¬t des Finanzsystems zu. Wiekann diese Mitverantwortung ambesten mit Leben gefu¬llt werden?

Es wird Sie nicht u¬berraschen,meine sehr verehrten Damen undHerren, wenn ich an dieser Stelleerneut dafu¬r pla¬diere, die Banken-aufsicht zumindest eng an die Noten-banken anzubinden. Es gibt guteGru¬nde fu¬r die institutionelle Ver-ankerung der Aufsichtsfunktion beider Zentralbank.

Die Notenbanken sind nicht nurdiejenigen, die naturgema¬§ das

Ernst Welteke



gro¬§te Interesse an stabilen Finanz-ma¬rkten haben. Die Notenbankensind auch diejenigen, die das besteHandwerkszeug dafu¬r haben, Krisen-symptome fru¬hzeitig zu erkennenund Gegenma§nahmen zu initiieren.Effizienzu¬berlegungen alleine gebie-ten es, mo¬gliche Synergieeffektezwischen Notenbank- und Aufsichts-funktion nicht brachliegen zu lassen.

Die Notenbanken des Euro-systems stehen wie alle anderenNotenbanken dieser Welt in engemKontakt mit den Finanzmarktteil-

nehmern. Diese sindunsere Partner beiden geldpolitischenGescha¬ften, aber auchnicht mehr. Das hei§t,die Unabha¬ngigkeitund politische Distanzzu den Instituten istjederzeit gewahrt. DerZentralbank fallen in

Ausu¬bung ihrer Funktion zwangs-la¬ufig genaue Kenntnisse u¬ber dieeinzelnen Kreditinstitute und ihreRisikoprofile zu. Die Marktna¬heproduziert zudem ausfu¬hrliche Infor-mationen u¬ber die Vernetzung dieserindividuellen Risikoprofile zu mo¬g-lichen Systemrisiken.

Mikro- und makroprudenzielleAnalyse geho¬ren eng zusammen.Einerseits gru¬nden Erkenntnisseu¬ber mo¬gliche systemische Gefahrenauf Informationen u¬ber die individu-ellen Positionen einzelner system-relevanter Institute. Andererseitssind Informationen u¬ber Trends imFinanzsystem bei der Beurteilungder individuellen Risikopositioneines Institutes von gro§er Be-deutung.

Die makroprudenzielle Analyseist fu¬r Notenbanken aufgrund ihresstabilita¬tspolitischen Auftrages einunverzichtbares Kerngescha¬ft, dasnoch dazu immer wichtiger wird.Zentralbanken verfu¬gen daher u¬bersehr viel Expertise auf diesem

Gebiet der Finanzmarktanalyse. Dieenge Einbindung der Notenbank indie Institutsaufsicht macht sich dieseKompetenz zunutze.

Stichwort ãZahlungsverkehrÒ:Die Verantwortung fu¬r dessen rei-bungsloses Funktionieren liegt beiden Notenbanken. Im Zahlungsver-kehr stecken aber zweifellos erheb-liche systemische Risiken fu¬r denBankensektor. Nicht zuletzt deshalb,weil die Volumina und die Zahl derTransaktionen exponentiell gewach-sen sind. Eine enge Verbindung derU¬ berwachung des Zahlungsverkehrs-systems und der U¬ berwachung derFinanzintermedia¬re bietet sich daheran. So ko¬nnen mo¬gliche Gefa¬hrdun-gen sowohl fu¬r einzelne Institute alsauch fu¬r das Finanzsystem als Ganzesrechtzeitig erkannt werden.

Kommt es trotz aller pra¬ventiverBemu¬hungen der Finanzaufsichtdoch zu einer Schieflage, ist die Zen-tralbank gefragt. In so einem Fallegilt es, die Stabilita¬t des Finanz-systems kurzfristig zu sichern, damitdie reale Volkswirtschaft gar nichterst in Gefahr gera¬t. Erinnern Siesich an den Herbst 1998. BeimZusammenbruch eines Hedge Fondsin den USA zeigte sich kurz dasGespenst eines ãcredit crunchÒ, derzweifellos das Potenzial gehabt ha¬tte,die Ma¬rkte nicht nur in den USAempfindlich zu sto¬ren.

Im Krisenfall muss schnellgehandelt werden. Der Zentralbankkommt eine doppelte Aufgabe zu.Die Bereitstellung liquider Mittelals ãlender of last resortÓ ist dabeider absolute Ausnahmefall, dennãmoral hazardÓ ist eine ernst zu neh-mende Gefahr. Der Zentralbank, diefu¬r die Finanzmarktstabilita¬t zusta¬n-dig ist und auf die sich alle Erwartun-gen richten, mu¬ssen sa¬mtliche rele-vanten Informationen unverzu¬glichzur Verfu¬gung stehen. Die Zentral-bank muss gegebenenfalls in Zusam-menarbeit mit der Aufsichtsbeho¬rde

Ernst Welteke



ein illiquides von einem insolventenInstitut unterscheiden, und zwarschnell. Sie muss diese Entscheidungvor den Ma¬rkten und vor demSteuerzahler verantworten.

Die Fa¬higkeit der Zentralbank,zwischen Illiquidita¬t und Insolvenzunterscheiden zu ko¬nnen, ist keineFiktion. Im Gegenteil, sie bleibt auchim Fall eines systemisch relevantenInstitutes, das von manchen Markt-teilnehmern vielleicht allgemein alsãtoo big to failÒ angesehen wird,besonders wichtig. Die Entschei-dung, ob einem Institut Ð da illi-quid Ð geholfen wird oder ob imFall eines insolventen Institutes dieLiquidita¬tshilfe zur Abwendung derKrise den gefa¬hrdeten Drittinstitu-ten zuflie§t, kann nur auf derGrundlage einer engen Einbindungin die Bankenaufsicht und anhandvon Informationen aus eigenenQuellen getroffen werden.

Weniger im Blickpunkt deso¬ffentlichen Interesses steht dieModeratorenrolle, die Zentral-banken in Krisensituationen ha¬ufigwahrnehmen. Fu¬r die Abwendungsystemischer Krisen ist sie aberungleich wichtiger. Die Notenbankhat sowohl die no¬tigen Kontakte zuden Banken als auch die Autorita¬t,alle beteiligten Parteien um einenTisch zu versammeln. Sie ist un-parteiisch und genie§t das Vertrauender Kreditinstitute. Um einenInteressenausgleich herbeizufu¬hren,beno¬tigt sie jedoch Informationenu¬ber die einzelnen Institute, u¬berihre Position im Markt und u¬ber ihreVerflechtung mit anderen Banken Ðzuverla¬ssige Informationen auserster Hand.

Die Erfahrung lehrt leider, dassKrisen trotz Pra¬vention nicht aus-zuschlie§en sind. Krisen schnellund gera¬uschlos bewa¬ltigen zu ko¬n-nen, um Schaden von der Volkswirt-schaft in ihrer Gesamtheit abzuwen-den, sollte ein guter Grund sein,

die Zentralbanken mit ma§geblichenFunktionen im Rahmen der Banken-aufsicht zu betrauen.

Die Einbindung der Notenban-ken in die Finanzaufsicht ist alsowohlbegru¬ndet. Dennoch sehen wirderzeit unterschiedliche Vorgehens-weisen. Einige La¬nder Ð etwa dasVereinigte Ko¬nigreich und AustralienÐ haben die Funktionen der Finanz-aufsicht in einer von der Zentralbankgetrennten Beho¬rde zusammen-gefasst. Die Bewa¬hrungsproben fu¬rdiese Institutionen stehen noch aus.

In den USA hingegen wurde dieAufsichtsfunktion der Notenbankbewusst gesta¬rkt. Mit dem Gramm-Leach-Bliley Act wurde erstmalsdie gesetzliche Mo¬glichkeit zurErrichtung von Finanzholdinggesell-schaften geschaffen. Die Aufsichtu¬ber diese komplexen und gleich-zeitig systemrelevanten Konzernewurde dem Board der FederalReserve u¬bertragen. ãForm followsfunction.Ó Das ist konsequentesDesign eines Aufsichtssystems.

3 Internationalisierungder Aufsicht

Das Bankgescha¬ft ist heute ein inter-nationales Gescha¬ft. Doch gilt es,genau hinzuschauen. Die nationalenBankensysteme sehen sehr unter-schiedlich aus. Die gro§e Mehrzahlder Finanzinstitute und das Retail-gescha¬ft sind nach wie vor nationaleroder gar nur lokaler Natur. Dasgesamte Bankgescha¬ft Ð nationalwie international Ð unterliegt dernationalen Aufsicht. Die Heraus-

Ernst Welteke



forderung fu¬r die Aufsichtsbeho¬rdenliegt darin, das Spielfeld internatio-nal weiter zu ebnen. Aufsichtsarbi-trage zwischen Gast- und Heimat-land darf sich nicht lohnen.

Der Basler Ausschuss fu¬r Ban-kenaufsicht hat 1988 mit dem erstenEigenkapitalakkord in dieser Hin-sicht einen Meilenstein gesetzt. Derzweite Meilenstein ist in Arbeit.Heute endet die Frist fu¬r Stellung-nahmen zum Konsultationspapierfu¬r eine neue Basler Eigenkapital-vereinbarung. ãBasel IIÒ beschreibt

ein neues Aufsichtskonzept fu¬r inter-national ta¬tige Banken. Formal wirddieses neue Aufsichtskonzept zu-na¬chst nur fu¬r international ta¬tigeBanken in den G-10-La¬ndern gelten.Faktisch wird es die Finanzbrancheweltweit beeinflussen.

Die Entwicklung der Finanz-ma¬rkte und die Informationstech-nologie haben das typische Risiko-profil einer Bank vera¬ndert. Dasneue Aufsichtskonzept ãBasel IIÒtra¬gt dem in mehrfacher HinsichtRechnung. Operationelle Risikenetwa sind kein Novum des IT-Zeit-alters. Dennoch haben sie beimheute u¬blichen Technisierungsgraddes Bankgescha¬ftes ein gro¬§eresPotenzial, den Bestand eines Institu-tes zu gefa¬hrden. Bisher wird dasoperationelle Risiko einer Bankimplizit im Eigenkapitalstandardberu¬cksichtigt. Nach ãBasel IIÒ wirddas operationelle Risiko nach einemvon drei mo¬glichen Verfahren quan-tifiziert und explizit mit Kapitalunterlegt.

Die Eigenkapitalausstattung einerBank ist nach ãBasel IIÒ sehr vielgenauer an den o¬konomischen Risi-ken ausgerichtet. In unserer zuneh-mend komplexen und vernetztenFinanzwelt reicht dies allein jedochnicht aus. Das Risiko-/Ertragsprofileiner Bank und ihre Fa¬higkeit, dieseRisiken zu steuern, gewinnen anBedeutung. Das neue Aufsichtskon-zept ãBasel IIÒ tra¬gt dem Rechnung.Es ist ein Schritt zu einer sta¬rkerqualitativ ausgerichteten Banken-aufsicht. Fu¬r viele La¬nder, auch fu¬r

uns, geradezu einParadigmenwechsel.

Neben die risiko-ada¬quate Eigenkapital-ausstattung einer Banktreten zwei weitereSa¬ulen. Im SupervisoryReview Process nimmtdie Bankenaufsicht dasRisikomanagement und

die institutseigene Kapitalallokationder Bank in den Fokus. So setztsie den Banken Anreize fu¬rdie fortlaufende U¬ berpru¬fung undVerbesserung ihres Risikomanage-ments und ihrer internen Kontrol-len. Erweiterte Offenlegungspflich-ten schaffen in der dritten Sa¬ulemehr Transparenz und binden sodie Finanzma¬rkte in die Aufsichtmit ein.

Der Basler Prozess ist noch nichtam Ende angelangt. Eine Reihe vonFragen muss noch gelo¬st werden Ðin vertrauensvoller Zusammenarbeitmit der Kreditwirtschaft und diesbis zum Ende der Verhandlungen.ãBasel IIÒ ist schlie§lich auch einepolitische Angelegenheit, denkenSie nur an die Auswirkungen aufden Wettbewerb. Im Jahr 2004 wirdãBasel IIÒ gelten und das Spielfeld fu¬rinternational ta¬tige Banken hoffent-lich ebener sein als heute. Die Har-monisierung der Regeln und derAufsichtspraktiken wird jedoch auchdanach weitergehen. Die schnelle

Ernst Welteke


22


Entwicklung der Finanzma¬rkte undder Informationstechnologie lassenkeine Ruhepause zu.

Die nationalen Aufsichtsbeho¬r-den arbeiten in einer ganzen Reiheinternationaler Gremien auf ver-schiedenen Ebenen hervorragendzusammen. Gemeinsames Ziel istes, die Stabilita¬t des Finanzsystemszu schu¬tzen. In Europa tauschen sichhochrangige Vertreter der nationalenAufsichtsbeho¬rden der EU-La¬nderim Banking Supervision Committeedes ESZB aus. Es wurde gegru¬ndet,um den Auftrag zur Unterstu¬tzungder Finanzmarktstabilita¬t auszufu¬l-len. Wie die Bankenaufseher koope-rieren auch die Versicherungsauf-seher und die Wertpapieraufseherin ihren internationalen Standesorga-nisationen, der International Asso-ciation of Insurance Supervisors(IAIS) und der International Organi-sation of Securities Commissions(IOSCO), mit gro§em Erfolg.

Das Forum fu¬r Finanzstabilita¬t(FSF) ist hingegen sektorenu¬ber-greifend. Es wurde im April 1999im Auftrag der G-7 gegru¬ndet. Auf-gabe des FSF ist es, Finanzmarkt-probleme fru¬hzeitig aufzudecken so-wie Wege zur U¬ berwindung beste-hender Schwierigkeiten aufzuzeigen.In diesem jungen Gremium arbeitenVertreter der mit Fragen derFinanzmarktstabilita¬t befassten natio-nalen Beho¬rden zusammen, auch vonwichtigen Finanzpla¬tzen au§erhalbder G-7-La¬nder.

Auch der IWF spielt seine Rollebei der Sta¬rkung des internationalenFinanzsystems. Er beobachtet Ent-wicklungen in der Weltwirtschaftund auf den Finanzma¬rkten sowieim Rahmen der Artikel-IV-Konsulta-tionen die Wirtschafts-, Geld- undFinanzpolitik seiner Mitgliedstaaten.Er sucht aktiv nach Mo¬glichkeiten,die Tragfa¬higkeit des internationalenFinanzsystems zu verbessern. Diefru¬hzeitige Beteiligung von Gla¬ubi-

gern an der Krisenbewa¬ltigung solldabei unangemessenes Risiko-verhalten von Marktteilnehmernvon vorneherein unterbinden.

International sind wir in der Ban-kenaufsicht auf dem richtigen Weg.Wir arbeiten daran, durch einezunehmende Harmonisierung vonRegeln und Praktiken einen fairenWettbewerb der Marktteilnehmersicherzustellen. Gleichzeitig stehenwir Aufseher untereinander inengem Kontakt, um internationaleTrends oder neue Risiken fru¬hzeitigaufzuspu¬ren.

4 Allfinanzfragen

Die Allfinanzidee, die in den Acht-zigerjahren schon einmal in allerMunde war, erlebt heute einen zwei-ten Fru¬hling. Brauchen wir also eineinstitutionalisierte Konglomerats-aufsicht oder ist wiederum die Ko-operation der Spezialisten die Vor-gehensweise der Wahl?

A¬ hnlich wie bei den internatio-nalen Aktivita¬ten der Banken gilt esauch hier, nicht nur auf die Aufsehenerregenden Einzelfa¬lle zu achten.Der weitaus gro¬§te Teil der Finanz-dienstleistungen wird einzeln oderaus Kooperationen von Finanzdienst-leistern heraus angeboten, nicht aberunter einem gemeinsamen recht-lichen Dach. Die beschlossene U¬ ber-nahme der Dresdner Bank durch dieAllianz ko¬nnte der Anfang einesTrends sein. Sie muss es aber nicht.

Macht es Sinn, die Institutsauf-sicht zu integrieren, solange Finanz-konglomerate noch die seltene Aus-nahme sind? Die Gescha¬ftsrisikender verschiedenen Typen von Finanz-dienstleistern unterscheiden sichganz deutlich. Selbst der ZentraleKreditausschuss (ZKA) hat in seinerStellungnahme zu ãBasel IIÒ dieãvo¬llig abweichende CharakteristikÒder Versicherungsrisiken von denbanktypischen Kredit- und Markt-risiken besta¬tigt. Unterschiedliche

Ernst Welteke



Ziele und Schwerpunkte in derU¬ berwachung der Banken, derWertpapierha¬user und der Lebens-versicherungsunternehmen spiegelndas wider. Entsprechend sind auchdie Regeln und die Aufsichtsprakti-ken verschieden. Eine vom ZKAgeforderte weltweite Harmonisie-rung von Regeln fu¬r Finanzkonglo-merate wird noch la¬ngere Zeit aufsich warten lassen. Fortschritte sindhier bisher nicht erkennbar.

5 Schlusswort

Meine sehr verehrten Damen undHerren! Ich bin Notenbanker.Design muss fu¬r mich in erster Liniefunktionell sein. Die wichtigsteFunktion eines Aufsichtssystems ist

es, fu¬r Stabilita¬t zu sorgen. Wiewichtig finanzielle Stabilita¬t fu¬r diegesamte Wirtschaft, aber auch fu¬ralle Bu¬rger und Bu¬rgerinnen ist,zeigen Finanzkrisen rund um dieWelt. Die Notenbanken haben auf-grund ihres geldpolitischen Stabili-ta¬tsauftrages nicht nur einen kom-parativen, sondern sogar einen abso-luten Vorteil bei der Absicherungder Systemstabilita¬t. Die Marktna¬heder Notenbanken gilt es zu nutzen,und zwar in der Institutsaufsicht, inder internationalen Kooperation derAufseher und schlie§lich bei derEntwicklung neuer Aufsichtskon-zepte in Reaktion auf Trends imFinanzgewerbe. §

Ernst Welteke




Walter Rothensteiner

23


Die Gestaltung

des Bankenaufsichtssystems

aus Sicht der Gescha¬ftsbanken

Ich werde im Folgenden das ThemaFinanzmarktaufsicht aus der Sichtvon Gescha¬ftsbanken beleuchten.Ich schicke voraus, dass wir das der-zeitige System der Banken-, Ver-sicherungs- und Pensionskassenauf-sicht fu¬r prinzipiell gut und seinenAufgaben effizient nachkommenderachten. Wenn der politische Willein eine andere Richtung geht, so hal-ten wir die weiter unten beleuch-teten Faktoren fu¬r essenziell. Eindiesbezu¬glicher Entwurf ging alsRegierungsvorlage Anfang Juni 2001in den Ministerrat und soll noch vordem Sommer beschlossen werden,damit er Anfang 2002 umgesetztwerden kann.

Allfinanzaufsichtin unabha¬ ngiger Beho¬ rde

Der aktuelle Entwurf sieht vor, dassdie derzeit zwischen dem Finanz-ministerium und der Oesterreichi-schen Nationalbank in mehrerenAbteilungen aufgeteilte Bankenauf-sicht laut Vorschlag des Finanzminis-teriums in eine unabha¬ngige Institu-tion ausgegliedert werden soll.

Walter RothensteinerGeneraldirektor,

Raiffeisen Zentralbank O¬ sterreich AG

Obmann der Sektion Kredit,

Wirtschaftskammer O¬ sterreich


Deren Vorstand wu¬rde auf Vorschlagder Bundesregierung vom Bundes-pra¬sidenten bestellt und ko¬nnte nuraus wichtigen Gru¬nden vom Finanz-minister abberufen werden. Weiterssoll es einen Aufsichtsrat geben, des-sen Mitglieder vom Finanzminister,teilweise u¬ber Vorschlag der OeNB,bestellt werden. Eine Entsendungvon Mitgliedern ohne Stimmrechtseitens der Beaufsichtigten ist denBanken zugesichert. Das erscheintvor allem wegen der notwendigenKostenkontrolle als wesentlicher

Punkt. Diese Mit-glieder sind selbst-versta¬ndlich nur fu¬rThemen kooptiert, diesich mit Budget, Kos-ten, Stellenplan etc. be-scha¬ftigen.

Dieser Finanz-marktaufsichtsbeho¬rdesollen auch die Ver-

sicherungs-, Wertpapier- und Pen-sionskassenaufsicht u¬bertragen wer-den, womit der Finanzminister derzunehmenden Ð aber bis dato nochimmer sehr geringen Ð U¬ berschnei-dung der Produktpaletten derFinanzdienstleister auf dem MarktRechnung tragen und Doppelgleisig-keiten vermeiden will.

Weiters hat sicherlich auch derAusblick auf die neuen Eigenmittel-vorschriften (ãBasel IIÒ) eine wesent-liche Rolle gespielt. Zu ãBasel IIÒwa¬re grundsa¬tzlich festzuhalten:

Die Weiterentwicklung derEigenmittelvorschriften und derensta¬rkere Orientierung am wirtschaft-lichen Risikogehalt sehen die Bankengrundsa¬tzlich positiv. Aber aus derSicht eines kleinen Landes mit klein-und mittelbetrieblichen Strukturenin der Kredit- und Gesamtwirtschaftist auf eine Reihe schwerwiegenderProbleme hinzuweisen. O¬ sterreichist nicht selbst Mitglied in Basel.Daher ist zu hoffen, dass die EU-Kommission gerade diese Strukturen

besonders beru¬cksichtigt und unsereSorgen teilt. Die Tatsache, dass diegegensta¬ndlichen Papiere zuerst inNew York und dann in Europa ver-o¬ffentlicht werden, versta¬rkt dieseSorgen.

Die Anerkennung des internenRatings ist als wesentlicher Fort-schritt zu sehen, aber es mu¬ssen dieVoraussetzungen fu¬r die aufsichts-rechtliche Anerkennung des inter-nen Ratings auf breiter Ebene aucherfu¬llt werden ko¬nnen. Und amgrundsa¬tzlichen Ziel, die urspru¬ng-liche Eigenmittelverpflichtung imSystem nicht zu erho¬hen, sollteunbedingt festgehalten werden. Allebisherigen Hinweise deuten jedochdarauf hin, dass es zu einer Erho¬hungder Eigenmittelverpflichtungen unddamit auch der Kosten kommt. Dadie Ergebnisse einer einschla¬gigenStudie u¬ber die tatsa¬chlichen Auswir-kungen (Impact Study) erst im Som-mer vorliegen werden, mu¬sste vorder Festlegung der tatsa¬chlichenRisikogewichte nochmals die Kredit-wirtschaft in den Meinungsbildungs-prozess einbezogen werden.Andernfalls besteht die Gefahr ho¬he-rer Kosten fu¬r den Kunden.

Mit diesen fu¬r 2004 zu erwarten-den Regelungen sollen der Banken-aufsicht zusa¬tzliche Kompetenzenbei der Frage der notwendigen Eigen-mittelausstattung jeder Bank zukom-men. Die differenzierte Betrachtungder Risiken und Eigenmittel wirdes na¬mlich ermo¬glichen, dass imZuge der so genannten ãsupervisoryreviewÒ die Finanzmarktaufsicht ein-zelnen Banken aufgrund ihrer indivi-duellen Risikosituation Eigenmittel-zuschla¬ge verordnen kann. Darauswird unser Interesse an einer extremprofessionellen Bankenaufsicht miteinem Blick fu¬r gesamtwirtschaft-liche Zusammenha¬nge klar. Hierkann unsachgema¬§e Anwendung zubleibenden volkswirtschaftlichenScha¬den fu¬hren.




Anforderungenan die Finanzmarkt-aufsichtNicht nur dem Staat ist im Interessedes Funktionsschutzes (das ist derSchutz des volkswirtschaftlichenInteresses an einem funktionieren-den Bankwesen) und des Gla¬ubiger-schutzes eine gut funktionierendeAufsicht ein Anliegen, auch die zubeaufsichtigenden Banken selbstprofitieren von einem intakten Ver-trauen in den Finanzmarkt. Auchwenn die Ta¬tigkeit der Bankenauf-sicht fu¬r die gepru¬ften Institute nichtimmer angenehm und regelma¬§igmit Mehraufwand verbunden ist,erspart sie letztlich allen Beteiligten,vom Kunden u¬ber die Banken biszum Staat, finanzielle Verluste. Mandarf dabei auch nicht vergessen, dassjede Bankenkrise nicht nur finan-zielle Einbu§en, sondern auch nega-tive Auswirkungen fu¬r die Reputa-tion des Finanzplatzes mit sichbringt.

Die gute Zusammenarbeit sa¬mt-licher Teilnehmer in dieser Bezie-hung ist von gro§er Wichtigkeitund tra¬gt wesentlich zum Erreichendes Gesamtzieles bei. Die Anforde-rungen der Gescha¬ftsbanken werdendaher von einem zentralen Themadominiert:Ð der Ausnutzung sa¬mtlicher

Synergiepotenziale undÐ der Vermeidung von Doppel-

gleisigkeiten zwischen Finanz-marktaufsicht, Zentralbank undFinanzministerium.Der Wunsch der Banken konzen-

triert sich im Wesentlichen auf dieErzielung gro¬§tmo¬glicher Effizienzsowie auf die Vermeidung von orga-nisatorisch bedingten finanziellenMehrbelastungen im Allgemeinenbzw. bei zu pru¬fenden Institutenim Besonderen. Doppelte Pru¬fungenzu gleichen Themen und Verwal-tungsmehraufwand gilt es jedenfallsnachhaltig zu vermeiden.

Hier sind klare gesetzliche undorganisatorische Regeln vorzusehen,und es ist eine entsprechende Auf-gabenabgrenzung mit der Oesterrei-chischen Nationalbank zu treffen,wie beispielsweise bezu¬glichÐ bankenaufsichtsrechtlicher und

statistischer Meldungen,Ð EZB-Meldungen,Ð Datenerfassung, -pru¬fung und

-auswertung sowieÐ Vor-Ort-Pru¬fungen,um nur einige wesentliche Punkte zunennen. Die Banken wu¬rden sich

jedenfalls wu¬nschen, dass auch undinsbesondere die Risikofru¬herken-nungssysteme der Einlagensicherun-gen als konstengu¬nstige Hilfseinrich-tung fu¬r die Beho¬rde herangezogenwerden ko¬nnen.

Die Einrichtung einer Allfinanz-aufsicht entspricht der Entwicklungin Richtung Allfinanzkonzerne. DieÐ wie es in der Vorlage hei§t Ð ãfach-lichen Besonderheiten und unter-schiedlichen Zielsetzungen verschie-dener AufsichtsbereicheÒ sollenjedoch ãangemessen beru¬cksich-tigt É und auf sektorale Besonder-heiten soll mo¬glichst Bedachtgenommen werdenÒ (¤ 6/2). Dashei§t, die bewa¬hrte klare Sparten-trennung zwischen Bank-, Versiche-rungs-, Wertpapier- und Pensions-kassengescha¬ft soll erhalten bleiben.Die Banken haben das mit einergewissen Genugtuung aufgenom-men. Denn die Verschiedenartigkeitder Risiken bzw. der Risikogleichlaufmacht im Gegensatz zur Risikostreu-ung unterschiedliche Ansa¬tze und




differenzierte Techniken fu¬r die Auf-sichtsta¬tigkeit notwendig. Die Ban-ken werden jedenfalls darauf achten,dass diese Richtlinien dann in derGescha¬ftsordnung entsprechendumgesetzt werden.

Nach Meinung der Gescha¬fts-banken ist die Finanzmarktaufsichtletztendlich eine Kernaufgabe desStaates, die auch die Finanzierungs-verantwortung inkludiert. Geradeauf einem relativ kleinen Markt wieO¬ sterreich ist eine effiziente Banken-aufsicht naturgema¬§ mit vergleichs-weise hohen Kosten verbunden.

Resu¬ mee

Zusammenfassend la¬sst sich festhal-ten: Die o¬sterreichischen Gescha¬fts-banken begru¬§en im bereits erwa¬hn-ten Interesse an einem vertrauens-wu¬rdigen Finanzmarkt mit einergut funktionierenden Aufsicht Refor-men zur Verbesserung der Effizienz.Die Nutzung von Synergien undgro¬§tmo¬gliche Kosteneffizienz mu¬s-sen jedoch als zentraler Teil derReformbewegung gesehen werden.Die Kostenkontrolle ist ein zentralesAnliegen der Banken, die schlie§lichdie Hauptlast der Kosten zu tragenhaben.

Die Banken wollen nicht an ver-schiedene Stellen womo¬glich A¬ hn-liches melden mu¬ssen und auch nichtvon mehreren Stellen gepru¬ft wer-den. Wenn es eine Allfinanzaufsicht

geben soll, dann mit einer klarenUnterteilung der verschiedenenSparten, die trotz aller U¬ berschnei-dungen ein unterschiedliches Verfah-ren beno¬tigen. Schlie§lich hat sichdie sektorspezifische Unterteilunginnerhalb der eigentlichen Banken-aufsicht sehr bewa¬hrt und ihreBeibehaltung wu¬rde sicherstellen,dass die entsprechenden Erfahrun-gen der bestehenden Bankenaufsichtweiterhin genutzt werden ko¬nnen.

Der zur Zeit vorliegende Geset-zesentwurf zur Neugestaltung derBankenaufsicht kommt in einerReihe von Punkten und Wu¬nschenden Banken na¬her bis nahe. Aller-dings werden in der Durchfu¬hrungnoch eine Reihe von Diskussionennotwendig sein. Eines ist allen Betei-ligten, bei aller Unterschiedlichkeitihrer Standpunkte, jedoch klar:Keine noch so strengen zusa¬tzlichenBestimmungen, sowohl bei derFinanzaufsicht als auch bei denneuen Eigenmittelvorschriften lautãBasel IIÒ, ko¬nnen Bankenkrisenund Bankenzusammenbru¬che voll-sta¬ndig verhindern. Ziel der laufen-den U¬ berlegungen muss es dahersein, eine dem modernen Finanzwe-sen ada¬quate Aufsicht zu haben, dieaber auch im Rahmen ihrer eigenenOrganisation den Prinzipien Effi-zienz, Transparenz, Synergie mitanderen Beho¬rden und Wirtschaft-lichkeit verpflichtet sein muss. §



24



David T. Llewellyn


A Regulatory Regime

for Financial Stability

1 Introduction and issuesJust as the causes of banking crisesare multi-dimensional,1) so the prin-ciples of an effective regime forfinancial stability need to incorporatea wider range of issues than extern-ally imposed rules on bank behavi-our. This suggests that strategies toavoid future banking crises also needto be multi-dimensional involvingmacro policy, the conduct of regula-tion and supervision by official agen-cies, the creation of appropriateincentive structures, the develop-ment of market discipline and theinternal governance and manage-ment of financial institutions.

In this context, the paper consid-ers alternative approaches to achiev-ing the objective of financial stability.A maintained theme is that what areoften viewed as alternatives are infact complements within an overallregulatory strategy. The discussionis set within the context of what willbe termed a regulatory regime which iswider than the rules and monitoringconducted by official regulatory andsupervisory agencies. In essence,

1 See Brealey (1999), Corsetti, Pesenti and Rabini(1998), Lindgren, Garcia and Saal (1996) andLlewellyn (2000).

David T. LlewellynProfessor,

Loughborough University


the focus is on how the componentsof a regulatory regime are to be com-bined to produce an optimum regula-tory strategy.

The central theme is that thecomponents of the regulatory regimeneed to be combined in an overallstrategy, and that while all the com-ponents are necessary, none alone issufficient. A myopic focus on anyone of the components (e.g. regula-tion) is likely to produce sub-opti-mum outcomes. The objectiveshould be to optimise a regulatory

strategy by combiningthe components of theregime, bearing inmind that there maybe negative tradeoffsbetween the differentcomponents. Thus, ifregulation is badly con-structed or taken toofar, there may be nega-

tive impacts on other componentsto an extent that the overall effectof the regime in ensuring financialstability is weakened.

As bank failures clearly involveavoidable costs, there is a welfarebenefit to be derived from loweringthe probability of bank failures, andreducing the cost of those bank fail-ures that do occur. In what follows,these are the twin objectives of theregulatory regime. The objective ofthe paper is to suggest a wider para-digm for ensuring financial stability.

The general economic rationalefor financial regulation has been out-lined elsewhere (Llewellyn, 1999).For purposes of the present paper,the economic rationale for regulationis taken as given. While this groundwill not be repeated, two observa-tions are entered at the outset.Firstly, the presence of an economicrationale for regulation does not jus-tify everything that a regulator does.Secondly, the case for regulationdoes not exclude a powerful role

for other mechanisms to achievethe objectives of systemic stabilityand legitimate (but limited) con-sumer protection. On the contrary,the central theme of the paper is toemphasise that the various compo-nents of the regulatory regime needto be combined in an overall regula-tory strategy. There is a potential dan-ger that the regulation component, ifpressed too far, will blunt othermechanisms and in the processweaken the impact of the overallregime.

The structure of the paper is asfollows. Section 2 establishes theconcept of the regulatory regime andthe tradeoffs that can exist betweenits components. This is followed insection 3 by a more detailed discus-sion of six of the seven componentsof the regime. Section 4 suggests aseries of desirable shifts within theregulatory regime and, in this context,offers a brief assessment of therecently-issued Basel Committeeconsultative paper on capitaladequacy. A brief overall assessmentis offered in section 5.

2 The regulatory regime

The concept of a regulatory regime iswider than the set of prudentialand conduct of business rules estab-lished by regulatory agencies. Exter-nal regulation potentially has a posi-tive role in fostering a safe and soundfinancial system and consumer pro-tection. However, this role, whileimportant, is limited, and insuffi-cient in itself. Equally, and increas-ingly important, are the other com-ponents of the regime and mostespecially the incentive structuresfaced by financial firms, and the effi-ciency of the necessary monitoringand supervision by official agenciesand the market.

The central thesis is that regula-tion needs to be viewed not solelyin the narrow terms of the rules

David T. Llewellyn


25


established by regulatory agencies,but in the wider context of a regula-tory regime the seven components ofwhich are:(1) the explicit regulation component

(rules established by regulatoryand supervisory agencies);

(2) official monitoring and supervision(i.e. by official agencies);

(3) the incentive structures faced bybanks;

(4) the role of market discipline andmonitoring;

(5) intervention arrangements in theevent of bank failures;

(6) the role of internal corporategovernance arrangements withinbanks, and

(7) the disciplining and accountabilityarrangements applied to regula-tory agencies.What are often viewed as alter-

natives, are in fact complementswithin an overall regulatory strategy.

The debate should ultimately beabout how to optimise the combina-tion of the seven components of theregime. It is not a question of choos-ing, for instance, between eitherregulation or market disciplines. Thisis a false dichotomy.

A maintained theme is that aregulatory regime needs to be viewedmore widely than externally-imposed regulation on financial insti-tutions. In current conditions itwould be a mistake to rely wholly,or even predominantly, on externalregulation, monitoring and super-vision by the Òofficial sectorÓ. Theworld of banking and finance is toocomplex and volatile to warrantdependence on a simple set ofprescriptive rules for prudent behav-iour. The central role of incentivestructures needs to be constantlyemphasised. There are many reasons(market imperfections and failures,externalities, Ògrid lockÓ problemsand moral hazards associated withsafety-net arrangements) why incen-

tive structures within financial firmsmay not be aligned with regulatoryobjectives (Llewellyn, 1999).

This means that a central consid-eration for the regulator is theimpact its own rules have on regu-lated firmsÕ incentive structures,whether they might have perverseeffects, and what regulation can doto improve incentives. Incentivestructures need to be at the centreof all aspects of regulation becauseif these are wrong it is unlikely thatthe other mechanisms in the regimewill achieve the regula-tory objectives. It isnecessary to considernot only how the vari-ous components of theregime impact directlyon regulatory objec-tives, but also howthey operate indirectlythrough their impacton the incentives of regulated firmsand others. Incentive structuresare at the heart of the regulatoryprocess.

2.1 Tradeoffs within theregulatory regime

Within the regulatory regime tradeoffsemerge at two levels. In terms ofregulatory strategy, a choice has tobe made about the balance of the var-ious components and the relativeweight to be assigned to each. Forinstance, a powerful role for officialregulation with little weight assignedto market discipline might bechosen, or alternatively a relativelylight touch of regulation but withheavy reliance on the other compo-nents. A given degree of effective-ness can be provided by differentcombinations of rules, supervision,market discipline etc. and with vari-ous degrees of discretion applied bythe regulator.

The second form of tradeoffrelates to how the components of

David T. Llewellyn



the regime may be causally related.In some circumstances the moreemphasis that is given to one ofthe components (e.g. regulation)the less powerful becomes one ormore of the others (e.g. market dis-cipline on banks) and to an extentthat may reduce the overall impact.Thus, while regulation may beviewed as a response to market fail-ures, weak market discipline, andinadequate corporate governancearrangements, causation may alsooperate in the other direction with

regulation weakeningthese other mecha-nisms. For instance,the more emphasis thatis given to detailed,extensive and prescrip-tive rules, the weakermight be the role ofincentive structures,market discipline and

corporate governance arrangementswithin financial firms. This has beenput by Simpson (2000) as follows:ÒIn a market which is heavily regu-lated for internal standards ofintegrity, the incentives to fair deal-ing diminish. Within the companyculture, such norms of fair dealingas Ôthe way we do things aroundhereÕ would eventually be replacedby ÔItÕs OK if we can get away withitÕÓ. In other words, an excessivereliance on detailed and prescriptiverules may weaken incentive struc-tures and market discipline.

Similarly, an excessive focus ondetailed and prescriptive rules mayweaken corporate governance mech-anisms within financial firms, andmay blunt the incentive of others tomonitor and control the behaviourof banks. Weakness in corporate gov-ernance mechanisms may also be areflection of banks being monitored,regulated and supervised by officialagencies. The way intervention isconducted in the event of bank dis-

tress (e.g. whether forbearance ispractised) may also have adverseincentive effects on the behaviourof banks and the willingness of mar-kets to monitor and control banksÕrisk-taking.

3 Componentsof a regulatory regime

Having established the overall frame-work and the nature of the regulatoryregime, this section considers some ofthe key issues related to six of theseven components with particularreference to a regulatory strategydesigned to optimise the overalleffect of the regime.

3.1 RegulationThree particular issues arise withrespect to the regulation part of theregime: the weight to be given toformal and prescriptive rules ofbehaviour, the impact that rulesmay have on the other componentsof the regulatory regime, and theextent to which the rules differenti-ate between different banks.

3.1.1 Prescriptive rulesA former US regulator has noted:ÒFinancial services regulation hastraditionally tended towards a stylethat is command-and-control, dictat-ing precisely what a regulated entitycan do and how it should do it Égenerally, they focus on the specificsteps needed to accomplish a certainregulatory task and specify withdetail the actions to be taken bythe regulated firmÓ (Wallman,1999). This experience of the USalso suggests that the interaction ofthe interests of the regulator andthe regulated may tend towards ahigh degree of prescription in theregulatory process. Regulators tendto look for standards they can easilymonitor and enforce, while theregulated seek standards they cancomply with. The result is that

David T. Llewellyn



regulators seek precision and detailin their requirements, while theregulated look for certainty andfirm guidance on what they are todo. Wallman suggests: ÒThe resultis specific and detailed guidance,not the kind of pronouncements thatreflect fundamental concepts andallow the market to develop onits ownÓ.

Although precise rules have theirattractions for both regulators andregulated firms, several problemsemerge with a highly prescriptiveapproach to regulation:Ð An excessive degree of prescrip-

tion may bring regulation intodisrepute if it is perceived bythe industry as being excessive,with many redundant rules.

Ð Risks are often too complex tobe covered by simple rules.

Ð Balance sheet rules reflect theposition of an institution only ata particular point in time, andits position can change substan-tially within a short period.

Ð An inflexible approach based ona detailed rule book has theeffect of impeding firms fromchoosing their own least-costway of meeting regulatory objec-tives.

Ð Detailed and extensive rules maystifle innovation.

Ð A prescriptive regime tends tofocus upon firmsÕ processesrather than outcomes and theultimate objectives of regulation.The rules per se may become thefocus of compliance rather thanthe objectives they are designedto achieve. In this regard, it cangive rise to a perverse cultureof Òbox tickingÓ by regulatedfirms. The letter of the regula-tion may be obeyed but not thespirit or intention.

Ð A prescriptive approach isinclined towards Òrules escala-tionÒ whereby rules are added

over time, but few are with-drawn.

Ð A highly prescriptive approachmay create a confrontationalrelationship between the regula-tor and regulated firms, or alter-natively cause firms to overreactand engage in excessive efforts atinternal compliance out of fearof being challenged by theregulator. In this sense, regula-tion may become more pre-scriptive and detailed than isintended by the regulatorbecause of the culture that arules-based approach generates.

Ð In the interests of ÒcompetitiveneutralityÓ, rules may be appliedequally to all firms, althoughthey may be sufficiently hetero-geneous as to warrant differentapproaches. A highly prescriptiveapproach to regulation reducesthe scope for legitimate differen-tiations. Treating as equal firmsthat in practice are not equal isnot competitive neutrality.

Ð A prescriptive rules approachmay in practice prove to beinflexible and not sufficientlyresponsive to market conditions.

Ð A potential moral hazard arisesin that firms may assume that,if something is not explicitly cov-ered in regulations, there is noregulatory dimension to theissue.

Ð Detailed rules may also have per-verse effects if they are regardedas actual standards to be adoptedrather than minimum standardswith the result that, in somecases, actual behaviour of regu-lated firms may be of a lowerstandard than without rules. Thisis most especially the case if eachfirm assumes its competitors willadopt the minimum regulatorystandard.

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3.1.2 Impact of rulesA second issue refers to the questionof whether the degree of precisionin rules has a positive or negativeimpact on compliance and the othercomponents of the regime. For rea-sons already suggested, precisionand detail may have a negative impacton compliance and compliance cul-ture: If something is not explicitlydisallowed, it is presumed to beallowed. Conversely, a regime basedmore on broad principles thandetailed and extensive rules has cer-

tain advantages: Princi-ples are easily under-stood and remem-bered, they apply toall behaviour, and theyare more likely to havea positive impact onoverall compliance cul-ture. It might also bethe case, as suggested

by Black (1994), that principles aremore likely to become Board issueswith the Board of Financial Firmsadopting compliance with principlesas a high level policy issue, ratherthan a culture of Òleaving it to thecompliance departmentÓ. As put byBlack, Òit helps chief executives tosee the moral wood from the techni-cal treesÓ.

3.1.3 DifferentiationA central issue in regulation forfinancial stability is the extent towhich it differentiates between dif-ferent banks according to their riskcharacteristics and their risk analysis,management and control systems.Most especially when supervisoryresources are scarce, but also in theinterests of efficiency in the bankingsystem, supervision needs to bemore detailed and extensive withbanks deemed to be riskier thanothers. The objective of ÒcompetitiveneutralityÒ in regulation does notmean that all banks are to be treated

in the same way if their risk charac-teristics are different. Reflectingthe practice in the UK, Richardsonand Stephenson (2000) argue thatthe Financial Services Authority(and formerly the Bank of England)treats the requirements of the BaselAccord as minima and requires indi-vidual banks to hold more capitalthan the minima dependent upontheir risk exposure. Capital require-ments are set individually for eachbank. The authors list the major fac-tors that are taken into account whensetting individual bankÕs capitalrequirements: experience and qual-ity of the bankÕs management, thebankÕs risk appetite, the quality ofrisk analysis, management and con-trol systems, the nature of the mar-kets in which it operates, the quality,reliability and volatility of earnings,the quality of the bankÕs capital andaccess to new capital, the degree ofdiversification, exposure concentra-tions, the complexity of a bankÕslegal and organisational structure,the support and control providedby shareholders and the degree towhich a bank is supervised by otherjurisdictions. As the authors note,Òthese considerations imply that theappropriate margin above the mini-mum regulatory capital require-ments will differ across banksÓ.

3.2 Monitoring and supervisionBecause of the nature of financialcontracts between financial firmsand their customers, continuousmonitoring of the behaviour of finan-cial firms is needed. The question iswho is to undertake the necessarymonitoring: customers, sharehold-ers, rating agencies etc. In practice,there can be only a limited monitor-ing role for retail depositors due tomajor information asymmetrieswhich cannot easily be rectified,and because depositors face the lesscostly option of withdrawal of depos-

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its. Saunders and Wilson (1996)review the empirical evidence onthe role of informed depositors.The funding structure of a bankmay also militate against effectivemonitoring in that, unlike with non-financial companies, creditors tendto be numerous with each stake-holder having a small stake.

As most (especially retail) cus-tomers cannot in practice undertakemonitoring, and in the presence ofdeposit insurance they may have noincentive to do so, an important roleof regulatory agencies is to monitorthe behaviour of banks on behalf ofconsumers. In effect, consumers del-egate the task of monitoring to a reg-ulatory agency. There are strong effi-ciency reasons for consumers to del-egate monitoring and supervision toa specialist agency to act on theirbehalf as the transaction costs forthe consumers are lowered by suchdelegation (Llewellyn, 1999). How-ever, this is not to argue that a regu-latory agency should become amonopolist monitor and supervisorof financial firms.

In practice, in countries that haverecently experienced banking crisesÒsome form of supervisory failurewas a factor in almost all the samplecountriesÒ (Lindgren, Garcia andSaal, 1996). In many countriessupervisory agencies did not enforcecompliance with regulations (Reisen,1998). In Korea and Indonesia inparticular, banks did not complywith regulatory capital adequacyrequirements or other regulations(UNCTAD, 1998). In particular,connected lending restrictions werenot adequately supervised partlybecause of political pressure andthe lack of transparency in theaccounts of banks and their corpo-rate customers.

In many recent crisis countriesthere has often been a lack of politi-cal will on the part of supervisory

agencies to exercise strong super-vision. This may be associated withadverse incentive structures facedby politicians and others who maygain from imprudent banking (Finkand Haiss, 2000). While prudentbanking is a public good, hazardousbehaviour can be beneficial to someindividual stakeholders. Others havenoted the lack of political will toexercise strong supervision in thetransitional economies of EasternEurope (Baer and Gray, 1996).

3.3 Incentive structuresThe maintained theme of this paperis that the incentive structures andmoral hazards faced by decision-makers (bank owners and managers,lenders to banks, borrowers andregulators) are central parts of theregulatory regime. The issue is two-fold: there need to be appropriateinternal incentives for managementto behave in appropriate ways, andthe regulator has a role in ensuringinternal incentives are compatiblewith regulatory objectives. Overall,we need to know more about incen-tive structures within financial firmsand whether, for instance, incentivestructures align with compliance.Research is also needed into howregulation impacts positively andnegatively on incentives withinregulated firms. We have alreadyalluded to the possibility thatdetailed rules may have the negativeeffect of blunting compliance incen-tives.

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Within the regulatory regime para-digm, a central role for regulation isto create appropriate incentiveswithin regulated firms so that theincentives faced by decision-makersare consistent with financial stability.At the same time, regulation needsto avoid the danger of blunting theincentives of other agents (e.g. ratingagencies, depositors, shareholders,debt-holders) that have a potentialdisciplining role with banks. Theposition has been put well bySchinasi, Drees and Lee (1999):

ÒPolicy makers aretherefore faced withthe difficult challengeof balancing efforts tomanage systemic riskagainst efforts to ensurethat market participantsbear the costs of im-prudent risk takingand have incentives to

behave prudentlyÓ. They argue thatbanks have complex incentive struc-tures. There are internal incentivesthat motivate key decision-makersinvolved with risk, corporate gover-nance mechanisms (such as account-ability to shareholders), an externalmarket in corporate control, marketdisciplines which may affect the costof capital and deposits, and account-ability to bank supervisors. The pres-ence of regulation and official super-vision overlays the structure ofincentives faced by bank decision-makers.

If incentive structures are haz-ardous, regulation will always faceformidable obstacles. There are sev-eral dimensions to this in the caseof banks: the extent to which rewardstructures are based on the volumeof business undertaken, the extentto which the risk characteristics ofdecisions are incorporated into per-sonal reward structures, the natureof internal control systems withinbanks, internal monitoring of the

decision-making of loan officers,the nature of profit-sharing schemesand the extent to which decision-makers also share in losses etc. Inter-nal reward systems based on short-term profits can also be hazardousas they may induce managers to payless attention to the longer-term riskcharacteristics of their decisions.High staff turnover, and the speedwith which officers are moved within the bank, may also create incen-tives for excessive risk-taking. Asimilar effect can arise through theherd-behaviour that is common inbanking. In the case of the Baringscollapse, managers who were sup-posedly monitoring the trading activ-ity of Leeson also benefited throughbonuses derived from the profits hewas making for the bank. Dale(1996) suggests that profit-relatedbonuses were an important featurein the Barings collapse.

It is clear that some incentivestructures may lead to dysfunctionalbehaviour (Prendergast, 1993). Thismay often emerge when incentiveswithin regulated firms relate to vol-ume which create a bias towardswriting business. Bank managersmay be rewarded by the volume ofloans, not by their risk-adjustedprofitability. Many cases of bank dis-tress have been associated with inap-propriate incentive structures creat-ing a bias in favour of balance sheetgrowth and with moral hazard cre-ated by anticipated lender-of-last-resort actions (Llewellyn, 2000).

Given that incentives for individ-uals are never fully aligned with theobjectives of the bank, there needto be external pressures on managersto encourage adequate internal con-trol systems to be established. Sev-eral procedures, processes and struc-tures can, for instance, reinforceinternal risk control mechanisms.These include internal auditors,internal audit committees, proce-

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dures for reporting to senior man-agement (and perhaps to the super-visors) and making a named boardmember of financial firms responsi-ble for compliance and risk analysisand management systems. In somecountries the incentive on bank man-agers has been strengthened by a pol-icy of increased personal liability forbank directors and bank directorsbeing personally liable in casesinvolving disclosure of incompleteor erroneous information. TheFinancial Services Authority in theUK has also proposed that individualdirectors and senior managers offinancial firms should, under somecircumstances, be made personallyliable for compliance failures.

The form and intensity of super-vision can differentiate betweenregulated institutions according totheir relative risk and the efficiencyof their internal control mechanisms(Goodhart, Hartmann, Llewellyn,Rojas-Suarex and Weisbrod, 1998).Supervisors can strengthen incen-tives by, for instance, relating thefrequency and intensity of theirsupervision and inspection visits(and possibly rules) to the perceivedadequacy of the internal risk controlprocedures and compliance arrange-ments. In addition, regulators cancreate appropriate incentives by cali-brating the external burden of regu-lation (e.g. number of inspectionvisits, allowable business etc.) tothe quality of management and theefficiency of internal incentives.Evans (1999) suggests several routesthrough which incentive structurescan be improved: greater disclosureby financial institutions, subjectinglocal banks to more foreign competi-tion, ensuring a closer alignment ofregulatory and economic capital,greater use of risk-based incentivesby supervisors and lower capitaladequacy requirements for banksheadquartered in jurisdictions which

comply with the BISÕ core principlesof supervision.

With respect to prudentialissues, capital requirements shouldbe structured so as to create incen-tives for the correct pricing of abso-lute and relative risk. In this area inparticular, the potential for regula-tion to create perverse incentivesand moral hazard is well-established.The basic problem is that if regula-tory capital requirements do notaccurately map risks then banks areencouraged to engage in regulatoryarbitrage. For instance,if differential capitalrequirements are setagainst different typesof assets (e.g. throughapplying differentialrisk weights), the rulesshould be based onactuarial calculations ofrelative risk. If riskweights are incorrectly specified,perverse incentives may be createdfor banks because the implied capitalrequirements are either more orless than justified by true relativerisk calculations. A critique of thecurrently-enforced Basel capitalarrangements is that risk weightsbear little relation to the relative riskcharacteristics of different assets, andthe loan book largely carries a uni-form risk weight even though therisk characteristics of different loanswithin a bankÕs portfolio vary consid-erably. The current Basel Commit-teeÕs consultation paper seeks toaddress this issue (Basel Committee,2001).

3.4 Market disciplineThe fourth component of the regula-tory regime relates to the arrange-ments for market discipline on banks.The central theme is that regulationcan never be an alternative to marketdiscipline. On the contrary, marketdiscipline needs to be reinforced

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within the regime and is one of thethree pillars in the proposed newBasel capital adequacy regime. Astarting point is that, as noted byLang and Robertson (2000), theexistence of deposit insurance createsa large class of debt-holders who haveno incentive to engage in costlymonitoring of banks.

Monitoring is not only con-ducted by official agencies whosespecialist task it is. In well-developedregimes, the market has incentives tomonitor the behaviour of financial

firms. The disciplinesimposed by the marketcan be as powerful asany sanctions imposedby official agencies.The disciplining roleof the markets (includ-ing the interbank mar-ket) was evidently weakin the crisis countries of

South-east Asia in the 1990s. Thiswas due predominantly to the lackof disclosure and transparency ofbanks, and to the fact that little reli-ance could be placed on the qualityof accountancy data provided in bankaccounts. In many cases standardaccountancy and auditing procedureswere not applied rigorously, and insome cases there was wilful misrep-resentation of the financial positionof banks and nonfinancial companies.This is not an issue for less developedcountries alone. For instance,Nakaso et al. (2000) argue that mar-ket discipline did not operate effi-ciently in Japan due largely to insuf-ficient financial infrastructure (weakaccountancy rules, inadequate dis-closure etc.).

Market discipline works effec-tively only on the basis of full andaccurate information disclosure andtransparency. Good quality, timelyand relevant information needs tobe available to all market participantsand regulators so that asset quality,

creditworthiness and the conditionof financial institutions can beadequately assessed.

Several parties are potentiallyable to monitor the management ofbanks and other financial firms: own-ers, bank depositors and customers,rating agencies, official agencies andother banks in the market. In prac-tice, excessive emphasis has beengiven to official agencies. The dangeris that a monopoly monitor is estab-lished with many of the standardproblems associated with monopolypower. There may even be adverseincentive effects in that, given thatregulatory agencies conduct moni-toring and supervision on a dele-gated basis, the incentive for othersto conduct monitoring may be weak-ened.

In the interests of an effectiveand efficient regulatory regime, therole of all potential monitors (andnotably the market) needs to bestrengthened, with greater incen-tives for other parties to monitorfinancial firms in parallel with officialagencies. An advantage of increasingthe number of agents who monitorbanks is that it removes the inherentdanger of having monitoring andsupervision conducted by a monopo-list with less than perfect and com-plete information. A monopolistsupervisor may also have a differentagenda than the maintenance offinancial stability. It has been notedthat Ò(b)roader approaches to banksupervision reach beyond the issuesof defining capital and accountingstandards, and envisage co-optingother market participants by givingthem a greater stake in bank survival.This approach increases the likeli-hood that problems will be detectedearlier É (it involves) broaden-ing the number of those who aredirectly concerned about keepingthe banks safe and soundÓ (Caprioand Honohan).

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The issue is not about market ver-sus agency discipline, but the mix ofall aspects of monitoring, super-vision and discipline. In its recentconsultation document on capitaladequacy the Basel Committee re-cognised that supervisors have astrong interest in facilitating effectivemarket discipline as a lever tostrengthen the safety and soundnessof the banking system. It argues thatÒmarket discipline has the potentialto reinforce capital regulation andother supervisory efforts to promotesafety and soundness in banks andfinancial systems. Market disciplineimposes strong incentives on banksto conduct their business in a safe,sound and efficient mannerÓ.

Some analysts (e.g. Calomiris,1997) are sceptical about the powerof official supervisory agencies toidentify the risk characteristics ofbanks compared with the powerand incentives of markets. Alongwith others,1) he has advocatedbanks being required to issue a mini-mum amount of subordinated anduninsured debt as part of the capitalbase. Holders of subordinated debthave an incentive to monitor therisk-taking of banks.

While market discipline ispotentially powerful, it has its limita-tions and Bliss and Flannery (2000)argue that there is no strong evidencethat equity and debt-holders affectmanagerial decisions. This meansthat, in practice, it is unlikely to bean effective complete alternative tothe role of official regulatory andsupervisory agencies:Ð Markets are concerned with the

private costs of a bank failureand reflect the risk of this inmarket prices. The social costof bank failures, on the otherhand, may exceed the private

cost (Llewellyn, 1999) and hencethe total cost of a bank failuremay not be fully reflected inmarket prices.

Ð The cost of private monitoringand information collection mayexceed the benefits.

Ð Market disciplines are not effec-tive in monitoring and disciplin-ing public sector banks.

Ð ÒFree-riderÓ problems mayemerge.

Ð In many countries, there are lim-its imposed on the extent towhich the marketin corporate con-trol (the takeovermarket) is allowedto operate. In par-ticular, there areoften limits, if notbars, on the extentto which foreigninstitutions are ableto take control of banks, eventhough they may offer a solutionto undercapitalised institutions.

Ð The market is able to efficientlyprice bank securities and inter-bank loans only to the extent thatrelevant information is available,and in many cases the necessaryinformation is not available. Dis-closure requirements are, there-fore, an integral part of themarket disciplining process.

Ð It is not self-evident that marketparticipants always have the nec-essary expertise to make riskassessment of complex, andsometimes opaque, banks. Inaddition, there are some areaswithin a bank (e.g. its risk analy-sis and control systems) wheredisclosure is not feasible.

Ð In some countries, the market indebt of all kinds (includingsecurities and debt issued by

1 Including Evanoff and Wall (2000), who present a detailed set of proposals for the implementation of a subordi-nated debt rule.

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banks) is limited, inefficient andcartelised although market disci-pline can also operate throughinterbank and swaps markets.

Ð When debt issues are very smallit is not always economic forrating agencies to conduct a fullcredit rating on a bank.While there are clear limitations

to the role of market discipline,1) theglobal trend is in the direction ofplacing more emphasis on marketdata in the supervisory process.The theme being developed is notthat market monitoring and disci-pline can effectively replace officialsupervision, but that it has a power-ful role which should be strength-ened within the overall regulatoryregime. The recent consultative docu-ment issued by the Basel Committeeon Banking Supervision (Basel Com-mittee, 2001) incorporates the roleof market discipline as one of thethree pillars of a proposed newapproach to banking supervision.The Committee emphasises that itsapproach Òwill encourage highdisclosure standards and enhancethe role of market participants inencouraging banks to hold adequatecapitalÓ.

3.5 InterventionA key component of the regulatoryregime is the nature, timing and formof intervention by regulatory agen-cies in the event of financial distresswithin a bank.

The closure of an insolvent or,under a Structured Early Interven-tion and Resolution (SEIR) regime,a near-insolvent bank, can impose apowerful discipline on the futurebehaviour of banks. Such ÒcreativedestructionÓ has a positive dimen-sion. However, ÒclosureÓ does notnecessarily mean that, even in theabsence of deposit insurance, depos-

itors lose. Nor is it necessary forbank-customer relationships andinformation sharing to be destroyed.As with the bankruptcy of anycompany, there is always some resid-ual value within an insolvent bank.Bank closure may simply mean achange in ownership of a bank andthe imposition of losses on equityholders. In most countries, ÒbankclosureÓ has not meant the destruc-tion of the bank. Thus, Barings waspurchased by ING Bank. In manyinstances, regulatory authorities havebrokered a change in ownership ofinsolvent banks while imposinglosses on shareholders. The skill inintervention that leads to the Òclo-sureÓ of an institution lies in ensuringthat what remains of value is main-tained.

Intervention arrangements areimportant not the least because theyhave incentive and moral hazardeffects which potentially influencefuture behaviour by banks and theircustomers. These arrangementsmay also have important implicationsfor the total cost of intervention (e.g.initial forbearance often has theeffect of raising the eventual cost ofsubsequent intervention) and the dis-tribution of those costs between tax-payers and other agents. Differentintervention arrangements also haveimplications for the future efficiencyof the financial system in that, forinstance, forbearance may have theeffect of sustaining inefficient banksand excess capacity in the bankingsector.

The issue focuses on when inter-vention is to be made. The experi-ence of banking crises in both devel-oped and developing countries indi-cates that a well-defined strategyfor responding to the possible insol-vency of financial institutions isneeded. A response strategy in the

1 The limitations to the role of market discipline are discussed further in Lane (1993).

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event of bank distress has three keycomponents:Ð taking prompt corrective action

to address financial problemsbefore they reach critical pro-portions;

Ð being prepared to close insolventfinancial institutions while never-theless not destroying what valueremains;

Ð the closing of unviable institu-tions and vigorously monitoringof weak and/or restructuredinstitutions.A key issue relates to rules versus

discretion in the event of bank dis-tress: the extent to which interven-tion should be circumscribed byclearly-defined rules (so that inter-vention agencies have no discretionabout whether, how and when toact), or whether there should alwaysbe discretion simply because relevantcircumstances cannot be set out inadvance. The obvious prima facieadvantage for allowing discretion isthat it is impossible to foresee allfuture circumstances and conditionsfor when a bank might become dis-tressed and close to (or actually)insolvent. It might be judged that itis not always the right policy to closea bank in such circumstances.

However, there are strong argu-ments against allowing such discre-tion and in favour of a more of lessformal rules approach to interven-tion. Firstly, it enhances the credibil-ity of the intervention agency in thatmarket participants, including banks,have a high degree of certainty thataction will be taken. Secondly, allow-ing discretion may increase the prob-ability of forbearance, which usuallyeventually leads to higher costs whenintervention is finally made. Kane(2000), for instance, argues that offi-cials may forbear because they facedifferent incentives from those ofthe market: their own welfare, theinterests of the agency they repre-

sent, political interests, reputation,future employment prospects etc.Perhaps less plausibly, he also arguesthat, under some circumstances, thepresent generation of taxpayers maybelieve they can shift the cost ofresolution to future generations. Italso guards against the regulatoreffectively Ògambling for resurrec-tionÓ. Thirdly, and this was relevantin some countries which recentlyexperienced banking distress, itremoves the danger of undue politi-cal interference in the discipliningof banks and regulatedfirms. Experience inmany countries indi-cates that supervisoryauthorities face sub-stantial pressure todelay action and inter-vention. Fourthly, andrelated to the first, arules approach to inter-vention is likely to have a beneficialimpact on ex ante behaviour of finan-cial firms.

A rules-based approach, byremoving any prospect that a hazard-ous bank might be treated leniently,has the advantage of enhancing theincentives for bank managers tomanage banks prudently so as toreduce the probability of insolvency(Glaessner and Mas, 1995). In thissense, a rules-based approach maybe of assistance to the interventionagency as its hands are tied and it isforced to do what it believes to bethe right thing.

Put another way, time-inconsis-tency and credibility problemsshould be addressed throughprecommitments and graduatedresponses with the possibility ofoverrides. Many analysts have advo-cated various forms of predeter-mined intervention through a gen-eral policy of SEIR. There is a casefor a graduated-response approachsince, for example, there is no ma-

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gical capital ratio below which aninstitution is in danger and abovewhich it is safe. Other things equal,potential danger gradually increasesas the capital ratio declines. This initself suggests that there should be agraduated series of responses fromthe regulator as capital diminishes.No single dividing line should triggeraction but there should be a seriesof such trigger points with the effectof going through any one of thembeing relatively minor, but the cumu-lative effect being large. An example

of the rules-based approach is to befound in the Prompt CorrectiveAction (PCA) rules in the US. Thesespecify graduated intervention by theregulators with predeterminedresponses triggered by capital thresh-olds. In fact, several countries havesuch rules of intervention (BaselCommittee, 1999). SEIR strategiescan, therefore, act as a powerfulincentive for prudent behaviour.

The need to maintain the credi-bility of supervisory agencies createsa strong case against forbearance.The overall conclusion is that thereshould be a clear bias (though not abar) against forbearance when a bankis in difficulty. While there should bea strong presumption against for-bearance, and that this is bestsecured through having clearly-defined rules, there will always beexceptional circumstances when itmight be warranted in the interestsof systemic stability. However, whenforbearance is exercised the regula-tory agency should, in some way or

another, be made accountable forits actions.

A useful case study is to be foundin the example of Finland, wherestrict conditions were imposed inthe support programme. Theseare summarised by Koskenkyla(2000) as:Ð support was to be transparent

and public;Ð the attractiveness of public fund-

ing of the programme was to beminimised;

Ð the owners of supported bankswere, where possible, to be heldfinancially responsible;

Ð the terms of the programmewere to support the efficiencyof the banking system and thepromotion of necessary struc-tural adjustments within thesystem;

Ð the potential impact on compet-itive distortions were to be mini-mised;

Ð banks receiving support were tobe publicly monitored;

Ð the employment terms of bankdirectors were to be reasonableand possible inequities removed.It is also the case that some bank

directors and managers in Finlandhave been held financially liable forhazardous behaviour (see Halme,2000).

3.6 Corporate governanceIn the final analysis, all aspects of themanagement of financial firms(including compliance) are ulti-mately corporate governance issues.This means that, while shareholdersmay at times have an incentive totake high risks, if a financial firmbehaves hazardously it is, to someextent, a symptom of weak corpo-rate governance. This may include,for instance, a hazardous corporatestructure for the financial firm,interconnected lending within aclosely-related group of companies,

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lack of internal control systems,weak surveillance by (especially nonexecutive) directors and ineffectiveinternal audit arrangements whichoften includes serious underreport-ing of problem loans. Corporategovernance arrangements were evi-dently weak and underdevelopedin banks in many of the countriesthat have recently experienced bankdistress.

A particular feature of corporategovernance relates to cross-share-holdings and interconnected lendingwithin a group (Falkena and Llewel-lyn, 2000). With respect to Japan,Nakaso et al. (2000) note that suchcross-shareholdings, which have longbeen a feature of Japanese corporatestructures, increased during theÒbubble eraÓ that preceded the bank-ing crisis. In some cases, banks soldcapital to companies (in order toraise their capital-asset ratios) andat the same time purchased stock inthe companies. Several problemsarise in cross-shareholding arrange-ments: Credit assessment may beweak; the mix of debt and equitycontracts held by banks may createconflicts of interest; when equityprices fall, banks simultaneously facecredit and market risk; and banksoften counted unrealised gains ascapital even when in practice theycould not be realised.

There are several reasons to sug-gest that corporate governancearrangements operate differentlywith banks than with other types offirms. Firstly, banks are subject toregulation, which adds an additionaldimension to corporate governancearrangements. Secondly, banks arealso subject to continuous super-vision and monitoring by officialagencies. This has two immediateimplications for private corporategovernance: Shareholders and offi-cial agencies are to some extentduplicating monitoring activity, and

the actions of official agencies mayhave an impact on the incentivesfaced by other monitors, such asshareholders and even depositors.However, official and market moni-toring are not perfectly substitutable.Thirdly, banks have a fiduciary rela-tionship with their customers (e.g.they are holding the wealth of depos-itors) which is rare with other typesof firms. This creates additional prin-cipal-agent relationships (and poten-tially agency costs) with banks thatgenerally do not exist with nonfinan-cial firms.

A fourth reasonwhy corporate gover-nance mechanisms aredifferent in banks is thatthere is a systemicdimension to banks.Because in some cir-cumstances (e.g. thepresence of external-ities) the social cost of a bank failuremay exceed the private costs, there isa systemic concern with the behav-iour of banks that does not exist withother companies. Fifthly, banks aresubject to safety-net arrangementsthat are not available to other compa-nies. This has implications for incen-tive structures faced by owners,managers, depositors and the marketwith respect to monitoring and con-trol.

All these considerations have animpact on the two general mecha-nisms for exercising discipline onthe management of firms: internalcorporate governance and the mar-ket in corporate control. Prowse(1997) shows that accountability toshareholders, and the effectivenessof board monitoring, is lower inbanks than in nonfinancial firms. Akey issue noted by Flannery (1998)is that little is known about howthe two governance systems (regula-tion and private) interact with eachother and, in particular, the extent

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to which they are complementary oroffsetting.

A key issue in the management ofbanks is the extent to which corpo-rate governance arrangements aresuitable and efficient for the manage-ment and control of risks. In the UK,the FSA has argued as follows:ÒSenior management set the businessstrategy, regulatory climate, andethical standards of the firm É.Effective management of these activ-ities will benefit firms and contributeto the delivery of the FSAÕs statutory

objectivesÒ. Corporategovernance arrange-ments include issues ofcorporate structure,the power of sharehold-ers to exercise account-ability of managers, thetransparency of cor-porate structures, theauthority and power of

directors, internal audit arrange-ments, and lines of accountabilityof managers. In the final analysis,shareholders are the ultimate risk-takers, and agency problems mayinduce managers to take more riskswith the bank than the owners wouldwish. This in turn raises issues aboutwhat information shareholders haveabout the actions of the managersto which they delegate decision-making powers, the extent to whichshareholders are represented onthe board of directors of the bank,and the extent to which share-holders have power to disciplinemanagers.

Corporate governance arrange-ments need to provide for effectivemonitoring and supervision of therisk-taking profile of banks. Thesearrangements need to provide for,inter alia, a management structurewith clear lines of accountability,independent non executive directorson the board, an independent auditcommittee, the four-eyes principle

for important decisions involvingthe risk profile of the bank, a trans-parent ownership structure, internalstructures that enable the risk profileof the firm to be clear, transparentand managed and the creation andmonitoring of risk analysis andmanagement systems. There wouldalso be advantage in having a boarddirector being responsible for thebankÕs risk analysis, managementand control systems. Some bankownership structures also produceineffective corporate governance.Particular corporate structures (e.g.when banks are part of larger con-glomerates) may encourage con-nected lending and weak risk analysisof borrowers. This was the case ina significant number of bank fail-ures in the countries of South-eastAsia and Latin America. Some cor-porate structures also make it com-paratively easy for banks to concealtheir losses and unsound financialposition.

The Basel Committee has appro-priately argued that effective over-sight by a bankÕs board of directorsand senior management is critical.It suggests that the board shouldapprove overall policies of the bankand its internal systems. It arguesin particular that Òlack of adequatecorporate governance in the banksseems to have been an importantcontributory factor in the Asiancrisis. The boards of directors andmanagement committees of thebanks did not play the role they wereexpected to playÒ (Basel Committee,2001). According to the Committee,good corporate governance includes:Ð establishing strategic objectives

and a set of corporate values thatare communicated throughoutthe banking organisation;

Ð setting and enforcing clear linesof responsibility and account-ability throughout the organisa-tion;

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Ð ensuring that board members arequalified for their positions, havea clear understanding of theirrole in corporate governanceand are not subject to undueinfluence from management oroutside concerns;

Ð ensuring there is appropriateoversight by senior management;

Ð effectively utilising the workconducted by internal and exter-nal auditors;

Ð ensuring that compensation ap-proaches are consistent with thebankÕs ethical values, objectives,strategy and control environment;

Ð conducting corporate gover-nance in a transparent manner.An interesting possibility is the

extent to which weak corporategovernance arrangements resultfrom moral hazard associated withofficial regulation and supervision:a further possible negative tradeoffwithin the regulatory regime. It couldbe that the assumption that regula-tory authorities impose regulationand monitor banks reduces theincentive for non executive directorsand shareholders to do so. Thepresumption may be that regulatorshave more information than do nonexecutive directors and sharehold-ers, and that their own monitoringwould only be wastefully duplicatingwhat is being conducted by officialsupervisors.

4 Shifts within theregulatory regime

Drawing together some of the earlierthemes, several shifts within theregulatory regime are recommendedin order to maximise its overalleffectiveness and efficiency:Ð Less emphasis to be given to for-

mal and detailed prescriptiverules dictating the behaviour ofregulated firms.

Ð A greater focus to be given toincentive structures within regu-

lated firms, and how regulationmight have a beneficial impacton such structures.

Ð Market discipline and marketmonitoring of financial firmsneed to be strengthened withinthe overall regime.

Ð Greater differentiation betweenbanks and different types offinancial business.

Ð Less emphasis to be placed ondetailed and prescriptive rulesand more on internal risk analy-sis, management and controlsystems.

Ð More emphasis needs to be givento monitoring and supervisingrisk management and controlsystems and to recasting thenature and functions of externalregulation away from generalisedrule-setting towards establishingincentives and sanctions to re-inforce such internal controlsystems.

Ð Corporate governance mecha-nisms for financial firms needto be strengthened so that, forinstance, owners play a greaterrole in the monitoring and con-trol of banks and complianceissues are identified as the ulti-mate responsibility of a nomi-nated main board director.

4.1 Recent trendsin regulatory practice

Space precludes a detailed review ofhow regulatory arrangements havebeen evolving in practice. However,in some areas substantial changeshave been made and others are inthe pipeline. This section brieflyconsiders some of the trends thatare emerging with respect to theinternational approach to the pru-dential regulation and supervisionof banks. While the Basel Commit-tee would not necessarily adopt theparadigm of the regulatory regimeoutlined earlier, there are some shifts

David T. Llewellyn



in approach along the lines outlinedin this paper.

Four criteria may be appliedwhen judging the efficiency andeffectiveness of capital adequacy reg-ulation: (1) Does it bring regulatorycapital into line with economiccapital? (2) Does it create the correctrisk-management incentives forowners and managers of banks?(3) Does it produce the correctinternal allocation of capital asbetween alternative risk assets andtherefore the correct pricing of risk?(4) To what extent does it createmoral hazard?

4.2 BIS approachto capital adequacy

The problems with the current BIScapital adequacy regime (1988Accord) are well established andare not repeated here. Partly becauseof these weaknesses, the Basel Com-mittee on Banking Supervision hasproposed a new framework for set-ting capital adequacy requirements(Basel Committee, 2001).

It is not proposed to discuss thenew Accord in detail here other thanto note that it is based on three cen-tral pillars: Minimum CapitalRequirements (which will set newcapital requirements for credit riskand an operational risk charge), aSupervisory Review Process (whichwill require supervisors to takeintervention action if a bankÕs riskprofile is high relative to capitalheld), and an enhanced role for mar-ket discipline which will requiremore information disclosure bybanks. As described in Jackson(2001), the Supervisory Review(Pillar 2 of the new Accord) is basedon four interlocking principles:(1) banks will be required to haveprocesses for assessing their capitalrequirements in relation to their riskprofile; (2) their processes will beevaluated by supervisors; (3) banks

will be expected to operate with cap-ital above minima set in Pillar 1; and(4) supervisors should intervene atan early stage to prevent capital fromfalling below the level required tosupport the bankÕs risk characteris-tics. The last-mentioned is a movein the direction of SEIR.

A major feature of the proposedapproach to capital adequacy is that itwill be more risk-sensitive with theobjective of aligning economic andregulatory capital more precisely bymaking regulatory capital require-ments more accurately reflect theactual risks of banks. In addition,the range of risks to be covered willbe widened including setting capitaladequacy requirements for opera-tional risk.

The proposed Basel CapitalAccord can be viewed in terms ofthe regulatory regime paradigm out-lined in this paper:Ð Substantial emphasis is to be

given to the importance of banksdeveloping their own risk analy-sis, management and control sys-tems, and it is envisaged thatincentives will be strengthenedfor this. In some cases (i.e. thosebanks with sophisticated riskanalysis systems), this will enablebanks to apply their own meth-odologies for calculating riskand the required capital backing(a move in the direction of con-tract regulation). The Committeenotes that Òcapital should not beregarded as a suitable substitutefor addressing fundamentallyinadequate control or risk man-agement processesÓ (Basel Com-mittee, 2001).

Ð The CommitteeÕs consultativepaper stresses the important roleof supervision in the overall reg-ulatory process. The SupervisoryReview Process will mean thatsupervisors must ensure thatbanks have sound internal risk

David T. Llewellyn


29


analysis and management sys-tems to assess capital adequacy.This will require a high standardof sophistication on the part ofbank supervisors if they are tobe able to assess banksÕ systems.This in turn has implications forthe training and qualifications ofbank supervisors. This secondpillar of the capital adequacyframework will Òseek to ensurethat a bankÕs capital position isconsistent with its overall riskprofile and strategy and, as such,will encourage early supervisoryinterventionÓ (italics added). Thisrepresents a step towards SEIR.

Ð In an attempt to bring regulatorycapital more into alignment witheconomic capital, it is proposedto widen the range of riskweights and to introduce weightsgreater than unity. Risk weightsto be applied will be refined byreference to a rating providedby an external credit assessmentinstitution (such as a ratingagency) that meets strict stand-ards. A wider range of risks areto be covered, including legal,reputation and operational risk.

Ð Capital requirements are to takeinto account the volatility of risksand the extent to which risks arediversified.

Ð Two alternative approaches toassessing credit risk for purposesof defining required capital willbe applied: a Standardised Ap-proach (similar to the currentarrangement with the additionof more risk weights) and aninternal ratings-based (IRB)approach (which will allowbanks to use their own internalmodels). Although a modifiedform of the current accord willremain as the ÒstandardisedÓapproach, the Committeebelieves that, for some sophisti-cated banks, the use of internal

and external credit ratingsshould be incorporated, and alsothat portfolio models of riskcould contribute towards align-ing economic and regulatorycapital requirements. The IRBapproach will not rely on prede-termined supervisory riskweights. Banks will be able toinput their own assessment ofthe probability of default associ-ated with each borrower. Asnoted by Jokivuolle and Kauko(2001), Òthe IRBA is expectedto be pursued bythe more sophisti-cated institutionsand it is intendedto pave the way forthe ultimate accept-ance of the use ofbanksÕ own creditrisk portfolio mod-els in determiningregulatory capitalÒ. These assess-ments will be derived frombanksÕ historical data of individ-ual loan categories, rating agen-cies, or other external industrysources, and they must meetÒrobust supervisory standardsÓ.In practice, while banks willslot loans into buckets accord-ing to the internal ratings, thecapital requirements for eachbucket will be set by Basel. Theobject is to bring the regulatoryprocess more into line with theway banks undertake risk assess-ment. However, the Committeedoes not believe that portfoliomodels of risk can be used inthe foreseeable future. Never-theless, over time, the Commit-tee states that it would like tosee more banks moving fromthe ÒstandardisedÓ approach tothe IRB approach and also that,within the IRB approach, bankswill shift from the ÒfoundationÓto the ÒadvancedÓ approaches as

David T. Llewellyn



their risk management capabil-ities develop.

Ð The Committee recognises thatthe use of internal ratings islikely to incorporate informationabout customers that is not avail-able either to regulators orexternal rating agencies. Ineffect, in some respects thiswould involve asking banksthemselves what they believetheir capital should be. This is amove at least in the direction ofprecommitment.

Ð Allowance is to be made for risk-mitigating factors such as the useof derivatives contracts to theextent that they are applied toreduce or shift risk.

Ð Greater emphasis is to be givento the role of market discipline,which is the third pillar in theproposed new approach. It willencourage high standards oftransparency and disclosurestandards and Òenhance the roleof market participants encourag-ing banks to hold adequate capi-talÓ. It is envisaged that marketdiscipline should play a greaterrole in the monitoring of banksand the creation of appropriateincentives. The Committee hasrecognised that supervisors havea strong interest in facilitatingeffective market discipline as alever to strengthen the safetyand soundness of the bankingsystem. This will require moreinformation disclosure by banks,and regulators will specify theprecise detail of information dis-closure.

Ð The proposals also include thepossibility of external creditassessments in determining riskweights for some types of bankassets. This would enhance therole of external rating agenciesin the regulatory process. TheCommittee also suggests there

could usefully be greater use ofthe assessment by credit ratingagencies with respect to assetsecuritisation made by banks.

Ð The principle is established thatsupervisors should intervene atan early stage to prevent capitalfrom falling below the minimumlevels required to support therisk characteristics of a particularbank, and should require reme-dial action if capital is not main-tained or restored.

Ð The consultation document givessome emphasis to the importantrole that shareholders have inmonitoring and controlling banks.Overall, the new approach being

proposed by the Basel Committeeenvisages more differentiationbetween banks, a less formal relianceon prescriptive rules, elements ofchoice for regulated institutions, anenhanced role for market discipline,a greater focus on risk analysis andmanagement systems, some degreeof precommitment, and a recogni-tion that incentives for prudentialbehaviour have an important role inthe overall approach to regulation.The new approach would createpowerful incentives for banks toimprove their risk analysis and man-agement methods and to developtheir own estimates of economic cap-ital. Equally, there would be power-ful incentives for supervisors todevelop and enhance their monitor-ing skills (Stephen and Fischer,2000).

5 Assessment

This paper has introduced the con-cepts of regulatory regime and regula-tory strategy. Seven components of theregime have been identified: eachare important but none alone is suf-ficient for achieving the objectivesof regulation. They are complemen-tary and not alternatives. Regulatorystrategy is ultimately about optimis-

David T. Llewellyn



ing the outcome of the overallregime rather than any one of thecomponents. Regulators need toconsider that, if regulation is badlyconstructed or taken too far, theremay be negative impacts on othercomponents to the extent that theoverall effect is diluted. However,there may also be positive relation-ships between the components, andregulation can have a beneficial effecton incentive structures within finan-cial firms.

Regulation and supervision ofbanks and financial institutions hasthe potential to make a significantcontribution to the stability androbustness of a financial system.However, there are limits to whatregulation and supervision canachieve in practice. Although regula-tion is an important part of the regu-latory regime, it is only a part and theother components are equally impor-tant. In the final analysis, there is noviable alternative to placing the mainresponsibility for risk managementand general compliance on theshoulders of the management offinancial institutions. Managementmust not be able to hide behind thecloak of regulation or pretend that,if regulation and supervisoryarrangements are in place, thisabsolves them from their ownresponsibility. Nothing should everbe seen as taking away the responsi-bility of supervision of financial firmsby shareholders, managers and themarkets. §

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30



Jean-Claude The« bault


Financial Supervision:

The EU Approach

IntroductionThe debate about the ÒoptimalÓstructure for the supervision of thefinancial sector has moved to thetop of the agenda over the recentyears, as evidenced by changes inthe supervisory architecture of sev-eral countries. The model of thesingle integrated supervisory author-ities Ð with competence over bank-ing, investment and insurance activ-ities Ð has spread from the Scandina-vian area and has inspired the reformof supervisory structures in severalcountries. The UK Financial ServicesAuthority (FSA) was established in1998, and the creation of an inte-grated authority has been or is onthe agenda in Ireland and Germany.

In several other countries, stepshave been taken to strengthen co-operation between the existingsupervisory bodies. In the Nether-lands, a Council of Financial Super-visors was established in 1999 tosupplement the existing forms ofco-operation between the threesupervisory authorities. In France,co-operation between the differentauthorities has also been strength-ened.

Jean-Claude The« baultDirector, Financial Institutions, DG Internal Market

European Commission


On several occasions, thesereforms also entailed a redefinitionof the articulation between thesupervisory and central bankingfunctions. The debate on the organi-sation of supervision at domesticlevel is not specific to the EU. Therehave been similar reforms in thirdcountries, e.g. a single integratedsupervisor has been established inJapan. Australia has adopted an objec-tive-based supervisory architecturewith a distinction between pruden-tial supervision, market integrity

and systemic stability.In April 2000, Estoniaannounced the creationof an integrated super-visory agency.

The issue of super-visory structures takesparticular relief at EUlevel, in the context ofthe single market for

financial services, which has pavedthe way for cross-border financialactivities. Monetary union is alsowidely perceived as a catalyst to theintegration and consolidation of thefinancial services industry.

The guiding thread of my speechwill be formed by the question:What actions should be undertakento ensure that the regulatory andsupervisory framework for financialservices meet the challenge of inte-gration and cope with developmentsin industry and supervisory prac-tices?

My argumentation will be struc-tured along the following lines:Ð What are the main features of the

EU supervisory architecture?Ð What are the challenges to the

current framework?Ð What has been the contribution

of the Commission to a moreeffective supervision and regula-tion of financial services?

1 The EU institutionalframeworkand the emphasison cross-borderco-operation betweensupervisory authorities

Supervision of the financial servicesindustry in the EU has traditionallybeen organised along national andsectoral lines. The legal infrastruc-ture for the single market for finan-cial services does not aim to harmo-nise supervisory structures across theEU. Rather, the ÒfoundingÓ directivesfor the single market lay the founda-tions for an effective co-operationbetween the different authoritiesinvolved in the supervision of finan-cial groups. The intensity of the co-operation is reflected in the successof Memoranda of Understanding(MOU) between EU supervisors.Sectoral committees also play a pivo-tal role in designing the regulatoryframework and promoting co-opera-tion between supervisors.

1.1 The EU frameworklays down the conditions forco-operation and informationsharing between supervisoryauthorities

The ÒfoundingÓ directives for thesingle market in the banking, invest-ment and insurance sector providefor the harmonisation of the condi-tions to grant a license to creditinstitutions, investment firms andinsurance undertakings. They alsoidentify the relevant information tobe exchanged between home andhost country supervisory authoritieswhenever a regulated institutionwants to establish a branch or pro-vide services in another MemberState. The ÒfoundingÓ directives putthe emphasis on the co-operationbetween the home supervisor andthe host supervisor.

The expansion of internationallyactive groups has called for more



31


intensive forms of co-operation, toachieve an effective group-widesupervision. The legislative frame-work for consolidated supervisionin the banking/investment sector(Consolidated Supervision Direc-tive) and for solo plus supervisionin the insurance sector (InsuranceGroup Directive) provides for theexchange of information betweenthe different authorities involved.

EU legislation gradually removedthe legal obstacles to informationsharing between relevant bodies. Inparticular, Community provisionsallow national banking supervisoryauthorities to transmit to monetaryauthorities or overseers of paymentsystems information intended forthe performance of their task.1)

The emergence of financial con-glomerates has prompted an exten-sion of the scope of supervisoryinformation sharing. The ÒpostBCCIÓ directive (95/26/EEC) putsthe emphasis on cross-sectoral co-operation and lays the foundationsfor the exchange of confidentialinformation between all interestedparties, including auditors, depositinsurance schemes and clearinghouses.

1.2 The network of MOUThe legislation for group-widesupervision has encouraged thesupervisory authorities of differentcountries to enter into co-operativearrangements. Co-operation in day-to-day supervision as well as crisismanagement is facilitated by well-established channels of communica-tion between supervisory author-ities. Ex-ante agreements will flesh

out the conditions for co-operationbetween authorities.

A typical form of cross-borderco-operation is illustrated by thenetwork of bilateral MOU betweenbanking supervisors, in the con-text of consolidated supervision.2)MOU typically identify the informa-tion to be shared on a routine basisand may also pave the way forprompt circulation of informationin emergency situations. They havebeen instrumental in promoting co-operation and can be seen as a first

step towards more intensive formsof co-operation as the cross-borderintegration of banking activitiesgrows.

The recent development ofcross-border mergers and takeovershas prompted the supervisoryauthorities to institutionalise theirco-operation further and to developa customised framework for individ-ual groups.3)

Another challenge is the devel-opment of co-operation with finan-cially significant third countries, tocope with the globalisation of thefinancial industry. Building upon theexperience of Member States inbilateral co-operation with thirdcountries, the Commission con-cluded a framework agreement with

1 See Article 30/8 of the Codified Banking Directive 2000/12/EC.2 There are about 80 MOU.3 A classical illustration is provided by the co-operative arrangement between Belgian and French authorities

regarding the Dexia group resulting from the economic merger of Cre«dit Communal de Belgique and Cre«dit Localde France. Other examples include arrangements between Belgian and Dutch authorities to supervise cross-borderconglomerates and between Scandinavian authorities about Merita Nordbanken Unidanmark.




the US banking authorities in 1999,to serve as benchmark for bilateralMOU between Member States andthe US.

1.3 EU-wide fora for supervisoryco-operation

The existence of structures wherethe regulatory and supervisoryauthorities of the financial sectorcan meet and exchange views regu-larly has proved a key ingredient inpromoting a common understandingand a co-operative spirit between EUauthorities.

A distinction can be madebetween three categories of bodiesdepending on their main focus:Ð A first category is oriented

towards legislative activity. Tothis category clearly belong thecommittees that were establishedby the EU sectoral directives toassist the EU Commission inpreparing prudential legislationfor the supervision of the finan-cial sector, namely the BankingAdvisory Committee (BAC) andthe Insurance Committee (IC).The High-Level Securities Super-

visors Committee (HLSS) has servedthe same purpose in the securitiesfield since 1985 (albeit with nocomitology powers). The architec-ture of securities committees willbe refurbished following the Lamfa-lussy Report on the regulation ofsecurities markets. The report,which was endorsed by the Stock-holm European Council, recom-mends that two committees beestablished:

Ð A European Securities Com-mittee, with similar Òcomi-tologyÓ powers as BAC andIC.

Ð A Committee of EuropeanSecurities Regulators, withadvisory function.

Ð A second category is dedicated tothe exchange of views on super-visory practices and to the dis-cussion of individual cases. TheGroupe de Contact of the EUbanking supervisors and theConference of Insurance Super-visory Authorities are the lon-gest-standing groups of thiskind.1)In the banking sector, the

Groupe de Contact is playing animportant role in the convergenceof supervisory review practices inthe context of the revision of capitaladequacy rules. In addition, a high-level Conference of banking super-visors was established in November2000 (Copenhagen Conference) andwill meet at least once a year to dis-cuss convergence in banking super-visory practices.

Additional meetings of the Con-ference may be called by the chair-man of the Conference (presentlythe supervisor from Luxembourg)if the chairman of the Groupe deContact identifies a need for guid-ance. In the securities field, themore recently established Form ofEuropean Securities Commissions(FESCO) may also discuss individualcases and has been keen on promot-ing co-operation on enforcement andmarket surveillance, while alsodeveloping common standards.

The Committee of EuropeanSecurities Regulators, as contem-plated in the Lamfalussy Report, isexpected to work towards the con-vergence of supervisory practices.Ð A third category is primarily ori-

ented towards the prevention ofsystemic risk, with a focus onÒmacroprudentialÓ issues. This isthe case of the Banking Super-vision Committee (BSC), whichwas established in 1998 underthe aegis of the European System

1 The Groupe de Contact and the Conference were established in 1972 and 1958, respectively.




of Central Banks to assist in thesmooth conduct of supervisoryand financial stability policies.The BSC comprises bankingsupervisory authorities as wellas central banks.These arrangements for commit-

tees have been instrumental in fos-tering the co-operation within eachsector. The next ÒfrontierÓ is tostrengthen cross-sector co-operationand to involve all relevant authorities(including central banks, overseersof payment systems, deposit insur-ance schemes) in the co-operationloop.

2 The challengesto the institutionalarchitecturefor financial services

The famous Òadapt or dieÓ principlealso applies to the field of super-vision. It is crucial that the super-visory framework meets thedemands of a changing financial land-scape. There are three major chal-lenges that need to be addressed,namely conglomeration, concentra-tion and innovations.

2.1 The emergence of financialconglomerates calls forenhanced cross-sectoralco-operation

Conglomeration has gained momen-tum over recent years, and severalhigh-profile cross-sector acquisitionsare changing the traditional land-scape. Most of the top EU financialgroups offer both banking and insur-ance services. Conglomeration hasbecome a dominant feature of finan-cial industry in certain MemberStates.

In Belgium and in the Nether-lands, there were relatively few,albeit large acquisitions whichresulted in the emergence of cross-

sector groups. One typical exampleis Fortis, which has developed froman insurance group into a truecross-sector and cross-border con-glomerate. Another EU example ofcross-sector and cross-border con-centration includes the acquisitionof Unidanmark by the Swedish/Finnish group Merita Nordbanken.

The emergence of cross-sectoralgroups obviously calls for enhancedco-operation between supervisorsof different sectors. This has moti-vated the recommendation in the

Report by the EU Economic andFinancial Committee (EFC) on finan-cial stability in the EU, the BrouwerReport, that cross-sector co-opera-tion should be strengthened at inter-national level, and that co-operationcould be improved by clarifying andextending the concept of the co-ordinating supervisor for large finan-cial groups domiciled in Europe.

2.2 Concentration raises the issueof systemic risk at EU level

The recent merger frenzy in the EUfinancial sector has resulted in theacceleration of concentration in thesector. A recent IMF study notes thatthe average size of the top five euro-area banking groups has doubledsince 1995, and that 18 of the biggesteuro-area banks are the result ofrecent mergers.1)

It is certainly true that concen-tration has taken place mostly atdomestic level, giving birth to

1 Euro-Area Banking at the Crossroads (2001).




groups that can be seen as ÒnationalchampionsÓ. There are clear signs,however, that merger activity willspill over national borders. Suchcross-border deals as Dexia, Fortis,ING-BBL, Merita-Nordbanken,could well announce a further roundof cross-border acquisitions.

The emergence of pan-EuropeanÒbig playersÓ has raised the concernsabout their systemic impact and herewe come to the issue of crisis man-agement. Crisis at a large financialinstitution is likely to have cross-

border effects not least out of theintegration of large-value paymentsystems and to involve authoritiesin several countries.

Not surprisingly, the frameworkto prevent and, if things go wrong,deal with crisis at systematicallyimportant institutions is at the coreof the recently released EFC reporton financial crises management.The second Brouwer Report interalia calls for:Ð the removal of any remaining

legal obstacle to informationsharing among supervisors, withcentral banks, payment systemsoverseers and deposit-guaranteeschemes,

Ð the appointment of a co-ordinat-ing supervisor for the majorfinancial institutions, includingconglomerates,

Ð the further development ofMOU to deal with concretecrisis management issues.

2.3 Innovation in industryand supervisory practice callsfor an evolutive regulatoryframework

Financial markets are a blossomingfield for innovations. This is epitom-ised by the following aspects:Ð The creation of new financial

instruments. There were differ-ent ÒwavesÓ of new financialproducts:OTC derivatives expanded dra-

matically over the last decade andspilled over from the managementof market risk to the field of creditrisk management (the so-calledcredit derivatives). Techniques forsecuritisation have gained in sophisti-cation and complexity. The featuresof capital instruments have beenrefined to take advantage of thesupervisory acceptance for Tier 1and Tier 2 capital. All these innova-tions have challenged the ÒoldÓ capi-tal adequacy framework and haveprompted concerns about super-visory arbitrage.Ð The channels for marketing

financial products are changing.Progress in e-commerce ande-banking has been substantialin all Member States, ande-banking already accounts fora significant part of retail bank-ing in certain Member States,Scandinavian countries in partic-ular.1)The development of new chan-nels has prompted severalauthorities to update their pru-dential framework.

Ð There has been progress in riskmanagement tools: Internalmodelling was first developedfor market risks in the 1990sand is now being extended tocredit risk. The next ÒfrontierÓis the development of internalmodels for operational risk.

1 See the report by the European Central Bank (1999).



32


Progress in risks managementtechniques calls for the recognitionby supervisors, but this recognitionwill be conditional upon the degreeof confidence, and comfort super-visors may get about the reliabilityof these techniques. Typically, a setof qualitative and quantitative crite-ria will have to be laid down in theregulatory framework.Ð Supervision has become more

qualitative and more sophisti-cated, leaving more discretionto supervisory authorities.The move towards more risk-

sensitive capital requirements andthe related developments in internalmodelling techniques have urgedsupervisory authorities to developtheir own skills to ensure that super-vision remains up to date. For exam-ple, most authorities have createddedicated teams to deal with themore advanced approaches to riskand to provide horizontal assistanceto ÒlineÓ supervisors.

Equally, supervisors have putmore emphasis on qualitative aspectsof supervision, including risk man-agement and disclosure. The currentreview of bank capital adequacy rulesconcentrates on both, more sophisti-cated ÒquantitativeÓ and ÒqualitativeÓaspects of supervision: Supervisoryauthorities will have more leewayto fine-tune individual capitalrequirements following the super-visory review process (whichincludes an assessment of the effec-tiveness of risk management) andwill be asked to recognise advancedinternal systems on the basis of reli-ability standards.

These elements not only set achallenge in terms of building upresources, they also raise the issueof a potentially uneven implementa-tion of supervisory discretion acrossthe EU, i.e. ÒoverzealousÓ super-visors might put their institutions ata competitive disadvantage com-

pared to institutions subject to Òleni-entÓ supervisors. This concern hasbeen clearly expressed in the contextof the consultation on the capitalreview.

The ÒlessonsÓ for supervisorystandard setters are clear: First theregulatory framework should beflexible enough to cope with marketdevelopments. Second, the responseto the challenges of innovationshould be co-ordinated at EU level,to ensure that a level playing fieldis maintained. Reconciling thesetwo objectives is notnecessarily easy, as pastexperience with therecognition of internalmodels for market riskshas shown. You willremember that it tookmore than two yearsto amend the capitaladequacy directive torecognise internal models for marketrisks.

To achieve these objectives, theCommission will promote a moreflexible legislative approach forprudential services, as announcedin its Financial Services Action Plan(FSAP). So, let us now turn to whatthe Commission has undertaken tofoster an effective framework forfinancial services.

3 The CommissionÕscontribution toan effective frameworkfor financial supervision

The Commission is not a supervisorof banks, investment firms or insur-ance companies and certainly doesnot pretend to become one. But itdoes have a general responsibilityfor promoting a sound supervisoryframework that will contribute toreaping the benefits of the singlemarket for financial services. Thisincludes the initiative to set upharmonised rules at EU level and to




monitor their implementation bythe Member States. Therefore, theinterest of the Directorate-GeneralInternal Market for supervisorystructures should not come as asurprise.

The Commission is committedto fostering an effective structurefor financial supervision. This actionhas taken different forms. I wouldlike to emphasise three majoraspects:Ð progress in the implementation

of the Financial Services ActionPlan will deliver a more effectiveoverall framework,

Ð the Commission has taken stepsto foster cross-sector co-opera-tion between supervisors,

Ð the Commission supports a moreflexible legislative model forfinancial regulation.

3.1 There has been significantprogress in the implementa-tion of the Financial ServicesAction Plan

The FSAP is a comprehensive frame-work of inter-linked measures whichwill allow the EU to benefit from thesingle currency and an integratedfinancial sector. When adopted in1999, the FSAP identified the devel-opment of state-of-the art prudentialrules and supervision as one of thekey objective to be achieved.

The Stockholm European Coun-cil has recently added impetus to theimplementation of the FSAP. Thedeadlines set by the Heads of Stateor Government to implement theAction Plan by 2005 and to integrateEuropean securities markets by 2003are now firm. The Stockholm Euro-pean Council endorsed the conclu-sions of the Lamfalussy Report onsecurities regulation and the prior-

ities identified in the FSAP, includingthe adoption of the proposed direc-tive on the distance marketing offinancial services.

Over recent months, the Com-mission has delivered several actionsunder the FSAP, including the legis-lative proposal for the prudentialsupervision of financial conglomer-ates in April 2001. The Commissionis about to adopt two legislative pro-posals to foster the integration ofsecurities markets: about prospec-tus, aiming to establish a single pass-port for European issuers, and aboutthe prevention of market abuse.These proposals will also establish aCommittee structure in the secur-ities area.

This is encouraging, and willhelp concentrate resources on thepriorities identified by the EuropeanCouncil: pension funds, e-com-merce and distance marketing as wellas money laundering.

3.2 Fostering cross-sectoralco-operationbetween supervisors

Enhancing practical arrangementsfor the co-operation between super-visors was one of the main recom-mendations from the first BrouwerReport on financial stability. TheCommission has taken two mainsteps in that direction:Ð The Commission has taken the

initiative to convene a Round-table of Regulators. This Round-table gathers the chairpersons ofthe seven committees with theresponsibility of the regulation/supervision of the three sectorsof banking, insurance and secur-ities.1)The primary objective is to iden-

tify current issues of interest to the

1 The Banking Advisory Committee, the Banking Supervision Committee, the Groupe de Contact, the InsuranceCommittee, the Conference of Insurance Supervisors, the High-Level Committee of Securities Supervisors andFESCO.




three sectors. In practical terms,participants inform each other ofthe work in progress in their forain order to identify issues of com-mon concern and to avoid duplica-tion of effort.

There have been five meetings ofthe Roundtable so far. The Roundta-ble has been successful in co-ordinat-ing discussions on financial conglom-erates and promoting a cross-sectorperspective on electronic commerceand on institution building in theaccession countries.

In future, the Roundtable willprobably work on the cross-sectoraldimensions of the convergence ofsupervisory practices, in particularin the context of the supervisoryframework for financial conglomer-ates.Ð The second step relates to day-

to-day co-operation betweensupervisors of different sectors,the directive proposal for finan-cial conglomerates provides forenhanced co-ordination betweenthe different authorities involvedin the supervision of conglomer-ates. This co-ordination shouldapply on a going-concern basisas well as in emergency situa-tions.The CommissionÕs directiveproposal requires the mandatoryappointment of one or more co-ordinator(s) for any financialconglomerate. In most cases theidentification of the co-ordina-tor(s) will be obvious, given thestructure of the financial con-glomerate. However, to avoidsituations in which no co-ordina-tor is appointed, the directivelays down criteria to identifythe co-ordinator(s) in the eventthe supervisors involved couldnot reach agreement amongstthemselves.The co-ordinatorÕs task shallinclude:

a) the co-ordination of gather-ing and dissemination ofrelevant or essential infor-mation in going-concernand emergency situations;

b) the assessment of the finan-cial situation and the over-view and monitoring of thecompliance with the ruleson capital adequacy on riskconcentration and intra-group transactions;

c) the assessment of the finan-cial conglomerateÕs struc-ture, organisation and inter-nal control systems;

d) the planning and co-ordina-tion of supervisory activitiesin going-concern as well asin emergency situations, inco-operation with the rele-vant competent authoritiesinvolved.

Of course, arrangements be-tween supervisors may confineadditional tasks to the co-ordinator.The Commission is confident thatthese provisions will pave the wayfor an enhanced co-operation and islooking forward for more compre-hensive arrangements betweensupervisors.

3.3 Towards a more flexiblelegislative framework

The need for a more adaptable legis-lation that can cope with marketdevelopments was already noted inthe FSAP. Commission servicesbelieve that the regulatory frame-work for financial services shouldmeet the twin demands of speed ofadoption and flexibility. A thirdobjective, that of a consistent imple-mentation across Member States,is crucial to level playing fields inthe EU.

You are well aware of the four-level approach developed in theLamfalussy Report for securities reg-ulation with a distinction between




framework principles to be decidedby normal EU legislative procedures(Level 1), technical rules subject tocomitology procedures (Level 2),enhanced co-operation and network-ing among EU securities regulatorsto ensure the consistent and equiva-lent transposition of Level-1 andLevel-2 legislation, and strengthenedenforcement, notably with morevigorous action by the EuropeanCommission to enforce Communitylaw, underpinned by the enhancedco-operation between the Member

States, their regulators and theprivate sector.

There is no doubt that the debateabout the Lamfalussy approach willinform the thinking on the legislativestructure for the whole arena offinancial services. The Commissionservices had already developed theirthinking last October about a multi-ple-layer legislative approach in thecontext of the review of capitaladequacy rules for credit institutionsand investment firms, where a three-strand structure has been envisaged.This approach is similar Ð but notidentical Ð to the Lamfalussyapproach to securities legislation.The structure will distinguishbetween the core principles (ÒfirststrandÓ) to be enshrined in the bodyof the directive and the technicalrules (Òsecond strandÓ) that need amore flexible approach. Futureamendments to the core principleswould require a full co-decision pro-cedure, whereas amendments to thetechnical rules will be subject to a

comitology procedure. These twostrands would be complemented bythe convergence of supervisory prac-tices. This third strand would secureconsistency and coherence of imple-mentation. The mechanisms fordelivering supervisory convergencemay take a variety of forms, such asrecommendations and communica-tions from the Commission, bestpractices developed by supervisorsthemselves, some form of peergroup review etc.

This initiative in the context ofthe capital review will contribute tothe implementation of the fourthrecommendation of the Report onfinancial stability that supervisorsshould work towards convergenceof supervisory practices. Of course,the Commission will monitor theimplementation of the capital reviewby the Member States, with levelplaying fields as a primary objective.Making a more flexible approachwork through targeted and up-to-date legislation is central to achievingthe integration of EuropeÕs financialmarkets.

However, success will only bepossible if the three institutions Ðthe European Parliament, the Euro-pean Council and the EuropeanCommission Ð work together, fullyrespecting the present institutionalbalance in the Treaty and the prerog-atives of the institutions involved.The future legislative proposals forprospectus and for market abuseswill be Òtest casesÓ for a more flexi-ble approach.

Conclusion

Discussions this afternoon haveshown that we are all in Òsearch ofexcellenceÓ in the design of a super-visory framework. We are aware thatan effective Ð if not optimal Ð super-visory architecture should meet atleast the three objectives of financialstability, level playing fields and flex-



33


ibility. And the mechanisms todeliver these objectives are wellidentified:Ð Financial stability will depend on

appropriate microprudentialrules to ensure stability co-ordi-nation between all authorities.

Ð Level playing fields will beachieved by a combination ofthe harmonisation of rules atEU level and the convergenceof supervisory practices acrossthe EU.

Ð Flexibility in rule making can befacilitated by a layered approachto legislation.In all these aspects, work is pro-

gressing and going into the rightdirection. At the current juncture,I consider it appropriate to put theemphasis on an enhanced co-opera-tion and closer ÒnetworkingÓbetween supervisors. This is consis-tent with the conclusion by the firstBrouwer Report that, while no insti-tutional change is needed, there is aneed to enhance the practical func-tioning of current arrangements.

Over time, however, we need toensure that the EU supervisoryarchitecture keeps pace with thegrowing integration of EU financialsectors. In particular, more commonhigh-profile cross-border mergersand the emergence of systemically

important groups from an EU per-spective, together with the growingintegration of EU interbank markets,might call for more integrated formsof supervision.

Supervisory integration will haveto be commensurate with marketintegration. You are well aware ofthe different models that can beenvisaged, ranging from centralsupervision of major systemicallyimportant groups Ð a favourite con-cept from a financial stability per-spective Ð to the establishment of asingle EU agency for the regulationand supervision of the whole finan-cial sector under one roof.

You might also have in mind theÒwarningÓ that the creation of a sin-gle EU regulatory authority forfinancial services might be envisaged,in case the Lamfalussy approachcould not be implemented success-fully. It is difficult to predict the paceof integration and it is too early totell which architecture will be mostsuited in ten years. But the questionwill arise again, sooner or later. §

References

European Central Bank (1999). The

Effect of Technology on the EU Banking

Systems.

Euro-Area Banking at the Crossroads(2001) IMF Working Paper, March.




Arturo Estrella


Comments on

David T. Llewellyn,

ÒA Regulatory Regime

for Financial StabilityÓ

IntroductionThe current international system ofcapital regulation, originated by theBasel Committee on Banking Super-vision in 1988, has been the subjectof extensive skepticism over the pastfew years. Perhaps it is a bit surpris-ing that this wave of criticism hasbeen led by the Basel Committeeitself. In the introduction to a newproposal (Basel Committee, 1999)the Committee expounded on theshortcomings on the 1988 CapitalAccord, in particular on those short-comings that surfaced with the intro-duction of numerous financial inno-vations in the intervening period.With the Basel Committee itselfquestioning the adequacy of the cur-rent regulatory structure, this is aneminently appropriate moment toreconsider the optimal frameworkof bank capital regulation from theground up, as Llewellyn does in his

Arturo EstrellaSenior Vice Preident,

Federal Reserve Bank of New York


contribution to the OesterreichischeNationalbankÕs 29th Economics Con-ference.

David T. LlewellynÕs paperfocuses neither on the existingaccord nor on the revised newproposal issued by the Basel Com-mittee (2001). Instead, the paperproposes a broad regime that over-laps with many of the elements ofthe new accord, while at the sametime focusing on issues not explicitlyin the accord. The correspondenceof some elements in the new

accord and in LlewellynÕs frame-work is clearly visible, whereasfor some others the relationship issubtler.

Overall, this discussant findslittle to disagree with in LlewellynÕsthoughtful approach, which in away makes the job of a discussantmore difficult. Therefore, ratherthan attempting to criticize theapproach, the principal strategy ofthis discussion is to provide a frame-work within which to examine theproposals of the paper and to identifysome areas that perhaps requiremore attention than is devoted tothem in the paper. In addition, thereare a few minor issues with which itseems warranted to quibble. Thus,the rest of this comment reviewsLlewellynÕs proposed regime, elabo-rates on the structure of the bankingsystem, considers the responsibilitiesof banks in the regime, and discussesLlewellynÕs explicit recommenda-tions.

Componentsof a Regulatory RegimeWe begin with a review of the sevencomponents of LlewellynÕs regula-tory regime. The objective is notto replicate his already clear exposi-tion, but to emphasize aspectsthat will later clarify the position ofeach of the components in thestructure of the banking system.In addition, a critical review ofsome of the components will bringto the fore some minor departuresfrom LlewellynÕs analysis.

In fact, we beginwith a modificationof LlewellynÕs statedrationale for regulation,which will play a role inthe subsequent analysis.Llewellyn states thatregulation is necessaryas a result of external-ities, market imperfec-

tions, moral hazard arising fromsafety nets, and other such deviationsfrom a perfect market. It seems clearthat all of these phenomena can beused and have been used to justifybank regulation. However, it shouldalso be clear that banksÕ incentivesare in most cases aligned with regula-tory objectives. In particular, bankowners have an incentive to preservethe charter value of the bank andbank managers have an incentive toprotect their jobs and reputation.Thus, owners and managers gener-ally share the interest of regulatorsin avoiding the failure of the bank.In some pathological cases, thebanksÕ incentives may differ fromthose of regulators, and it is on thosecases that regulation and supervisionshould focus.

The first component of Llewel-lynÕs regime consists of regulatoryrules, which constitute the mostvisible and best known aspect ofmost current regimes. Thesetypes of rules were not always

Arturo Estrella


34


around,1) but have become com-monplace with the introduction ofthe 1988 Basel Capital Accord andare often considered the embodi-ment of capital regulation world-wide.

Initially, capital rules were basedon very simple ratios, such as theratio of equity to total assets (knownas the leverage ratio). These ratiossubsequently became more complex(as in the 1988 Accord) and morerecently (Basel Committee, 1996)have included direct measures of risksuch as value at risk (var). In the newBasel Accord, regulatory rules arefound mostly in Pillar 1 of the pro-posal. One characteristic that allthese rules share is that they involvethe application of a formula to afairly standardized set of data. Therelationship between the raw dataand the required amount of capitalis largely mechanical.

Llewellyn does not dispute thevalue of capital rules, but questionsthe balance of the weight assigned tothese rules in current regulatoryregimes, which seems to him exces-sive. This conclusion is essentiallythe same as that of Estrella (1998),which points to the difficulties arisingfrom the inflexibility of a purelymechanical approach to capital regula-tion. For instance, mechanical regula-tion is not well suited to the treatmentof new financial instruments, whichare frequently designed to avoid theeffects of the regulation itself.

Why is mechanical regulation soattractive? One reason is that it isseen to minimize the problem of reg-ulatory moral hazard, in whichsupervisors may apply excessive for-bearance in the face of adverse finan-cial and economic conditions. Aclear mechanical rule is seen as diffi-cult to bypass. A second reason is

that mechanical rules seek to providea level playing field for institutions ofdifferent types or across nationalboundaries. Finally, supervision-based regulation, which requiresgreater judgment than mechanicalrules do, also requires greatersophistication on the part of super-visors and auditors.

It is unclear that any of the fore-going reasons can be used to supportexclusive reliance on mechanicalrules. Regulatory moral hazard is apotential problem, but it may be

addressed with simple contractualrelationships that tie the supervisorsÕhands only in pathological cases. Sec-ond, mechanical rules do not neces-sarily provide a level playing field.When the same rules are applied tobanks in different legal systems, dif-ferent accounting systems, and dif-ferent financial market structures,the results can hardly be expectedto be the same. Finally, increasingthe level of sophistication of super-visors seems both desirable andunavoidable.

Another reason for reliance onmechanical rules is the hope orexpectation that such rules will beable to define the ÒcorrectÓ or Òopti-mumÓ level of capital that a bankshould hold. Estrella (1995) arguesthat the concepts of minimum capitaland optimum capital are conceptu-ally quite different, and that it canbe problematical to attempt to cap-

1 In the United States, capital rules were introduced at the federal level in 1981 and the 1988 Accord was adoptedin regulation dating from 1989.

Arturo Estrella



ture both in a single measure ofregulatory capital.

In order to avoid the foregoingproblems, Llewellyn points to theso-called pre-commitment approachto capital requirements, in whichbanks themselves set capital require-ments based only on minimal guid-ance from regulators. However, it isnot clear that such an approach isbeing pursued anywhere in the worldtoday. In the United States, where itwas first proposed, the original advo-cates (Kupiec and OÕBrien, 1998)have since concluded that the infor-mational requirements of theapproach are so large as to make itinfeasible in practice.

The foregoing extensive discus-sion of regulatory rules is motivatedby the conviction, shared with Lle-wellyn, that they require less relativeweight in the overall regulatoryregime. The other seven elementsof the regime will now be discussedmore briefly.

The second element consists ofmonitoring and supervision by officialauthorities. This element correspondsquite clearly to Pillar 2 in the newBasel approach. Reliance on super-vision is important because banks typ-ically need to hold more capital than amechanical minimum requirement islikely to imply, and because super-visors have the flexibility to assessthe additional cushions held by banksin different circumstances.

The third element of the regimeinvolves incentive structures, which maybe incorporated in the laws, regula-tions, and corporate structuresunder which banks operate. As such,these elements may be found in therules that apply to both supervisors

and banks. To a certain extent, thiselement overlaps with regulatoryrules, but is broader in conceptionand application.

The fourth element is market dis-cipline, which once more corre-sponds clearly to one of the compo-nents of the new Basel Accord, inthis case to Pillar 3. One difficultyin making this an element of the reg-ulatory regime is that it is not neces-sarily under the control of legal andregulatory authorities. These author-ities can promote the developmentof market discipline and can avoidmeasures that may impede theproper transfer of information andfunctioning of the markets. How-ever, in the final analysis, the onusof market discipline falls on marketparticipants themselves.1)

LlewellynÕs fifth element is inter-vention arrangements. These arrange-ments can be viewed as a separatecategory, but they could also be sub-sumed in the regulatory rules, orperhaps into supervision and moni-toring, as they are in the case ofPillar 2 of the new Basel Accord.

The sixth element is corporategovernance. As in the case of marketdiscipline, this is an element that reg-ulators can promote and avoidimpeding, but which must ultimatelybe implemented by the market, inthis case by corporations themselves.

The seventh and final element,accountability of regulatory agencies,could well be contained in rules andmonitoring, as in Pillars 1 and 2 ofthe Basel proposal. LlewellynÕs paperdoes not include much discussion ofthis element. Perhaps his subsequentwork could expand on this particulartopic.

1 We note that the proposals for minimum requirements on subordinated debt, discussed extensively by Llewellyn,have been rejected in a recent report from the U.S. Federal Reserve and Treasury Department (2000). The reportconcluded that the proposals, in focusing mostly on the benefits of such regulation, have failed to take sufficientaccount of the costs of mandatory subordinated debt. A similar conclusion based on corporate finance theory isreached by Estrella (2000).

Arturo Estrella



Structureof the Banking SystemIn order to examine the incidence ofLlewellynÕs seven elements, we pro-pose a framework for viewing thestructure of the banking system.The framework contains three levelsof operation. First, there are theagents who operate in the bankingmarkets in different capacities.Among these are banks, supervisors,and investors. Second, there is theinfrastructure upon which they allact. This infrastructure containslaws, regulations, and corporatestructures. Third, we have the build-ers of the infrastructure, who designthe regulatory regime, includinglegislatures, regulators, courts, andcustom. ÒCustomÓ refers to thecollection of business practices Ð for-mal and informal Ð that evolve overthe years, and which constitute thecultural backdrop of the bankingindustry.

Table 1 shows the structuredefined in the foregoing paragraphand locates within that structurethe seven elements of LlewellynÕsregulatory regime. As a reminder,the seven elements are:1. Regulatory rules,2. Monitoring and supervision,3. Incentive structures,4. Market discipline,5. Intervention arrangements,6. Corporate governance, and7. Accountability of regulatory

agencies.

We see from the table that thedistribution of the seven elementscovers almost every cell in the Òinfra-structureÓ and ÒagentsÓ columns. Theone cell that is not explicitly coveredby any of the elements is ÒbanksÓthemselves. This analysis suggeststhat it may be useful to considernot only the elements that a regula-tory regime should impose on banks,but also the responsibilities thatbanks should impose on themselves.Recall that we argued earlier thatbanks have an interest in self-preser-vation, derived at least in part fromthe desire of owners to protect char-ter value and of managers to protecttheir jobs and reputations. If so,banks can and should take certainmeasures to contribute to the effec-tiveness of the regulatory regime.In the next section, we considersome steps that they can take in thisregard.

Responsibilities of Banks

A simple way of defining banksÕ ownrole in the regulatory regime is pro-vided by Pillar 2 of the new Baselproposal, which focuses on theSupervisory Review Process. Eventhough the stated objective of thatsection of the proposal is to look atsupervision, it establishes some clearguidelines for banks themselves tofollow. The following principles arequoted from the Pillar 2 document.

The supervisory review processis based on four key principles:

Table 1

Banking System

and Location of the Seven Elements of LlewellynÕs Regime

Builders Infrastructures Agents

Legislatures

RegulatorsCourtsCustom

Laws1., 3., 5., 7.Regulations1., 3., 5., 7.Corporate structures3., 6.

BanksÐSupervisors2.Investors4.

Arturo Estrella



Principle 1: Banks should have aprocess for assessing their overallcapital adequacy in relation totheir risk profile and a strategyfor maintaining their capitallevels.Principle 2: Supervisors shouldreview and evaluate banksÕ inter-nal capital adequacy assessmentsand strategies, as well as theirability to monitor and ensuretheir compliance with regulatorycapital ratios. Supervisors shouldtake appropriate supervisoryaction if they are not satisfiedwith the result of this process.Principle 3: Supervisors shouldexpect banks to operate abovethe minimum regulatory capitalratios and should have the abilityto require banks to hold capitalin excess of the minimum.Principle 4: Supervisors shouldseek to intervene at an earlystage to prevent capital from fall-ing below the minimum levelsrequired to support the riskcharacteristics of a particularbank and should require rapidremedial action if capital is notmaintained or restored.Thus, we see that onus is on

banks to (1) have a process for assess-ing the overall adequacy of capitaland (2) operate above the minimumregulatory ratio. On their part,supervisors must (1) review the cap-ital adequacy process of banks and(2) take appropriate actions torequire banks to hold capital abovethe minimum and to intervene earlyif necessary.

Conclusions

Llewellyn concludes with six recom-mendations, and we conclude with areview and prioritization of thoserecommendations. Most of them fol-low directly from the seven elementsof the regulatory regime, althoughsome require a greater degree of

extrapolation from the analysis ofthe paper. Briefly, the recommenda-tions are:1. Less emphasis on formal pre-

scriptive rules,2. Greater focus on incentive struc-

tures,3. Strengthen market discipline and

monitoring,4. Differentiate banks and other

financial businesses,5. More emphasis on internal risk

management and control, and6. Strengthen corporate gover-

nance mechanisms.The first recommendation is

important. Taken together withnumbers 2, 3 and 5, it implies arefocusing of the regulatory struc-ture away from mechanical rulesand toward supervision and marketdiscipline. In this sense, the recom-mendations are consistent with theapproach of the new Basel proposal,which supplements the rules ofPillar 1 with the supervision andmarket discipline of Pillars 2 and3. The key question that arises inthis regard is how the increasedemphasis on incentive structures,internal risk management and mar-ket discipline is to be accomplished.BaselÕs Pillar 2 suggests how super-vision can play a role, and Pillar 3how the market may be allowed tooperate efficiently.

A question arises with regard torecommendations 3 and 6, namely,whose responsibility is it to effectthe necessary measures? To a greatextent, incentive structures and gov-ernance mechanisms are institutedby firms themselves and by marketforces, and the direct active role ofthe regulator may be somewhat lim-ited. Finally, with regard to recom-mendation 4, we note that it seemsto go against the current trend infinancial markets, which goes in thedirection of less differentiation, notmore.

Arturo Estrella


35


How should these recommenda-tions be prioritized? The individualgoals are important, but it is alsoimportant that the regulators andthe other ÒbuildersÓ in Table 1 havethe means at their disposal to achievethe goals. For this reason, recom-mendations that involve improve-ments in supervision, for instancerecommendation 5, would seem tobe the most attainable at this pointin time. There is much to be saidin favor of LlewellynÕs call for bal-ance among the various elements ofthe regulatory regime. However,the overall task is large and it is diffi-cult to attack every single issue atone time. In the short run, a pushto improve supervision may havethe highest payoff. §

References

Basel Committee on Banking Super-vision (1996). Amendment to the Capital

Accord to Incorporate Market Risks. Bank

for International Settlements, Basel, Swit-

zerland, January.

Basel Committee on Banking Super-vision (1999). A New Capital Adequacy

Framework. Bank for International Settle-

ments, Basel, Switzerland, June.



Basel, Switzerland, January.

Estrella, A. (1995). A Prolegomenon to

Future Capital Requirements. In: Economic

Policy Review, Federal Reserve Bank of

New York, July.

Estrella, A. (1998). Formulas or Super-

vision? Remarks on the Future of Regula-

tory Capital. In: Economic Policy Review,

Federal Reserve Bank of New York, Octo-

ber.

Estrella, A. (2000). Costs and benefits of

mandatory subordinated debt regulation

for banks. Federal Reserve Bank of New

York, working paper.

Board of Governors of the FederalReserve System and United StatesDepartment of the Treasury(2000). The Feasibility and Desirability of

Mandatory Subordinated Debt. Washing-

ton DC., December.

Kupiec, P. H. and OÕBrien, J. M. (1998).Deposit Insurance, Bank Incentives, and

the Design of Regulatory Policy. In: Eco-

nomic Policy Review, Federal Reserve Bank

of New York, October.

Arturo Estrella



Norbert Walter


Comments on

David T. Llewellyn,

ÒA Regulatory Regime

for Financial StabilityÓ

David T. Llewellyn has presented astimulating paper because not onlydoes it lay out in great clarity thenecessary design elements of a regu-latory regime, but, more impor-tantly, it also discusses the interrela-tion and interdependence of thoseelements. Thus, Llewellyn drawsattention to the fact that none ofthe regulatory instruments can orshould be used in isolation but ratherthat one should talk about a regulatoryregime which is built from a mix ofthe seven components proposed inthe paper. Llewellyn also rightlypoints out that there are differentcombinations of those elementsyielding equally efficient regimes.Finally, he argues that the optimummix of the components will varybetween countries, over time, andbetween banks.

Norbert WalterChief Economist,

Deutsche Bank


It is hard to add substantial con-tent to LlewellynÕs paper. Conse-quently, I shall, first, provide only afew comments on the paper. Second,I intend to build Ð from a practi-tionerÕs point of view Ð on Llewel-lynÕs comments as to whether theproposed reform of the capitaladequacy accord (ÓBasel IIÓ) corre-sponds to the requirements for anefficient supervisory regime, assketched by Llewellyn.

1 Some comments

1. A minor point to start with:Unfortunately, Llewellyn doesnot discuss the seventh compo-nent of the regulatory regime,i.e. the discipline and account-ability arrangements applied toregulatory institutions. This is aregrettable gap, especially con-sidering that regulatory institu-tions over time have gained evermore influence and autonomyÐ a process that can onlystrengthen in the future.

2. It might be questioned whetherthe Òincentive structureÓ shouldreally be part of the list of com-ponents. It might reasonably beargued that the incentive struc-ture is the result of all the othercomponents rather than a com-ponent in itself. Alternatively,one could reduce the list tosimply this one component, i.e.the incentive structure, as that,fundamentally, is the only thingthat counts. This option wouldprobably be in line with Llewel-lynÕs own thinking as he stateshimself that incentive structuresÒare at the heart of the regulatoryprocessÓ.

3. It is interesting to note that someinternal corporate governancestructures are already part ofthe rules and, indeed, willincreasingly become so. In par-ticular, the Basel CommitteeÕs

ÒCore Principles of EffectiveBanking SupervisionÓ includemany of the elements thatLlewellyn lists under the head-ing of internal corporate gover-nance structures. Most peopleÐ including myself, Ð wouldargue that this is a sensible devel-opment, as it codifies structuresand best practices, which haveproven to be important in orderto avoid financial crises, andmakes them compulsory for allinstitutions. However, followingLlewellynÕs arguments, a moresceptical assessment may be war-ranted: Turning internal controlmechanisms into externallyimposed rules may blunt theireffectiveness and weaken theirincentive structure, as institu-tions might be induced to,henceforth, merely follow theletter of the rules in order to sat-isfy regulators, rather than tofollow the spirit of a self-imposed mechanism in order tosatisfy the own conscience.

4. The question about the rightcombination of componentswithin the regulatory regime isa most intriguing and fascinatingone. First, there is the questionabout whether all componentsmust always be part of the regu-latory regime, albeit in differentcombinations, i.e. with differentweights attached to them.Llewellyn answers in the affirma-tive, which is based on theimplicit assumption that individ-ual components are not fullysubstitutable. But one mightraise the question of whetherthat is indeed the case. Forinstance, it is instructive to recallthat there was a time in history,when there was banking, but noofficial supervision. While suchan arrangement may no longerbe tenable in a modern and com-

Norbert Walter


36


plex financial system, it may beuseful to question whether thepresence of all seven compo-nents in any regulatory regimeis really necessary.Second, as Llewellyn points out,some of the components maybe causally related. This is prob-ably the most interesting aspectof the paper and raises a fascinat-ing set of topics for futureresearch. It implies that the spec-trum of potential choices is morelimited than one might think.It would be a real breakthroughto determine the minimumamounts needed of each compo-nent and the marginal rates ofsubstitution (MRS) between thecomponents. In other words:Could one exchange two addi-tional units of, e.g. market disci-pline for one unit of monitoringand supervision Ð or would it haveto be three? And is that rate ofsubstitution constant or arethere, which I consider likely,decreasing returns to each com-ponent, so that the MRS wouldvary.

5. LlewellynÕs proposal that therebe different financial regimesdepending on the specific charac-teristics of the individual institu-tion and the respective nationalfinancial market raises a lot ofquestions. While it may arguablyenhance the efficiency of regula-tion, it is problematic in view ofthe competitive neutrality ofregulation. It must be kept inmind that the structure of theregulatory regime is a majordeterminant of the competitive-ness of a jurisdiction and thefinancial institutions operatingtherein. There are two factorsdetermining how problematicdifferent regimes are: (1) theextent of market integrationand (2) whether one puts more

emphasis on the neutrality ofinstruments rather than the neu-trality of results of regulation.First, the extent of market integra-tion is relevant on two levels:between national markets andwith respect to the blurring ofborders between market seg-ments. As to the former, thecoexistence of a global financialmarket and regulation stillbroadly organised along nationallines is creating tension. Withnational agencies regulating inparallel in a singlemarket, the princi-ple of competitiveneutrality is at risk.Besides, the regu-latory environmentis actually one keyfactor affectingmarket integration.For example, exist-ing deficiencies are a seriousobstacle to achieving a trulyintegrated European financialmarket. This is not a Òchickenand eggÓ problem; rather, it is amutually reinforcing process. Inany case, international marketintegration has, in fact, pro-ceeded further than is commonlyperceived and it is time that theregulatory environment reactedto that. In a global financialmarket, the profitability, riskstructure, and exposure of banksare influenced by what happensbeyond the borders of the homecountry as well as in theirdomestic market Ð irrespectiveof how active an institution itselfis on international level. As tothe blurring of borders betweenmarket segments, it should beobvious that the same rules mustapply if different institutionsessentially perform the samebusiness, irrespective of whetherthey are incorporated as insur-

Norbert Walter



ance companies, banks, or secur-ities houses.Second, the issue of instrument vs.results neutrality is a complexproblem: Should we be con-cerned that rules are identicalfor everybody (instrument neu-trality) or should we ratherensure that the effective level ofsupervision is identical (neutral-ity of results)? Neutrality ofinstruments seems to be calledfor on grounds of competitiveneutrality, especially as regardshighly prescriptive official regu-lation. It seems intuitive that allmarket participants should besubject to the same rules aslong as they conduct the sametype of business and assume thesame type of risk. However, asLlewellyn rightly points out,treating as equal firms that inpractice are not equal is notcompetitive neutrality. To givean example: Assume that twobanks conduct the same kindof business (e.g. lending to anemerging market government),but that one of the two has avastly superior risk management,higher transparency, and bettercorporate governance. Obvi-ously, this institution wouldimply significantly lower risk tothe stability of the financial sys-tem and would therefore deservea more lenient treatment withrespect to official regulation andsupervision. Thus, somethingseems to speak for striving forthe neutrality of results ratherthan instruments.Nevertheless, such a model isunlikely ever to be imple-mented. To put such an ideainto reality, there would have tobe a system of supervision thatwas constantly tailored to theindividual institution Ð no meanfeast given the seven components

of the regime and given thatthe institution itself constantlychanges, which requires thatthe mix of components beadapted accordingly! It is highlyimprobable that any regulatorwould live up to this task. Inaddition, leaving too much dis-cretion to regulators and banksin devising their optimal, tailor-made regulatory regime carriesthe serious danger of introducingcompetitive distortions into thesystem.

2 Does Basel II live upto the requirementslaid out by Llewellyn?

Before assessing Basel II in greaterdetail, let me emphatically underlineLlewellynÕs statement that Òthe pres-ence of an economic rationale doesnot justify everything that a regulatordoesÓ and that Òthe case for regula-tion does not exclude a powerful rolefor other mechanisms to achieve theobjectives of systemic stability andlegitimate (but limited) consumerprotectionÓ. Not everything thatcan be regulated by rules needs tobe regulated or, as Alan Greenspanonce put it: ÒThe physicianÕs admon-ition: ÔFirst do no harmÕ is a desir-able starting point for bank super-visors as well.Ó I also fully agree withLlewellynÕs assessment that thereneeds to be a shift within the regime,in particular towards an enhancedrole for market discipline, towardsless reliance on detailed and pre-scriptive rules and a greater focuson incentive structures. The morecomplex banking operationsbecome, it is likely that less reliancecan and should be placed on detailedand prescriptive rules. While it isprobably true that it would neverbe possible to fully substitute marketdiscipline for rules, it is equally truethat market discipline must assume agreater role.

Norbert Walter



Fortunately, for all its deficien-cies as to the details, Basel II in itsgeneral conception reflects thesetwo premises. In a way, by proposingthe three-pillar system, Basel II cer-tainly moves into the direction ofthe concept of a regulatory regime asproposed by Llewellyn. There is gen-eral agreement that Basel II is a sen-sible move into the direction of aregulatory regime striking a betterbalance between the different com-ponents than has been the case hith-erto. Thus, the intellectual spirit ofthe Basel II approach and LlewellynÕsproposal is very similar, indeed.

The revision of the CapitalAccord offers a great chance to bet-ter align banking supervision withmarket practices and to set incen-tives for further progress in the riskmanagement process of banks.Basel II will remove the distortionsin incentives which have arisen fromthe possibility of regulatory arbitrageintroduced by Basel I.1) The BaselCommittee explicitly recognises thata major role of supervisors is toensure that banks have suitable proc-esses in place, which ensure that tar-gets for capital are set at levels whichare commensurate with the bankÕsrisk profile. The recognition of inter-nal ratings is an important element inproviding incentives for banks toimprove their risk management.

It is particularly welcome thatthe Basel Committee explicitlypoints out that the three pillars aremutually reinforcing and must beseen as a package Ð a notion that is,incidentally, very much in line withLlewellynÕs point that there aretradeoffs between the different com-ponents of the regulatory system.

So much for the good part, i.e.the general conception of Basel II.Unfortunately, at least in its current

form (i.e. based on the second con-sultative document) the reality andthe implications of Basel II fall wellshort of achieving those generalaims. Let me address the three pillarsin turn.

Pillar 1While emphasis is given in princi-ple to banksÕ improving their inter-nal risk models and risk manage-ment, the accord will offer onlylimited incentives to move to themore sophisticated approaches.

Ð The Basel Committee intro-duced caps and floors for theuse of the more advanced inter-nal methodologies as well as forthe recognition of credit riskmitigation instruments. TheCommittee expects that thefoundation approach will resultin a reduction of risk weightedassets (RWA) of 2% to 3%compared to the standardisedapproach. For the advancedapproach, for the first two yearsafter implementation a floor willbe set at 90% of capital require-ments as would result fromfoundation approach. Caps oncapital relief are inconsistentwith the objective to offeradequate incentives for banks toimprove their internal processes,would cause unnecessary doublework, and should therefore bedropped.

1 The deficiencies of the existing Basle Capital Accord are amply known by now and have been discussed to greatlength in several studies Ð including the brief summary in LlewellynÕs paper.

Norbert Walter



Ð There is a double counting ofexpected loss both for creditand operational risk, whichresults from an inclusion ofexpected loss into the calibrationof regulatory capital require-ments. This is neither economi-cally justified, as expected lossis part of the normal cost ofdoing business and shouldalready be covered by risk provi-sions and accounted for in prod-uct pricing; nor would it fosteran alignment of regulatory andeconomic capital.

Ð The much broader recognition ofcredit risk mitigation as pro-posed by the Basel Committeeis very much in line with indus-try expectations. However, weare concerned with potentialdistortive effects resulting fromthe introduction of the ÒwÓ-factor as a floor for capitalrelief.

Ð With regard to operational risk,Deutsche Bank appreciates thatthe Basel Committee followsindustry proposals to allow thechoice between different meth-odologies for the determinationof a capital charge for opera-tional risk with a varying degreeof sophistication. However, weare concerned of the level ofdetail with regard to the quanti-tative and qualitative require-ments for the use of sophisti-cated regulatory capital options.Banks will be burdened with acomplex set of regulatoryrequirements whilst the opera-tional risk (OR) capital chargebenefits are still unclear. It is alsoa matter of concern that the basicindicator approach does not con-stitute a risk-sensitive measure.In fact, it would lead to theabsurd result, that banks whichmanage to realize higher earn-ings would be punished for doing

so by a higher capital charge foroperational risk.

Pillar 2Deutsche Bank, in principle,acknowledges that more individual-ised supervision is the logical conse-quence of the recognition of internalmethodologies as was demanded bythe industry. However, as the experi-ence with the review process formarket risk models shows, inter-nationally active financial institu-tions are often confronted with dif-ferent standards and conflictingrequirements from various nationalsupervisors for the application ofinternal methodologies. Not infre-quently, this results in prohibitiveworkloads and costs. Therefore, theÔhome state regulatorÕ should havethe ultimate responsibility for therecognition and group-wide applica-tion of internal methodologies, andthis should be firmly declared inPillar 2.

It is appreciated that the BaselCommittee recognizes that Òtheemphasis of the supervisory review processshould be on the quality of the bankÕs riskmanagement and controls and should notresult in supervisors functioning as bankmanagementÓ. The ultimate responsi-bility for business decisions has tostay with the senior management ofa bank. Shareholders, market forces,and regulations provide directionsand limitations, but cannot and mustnot be a substitute for managementdecisions. However, there is legiti-mate concern that the supervisoryreview process could indeed takeon the quality of managing a bank ifnot appropriately framed by stand-ards and limits, i.e. if it is not definedwhere supervision turns into man-agement. This view is fully in linewith one of the overriding principlesattached to the supervisory reviewprocess, namely: ÒSupervisors musttake care to carry out their obliga-

Norbert Walter


37


tions in a highly transparent andaccountable mannerÓ.

While it is true that too detailedand prescriptive a rule-book may addcompliance costs without providingcommensurate benefits, it is neces-sary to strike a balance between theadvantages of discretion and the dan-gers of unequal treatment, whichmay result in distortions to competi-tion due to regulatorsÕ actions. Itshould be emphasised that DeutscheBank does not call for a detailed cata-logue of minimum requirement forsupervisors that would not leave anappropriate amount of national dis-cretion to reflect the respective mar-ket structure and culture of super-vision.

While we agree with the Com-mittee that additional capital require-ments are not in all cases the appro-priate solution to address deficien-cies in the risk management proc-esses of banks, we disagree with theview taken by the Basel Committeeon capital increases, namely to sug-gest that Òincreased capital might beused as an interim measure whilepermanent measures to improve thebankÕs position are being put inplaceÓ. It should be well understoodthat capital measures cannot instanta-neously be switched on or off with-out causing potentially severe distor-tions.

Furthermore, Deutsche Bankdoes not see the need for other cap-ital ratios than the minimum regula-tory capital ratio to be introduced bysupervisors and monitored for indi-vidual banks. The so-called triggerand target ratios would result insupervisors trying to micromanagebanksÕ capital and would cause con-fusion rather than add to the stabilityof financial markets. (In contrast,LlewellynÕs support for a StructuredEarly Intervention and Resolution(SEIR) system is obviously very closein spirit to the proposals of the Basel

Committee.) If national supervisorsdecide to apply higher capital ratiosto all banks in their jurisdiction(well-capitalised ratios) these shouldnot be applicable to foreign banksoperating in this country on agroup-wide basis. Otherwise, notonly would the capital rules accord-ing to the Basel Accord, but alsothe responsibilities of the Òhomestate regulatorÓ be undermined.

Finally as to Pillar 2, Llewellynrightly draws attention to the factthat this will require a high standardof sophistication on thepart of bank super-visors Ð somethingthat, despite their highmotivation and com-mitment, is not assureddue to the fact thatmost supervisory agen-cies Ð operating, as theydo, within the narrowconfines of a public-sector budget Ðlack the appropriate financial meansto attract highly qualified professio-nals.

Pillar 3It is highly welcome that the pro-posed new Basel Accord explicitlyacknowledges market discipline asone of the three pillars on whichthe future capital adequacy regimewill rest. Deutsche Bank stronglywelcomes Pillar 3 and views it asan important innovation of the newBasel Capital Accord. Better disclo-sure standards will have a powerfulimpact through self-regulation ofthe market. Attempts should beencouraged to use self-regulationwherever possible as a substitute(not only as a supplement) to super-visory intervention.

However, besides the require-ment for a formal bank policy fordisclosure (including objectives,strategy, review process) the rangeof intended requirements comprises

Norbert Walter



very detailed basic, as well as highlycomplex, qualitative and quantitativeinformation. Thereby, the currentproposals go significantly furtherthan the CommitteeÕs initial objec-tives that were stated in the first con-sultative paper. The information anddata required exceed practicaldimensions. There is also legitimateconcern about the disclosure of pro-prietary information (e.g. internalmodels).

Pillar 3 is intended to allow theÒreasonableÓ investor to get a clearpicture of a bankÕs risk profile andcapital position in order to assessits ability to absorb losses. However,it remains questionable whether thesheer amount and the complexityof disclosed information would not

result in an Òinformation overkillÓthat could lead to misinterpretationsor rational ignorance. The super-visory approval seal on the qualityof the banksÕ internal methodolo-gies and risk strategies should sufficeto meet investorsÕ information andlevel of safety requirements. Volun-tary disclosure continues to expandrapidly among financial institutions.Overburdening the industry withmandatory, inflexible disclosurerequirements rather than strengthen-ing this market-driven approachwhich is highly responsive to investorrequirements could stifle innovationand prevent the timely reflectionof fast moving market develop-ments. §

Norbert Walter




Karl-Heinz Grasser

38


Dinner Speech:

Aktuelle Themen

der Budgetpolitik

Sehr geehrter Herr Gouverneur,verehrte Damen und Herren! Ichfreue mich sehr u¬ber die Einladungzur Volkswirtschaftlichen Tagungder Oesterreichischen Nationalbank.Sie werden sich sicher noch an dievorja¬hrige Veranstaltung erinnern,an der einige von Ihnen bereits Gastund auch Zeuge waren, dass wirwesentlich mehr ãGa¬steÒ hatten, alseigentlich eingeladen waren. Diediesja¬hrige Veranstaltung wird sichdeutlich hievon unterscheiden. Ichdarf mich auch freuen daru¬ber, dassso viele Vertreter aus verschiedens-ten La¬ndern, besonders aber ausden Nachbarla¬ndern, zu uns gekom-men sind.

Gouverneur Liebscher hat esbereits angesprochen: Wir habeneine Ð so glaube ich Ð wesentlicheWende in der Finanzpolitik O¬ ster-reichs im letzten Jahr eingeleitet,eine Wende in Richtung Konsolidie-rung und in Richtung ausgeglichenerHaushalt. Es ist eine Konsolidierung,die ab dem Jahr 2003 zu mehr alszwei Dritteln auf der Ausgabenseitebasieren wird und nur zu etwa einem

Karl-Heinz GrasserBundesminister fu¬ r Finanzen

der Republik O¬ sterreich


Drittel auf der Einnahmenseite. Wirhaben uns zu bedeutenden struktu-rellen Reformen in der o¬ffentlichenVerwaltung bekannt und werden imJahr 2003 zumindest eine Ersparnisvon rund 0,5% des Bruttoinlands-produktes, also rund 15 Mrd ATS,alleine im o¬ffentlichen Bereich er-bringen. Bereits im vergangenen Jahrhaben wir eine Pensionsreformbeschlossen, um in der ã1. Sa¬uleÒder Altersversorgung die Nach-haltigkeit der Finanzierung zu ver-bessern. Wir konnten auch ein

Bekenntnis der o¬ster-reichischen Bundes-la¬nder und Gemeindenzur Budgetkonsolidie-rung in O¬ sterreicherreichen. Damit ist eszu einer gesamto¬ster-reichischen Anstren-gung geworden, denHaushalt zu konsolidie-

ren. Der Finanzausgleich zwischendem Bund und den La¬ndern leistetdazu einen sehr deutlichen Beitrag.

Jeder hier im Zuho¬rerkreis, derdie Politik der o¬sterreichischen Bun-desregierung verfolgt, muss, so hoffeich, erkennen, dass wir uns der Glo-balisierung, dem Wettbewerb unddem zunehmenden Konkurrenz-druck als Chance und auch alsHerausforderung fu¬r unser Land ver-schrieben haben. Wir schaffen es Ðtrotz Konsolidierung des Haus-haltes Ð, Schwerpunkte in Bezugauf die Verbesserung der Qualita¬tder o¬ffentlichen Finanzen zu setzen.Beispielhaft haben wir eine Sonder-offensive fu¬r Forschung und Ent-wicklung fu¬r die na¬chsten drei Jahregestartet, weil wir wissen, dass wirInnovationen, neue Produkte, eineRestrukturierung der Wirtschafthin zur New Economy auch in O¬ ster-reich vorantreiben mu¬ssen, um iminternationalen Wettbewerb stand-halten zu ko¬nnen. Wir habenSchwerpunkte im Bereich der Bil-

dung und Ausbildung gesetzt undwir haben auch Ð trotz Konsolidie-rung der Haushalte Ð, was dieInfrastrukturinvestitionen anbelangt,deutliche Steigerungen in derGro¬§enordnung von 25% bis 30%der bauwirksamen Investitionen inO¬ sterreich erreichen ko¬nnen.

Zu dieser Globalisierung, zumliberalen Zugang einer Wirtschafts-und Finanzpolitik geho¬rt auch eineumfassende Privatisierungsoffensive.Wir haben einige Unternehmen, andenen die Republik nach wie vorwesentlich beteiligt ist. Wir sindinmitten einer, wie ich meine, sehrerfolgreichen Privatisierung, dieauch Druck auf all diese Unter-nehmen ausu¬bt, was ihre Ergebnis-entwicklung, was ihre strategischePosition auf den Ma¬rkten und Ð soerforderlich Ð was einen Turnaroundbetrifft. Dies alles ist von einemGrundsatz getragen, na¬mlich privatist besser als Staat im Bereich derUnternehmensfu¬hrung mit all denEffekten auf Wachstum, Bescha¬fti-gung und Wertscho¬pfung in O¬ ster-reich. Die Bundesregierung verfolgtauch eine Politik der Liberalisierungim Gas- und Strombereich. Wirhaben im Gegensatz zu anderenLa¬ndern Ð Sie kennen die Diskussio-nen auf europa¬ischer Ebene Ð eineLiberalisierung im Strombereichbeschlossen, die bereits im Oktober2001 wirksam wird und wir errei-chen den gleichen Liberalisierungs-grad im Gasbereich im Oktober2002. O¬ sterreich liegt hier in derLiberalisierung weit vor vielen ande-ren La¬ndern, was im U¬ brigen auchfu¬r die Freiheitsgrade der Wirt-schaft gilt.

Ladies and gentlemen, Mr.Liebscher told me that we have someproblems with our interpreters, so Icannot continue in German, but I tryto switch into English.

Regarding liberalization in theenergy sector in the European

Karl-Heinz Grasser



Union, Austria will achieve therequired steps in the electricityand in the gas sector at a very earlytime. An analysis conducted by sev-eral institutions and presentedrecently examines the degrees offreedom of an economy and showsthat Austria made a huge step for-ward in the rankings: from number25 to number 15 of all countriesin the world. Looking at the recentWorld Competitiveness Report, wehave advanced forward for the thirdyear in a row. I think our most recentranking was 14th in theworld. Let me mentionanother study carriedout by the InstitutionalInvestor, in which wewere ranked number16 in September lastyear and our actualranking is number 9.So it is my impressionthat also international institutionstake into consideration what we aretrying to achieve by our policy of lib-eralizing the market and taking theprocess of globalization as an oppor-tunity for Austria.

Let me now say some words tothe economic policies of the Euro-pean Union: It is my opinion thatLisbon was a very important signalfor the European Union and forAustria as well; it was a signal to cre-ate a knowledge-based society, it wasa signal for the European Union, itwas a signal for innovation and itwas a signal for research and devel-opment, too. That was importantfor all of us and I really think weshould work toward fulfilling theobjectives. At the same time, how-ever, I have to admit that I am a littlebit concerned about the progress weare making in the European Union.Regarding the results of the Euro-pean Council in Nice, from a Euro-pean perspective, Nice was not a suc-cess at all. Considering the Swedish

presidency, I am a little afraid thatthe European Union cannot afford astandstill. Rather, important deci-sions must be made. For example,finance ministers in the Ecofin andalso in the Euro-12 group are discus-sing a lot of structural reforms. As toassessing what is really implemented,as far as structural reforms are con-cerned, I think we should do farmore. Especially looking at networkindustries, harmonization, and flexi-bility of the European labor markets,the progress with pension reforms in

the European Union: I think weshould make an analysis of our needsin these fields for the next 40 to 50years in the European Union. Paral-lel to such an analysis we really musttry to implement reforms of the pen-sion schemes in order to make thefunding of the system sustainable.At the same time we discuss tax har-monization and I think we should beable to make a progress as far as thetax base is concerned. So, if we can-not agree on harmonization in total,we should reach a compromise onthe tax base. We should also be ableto find an agreement on the 66 harm-ful tax measures in the EuropeanUnion and we should come to a faircompetition in the matter of taxes.

So, we have to keep in mind thestructure of policies which necessi-tate reforms. I am convinced thatspeeding up these reforms will alsoincrease the potential growth ofGDP in the European Union. Wecannot accept an (optimistic) grow-ing rate of Ð let us say Ð 3% to

Karl-Heinz Grasser



3.5% in the European Union, whenat the same time the United Statesachieve an annual growth of GDPof Ð let us say Ð 5%. We have toask ourselves: What are the reasonsfor the weakness in the EuropeanUnion and how can we improve thissituation.

This also concerns the progressof the enlargement of the EuropeanUnion. Let me express my opinionvery clearly: We are very optimisticand very much in favor of enlarge-ment because it is important to meet

also the expectations of so many peo-ple in Hungary, the Czech Republic,Poland, in Slovakia, in Slovenia andthe other accession countries. I thinkthese countries have achieved somereally serious progress. Enlargementwill be a win-win situation for theexisting Member States of the Euro-pean Union as well as for the acces-sion countries. But at the same timewe have to consider that with theenlargement the population of theEuropean Union will increase byabout 30%, while the nominalGDP will just increase by about5%. We have to consider that theincome of the poorest presentMember State of the EU is abouttwo thirds of the average GDP percapita in the European Union,whereas the average GDP per capitaof the poorest accession country isbelow one third of the averageGDP per capita of the existingMember States. So, in my mind wewill really have to focus on new chal-lenges as far as cohesion and struc-

tural policies are concerned. Wehave to discuss what are the impactson the sustainability of the financialconcept within an enlarged EuropeanUnion. There are several studies onthis topic, let me mention the studyof Dresdner Bank and the study thatSweden elaborated on. Speakingfrom the view of a net contributorto the EU budget, we should takeinto consideration that in my mindour objective must be to reach afair distribution of the contributionswithin the existing Member States

of the European Union.If you remember Mrs.Thatcher and her suc-cess in reducing thecontributions for theUnited Kingdom, Ithink we have to discussthis question in theEuropean Union. Atthe same time, we

should be able to make some deci-sions in place, shifting benefits fromSouthern Europe Ð from Spain,Greece, Portugal, and also IrelandÐ to the new accession countries. Itis obvious that we must try to speedup their progress, to increase theeffectiveness of investments thereand to support their development.We all know that it is not possibleto keep the existing European finan-cial system unchanged and at thesame time take in new membersand deliver additional benefits tothem. Let me make it very clear:From an Austrian perspective, I amnot in favor of a new tax at Europeanlevel to finance the European Unionbecause Ð in my mind Ð such a deci-sion would take us into the directioncovered by the debate now going onbetween Prime Minister Schro¬der,President Chirac, and Prime Minis-ter Jospin and others. It is the keyquestion: Should there be a cen-trally-governed European Union, acentral state or do we strive toward

Karl-Heinz Grasser


39


the idea of working together and ofthe cooperation of different andindependent states. This debate con-tinues and it will be a long timebefore any decisions are made. Wealso have not yet reached agreementon the question what the competen-ces of European institutions are andhow centralistic Ð or how federal Ðthe European Union should be.

So, in my mind we really have toface this discussion and to see howwe are able to change structuralcohesion policies and to reach anew agreement there.If we take Lisbon seri-ously, we also shouldbe in a position tochange the fiscal policyof the European Unionas a whole. Regardingthe amount of moneytransferred to the agri-cultural sector Ð wespend half of the budget of the Euro-pean Union on agriculture Ð thiscontradicts the idea of a Europe ofinnovation, a Europe of researchand development, or a knowledge-based Europe. So, although it is aserious political question, I reallyhave to say: If we take our own mes-sages and objectives seriously, wealso should be able to move forwardas far as the European budget is con-cerned.

Finally, since today you discussedespecially financial supervision. Youwill be aware that in Austria we arejust discussing a reform of our finan-cial market supervision. I think thatwe developed a good concept, a con-cept that implies serious progress forAustria as presently most of thesupervisory responsibilities arelocated in the Ministry of Financeitself. This holds for insurance andbanking supervision, keeping inmind that the Ministry here is sup-ported by the OesterreichischeNationalbank, but on a material basis

the responsibility remains with theMinistry of Finance. The supervisionof pension funds is another task ofthe Ministry of Finance, and alsosecurities supervision. We intend toestablish a new authority that willbe independent, both politically andconcerning its resources. Thisagency will be responsible for allthose branches of financial super-vision I mentioned before. Regardingthe debate in Germany, GovernorLiebscher handed an article to methat says (in German): ÒMr. Eichel,

Bundesminister der Finanzen inDeutschland, lenkt im Streit mitder Deutschen Bundesbank ein Ðvolle Mitwirkung in Bankenaufsichtzugesagt.Ó So the complete integra-tion of the Bundesbank in Germanyin banking supervision is granted.Let me say: We already achieved acomparable solution in Austria, sothere is no need to make furthersteps in the direction Germanyannounced. It is my opinion thatnot all functions of banking super-vision should be concentrated withina central bank. The better way is toestablish an independent new institu-tion co-operating with the centralbank. The Austrian Financial MarketAuthority will be an agency that isbuilt in consensus between theMinistry of Finance and the Oester-reichische Nationalbank. Both ofthem will do their best to supportthat institution, will decide jointlyon the new management, and willconstitute the new supervisory boardof that agency. So I think we are

Karl-Heinz Grasser



creating a financial market super-vision which is in line with the trendof organizing financial supervision inthe European Union. Since I knowthat there are many representativesof central banks in the auditorium,it was really not a surprise when Pro-fessor Bruni told me: The ECBÕsfeedback on our reform is an analysiswhich takes our reform seriously,but it is not really very much in favorof that reform. This position is to beexpected from the point of view of acentral bank. So, taking the freedomof a Minister of Finance, I would say,if the ECB is not totally against ourconcept and we seriously have dis-cussed on how we can adapt thatconcept, then at the end of the day

it will be possible to make a reformto which both, OesterreichischeNationalbank and Ministry ofFinance, can agree. It is clear to methat there is a very high need ofinvolving central banks in financialsupervision. On the other hand, Iam strongly convinced that financialsupervision is a core competence ofevery state. In this sense, dividedpowers between central banks andsupervisory authorities are the bestconcept in this area.

Thank you very much for listen-ing and I hope, you will have a suc-cessful proceeding of the conferenceand Ð if possible Ð a nice weekend inAustria. §

Karl-Heinz Grasser




Wolfgang Schu¬ ssel

40


Kamingespra¬ch:

Aktuelle Themen

der Wirtschaftspolitik

Ich habe das Programm der heutigenTagung kurz u¬berflogen und gese-hen, mit welcher intellektuellenBrillanz und welchen geistigenHo¬henflu¬gen Sie bereits konfrontiertwurden. Ich werde demnach meinenVortrag eher ãdown to earthÒ gestal-ten, und Ihnen eine kleine TourdÕHorizon u¬ber die o¬sterreichischeSituation sowie einen Einblick indas geben, was nun beim Euro-pa¬ischen Rat in Go¬teborg auf euro-pa¬ischer Ebene auf uns zukommt.

Es freut mich, dass in O¬ sterreichdie Dinge gut laufen. Lassen Sie unsdie wirtschaftliche Situation betrach-ten: Das vorige Jahr war das besteWirtschaftsjahr seit Menschen-gedenken. Wir haben den idealenZeitraum fu¬r die Budgetkonsolidie-rung genutzt. Das ist durch die her-vorragende Arbeit des Finanzminis-ters, aber auch durch die guteKooperationen mit den Bundes-la¬ndern, den Sozialpartnern, denpolitischen Gruppen sowie denExperten aus der Wissenschaft undWirtschaftsforschung gelungen. VonErfolg ko¬nnen wir natu¬rlich erst

Wolfgang Schu¬ sselBundeskanzler

der Republik O¬ sterreich


sprechen, wenn mit dem Jahr 2002das Nulldefizit auch wirklich erreichtist. Im Moment sind wir noch mittenin der Arbeit, um auch im Bereichder Verwaltungsreform die von unsangestrebten Ziele zu erreichen.Aber ich bin zuversichtlich, dasswir auch das schaffen werden.Zusa¬tzlich zu den drei beschlossenenBudgets haben wir in diesem Jahrauch das Pensionsantrittsalter umeineinhalb Jahre hinaufgesetzt undden Gas- und Strommarkt vollliberalisiert. Das bedeutet, dass ab

Oktober die wildeFrische des freienMarktes auch O¬ ster-reich erreichen wird.Mit diesen von unsgesetzten Ma§nahmenbefinden wir uns nunin der Spitzengruppeder EU-Liberalisie-rungsla¬nder.

Wir haben wichtige Reformenbegonnen, die zum Teil natu¬rlichauch schmerzhaft und ungewohntãuno¬sterreichischÒ sind. Wir arbei-ten z. B. gerade intensiv daran, dieUniversita¬ten in die Vollautonomiezu entlassen. In Einigkeit mit denGewerkschaften haben wir mit derDienstrechtsnovelle einen gro§enDurchbruch erreicht. Das wesent-lich Neue daran ist, dass es an deno¬sterreichischen Hochschulen undUniversita¬ten in Zukunft keine Prag-matisierungen mehr geben wird.Dadurch haben wir eine ho¬hereFlexibilita¬t geschaffen. Das halte ichfu¬r ein ganz wichtiges Symbol.Zudem fu¬hren wir ab Herbst 2001Studiengebu¬hren fu¬r o¬sterreichischeStudierende ein.

Die Sanierung der Krankenkas-sen und des Gesundheitswesenswurde von uns ernsthaft in Angriffgenommen. Wir befinden uns au§er-dem gerade in einer sehr interessan-ten Diskussion u¬ber ein neues Abfer-tigungsmodell, die hoffentlich noch

dieses Jahr erfolgreich abgeschlossenwerden kann. Die Fragestellung ist,ob die Abfertigung, das ist eine ArtTreuepra¬mie fu¬r lange Betriebs-zugeho¬rigkeit, nicht schrittweise zueiner zweiten Sa¬ule, der Betrieb-spension, umgewandelt werdenkann. Das ist eine faszinierend neueIdee, die auch fu¬r den Kapitalmarktenorm interessant wa¬re. Es gehtschlie§lich um 20 Mrd ATS, dieadditiv jedes Jahr hinzukommenko¬nnten. Damit wa¬re ein gro§erNachfrager auf dem Kapitalmarktgeschaffen. Die Einzelheiten werdenwir noch mit den Sozialpartnern undpolitischen Gruppen aushandeln. Ichglaube jedoch, dass das neue Abfer-tigungsmodell fu¬r O¬ sterreich einerevolutiona¬re Idee darstellt, obwohldiese Form von Abfertigung in ande-ren La¬ndern la¬ngst gang und ga¬be ist.In Deutschland wurde ein etwasanderes Modell entwickelt, das aberin Wahrheit in die gleiche Richtungfu¬hrt.

So viel sei erst einmal zur heuti-gen o¬sterreichischen Situation ge-sagt. Wirtschaftlich geht es uns gut.Wir haben nahezu Vollbescha¬ftigungerreicht, die in Zukunft noch aus-baufa¬hig ist. Unsere Arbeitslosenrateliegt etwa um 3.5%. Ich glaube, dasssich diese auch na¬chstes Jahr nacheiner leichten Einbremsung der Kon-junktur nicht wesentlich erho¬henwird. Trotzdem mu¬ssen wir unsanstrengen, denn wir haben einigesensible Bereiche zu bewa¬ltigen, indenen wir einfach besser werdenmu¬ssen. Einer dieser Themen-bereiche ist der Bildungs- und For-schungssektor. Hier haben wir trotzder Budgetkonsolidierung einenwichtigen Impuls gesetzt. Wir stel-len zusa¬tzlich 7 Mrd ATS fu¬r For-schung und Entwicklung zur Ver-fu¬gung. Vor allem wollen wir fu¬rden Wirtschaftssektor Anreize schaf-fen, die Forschungsta¬tigkeit zu erho¬-hen. Das Ziel lautet eine Forschungs-




quote von 2.5% im Jahr 2005. Dasist erreichbar. Es ist aber nur dannerreichbar, wenn die Wirtschaftihren Beitrag zu den Forschungsaus-gaben massiv erho¬ht. Im ZweitenReformdialog zu Forschung und Ent-wicklung, der vor wenigen Tagenstattfand, hat sich die Wirtschaftbereit erkla¬rt, ihren Beitrag von50 Mrd ATS bis zum Jahr 2005 auchwirklich zu leisten. Es kommt nuneine nationale Kraftanstrengung zurFo¬rderung von Forschung und Tech-nologieentwicklung auf uns zu.Doch die Mu¬he wird sich lohnen,denn damit setzen wir langfristigeinen wichtigen Impuls fu¬r denStandort O¬ sterreich.

Wir mu¬ssen aber auch im IT-Bereich noch besser werden. Umdas zu erreichen, haben wir bereitsin den letzten Jahren Milliardenin die Computerausstattung vonSchulen investiert. Und wir ko¬nnenmit dem Ergebnis zufrieden sein.Alle ho¬heren und weiterfu¬hrendenSchulen O¬ sterreichs verfu¬gen nunu¬ber Internetzuga¬nge. Es ist aberauch fu¬r die na¬chste Zukunft fu¬runs ein Muss, hier weiter aufzuholenund nicht zuru¬ckzubleiben.

Ein Thema der Zukunft sind aberauch die Engpa¬sse auf dem Arbeits-markt. Wenn die Konjunktur eini-germa§en greift, brauchen wirnatu¬rlich auch mehr Arbeitskra¬fte.Daru¬ber wird in O¬ sterreich ebensowie in Deutschland diskutiert. DieFrage ist jedoch: Brauchen wir dafu¬reine erho¬hte Zuwanderungsquoteoder gibt es auch auf dem hei-mischen Arbeitsmarkt Potenzial?Zur Zeit haben wir ungefa¬hr 20.000Arbeitslose. In dieser Zahl liegtPotenzial, denn ein Viertel bis einDrittel dieser Menschen ko¬nntedurch Schulungen und Motivationwieder fu¬r den Arbeitsmarkt ge-wonnen werden. Besonderes Poten-zial liegt in der Bescha¬ftigung vonFrauen. Die Vereinbarkeit von Beruf

und Familie wird das Thema derna¬chsten Jahre werden. Vor allemdie Wirtschaft wird sich hier einigeseinfallen lassen mu¬ssen, um jungenFrauen Job- und Familienchancenzu geben. Das bedeutet unter ande-rem, dass die Ausstattung mitBetriebskinderga¬rten zur Betriebs-realita¬t geho¬ren wird. Potenzial liegtaber auch bei den a¬lteren Arbeit-nehmern. In einer Zeit, in der dieZahl der a¬lteren Bescha¬ftigten gegen-u¬ber den jungen unaufho¬rlich steigt,ko¬nnen wir O¬ sterreicher nicht dentraurigen Weltrekordaufstellen, die ju¬ngstenFru¬hpensionisten zuhaben. Mit dem Hin-aufsetzen des Fru¬hpen-sionsalters haben wireinen ersten Schrittgegen diesen Trendgesetzt. Jetzt geht esaber darum, Motiva-tionselemente zu schaffen und wei-tere mittel- und la¬ngerfristige Ma§-nahmen im Einvernehmen mitArbeitgebern und Arbeitnehmernzu treffen, um von der sta¬ndigenãstop-and-go policyÒ wegzukommen.Es muss einen nationalen Konsensdaru¬ber geben, Berechenbarkeit aufzehn Jahre hinweg zu schaffen. Eskann so nicht sein, dass die Politikervor jeder Wahl den Wa¬hlern dieSicherheit und Besta¬ndigkeit desPensionssystems versprechen. Unddann nach der Wahl kommt dasbittere Erwachen und die damit ver-bundenen kurzfristigen Ma§nahmen.Denn, wenn mich etwas perso¬nlichgetroffen hat und das mit Recht, sowar das die Kritik, dass wir diesmalrelativ kurzfristig handeln mussten.Und diese Vorwu¬rfe mo¬chte ichbeim na¬chsten Mal nicht haben.Deshalb ist es wichtig, dass wir hiereine la¬ngerfristige Perspektive ent-wickeln. Das wird schlussendlichin allen europa¬ischen La¬ndern not-wendig sein und auch O¬ sterreich




wird dabei keine Insel der Seligenmehr bleiben ko¬nnen, denn dieseInselposition gibt es nicht mehr.

Nun zu Europa, denn diesesThema ist ja auch eng mit Wirt-schaftsthemen verflochten. In derEuropa¬ischen Union gibt es derzeitdrei faszinierende Entwicklungs-stra¬nge. Der eine ist die EU-Erweite-rung, der zweite die Einfu¬hrung desEuro, der nun praktische Gestaltannimmt. In wenigen Wochen haltenwir den Euro physisch in Ha¬nden.Damit wird das neue Geld zur kon-

kreten Wirklichkeit.Das dritte Thema sinddie Reform der Institu-tionen und die Diskus-sion um die ZukunftEuropas. All diese Ent-wicklungen schreitenrasch voran. Lassen Siemich das nur kurz anHand der Positionen

der 15 EU-La¬nder bezu¬glich U¬ ber-gangsfristen fu¬r die Freizu¬gigkeitder Arbeitskra¬fte und die Dienstleis-tungen veranschaulichen. Heute um12 Uhr lief die Deadline fu¬r die15 Mitgliedstaaten ab. Das bedeutet,dass die Frist, in der man nochEinspruch zu den U¬ bergangs-bestimmungen erheben konnte, nunabgelaufen ist. Ab heute 12 Uhrhaben wir eine gemeinsame Position.Damit haben wir eines der wichtigs-ten und schwersten Kapitel der EU-Erweiterung abgeschlossen. Natu¬r-lich werden nicht alle Kandidaten-la¬nder damit glu¬cklich sein. Aberangesichts der Tatsache, dass 500verschiedene U¬ bergangsfristen-wu¬nsche der Beitrittsla¬nder aufdem Tisch liegen, wird sich unserePosition als ein vernu¬nftiger und fle-xibler Lo¬sungsansatz zur Entscha¬r-fung der Arbeitsplatzproblematikheraus kristallisieren. Ich hoffe sehr,dass wir auch in der Frage des Kapi-talverkehrs, die derzeit noch vonFrankreich blockiert wird, bis Go¬te-

borg einen Durchbruch schaffen.Damit ha¬tten wir die erste Phaseder Erweiterung in einem sehr ambi-tio¬sen Tempo abgeschlossen.

Der Fahrplan gestaltet sich dem-entsprechend: Anfang 2002 habenwir den Euro auch als Bargeld,Anfang 2003 vielleicht schon die ers-ten neuen Mitglieder und potenzielleMitglieder werden zu diesem Zeit-punkt ihre Verhandlungen abge-schlossen haben. Ein Ziel ist es auch,im Jahr 2003 die Entscheidung u¬berdie Eingreiftruppe der Europa¬ischenUnion zu treffen. Damit stehen derEuropa¬ischen Union 60.000 Sol-daten als milita¬rische Kapazita¬t zurVerfu¬gung. 2004 findet dann dieRegierungskonferenz um dieZukunft Europas statt. Wenn dieserFahrplan ha¬lt, werden wir in einerrasanten Abfolge Themen und The-menblo¬cke bewa¬ltigt haben, die fru¬-her wahrscheinlich fu¬nf, sechs, sie-ben Jahre beno¬tigt ha¬tten.

Eines der gegenwa¬rtig span-nendsten Themen ist die ZukunftEuropas. Diese Diskussion ist umsofaszinierender, weil das Thema neuist und jeder seine Ideen einbringenund Impulse geben kann. Jedochbeginnt man meiner Meinung nachdie Debatte am falschen Ende. DieFinalita¬t Europas definieren zu wol-len, finde ich zwar perso¬nlich einesehr spannende Diskussion, sie wirdjedoch nicht sehr weit fu¬hren. DieseFrage ist seit 50 Jahren unbeantwor-tet, und sie wird auch die na¬chstenzehn Jahre ohne Antwort bleiben.Viel entscheidender ist, dass sichein Konsens in der Frage bildet, inwelchen Bereichen es mehr Europaund in welchen es mehr Subsidiarita¬tgeben muss. Die gestrige gro§eEuroparunde mit allen gesellschaft-lich relevanten Kra¬ften in Wien hatgezeigt, dass es eine weitgehendeHarmonie und einen breiten Kon-sens u¬ber die Bereiche gibt, in denenmehr Europa gebraucht wird. Das



41


sind die Au§en- und Sicherheitspoli-tik und die Wirtschafts- und Wa¬h-rungspolitik. Wichtig ist zudem aberauch eine starke gemeinsame Vertre-tung der Europa¬ischen Union nachau§en. Das gilt ebenso fu¬r die EU-Vertretung in den Finanzinstitutio-nen, in der Welthandelsorganisationund irgendwann auch in der UNO.Wenn Europa ein Global Player seinwill, dann mu¬ssen wir unsere Kra¬ftebu¬ndeln. Nur dann spielen wir auchwirklich die Rolle, die Europaschlussendlich zukommt.

Wenn wir die Erweiterung effi-zient betreiben und finanzieren wol-len, dann mu¬ssen wir auch den Muthaben, die inneren Reformen derEuropa¬ischen Union in Angriff zunehmen. Und das kann fu¬r michnur eines hei§en: Umschichten,z. B. innerhalb der Agrarpolitik.Wir geben heute 90% des giganti-schen Budgets fu¬r den ersten Blockder Agrarpolitik, die Marktordnun-gen aus. Das sind Direktpra¬mien,die nicht kofinanziert sind. Nur10% kommen der Entwicklung desla¬ndlichen Raumes zu gute. Diesesind kofinanziert. Meiner Meinungnach ist es auch fu¬r die Beitritts-kandidaten viel wichtiger, nichtu¬berholte Strukturen zu petrifizie-ren, sondern sich auf die versta¬rktemoderne Entwicklung des la¬ndlichenRaumes zu konzentrieren. Dafu¬rwa¬re eine Verschiebung auf etwazwei Drittel zu einem Drittel ebensowie die Einfu¬hrung der Kofinanzie-rung auch in der ersten Sa¬ule fo¬rder-lich. Eine solche Umorientierungwu¬rde die Finanzierbarkeit desSystems sicherstellen und zudemdie Weiterentwicklung der EU zueinem o¬kologischeren und natur-na¬heren Europa fo¬rdern. Dies giltebenso fu¬r die Regionalpolitik. Ichbin sehr dafu¬r, schwa¬chere RegionenEuropas solidarisch zu unterstu¬tzen.Aber es wa¬re auch sinnvoll u¬ber diePauschalierung der Subventionen

und eine Evaluierung mancher Pro-jekte nachzudenken. Dies ist not-wendig, weil andere gro§e Themen-bereiche wie z. B. die Infrastrukturvon der Europa¬ischen Union nichtnachhaltig genug gefo¬rdert werden.Auf diese Frage mu¬ssen wir unskonzentrieren und Lo¬sungen erar-beiten, dann wird auch innerhalbder Eigenmittelgrenze die EU-Erweiterung finanzierbar sein.

Den dritten gro§en Themen-bereich bilden die Institutionen.Eben diese Diskussion sollte manmeiner Meinung nachzuletzt fu¬hren, undnicht kurz nach Nizzawieder damit beginnen.Das, was wir in Nizzanicht gelo¬st haben,kann sich in den na¬chs-ten Monaten nicht wieein Wunder aufknotenund regeln lassen.Meine perso¬nliche Meinung dazu istaber, dass auch kleinere La¬nder nichtgut beraten wa¬ren, den Europa¬i-schen Rat und die Ratsformation zueinem neuen Bundesrat zuru¬ckzustu-fen. Wir O¬ sterreicher haben jabesondere Erfahrung auf diesemGebiet, und ich glaube nicht, dassdas Modell des o¬sterreichischen Bun-desrates auf eine Staatenkammeru¬bertragbar ist. Ich habe imGespra¬ch mit Gerhard Schro¬der,der am Wochenende in Wien war,dieses Thema angesprochen undeinige Punkte hinterfragt. Und dahabe ich den Eindruck bekommen,dass manche der Schlagworte, diesich im SPD-Leitantrag finden, wiedie Renationalisierung der Agrar-und Strukturpolitik oder die zweiteStaatenkammer a« la Bundesrat, nichtnach ihrer augenscheinlichen Bedeu-tung zu verstehen sind. Das bedeu-tet, man sollte dieses gro§ to¬nendeVokabular auf das zuru¬ckfu¬hren,was eigentlich dahinter steckt. Wirbrauchen nicht mehr Unterordnung,




sondern mehr Koordination. Dafu¬rist eine Klarstellung der Aufgabendes Dreiecks Kommission Ð Rat ÐEuropa¬isches Parlament erforder-lich. Die Kommission muss einestarke Kommission sein, die wirklichauch das Monopol auf Initiativenbeha¬lt. Ebenso ist ein starker undmutiger Europa¬ischer Rat wesent-lich, der sich auch traut, etwasweiter zu entwickeln, Themen vor-zugeben, einen regelma¬§igenReview zu machen und sich, wieJospin vorgeschlagen hat, vielleicht

wirklich alle zweiMonate trifft. Ebensoist ein starkes Par-lament wu¬nschens-wert, das auch die volleBudgethoheit bekom-men und daher auchdie volle Kontrollfunk-tion ausu¬ben soll. Dasko¬nnte, glaube ich, ein

vernu¬nftiges Dreieck sein. Ebensowichtig ist es, Duplizita¬ten undParallelita¬ten zu vermeiden. Dafu¬rsind zum Teil Reformen, die garkeine Vertragsa¬nderung bedeuten,notwendig, z. B. bei dem Themader Arbeitssprachen. Um die Schlag-kraft Europas wesentlich zu erho¬hen,mu¬ssen wir den Mut haben, eineklare, nicht nur vertikale, sondernauch horizontale Aufgabenverteilungdurchzufu¬hren.

Abschlie§end mo¬chte ich nochbetonen, dass wir in eine sehr span-nende Diskussionsphase eintreten.Und diese Diskussion mu¬ssen wirauf breiter Basis fu¬hren und dabeiauch die Interessen der europa¬ischenBu¬rger miteinbeziehen. Das bedeu-tet, u¬ber die Einfu¬hrung eines Schul-pflichtfaches Europa, die Vorschrei-bung von Austauschprogrammen

fu¬r Schu¬ler, Lehrlinge und Studentensowie u¬ber die Sprachpflege nach-zudenken und zu diskutieren. Ineinem gemeinsamen Europa ist eswichtig, mehrere Sprachen ganzselbstversta¬ndlich als unsere ãMutter-zungeÒ und unsere Vatersprache zusprechen, und somit die Trennungzwischen Muttersprache und Fremd-sprache aufzuheben. Es ist auchwichtig, u¬ber die Einrichtung vonidentita¬tsstiftenden Institutionennachzudenken. Zum Beispiel u¬berdie Schaffung einer Akademie derguten Nachbarschaft, in der manvon guten Beispielen des Zusammen-lebens mit Minderheiten, mit Volks-gruppen lernt und dadurch endgu¬ltigdie Schatten der Vergangenheitabstreifen kann. Auch sollte ein fai-res Modell entwickelt werden, indem gekla¬rt wird, wo in Europadie Institutionen angesiedelt werden.Denn ich finde, dass Europa fu¬r alleEuropa¬er sichtbar sein muss und sichnicht in Bru¬ssel verstecken soll.Daher bin ich auch skeptisch, dassin Zukunft alle Europa¬ischen Ra¬tein Bru¬ssel stattfinden werden. Ichglaube, es hat einen Sinn, dass dieBevo¬lkerung, wie jetzt wa¬hrend derschwedischen EU-Ratspra¬sident-schaft, spu¬rt: ãUnser Land ist Spre-cher Europas und macht das sehrgutÒ. In Schweden ist innerhalbweniger Monate die Zustimmungs-rate zur Europa¬ischen Union um10% gestiegen. Go¬ran Persson hatheute gesagt, dass es zum erstenMal eine Mehrheit derer gibt, dieVorteile und nicht Nachteile in derEuropa¬ischen Union sehen. Ebendiese ãVisibilita¬tÒ werden wir auchfu¬r die Erweiterung brauchen. Dahersollten wir uns ganz bewusst zu die-ser Vielfalt bekennen. §





29. Volkswirtschaftliche Tagung 2001

42


der Oesterreichischen Nationalbank


Hermann-Josef Lamberti


New Technologies

and Financial Markets

in the Long Term

Taking a look at the title of my pre-sentation, one might be remindedof Winston ChurchillÕs sarcasticremark, ÒForecasts are difficult,especially when they concern thefuture.Ó This should be a reminderthat very often there is the tendencyto look into the rear-view mirrorwhen attempting to predict thefuture.

In the following, a closer look istaken at three aspects of financialmarkets. The first focus is placedon technologies and how theychange. The second aspect refers tothe impact this change has on thebanking industry; here the perspec-tive of Deutsche Bank is illustratedby three key theses. Last but notleast, a glance is taken at DeutscheBankÕs strategy with regard to howthe Bank, as a Global Player in thefinancial services world, meets thesechallenges.

It is well-known that we are inthe middle of a huge disruptivechange, which is often labeled Ótheinformation societyÓ. Technology,deregulation, as well as globalisation

Hermann-Josef LambertiDeutsche Bank


are its drivers. The interesting parthere is that they all commingletowards one trend, which we wouldlike to call Òdirected changeÓ, with-out any particular person or institu-tion driving towards that directionor sitting at the steering wheel. Thevehicle of this driving change is con-nectivity. Before the end of the firstdecade of the 21st century we willsee more than a billion people beingconnected, and probably around90% to 95% of all supply chaincompanies will be working in a fully

interconnected fashion.Some very interest-

ing movements can beobserved when lookingat last yearÕs develop-ments of the New Eco-nomy, at the Nemax,and the Nasdaq. Com-paring last yearÕs evalu-ation of Yahoo amount-

ing to USD 93.7 billion with theevaluation in March 2001 comingto only USD 9.7 billion points to acrash which puts a heavy strain onthe capital market, particularly onequity markets, where future devel-opments need to be reassessed.

The reason for this is the hypeand reality curve, which can beobserved with any type of technol-

ogy movement and will continue toaccompany us during this presenta-tion. UMTSÕs recent proceedingsare maybe the best example, espe-cially in Germany and now also inFrance. We can observe how muchmoney is spent on this technology,which in the future should translateinto a completely different level ofvalue-added services driven bymobile telephony. However, weshould at the same time realize thatthis type of movement, goingthrough the hype phase and comingdown again, is not a short-term phe-nomenon but is definitely here tostay and will continue to determineour actions.

MooreÕs law states that every18 months we see a doubling ofcomputing power. This is currentlyaccompanied by a hundredfold in-crease on storage capability and athousendfold increase in bandwidth.When translating this into the eco-nomic environment, the rules ofthe game, which applied for a wholegeneration of 30 to 40 years in thelast century, the industrial century,are being redefined. The structuralintegration of the economy, probablythe most important consequence ofthis process, transgresses traditionalboundaries of industry.

USD billion

US market capitalization

New versus Old Economy

Figure 1

100

80

60

40

20

0

Source: Thomson Financial Datastream.

3/2000 3/2001 3/2000 3/2001Yahoo Boeing, HJ Heinz, General Motors

93.7

9.7

89.8

104.0



43


There are two trends associatedwith the emergence of a techno-logy-driven financial services indus-try: First of all, end devices such asmobile phones, personal digital assis-tance, WAP telephones etc. will bethe major access points for any typeof financial services including theauthentication of transactions. It ispredicted that as early as 2003 therewill be more mobile handsets con-nected to the Internet than PCs. Atthe same time we have to rememberthat everything dealing with financialservices even today is digitized. In

the financial world there are no phys-ical products. Thus, there is a needto increase the co-operation of telcosand banks as far as future value pro-positions are concerned.

Three theses

Thesis 1: New Technologies enable Deut-sche Bank to meet higher customer expect-ations by providing innovative products,services and security.

Taking a closer look at the firstthesis we see the customer and heror his expectations at the center ofour focus. Since all products and

Visibility

Internet hype cycle

Figure 2

Source: Thomson Financial Datastream.

Maturity

Technologyinitiator

Mountingperceptions Disillusion Rising

knowledgePlateau

of productivity

Digitalpaper

Wareablecomputing

Smart labels

Interactive TV

Bluetooth

UMTS

Biometric

KnowledgeManagement

Micropayment

XMLxDSL/Cable modems

Smart cards

Speechrecognising

Voice over IP

Mio

Mobile Internet access

Figure 3

Source: Dataquest, Nokia.

1,200

1,000

800

600

400

200

0

1996 1997 1998 1999 2000 2001 2002 2003

More handsets than PCs connectedto the Internet by the end of 2003

Projectedcellular subscribers(Nokia 2000)

ProjectedWeb handsets(Nokia 2000)

Projected PCsconnected to the internet(Dataquest 2/2000)




services offered in the financial sec-tor are digitized, banks have to utilisenew technologies, and thereby meethigher customer expectations. Wesee a whole Òsophistication waveÓgoing on with respect to financialservices, which will overthrow thetraditional structure of delivery offinancial services as it is presentlyfor example on the retail side inbranch office environments. In addi-tion to branches we will see a prolif-eration of different access channels.These include the Internet as wesee it today, but do by no means stopthere. New devices, such as mobilephones and personal digital assistantswill be used as well as interactivetelevision to deliver services to usersin their private environment. It isimportant that we start adoptingthe different channels early andchoose an appropriate match of serv-ice and channel. The closing of majorfinancial transactions, such as amortgage on the family home, willmost likely not be performed on amobile phone, while on the go, butpayment transactions for goods andservices will.

If one examines the scenario ofcapital markets, retail markets andthe risk proposition, one will findsome very interesting trends. In cap-

ital markets we see that the behaviorof trading has completely changed inthe last couple of years. We all knowabout the past trends of proprietarytrading which we saw in fixed incomeas well as in equity markets. Theyhave changed into a completelyflow-driven environment. By usingmodern technology, presently weare able to create a throughput ofroughly USD 2 billion per hour forany type of stock inside the EuroStoxx. The amount of volume willfurther increase and thus reduce itsmargin. At the same time, the highervolume also creates more capabilityaround the world and definitely isliked by institutional investors as theychurn their large portfolios againstdifferent markets in the United Statesor in Europe. Such a development isquite interesting from a national bankperspective. By looking at the USdollar/euro rate early in the morn-ing, it can easily be imagined that Ðindependently from fundamentalfigures Ð this has to do with generalconfidence levels of institutionalinvestors translated into offering ordemand of currency or currencyunderlying assets.

When it comes to delivery chan-nels, you have to look at the changeof the overall landscape for example

Customer-oriented services

Figure 4

Customer

Flexibleaccess

Qualityof products

Security

Convenience

Rangeof products

PDA Web-TV

Internetscreenphones

Palm-PC

Communicator/Mobile phones

db-business direct

maxblue e-trade




of retail banks. Deutsche Bank forinstance today has around 1,000retail branch offices in Germany.The bank Fortis, in the small countryof Belgium, counts 2,100 branchoffices. Can this be sustainable inthe future with a rather more sophis-ticated customer, with the sophisti-cation of OTC trading driventowards equity markets and rightinto the asset gathering attitude ofretail clients? We do not think so.That means that we will definitelysee a further dramatic decline ofour overbanked infrastructure acrossEurope.

The mobile phone as the deviceof the future: We recently intro-duced something we call paybox,which is a mechanism to performpayments via the mobile phone byauthentication with a personal iden-tification number (PIN). Today, thissystem not only allows to make anytype of Internet payment, but basi-cally completely erases the necessityfor credit cards or cash in any coun-try across the European continent.Why is only the European continentcovered? Because the defining limitof this technology is the GSM stand-ard. It refers to a technology stand-

ard and not to the functionality ofthe product. It is very interesting tosee that all of a sudden a technologystandard becomes the limitation ofthe proliferation of a financial prod-uct. As of today, there are some300,000 people across Europe whouse devices like a mobile phone toperform authorisations or paymentsdirectly. In four to five years we willsee a dramatic increase of this num-ber. The impact can easily be quanti-fied, by looking at the developmentof SMS messaging over the past fiveyears.

Thesis 2: New technologies enableDeutsche Bank to realise economies ofscale based on optimised processes.

The cost pressure and thedecrease of margins, the disinterme-diation of any type of financial ser-vices product is going to be a hugedriver for economies of scale. Oneindicator is the fact that financialservices markets integrate and co-mingle with telecommunicationindustries. Ultimately, there will bemore mergers and acquisitions.

New technologies dramaticallyreduce the production costs, as theyincrease connectivity of markets andconnectivity of customers. When

Cost situation

Figure 5

Current DB volume Double current DB volumes

Currenttechnology

Web-basedtechnology

100%

Current cost62% variable38% fixed

100%

25% reduction56% variable19% fixed

100%


100%


Global fixed income and equities cost per trade � simulation of key effects � 2005.




looking at the current volume oftransactions, the application of newtechnologies can achieve a reductionof the cost level to 54%. Growth oftransaction volume constitutes atrend observed in markets withincreased demand, especially onthe retail side, and an increasechurn on the institutional side. Ifwe assume a doubling of the trans-action volume over the course ofthe next two years, which we believeto be plausible, the cost impactwill be as large as 69%.

Such a change ofthe cost situation takesus to a completely dif-ferent playing field,which is not the optimi-sation of a process, nora cost-cutting programof 3%, 4% or 10%,but which implieschanging the landscape

fundamentally. It is very importantto understand that this exampleabout a clearing and settlementinfrastructure of a large player likeDeutsche Bank will not stop at thelimits of the bank but in fact has itscounterpart on the clearing andsettlement side of the financialmarkets across Europe.

The discussions about the inte-gration of the International CentralSecurities Depositories (ICSDs),namely Euroclear and Clearstream,are just an example of how the forcesof this type of cost leverage also cre-

ate pressure on management teamsand on institutional setups in Euro-pean markets.

Apart from the perception of ourdifferent constituencies of the euro,the biggest obstacle of the euro tobecome a success in the next coupleof years is the differences of regula-tions in the participating countries.Regulations for financial markets dif-fer considerably as far as the clearingand settlement infrastructure isconcerned. This concerns both thepayment side and the security side.

If institutions are not able to fun-nel their operations into a stream-lined process, which applies the typeof cost leverage described above,they will face a major problem asretail customers compare the differ-ent offerings of security exchangesacross Europe. A major problemcontinues to be the comparison withthe United States, where, as of today,cost levels in capital markets areroughly 10% of what can beobserved in cross-border trading inEurope.

Thesis 3: New technologies increasecompetition from near and nonbanksdue to the fragmentation of the valuechain and the elimination of market entrybarriers.

Banks will face increasing com-petition, when it comes to buildingnew relationships with clients, onthe commercial as well as on theinstitutional front. On the retail side,we should not only turn our atten-

Industry integration

Figure 6

Yesterday(80s, 90s)

Tele-communication

Banking Insurance

RetailTele-

communication

Banking Insurance

RetailTele-

communication

Banking Insurance

Retail

Today(2001)

Tomorrow(> 2002)



44


tion to the telecommunication indus-try, but for instance to car manu-facturers, which are involved asmuch as retailers. They will leveragetheir power, which lies in the sheernumber of clients in their own data-bases, to drive additional digitallydriven value-added services, i.e.financial services, towards their cus-tomer base.

Depending on which area ofcompetence one focuses on, newmarket entrants can be observedfrom different directions. In thedelivery of information and services,IT providers are competing withbanks. Products and services tradi-tionally associated with banking arealso being offered by discountbrokers, credit card companies, con-tent providers and leasing compa-nies. Even settlement functions aretaken over by application serviceproviders (ASP).

Another interesting aspect in thatthesis is Òorder flowÓ. As marginsdecrease it becomes very interestingfor large players to try to capturethe order flow, i.e. they try to inter-nalise the order flow, take it awayfrom the public exchanges, andtherefore gain the quality of the fullmargin between bit and offer. Thisalso means that to a certain degree

pricing on a public exchange in theform of an open order book is goingto be disintermediated by newtechnologies. It becomes at leastquestionable if in the future publicexchanges will have the propositionof the best price at any given time.When looking at the activities ofretail brokerages in the United Statestoday, and how this retail brokeragetranslates into websites, where youcan do OTC trading on the spot,you can easily imagine that this trendwill cross the Atlantic and emerge inEurope as well.

IT strategyof Deutsche Bank

Let us look at the strategy of Deut-sche Bank: How do we position our-selves knowing about all these funda-mental changes going on, about thishuge disruptive technology impacton our digitized products.

We see our strength basically inbringing capital markets in closeconnection with the investor. Thismeans that we deliberately departfrom the classical bank operationswhere we lived from the spreadbetween the passive side, the depositside, and the active side of the bal-ance sheet, the loan side, and turntowards a product transformation

Industry integration

Figure 7

Access Delivery Products Clearingand settlement

IT-provider

Insurance companies

Discount broker Industry

Credit cardcompanies

Content provider

Leasing companies

Application serviceprovider

Retail industry




into what our analysts call a ÓFlowMonsterÓ. This ÒFlow MonsterÓ triesto generate flows from capital mar-kets by using any type of structuredproduct. It offers investors an envi-ronment which allows them to investaccording to their risk classificationand their specific appetite. Thistransformation process generatesfee and commission income, which

is our source of our future growth,rather than interest income.

Initial public offering (IPO)using the Internet

Some tangible examples of IPOs inGermany in the last year were Deut-sche Telekom III, EADS and Infin-eon, the semi-conductor subsidiaryof Siemens.

Linking financial markets

Figure 8

Corporateand Investment Banking (CIB)

Private Clientsand Asset Management (PCAM)

Capitalmarket

Trans-formation InvestorsOrigination Placement/

access

IPO and demand

Figure 9

in million of shares

Offering Deal size Allocation Demand Rate of oversubscription

2301)

133

154

167

63

80

58

53

107

381

319

103

120

1,547

4,007

2.3

5.1

1.3

2.1

29.2

37.4

1) Including Greenshoe.

RetailInstitutional




The book building of the InfineonIPO on 21 February 2000, for thefirst time was managed over the webusing Deutsche BankÕs maxbluetechnology. Between 11:00 am and2:30 pm about 3.5 million Germanretail customers accessed this website.Related to our capability in traditionalbranch networks, one would basicallyhave to compare this with a customerbase of 7 million in the 1,000 branchoffices mentioned above. It can easilybe imagined that the existing physicalinfrastructure in German cities wouldnot have allowed a run of 3.5 millionpeople in a network of branch officeswithin a three-hour timeframe. Thisis just a minor indication and maybean odd example of what we will seein the future as we open up our prod-uct offerings into the Internet world,we will see peak loads of dramaticimpact.

New affluent segment

When looking at the European inte-gration, basically this disruptive

change of technology also producessomething we call the modern afflu-ent segment. It is a sort of reinven-tion of retail banking, and we believethat 60 million Europeans, who arepart of the modern affluent segment,form the first real Europeans interms of utilising the currency forwealth creation. This is a chancenot just for Deutsche Bank, but foranybody who sees Europe as a largerterritory to build a value proposi-tion.

Summary

This was a brief overview of whattechnology does. Joseph Schumpeterhas already stated that we live in aworld where innovation drives dis-ruptive change and where innovationcompletely changes existing struc-tures.

It is not about the Old and theNew Economy, but about the OldEconomy needing the capabilities ofthe New Economy to build the soci-ety of the 21st century. §

European strategy changes

Figure 10

1) Derived from JPMorgan European Online Investor, 21 February 2001.

TodayOpportunistic approach by country

TomorrowImplement pan-European strategy

Virtualinvestmentbankingplatform

Strong BrandPan-European managementPremier European asset gathererPan-European online-centereddistribution network

Estimated overall online accountsin Europe1)million accounts

40

30

20

10

0

1999 2000 2001 2002 2003

+412%

+1,040%

Online banking

Online brokerage




Christophe Bisiere

45


The Internet

and Financial Markets:

Island versus Nasdaq

1 IntroductionThe role of financial markets is tobring together buyers and sellersand discover the prices at which theycan trade. A crucial ingredient in thisprocess is the information about theextent to which different agents arewilling to buy or sell, and at whatprice. When information on prices,bids and orders is available only toa small group of market professio-nals, they enjoy an informationaladvantage and correspondingly earnrents. They are also well placed toearn rents when they have the privi-leged ability to produce and dissem-inate information by posting pricesand making offers. These rents arethe mirror image of the trading costsborne by less informed parties. Untilrecently, access to information onprices and offers in financial marketswas relatively unevenly distributed.For example, agents physically pres-ent on trading floors had faster andbetter access to information aboutthe trading process than investorsremote from the market center.1)

1 E.g. as illustrated by the analysis of Rock (1990).

Christophe BisiereProfessor,

Universite« de Perpignan

Bruno BiaisUniversite« de Toulouse

Chester SpattCarnegie Mellon University


In the words of the Chairman ofIsland Matthew Andresen:

ÒThe so-called time and placeadvantage has allowed professionals tomake very handsome living. Seats on theNYSE sell for millions of dollars thanksto the informational advantage of thosephysically present on the trading floor.Ó(Andresen, 2000)

Admittedly, Andresen has somevested interest in these matters,which may well be not totally uncor-related with his views on the relativemerits of floors and electronic mar-

kets. The academic lit-erature, however, alsooffers systematic evi-dence on the rent-mak-ing potential of a smallgroup of financial inter-mediaries with privi-leged access to infor-mation collection anddissemination.1)

The advent of the Internet tech-nology brings about a dramaticreduction in the cost of transmittingand exchanging information rapidlybetween a large number of people.This makes it possible to design moreopen and transparent market mecha-nisms, based on widely disseminatedinformation, and the generalizedability to make offers and post pri-ces. In conjunction with this techno-logical revolution, the regulatorychange brought about by the 1997Securities and Exchange Commis-sion (SEC) order display rule, hasmade it possible for Electronic Com-munication Networks (ECNs) tooffer information dissemination,price quotation and order matchingmechanisms for Nasdaq securities.

This evolution raises a numberof interesting issues for financescholars, economists at large andpractitioners: What are the econom-ics of the competition between

ECNs and more traditional marketparticipants? Do the limit ordersplaced on ECNs compete away therents of Nasdaq market makers,and how? Does the presence ofECNs lead to a free-entry/per-fectly-competitive market situation,as in Glosten (1994)?

To study these issues, we focuson Island, the second largest ECN,which offers a particularly interest-ing market structure: It is operatedas a fully transparent limit-ordermarket, and its book is freely observ-able to all on the Island website. Toconduct our analysis, we combinetwo sources of data for activelytraded Nasdaq stocks, downloadingthe sequence of trades and orderbook dynamics from the Island siteas well as acquiring the Nastraqdataset. To take into account therecent decimalization, we are goingto download new Island data andcompare it to new Nasdaq data.

Based on the March 2000 sam-ple, we obtained the following pre-liminary results:

The best Island quotes werequite frequently strictly better thanthe Nasdaq quotes. Orders placedon Island often bettered the Nasdaqtouch by using a finer price gridthan the Nasdaq grid. This suggeststhat the coarseness of the Nasdaqgrid, and possibly strategic marketmakersÕ behavior, resulted in exces-sively large Nasdaq inside quotes.Responding to this situation, Islandlimit order traders undercut theNasdaq quotes. This raises the issueof the profitability of such a compet-itive strategy. Was it profitable orloss making to undercut the Nasdaqquotes? To answer this question weanalyzed the profitability of executedIsland limit orders.

On average limit orders placedon Island earned positive profits. In

1 See for example Christie and Schultz (1994) or Chen and Ritter (2000).

Christophe Bisiere



fact, these profits were greater whenthe Island orders matched theNasdaq quotes than when theyundercut these quotes. These pre-liminary results suggest that thecompetition to supply liquidity onNasdaq and Island is closer to theCournot type of imperfect competi-tion analyzed by Bernhardt andHughson (1997) and Biais, Marti-mort and Rochet (2000) than tothe free-entry/zero-profit equili-brium analyzed by Glosten (1994).

In the next drafts of the paper wewill undertake more systematic sta-tistical tests of the free-entry equili-brium hypothesis. We also will usedata from Island and Nasdaq, col-lected after both markets were deci-malized. We will thus study if deci-malization makes the Nasdaq spreadtighter, and if, after the decimaliza-tion, limit orders placed on Islandcontinue to often better the Nasdaqquotes and to earn expected positiveprofits.

2 InstitutionalEnvironment

ECNs are e-brokers, relying on web-based platforms that collect limit andmarket orders, and match them ordisplay them on Internet-based orderbooks. In 2000, they have beenestimated to capture 26% of thedollar volume of Nasdaq trading(McAndrews and Stefanadis, 2000).The major ECN, Instinet (INCA),was estimated to represent 14% ofthe trading volume on Nasdaq inMarch 2000 (see The Economist,May 20, 2000), while Island (ISLD)amounted to 6%, and Redi Book,B-trade (BloombergÕs Tradebook),Brut and Archipelago (ARCA)accounted for less than 2% each.Other ECNs include Attain (ATTN),Pim Global Equities (NTRD) andStrike Technologies (STRK).

While ECN compete with thetraditional source of liquidity onNasdaq (i.e. market makers), theyare brokers: They do not takeproprietary positions, but simplyhandle and display their customersÕorders. Since they are regulatedas brokers, they are subject to thebest execution rule, which meansthat they cannot conduct tradesaway from the current best marketprices.1) This best execution ruleimplies that price priority isenforced on Nasdaq.

Island is a web-based transparent limit-order book. It canfreely be viewed in realtime through the Inter-net. When an order istransmitted to Island,if it is not immediatelymarketable, it is storedin the Island orderbook. The best Island bid and askquotes are displayed on the Nasdaqscreen, along with the best quotesof ECNs and market makers. If theorder received by Island is market-able, it is executed at the best marketprice. As mentioned above, pricepriority is enforced between Islandand the other ECNs as well as Nasdaqmarket makersÕ quotes. Hence, if theIsland quotes are strictly dominatedby other quotes in the Nasdaq archi-tecture, the order is channeled awayfrom Island to receive execution.However, time priority is notenforced between ECNs and Nasdaqmarket makers.

Interestingly, there is no evi-dence that the trading processmanaged by ECNs is systematicallyfree riding on price discoveryachieved by the traditional marketparticipants (the Nasdaq dealers).Quite to the contrary, Huang(2000) shows empirically that ECNs

1 Island and Archipelago have applied for the status of exchanges, which has not yet been granted.

Christophe Bisiere



are important contributors to theprice discovery process.

Until April 2001, the Nasdaqtick size was 1/16 and the Island ticksize was 1/256. The thinner price gridon Island made it easier for tradersplacing orders on Island to undercutNasdaq market makersÕ quotes. Notehowever that Island quotes displayedand ÒadvertizedÓ on the Nasdaqscreen were not shown at theiractual price (quoted on a thin grid)but at rounded prices (from theNasdaq grid). For example, if thebest ask for stock XYZ on Islandwas USD 1 and 1/24, it was displayedon Nasdaq at USD 1 and 1/16. SinceApril 2001, Nasdaq and Island oper-ate on a decimalized basis whereprices are quoted with a three-digitprecision.

3 Data

We downloaded a continuous recordof the Island book from the Islandwebsite from March 8 to March16, 2000. We collected this datafor 8 stocks: COMS, Cisco, Dell,EGroup, Intel, Microsoft, QCom,and Sun. For these 8 stocks, we alsouse the Dealer Quotes (DQ) file andthe Inside Quote (IQ) file, purchasedfrom Nasdaq.

Currently, for the exploratoryanalysis of spreads and order place-ment we are only studying a pilotsample of two stocks: Dell and3Coms. We retain the other stocksas a holdout sample. This will giveus an opportunity to examine theout-of-sample robustness of ourresults.1) For the analysis of profits,where we are guided by theory, theneed to keep a holdout sample isless severe. So we analyze the datefrom all stocks in our sample to gainstatistical power.

We consider data starting at theopening of Nasdaq (at 9:30 a.m. or

a few minutes before) and endingat the Nasdaq close at 4:00 p.m.(because of a data feed problem,for March 10, we have data onlybetween 9:30 and 2:30).

For the sample period, there are26,487 trades for Dell, with anaverage per-trade dollar value ofUSD 25,493. For 3Coms the totalnumber of trades is 13,023 with anaverage value of USD 25,281.

One advantage of the Island data(downloaded from the Island web-site) is that it is not rounded to six-teenths (unlike the ECN quotesreported in the Nasdaq DQ file).Hence we can study the use of fineticks by Island traders. This is lessrelevant now that Island and Nasdaqare decimalized.

4 Spreads

4.1 Spreads on Islandand Nasdaq in March 2000

In this section we analyze and com-pare the spreads prevailing on Islandto the Nasdaq inside touch in March2000. Note that the latter incorpo-rates the Island quotes. Conse-quently, if the grid size was the samein the two market segments, theNasdaq inside touch would, by con-struction always be at least as goodas the Island spread. In this context,the issue would be: How muchbetter is the Nasdaq inside touch?Until 2001, however, the grid wasthinner on Island than on Nasdaq.Therefore, if the coarseness of theNasdaq grid was a binding constraintand the Nasdaq spreads correspond-ingly too large, one would expectlimit orders to be placed on Islandinside the Nasdaq touch. We investi-gate these issues below.

First consider the inside Nasdaqspread in March 2000 (obtainedfrom the Nasdaq IQ file). For Dell,it was equal to one tick, i.e. one six-

1 This is similar to the approach taken in Biais, Hillion and Spatt (1995).

Christophe Bisiere


46


teenth, most of the time (94.99%).Other realizations were 0, only1.76% of the time, two ticks,3.22% of the time, and three ticks,only 0.03% of the time. Corre-spondingly, the time-weighted aver-age of the Nasdaq inside spread forDell (reflecting market makersÕquotes and ECNsÕ rounded quotes)was USD 16.242/256, which is very closeto one tick, and the mode andmedian were exactly equal to onesixteenth. For 3Coms, the distribu-tion of the inside spread was a littleless concentrated. The inside spreadwas equal to 0 only 1.3% of thetime, one tick 80.77% of the time,two ticks 13.94% of the time, andthree ticks 2.977% of the time.Correspondingly, the time-weightedaverage spread was 19.5/256, while themedian and mode were just one tick.

Now we turn to the inside spreadprevailing on Island for the same twostocks and the same period. ForDell, the most frequent occurrencewas the Nasdaq tick, one sixteenth.But this occurred much less often

(17.47% of the time) than for theNasdaq inside quote. The two nextmost frequent sizes were 12/256

(12.26% of the time) and 28/256

(11.16% of the time). Interestingly,the spread was often equal to 15/256

(8.7% of the time). This is likely tohave occurred mainly when theNasdaq spread was one sixteenthand an Island trader undercut it by1/256. The spread was also often equalto 31/256 (4.16% of the time). This islikely to have occurred mainly whenthe Nasdaq spread was two six-teenths and an Island trader undercutit by 1/256. The time-weighted meanspread was 23.64/256, while the modeand the median were equal one six-teenth. Figure 1 offers a graphicrepresentation of these results. For3Coms similar patterns wereobserved. The most frequent valuesof the spread were on the Nasdaqgrid: 32/256 (14.33% of the time) or16/256 (9.19% of the time), and justone tick below these values: 15/256

(6.92% of the time) or 31/256

(8.95% of the time). The time-

% of time the spread takes this vale

Inside Spread for Dell on Island and Nasdaq

March 2000

Figure 1

90

80

70

60

50

40

30

20

10

0


1Number of Island ticks (1/256)

NasdaqIsland

2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33

Christophe Bisiere



weighted average spread was 55.9/256,the median was 47/256, and themode 32/256.

To obtain more insights on thecomparison between the Island andNasdaq spreads we merged the Islanddata file and the Nasdaq IQ data file.This raises synchronicity problems.First, there are points in times whenthere is more than one change persecond in the Nastraq file. In thiscase, as the Nastraq clock operateson a second-by-second basis, wecannot tell which was the lastchange, and consequently we cannottell which state of the IQ spread pre-vails after this second. In this case wedraw randomly one of the data pointsin that interval. Second, the Nastraqand Island clocks may not be per-fectly aligned. Subject to these ca-veats, we obtain the following resultsfor our March 2000 sample for Dell:The best Island bid quote was betterthan the best Nasdaq (IQ) bid43.19% of the time, while the

Nasdaq bid was better than the Islandbid 33.43% of the time, and the twobids were equal 23.38% of the time.The best Island ask quote was betterthan the best Nasdaq (IQ) ask40.97% of the time, while theNasdaq ask was better than the Islandask 26.18% of the time, and the twoasks were equal 32.85% of the time.For 3Coms, the best Island bid quotewas better than the best Nasdaq (IQ)bid 31.05% of the time, while theNasdaq bid was better than the Islandbid 45.38% of the time, and the twobids were equal 23.56% of the time.The best Island ask quote was betterthan the best Nasdaq (IQ) ask17.29% of the time, while theNasdaq ask was better than the Islandask 47.15% of the time, and the twoasks were equal 35.57% of the time.The Island best quotes are much lessfrequently better than the Nasdaqinside quotes for 3Coms than forDell. This is likely to reflect the factthat, as Dell is a very liquid stock,

frequency (% of the time the condition holds)

Are the Best Island Quotes Better

than the Nasdaq Inside Quotes?

March 2000, Dell

Figure 2

45

40

35

30

25

20

15

10

5

0


AskBid

Best Island quoteinside Nasdaq IQ

Best Island quoteequal to Nasdaq IQ

Nasdaq IQinside Island spread

Christophe Bisiere



its natural spread is very tight, so thatthe price grid constraint imposed byNasdaq is more often binding.

Since the Island quotes are incor-porated in the Nastraq inside quotes,the former can be better than the lat-ter only when they are on a finerprice grid than the Nasdaq grid. Thisoffers an opportunity to assess themagnitude of the problems inducedby synchronicity. When the bestIsland bid (resp. ask) is better thanthe best Nasdaq bid (resp. ask), itshould be on a finer tick than theNasdaq grid. In our data, this isthe case for Dell 84.60% (resp.84.63%) of the time. This suggeststhan in 15% of the cases synchronic-ity problems induce mistakes in ourbest quotes comparisons.

4.2 Implicationsfor Market Design

Tick SizeOur results suggest that the one-six-teenth grid used on Nasdaq did con-strain spreads. This constraint, possi-bly in conjunction with strategicmarket makersÕ behavior, resultedin an excessively wide Nasdaq touch.Island limit order trades reacted tothis situation by undercutting theNasdaq inside quotes, resulting inthe Island spread often beating theNasdaq touch.

These results highlight a tradeofffaced by the Nasdaq market makers.On the one hand, keeping a relativelycoarse grid size (one sixteenth) wasa way to maintain artificially highspreads and earn rents. On the otherhand, keeping such a coarse gridmade it easier for Island to competethe order flow away from Nasdaq.

RoundingOur results are consistent with thefindings by Simaan, Weaver andWhitcomb (1998), that ECNs oftenestablish the inside market and areless likely to quote odd-sixteenths.

Our results differ from and comple-ment those of Simaan, Weaver andWhitcomb (1998) because we ana-lyze data on unrounded Islandquotes, downloaded from its site,rather than rounded quotes fromthe Nasdaq DQ file. Hence, we findmore frequent occurrences of thesituation in which Island improvesthe Nasdaq market makers quotes,and we document undercutting byIsland orders on a finer grid thanthe sixteenth grid.

To better document the impactof the rounding proce-dure on the quotesobserved on the Nasdaqsystem, we conductedthe following experi-ence. Using the Islanddata for March 2000(from the Nastraq DQfile), we computedthe mean spread onIsland for Dell. It was equal toUSD 31.49/256. Similarly, the averageIsland spread for 3Coms computedusing the Nasdaq DQ data (67/256)was greater than its Island datacounterpart. This shows thatthe rounding procedure made theIsland quotes much less attractivethan they actually were. This con-firms our remark above that Islandtraders relied on other ticks thansixteenths to quite a large extent.

This can be interpreted in termsof competition between markets:Rounding the Island quotes enabledNasdaq to get around price priorityconstraints, and reduced the abilityof the ECN to advertize good quotesand thus attract orders. The lattermade it very important for Islandto use another vehicle than Nasdaqscreens to disseminate information.Hence its excellent website.

Christophe Bisiere



5 ProfitsTo compute profits earned by limitorders placed on Island we take thefollowing steps: When there is atrade in the Island data, we examinethe Island order book to find out if anIsland limit order has been hit at thispoint in time. If no Island limit orderhas been hit, we infer that the tradecorresponds to a market orderplaced on Island that has been imme-diately executed against quotesposted outside Island. On the otherhand if we identify limit orders exe-cuted on Island, we compute theirprofit taking the closing price forthat day as a proxy for the fundamen-tal value. Note that we consider allthe limit orders present in the Islandbook that have been hit and do notrestrict the attention to the ordersat the best quote.

We report descriptive statistics(averages and variances) on the ratesof return earned by executed limitorders for the 67,416 trades in ourMarch 2000 sample. Overall, thesize-weighted average rate of returnof executed limit orders for the8 stocks in our March 2000 sample

was: 0.299%, while the variancewas: 0.138%. The average rate ofreturn earned by orders placed onsixteenths (the Nasdaq grid) is:0.366% (with variance equal to0.151%), while the average rate ofreturn earned by orders off theNasdaq grid is: 0.127% (with var-iance equal to: 0.104%). This isgraphically represented in figure 3.

In line with the theoreticalresults of Bernhardt and Hughson(1997) and Biais, Martimort andRochet (2000), these preliminaryresults are consistent with the viewthat limit orders placed on Islandearn profits. While we have not car-ried statistical tests yet, this suggeststhat the free-entry equilibriumhypothesis might be rejected.

Interestingly, limit orders arefound to be more profitable whenthey are placed on the Nasdaq grid(and thus are likely to be matchingthe market makers quotes) thanwhen they are placed on a thinnergrid (and undercut the Nasdaqmarket makers quotes). This sug-gests that while undercutting maywell enable Island traders to cap-

%

Size Weighted Mean Rate of Return

of Executed Island Limit Orders

March 2000, all stocks

Figure 3

0.35

0.30

0.25

0.20

0.15

0.10

0.05

0


All executedorders

Orders placedon odd sixteenths

Orders placed oneven sixteenths

Christophe Bisiere


47


ture more order flow, it leads to areduction in profits per share. Thisis consistent with the Cournot oli-gopoly flavor of the equilibriumcharacterized in Biais, Martimortand Rochet (2000) for a finite num-ber of liquidity suppliers.

The zero-profit/free-entry equi-librium theoretically characterizedby Glosten (1994) offers an addi-

tional empirical implication: Whenmarket orders only hit the firstprice level in the book, the corre-sponding limit orders are expectedto be profitable. In contrast, whenthe market order is executed againstseveral consecutive levels in thebook, the limit order placed at thefirst level is expected to be un-profitable.

More than oneprice level is hit

%

Rate of Return of Executed Island Limit Orders

Placed at Different Levels in the Book


Figure 5

0.40

0.30

0.20

0.10

0

Source: Own calculations.

Only the firstprice level is hit

Orders at the first price level in the bookOrders at the second price level in the book

%

Frequency with which the Different Price Levels

in the Book are Hit


Figure 4

80

70

60

50

40

30

20

10

0

Source: Own calculations.

Only first pricelevel in the bookis hit

First and secondprice levelsare hit

Three firstprice levelsare hit

Christophe Bisiere



In our March 2000 sample,82.7% of the trades hit only the firstline of the book, while 15.5% hit thefirst and second lines, and 1.5% hitthe first three lines. This is graphi-cally represented in figure 4. Figure5 depicts our results on the profit-ability of limit orders placed at dif-ferent levels in the book. When onlythe first price level is hit, the average(size-weighted) rate of return of theexecuted limit orders is 0.313%(with a variance of 0.142%). Thisresult is consistent with the theory,

which predicts that when only thefirst price level is hit, the expectedprofit earn by the executed limitorders is positive. When more thanone price level is hit, the averagerate of return of the orders presentat the first price level is 0.361%(with a variance of 0.151%), andthe average rate of return of theorders placed at further price levelsis 0.467% (with a variance of0.139%). This result is in contrastwith the predictions of the zero-profit/free-entry equilibrium, ac-cording to which, when the marketorder walks up or down the book,the limit orders that are hit thefirst are loss-making on average.This provides further evidenceagainst the hypothesis of perfectlycompetitive liquidity supply. Ourresult that limit orders placed atthe first price level in the book earngreater average profits when themarket order walks up or downthe book is a little puzzling. Maybethe sample of orders that are exe-

cuted alone include a group of out-of-line orders picked off by savvytraders.

6 Conclusion

The goal of this paper is to analyzethe competition to supply liquidityon Nasdaq and Island. Our prelimi-nary results suggest that, before thedecimalization, the following marketconditions prevailed:Ð Nasdaq spreads were constrained

by the tick size and were corre-spondingly excessively wide.

Ð Reacting to this situation, limit-order traders used Island as aplatform to compete for the sup-ply of liquidity. To do so theyoften undercut the Nasdaq insidequotes by using the finer Islandgrid.

Ð In contrast with the implicationsof free-entry equilibrium, limitorders placed on Island earnedpositive profits. While both thelimit orders undercutting theNasdaq quotes and those match-ing them were profitable, the lat-ter were more profitable thanthe former. In sharp contrastwith the free-entry equilibriumimplications, even when marketorders walk up or down thebook, the executed limit ordersplaced at the first price level inthe book still earn non-negativeprofits.Taken together these results sug-

gest that prior to the decimalizationNasdaq and Island spreads werewider than warranted by the zero-profit/free-entry equilibrium theo-retically characterized by Glosten(1994). This in part reflected thatthe coarseness of the Nasdaq gridwas binding. ItÕs also likely that itreflected the strategic behavior ofliquidity suppliers on Nasdaq andIsland. §

Christophe Bisiere



ReferencesAndresen, M. (2000). DonÕt CLOBer the

ECNs. In: Wall Street Journal, March 27.

Bernhardt, D. and Hughson, E. (1997).Splitting orders. In: Review of Financial

Studies, pp. 69Ð102.

Biais, B., Hillion, P. and Spatt, C.(1995). An empirical analysis of the order

book and order flow in the Paris Bourse.

In: Journal of Finance, vol. 50, pp.

1655Ð1689.

Biais, B., Martimort, D. and Rochet,J. C. (2000). Competing mechanisms in

a common value environment. In: Econo-

metrica.

Chen, H. and Ritter, J. (2000). The seven

percent solution. In: Journal of Finance, vol.

55, pp. 1105Ð1131.

Christie, W. and Schultz, P. (1994). Why

do Nasdaq market makers avoid odd-

eight quotes? In: Journal of Finance,

pp. 1813Ð1840.

Glosten, L. (1994). Is the electronic limit

order book inevitable? In: Journal of

Finance, vol. 49, pp. 1127Ð1161.

Huang, R. (2000). Price discovery by ECNs

and Nasdaq Market Makers. Vanderbilt

University, Working paper.

McAndrews, J. and Stefanadis, C.(2000). The emergence of Electronic

Communications Networks in the US

equity markets. In: Federal Reserve Bank

of New York Current Issues in Economics

and Finance, vol. 6, no. 12, pp. 1Ð6.

Rock, K. (1990). The SpecialistÕs Order

Book and Price Anomalies. Working paper.

Simaan, Y., Weaver, D. and Whitcomb,D. (1998). The Quotation Behaviour of

ECNs and Nasdaq Market Makers. Baruch

College, working paper.

Christophe Bisiere



Clive Briault

48


Comments on

Hermann-Josef Lamberti,

ÒNew Technologies and Financial Markets

in the Long TermÓ

and

Christophe Bisiere, Bruno Biais

and Chester Spatt,

ÒThe Internet and Financial Markets:

Island versus NasdaqÓ

Clive BriaultDirector,

Prudential Standards Division

UK Financial Services Authority


I welcome the opportunity to offer afew comments on the thoughtful andinteresting papers by Hermann-JosefLamberti and by Christophe Bisiere,Bruno Biais and Chester Spatt. I doso as a humble financial services reg-ulator, rather than as an academic oran expert on new technologies. But Ihope that a regulatory perspectivehas some useful insights to offer.

I therefore begin by explainingthe Financial Services AuthorityÕs(FSA) approach to the developmentof e-commerce within the financialsector and to the prospects for itscontinuing rapid growth. I commenton the papers within this context.

As a single regulator, the FSA hasfour statutory objectives:Ð maintaining confidence in the

financial system,Ð promoting public understanding

of the financial system,Ð securing the appropriate degree

of protection for consumers andÐ reducing the extent to which it is

possible for a regulated firm tobe used for financial crime.In pursuing these four objectives

we are required to have regard toseven considerations (what we callour Òprinciples of good regulationÓ).These include having regard to theresponsibilities of the senior manage-ment of firms, the desirability offacilitating innovation and competi-tion and the importance of the inter-national character of financial serv-ices.

Indeed, the FSA is probablyunique as a financial services regula-tor in having a statutory objective topromote public understanding of thefinancial system, and a statutory dutyto have regard to the desirability ofinnovation and competition whenpursuing our four statutory objec-tives.

It is against this background, andthe need to set priorities in the use ofour scarce resources, that the FSA

has undertaken a major review ofthe appropriate regulatory responseto the growth of e-commerce(Financial Services Authority,2001b). This reflects the potentiallyenormous importance of e-com-merce to all aspects of the activitiesof regulated firms, across all sectorsof the financial services industry.

In our work on e-commerce wefocused on opportunities as well asrisks. Although this may sound likea novel approach for cautious andrisk-averse regulators, it is drivenby the objectives and principles setout above. In particular, our objec-tives relating to consumer awarenessand consumer protection, and theprinciples relating to innovation andcompetition, lead us inexorably tothe conclusion that we as a regulatorshould be seeking to harness ratherthan to hold back the forces of tech-nological change. With apologies forusing this analogy in a land-lockedcountry such as Austria, we are look-ing to exploit wave power ratherthan to attempt, like King Canute,to hold back the tide.

Financial services firms shouldbenefit from opportunities to exploitcompetition and innovation, from alower cost base, from wider andmore efficient distribution channelsand from better informed consumerswho should be better able to identifyand purchase good value products.

For consumers Ð and we takeaccount here of both retail and cor-porate consumers Ð e-commerceoffers at least the prospect of accessto a wider range of products, to bet-ter value products, to additional andmore accessible sources of informa-tion and advice on financial matters,and to all the other benefits of amore competitive and innovativemarket for financial services. Buthow far this prospect has been, orwill be, translated into realityremains uncertain.

Clive Briault



Despite its rapid growth, the useof e-commerce by retail consumersremains limited, not least in the areaof financial services. Different sur-veys offer different results, butaround 30% of households in theUK are ÒInternet enabledÓ, up fromjust 5% in 1997. However, only asmall subset of these potential usersare logging on for reasons connectedwith financial services. The highestestimate is that a quarter of the30% (so 8% to 9% of all households)have used the Internet for financialservices purposes. Most of the retailsector use it as a source of informa-tion and advice on financial products,or to undertake straightforwardonline banking and share dealingtransactions Ð exploiting the lowercosts and greater convenience ofe-commerce.1)

A second dose of reality here isthat consumer surveys show thatalthough consumers tend to be suit-ably cautious in buying from unfami-liar names and do not use informa-tion from e-media in isolation fromother sources, many consumers donot understand properly the risksinherent in e-commerce transactionsand tend to place too much relianceon information that appears to havebeen ÒpersonalisedÓ (which is easierfor firms to deliver electronically).I will return to some of these con-sumer issues when I comment onthe paper by Hermann-Josef Lam-berti.

I do not know whether, or towhat extent, these benefits for firmsand consumers have raised the trendrate of potential output or produc-tivity growth. There is an activedebate under way on this.2) But thebalance of considerations does seemto be firmly on the side of the bene-fits here.

The FSA has therefore taken apositive approach to the develop-ment of e-commerce in financialservices. We have of course insistedthat regulatory entry standards mustbe met, and that regulatory require-ments are met on a continuing basisonce a firm is authorised, just aswe insist on this for any otherdelivery channel. But we have notimposed any restrictions beyondthis. And in Europe we arguedagainst the idea that the provisionof e-money should be confinedto credit institutions.E-commerce financialservices have expandedrapidly in the UK. Bothnew entrants and exist-ing firms have movedinto e-banking, e-brok-ing and other forms ofe-business. One-thirdof the 50 or so elec-tronic alternative trading systems inEurope are in the UK.

But significant risks for consum-ers do nevertheless arise from e-commerce. Consumers and/or mar-ket confidence more generally maysuffer as a result of:Ð Losses in firms resulting from a

failure in key e-commerce sys-tems, from an inability to copewith the customer-driven vol-ume of demand, and from fail-ures in an outsourced function,in other internal systems andcontrols and senior managementoversight, and in strategicchoices. In many respects thereis nothing new here, but e-com-merce has created a publicexpectation of 24-hour availabil-ity, seven days a week; and it hasmade it more difficult for firmsto predict or to control volumesof business.

1 See Durlacher (2001) and research commissioned by the FSA.2 See, for example, the recent contributions by Gordon (2000) and Jorgenson (2001).

Clive Briault



Ð Fraud (which may be againstfirms or their customers),breaches of security procedures,criminal or terrorist attacks onsystems (including payment, set-tlement and clearing systems)and other types of financialcrime.

Ð Consumers may find it less easyto tell who they are dealing withover the Internet and similarchannels, whether firms areregulated, and what rights theyhave if things go wrong. This riskis amplified by the global natureof e-commerce, which chal-lenges the traditional way inwhich countries exercise regula-tory control over the provisionof financial services. The initialregulatory response to this riskwas for countries to adopt aÒdirected atÓ test, under whiche-commerce promotions had tomeet local requirements in eachof the countries they were tar-geted at. The EU has taken asingle market approach and gonefurther through the e-commercedirective, under which the pro-vider of e-commerce services inmost areas of financial serviceswill be regulated in the countrywhere the provider is based,rather than in the country wherethe consumer is sitting at his orher terminal.

Ð Market manipulation through the(mis)use of chat rooms and bul-letin boards.The main conclusions from our

work on e-commerce have thereforecentred on:Ð the need for adequate IT systems

and controls to be in place inproviders of e-commerce serv-ices,

Ð the need for consumers to beable to understand better howto use the greater volume ofinformation and transaction

opportunities available to them,to understand the nature of thetransactions they are enteringinto and to take appropriatesecurity measures,

Ð the need for continuing surveil-lance of the development ofe-commerce, both domesticallyand internationally and

Ð the need to exploit the opportu-nities offered by technologicaldevelopments to make regula-tion itself more efficient andeffective. It will be possible tomonitor and supervise firmsand markets more efficientlyand effectively, and to makeinformation available more effec-tively to firms and consumers(where we already have an initia-tive underway to provide compa-rative information on a range offinancial products to consumersthrough our website). Theremight also be a case for introduc-ing identifiable and restricteddomains for regulated firms sothat consumers can tell immedi-ately if a service provider is aregulated firm, or to insist thata hyperlink is provided to thewebsite of a firmÕs regulator,although we are not yet per-suaded that these initiatives canbe justified on cost benefitgrounds.The paper by Christophe Bisiere

and his colleagues provides an exam-ple of the impact that new entrants,exploiting new technology, can haveboth directly Ð through the improvedor cheaper service they can provideto customers Ð and indirectlythrough changing the behaviour ofincumbent firms. It is a reflectionof how rapidly market developmentsare occurring when we begin tothink of Nasdaq as the ÒtraditionalincumbentÓ in an increasingly con-testable market, but that is preciselythe situation that this paper explores.

Clive Briault


49


And the incumbent has duly changedits behaviour (here in the form ofmoving to decimalisation) in anattempt to retain market share Ðalthough in practice this was at SECinsistence as part of a general switchto decimalisation in US markets,rather than directly the result of spe-cific market forces or even academicanalysis. It will be fascinating to seewhat impact this has had on the abil-ity of Island to compete effectively,as promised in the next version ofthis paper.

These direct and indirect impactsare to be found throughout the finan-cial sector and beyond. To give justone example, Brown and Goolsbee(2000) found that, in the life insur-ance industry, comparison shoppingon the Internet has driven downthe prices charged by offline pro-viders.

But even where the incumbentresponds to competitive pressures,the impact of new technologies onentry costs, on the speed of under-taking transactions or of processingand communicating information,and on global reach is always likelyto generate new areas of contestabil-ity. The Schumpeter view of Òcrea-tive destructionÓ is perhaps beingechoed here in a more limited waythrough Òcreative fragmentationÓ.

I am less sure that the results inthe paper on the profitability of trad-ing through Island tell us very much.By having a finer price grid, Islandeffectively allowed traders to stepinside the Nasdaq quotes in orderto effect a transaction. But if you giveone group of traders an option tostep ahead whenever they want to,it is not surprising that when theychoose to exercise this option theymake money. Equally, I doubt thatthe results in the paper can tell usanything about price discovery Ðmoving fractionally inside the Nas-daq quote in order to effect a trans-

action is not really price discovery inthe sense of forming the inside quoteitself, but more akin to free riding.

Research of this type is howeverpotentially relevant to the potentialimpact of market fragmentation onliquidity, on the efficiency of priceformation and discovery, on thetransparency of prices and trades,and on whether a market might bemore prone to disorderly behaviour.Most work in this area suggests that,so far at least, the advantages of com-petition and innovation are consider-able, and that marketforces have themselvesgenerated solutions tothe potentially detri-mental impact of frag-mentation on liquidity,price formation andtransparency.

Nevertheless, regu-lators must remain vig-ilant. The FSA issued a discussionpaper (Financial Services Authority,2000) last year on the impact ofalternative trading systems, and onhow regulation should adjust to theblurring of the distinction betweentraditional exchanges and alternativetrading systems. And we have justissued another paper (Financial Serv-ices Authority, 2001a) on how theÒbest executionÓ rule might beamended to reflect market fragmen-tation.

The paper by Hermann-JosefLamberti makes some importantpoints on the impact of new technol-ogy on existing financial services.Almost irrespective of technologicaldevelopments, consumers will stillneed advice and information; riskswill still need to be transformed sothat they can be transferred Ð at aprice Ð to those willing to take onthese risks; and transactions will stillneed to be processed. And it isalready clear that the response ofmany consumers, especially retail

Clive Briault



consumers, to technological devel-opments is to place their trust inestablished brand names and to usea combination of high-tech andlow-tech sources of services. Thishas been to the advantage of existinglarge suppliers, who have been ableto grow their e-commerce servicesto consumers alongside the moretraditional bricks and mortarapproach. And indeed we have seenmuch the same thing in many nonfi-nancial services markets as well.

This is not to deny the importantrole that many purelye-commerce basedentrants to the industryhave played in contest-ing these markets andin forcing the estab-lished firms to adjustin response. But oneimpact of the impor-tance placed by many

retail consumers on trust and brandnames Ð irrespective of whether thisis sensible and rational behaviour Ðhas been to reduce the degree ofcontestability in these markets andto limit the potential impact of tech-nological advances in reducing infor-mation asymmetries.

One potential advantage of tech-nology is the use of automated chan-nels of advice to consumers. Thisautomation could be used to tailorservices and products to a customerÕsneeds, based on their profile andpersonal preferences. This soundsenticing, but is it all good news forthe consumer? As Vulkan (1999) dis-cusses in his paper on intelligentagents, there are two particularproblems here.

First, what information will theautomated advisor gather before giv-ing advice to individual consumers?How will it ensure that consumersare advised to buy products that are

genuinely suitable to their needs?Second, whose products will theautomated advisor search acrossbefore making its recommendations?Is Deutsche Bank going to set itselfup as a genuinely independent adviceservice, offering advice on the fullrange of services and products pro-vided by its closest competitors?And in these days of the euro area,let alone the global marketplace, towhat extent will it select from serv-ices and products provided by firmsin other countries? How manyAustrian providers will it searchacross?

As for the products that a firmlike Deutsche Bank might itself cre-ate for its customers in a high tech-nology world, a series of papers byArmstrong and Vickers (1999) andby Ulph and Vulkan (2000a and2000b) consider the implications ofthe possibilities arising from the useof technology to process consumerspecific information and to generatedifferentiated products at low cost.Firms may be able to sell the sameservice or product at different pricesto different consumers or groupsof consumers (first degree pricediscrimination); to offer differenti-ated products while retaining econo-mies of scale (mass customisation)and to sell different products at dif-ferent prices to different consumersat different prices (second degreeprice discrimination). An interestingbattle may arise between thisÒenhanced surplus extraction effectÓand the intensified competition thatshould also result from the new tech-nology. And the consumer might notbe the winner.1)

Meanwhile, and related closelyto the impact of technology on cost,financial services providers and non-financial firms alike have movedincreasingly to the outsourcing of

1 See also the Office of Fair Trading (2000).

Clive Briault



many of their functions. Whereasthis used to be confined mostly tothe outsourcing of Òback officeÓ func-tions, this is extending rapidly intomiddle and front office functions aswell. Contestability, and the inexor-able effects of declining marginalcosts, are taking their predictableeffect on functions that the consumerdoes not see, or does not even realisehave been outsourced. And the FSAis becoming increasingly concernedabout the low standards of diligenceand responsibility exhibited by manyregulated firms when outsourcingtheir key functions.

I turn finally to the longer termÐ the Ònow for something completelydifferentÓ scenario. I cannot predictwhat the future holds here, but wemust expect to see new productsand services in the financial sector,and new channels through whichboth existing and new products aredistributed. Mergers among thelarger players are increasing the mar-ket shares of the largest firms; butequally there is no shortage of newentrants to financial markets. Someof these entrants are small newfirms, but others are large firmsdiversifying from other activities.For both types of new entrants,new technology is reducing the costof entry and thereby making marketsmore contestable. So even if thereare fewer and larger firms, theirdominance in terms of market sharemay not be so easy to turn into prof-itability as new entrants constantlysnap at their heels. And some ofthe dominant players in the futuremay not be the same firms as thosethat have large market sharestoday. §

ReferencesArmstrong, M. and Vickers, J. (1999).

Competitive price discrimination. Nuffield

College, Oxford. Working paper.

Brown, J. R. and Goolsbee, A. (2000).Does the Internet make markets more

competitive? Evidence from the life insur-

ance industry. NBER Working paper, no.

7996, Cambridge MA, November.

Durlacher Quarterly Internet Report(2001). London, March.

Financial Services Authority (2000).The FSAÕs Approach to the Regulation of

Market Infrastructure. Financial Services

Authority, London. Discussion paper,

January.

Financial Services Authority (2001a).Best Execution. Financial Services Authority,

London. Discussion paper, April.

Financial Services Authority (2001b).The FSAÕs approach to the regulation of

e-commerce. Financial Services Authority,

London. Discussion paper, June.

Gordon, R. J. (2000). Does the ÒNew Econ-

omyÓ measure up to the great inventions of

the past?Ó. In: Journal of Economic Perspec-

tives, vol. 14, no. 4, pp. 49Ð74.

Jorgenson, D. W. (2001). Information

Technology and the US Economy. In:

American Economic Review, vol. 91, no. 1,

pp. 1Ð32, March.

Office of Fair Trading (2000). E-com-

merce and its implications for competition

policy. Office of Fair Trading, London.

Discussion paper no. 1, August.

Ulph, D. and Vulkan, N. (2000a). Electro-

nic commerce and competitive first-degree

price discrimination. Mimeo, February.

Ulph, D. and Vulkan, N. (2000b). E-com-

merce, mass customisation and price discri-

mination. Mimeo, May.

Vulkan, N. (1999). Economic implications of

agent technology and e-commerce. In:

Economic Journal, vol. 453, pp. 67Ð90,

February.

Clive Briault



Gert Wehinger

50


Comments on


ÒNew Technologies and Financial Markets

in the Long TermÓ

and

Christophe Bisiere, Bruno Biais

and Chester Spatt,

ÒThe Internet and Financial Markets:

Island versus NasdaqÓ

1 These comments have greatly benefited from discussions with Hans Christiansen, OECD Directorate for Financial, Fiscal, and Enterprise Affairs. The viewsexpressed here are those of the author and do not necessarily correspond to those of the OECD.

Gert WehingerEconomist,

OECD1)


Introductory RemarksSince the early to mid-1990s, advan-ces in communication technologyhave left their mark in all sectorsof the economy. In fact, whether thisalso calls for a new paradigm in eco-nomics was the topic of last yearÕsOeNB Economics Conference.How these new technologies haveshaped and will shape the financialsector are the issues of the currentsession, and these issues areaddressed in the papers presentedby Hermann-Josef Lamberti and

Christophe Bisiere (thelatter co-authored byBruno Biais and Ches-ter Spatt). While thefocus and scope of bothpresentations is differ-ent, there is a commondenominator: the Inter-net. In my commentsI will quickly sketch

the new landscape, and by doing sorefer to the specifics covered bythe papers.

Even though financial institutionshave for decades communicated viaelectronic networks, open networkarchitectures such as the Internetallow for a new quality of theirinteractions. And this is not onlytrue for business-to-business (B2B)relationships, but also for thosewith consumers (B2C). Enhancedplatforms and Internet penetrationwill allow households to activelyparticipate in financial transactions,and increased speed (in terms ofcomputing power as well as networkconnections), transparency, andparticipation could help to makefinancial markets more efficient. Soa modest view that the Internetserves as merely another channel ofcommunication and distribution willcertainly be challenged by the newdevelopments, which might revolu-tionize the financial sector as awhole.

Business ModelsHowever, as also stated in LambertiÕspresentation, one should bear inmind the obstacles to those newdevelopments and that not all finan-cial markets and financial productslend themselves easily to an onlineInternet application. On the demandside, customers choose new technol-ogies generally on the grounds thatthey are cheaper, allow for fast andreal-time access, but such advantagesare weighed against concerns aboutsecurity. On the supply side, byintroducing new technologies, com-panies expect to cut costs and attractnew clients (or at least retain theirclient base in the face of competitorsoffering e-services). The financialbusiness will not only have to beselective with regard to existing busi-ness models (choosing which serv-ices to adapt for the new technol-ogy), but also creative in developingnew business models. From todayÕsstandpoint, what can be said inassessing those business models?

E-moneyE-money schemes have reached con-siderable value in some countries,but still do not meet their expecta-tions with regard to growth and dif-fusion. However, as the transactionsinvolved constitute pure transfers offunds rather than trade in financialmarket services, e-money will notbe our issue in this discussion.

BankingSo far, pure Internet banks have Ð atleast for the time being Ð not been agreat success. If at all, the winnershave rather been the online Òclicksand mortarÓ presences of entrenched(Óbricks and mortarÒ) financial insti-tutions. Even if they come as sepa-rate entities (which can also besupplemented by nonbanking serv-ices), customers prefer them to belinked to banks well known to them.

Gert Wehinger



E-banking services are demanded ongrounds of convenience, not price.Thus, for the banks the optimal strat-egy is offering a mix of traditionaland online services. Even thoughthis usually comes at an additional(initial) cost to the bank, it will haveto be weighed against the benefit ofretaining (or even enhancing) clientloyalty. Of course, the overall suc-cess of such strategies will dependon the Internet penetration in agiven country, but even if this islow, active policies embracing thenew technologies can overcomethose disadvantages (Spain andPortugal, both with a low numberof Internet connections, but rela-tively high e-banking activity, mightserve as examples).

Securities ServicesOnline brokers have gained largemarket shares, and are on the upbeatgiven the developing equity culture,increasing wealth, and demand forpension fund investments in manycountries. To a lesser extent, this isalso true for online asset manage-ment, but clientsÕ concerns aboutsecurity, their demand for personalcontact, and uncertainties regardingthe security of the online channellead to a less upbeat developmentof this sector. Furthermore, giventhe competitive environment, oneshould also not be worried by acurrent wave of retrenchment inresponse to stiff price competition.Again, the winners are likely tobe online services offered byentrenched asset managers (in thiscontext, it should be noted that90% of online asset management inthe United States is with Schwaband Fidelity). It will also be easierfor them to cross-subsidize theiraddition to the traditional distribu-tion channels during a start-upphase.

Mortgage FinanceMortgage lending is at best at itsearly stages in electronic financeapplications, also as it is among thefinancial services least suited foronline distribution Ð given its com-plexity, size, and potential for dis-putes. However, the Internet hasproven useful for mortgage lendersto market their products, as custom-ers can use the net to easily comparevarious offers and prices. At themoment, in addition to being quitelimited in size, the market for onlinemortgage services islargely confined to theUnited States, where itis linked to an impor-tant degree with theexisting network ofmortgage brokerageand agents. In the longrun, the structures ofmortgage finance inthe United States and Europe couldconverge, as European mortgagelenders increasingly see the Internetas an opportunity for outsourcingand reducing costs at the retail level.

Insurance ServicesAs in the case of mortgage financeand for similar reasons, online insur-ance is rather marketed than soldonline. Some of the predominantchannels are point-of-sale portalswhere insurance is sold togetherwith insurable objects and insuranceaggregators providing online pricecomparisons.

Account AggregationAccount aggregation (AA) Ð so faronly in its infancy in Europe Ð is aprocess by which the so-called aggre-gators offer customers one-stopshopping for financial and nonfinan-cial services and are equipped withthe information and authorizationto address clientsÕ accounts withseveral financial institutions. This

Gert Wehinger



allows e-finance clients to do all theironline transactions via one website.AA is novel in using the Internetfor such services, which had alreadybeen provided in the B2B segmentsof the markets, and thus makingthese services available for house-holds. The start of AA in 1999 wasslow, as the major impediment atthe time was clientsÕ reluctance toshare confidential financial informa-tion with relatively unknown Inter-net companies. In 2000, the aggrega-tors therefore changed strategy to

start offering entrenched financialinstitutions the backbone technolo-gies to design their own aggregatorsites. This in turn could makebanks, which are generally stillhostile toward AA, more favorable,as they would feel less in danger ofloosing contact to customers andcontrol over their retail process,and could even expect additionalcustomer loyalty. While AA is notyet wide-spread (in the U.S. onefourth of the e-banking clients),the client base is expected toincrease exponentially, and this willalso raise new regulatory issues,most importantly creating a level-playing field for the players in-volved.

Cross-border E-Finance

Cross-border finance is still under-developed, and this is true evenfor the European Economic Area(EEA), where progress toward thesingle financial market should havefacilitated such transactions (within

the EEA, the only bank that hasso far developed a business conceptbased on cross-border delivery isFirst-E, which operates in fourcountries from a corporate presencein Ireland). Among the factors hold-ing back intra-EEA cross-borderfinance areÐ the need for further harmoniza-

tion;Ð nonintegration of retail payment

systems across the area;Ð inconsistencies between the e-

commerce directive and someof the specific financial servicesdirectives;

Ð lack of consumer confidence innonresident e-finance providersand an inadequate level of con-sumer redress on a cross-borderbasis; and

Ð that one-off operations such asopening a bank account are gen-erally difficult for nonresidents,and online clients who reside inother jurisdictions are usuallynot solicited by banks Ð or mayeven not be accepted, as banksmay be unwilling to make them-selves subject to the dispute set-tlement mechanisms and cus-tomer protection rules of juris-dictions with which they maynot be acquainted.

New Platformsand Further Developments

Besides the ÒtraditionalÓ PC withInternet connection, new deliverytechnologies for e-finance serviceshave to be considered, in particularhandheld devices. In general, only asmall proportion of e-finance serv-ices are suited for the latter, andclients are unlikely to wish to per-form a transaction on a mobiledevice unless it is relatively uncom-plicated, or timeliness and instantavailability aspects are important.In this regard, obvious candidatesfor mobile finance (Òm-financeÓ) are

Gert Wehinger


51


day trading of securities, bill pay-ments, and money transfers.

Personal Digital AssistantsGiven the complexity of transactionsand secure software necessary, per-sonal digital assistants (PDAs) areless suitable for e-finance (a view alsoshared among market participants).Even if those devices are becomingincreasingly powerful, this view isunlikely to change in the future forPDAs proper Ð also in the light ofthe alternatives being developed(notably in the mobile phone mar-ket, where new devices merge phoneand PDA functions).

Mobile PhonesBesides allowing customers mobileaccess to voice services provided bytheir financial intermediaries,mobile phones increasingly allowInternet access. Even though the cus-tomer acceptance of WAP (wirelessapplication protocol, the first gener-ation mobile phone Internet access)was disappointing in many countriesÐ mainly due to slow access and alimited supply of services Ð, secondand third generation technologiesallowing for more speed and band-width (currently, GPRS, and later,UMTS) should be more promisingin gaining hold in the distributionof financial services. One advantageof mobile phones is also that theyare available to a larger group ofpeople than Internet-connected PCs(Italy can serve as an illustration ofthis point, where more than half ofall e-banking clients connect withtheir banks via WAP phones). Untilnow, however, the share of mobilephones in total e-finance is estimatedto remain below 2%.

Interactive TelevisionGiven the larger penetration ofhouseholds with TV sets as comparedto PCs, this could be a promising

channel. However, it will remain tobe seen whether customers acceptmanaging their personal finances viathe family television. Estimates sug-gest that less than 5% of all elec-tronic banking transactions in 2000took place using interactive tele-vision (iTV) technologies.

Financial Markets,the Internet, and FinancialStability Implicationsof E-Trading

As hinted at in the paper by Biais etal., the Internet can be expected tohave a major impact on the structureand functioning of trading systems.The new technology will renderthe markets more transparent,potentially more liquid, and thusmore competitive. On a technicalnote, it will be interesting to seethe results of their paper once therecent decimalization is analysedunder this approach. As the authorsthemselves suppose, lifting the obvi-ously binding restriction of thecoarseness of the Nasdaq grid, thenoncompetitive behavior in thatmarket should be reduced or eveneliminated.

Automated trading systems thatuse computer software to matchbuy and sell orders, the so-calledECNs (Electronic CommunicationsNetworks), have expanded rapidlyin the United States and also inEurope. The supply-side benefits ofcost-efficiency, accelerated tradeexecution and enhanced price infor-mation add to the demand-sidedevelopment of an equity cultureamong retail investors. As also statedin the paper, traditional dealersÕmargins are coming under increasingpressure as bid-ask spreads diminish.One reasonable response, chasingvolume, will again be facilitated byelectronic trading.

One important impact of elec-tronic trading will be one on market

Gert Wehinger



liquidity, but it is difficult to assess itssign and size ex ante (see Crockett,2001). On the one hand, as elec-tronic trading leads to tighter pricing(lower bid-ask spreads) due todecreasing transaction costs, onedimension of liquidity may beimproved. But by reducing bid-askspreads, electronic trading will tendto reduce the profitability of activemarket-making, causing financialinstitutions to scale back this activity,with negative effects on liquidity.Furthermore, as markets maybecome more fragmented with morecompetitors crossing the lower bar-riers to entry, this may again reduceliquidity. Shallower markets mayincrease intra-day volatility and a lessefficient price-discovery mechanism.In periods of market stress, liquiditymay dry out even more quickly andexacerbate turbulence. A recentreport by the Committee on theGlobal Financial System suggests thatelectronic trading in foreignexchange and fixed income securitiesis centralizing many OTC marketsand putting some dealers under pres-sure. However, the report found no

conclusive evidence that these devel-opments have led to a marked reduc-tion in liquidity (see The Committeeon the Global Financial System,2001).

In any case, such new develop-ments in financial markets willrequire supervisors to stay alert.But while doing so, their actionsshould not stifle further develop-ments in that rapidly evolving sector,which may bring about increases inoverall economic welfare. As to suchwider economic implications of e-finance, notably on economicgrowth, they have been covered else-where at this conference and willalso be addressed in the next presen-tation of this session. §

References

The Committee on the Global Finan-cial System (2001). The Implications of

Electronic Trading in Financial Markets.

Bank for International Settlements, Basel,

January.

Crockett, A. (2001). Financial Stability in

the Light of the Increasing Importance of

Online-Banking and E-Commerce. BIS

Review 2001, no. 5.

Gert Wehinger




Erich W. Streissler

52


Financial Institutions

and Technological

Progress:

An Historical Perspective

1 The Field to SurveyAs Jules Verne tells us, Phineas Foggwas not only willing but able totravel around the world within 80days. Not a mean feat in 1873, theyear of the greatest financial crashof the 19th century. I have beenassigned the altogether more daunt-ing task of presenting an historicalperspective of financial institutionsas well as technological progress,and that in no more than about 25minutes. And I can only hope thatin the near future a world-widefinancial crash of the dimensions ofthat which started in Vienna onMay 8 and 9, 1873, the other sideto the story of Phineas Fogg, willbe avoided.

In order to make my task a littlemore tractable I shall only speak ofinternational financial markets andtheir institutions. I hope this will be

Erich W. StreisslerProfessor,

Universita¬ t Wien


in conformity with our generaltopic, the single financial market.

Is the development of inter-national financial markets mainlytechnological at all? And is thisdevelopment progress? These wouldactually have to be our first ques-tions. The doubts expressed in thesequestions I shall leave unanswered,and merely, after a short prelude,approach my topic in four ways. FirstI shall argue that within (roughly)the last three centuries there whereonly two or three great innovationswhich shaped international financialmarkets. The first was institutional,in fact, and only the latter one ortwo innovations were technical inthe narrower sense. Second, I shallshow that there actually was destabi-lizing institutional retrogressionduring the 20th century, now happilypast. Third, I shall examine theeffects of the undoubted growth insize of international financial marketsand what that means institutionally.Finally, I shall deal very briefly andsketchily with the speed of financialinnovation and the effect which thishas on financial markets.

2 Prelude

The Nobel Memorial Prize winner inEconomic Sciences of the year 1999,the Canadian (living in Europe)Robert A. Mundell, has publishedÒA Reconsideration of the TwentiethCenturyÓ from a mainly financialperspective. Its key sentence, exactlyfor the case of international financialinstitutions, runs: ÒForget the 75years between 1914 and 1989!Ó(Mundell, 2000, p. 327). As far asinternational financial markets areconcerned, most of the 20th centurywas that rarest of phenomena in themodern world, a period of mereretrogression. Toward the end ofthe 1930s we retrogressed to thelowest level of internationalexchange for centuries and to next

to no financial exchange. Not onlyKeynesÕ General Theory was con-ceptually one for a closed economy,we had actually degenerated to aworld system of nearly closed econo-mies. ÒThe clue to the twentieth cen-tury lies in the links between its firstand last decadesÓ (Mundell, 2000,p. 327), Robert Mundell adds some-what optimistically. True, only the(long) first and the last decade ofthe 20th century had full inter-national capital mobility. In thatrespect only these Òbook ends ofthe centuryÓ, as Mundell calls them,came up to the European standardsince about 1700. But we have notyet regained the single monetaryanchor which the period from 1717to 1914 had found in gold. Thus,we are still far behind the financialintegration of the 19th century.

We have no single reliable mon-etary standard and thus no commonexpectational basis. Otherwise howcould it have been possible that theworldÕs greatest debtor nation, aneconomy with a continuous currentaccount deficit since 1982, and, toboot, at record levels in both 1999and 2000, could convince the world,by a concerted propaganda effort,that because of its unproven ÒNewEconomyÓ its currency relative tothe euro is now worth more by30% or 40% as compared to threeyears and some 60% as comparedto six years ago? Or how could lag-gard Germany convince itself and Ðunfortunately Ð many others thatthe accession of Italy to EMU is aburden on that currency when Italy,in contrast to Germany, was runninga substantial international currentaccount surplus up to 1999, withonly very small deficits thereafter,thus strengthening and not weaken-ing the euro? We have not yet re-established clear international finan-cial measuring rods, neither the clearstandards nor the clear theories

Erich W. Streissler



which we had up to 1914. In a fieldso rife with unproven speculation wehave not yet regained the certitudesof the unjustly despised 19th century.

3 Technological Progress?

After these sceptical remarks let usturn to Progress (with the capital Pof the optimistic 19th century), to beexact: to technical economic prog-ress, once more a 19th century idea,much propagated by Karl Marx.

For international financial mar-kets there were only two or threetechnical advances in the widersense. As P. G. M. Dickson convinc-ingly showed there was a ÒFinancialRevolution in EnglandÓ around1700, a revolution substantially pre-ceding the so-called Industrial Revo-lution (Dickson, 1967). The Dutchalready before that and then Englandin the early 18th century established atruly international financial market,and not only for governments butfor private individuals, though, onemight say, the two were largely com-plementary, government securitiesbeing bought by private individuals:Sarah Jennings, the widowed duchessof Marlborough, invested in suchpaper securities, unthinkable onlyhalf a century before. In fact, secur-ities, even of governments, for thefirst time became just that Ð secur-ities. The Swiss canton Berneinvested in English, in French, andin Dutch securities, i.e. widely inter-nationally. For the first time in mod-ern European history there was agenuinely international market instocks and bonds.

At the same time it became amarket-based on an internationalmonetary standard, on gold. To acertain degree this came about,curiously enough, through a miscal-culation by one of the greatest math-ematicians of all times, the thenMaster of the British Mint, Sir IsaacNewton.

In 1717 Isaac Newton miscalcu-lated the correct silver price to beset for the British gold coin, theguinea. He miscalculated it at 21shillings. Or, in a slightly kinderinterpretation of his advice, theBritish Parliament chose the wrongoption among his several sugges-tions. The silver price of the Britishgold coin was set too low so that,quite inadvertently, Britain stumbledinto mono-metalism, into the goldstandard. Add to that the fact that,of all the nations of Europe, Britainalone had made coinagea completely costlesspublic good, so thatthe slightly cheapergold coinage rapidlyreplaced silver (in thesense of new full weightsilver coins). Thus, itwas more or less byaccident that the lead-ing financial nation of the 18th cen-tury, Great Britain, created a trulyinternational market, we may evensay a world financial market-basedon its newly created gold standard.

This was the first great Òtechni-calÓ innovation in financial marketsto be considered here, certainlyÒprogressÓ, though ÒtechnicalÓ inthe narrower sense only by courtesy.

With the gold standard inter-national finance had become Ð forthe first time since antiquity Ð amore or less private commercialbusiness. As an example, the lasttwo Habsburg emperors, Joseph Iand Charles VI, could raise fourgreat foreign loans on the Londoncapital market, denominated in Brit-ish pound sterling: in 1706, 1710,1735, and 1737, altogether totalingnearly one million Ð 910,000 tobe precise Ð British pound sterling.These international loans to theHabsburgs amounted in sum to some2% of one yearly British GDP, thusproving quite substantial even

Erich W. Streissler



from a modern perspective. Theywere much larger than what couldbe raised in Germany, where CharlesVI floated only a loan of one millionReichstaler in 1730, with about180,000 British pound sterlingconsiderably smaller than the Britishloans of 1706, 1735, and 1737.That both the German loan of 1730and the British loan of 1735 weresecured on the revenues of Silesiaproved not the wisest of decisionsafter 1741, when Frederick ofPrussia alienated that rich part ofthe Habsburg Empire.

Let us leave the first half of the18th century, which, with the goldstandard and the London market,had established an internationalfinancial system in a sense muchmore advanced than our own. For,be it remembered, within the lasttwo years or a little more we havewitnessed a depreciation of the yenagainst the U.S. dollar by about70% and of the euro by about40%, calculating in each case fromthe lowest point to the highest. Suchrapid changes in monetary standardswould have appeared quite unimag-inable to any 18th century financier.One problem that he had, however,was that it took many days for himto find out what happened simulta-neously in other financial markets,that it took at least five weeks toknow what happened in NorthAmerica, and months to know whatwas the case in India. In early 19th

century, Nathaniel Rothschild couldstill make money by being informedby his own private packet boat abouta day earlier than other market par-ticipants of the outcome of the battleof Waterloo.

All this was changed in the lastthird of the 19th century by the intro-duction of the international tele-graph and soon after, in the 1890s,by the introduction of the telephone.From now on, news of what hap-

pened in distant financial marketsspread within minutes by telephone.Financial markets all over the worldwere now informatively linked andthe financial decision period shrankto about five minutes. From the1890s onward financial marketsbecame simultaneously acting mar-kets, a great technical advanceindeed.

About one hundred years laterfinancial markets are now linked byInternet. The difference of thisfurther technical advance relative tothe telephone is that decisions havenow to be taken within only half aminute and not within five minutes,and that much more people can seethe same news bits simultaneouslyon the Internet screens. Still, I amnot sure whether I should speak oftwo phases of technical progress,telephone, and a century later theInternet, or basically only of one.From five days to five minutes thetime dimension of reliable up-to-date international information isreduced by a factor of about 1,500to 1. From five minutes to half aminute it is further reduced by afactor of ten only. And it is not clearwhether processing complex infor-mation in only half a minute is notbeyond the capacity of most humanbrains. One gets the impression thatthe first panicky reaction after half aminute tends to be soon reversed.Therefore, I think that it was thetelephone which more than a cen-tury ago brought the decisive techno-logical advance and that the massuse of the Internet has to be consid-ered as basically only a minor addi-tional frill to the great advancebrought about by the telephone. Thisquestion is, in fact, part of theongoing debate about the extent ofÒnewnessÓ of the New Economy. Tomy mind the multitude of technicalinnovations just before 1900 andthen again around 1950 is far more

Erich W. Streissler


53


important than the sole advance ofcomputer and of Internet techno-logy during the last decade of the20th century.

4 Unity and Stability Lost

Thus, the last great innovation forinternational financial markets, theintroduction of the telephone, tookplace more than a century ago. Andthe 20th century presents itselffinancially not as one of great tech-nological progress, not even one ofstagnation, but actually as one ofretrogression, of unity and stabilitylost.

May I remind you first that Ð forcountries not on the brink of rapiddecline Ð the inflationary experienceof the 20th century is historicallyunique. From about 1630 to 1750the British price level changed hardlyat all and from then on only modestlyup to 1790. Then, again, from 1820to 1913 there was no price levelchange, though this time with some-what larger swings in between. Onlythe quarter of a century of wararound 1800, first with revolution-ary, then with Napoleonic France,brought inflation, but that was verymodest compared to the inflationshown even by the respective victornations in the great wars of the 20th

century.The real inflationary problem of

the 20th century is the extent towhich it shifted relative values ofthe major currencies against eachother within only a few decades.This, basically, was disquietingly new.

Robert Mundell has documentedthe astonishing fact that the UnitedStates of America suffered the great-est inflation by far in its entire his-tory in the 1970s: During the elevenyears form 1971 to 1982 the U.S.price level rose by a full 157% whileduring World War I, from 1913 to1920, it had only risen by 121%,during the Civil War it had risen by

118% between 1861 and 1864 andduring the commonly so highly infla-tionary World War II, to be exactfrom 1939 to 1945, the U.S. pricelevel had risen least of all periods,by only 108% (Mundell, 2000,p. 335). The Deutsche mark, onthe other hand, during its whole his-tory, in the fifty years from 1948 to1998, showed the lowest rate ofinflation of all world currencies with23/4% inflation on average, beingmarginally lower even than the Swissfranc in the same period of time.

During the financially uneasyyears of the 1970s, gold had shownan astonishing boom, rising in itsdollar price from USD 35 the troyounce in 1970 to USD 850 in early1980, causing an average dollar priceincrease of 37.5% a year! Todaygold, measured in U.S. dollars, isdown to less than a third of the priceof 1980. After 1980 the phoenixflight of gold was replaced by thephoenix flight of U.S. commonstocks: The Dow Jones index ofstock prices, conservatively calcu-lated, increased from 1982 to 1999more than fifteenfold or, in realterms, i.e. after subtracting infla-tion, by an average of 13.5% a year,less than gold in the 1970s, but stillat a quite unsupportable rate. Evenif you correct for the fact that manyU.S. companies have bought backaround 2% of their common stockseach year in order to fulfill stockoptions of their top managementand if you correct for the fact thatthe Dow Jones weighs its composite

Erich W. Streissler



stocks in such a way that particularlysuccessful stocks constantly get ahigher weight and that it periodicallytakes out unsuccessful stocks alto-gether, the corrected real increasein average U.S. stock prices has tobe around 9% or 10% a year. Addto that the average dividend yieldand you get more than double thereal return on capital, which cannotexceed 5% or at the very most 6%per annum for long, even in theU.S.A. Thus, from the 1970sonward, since the introduction offlexible exchange rates, we havebeen living through a period of vastfinancial instability, an instabilitywhich, apart from world wars, wehad not witnessed since the early18th century.

Add to that the historicallyunique experience that the leadingfinancial nation of the world, theUnited States of America, does nolonger save at all, in fact it shows anegative national saving rate, a cir-cumstance certainly partly due tothe astonishing stock market pricerise which makes Americans feelmuch richer than they can be in thelong run. This means that all U.S.real investment is at present financedby Japan and certain Europeannations. We are thus faced with afrighteningly unstable scenario forthe long run. Since the 1980s noteven inflation rates have been a reli-able guide any more because inflationdoes no longer differ very muchbetween the leading nations.

Since the creation of the euro wenow have three great world curren-cies, the U.S. dollar, the euro andthe yen. Their values need not bebound to any real fact whatsoever.They can represent just commonlyheld fantasies for the future dis-counted to the present. Or, as LordKeynes so aptly wrote, they canmerely be Òwhat average opinionexpects the average opinion to beÓ

(Keynes, 1936, p. 156). So by now,exchange rates are anchorless.

Or, if you wish to have a moreprecise statement, since 1973 themovement of the exchange rates ofthe leading industrial nations (with-out substantial inflation), and thatincludes the nations behind theU.S. dollar, the yen, and, on average,also the nations behind the euro,cannot be shown to have differedsubstantially from a random walkwithout drift. And it is an importantfeature of such a random walk in pri-ces that starting from any price thisprice and each and any other pricewill again be reached with certitude,but on average one has to wait infin-itely long till any given price isreached. This is an uncomfortablethought for mortal human beingswho will, I confidently believe, liveinfinitely long, though no longer ina state where they care about prices.To put it in a nutshell: 20th centuryfinancial markets have severed theirfirm moorings, secured by an anchorof gold, and have substituted it withan unpredictable random walk.

5 Growth in Market Sizeand its Consequence

However, after the lull of themid-20th century, an unprecedentednumber of boats are now birthed inthe storm-threatened harbour ofinternational financial markets. Inreading the newspapers one getsthe impression that the admirals ofthis fleet of financial investors arethe great international speculators.But that is largely misleading. Theowners of the numerous boats areactually the vast crowd of old agepensioners and those who invest forfuture old age pensions. On averagewe live much longer than our fore-bears a century ago. And, further-more, most of us live long and thendie in the same age bracket. Thereally great change in modern inter-

Erich W. Streissler



national financial markets is its dom-ination by funds basically tuned in tothe investor demand of future oldage pensioners and those who havealready reached that happy state.

U.S. financial investment theorycounseled that in order to even outthe financial risks of the late20th century one should hold aboutone half of oneÕs own investmentsoutside the country. But then theunprecedented long-term boomduring the 1980s and 1990s of theU.S. stock market came along.Thus, exactly U.S. citi-zens on average did notfollow the advice ofinternational diversifi-cation; however, Japa-nese and also Europeaninvestors did. And inEurope since July 1,1990, everyone hasbeen allowed to do so,which is once again proof that, inthe 20th century, the period up to1914 and that from 1990 onwardare twin eras of free financial invest-ment. ÒForget the 75 years between1914 and 1989!Ó It is the size ofold age pensioner investment thatdominates the markets today. Andwith the increase in average wealthold age pensioners investing com-mercially have vastly increased innumber. It is exactly old age pen-sioner sentiment which also explainswhy in most of the developed worldwe are no longer faced with substan-tial inflation. For inflation makesinvestment for retirement a night-mare.

There is, however, a downside tothat great and still rapidly increasingdepth of the international financialinvestment market dominated byold age pensioners and those plan-ning to become so: By now, the for-eign exchange market deals only tothe tune of 1% with current accounttransactions and is employed for a

full 99% for capital transactions. Ifthe forex market were mainly forexport and import finance, for cur-rent account transactions, priceswings would tend to be self-correct-ing. Those actual or aspiring old agepensioners, however, who dominatethe capital account, show low riskaversion. They mainly invest for areturn in 10 or 20 yearsÕ time oreven further in the future. By theneverything, the entire situation,may be quite different and will mostlikely be so if the exchange rate

movement basically follows a ran-dom walk. Furthermore, if they suf-fer a drop in value of their invest-ment there is no way for them toget out of such a loss. And if theygain, why should they switch horses?This implies that the increase involume of transactions in inter-national financial markets has madethe markets close to insensitive toprice fluctuations, to exchange ratechanges. And the fall in the averagerisk aversion of the dominant invest-ors tends to make exchange ratechanges all the larger. After the lossof the unique exchange rate anchorof the 18th and the 19th century thevery thickness of modern inter-national financial markets has madethese markets next to insensitive tolarge price fluctuations. This is instark contrast to what used to be,where a thin market showed sharpprice fluctuations because it is diffi-cult to find in them sufficient buyerswhen large sellers come along andvice versa. Today international finan-

Erich W. Streissler



cial markets, though thick markets,have become highly risky and it isdangerous to deal in them.

6 Does FinancialInnovation Count?

Does financial innovation in interna-tional financial markets count formuch? Actually, so far for surpris-ingly little. Remember, accordingto the Nobel laureate RobertMundell, we should Òforget the 75years between 1914 and 1989!Ó,and thus forget all the mainly short-run innovations, effected mainly fornational financial purposes. Notmuch has happened to the instru-ments of international finance after1914.

One important financial innova-tion of the 20th century was the risein regulatory importance of thecentral banks. By the 1990s, whenfreely moving international financialmarkets were once more established,the funds of the central banks had,however, become so small, relativelyspeaking, that they were unable todominate these markets and even lessable to dictate to them. One not verylarge international investor, Mr.Soros, could break the British poundsterling within hours, willinglyaided, however, by the British com-mercial banks. After the half-heartedand not very successful attempts ofthe European Central Bank to shoreup the euro last year we can moreor less forget central bank influence,as long as international financialmarkets are not very uncertain asto the probable future price move-ment.

But there was one sign of warn-ing of the possible dangers presentedby financial innovations. That was thecrisis of Long-Term Capital Manage-ment (LTCM) in September 1998(see Edwards, 1999, pp. 189Ð210).First, we learned to our surprise thathedge funds, being investment funds

open only to very large investors, Òassuch are left mostly unregulatedÓ(see Edwards, 1999, p. 190). Sec-ond, we found out that accordingto U.S. law derivative contracts, ifthey failed, were not subject tonormal bankruptcy protection of allcreditors, but that each and everycounter-party could Òliquidate anyof the defaulting counter-partiesÕassets in their control for any reasonÓ(see Edwards, 1999, p. 201), thuspossibly causing financial chaos.Third, the size of the engagementof LTCM and the low level of theirsecurity was eye-opening: With anapparently huge paid-up capital ofslightly less than USD 5 billionLTCM secured more than USD 125billion of bank credit from sixteenof the largest banks of the world.Thus, its capital was only 4% relativeto its debts. With this dangerouslyÒsmallÓ financial basis Ð if one canever call USD 5 billion small Ð itsecured contracts of more thanUSD 1,000 billion, or, as some say,of over USD 1,350 billion. Thus itspaid-up capital was not much morethan �% or even only 1/3% of its con-tracts. Its contracts were about fiveor even more than six times the thenannual Austrian GDP.

Does financial innovation countin international financial markets?With these huge and unguardedsums it very well might, and in ahighly destabilizing way. Had therebeen a crash of LTCM, the long-last-ing U.S. boom would most likelyhave ended then and there, after anormal eight-year period since1999, while it is now in a veryunusual eleventh year. It was WilliamMcDonoughÕs and, behind him, oneof Alan GreenspanÕs greatest achieve-ments to handle that dangerous crisisso adroitly. Even so, the Japaneseyen, most likely as a consequenceof LTCM, appreciated within daysof the crisis by altogether some

Erich W. Streissler


54


25%, and 15% within a few hours onone early October morning.

Therefore we may conclude: It isquite likely that financial innovationwill count on international financialmarkets, though it has not reallydone so yet. And it is quite possiblethat innovation might bring addeddangers.

This may seem to be a rathergloomy conclusion. But I am an opti-mist. In a further half century I amsure we shall be faced once morewith substantial technological prog-ress in international financial mar-kets. Historical experience teachesus that progress comes with upsand downs.

The 20th century was more aperiod of retrogression than ofadvance for international financial

institutions, a period more of downsthan ups. A single internationalmonetary standard may be hopedfor in the future. §

References

Dickson, P. G. M. (1967). The Financial

Revolution in England Ð A Study in

the Development of Public Credit

1688Ð1756. London.

Edwards, F. R. (1999). Hedge Funds and

the Collapse of Long-Term Capital Manage-

ment. In: Journal of Economic Perspectives,

vol. 13, no. 2.

Keynes, J. M. (1936). The General Theory

of Employment Interest and Money. Lon-

don.

Mundell, R. A. (2000). A Reconsideration

of the Twentieth Century. In: American

Economic Review XC, pp. 327Ð340, June.

Erich W. Streissler



Gianni Toniolo


A Tale of Two Financial Market Integrations Ð

Comments on

Erich W. Streissler,

ÒFinancial Institutions

and Technological Progress:

An Historical PerspectiveÓ

Erich W. Streissler has succeeded inthe extraordinary feat of compactinginto a few pages a somehow hetero-dox and stimulating account of thedevelopment of international finan-cial institutions over more than twocenturies. His dim view of the20th century Ð perhaps in need ofsome qualification Ð reminds us ofhow naõ¬f it is to see history, evenfinancial history, as an endless linearprogress. SteisslerÕs paper shows thatbacklashes and retrogressions arealways possible and that they aremostly man-made. As such, how-ever, they can equally be avoided by

Gianni TonioloProfessor,

Universita di Roma ÒTor VergataÓ,

Duke University, and CEPR


human actions. Among such actions,institution building is of paramountimportance.

Rather than discussing Streiss-lerÕs views on financial, institutional,and technical progress I thought Imight use my space to complementhis paper, in a more micro-vein, bytelling two stories of technical prog-ress, institutions, and financial mar-ket integration. Historical tales arenever void of metaphorical content,and mine, particularly the secondone, are no exception to the rule.

1 Early Integrationof Financial Markets

Streissler has argued that financialmarket integration is driven by tech-nical change, notably in the Informa-tion and Communication Techno-logies (ICT), and by apt institutions.Financial innovation may also playa role.

Integration is correctly measuredby price convergence, rather thanby large flows of financial capital.By this token, as mentioned byStreissler, financial markets werefairly well integrated as early asthe mid-18th century (Neal, 1985,1990). Integration accelerated afterthe end of the Napoleonic wars.

Contemporaries were fullyaware that ICT was crucial to thedevelopment (and integration) offinancial markets. In the 16th cen-tury, George Lloyds, the clever inn-keeper, provided information to hisclients; eventually publishing theLloyds Gazette. Streissler quotes the

excellent communications networkcreated by the Rothschild brothers.He stresses the role of the twininnovations of railways and tele-graph immensely increasing thespeed and reliability of communica-tion and information, with enor-mous spillovers into the financialindustry.

Institutions, on the other hand,had a mixed impact on the integra-tion of financial markets. If eventu-ally they evolved in a way thatfavored integration, in the shorterrun they were sometimes cleverlyused as a protective tool by thosewho stood to lose from closer finan-cial market integration.

I shall use two case studies tobriefly illustrate the interplay oftechnical and institutional change inshaping the integration of financialmarkets.

2 Transatlantic FinancialMarket Integration

As late as 1866 the fastest crossingtime from New York to Londonwas about ten days (Officer, 1996,p. 166). A great increase in the speedof ships had taken place in the pre-vious twenty years but ten days wasstill quite a long time for news totravel. Fairly large differences inprices for the same securities, there-fore, existed between the two largestfinancial markets in the world,London and New York. Then, onJuly 27, 1866, the transatlantic cablewas opened for business. In thefollowing three months, the meanabsolute price differential of theU.S. Treasury 6% bonds in the twomarkets fell by 69% (Garbade andSilber, 1978, p. 827). OÕRourkeand Williamson rightly observethat the impact of the cable onmarket integration emerged imme-diately and was of enormous size(OÕRourke and Williamson, 2000,p. 220).

Gianni Toniolo


55


As Streissler has pointed out, this19th century improvement in net-work communication technologyhad possibly a larger impact onmarket integration than that of themore recent Net, also because, aswe shall see below, communicationcosts fell more rapidly at that timethan now.

Yet, price differentials remained.According to Garbade and Silber(1978, pp. 827Ð828), Òa number ofinstitutional details and quoting con-ventionsÓ go a long way in explainingthe lack of full convergence betweenthe London and New York stockexchanges. By keeping the costs ofcross-market transactions relativelyhigh, institutional differences didnot allow for arbitrage to fully exertits influence on prices in the twomarkets. Nevertheless, it seems thatstockbrokers in New York andLondon welcomed the impact ofICT on their business. Probably, asleaders in their respective nationalmarkets, they saw in transatlantictransactions the opportunity for fur-ther increasing the volume of theirbusiness at the expense of the lesserregional stock exchanges and, there-fore, of consolidating profits derivingfrom national leadership.

3 ItalyÕs Financial MarketIntegration after 18611)

Italy was unified into a single state inMarch 1861. In the following year,the Piedmontese lira was made thesole legal tender for the new king-dom, thereby legally providing formonetary unification.

In the early 1860s, as many as 13stock exchanges existed in the coun-try. Any given security fetched quitedifferent prices in the individual

regional bourses, indicating financialmarket fragmentation. As we shallsee, neither political nor legalmonetary unification brought aboutswift financial market unification, inspite of the tremendous improve-ments in ICT.

The new state in fact investedheavily in communication technol-ogy. In 1861, only 12,000 kilo-metres of telegraph lines and 246telegraph offices existed in theterritory of the Kingdom of Italy.Five years later, these two figureshad roughly trebledand in 1870 Italy pos-sessed 50,000 kilo-metres of lines and asmany as 1,237 offices.More important, theprices of communica-tion services fell dra-matically. Sending a15-word cable acrossthe country (to a distance of 1,000kilometres) cost 20 lira in 1860, fiveyears later the price of the samecable was down to 2.4 lira. Pricescontinued to fall afterwards, if atreduced speed.

Communication technology,therefore, made colossal progress ina very short period of time even inrelatively backward Italy. One wouldthus expect rapid convergence in theprices of the securities listed on thevarious stock exchanges of thepeninsula. This was, however, notthe case.

The graph shows the five yearaverages for the coefficient of varia-tion of the price of the Italian 5%consols (Rendita Italiana), by farthe most liquid and widely tradedfinancial asset, across the five mostimportant Italian stock exchanges.2)

1 I am grateful to Leandro Conte and Giovanni Vecchi for permission to offer here a brief preview of some of theresults of our joint ongoing research into factor market unification after ItalyÕs monetary unification. See also:Conte, Toniolo, Vecchi (2000).

2 Rome, Florence, Turin, Milan, and Genoa.

Gianni Toniolo



Quite surprisingly, in spite ofthe enormous spread of the commu-nication network and of the tremen-dous fall in the price of telegrams,no progress in financial market inte-gration appears to have been madeuntil the 1880s.

The reasons for this unexpectedoutcome are entirely institutional.They can be summarized underthree headings: (i) the slow pace ofthe monetary unification progress,(ii) the resistance to change bypowerful vested interests, (iii) theinadequate understanding of theway financial markets operate bythe judiciary powers.

Slow Monetary UnificationIn 1862, the Piedmontese lira wasmade the sole legal tender, therebylegally providing for the monetaryunification of the country. However,it took a long time about 15 to 20years for actual monetary unificationto be achieved. Silver coins of thevarious pre-unification states contin-ued to be used alongside the Italianlira and were often preferred to it.Resistance to the introduction ofthe new currency was particularlystubborn in the South.

Confusion about exchange rates(roughly 240 different types ofmonies circulated in Italy at the time

of political unification) and conver-sion costs blurred the meaning ofprices and increased transaction costsmaking arbitrage among the differentstock exchanges unattractive to thesmall and medium-sized investor.

Vested Interestsand Institutional ChangeWhile the integration of financialmarkets promised better deals toindividual investors (consumers)and a more efficient allocation offinancial resources for society as awhole, it also threatened the oligop-oly of stockbrokers and stockexchange employees in the localbourses.

Quite understandably, thoseendangered by the new technologydevised ways to protect themselves.These took various forms:

(i) For a number of years, thelocal Chambers of Commerce,which at the time ran the stockexchanges, did not allow telegraphoffices to be opened within stockexchange premises.

(ii) Changes in traditional rulesand procedures (including those forstock listing and pricing), specificto individual local markets, wereresisted, thereby increasing informa-tion costs in arbitraging from onestock exchange to the other.

%

Italian Rent 5% (1862�1912) � Coefficient of Variation

(Five-year Averages of the Medians)

Figure 1

100

80

60

40

20

0


1862�66 1867�71 1872�76 1877�81 1882�86 1887�91 1892�96 1897�01 1902�06 1907�11 1912�13

Gianni Toniolo



(iii) Stockbrokers resisted gov-ernment regulation of the profes-sion. The 1865 Code of Commercederegulated the stockbroker profes-sion: unlicensed stockbrokers wereallowed to trade. In 1868/69, pro-fessional stockbrokers opened a dis-pute with the government whichlasted many years. Several of themrefused to carry out operations fromthe parterre. Trade outside the offi-cial stock exchanges blurred prices:At times even the fixing of the offi-cial closing price proved impossible.In 1874, an Act of Parliamentincreased taxes on financial transac-tions. The stockbrokersÕ protestsdeepened, a large number of themdid not renew their licenses. Thenumber of off-market transactionsincreased.

Inadequate Economic Cultureof the JudgesMany members of the judiciary didnot recognize futures contracts, oneof the main financial innovations asfar as Italy was concerned, as legallybinding. This meant that transactionsof this kind could only be performedon the basis of personal trust. Andthe latter mostly develops at the locallevel, through repeated interaction.The judgesÕ lack of economic cul-ture, therefore, provided a ÒnaturalÓprotection to local interests.

The Achievementof Financial Market IntegrationFinancial market integration wasaccomplished only in the 1880s, asinstitutional obstacles were removed.

Actual, as opposed to legal,monetary unification was eventuallyaccomplished. According to Mintrecords, the conversion of old coinsinto Italian lira was completed onlyaround 1874. In the same year, aBank Act concerning the banks ofissue gave one of them a decidedlynational, as opposed to local, role

providing for the birth of an embry-onic central bank. The resumption offull convertibility (1883) made thelira universally preferred as themeans of payment.

In 1882, a revision of the Com-mercial Code finally made rent-seek-ing by local stockbrokers almostimpossible to achieve (Baia Curioni,1995, p. 125): The stockbroker pro-fession was opened to competition,as entry requirements became easierand cheaper. At the same time, fromthe late 1870s onward, banksacquired an increasingly larger shareof the stockbrokersÕ business. Theirnational branch network allowedthem to be actively involved in pricearbitrage both on their own accountand on that of their clients.

Finally, futures contracts wereexplicitly recognized by the law,ending judgesÕ discretion on whetheror not they should be made legallybinding.

4 De Te Fabula Narratur?

What is the metaphor of these twotales? They may, it seems to me, illu-minate one of EuropeÕs paradoxes: ofthe achievement of monetary unifica-tion without financial market unifica-tion. Two years into EMU, Europeanfinancial markets do not appear to befully integrated, in spite of the enor-mous potential for complete integra-tion offered by the progress in ICT.

As in the case of 19th centuryItaly, the present failure seems tobe mostly institutional.

European financial marketsremain segmented into national mar-kets to an undesirable degree due to:a) institutional obstacles (such as dif-ferences in legal systems, includingtax legislation, and cultural gaps);b) obstacles created by the financialindustry itself, often for protection-ist reasons (e.g. fragmentation ofclearing and settlement rules); c) asituation which Spaventa recently

Gianni Toniolo



defined as one of Òregulatory balkan-izationÓ.

In this respect, there seem to bethree lessons that can be drawn fromthe tale about 19th century Italy.They can be briefly stated as follows.a) The Italian case shows that de

facto monetary unification maybe much slower than its legalcounterpart. While EuropeÕsmonetary unification will nottake as long as ItalyÕs, it is possi-ble that the old currencies willnot dissolve into the euro asspeedily as is desirable. Some, ifminor, transaction costs (pre-sumably mostly psychological innature) may indeed be slow todisappear.

b) Financial market integrationdoes not benefit everybody tothe same extent. Consumersand savers stand to gain, someprofessionals in the field maylose lucrative rent positions. Asin Italy almost a century and ahalf ago, in todayÕs Europe finan-cial market integration is subtlyresisted by segments of the finan-cial intermediation industry.

c) Another lesson from the Italiancase is that, at least in those cir-cumstances, only well-designedand firmly implemented actionsby the legislative and administra-tive central authorities couldbreak vested interests and regu-late legitimate ones so as to bringabout market integration.Present-day Europe may not bemuch different. National govern-ments do not always turn a deafear to the vested interests

demanding a slower pace of uni-fication on the basis of the notionthat Ònational championsÓ shouldbe given enough time to adjustand, in any case, that market lib-eralization requires full reci-procity. If this is the case, onlyenergetic action from supra-national authorities may resultin the creation, before we areall dead, of a single Europeanfinancial market alongside thesingle currency. §

References

Baia Curioni, S. (1995). Regolazione e

competizione. Storia del mercato azionario

in Italia (1801Ð1938). Bologna.

Conte, L., Toniolo, G. and Vecchi, G.(2000). The Euro and EuropeÕs Single

Market: Lessons from ItalyÕs Monetary

Unification (1862Ð1880). In: David, P. A.,

Solar, P. and Thomas, M. (eds.). Economic

Challenges of the 21st Century in Historical

Perspective. Oxford, London, forthcoming.

Garbade, K. D. and Silber, W. L. (1978).Technology, Communication and the

Performance of Financial Markets:

1840Ð1975. In: The Journal of Finance,

vol.33, no. 3, pp. 819Ð832, June.

Neal, L. (1985). Integration of International

Capital Markets: Quantitative Evidence

from the Eighteenth to Twentieth Centu-

ries. In: Journal of Economic History,

vol. 45, pp. 219Ð226, June.

Neal, L. (1990). The Rise of Financial Capit-

alism: International Capital Markets in the

Age of Reason. Cambridge.

OÕRourke, K. and Williamson, J. (2000).Globalization and History. Cambridge.

Officer, L. H. (1996). Between the Dollar-

Sterling Gold Points: Exchange Rates, Parity

and Market Behaviour. Cambridge.

Gianni Toniolo


56



Gertrude Tumpel-Gugerell, ModerationGraham BishopAlessandro ProfumoUrs Philipp RothReinhard H. Schmidt


The Banking Industry

and Financial Services

Podiumsdiskussion


Widespread deregulation and liberal-ization, accompanied by technologi-cal developments, have fundamen-tally changed the environment inwhich banks operate. In the euroarea, the impact of these develop-ments has been amplified further bythe introduction of a common cur-rency and the single monetary policyframework.

Today, EMU provides banks witha home market large enough to effec-tively support their efforts in becom-ing global players. It is, incidentally,

often argued thatsmaller countries bene-fit most from inte-grated financial marketsas their national cur-rency markets tendedto be small and seg-mented, with lowliquidity, few actors,and a limited range of

financial instruments.The euroÕs catalyzing abilities

have been particularly importantfor the banking sector. The launchof the single currency reinforcedtrends already prevailing in the EUbanking systems, such as the driveto shed excess capacity, to ventureinto global markets, and to step upmergers and acquisitions.

I would like to point out therapid integration of the nationalmoney markets into a single euroarea money market. As a result, cer-tain market segments, like the unse-cured deposit market and the deriv-atives markets, have already becomefully integrated. TARGET, the lead-ing settlement system for paymentsin euro, has played a key role in facil-itating the redistribution of liquidityacross the euro area.

Similarly, the trend toward theintegration of the government bondmarkets and the rapid growth ofthe euro-denominated private bondmarket come to mind. The euro

bond market has quickly evolved intoa major competitor for the respec-tive dollar-denominated market,and the corporate bond market isgrowing at an even faster pace.

So, where do we stand at thepresent juncture, and where shallwe go?

In spite of the achievements todate, we should keep in mind thatthe integration of the euro areaÕsfinancial markets is an evolutionaryprocess. In fact, significant barriershave yet to be overcome, forinstance, in the capital market,where national laws, market practi-ces and traditions still differ consid-erably across the euro area. Anotherexample is the repo market, which isstill far from being integrated.

Measures to promote the inte-gration of the European financialmarkets are high on the agenda. Inparticular, I would like to highlightthe importance of the FinancialServices Action Plan drawn up bythe EU, which aims at abolishinglegal and structural obstacles to fullyintegrated financial markets by theyear 2005. In its recent meeting inStockholm, the European Councilagain stressed the importance ofintegrated financial markets. To thisend, common standards for financialregulation must be introduced toEuropean financial markets, a keydemand also pointed out in theLamfalussy Report.

What do these developmentsimply for the banking industry?

Not only has more competitionresulted in narrower bank margins,but it also offers substantial advan-tages: Transaction volumes are onthe increase, and it is becomingmuch easier for euro area banks toraise funds in a larger and moreliquid bond market at reduced issu-ance costs.

To ensure a smooth changeoverto the single currency, banks in par-

Gertrude Tumpel-GugerellVice Governor,



57


ticular faced heavy investments in therun-up to the introduction of theeuro in 1999. Besides, major andrapid changes in their economicenvironment induced them to under-take restructuring and consolidationmeasures. Further challenges are onthe horizon, not least the rollout ofeuro banknotes and coins at thebeginning of 2002, which presentsbanks with a logistical litmus test.On the banking supervisory front Ðsuffice it to drop the catchphraseÒBasle IIÓ at this point Ð banks willhave to take action as well. In otherwords, banks are faced with perma-nent change, which offers both risksand opportunities.

The use of new informationtechnologies Ð especially the Inter-net Ð offers tremendous opportu-nity. Technological innovations haverevolutionized or are about to rede-fine virtually all of banksÕ businessareas. Banks have been investingheavily in enlarging and improvingtheir infrastructures. The introduc-tion of new products and services isoften based on modern informationtechnologies. Multi-channel bank-ing, which refers to the combinationof various distribution channels, suchas sales representatives, direct sales,and the brick-and-mortar branchsystem, is gaining in importance.The impact increasing e-businesssolutions will have on banks, espe-cially in countries with dense branchnetworks, such as Austria, is a hottopic.

Consolidation has been reshapingthe European banking industry. Overthe past decade, the number of creditinstitutions based in the euro area hasdropped considerably: from morethan 11,000 credit institutions regis-tered in the mid-1980s to around7,500 today. In Austria, by the way,there are currently 923 banks.

The intensified consolidationdrive in the euro areaÕs banking sec-

tor is traceable mainly to mergersamong savings and cooperativebanks, often referred to as Òdefen-siveÓ mergers, which are aimed atcutting costs and possibly also atdiversifying risks. Yet a number ofbank mergers has taken placebetween relatively large institutions,mainly within national boundaries.

The predominance of domesticmergers may be explained by the factthat the relevant market for retailservices is still national rather thanpan-European. In addition, culturalfactors influencing cor-porate governance andmanagement may comeinto play, again tip-ping the scale towarddomestic mergers. Per-haps we can gain someinsights from the expe-riences of Bank Austria,which was involved inone of the few larger cross-bordermergers that took place just a fewmonths ago.

Are financial systems in the euroarea departing from a bank-domi-nated structure and are they becom-ing more market-oriented or evensecuritized? Institutional investorsare playing an increasingly importantrole in allocating savings from thehousehold sector to the corporatesector. Asset-side disintermediationis under way in a number of Euro-pean countries. In Austria, this proc-ess has had limited implications only,with banks still in a dominant posi-tion, as institutional investors, likeinvestments funds, often are part ofbanking groups.

The question arises: Are univer-sal banks suited to cope with the cur-rent transformation process?

Universal banks that have estab-lished themselves as successful play-ers on international markets are flex-ible in adapting to local needs. Todaythere are both highly international-




ized markets for certain productsand markets that still have a strongdomestic focus. Retail activities, likelending and deposit taking, are stillconfined very much to national terri-tories.

Nevertheless, internationaliza-tion is making progress. Cross-bor-der transactions between financialintermediaries are bound to openup new and attractive markets and

allow for better risk diversification.AustriaÕs major banks have, forinstance, been very active in the Cen-tral and Eastern European countries,establishing business contacts, open-ing local subsidiaries, and acquiringlocal banks. This also illustrates thetrend of closer cooperation andincreasing integration in the bankingindustry. §




Comments for the Panel Discussionon the Banking Industryand Financial Services

These initial remarks are designed toput the development of the bankingsector into the perspective of thewider securities market. A key issuefor the future is the extent to whichthe securities markets take over therole of providing credit to the highquality sector of the economy. Inpractice, this would represent a dis-intermediation of the banking sectorand would have profound consequen-ces for it because the principal resid-ual role would be that of makinglower-quality/smaller-size loans thatmay therefore be more risky.

Introduction

Established demographic trends areleading inexorably to a build-up offinancial assets to fund retirement.These savings may be in the secondpillar in a formal pension fund orthey could be in the more informalthird pillar Ð held either directly byindividuals or via financial institu-tions. However, the impact of theinfrastructure revolution may wellcause these savings to flow throughdifferent intermediation routes.

The surge in financial assets forretirement is going to coincide withthe time Ð just ahead now Ð whenthe financial services industry isdigesting the full implications of thecompletion of the single market inmoney in Europe Ð not only the eurobut also financial services regulation.That alone is a revolutionary combi-nation but there is another element Ðthe technological revolution Ð that

promises (some may say threatens)to change the mechanics of deliver-ing financial services. This infra-structure revolution may enable thegusher of pension fund money toflow through some rather unex-pected conduits.

Whether analysingDefined Benefit (DB)schemes or DefinedContribution (DC),cost savings will be highon the agenda in theyears ahead. To illus-trate the significanceof this trend: In theUK, Òstakeholder pension schemesÓare about to be introduced. TheGovernment has specified a maxi-mum annual cost of 1% of the premi-ums Ð to the horror of an industryaccustomed to nearer 2% annually.If that 1% saving compounds at theinvestment return for 20 years ormore, then the impact on the citi-zenÕs retirement income is extremelysignificant Ð perhaps obviating anyneed for extra payments from thestate.

Inflation is now dead Ð so infuture we must look at investmentreturns, which may still be quitegood in real terms. But in nominalterms, they could be much moremodest than we have been used toover the last decade or so. So that1% cost saving may seem much morematerial in future.

The central question for the bankingindustry is: Could the gusher of pension

1 Graham Bishop is a consultant on European Financial Affairs and is also a consultant to Schroder Salomon SmithBarney but his views do not necessarily represent those of Schroder Salomon Smith Barney, or any of its affiliates.

Graham Bishop1)Adviser to Schroder Salomon Smith Barney

on European Financial Affairs



money flow into the bond markets, insteadof bank deposits? If the answer is ÒyesÓ,then the banks may find themselvesdisintermediated by their best cus-tomers Ð starting with governments,moving on to high-grade corpora-tions and then into the core of thecommercial sector Ð Single-A/Tri-ple-B-rated companies. Securitisa-tion techniques may also enhancethe opportunity for many othertypes of borrowers to access the cap-ital markets directly.

The remainder of these remarks willbe designed to answer two questions:1. Is there any evidence of this happen-

ing already?2. Are there any developments under way

that might encourage this process?

I What has the euro bondmarket achieved so far?

Some salient points:Ð After two years of the euro bond

markets, their scale is establishedbeyond doubt Ð the euro govern-ment ÔbondÕ market is 40%larger than the US Treasurymarket and many individualissues are larger than the UScompetitors.

Ð Issuance of ÒallÓ euro bonds viaunderwriters exceeded that ofcompeting ÒinternationalÓ dollarissues in both 1999 and 2000,though the total size of theÒinvestibleÓ dollar bond marketis still much larger than that ineuro.

Ð International dollar bond issu-ance rose 27% in 2000, but justfailed to close the gap with theissuance of ÒallÓ euro bonds,which declined by 8%.But the first quarter of this year

saw dramatic events:Ð Equities crashed, but euro bonds

provided a solid bulwark. Thevalue of euro area equities avail-able to investors shrank 14% inthe quarter (by more than EUR

300 billion), to EUR 2,700 bil-lion. However, the overall valueof euro bonds is about EUR7,300 billion, so the 2% totalreturn offset half that loss. Evenso, the net wealth destructionamounted to 2.7% of GDP.

Ð So the bond issuing boom wasdramatic: volume up 71%, to anew record Ð 15% above thepent-up demand levels in thefirst quarter of the euroÕs life Ðand was 17% above Òinter-national dollarÓ issuance. Someof the issuance was one-off, asthe telecom companies struggledto fund their UMTS licence bids,but there was some evidence thatthe demonstrated capacity tofinance very large issues encour-aged other borrowers to do thesame.

Ð At current yield spreads, invest-orsÕ willingness to take risk wasclear Ð Single-A issues wereone-third of issuance and thehigh-yield market reopenedexplosively. Corporate bond vol-ume more than doubled in thequarter Ð partly due to thatone-off supply from telecomcompanies. However, the moststriking demonstration of theeuro markets maturity came inthe corporate sector. For the firsttime, private corporations and util-ities raised more funds in euro thanin ÒinternationalÓ dollars Ð anothermilestone in the rising significanceof the euro as a reserve currency.

Ð Trading liquidity has become aprime motive for investors. Thenumber of bond issues is declin-ing somewhat, but the averagesize has shot up. Astonishingly,Òover EUR 1 billionÓ bondsraised nearly half the value inthe first quarter. Yet, 40% ofthe issues were under EUR 100million each Ð raising only 5%of the value Ð a new low. The

Graham Bishop


58


liquidity premium attached togovernment/agency bonds thatare big enough to trade onEuroMTS is becoming an ever-stronger magnet. Moreover, thispremium is also becoming appa-rent in the corporate bondmarket.Euro issuance comfortably

exceeded that in the internationaldollar markets again Ð by 17%. Evenif the EUR 19 billion of Òdomesticprivate placementsÓ were excluded,

euro issuance remains ahead. ManyPfandbriefe are formally describedas ÒdomesticÓ issues, even whenthey exceed EUR 1 billion in sizeand have substantial internationalplacement, so a correction for thatelement would give a similar issu-ance to that in US dollars, even ona strict comparability test, for thefirst time.

Several European sovereignissuers launched new fungible lineswith underwritten issues last quar-

Table 1

Issuance of ÒallÓ euro- and dollar-denominated bonds

1999 to 1st quarter 2001

1st quarter 2001 4th quarter 2000 2000 1999

All euro-denomi-nated

Int. dollar-denomi-nated







EUR billion

Sovereign/government/authority 30 15 9 1 66 34 58 33Supranational 4 13 4 2 8 22 15 23Private corporates/utilities 49 47 18 34 104 157 110 129Public corporates/utilities 13 12 6 2 29 18 24 11Private finance 116 70 88 46 401 229 416 185Public finance 76 90 43 67 162 267 213 192Total 288 247 168 152 770 727 836 573Memo: EU-12 centralgovernment issuance 148 90 436 437

Sources: Capital DATA Bondware, Salomon Smith Barney, April 2001.

Table 2

Government debt1)

Bonds2) as %of ÒMaastrichtdebtÓ end-2000

Averagematurity

Market value Average sizeover 7-year life

10-yearbenchmark

% years EUR billion,December 2000

EUR billion, March 2001

Germany 45 7.62 572 14 23Italy 44 7.84 564 17 21France 64 7.21 535 15 18Spain 62 7.29 228 8 11Belgium 65 7.49 183 10 5Netherlands 71 7.38 148 8 2Memo:EU-12 42 7.48 2,472 11US 283) 9.29 1,827 14 12Japan 313) 5.99 1,792 14 15UK 60 11.15 362 13 8

Sources: European Commission, OECD and Schroder Salomon Smith Barney.1) The ratio of central government fixed-rate bonds to the general government sectorÕs debt (as defined for the Maastricht Treaty) is

designed to indicate the degree of securitisation of public debt.2) Bonds as defined in SSMB World Govt. Bond Index: fixed rate, over one-year remaining life.3) US/Japan debt is OECD Òfinancial liabilitiesÓ definition.

Graham Bishop



ter, thus boosting that sector. How-ever, the most striking demonstra-tion of the euro markets maturitycame in the corporate sector. Forthe first time, private corporations andutilities raised more funds in euro thanin ÒinternationalÓ dollars Ð another mile-stone in the rising significance of the euroas a reserve currency.

Apart from issuance, the mostimportant current factor in govern-ment bond markets is the risinginfluence of electronic trading plat-forms. For the smaller EU MemberStates, the rise of the ReferenceNote programmes from the Òsurro-gatesÓ, such as EIB, Freddie Macand now KfW, is an important com-petitive influence as they are able tolaunch issues that can benefit fromthe liquidity premium from cashtrading on EuroMTS. This systemnow covers ten of the euro areastates, as three Greek governmentbonds were listed from the end ofJanuary. Away from the cash market,Brokertec is making its presence feltin basis trading.

The Dutch Government pio-neered the launch of its new ten-yearissue by dealing entirely with itsdealer community via EuroMTS.Other debt managers use electronicmessaging systems rather thanactually dealing online. Yet, thetrend towards technological sophisti-

cation is clear, imposing a significantcost burden on the dealer commun-ity to keep up. Presently, these sys-tems are interdealer, but the nextstep is already developing Ð linksfrom the dealers to theirown customer base. The final stepÐ commingled prices from the dealercommunity to multi-client Ð isalready happening, but on a limitedscale for the moment.

European debt managers are con-tinuing the steady progress towardslarger issues, and 2000 witnessed aremarkable debate on how clearingand settlement should be developedas this is now seen as a critical barrierto cross-border trading.

Size of euro bondsversus euro bank depositsand US dollar bondsThe ECB provides data on the bondsoutstanding that are reported to it aseligible for collateral purposes, andthe bonds that would be attractiveto mobile international investorsmake up about half that total. Sur-prisingly, total bonds are already athird larger than bank deposits.Interestingly, the smaller bond issuesare equivalent to nearly 70% of bankdeposits of euro area residents(excluding interbank deposits).

In international comparisons, thetotal size of bond markets still heavily

Table 3

Comparison of ÒinvestibleÓ bonds Ð EU versus USA

(Minimum issue size EUR 500 million)

EuroBIG US BIG

EUR billion

Number of issues 1,103 1,447Market capitalisation (EUR billion) 3,453 5,761

%

Memorandum Items:Investible bonds as % of GDP (2000E) 40 55

number

Total bonds (issued byeuro area + foreign: ECB ÒeligibleÓ; December 2000) 7,260Total bank deposits of euro area residents (ex MFIs; January 2001) 5,454

Sources: ECB, Salomon Smith Barney Fixed Income Indices, April 2001.

Graham Bishop



favours the US dollar segment. Theexceptional performance of the USdollar bond markets in the first quar-ter, combined with renewed weak-ness in the euro against the US dollar,means that the US dollar index isnow 67% larger than the euro index,up from 56% at year-end. However,the euro market is still 88% largerthan the number-three market ÐJapan Ð and is seven times the sizeof the fourth-ranking market Ð theUK. But a comparison of the US dol-lar and euro markets shows someclear structural differences.Ð The yield on all US dollar bonds is

about 120 basis points higher thanon the euro equivalent, rather thanthe, say, 30 basis points ten-yeargovernment bond spread that is nor-mally quoted.

Ð The US dollar market has a morelinear maturity structure.

Ð The rating distribution is verydifferent Ð largely due to thevery large mortgage sector inthe US. However, the significantsurge in Single-A-rated issues inthe last quarter has increased thatsegment by 80% in the EuroBIG,bringing it close to the US dollarlevel. However, the absolute sizeof that US dollar sector is stilltwice the euro equivalent.

Ð European government bondsaccount for a much larger pro-portion of the index than inthe US.

Ð Looking at finance for the indus-trial economy, that sector repre-sents 7.4% of the US index Ð61% more than the Europeanratio. However, that is downfrom 75% at year-end Ð anotherreflection of the surge in corpo-rate bond issuance in the euroarea in early 2001.From this evidence, it appears that

the euro bond market already constitutesa major rival to the banks in providingcredit to many sectors of the euro area

economy. The rapid growth of the corpo-rate bond market is perhaps the most sig-nificant. The more the euro bond marketis seen as an Òeligible asset classÓ by inter-national investors, the more competitivethe financing terms for European industryÐ and the greater the competition for thebanks.

2 Will current develop-ments encourage thegrowth of securitiesmarkets?

Legal reform via the FinancialServices Action Plan (FSAP)The intention is a clear and unequi-vocal ÒyesÓ Ð but the question inthe minds of many market partici-pants is whether it will actually getdone. The Heads of Governmenthave now formally committed to cre-ating the framework for a genuinelysingle Òcapital marketÓ by 1 January2003, even earlier than the rest offinancial services.

The March Stockholm Summitof EU leaders may have been a turn-ing point for reform. EU leaderssucceeded in offering the EuropeanParliament a compromise that shouldbe acceptable, clearing the way forrapid action on the LamfalussyReport on securities markets regula-tion.

This decision underlined thecontinuing commitment of EU lead-ers to implement the reforms neces-sary to create a single capital marketwithin the EU that is globally com-petitive. Providing the heads of gov-ernment can get their negotiators tofollow through this process, theeuro-denominated financial servicesindustry can look forward to signifi-cant legislation in the remainder ofthis year, which would be an encour-aging backdrop for financial marketsduring the changeover to notes andcoins on 1 January 2002.

For once, the EUÕs penchant forcompromise seems to have achieved

Graham Bishop



all that is necessary to install the sys-tem for the rapid updating of secur-ities market legislation. For marketparticipants, perhaps the mostencouraging sign was the commit-ment to give reasons for any pro-posed regulatory action. This alsomeets the objection that the Councilcould use its strengthened power togo back to the old ways of protec-tionist measures. The prime safe-guard is the commitment in theEuropean CouncilÕs Resolution:ÒThis process should take full

account of the concep-tual framework of over-arching principles setout in the reportÓ, asthe Lamfalussy Reportincludes the principleof fostering innovation.Thus, the scene shouldnow be set for a pro-gressive reform that

removes the remaining obstacles toa genuine pan-EU capital market.

Along the way, many intenselytechnical details must be resolvedand perhaps the largest remaininginfrastructure problem is the natureof the clearing and settlementarrangements across Europe. TheLamfalussy Report carefully avoidedgiving an opinion on whether thepublic authorities should becomeinvolved in the debate. Instead, thereport noted that another groupwas examining the issue. The Euro-pean CommissionÕs ÒGiovanniniCommitteeÓ1) has been asked toreport back by July on the subjectand its mandate is:1. To analyse the current situation

(including institutional set-up)for cross-border clearing andsettlement.

2. To consider the requirementsagainst which the efficiency ofpossible alternative arrange-ments for clearing, settlementand depository services can beassessed.

3. To identify some possible alter-native arrangements for clearing,settlement and depository func-tionalities.

Lamfalussy/Wise MenÕs Report:What is the real significance?We should all welcome the WiseMenÕs Final Report. It is a thoroughand comprehensive analysis andshows all the hallmarks of listeningcarefully to the points that have beenmade in the 41 responses. Nonethe-less, the Working Group2) for which Iam Rapporteur believes that the proposalcould still be improved through a greaterwillingness by the Council to share powerin an open, reasoned manner. This wasa central plank of our initial reactionand it remains a fundamental source ofconcern.

The priority now is to deliverthese changes Ð with good qualitylegislation that is speedily enactedand implemented. But the debate hasnow moved to the end game Ð do theMember States really want to have anefficient capital market? The way theyshare power with the Parliament will bea litmus test of their will. Powerful impli-cations flow if it becomes apparent thatthe Member States do not want to achievea good result.

If the Council will not do this Ðand we recognize the precedentvalue that might be created in otherareas Ð then the question will even-tually be put ÒDo the Member Statesreally want to adapt to the existenceof global financial markets?Ó

1 The author of the present paper is a member of that committee.2 Working Party of the Federal Trust on the Wise MenÕs Report. The text is available on www.grahambishop.com/

fedtrust.

Graham Bishop


59


It is worth pursuing the logic ofthis scenario. If they do not wantsuch capital markets, then what arethe practical alternatives? One is togo backwards and retreat to individ-ual national financial systems Ð but isthat consistent with a single currencyand even a Òsingle marketÓ. In otherwords, the logic implies a profoundbacksliding in Europe that wouldprobably precipitate a run out ofEuropean capital markets while theopportunity still existed.

That seems a dramatic scenario.Is there a halfway house? Yes Ð con-tinue with a muddling through butthat inevitably means giving up realeconomic benefits Ð as carefully laidout by the Wise Men. It also meansthat the power of the US dollarwould remain unchallenged so thatthe monetary operations of theUnited States Ð to meet its owndomestic economic needs Ð wouldstill have a disproportionate influ-ence on Europe.

Unless a third plausible scenariois forthcoming, then a decision tomaintain the old proven-to-fail deci-sion-making system may only serveto show Ð even more transparentlyÐ that it is failing again. The stakesare high Ð precisely the reason whythe Wise MenÕs Report has turnedout to have only minor commentson the measures to be taken Ðbecause the measures have beenbroadly agreed for years. Instead,the debate has moved to the end game Ðdo the Member States really want to havean efficient capital market? The way theyshare power with the Parliament will be alitmus test of their will.

So we must brace for a fierceconstitutional argument that themedia will fail to report sensibly.But we must focus on the real issue:Do the Governments really want agenuinely single capital market? Ifthe answer is ÒnoÓ, then much ofthe progress that I outlined in my

opening comments will be put at riskin the next few years.

However, there are grounds foroptimism that a satisfactory Ð ifinelegant Ð solution is possible,based on the Stockholm Communi-que.1. If the Parliament resolves that

the secondary legislation goesbeyond the implementingpowers in the primary legislationthen Óthe Commission commitsitself to expeditiously re-exam-ine those draft measures, takingthe utmost account of the Parlia-mentÕs position and stating itsreasons for the action it intendsto take.Ó

2. The commitment to give reasonsfor the proposed action alsomeets the objection that theCouncil could use its strength-ened power to go back to theold ways of protectionist meas-ures. The first safeguard is thecommitment in paragraph 1 ofthe European CouncilÕs Resolu-tion: ÒThis process should takefull account of the conceptualframework of overarching prin-ciples set out in the report.ÓThe formal obligation on the

Commission is to give reasons onlywhen the Parliament votes that thesecondary legislation goes beyondthe implementing powers grantedby it in the Level 1 legislation. How-ever, it seems reasonable to expect aCommission analysis to show that itsproposal is within the overarchingprinciple. As a matter of practice,that may well amount to a reasonedopinion that the proposal accordswith the results of the consultationswith market practitioners. If the pro-posal is not demonstrably within theoverarching principles, then by defi-nition it will be outside the scope ofmere implementing legislation. Sothe Parliament will have an obliga-tion to express that opinion Ð

Graham Bishop



thereby triggering the response thatthe Commission has now agreedto give.

From the ParliamentÕs perspec-tive, the mechanics of negotiatingthis compromise was surprising:Council and Commission thrashedout their own compromise and thenunilaterally offered a solution toParliamentÕs objections. This solu-tion falls short of the formal symme-try that might be expected in theÒco-decisionÓ system. Yet, it prob-ably achieves the desired result Ð in

a circuitous, but practical way. If itturns out not to do so, then theParliament has a key negotiatingadvantage in the future Ð it simplyrequires the Level 1 legislation tobe fully detailed. At this stage itwould be regrettable if the need forsuch behaviour arose as the opportu-nity now seems to exist to process the nec-essary legislation rapidly, transparentlyand in a democratic manner.

But there is more downside thanthat: If it becomes clear that the EUMember States are not really deter-mined to have a single capital mar-ket, then there will be continuousbitching and rising discord in theyears to come. But in not very manyyears comes the 2004 Inter Govern-mental Conference (IGC) on theserious constitutional reform that isnecessary for enlargement. It couldbecome clear that the high watermark of European integration haspassed.

Will this have an impact on the euro?YES Ð and that is a possible reason for

the surprising weakness of the euro.Maybe the market Ð in its inchoateway Ð has grasped that the crunch stilllies ahead and that EMU could stillexplode again. Small probability Ð butdefinitely non-zero!

Impact of technologyI suspect the Internet is an idealmechanism for the relatively wealthyabout-to-become-retiree, or actualretiree. (We heard about the propor-tion of people who are retiring intheir fifties and early sixties Ð well

before the normalage). They are the peo-ple who are the cus-tomers of these finan-cial institutions. Theyhave the time and thereason they have builtup such a large pool ofassets is because theyhave the ability to cre-

ate them. Perhaps they are lookingfor some new interest in life. Willthey have a computer at home? Willthey have Internet access? Of coursethey will.

They have a powerful incentiveto do something themselves whichdirectly increases their retirementincome. Currently, they have gonedown the equity investment route.However, equity dealing onlinehas gone down very sharply forÒtechnical reasonsÓ following theindex decline! The surprise is thatbond dealing-online has not gonevery far yet. I suspect this is goingto be one of the most interestingareas.

In a low inflation world retiredcitizens Ð or the just about to beretired (there is that swing in atti-tudes approaching retirement) Ðbecome much less interested in tak-ing risks to build up their pool ofassets Ð their wealth Ð and muchmore in retaining it. They want tomake it certain and maximise the

Graham Bishop



income from it. Instead of havingmaybe a 1% or 2% income fromequity, they might like to have some-thing much higher. That set of pref-erences has described, exactly, abond portfolio. And that is why,quite naturally, around the momentof retirement, individuals (or theirintermediary institution) movetowards bond portfolios.

The dynamics are interesting.Presuming the citizens have thechoice of investing their money ina bank deposit. As we are talkingabout euro here, the yield could be4% or a little less. But they coulddo something more adventurous:They could buy Ð (eventually thatcould be done very simply andcheaply, online) Ð a bond from theirlocal Government and, if they hadaccess to the depository, that couldalso be done online. That does notseem a very risky thing to do. Simplyby going from a bank deposit to aten-year Government bond, ourpensioners could increase their yieldfrom 4% to about 5%.

If they felt really adventurous andwell-informed, they could choose totake a bit more maturity risk, theycan go out to thirty years and thenthey can have a 5.75% yield. If theywanted to take credit risk, there isa South African Government bondjust issued in euro yielding 7%.Increasing the yield from 4% to 7%translates into quite a large increasein retirement income!

Put yourself in the shoes of thatretiree: You are sitting at home withthat pool of assets and plenty ofinformation. You know thatÐ you can do this transaction very

easilyÐ for next to nothingÐ onlineÐ simplyÐ in real-time.Ð So the risk of exposure to these

various intermediaries duringthe transaction is quite low,

Ð and you can raise your income by50% (or 70% if you want to gothat far).Is that something you would be

interested in doing?I suspect that over the next few

years a very attractive opportunitywill present itself. With the emer-gence of the Prospectus Directive,an individual citizen will be able todecide to buy, online, a credit bondÐ not just their Government bondÐ and get it paid for and deliveredto their custodian in a flash, and fornext to nothing.

The result is that the infrastructurerevolution will drive a financial servicesrevolution because the rising tide of pen-sion money is looking for the highest netreturn.

I suspect we shall see some veryinteresting developments in the nextfew years as the bond marketsmature in this high-technologyworld. They may offer stiff competi-tion to the banking sector. §

Graham Bishop



The Banking Industryand Financial Services

I will go very rapidly through mypresentation, which focuses largelyon the banking industry and financialservices, then I will spend a fewwords on our strategy in CentralEurope.

The single currency has been one ofthe major factors for change in the Euro-

pean banking industry, but it is not theonly one. We always have to considerthat there are many different forcesat work: privatization, technologicalchange, shareholder pressure (whichis increasing in all European banks)and deregulation, just to name someof them. So, to stay ahead of thepack, we have to focus not only onthe single currency but on the manydifferent forces that are reshaping thefinancial and banking industry.

The main trends that are puttingall the European financial playersunder pressure are:Ð the concentration process and

the subsequent reduction in thenumber of banking players;

Ð the incumbentsÕ aggression inthe ÒcoreÓ market;

Ð the development of new financialinstruments within the euro-denominated capital markets;

Ð the strong integration, standard-ization and growth in the deriva-tives market (swaps, futuresetc.).

We have to change our activity.Monetary policy is favoring the crea-tion of an integrated capital market.There is a larger offer of bonds andan increased demand for bank inter-mediation services. The structure ofbanks must change, reducing theirovercapacity in traditional services

(above all in terms ofnumber, of branchesand staff) but increas-ing their ability todeliver new productsand services.

The pressure on thebanking sector in Europehas made it convergetoward higher levels of

efficiency and profitability. There arefewer disparities than beforebetween the different players withinthe European market.

In the past two years, the averageROE (return on equity) improvedand the dispersion rate among theeuro countries decreased. At thesame time, the cost/income ratioand its dispersion rate fell. Thismeans that the European market isgradually becoming a single marketin terms of efficiency and profit-ability. I think that it is very impor-tant to take additional steps towardthe creation of an integrated areaso as to be able to play a majorrole among the world financialmarkets.

There are still several obstaclesto overcome in order to create a sin-gle market. Among them are:Ð taxation;Ð culture and language (the main

obstacles to cross-border con-centration);

Ð legislation;

Alessandro ProfumoChief Executive Officer

UniCredito Italiano


60


Ð supervision Ð the powers, com-petences and duties of super-visory bodies differ (40 differentregulatory authorities are cur-rently operating in the EU);

Ð protectionism Ð for instance,imposition of host country rulesto protect the national industry;

Ð clearing and settlement Ð thereare still more than 40 differentclearing and settlement struc-tures within Europe, which is abig problem for the creation ofa single market, e.g. in terms oftrading. The coststhat we have fortrading activitiesare far higher thanthe costs per trans-action in the UnitedStates.The process of cre-

ating an integrated EUbanking and financialmarket will be the necessary stepfor the affirmation of a system compara-ble with other big world banking andfinancial systems. If we compare thefirst banking systems in the worldin terms of cost/income and returnon assets, we can see that despitethe improvement I have mentionedEuropean banks have further roomto improve their positioning.

IÕd like to spend a few words onhow we are dealing with this newenvironment at UniCredito Italiano.

First of all, UniCredito is comingout of a privatization process. Cred-ito Italiano was privatized in 1993.In 1994 the return on equity ofCredito Italiano was 1.4% and thetotal value of Credito Italiano was,more or less, EUR 2 billion. Today,after taxes, the ROE is 21%and the market capitalization isEUR 26 billion to EUR 27 billion.So in six years we have changeda lot.

Now we have a big problem. Thefinancial market is asking us: ÒYou

are so efficient. How will youincrease the values for your share-holders?Ó The market poses thisquestion because at tax rates of43%, such as those we have in Italy,it is impossible for a company tosharply improve their ROE or effi-ciency.

The cost/income ratio is around51%. So, we have to identify otheroptions, as the value of our sharesis linked to ROE and to the cost ofcapital. If the cost of capital is even,we have to work on the activities.

How are we identifying otherimportant opportunities to increaseshareholdersÕ value?

One is in the distribution area inCentral Europe; another is in theproduction area with, for instance,Pioneer, our investment manage-ment company.

In our opinion, Central Europe isa great opportunity for distribution,as in that area we want to be a classi-cal commercial bank, structured bycustomer segments, and so on. Butwe are not producing because thefactories, for instance, of asset man-agement or financial products are inBoston (with Pioneer) or in Italy(with the trading bank).

In terms of distribution, why didwe choose Central Europe? First ofall, because these countries areentering the European Union; theeconomic and financial policy thatthey have to follow is very clearand the Eastern countries are ready.

Second, they are very close toItaly in terms of foreign trade; we

Alessandro Profumo



are always one of the first three part-ners in commercial trade with thesecountries.

The privatization process is nowfinishing; so the opportunity is tobuy a good portion of the marketat a reasonable price and we alwayscompare in terms of how manyU.S. dollars we have to pay forUSD 1,000 of intermediate that weare buying per country.

Finally, the people of the area arealways very well trained. We havefound exceptional people from thetechnical point of view. So todaywe are one of the three big playersin the area along with the Hypo-Ver-einsbank/Bank Austria, which isvery big in the area, and KBC, a Bel-gian bank. It is interesting to see that

the three major players are not frommajor countries: Bank Austria wasthe first bank in its country, the sec-ond bank is from Belgium, and weare from Italy. I think this develop-ment is due to the fact that, sincewe no longer have merger opportu-nities in our own countries, we haveto go abroad to become bigger and tobe able to create value for the share-holders.

The results that can be achievedare really good. For instance,with the bank that we bought sometwo years ago, we have been ableto increase the ROE from 10%to 20% in one year, and we re-duced staff by around 22% from26,000 to 21,000 in less than 12months. §

Alessandro Profumo



The Single Financial Market:A Swiss Perspective

Having the opportunity to present anopening statement at this panel dis-cussion is for me at the same timean honor, a pleasure and a challenge.

It is obviously an honor given thevery prestigious audience that yourepresent. When looking throughthe program in advance of this29th Economics Conference, I wasdeeply impressed by the list of speak-ers from academia, politics, institu-tions, as well as the industry. It isin this sense that I consider it a greathonor to be offered the possibility tospeak to you over the next ten or fif-teen minutes from the perspective ofthe Swiss Bankers Association (SBA).

It is also a pleasure to be here, tofollow the speeches presented so far,and to discuss with you the impact ofthe European Monetary Union(EMU) from a general point of viewin connection with issues specificallyregarding the banking industry andfinancial services. My considerationsare going to represent a broad andsimplified Òhelicopter view,Ó in otherwords an incomplete ÒcocktailÓ ofviews and positions from the per-spectives of both, the Swiss bankingindustry and financial sector andSwitzerland or the Swiss economyas a whole.

Last, but not least, I am alsofaced with a major challenge. Asalready pointed out, my thoughtswill be eclectic in nature, due tothe obvious time constraint. More-over, and although the single finan-cial market has now been operationalfor nearly two and a half years, agreat deal of its future impact onthe Swiss economy and the Swissbanking sector remains speculative.And, according to the famous saying

of economists, Òforecasts are diffi-cult, particularly if they refer to thefuture.Ó

In what follows, I would liketo address two points. First, I willbriefly comment on the macro-economic impact of EMU inSwitzerland. From the setup of the

panel discussion I understand that itis my task to discuss the role ofSwitzerland as a non-EU and non-EMU country. Second, I will brieflytalk about the impact of EMU onSwitzerland from a regulatory pointof view.

Macroeconomic Impact

Clearly, a long road has been traveledfrom Winston ChurchillÕs well-known words (ÒTherefore I say toyou: Let Europe arise!Ó) in 1946 toEMU in 1999. And obviously,Switzerland has closely followedthe development of EMU as well asthe EU in recent years. From a verygeneral macroeconomic perspective,the introduction of the euro as theEMUÕs single currency has notaffected Swiss economic policydirectly. For example, as you allknow, Switzerland still implementsan autonomous monetary policy.However, the Swiss National Bankhas, of course, to consider carefullythe development of the exchange

Urs Philipp RothChief Executive Officer,

Swiss Bankers Association



rate between the euro and the Swissfranc.

The Swiss currency has a longhistory dating back to 1799, whenthe Helvetic Republic introducedthe ÒSchweizerfrankenÓ as a commonunit for coins. The Swiss franc in itsdifferent forms has not always beentotally independent. In 1865, forexample, Switzerland entered theso-called Latin monetary union, apartnership that ended in 1926.Later our currency was de factolinked to the fixed exchange rate

mechanisms of the Bretton-Woodsagreement that broke down in1973. Since then, the Swiss franchas steered an independent course.Since Switzerland did not enter intothe European integration process,the question of participating in theEuropean exchange rate mechanismor European Economic and Mone-tary Union never arose. Neverthe-less, economic ties between Switzer-land and its European neighbors arevery close, which is also reflectedin the parallel nature of their respec-tive business cycles.

All the same, the question hasarisen as to whether Swiss monetaryautonomy remains the ideal strategyor whether, alternatively, the Swissfranc should be linked to the euro.Assessing the corresponding prosand cons typically produces the con-clusion that Switzerland, due to itshigh degree of monetary stability,cannot be expected to gain verymuch from an exchange rate linkto the euro. Without the veil of

exchange rate uncertainty Swissinterest rates Ð which have tradition-ally been low Ð would be forced toadjust to the higher euro levels,which, of course, would not bedesirable from a Swiss perspective.The experience of the period1999/2000, in which volatility ofthe Swiss franc relative to the eurofell to historically low levels, showsthat an independent Swiss franc isimportant to the Swiss financialcentre. In the absence of exchangerate uncertainty international invest-

ors would no longerconsider our franc asan independent diversi-fication currency, thusgiving rise to a narrow-ing of the Swiss ÒZins-bonusÓ.

Rising interestrates, it is no secret,would not only harm

the financial sector but the entireSwiss economy. Let me just remindyou that with a contribution to grossnational product of currently about11% and with a proportion ofemployees of about 4%, labor pro-ductivity of the Swiss banking sectoris high compared with other sectorsof the economy. Also, the Swissbanking sector is of extreme interna-tional importance in terms of thetotal of balance sheets of banks rela-tive to gross domestic product. Byreorienting its monetary policy con-cept in December 1999, the SwissNational Bank has created the neces-sary conditions to guarantee thefuture independence of the Swissfranc. Exchange rate volatility hassince reached the long-run average.

In addition to these aspects I havesketched concerning exchange rates,the single European currency hasincreased and probably will furtherincrease competition, also in Swit-zerland. I do not have to elaborateon the very tight relationship

Urs Philipp Roth


61


between Euroland and Switzerland.Everyone knows that Europe is anextremely important trading partnerfor Switzerland, both in terms ofimports as well as exports. In thiscontext of increased competition, Iam firmly convinced that it is ofenormous importance that Switzer-land permanently enhances its attrac-tiveness and economic competitive-ness, based on a careful evaluationof comparative advantages. As far asthe banking industry is concerned,this also implies promoting whatwe call the ÒSwiss Value ChainÓ(i.e. the integration of payment andsettlement systems in securitiesdealing, following a philosophy ofÒStraight Through ProcessingÓ) and,more generally, the Swiss financialmarket infrastructure.

Within the Swiss economy, banksand the financial sector have beenparticularly affected by EMU. Onthe one hand, banks offer accountsand payment services in euro, andthis required quite a lot of invest-ment in information technology.Foreign exchange, of course, hasbeen reduced. On the other hand,the introduction of a single currencyhas enhanced market transparency offinancial services as well as rein-forced existing trends in the fieldsof deregulation, globalization, disin-termediation and the like. Both retailbanking and private banking will beaffected by these developments.The single financial market also con-firms Swiss banks in their continuousevaluation of their strategic posi-tions. Taken together, I would liketo summarize the previous remarksin a ÒProposition 1Ó as follows: TheSwiss financial industry has to beaware of the fact that the introduc-tion of EMU Ð even though Switzer-land cannot be expected to become amember in the near future Ðincreases international competitionand, correspondingly, the industry

must permanently examine andenhance its international attractive-ness.

Regulatory Impact

Turning now from macroeconomicconsiderations to some specific issuesregarding financial market regula-tion, I would like to come up withmy ÒProposition 2:Ó The Swiss finan-cial sector will have a relatively hardtime avoiding regulatory discrimina-tion. This is not a direct consequenceof the single currency, but more gen-erally results fromSwitzerland not beinga member of the EU. Iwould like to illustratethis point with a recentexample.

In April this yearthe European Commis-sion has presented afinal proposal for adirective on the supplementarysupervision of credit institutions,insurance undertakings, and invest-ment firms in a financial conglomer-ate. As is well-known, this proposalfalls within the scope of the FinancialServices Action Plan, the objectiveof which is, among other goals, toachieve prudential soundness andfinancial stability within the Euro-pean Union. According to this direc-tive, competent authorities may Ð incertain circumstances Ð require theestablishment of a mixed financialholding company that has its headoffice in the European Community.More concretely, the correspondingauthorities in the EU would havethe power to force a non-EU parentundertaking (or mixed financialholding company) which is locatedin a jurisdiction deemed by the EUto have no equivalent supervision toestablish a holding company withinthe EU solely for the purpose of sup-plementary supervision. Not onlydoes this, from our perspective, con-

Urs Philipp Roth



flict with elementary principles ofsupervisory cooperation, but it alsomay undermine the ability of theparent undertaking to be a sourceof strength for its subsidiaries, sinceit may incur significant tax andaccounting liabilities and other costsin connection with such a restruc-turing. Therefore, this provisionobviously has the potential to be det-rimental to those conglomerateswith head offices outside the Com-munity.

My underlying intention is toillustrate with this example the moregeneral point that in the field ofinternational financial market regula-tion standing outside the EU and theEMU bears, of course, the danger ofbeing at the receiving end of discrim-ination. Nevertheless, the fact thatthe Swiss Bankers Association is amember of the European BankingFederation (EBF), and, hence, theSwiss banking sector is representedat the European level, is reassuringand I could cite many other exampleswhere coordination and cooperationbetween the EMU region and ourcountry works in a very effectiveand constructive way.

As far as regulation is concerned,there would be a lot more to say con-cerning the New Basel CapitalAccord, the discussion of a possibleintegration of financial market regu-lation, which is going on also in ourcountry, on Lamfalussy and EUsecurities market regulation, onvirt-x or on the ongoing revision ofour National Bank Act, and so on. Ihope that we will be able to addressat least some of these issues in thesubsequent panel discussion.

For the moment, let me finish byreiterating some points of generalinterest and coming to a conclusion:Switzerland, as a so-called ÒsmopecÓ,a small open economy, has Ð

although not being a Member StateÐ been affected by the introductionof the single European financial mar-ket in a number of ways. I do notconsider it my role here to judge towhat degree Europe can be consid-ered as what is called an Òoptimalcurrency region.Ó At this point Iam reminded of that wonderful defi-nition of an economist: ÒAn econo-mist is someone who sees somethingwork in practice and then wonderswhether the same thing would alsowork in principle.Ó

Only the future will show theeffects of a single currency to elimi-nate adjustment processes throughnominal interest rates and to forceexchange rate adjustments to takeplace via real exchange rates, i.e.via movements in international pricelevels.

Switzerland has a long traditionof economic and exchange ratestability. This is reflected in lowinflation, moderate interest rates,and a significant international rolefor the Swiss franc. At the moment,pegging the franc to the euro wouldtend to produce more disadvantagesthan benefits. Switzerland has tokeep its international competitive-ness in a dynamic context, and theindependence of the Swiss francplays a central role for a competitivefinancial market.

Concerning regulation, the factthat the meeting of EU finance min-isters some weeks ago in Malmo¬explicitly considered the under-developed financial sectors in manycountries that would like to jointhe EU as a major challenge demon-strates in an impressive way theimportance of financial regulationpromoting both financial stabilityand international competitiveness. Ithank your for your attention andlook forward to our discussion. §

Urs Philipp Roth



The Banking Industryand Financial Services

I first want to address three of thequestions posed to the panelists bythe organizers of this conference,and then briefly discuss what I thinkis an important aspect of the futureof the banking industry in Europe:Will the traditional characteristicfeatures of banking in continentalEurope prevail in spite of worldwidederegulation and liberalization, glob-alization, financial integration inEurope, including EMU, and unpre-cedented advances in communicationand information technology?

1 Points for Discussion ÐQuestions from the Chair

1.1 Do Banks Benefit from EMU,Financial Integration,and from Technical Progress,or are they Hurt?

EMU and financial integration inEurope will almost certainlystrengthen the role of financial mar-kets. This goes at the expense ofbanks in their traditional role asintermediaries. In so far, one couldsay that it hurts the banks as a group.Moreover, EMU and financial inte-gration in Europe and globalizationlead to increased competitionbetween banks, and this shouldbenefit their clients rather than thebanks as a group. Thus overall, banksas a group will not benefit.

However, there are considerabledifferences between the way inwhich different groups or types ofbanks are affected by these factors.It seems appropriate to differentiatebetween three groups or types ofbanks. The first group comprises aselection of big universal bankswhich already have a strong positionin investment banking, and those

banks which already are technicallymore sophisticated than others.These banks will probably benefit.The second group is that of large,but not very large universal bankswith a national focus which do nothave a protected market niche. Banksin this group are likely to suffer fromthe current develop-ments. The third groupcomprises smaller andmore locally orientedbanks and in particularbanks which are affili-ated to large nationalnetworks like the sav-ings banks and thecooperative banks net-works. I tend to think that thesebanks will not be affected in a nega-tive way to a great extent.

1.2 Consolidation of the EuropeanBanking Industry Ð Culturalor Political Impedimentsto Cross-border Mergers?

It is difficult to predict the extentand the forms of future consolidationin the banking industry. To date,most of the merger activity is con-fined to the individual national bank-ing systems. The low level of cross-border merger activity is not dueto cultural nor to political impedi-ments, but rather to relatively simpleeconomic arguments. The mainreason why national mergers areundertaken these days is that thereis a cost-saving potential. It can beexploited if two German or twoAustrian or two Italian banks merge.In contrast, if Deutsche Bank andBanque Nationale de Paris (BNP)were to merge, or if one were toacquire the other, they would not

Reinhard H. SchmidtProfessor,

University of Frankfurt



be in a position to cut jobs and closebranches and save costs as a conse-quence of the merger.

Investment and wholesale bank-ing has already been much moreinternational than retail banking fora long time, and the trend towardconsolidation in the investmentbanking field is already more pro-nounced than in the field of commer-cial banking. Again, the reason iseconomic in nature. In investmentbanking, size matters, and it mattersall the more, the more important

capital markets are forthose who seek fundingand those who want toinvest their savings. Sizeis important because itmakes it easier for abank to attract high-calibre staff and toestablish and use repu-tation. Moreover, size

provides the advantage of ÒplacementpowerÓ and thereby attracts impor-tant clients. As globalization andliberalization in Europe lead to muchmore merger and capital market-related activity in the real sector ofthe economies in Europe, the argu-ments favoring size in investmentbanking gain in importance. Thus,the trend toward consolidation ininvestment and wholesale banking islikely to continue in the future.

Of course, there are also culturaland political impediments to cross-border mergers. The main culturalimpediment can be seen in the factthat integrating the staff and theoperations of two banks is always dif-ficult; and it is more difficult if thesebanks have different national identi-ties. The organizational culture ofalmost all banks still reflects theimportant differences between thegeneral economic, political, cultural,and social norms and patterns of thedifferent European countries. Themain political impediment is, in my

view, that in spite of relevant Euro-pean regulation there also still aretendencies in some countries to pro-tect the independence of a nationalbank when a takeover by a foreignbank is imminent. It is beyond thelimitation of what an economistcould claim to know if he were toassess whether the cultural or thepolitical impediments to cross-bor-der mergers and acquisitions aremore important in practice. More-over, it seems to me that both kindsof obstacles to European financialintegration are losing force rapidlyin spite of the recent failure of theEU takeover directive.

1.3 Should the Transformationof European BankingBetter Be Donein Terms of Universalor Specialized Banking?

In particular since the last decadeand after the second EU bankingdirective and the creation of theinternal market, universal bankinghas become the general model ofbanking all over Europe. With muchstronger competition and a growingimportance of capital markets, thismay change again in the near future.

In the past, the term universalbank was used in a broad sense todesignate a bank which provides allkinds of banking services to all kindsof clients. Universal banks in thissense may continue to exist, but theyare certainly no longer the prevailingform of banks even within nationalbanking systems. Given the growingcompetitive pressure, the need tospecialize is so great that banks willnot want to remain universal banksin this broad sense. A fortiori, we willnot have universal banks of this typecovering several European countries.

However, one can also speak ofuniversal banks in the sense of bankswhich provide a comprehensive setof services to specific groups of

Reinhard H. Schmidt


62


clients. Universal banks in this nar-rower sense are here to stay andmay even gain in importance incatering for specific, but economi-cally important, groups of clientssuch as small and medium-sizedfirms. They are the appropriateorganizational form for relationshipbanking.

2 Will the CharacteristicFeatures of Bankingin Continental EuropePrevail in the ComingYears, or Will They RatherGive Way to a GeneralAdoption of eitheran Anglo-Saxon Modelof Banking or someMixture betweenTraditional Europeanand American Banking?

In the past, banking in continentalEurope has been characterized by anumber of features that are quitespecific to the region. They includethe following:(1) a strong role of traditional bank-

ing in the sense of financial inter-mediation,

(2) relationship banking and univer-sal banking as the dominantmodel of banking,

(3) nonprofit banking, or more spe-cifically banks which are notstrictly profit-oriented, as animportant element in the bank-ing industry,

(4) the dominance of banks in therespective financial systems, andfinally

(5) important ÒstructuralÓ differen-ces between national financialand banking systems.One way of approaching the gen-

eral topic of the future of the bankingindustry and financial services inEurope, consists in asking whetherthese characteristics are likely to

remain, or whether the financial sys-tems in Europe will adapt to theAnglo-Saxon type of a financial sys-tem, which is capital market-domi-nated and in which banks play a role,but one that is different and muchmore limited than their traditionalrole in continental Europe.1)

If there are fundamental changesahead of us, they are likely to be aconsequence of three importantexternal developments:(1) deregulation and liberalization,(2) advances in information and

communication technology, and(3) economic, financial, and mone-

tary integration in Europe andeven worldwide.But how could these develop-

ments shape the characteristics ofbanking in Europe? Any effectswhich they could have would be indi-rect effects. They would workthrough the strategies of banks andtheir nonbank competitors and thestructure of the financial industryand the nature of the competitionin the financial sector in Europeand in the individual European coun-tries, which are in turn mainly areflection of the strategies of thebanks. The possible chain of effectsis summarized in figure 1.

The three external developmentsare likely to affect bank strategies inseveral respects. As an immediateconsequence of deregulation andliberalization competition is goingto be stronger in the future. This willlead banks in Europe to pay moreattention than in the past to cost-containment, to the option to leavecertain markets or to enter them,and to alliances, acquisitions, andmergers. The traditional forms ofbundling together different bankingproducts and of following inte-grated pricing strategies, which hasbeen a characteristic feature of uni-

1 The argument summarized here is developed in more detail in Schmidt (2002).

Reinhard H. Schmidt



versal banking in the past, maybecome less attractive or outrightinfeasible.

Advances in information andcommunication technology (ICT)will change bank strategies becausethey reduce the costs of producingbanking services in general andbecause they tend to strengthencapital markets. ICT developmentswill increase the minimum efficientsize of banks, because ICT costs arelargely fixed costs.

Financial market integration anda common currency in much ofEurope tend, first of all, to furtherstrengthen capital markets and toweaken the traditional commercialbanking business with large corpora-tions as customers. Thus, recentdevelopments tend to call intoquestion the traditional concept ofuniversal banking. However, theimplications of financial integration,as well as the two other externalfactors, are very different for mainlyretail-oriented commercial banks,for wholesale-oriented commercialbanks, and for genuine investmentbanks. We are not likely to see a fullyintegrated European banking marketany time soon except for wholesale(and) investment banking.

One implication of the threeexternal factors and their interactionis that we can expect competition inbanking to intensify in the nearfuture as a general tendency. Com-petition between existing competi-tors is likely to become stronger,mainly because of the effects of ICTon the cost structures of banks. Theefforts of banks to spread theirhigher fixed costs over a larger vol-ume of business will induce themto compete for market shares, andthis typically leads to a general pres-sure on bank profitability. Nonbanksand near-banks and organized capitalmarkets are likely to enter marketswhich were formerly reserved forthe banks of a given country. Marketentry of various types of new com-petitors from other countries, whichmay be foreign banks or other finan-cial service providers, has become atleast a realistic possibility, if not areality.

What does this suggest for thestability or the fading-away of theabove-mentioned five peculiaritiesof continental European financialsystems and banking systems? I wantto limit myself to a few remarks herewhich will, hopefully, serve to stim-ulate the discussion.

The Future of Banking in Europe

Figure 1

Source: Schmidt (2002).

Deregulationand

Liberalization

Developmentof InformationTechnologies

European Monetaryand FinancialIntegration

Strategies(and OrganizationalStructures) of Banks

Industrial Structureand Competition

in the Banking Sector

TraditionalBanking/Financial

Intermediation

RelationshipBanking/UniversalBanking

Non-ProfitBanking

BankDominance

�Structural�Differencesin Financial

Systems

Level A:Exogenous Factors

Level B:Firms� Decisionsand IndustryDevelopment

Level C:Consequences

Reinhard H. Schmidt



1 The Important Role Played byTraditional Banking and Bank-based Financial Intermediation

Financial intermediation, i.e. thecombination of deposit mobilizationand lending, was once the essenceof banking. The decline of financialintermediation in general and bybanks in particular has been pre-dicted for quite some time. Recentempirical research indicates howeverthat this prediction was wrong atleast until the late 1990s.1) But thismight have changed recently. Thegrowth of securities market activityin the years 1999 and 2000 pointsin this direction; and some bigprivate banks are eager to react tothis situation by curtailing theirinvolvement in traditional bankingoperations. But I do not expect thisto be a general tendency, and thesteep decline of stock price levelsand new issue activity in the past12 months and specifically in the firsthalf of this year tends to confirm mydoubts concerning the view that therole of banks is changing in a funda-mental way.

2 Relationship Banking as theDominant Model of Banking

Relationship banking will remain animportant feature of banking inEurope. But it is questionablewhether it will remain the dominantmodel for all types of clients. Big andeven not-so-big corporations havebegun to use capital markets to amuch larger extent than they usedto, and many banks have shifted thefocus of their activity to investmentbanking. In this context, the scopefor relationship banking is limited.Relationship banking will, however,remain important or even increaseits importance for small andmedium-sized firms and thus alsofor the savings and cooperative banks

which will specialize, to an evengreater extent than they have in thepast, in serving these clients if, orbecause, private banks turn awayfrom them.

3 The Important Role Playedby not strictly Profit-orientedTypes of Banks

In the past, savings banks and coop-erative banks have played an impor-tant role in the banking systems ofmany European countries, and theyclearly differed from other banks.This still holds true today. Coopera-tive and savings banks are not likelyto be eliminated by market pres-sures. Their specific feature of notbeing strictly profit-oriented evenhas some advantages in the emergingnew financial environment. They canbenefit from the retreat of otherbanks from the segment of retailbanking and lending to small andmedium-sized firms; and they couldgenerate successful pan-Europeanalliances in the future, because theprofit limitation to which they aresubject tends to mitigate the tempta-tion to act in an opportunisticmanner toward their internationalalliance partners.

4 The Dominant Role of Banks,as Opposed to Capital Markets,in National Financial Systems

The importance of banks relative tocapital markets will decline in thefuture. However, this does not implythat the financial systems in conti-nental European countries will soonchange their general character andbecome capital market-dominated.Whether a financial system can beconsidered bank- or capital market-dominated depends on many moreaspects than merely the level ofcapital market activity. In spite ofall the changes, banks seem able to

1 See Schmidt, Hackethal and Tyrell (1999).

Reinhard H. Schmidt



maintain their strategic position in afinancial system if this position hastraditionally been strong. The cur-rent stock market crisis indicatesquite clearly where banks as finan-ciers may have a comparative advant-age vis-a-vis capital markets: Basedon the high level of informationwhich they can obtain and evaluate,banks are better suited than capitalmarkets to finance firms whose plansand prospects are difficult to assess,and to help their clients overcomedifficult stages in their developmentby offering them a certain level ofliquidity insurance.1)

5 Considerable Differencesbetween the Financial Systemsof Different Countries

Even though the banking system inEurope will remain fragmentedalong national lines to a certainextent, banking markets and evencapital markets are in the process ofbecoming more and more inte-grated. However, this alone will noteliminate the profound or Òstruc-turalÓ differences which still existbetween some financial systems inEurope. A financial system is a con-figuration of several elements whichcomplement each other.2) Thisfeature makes coherent financialsystems resistant to ÒstructuralÓchange and thus also to forces whichcould be assumed to lead to a gradualconvergence. Increasing similaritywith respect to one or a few ele-ments is not sufficient to changethe fundamental structure of a given

financial system and thereby leadsto a convergence. However, it is anopen question whether recent devel-opments in the years 1999 and 2000are important enough to underminethe coherence of the individual finan-cial systems in Europe and therebydestabilize them, and whether theywill converge after having been Òsuf-ficiently destabilized.Ó3) §

References

Diamond, D. (1984). Financial Inter-

mediation and Delegated Monitoring.

In: Review of Economic Studies, vol. 51, p

393Ð414.

Diamond, D. and Dybvig, P. H. (1983).Bank Runs, Deposit Insurance and Liquidity.

In: Journal of Political Economy, vol. 91,

p. 401Ð419.

Hackethal, A. and Schmidt, R. H.(2000). Finanzsystem und Komplemen-

tarita¬t. In: Kredit und Kapital, Beiheft 15

(Neue finanzielle Arrangements: Ma¬rkte

im Umbruch).

Schmidt, R. H. (2002). The Future of

Banking in Europe. Forthcoming in Kapital-

markt und Portfolio Management.

Schmidt, R. H., Hackethal, A. andTyrell, M. (1999). Disintermediation

and the Role of Banks in Europe: An Inter-

national Comparison. In: Journal of Financial

Intermediation, vol. 8, pp. 36Ð67.

Schmidt, R. H., Hackethal, A. andTyrell, M. (2002). The Convergence of

Financial Systems in Europe. Forthcoming

in Schmalenbach Business Review.

Tyrell, M. (2002). Kapitalma¬rkte und Banken

Ð Unterschiedliche Formen der Informa-

tionsverarbeitung als konstitutives Merkmal.

Wiesbaden.

1 Based on the pioneering work of Diamond (1984) and Diamond and Dybvig (1983), this is shown in Tyrell(2002).

2 See Hackethal and Schmidt (2000) for details.3 See Schmidt, Hackethal and Tyrell (2002).

Reinhard H. Schmidt


63



Franco Bruni


Summary Statement

This is not going to be a tentativesummary of two days of hard work,neither it is my duty to draw conclu-sions from a long and variegated con-ference from which each of you hashad, I am sure, a rather rich oppor-tunity to derive many different andvaluable ideas. I will simply try tooffer a rapid synthesis of what I havepersonally received as the crucialmessages of the various sessions ofthe conference. Which was magnifi-cently introduced by the speechesof Governor Liebscher and of Presi-dent Duisenberg. Their statementshave been an illuminating guide tothe very complex menu of problemsthat we have been discussing in thefollowing three sessions on the evo-lution of European financial markets:the first on the convergence ofnational financial systems, the secondon regulation and supervision, withthe privilege of listening to the viewsof the President of Deutsche Bundes-bank, the third on the consequenceof new technologies. As to the finalpanel discussion, which has beengoing on until a few minutes ago,I will limit myself to saying thatI enjoyed listening to the speakersand that their comments fitted verywell, from different points of view,in the overall framework of theconference.

The basic message that I got fromsession 1 can be stated as follows.Accelerating the structural reformsof European financial markets is a

Franco BruniProfessor,

Universita Bocconi


necessary condition for the sustain-ability of their convergence and forthe consolidation of the successobtained with the introduction ofthe euro. Let me elaborate a bit onthis synthetic message, also pointingto the fact that there are many con-nections between the topics of thefirst and the second session, betweenconvergence and regulation.

Sir Edward George centred hiscontribution around the typicallyBritish idea that Òthere are manyother things beyond the introduction

of the single currencythat we can and shoulddoÓ together in Europeto foster convergence.I strongly agree withthis idea but I think itcan also be interpretedin, let me say, a non-British way. It is suffi-cient to add to Sir

EdwardÕs statement the followingtwo sentences: (i) Only if these manyother things are done, the euro willbe a substantial success (which is,as I understand, a condition for SirGeorge to converge to it); (ii) onits part, the adoption of the eurocan produce an automatic stimulusto do these other things, namely toaccelerate the reform of financialmarkets.

This integration of Sir EdwardÕssentences is precisely what I haveunderstood as the substance of ErnstLudwig von ThaddenÕs presentation.In his opinion, which I fully share:(a) We can be very optimistic aboutthe direct and indirect gains thatEuropean markets are getting fromthe euro; (b) but our optimism mustbe moderated by some concerns:because the gains are not irreversi-ble, in a model with multiple equili-bria, and there is a danger to loosethem if policy makers and regulatorsdo not speed up the reform of Euro-pean financial markets. These

reforms, along the lines of the Com-missionÕs action plan and of the Lam-falussy project, should foster theirtrue unification, including the estab-lishment of common tax andaccounting standards, the reorgan-ization of regulation and supervision,the abolition of explicit and implicitobstacles to cross-border consolida-tion of the banking and financialindustry.

I therefore think that both Gov-ernor George and von Thaddenagree that currency unification andstructural reform should comple-ment each other in delivering con-vergence toward a fully integrated,efficient, and globally competitiveEuropean financial market. In thisperspective the theme of regulationcame also into the picture of our firstsession, connecting it with the sec-ond one. An important regulatoryand institutional issue, to be sure,was explicitly anticipated by FranklinAllen during session 1: He argued thatthe European setting for dealing withbanking and financial crises is seri-ously and dangerously inefficient,and that perhaps this is currentlythe major problem of the euro area.

But let me come explicitly to ses-sion 2. In the spirit of this confer-ence, regulation is discussed as anissue for the euro area. Jean-ClaudeThe«bault gave us a very informativesurvey of the efforts of the Commis-sion to improve the quality of finan-cial regulation and supervision,pushing for a much stronger degreeof cooperation between MemberStatesÕ national authorities.

An original taxonomic and theo-retical perspective of the economicsof financial regulation was then pre-sented by David T. Llewellyn. It isfrom his sophisticated paper that Igot the basic message of session 2:Economists have a lot of difficultwork to do in order to suggest topolicy makers a convincing and

Franco Bruni


64


coherent model of what could bean optimal regulatory regime. AÒregime,Ó as Llewellyn calls it, iscomposed by several elements, thatcan be traded-off in subtle ways. Pre-scriptive rules constitute only one ofthese elements. In his opinion, it isnot the more important, while theincentives are such that it is probablyoversupplied. As Norbert Walterpointed out, Basel II is a move inthe direction of LlewellynÕs conceptof a regulatory regime. But in its cur-rent form it falls short of consistentlyachieving its ambitious aims. Onefeels that also the Basel proposals(on which specific comments andcriticisms were offered by numerousspeakers in this conference) lacks thetheoretical support of a well-devel-oped model of an optimal regime.

Let me introduce here the prob-lem of the institutional arrangementsthat govern the assignment ofresponsibilities in matters of regula-tion and supervision. I think thatsuch arrangements are another spe-cific element of a Òregime.Ó Discus-sions on how much and how centralbanks must be involved in regulationand supervision, on how valid is anFSA-type mega-regulator, on theindependence and accountability ofprudential authorities, are of utmostimportance. But I share LlewellynÕsidea that they may be considered lessimportant than the overall design ofthe regulatory regime. We are notprepared to make the right decisionon the institutional setting, on whohas to do what, until we have a moreprecise and convincing idea of whatthe substance of the prudentialregime should be.

Just think of the comparisonwith monetary policy. The Europeanmonetary constitution has beenchosen on the basis of a well-devel-oped theory of optimal monetarypolicy, founded on the German tra-dition of price stability and long-

term oriented monetary strategy.Nothing as solid as that is still avail-able in matters of prudential strat-egy. Neither in academia, nor amongpolicymakers, neither in Europe, norin the USA, where, to be sure, regu-lation and supervision, in spite of theability of the American politicalsystem to produce frequent reforms,are still far from being framed in arigorous and satisfactory way.

The problem of reforming theassignment of regulatory and super-visory responsibilities in the Euro-pean Union has to betackled with someimpetus and withoutfurther delay, but:(i) without any dogma-tism, because there willnever be such a thingas a perfect solution;(ii) with the right mixof due respect andrevolutionary spirit toward the spe-cial and vested interests of existingbureaucracies, currently bearing theresponsibilities of prudential policiesand having a valuable experiencein their practical implementation;(iii) always thinking in a euro-areaperspective, for the benefits of theEuropean capital markets as a whole,avoiding moves toward conflictingnational solutions; (iv) coming to adecision on a desirable institutionalsetting for the long term, butapproaching it in a gradual way, nottoo fast, along a reform path wherethere must be room for learning bydoing (has the U.K. reform beentoo precipitous?); (v) keeping inmind what President Duisenbergsaid here yesterday on this topic:that Òdetails are crucial.Ó In thislast respect let me cite the Austrianexample.

The European Central Bankmade available in its website itsrecent opinion (dated May 25,2001) on a draft of the reform proj-

Franco Bruni



ect prepared by the Austrian Minis-try of Finance. This project goes ina direction, namely the establishmentof a new, comprehensive prudentialauthority, outside the central bank,which contrasts with the positionexpressed by the ECB in its officialnote released on March 22. The textof the ECBÕs opinion on the Austrianreform project starts by restatingthe general idea that any reductionin the involvement of the system ofcentral banks in prudential super-vision is inappropriate. But it then

goes on carefully sug-gesting a series ofdetailed improvementsto the Austrian draftproject. I counted sixcategories of sugges-tions collecting some18 very specific pro-posed changes to thedraft. As far as I under-

stand, these changes would make theproject compatible with the letterand the spirit of the Treaty andacceptable to the ESCB.

Quite apart from my personalopinion on the matter, I must say thatreading this articulated opinion hasenhanced my propensity to think thatone must not be dogmatic in lookinginto this problem, that details arecrucial, and that good solutions canbe found within a framework ofcooperation and careful exchange ofviews between the governments ofMember States, national centralbanks and other regulatory author-ities, the European Commission,and the ECB. We academics shouldserve as wise catalysts of this cooper-ative search and keep away fromexacerbating potential conflicts mak-ing use of abstract models and one-sided theoretical ideas.

Session 3 has been about newtechnologies. Two years after thelaunch of the single currency, howmuch have we enhanced our vision

of the long-term impact of techno-logical innovation on the functioningof financial markets and on the tasksof financial supervision?

The relationship between mod-ern technological advances andfinancial activities is obviously veryspecial. But I have been impressedby the opinion expressed here byHermann-Josef Lamberti, memberof Deutsche BankÕs board, that itmight be special to the point to makeit difficult to decide whether thetechnological developments causetrends in financial markets or vice-versa. I had never thought to thepossibility that progresses in infor-mation technology could be aneffect, and not only a cause, of devel-opments in financial markets. But itis certainly true that many producersof financial services are putting a lotof emphasis (with, perhaps, a bit ofmarketing effort) on the idea thatthey are operating through a periodof enormous technical progress, thatthey are selling revolutionary prod-ucts, that they are dominating tre-mendously new technologies forthe benefit of financial efficiency.

Considering this emphasis, Ihave also been struck by ErichW. StreisslerÕs point that the intro-duction of the telephone, at the endof the 19th century, has been a prog-ress in technology the value ofwhich, for financial transactions,can be considered 150 times largerthan the value of recent Internet-type innovations. Are we makingtoo much noise and perhaps notalways in Òbona fide,Ó just becauseSanta Klaus brought us some new,little informational toys? Perhaps thisis not the case, given that financialproducts are made of nothing elseexcept of information. The marginalproductivity of saving a unit of timein transferring information can thusbe enormously increasing, in spiteof the limits of the speed of reaction

Franco Bruni



of human brains, as the continuousflourishing of financial innovationproves. And I bet with GiovanniToniolo, whose discussion of Streiss-lerÕs paper has been very stimulating,that the institutional resistance to thepotential international financial inte-gration brought about by Internet,will be much more short-lived thanthe corresponding resistance thatwas opposed to the consequencesof the previous centuryÕs technologi-cal shock.

But, be that as it may, one istempted to consider as totallyobvious facts that the impact of tech-nological progress on financial mar-kets (a) renders them more liquid;(b) makes them more transparent;(c) increases the degree of concen-tration in the financial industry;(d) makes these markets, to a certainextent, easier to regulate and super-vise because information technologydecreases, almost by definition,information asymmetries, while itincreases both the incentives andthe opportunities for market disci-pline and for self-monitoring andself-regulation.

The basic message that I got fromsession 3 is that these consequences oftechnological progress are not soobvious. Certain aspects of techno-logically-induced financial innova-

tion, to be sure, have been pointedout that, in some cases, can limitthe trend toward concentration inthe financial industry, can put in dan-ger both the liquidity and the trans-parency of financial markets, espe-cially when incorporated in veryexotic financial instruments, and,most importantly, can make regula-tion and supervision a much morecomplicated and sophisticated task.

In this respect, let me emphasizewhat Clive Briault has reminded usabout the statutory objectives of theU.K.Õs Financial Services Authority,that they include the active promo-tion of public understanding of thefinancial system and of the desirabil-ity of innovation and competition.

I think that by organizing thisconference, and by proposing todiscuss the topics to which thethree well-connected sessions weredevoted, also the OesterreichischeNationalbank has been successfullypursuing the objective of promotingthe public understanding of theEuropean financial markets and ofthe desirability of innovation. As tothe fact that what has to be under-stood remains difficult to under-stand, even after such a rich and suc-cessful conference, it is not a fault ofthe organizers! §

Franco Bruni




65


Closing Remarks

Ladies and Gentlemen,We have now almost come to the

end of this conference. We have seenone and a half days of extremelyinteresting and stimulating discus-sions. When we picked this confer-enceÕs subject as ÒThe Single Finan-cial Market Ð Two Years intoEMUÓ, we had all the theories inmind that were discussed before theeuro was introduced. Those theoriestried to give answers to the question,what the impact of one common cur-rency might be on the developmentof financial markets in the area con-cerned.

Prior to EMU it was argued thatthe single currency willÐ enhance the depth and liquidity

of capital markets,Ð lower transaction costs,Ð increase opportunities of diversi-

fication,Ð make the European financial sys-

tem more competitive androbust, and

Ð trigger a restructuring process inthe banking and financial servicesindustry.Now, two years after the euro

was introduced, we see that mostof those predictions have come trueto a large extent.

The banking and financial serv-ices industry has seen a fundamentalconsolidation process in recentyears. In our discussions there wasbroad agreement that the environ-ment for the provision of financialservices has changed fundamentally.

Gertrude Tumpel-GugerellVice Governor,



Partly due to technological progressÐ one only needs to mention e-bank-ing and the Internet Ð but also due toa much more globally orientedapproach and growing competitionthe financial industry had to developnew products and new channels ofdistribution.

While risk capital has gainedimportance in corporate financingalso in continental Europe, there isstill an important role for banks toplay as financial intermediaries.Especially in Austria and Germany,

but also in other countries wheremost of the economy accounts forsmall and medium-sized enterprises(SMEs) banks will remain the mostimportant providers of credit andliquidity. Small financing volumes,low international profile, and hightransaction costs make it difficultfor SMEs to find direct access tothe capital market.

In Central and Eastern EuropeanCountries and other emerging mar-kets, where both financial regulationand supervision as well as liquidity ofcapital markets are not yet highlydeveloped, banks will play an impor-tant role in corporate financing.Close personal contact with theircustomers and a thorough knowl-edge of a clientÕs financial situationare other advantages of the bankingindustry. From the point of view ofa central bank one should not under-estimate the importance of banks inthe transmission process from mone-tary policy decisions to the real econ-omy.

Rapidly changing and increas-ingly globalized financial marketshave given rise to many reform proj-ects both on a European and on aglobal level in order to improvefinancial regulation and to preventfinancial crises. Let me only mentiona few:Ð the Brouwer Group that worked

on financial crisis management,Ð the Group of Wise Men under

the leadership of Mr. Lamfalussy,which provided us with new pro-posals on how to improve thesupervision and integration ofsecurities markets, or

Ð the so-called ÒBasel IIÓ processwhich was touched upon on thefirst day of our conference.The ideas of how to improve the

functioning of financial markets aremanyfold. The obstacles that we faceare mostly in the process of imple-mentation of those ideas. I can there-fore only support those in the con-ference who claimed for pressingon with the Financial Services ActionPlan of the European Commission.The question of how high the degreeof convergence should be is thereforemore a question of increasing theconvergence of financial regulationacross borders rather than pushingfor convergence of financial marketsthemselves.

One important brick in thebuilding of financial stability is anup-to-date and effective financialsupervision. There is a commoninterest among the financial industry,central banks, and governments toestablish the best and most efficientsystem of financial supervision inorder to maintain the stability offinancial markets and to prevent pos-sible crises at the earliest possiblestage.

In our discussion we came to theconclusion that there is no one-size-fits-all solution for the best institu-tional setup of financial supervision.




ÒThere are many ways that lead toRome.Ó

There was broad agreementthough that it is crucial to build upa European and international net-work to exchange informationamong supervisors. Through thisnetwork information shall beexchanged on a regular basis, butalso in the case of an emerging crisis.

Another point that was raised inthe discussions of yesterday andtoday was that there are many argu-ments in favor of a close involvementof central banks in financial super-vision:Ð synergies that emerge from

monetary policy making andfinancial supervision,

Ð the use of the central banksÕ pro-found expertise in monetary andfinancial issues, and

Ð the provision of adequate resour-ces, necessary to cope with thefuture challenges of financialsupervision.The strong involvement of cen-

tral banks in financial supervisionhas been a guarantee for financialmarket stability so far. In its recentpublication on ÒThe Role of CentralBanks in Prudential SupervisionÓthe European Central Bank stressesthat Òin ten of the twelve euro areacountries, national central banks areeither directly responsible for pru-dential supervision or stronglyinvolved in its activity.Ó §




Franz-Weninger-Stipendien

66


U¬ berreichung derFranz-Weninger-Stipendiender OesterreichischenNationalbankGouverneur Dr. Liebscher und Vize-Gouverneurin Dr. Tumpel-Gugerellu¬berreichten am 1. Juni 2001 imRahmen der 29. Volkswirtschaft-lichen Tagung der OesterreichischenNationalbank die Franz-Weninger-Stipendien an vier Preistra¬ger. DasFranz-Weninger-Stipendium wirdvon der OeNB fu¬r hervorragendeDiplomarbeiten und Dissertationenauf dem Gebiet der Geldtheorieund Geldpolitik vergeben und erin-nert mit seinem Namen an den vorfu¬nf Jahren to¬dlich verunglu¬cktenLeiter der Abteilung fu¬r volkswirt-schaftliche Analysen. Die Stipendienwerden vom Direktorium derOesterreichischen Nationalbank aufVorschlag einer Fachjury vergeben.

Diesmal wurden die Franz-Weninger-Stipendien den im Folgen-den genannten Personen fu¬r Arbei-

ten mit den jeweils angefu¬hrtenTiteln zuerkannt:Ð Dr. Simon Quijano-Evans fu¬r

seine Dissertation ãCan Move-ments in Emerging MarketCurrencies Be Explained UsingFundamentals-Based ExchangeRate Models?Ò

Ð Mag. Harald Badinger fu¬rseine Diplomarbeit ãAda¬quanzund Optimalita¬t internationalerReserven Ð theoretische Aspekteund eine Scha¬tzung der Reserve-nachfrage O¬ sterreichs (1970 bis1998)Ò

Ð Mag. Martin Buchner fu¬rseine Diplomarbeit ãMarkteffi-zienz und mechanistische Ver-fahren der Spekulation am Bei-spiel der USD/DM und USD/JPY-WechselkurseÒ

Ð Mag. Margit Hraschek fu¬rihre Diplomarbeit ãHatten dieju¬ngsten AktienkurssteigerungenAuswirkungen auf die Wechsel-kurse?Ò §

Franz-Weninger-Stipendien



Die Vortragenden


Franklin Allen,is Nippon Life Professor of Finance,Professor of Economics at the Uni-versity of Pennsylvania, Co-Directorat the Financial Institutions Center.He obtained his BA at the Universityof East Anglia in 1977 and his Ph.D.at the University of Oxford in 1980.He was Associate Director of Doc-toral Programs from 1988 to 1990and Vice Dean and Director of Doc-toral Programs from 1990 to 1993.He was appointed a Research Fellowat Nuffield College, University ofOxford, the Yamaichi Visiting Pro-fessor at the University of Tokyoand the Metzler Visiting Professorat the University of Frankfurt and isprimarily concerned with researchon corporate finance, asset pricing,and the economics of information.In his current projects, he isresearching on the comparison ofthe financial systems of differentcountries and on financial crises.

His professional career includesthe following steps: since 1991 Asso-ciate Editor of ÒFinancial Manage-ment;Ó from 1993 to 1996 ExecutiveEditor of the ÒReview of FinancialStudies;Ó from 1996 to 1997 Direc-tor of the American Finance Associ-ation and Vice President of the West-ern Finance Association; from 1997to 1998 President-Elect of the West-ern Finance Association; from 1997to 1999 President of the Society forFinancial Studies; from 1998 to2000 Vice President of the AmericanFinance Association; from 1998 to1999 President of the WesternFinance Association and President-Elect of the American Finance Asso-ciation; for 2000 President of theAmerican Finance Association. Heis also Director of the GlenmedeFund since 1991.

Recent publications include:ÒComparing Financial Systems,Ó co-authored with D. Gale, (MIT Press,2000); ÒFinancial Contagion,Ó co-

authored with D. Gale (Journal ofPolitical Economy 108, 2000), andÒUsing Genetic Algorithms to FindTechnical Trading Rules,Ó co-auth-ored with R. Karjalainen (Journalof Financial Economics 51, 1999).

Graham Bishop,

is a member of the European Com-missionÕs Consultative Group onthe Impact of the Introduction ofthe Euro on Capital Markets. Otherfunctions include Deputy Chairmanof the European League for Eco-nomic Co-operation (ELEC) ÐBritish Section, Council Member ofthe Federal Trust, Member of theGroup Euro (the European Commis-sionÕs panel of speakers on EMU),and member of the Advisory Boardof the European Policy Centre.

During the past few years,Graham Bishop has been a SpecialistAdviser to the Treasury Committeeof the House of Commons (1998and 1996 EMU Reports), Chairmanof the London Investment BankingAssociation (LIBA) Committee onconverting LondonÕs capital marketsto the single currency, DeputyChairman of the Kingsdown Enquiryof the Action Centre for Europe(ACE) on the implications of EMUfor Britain (1995 and 1997 update),and Member of the European Com-missionÕs Strategy Group on Finan-cial Services (1998) and Committeeof Independent Experts on the prep-aration of the changeover to the sin-gle currency (the ÕMaasÕ Committee1994/5). In addition, he participatesin studies and meetings of researchinstitutes such as the Royal Instituteof International Affairs, the Centrefor the Study of Financial Innovation(CSFI), and Socie«te« UniversitaireEurope«ene de Recherches Finan-cieres (SUERF).

Several continuing themes havedominated his work at SalomonSmith Barney, starting with the tech-

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nical nature of the financial systemand building up to the politicalimpact of modern markets: EMUand the impact on financial institu-tions and the structure of financialmarkets, the role of financial marketsin the drive to EMU, EMU and therole of market discipline in maintain-ing fiscal sovereignty, EMU andPolitical Sovereignty. This workstarted as the Ò1992Ó single marketprogram commenced and thenexpanded as negotiations started forthe Treaty of Maastricht. Seriouspreparations for the introduction ofthe single currency began in 1994and that provided another stimulus.

Graham Bishop graduated fromSheffield University in 1972 with adegree in Jurisprudence and workedfor U.K. stockbrokers, Phillips &Drew, as an international economistwith particular reference to equitymarkets. In 1979, he joined S. G.Warburg to manage pension fundportfolios. His emphasis moved fromEuropean equity markets to bondsand currencies, culminating in amove to Salomon Brothers. Initially,his economic commentaries coveredthe bond and currency markets ofEurope. He has authored SalomonBrothers research on the issues sur-rounding monetary union since itbecame a serious possibility in1988. As Adviser on EuropeanFinancial Affairs at Salomon SmithBarney in London, he reported tothe Co-Chief Executives in Europe.

Christophe Bisiere,

is Professor of Finance at the Uni-versity of Perpignan since 1998 andDirector of the Department of Eco-nomics and Management at theUniversity of Perpignan. He earnedhis Ph.D. at the Aix-Marseille IIUniversity in 1994. In 1988, heobtained diplomas in internationaleconomics and finance and in com-puter science and mathematics at

the Aix-Marseille II University. Histeaching experience includes gradu-ate and undergraduate courses ininternational economics, financialeconomics, macroeconomics, opera-tional research, and in empiricalfinance.

His recent research is publishedin the following papers: ÒTiming oforders, orders aggressiveness andthe order book in the Paris Bourse,Óco-authored with Th. Kamionka(Annales dÕE«conomie et de Statis-tique 60, 2000), ÒShort sales con-straints, liquidity and price discov-ery: an empirical analysis on theParis Bourse,Ó co-authored withB. Biais and J.-P. De«campsÒ (Euro-pean Financial Management, 5, pp.395Ð409, 1999), and ÒSD-SOLVER:towards a multidirectional CLP-based simulation tool. Frameworkand short financial examplesÓ(Computational Economics 9, pp.299Ð315, 1996).

Clive Briault,

has been Director, Prudential Stand-ards, at the Financial ServicesAuthority since April 2001. Hejoined the Bank of England in 1980and, after a period of working oninternational finance (including asecondment to Schroders) and inbanking supervision, worked asPrivate Secretary to the Deputy Gov-ernor from 1989 to 1991, as Head ofMonetary Assessment and Strategyfrom 1991 to 1996, and Head ofCapital and Wholesale MarketsDivision from 1996 to 1998. Hejoined the Financial Services Author-ity at its formation in 1998 as Direc-tor of Central Policy.

Franco Bruni,

is Full Professor of InternationalMonetary Economics at BocconiUniversity in Milano, where he wasDirector of the Department of Eco-nomics from 1994 to 2000. He grad-

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uated in economics at Bocconi Uni-versity in 1971 and obtained aMaster of Science in economics atthe Massachussetts Institute of Tech-nology in 1974. From 1987 to 1990he has served as Full Professor ofEconomic Policy at the State Univer-sity of Brescia. From 1998 to 2000he was a member of the FoundingCommittee of the Free Universityof Bolzano. He has been visitingprofessor at New York University,University of California at Berkeley,Chulalongkorn University at Bang-kok, Getulio Vargas University atSao Paulo, and Instituto de EstudosEuropeus of the University ofMacau.

He has been working for parlia-mentary and governmental studygroups on the Italian banking andfinancial system. In 1997, he has par-ticipated in the European Commis-sion working group on the ÒImpactof the Single Market Programmeand of EMU on the European Bank-ing Sector.Ó In 1998, he has contrib-uted to the Report for the EuropeanCouncil of Cardiff of the Commis-sionÕs Competitive Advisory Group,on ÒCapital Markets and Competi-tiveness.Ó He is currently a memberof the International Steering Com-mittee on ÒPolicies for the GlobalMarketÓ set up by the Italian Confed-eration of Industry.

He is Deputy President andScientific Director of MilanÕs Insti-tute for International Political Stud-ies (a think tank connected to ItalyÕsMinistry of Foreign Affairs), Editorof the ÒGiornale Degli Economisti eAnnali di EconomiaÓ (the oldest andbest-known Italian academic journalin the field of economics), memberof the Council of Management ofthe Socie«te« Universitaire Europe«-enne de Recherches Financieres (ofwhich from 1995 to 2000 he hasbeen Vice President and then Presi-dent), member of the European

Shadow Financial Regulatory Com-mittee. He writes editorials for ÒLaStampaÓ.

He serves as an independentdirector, member of the board of,UniCredito Banca Mobiliare, Pio-neer Global Asset Management,and other financial companies, aswell as of Saipem, a major multi-national oil service company. He isauthor of many publications in thefields of macroeconomics, moneyand banking, international finance.

Willem F. Duisenberg,

was born in the Netherlands in 1935.After completing his secondary edu-cation in 1954, he studied at the Uni-versity of Groningen and graduatedwith a degree in Economics (cumlaude) in 1961. From 1961 to 1965he worked as a teaching assistantduring his postgraduate studies atthe University of Groningen andwas awarded a doctorate (PhD) in1965. In the same year he joinedthe staff of the International Mone-tary Fund (IMF), Washington, DC.He returned to the Netherlands in1969 to join De Nederlandsche Bankas Adviser to the Governing Board.Dr. Duisenberg was appointed Pro-fessor of Macroeconomics at theUniversity of Amsterdam in 1970,a position he held until 1973, whenhe became Dutch Minister ofFinance. From 1977 to 1978 hewas a Member of Parliament forthe Partij van de Arbeid (SocialistParty) and from 1978 to 1981 wasa member and Vice-Chairman ofthe Executive Board of RabobankNederland. Dr. Duisenberg rejoinedDe Nederlandsche Bank as ExecutiveDirector in 1981 and was appointedPresident in 1982, holding this postuntil 1997. Between 1988 and1990 and from January 1994 to June1997 he was Chairman of the Boardand President of the Bank for Inter-national Settlements (BIS) in Basle,

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and between 1991 and 1993 servedas a member of the Board of Direc-tors of the BIS. Dr. Duisenberg wasa member of the Council of theEuropean Monetary Institute (EMI)from January 1994 to June 1997and President of the EMI from July1997. Since 1 June 1998 he has beenPresident of the European CentralBank (ECB).

Arturo Estrella,

is Senior Vice President and head ofthe Capital Markets Department inthe Research and Market AnalysisGroup of the Federal Reserve Bankof New York. He first joined theBank as an economist in 1983 andhas held various positions inresearch, bank supervision, and mar-kets. He holds a Ph.D. in economicsfrom Harvard University, as well asgraduate degrees in pure and appliedmathematics. He has publishedextensively in the fields of finance,macroeconomics, monetary policy,bank regulation, and econometrics.

Since 1991, he has participatedin the development of capital stand-ards set by the Basel Committee onBank Supervision. In this connec-tion, he has been a member of theOff-Balance Sheet and CapitalGroups, and is currently a memberof the Basel CommitteeÕs ResearchTask Force. In 2000, he chaired aninternational working group thatpublished a comprehensive reporton credit ratings and complementarysources of credit quality informa-tion, distributed by the Basel Com-mittee.

He has previously held positionsas manager of portfolio strategy ofthe General Motors InvestmentFunds and as chief actuary of theRetirement System of the Govern-ment of Puerto Rico. He has beena lecturer in economics at the Ford-ham University Graduate Schooland in quantitative methods at the

University of Puerto Rico BusinessSchool.

Recent publications in the area ofbank regulation include: ÒA Prolego-menon to Future Capital Require-mentsÓ (Economic Policy Review,Federal Reserve Bank of New York,July 1995), ÒFormulas or Super-vision? Remarks on the Future ofRegulatory CapitalÓ (Economic Pol-icy Review, Federal Reserve Bankof New York, October 1998), andÒRegulatory Capital and the Super-vision of Financial Institutions: SomeBasic Distinctions and PolicyChoicesÓ (In: Challenges for ModernCentral Banking, Sveriges Riksbank,2001).

Sir Edward George,

was educated at Dulwich Collegeand Emmanuel College, Cambridge,and graduated in Economics in 1962.After leaving Cambridge he immedi-ately joined the Bank of England,where he initially worked on EastEuropean Affairs. From 1964 to1965 he was seconded to MoscowState University to study Russian.From 1966 to 1969 he worked asan economist for the Bank for Inter-national Settlements in Basel, andfrom 1972 to 1974 as personal assis-tant to Sir Jeremy Morse, who wasthen Chairman of the Deputies ofthe IMFÕs Committee on Interna-tional Monetary Reform (Commit-tee of Twenty). Before beingappointed Deputy Governor of theBank of England in March 1990, heworked as adviser in the OverseasDepartment on external and interna-tional monetary questions, assumedthe post of the Deputy Chief Cashier,in which function he was particularlyconcerned with the management ofthe gilt-edged market, the imple-mentation of monetary control andwith the management of public sec-tor external borrowing; the post ofthe Assistant Director in charge of

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the Gilt-Edged Division; and then ofExecutive Director with responsibil-ity for monetary policy, marketoperations and market supervision.

In 1993 he was appointed to afive-year term as Governor, whichwas renewed in 1998. In 1994 hewas elected an Honorary Fellow ofEmmanuel College. In 1999 he wasappointed a member of the PrivyCouncil and Chairman of the G10Governors. In 2000 he received theGrand Cross of the Order of theBritish Empire.

Karl-Heinz Grasser,

born in 1969, was appointed FederalMinister of Finance of the Republicof Austria in February 2000. Hecompleted his studies of appliedbusiness administration at the Uni-versity of Klagenfurt in Austria in1992. In the same year he joinedthe parliamentary group of theAustria Freedom Party (FPO¬ ),where initially he was entrusted withissues regarding European integra-tion and tourism. His further profes-sional career includes the followingsteps: 1993 Secretary General ofthe FPO¬ and Managing Director ofthe Freedom PartyÕs educational cen-ter; 1994 Second Deputy to theGovernor of Carinthia; 1998 VicePresident for Human Resources andPublic Relations of Magna Europe.In 1999, he was also entrusted withthe management of the MagnaGroupÕs affiliate Sport ManagementInternational (SMI). Until the endof 1999 he was a Board Member ofthe Sir Karl Popper Foundation, inwhich he still is a regular member.Being Federal Minister of Financehe serves as the Austrian Governorat the following international organ-izations: the World Bank Group, theAsian Development Bank, the Inter-American Development Bank,Inter-American Investment Corpo-ration, the African Development

Bank, the African DevelopmentFund, the European Bank for Recon-struction and Development and theEuropean Investment Bank.

Esa Jokivuolle,

born in 1964 in Kannus, Finland, heholds a MasterÕs degree in economicsfrom the University of Helsinki and aPh.D. in finance from the Universityof Illinois at Urbana-Champaign. Heis currently working as a projectsupervisor at the Bank of FinlandÕsfinancial markets department. Healso acts as Lecturer, specialized inderivatives and risk management, atthe Helsinki School of Economics.

Previously, he was a researchfellow at the University of Helsinkiand he also served as a deputy direc-tor of the Finnish Postgraduate Pro-gram in Economics. From 1997 to1999 he was a senior quantitativeanalyst in Leonia plc, then the secondlargest commercial bank in Finland.His main responsibility was thedevelopment of credit risk portfoliomanagement.

Currently, he is a member of theEuropean CommissionÕs WorkingGroup on Internal Ratings concern-ing the capital adequacy reform.His earlier research on stock indexesand index options has been publishedin well-known finance journals andhis work on The New Basel Accord,joint with Samu Peura, has recentlyappeared in the Risk Magazine.


is a Member of the Board of Manag-ing Directors of Deutsche Bank AG.In this role he is responsible asChief Information Officer (CIO)for Group-wide Information Tech-nology. In addition he is in chargeof the distribution channel of thebusiness area Private Clients andAsset Management (PCAM), com-prising Deutsche Bank 24, PrivateBanking and Asset Management.

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Until the end of 2000 he wasHead of Global Technology andServices and the European Trans-action Bank. Mr. Lamberti success-fully managed the GTS-Transforma-tion, IT-Integration of Bankers Trustas well as the Y2K compliance.

Hermann-Josef Lamberti wasappointed Member of the Board ofManaging Directors effective Octo-ber 1999.

Before joining Deutsche Bank,Hermann-Josef Lamberti was withIBM for the better part of two deca-des. He began his career at IBM in1985 as a management trainee, andwas soon entrusted with manage-ment positions in the companyÕsGerman offices involved with thebanking and insurance industries. In1993, he then moved on to appoint-ments at IBM Europe in Paris, wherehe was General Manager of the Per-sonal Software Division and headedsoftware sales for Europe, the Mid-dle East and Africa. In 1995, Mr.Lamberti transferred to IBM in theU.S., where he was Vice Presidentfor Marketing and Brand Manage-ment for IBMÕs mainframe business.Mr. Lamberti returned to Germanyin 1997 to become General Managerof IBM Germany in Stuttgart.

Hermann-Josef Lamberti studiedin Cologne and Dublin before start-ing his professional career in thefinancial sector. In 1981 he took hisdegree in Business Administrationand began working for Touche Rossin Toronto where he was involvedin auditing and consulting and he alsoworked for Chemical Bank in Frank-furt in the Foreign Exchange Tradingsector.

Klaus Liebscher,

born in 1939, is presently servingas Governor of the OesterreichischeNationalbank (OeNB). Moreover,since the foundation of the EuropeanCentral Bank (ECB) in June 1998 he

has been an independant memberboth of the ECB Governing Counciland the ECB General Council. Healso represents the OeNB at the Bankfor International Settlements (BIS)GovernorsÔ Meeting and is AustriaÕsGovernor to the International Mone-tary Fund (IMF).

Before he joined the Oester-reichische Nationalbank on June 1,1995 Ð then presiding the GeneralCouncil of the Bank as its Presidentuntil August 31, 1998 Ð he startedat the Raiffeisen Zentralbank O¬ ster-reich AG in 1968, where he was amember of the Executive Boardsince 1980 and Chief ExecutiveOfficer and Chairman of the Boardfrom 1988 to 1995. He served asPresident of the Vienna StockExchange Council from 1990 to1995 and on the supervisory boardsof several banks and other corpora-tions in Austria and abroad.

Mr. Liebscher earned his lawdegree (Dr. iur.) at the Universityof Vienna.

David T. Llewellyn,

is Professor of Money and Banking atLoughborough University and Chair-man of the Loughborough UniversityBanking Centre.

After graduating from the Lon-don School of Economics, he workedin the Economics Department ofUnilever in Rotterdam. He subse-quently served in the Economic Sec-tion of the U.K. Treasury, and thenas a Lecturer in Economics at theUniversity of Nottingham. Between1973 and 1976 he worked inWashington at the InternationalMonetary Fund. In 1976 he wasappointed to the Chair of Moneyand Banking in the Department ofEconomics at Loughborough Univer-sity, and is Chairman of the Lough-borough University Banking Centre.He writes and researches extensivelyin the field of financial regulation,

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the structure of financial systems,banking and financial markets, andin strategies and financial perform-ance of financial institutions. Hislatest books include: ÒFinancial Reg-ulation: Why, How and WhereNow?Ó (co-authored with C. Good-hart and others) and ÒThe NewEconomics of Banking.Ó

Outside the University, he is theConsultant Economist to Butlers (adivision of money brokers GarbanIntercapital), and a member of theInternational Advisory Board of theItalian Bankers Association. He hasbeen a Public Interest Director ofthe Personal Investment Authority,the PIA Ombudsman Bureau, andChairman of the PIAÕs Effectivenessand Strategy Committee which wasresponsible for advising the Boardon the PIAÕs regulatory strategy andmonitoring its effectiveness. He hasserved as a consultant to banks,building societies, central banks andregulatory authorities in severalcountries, including Sweden, Nor-way, Finland, Iceland, South Africa,Australia, Poland, and the CzechRepublic. He is currently a memberof a four-person Regulation TaskForce at the Reserve Bank of SouthAfrica. In 1998 he became a foundermember of the European ShadowFinancial Regulatory Committee.

In May of last year he was electedPresident of SUERF (Socie«te« Uni-versitaire Europe«enne RecherchesFinancieres) which has its permanentsecretariat at the OesterreischischeNationalbank in Vienna. SUERF is anetwork of European central banks,banks and academics with a researchor professional interest in bankingand financial markets.

One of his current projects is ananalysis of the causes, consequencesand public policy responses of bank-ing crises, some of which has been inconjunction with the Bank of Eng-land, International Monetary Fund,

and the Nederlandsche Bank. In2000 he was commissioned by theBank of England to co-author a studyon systemic stability for the CentralBank GovernorsÕ Symposium.

Alessandro Profumo,

born in Genoa (Italy) in 1957,earned a Degree in Business Eco-nomics from the Luigi Bocconi Busi-ness University in Milan. AlessandroProfumo is Chief Executive Officerof the Unicredito Italiano Group,Chairman of the Supervisory Boardof Bank Pekao, Member of the Boardof Directors and of the ExecutiveCommittee of Mediobanca, andChairman of Xelion Sim. He is alsoDeputy Chairman of UniCreditoBanca Mobiliare (UBM) and holdsa number of posts within the Uni-Credito Italiano Group of banks.

In 1977, he joined Banco Lar-iano, where he gathered ten yearsÕexperience in the bankÕs branchesand headquarters in both the com-mercial and executive areas. Afterthat he joined McKinsey & Co.,where he was involved in three stra-tegic and organizational projects forfinancial companies. In 1988, hejoined Bain, Cuneo & Associati.Here he was in charge of marketing,study and the completion of numer-ous projects as well as the develop-ment of relations with financial insti-tutions. After an engagement withRiunione Adriatica di Sicurta (RAS)as its General Manager in charge ofthe banking and parabanking sectors,his main responsibilities includingthe yield increase of the companyÕsbank and of the other group compa-nies operating in the field of assetmanagement, in 1994 he joinedCredito Italiano as Deputy GeneralManager in charge of Planning andGroup Control. A year later he wasappointed Chief General Managerand in 1996 Chief Executive Officer,both at Credito Italiano. In 1999

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he was nominated Chief ExecutiveOfficer of UniCredito Italiano.Other posts Alessandro Profumoheld include Member of the Execu-tive Board of Associazione BancariaItaliana (ABI Ð the Italian BankingAssociation), Member of the Associ-ation for the Development and Studyof Banks and the Stock Exchange,Member of the Institut InternationaldÕEtudes Bancaires, and Member ofthe Executive Board of the ItalianAssociation for Cancer Research(AIRC).

Helmut Reisen,

born in 1950, is Head of Division ofthe Research Department at theOECD Development Centre since1994. He studied economics at SaarUniversity of Saarbru¬cken and grad-uated in 1976. He obtained hisdoctorate in economics at the Uni-versity of Cologne in 1987 and hishabilitation at the University of Baselin 1993.

His professional experienceincludes banking at the Commerz-bank AG, Mo¬nchengladbach, assis-tantship in economics at Saar Univer-sity of Saarbru¬cken from 1976 to1977, the position of a ResearchFellow at the Kiel Institute of WorldEconomics from 1977 to 1980, theactivity as an adviser for the Confed-eration of German Industries inCologne and the German Ministryof Economics in Bonn since 1981.He worked as an economist andsenior economist at the OECDDevelopment Centre in Paris from1983 to 1994.

He is Professor of InternationalEconomics at the University of Basle,Founding Member of the AdvisoryBoard of International Finance,Member of the American EconomicAssociation, and the Verein fu¬rSocialpolitik.

Urs Philipp Roth,born in 1947, is Chief ExecutiveOfficer of the Swiss Bankers Associ-ation (SBA) and Delegate of its Boardof Directors.

After finishing his law studieswith a doctorate in Zurich and qual-ifying as an attorney-at-law, UrsPhilipp Roth joined UBS in 1976and worked until March 2001 inZurich as UBS AGÕs Group GeneralCounsel. As such he was responsiblefor advising UBS AG globally on legaland compliance issues.

He has served for many years onvarious commissions and workinggroups of the SBA. Since January2001 he has also chaired the Execu-tive Committee International Finan-cial Centre Switzerland (LAIF). Heholds a teaching post at the Univer-sity of Zurich and lectures exten-sively on political and legal issuesaffecting financial markets. In recentyears he has written numerous aca-demic papers on banking and stockexchange law. He is also co-editorof commentaries on stock exchangeand banking law.

Walter Rothensteiner,

born in 1953, became Member ofthe Board of Management of Raiff-eisenlandesbank Lower Austria-Vienna in 1990. He was alsoappointed Member of the Board ofManagement of Leipnik-Lunden-burger Industrie AG and ofAGRANA-Beteiligungs-AG (sugarand starch industry), where from1992 to 1994 he was also DeputyChairman. In 1995 he was appointedDeputy Chairman and Ð later inthe same year Ð Chairman of theBoard of Management of RaiffeisenZentralbank O¬ sterreich AG (RZB-Austria). He is Honorary Consul-General of the Republic of Singaporein Austria. As an additional functionDr. Rothensteiner became Presidentof the Department of Bank and

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Insurance at the Federal EconomicChamber of Austria in 1997.

Reinhard H. Schmidt,

born in 1946, is Wilhelm MertonProfessor for Business Administra-tion and International Banking andFinance at the University of Frank-furt since 1998.

He concluded his studies of busi-ness administration and economics atthe Universities of Heidelberg andFrankfurt in 1971. In 1974, heobtained his Ph.D. degree in eco-nomics and business administration.After visiting the Graduate Schoolof Business of Stanford Universityas a scholar from 1975 to 1976 andworking as Assistent Professor ofBusiness at the University of Frank-furt from 1977 to 1981, he earnedhis habilitation in the field of businessadministration in 1980.

From 1981 to 1983 Reinhard H.Schmidt was Associate Professor ofFinance at the University of Go¬ttin-gen. From 1983 to 1991 he was FullProfessor of Business Administrationand Finance at the University ofTrier and from 1989 to 1990 VisitingKonrad Adenauer Professor at theGeorgetown University in Washing-ton, D. C. Principal fields of researchand teaching include financial theory,in particular capital markets andinstitutions, finance in developingcountries, organization theory andcorporate governance and compara-tive financial systems. His mainresearch project to date deals withthe convergence of financial systemsin Europe (with the financial supportof Deutsche Forschungsgemein-schaft). Among his publications are16 books, about 40 articles in Ger-man and international academicjournals, and about 60 chapters inbooks.

Dirk Schoenmaker,was born in the Netherlands in 1967.He obtained his Master in BusinessEconomics in 1990 (cum laude)and his Master in Law in 1991, bothat the Erasmus University in Rotter-dam. In 1995, he earned his Ph.D. inEconomics at the London School ofEconomics. During his studies heserved as an intern at the Depart-ment for International Affairs of DeNederlandsche Bank (Dutch CentralBank) (in 1991) and as a Summer-intern at the Capital Markets andFinancial Studies Division of theInternational Monetary Fund (in1994), where he was also a VisitingScholar in 1995. From 1991 to1996 he was Research Officer onFinancial Regulation of the FinancialMarkets Group at the London Schoolof Economics. In 1996, he joinedthe Bank of England, where heserved as a Senior Analyst of BankingSupervisory Policy in the Division ofSupervision & Surveillance. In 1998,he joined the Ministry of Finance ofthe Netherlands, where he was firstappointed Deputy Head and a yearlater Head of the General and Mon-etary Affairs Division of the FinancialMarkets Policy Directorate. SinceNovember 2000 he is Head of theFinancial Stability Division of theFinancial Markets Policy Directorateat the Ministry of Finance.

Wolfgang Schu¬ ssel,

was born in Vienna on June 7, 1945.Following his elementary schooling,he attended a well-known classicalgrammar school in Vienna (theÒSchottengymnasiumÓ) where hetook his secondary school leavingcertificate in 1963. He went on tostudy at Vienna University andreceived a Doctorate in Law in1968. Dr. Schu¬ssel was secretary ofthe parliamentary group of theAustrian PeopleÕs Party (O¬ VP)from 1968 to 1975; from 1975 to

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April 1991 he was Secretary Generalof the Austrian Business Federa-tion, a sub-organization of thePeopleÕs Party. On April 24, 1989Dr. Schu¬ssel became Minister forEconomic Affairs in the coalitiongovernment formed by the AustrianSocial Democratic Party (SPO¬ ) andthe PeopleÕs Party under ChancellorFranz Vranitzky. At the 30th PartyCongress of the O¬ VP, Dr. Schu¬sselwas elected national leader of theParty on April 22, 1995. On May 4,1995 Dr. Wolfgang Schu¬ssel wassworn in as Vice-Chancellor andFederal Minister for Foreign Affairsin Franz VranitzkyÕs fourth govern-ment. He held the same posts inChancellor VranitzkyÕs fifth Cabinet.In Chancellor KlimaÕs first govern-ment, from January 28, 1997 toFebruary 4, 2000, Dr. Schu¬ssel wasagain Vice-Chancellor and FederalMinister for Foreign Affairs. OnFebruary 4, 2000 Dr. WolfgangSchu¬ssel was sworn in as FederalChancellor.

Erich W. Streissler,

was born in 1933 in Vienna as theson of Dr. Albert Streissler, whoworked at the Ministry of Financeand was later director of the O¬ ster-reichisches Hypotheken- und Credit-institut. He obtained his Ph.D. at theVienna Law School in 1955 andpassed the habilitation in economicsin 1959 in the same school.

He was appointed Full Professorof Statistics and Econometrics at theUniversity of Freiburg in Germanyand was twice Dean of the Facultyand Political Science. Since 1968 hewas Full Professor of Economics,Econometrics, and Economic His-tory at the University of Vienna (inthe chair formerly held by CarlMenger). From 1973 to 1974 hewas Dean of the Faculty of Law andPolitical Sciences in Vienna. Duringhis studies and researches he visited

the United States, Spain, France,England, and was a frequent guestat Oxford University. In 1983 hewas appointed DistinguishedAustrian Visiting Professor at Stan-ford University in California.

He is a member of the Bavarian,Hungarian, Austrian, and EuropeanAcademy of Sciences. From 1990to 1991 he was President of the Con-federation of the European Eco-nomic Associations. Since 1992 heis Treasurer of the International Eco-nomic Association. His teachingincludes economics, econometrics,and the history of economics, hisspecial interests being devoted toexchange rate theory, social old ageand health insurance, history oftheory and science, especiallyregarding Adam Smith, liberalism,German national economy from1825 to 1880, and the AustrianSchool of National Economy.

Ernst-Ludwig von Thadden,

is Professor of Economics at Univer-site« de Lausanne. He has been Fellowof the Center for Advanced Studiesin the Behavioral Sciences at StanfordUniversity and is Research Fellow ofthe Center for Economic PolicyResearch in London. He studiedmathematics and economics at theUniversity of Heidelberg, obtainedhis Ph.D. in economics from theUniversity of Bonn within the ÒEuro-pean Doctoral Program in Econom-ics,Ó and a Habilitation in economicsfrom the University of Basel.

He is director of the FAMEdoctoral program at the Universitiesof Lausanne and Geneva and mem-ber of the scientific boards of anumber of academic and professionalinstitutions. He has been an advisorto the World Bank and other inter-national organizations. Among hisacademic activities are the editorshipof the Journal of Financial Inter-mediation and associate editorship

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69


of the Review of Economic Studies.He has written extensively on issuesranging from game theory to finan-cial institutions and law and eco-nomics.

Jean-Claude The« bault,

born in 1950 in Paris, has been anofficial of the European Commissionsince 1984. After finishing his studiesin public law at the University ofRennes in 1974, he obtained a post-graduate diploma in public law, witha specialisation in public inter-national law, at the University ofParis in 1975 and a postgraduateaccountancy qualification.

From 1976 to 1979 he worked atthe Caisse des De«poöts et Consigna-tions in Paris, where he was assistantto the head of the departmentresponsible for managing loans tolocal government and social housingand researcher in the departmentresponsible for loans to publicamenities. From 1979 to 1983 hewas organizational consultant withSINORG, an information technologyconsultancy, posted to Abidjan (CoötedÕIvoire) as advisor to the Ministry ofEconomics and Finance and head ofthe Cabinet of the Director-Generalof Finance.

He joined the Directorate-Gen-eral XX in 1984, where he was incharge of the financial control and,later, principal administrator in UnitXX/B/2, with responsibility for thecontrol of EAGGF Guarantee Sec-tion expenditure. After working atSG-UCLAF from 1988 to 1989,where he was involved in the crea-tion and establishment of the Coor-dination of the Fraud PreventionUnit, he assumed the position ofthe Head of the Common Agricul-tural Policy Unit of the DG forBudgets, responsible for PAC budgetmanagement and control, in 1989.From 1995 to 1998 he was DeputyChef de Cabinet to Yves-Thibault

de Silguy, European Commissionerresponsible for economic, financialand monetary affairs and the statisti-cal office. He was in charge of thegeneral coordination and questionsrelating to agriculture, budget andpersonnel, fisheries, financial controland fraud prevention, employmentand social affairs, political and socialcohesion policy, tax and customs.After his engagement as the Directorof the Forward Studies Unit of theEuropean Commission from 1998to 2000 he was appointed Directorof the Direction of Financial Institu-tions at the Directorate-GeneralInternal Market in June 2000.

Gianni Toniolo,

is Professor of Economics at theUniversity of Rome Tor Vergataand Research Professor of Econom-ics at Duke University, Durham,U.S.A. He currently is ResearchFellow at the Centre for EconomicPolicy Research (CEPR) in London,Member of the Board of Trusteesof the European Association ofHistorical Economics, Member ofthe Board of Directors of VeniceInternational University, and holdsthe Chair in the Program Committeeof the Mattioli Memorial Lectures inMilan. Additionally, he is ExecutiveVice President of Fondazione Cassadi Risparmio di Venezia and colum-nist for the Italian daily ÒIl Sole24 Ore.Ó

He earned a degree in economicsÒsumma cum laudeÓ at the Universityof Venice in 1966. From 1967 to1968 he was Research Fellow of theEconomic History Workshop atHarvard University. From 1968 to1986 he was, first, Assistant Profes-sor of Economics and, then AssociateProfessor of Economic History at theUniversity of Venice. From 1986 to1996 he was appointed Professor ofEconomics at the University ofVenice. His visiting positions include

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the Duke University, Durham, AllSouls College and St. AntonyÕsCollege in Oxford, the Universityof California in Berkeley, U.S.A.,Hitotsubashi University in Tokyo,and the University of Connecticut,U.S.A.

He is co-editor (with P. Cioccaand G. Federico) of the ÒRivista diStoria Economica,Ó co-editor (withC. Feinstein, P. OÕBrien, B. Suppleand P. Temin) of the ÒCambridgeStudies in Modern EconomicHistory,Ó and co-editor (with T.Bianchi, P. Ciocca and M. Onado)of ÒStoria di banche.Ó He is amember of the editorial board ofÒIndustrial and Corporate Change,ÓÒEuropean Economic HistoryReview,Ó ÒJournal of Modern ItalianStudies,Ó ÒJahrbuch fu¬r Wirtschafts-geschichte,Ó ÒRevue Economies etSocietes,Ó of the series ÒHistoireEconomique Quantitative,Ó and ofthe ÒBulletin of Economic Research.ÓHe is a Member of the AcademiaEuropaea in Cambridge, U.K., anda Senior Common Room Memberof St. AntonyÕs College in Oxford.Additionally, he is a member of theEuropean Economic Association, ofthe Societa Italiana degli Economisti,the Societa Italiana degli Storici del-lÕEconomia, the Economic HistoryAssociation, the Economic HistorySociety, the Cliometric Society, andthe European Historical EconomicsSociety.

Gertrude Tumpel-Gugerell,

born in Killing (Lower Austria),graduated with honors from highschool in St. Po¬lten in 1971 and withhonors from the University ofVienna with a masterÕs degree in eco-nomics and social sciences in 1975.In the same year she joined the Eco-nomics Department of the Oester-reichische Nationalbank (OeNB),attended the Financial Analysis andPolicy Training Program of the Inter-

national Monetary Fund in 1980 andreceived a doctorate of economicsand social sciences in 1981.

She worked from 1981 to 1984as the economic policy advisor tothe Minister of Finance and was amember of the Supervisory Boardof O¬ sterreichische La¬nderbank AG.In 1985 she was appointed DeputyHead of the OeNBÕs EconomicsDivision and in 1986 became Comp-troller General and put in charge ofdeveloping strategic planning andauditing. From 1990 she has repre-sented the OeNB in economic andsocial science research institutes,was appointed Director of the AreaCorporate Planning and Manage-ment at the OeNB in 1992. From1996 she has been in charge of coor-dinating the OeNBÕs preparations forEMU, was appointed Chief Execu-tive Director of the Economics andFinancial Markets Department in1997 and in September 1998 becameVice Governor of the OeNB.

Mrs. Tumpel-Gugerell is a mem-ber of the Council for the Founda-tion of Fachhochschulen (specializedinstitutions of higher education) inAustria, the International RelationsCommittee and the Banking Super-vision Committee of the ECB, theEconomic and Financial Committeeand Vice Chairperson of the BankingAdvisory Committee

Norbert Walter,

born in 1944, studied at the JohannWolfgang Goethe University inFrankfurt am Main, where he earnedhis Ph.D. He worked at the Institutfu¬r Kapitalmarktforschung between1968 and 1971. In 1971 he movedto the Kiel Institute of World Eco-nomics as assistant to ProfessorGiersch, president of the institute.He also headed various researchgroups, in 1975 Mr. Walter becamehead of the ÒKonjunktur und Welt-wirtschaftÓ Department and later of

Die Vortragenden



the ÒRessourceno¬konomik.Ó In 1978he was appointed Professor andDirector of the Kiel institute. Hewas John J. McCloy, DistinguishedResearch Fellow, resident scholarat Johns Hopkins University inWashington D.C. in 1986/87.

In 1987 he joined Deutsche Bankas a senior economist and since 1990he has been Chief Economist ofDeutsche Bank Group. In 1992 hewas appointed Managing Directorof the newly founded Deutsche BankResearch, Deutsche BankÕs economicthink tank. He has been a member ofthe Committee of Wise Men on theregulation of European SecuritiesMarkets since July 2000.

Gert Wehinger,

born in 1963 in Bregenz in Austria,works as an economist in the Moneyand Finance Division of the Eco-nomics Department of the OECDsince 1999. His major fields ofresearch include financial marketsand monetary policy, financial sys-tems and growth, financial sectorconsolidation, and public debt man-agement. Since April 2000 he islecturer and thesis advisor in eco-nomics at the American GraduateSchool of International Relationsand Diplomacy in Paris. He obtainedhis MasterÕs degree in economics atthe Karl-Franzens-University of Grazin 1988. In 1990 he concluded hispostgraduate studies in economicsat the Institute for Advanced Studiesin Vienna. He received the doctoraldegree with excellence at ViennaUniversity of Economics and Busi-ness Administration in 1995.

From 1990 to 1995 he was uni-versity assistant at Vienna Universityof Economics and Business Adminis-tration, where he did teaching, thesissupervision and research in the fieldsof international economics andmacroeconomics, stabilisation, andeconomic development. After work-

ing as a lecturer in economics atVienna University of Economicsand Business Administration and atthe Polytechnical College for Busi-ness Consulting in Wiener Neustadt,Austria, from 1990 to 1999, he waseconomist in the Economic StudiesDivision of the OesterreichischeNationalbank in Vienna, where heworked on macroeconomic issuesof the European Monetary Unionand electronic money. He presentedvarious conference papers and publi-cations in the fields and assumed thefunction of a deputy representativeof the OeNB in the EMI Task Forceon Electronic Money.

His research visits and coursesinclude the University of Rome,Fundacüa÷o Getu«lio Vargas in Rio deJaneiro, the University of Bonn/ZEI, and the SNB Study Centre Ger-zensee in Switzerland. He is a Mem-ber of the European Economic Asso-ciation, the Austrian Economic Asso-ciation, the Western Economic Asso-ciation, the AIESEC Austria Alumni,and the Austrian Latin AmericanInstitute. He is also journal refereefor Empirica, Empirical Economics,Journal of Macroeconomics, andZagreb International Review of Eco-nomics and Business. He wrote vari-ous publications, including papersand articles, on financial marketsand growth, European MonetaryUnion issues, analyses of inflation,cash innovations, and a book on highand chronic inflation and stabilisationpublished in 1996.

Ernst Welteke,

has been President of the DeutscheBundesbank and a member of theGoverning Council of the EuropeanCentral Bank since September1999. He was born in Korbach, asmall town in the central Germanstate of Hesse, in 1942. He leftschool in 1959 to learn a practicaltrade, qualifying as an agricultural

Die Vortragenden



mechanic in 1962, before resuminghis academic education at a pre-uni-versity college in Wiesbaden.Between 1965 and 1971 he studiedeconomics at the universities ofMarburg and Frankfurt am Main,graduating with a degree in econom-ics in 1971.

He began his professional careerin 1972 when he joined the Officeof the Prime Minister of Hesse. In1974 he was elected to the HesseState Parliament and remained amember until 1995. He was chair-man of the parliamentary group ofthe Social Democratic Party (SDP)in the Hesse State Parliament from1984 to 1987 and from 1988 to1991. From 1991 to 1994 he wasthe Minister of Economics, Trans-port and Technology in the State of

Hesse Ð which has a population ofover six million and includes theimportant city of Frankfurt am MainÐ before serving as HesseÕs Ministerof Finance between 1994 and 1995.During these years, Hans Eichel,the current Minister of Finance ofthe Federal Republic of Germany,was Prime Minister of Hesse. In1995 Mr. Welteke was appointedPresident of the Land Central Bankin Hesse and a member of the Cen-tral Bank Council of the DeutscheBundesbank.

Ernst Welteke is an active mem-ber of numerous political, social, andcultural organizations. Among manyother interests and functions, he isChairman of the Friends of theHebrew University of Jerusalem inGermany. §

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70


Medieninhaber:Oesterreichische Nationalbank

Fu¬ r den Inhalt verantwortlich:Wolfdietrich Grau, Sekretariat des Direktoriums/O¬ffentlichkeitsarbeit

Redaktion:Alexander Dallinger,Abteilung fu¬r volkswirtschaftliche Analysen

Grafische Gestaltung:Peter Buchegger, Sekretariat des Direktoriums/O¬ffentlichkeitsarbeitHannes Jelinek, Hausdruckerei

Fotografien:Foto Knoll

Satz, Druck und Herstellung:Hausdruckerei

Ru¬ ckfragen:Oesterreichische NationalbankSekretariat des Direktoriums/O¬ffentlichkeitsarbeitWien 9, Otto-Wagner-Platz 3Postanschrift: Postfach 61, A-1011 WienTelefon: (+43-1) 404 20 DW 6666Telefax: (+43-1) 404 20 DW 6696

Nachbestellungen:Oesterreichische NationalbankDokumentationsmanagement und KommunikationsserviceWien 9, Otto-Wagner-Platz 3Postanschrift: Postfach 61, A-1011 WienTelefon: (+43-1) 404 20 DW 2345Telefax: (+43-1) 404 20 DW 2398

Internet:http://www.oenb.at

Papier:Salzer Demeter, 100% chlorfrei gebleichter Zellstoff, sa¬urefrei, ohne optische Aufheller

DVR 0031577

Wien 2001



Documents

Volkswirtschaftliche Tagung 2001 - Startseite39f95114-efda-4bc0-ac2e-7bfa8c982026/... · speaker of this conference, Mr. Duisenberg, President of the ECB. This yearÕs topic ÒThe