Bank Structure and Regulation in the EU - Modern Banking


In common with the United Kingdom and Japan, the European Union has adopted the key global recommendations and agreements reached by various international committees. For example, it is expected that Basel 2 will be integrated with the EU’s new Capital Adequacy Directive III. This begins with a brief review of the banking systems in Germany, France, Italy and Scandinavia, before turning to three issues central to the European Union: the achievement of a single market, the European Central Bank, and the extent to which regulation should be integrated at European level.

Bank Structure – Germany

As was noted earlier, Germany is the home of the universal bank, and the hausbank system. Not only do they engage in retail and wholesale commercial and investment banking but, as in Japan, they will hold equity in commercial entities, to whom they also grant loans. Like the keiretsu in Japan, Germany’s hausbank system involves close relationships between these commercial concerns and their banks, with cross-shareholdings and shared directorships. Normally senior bank executives sit on the supervisory boards of these companies. The big three to five national banks or Gros ß anken (e.g. Deutsche Bank, Dresdner) date back to the 19th century and offer a full range of banking services, as do 200 regional banks, which have their headquarters and branches concentrated in a particular region. The 13 Landesbanken began as regional girobanks in the 1900s – clearing was their primary function, though by the 21st century they too offer a full range of banking services, making them effectively universal banks. There are just under 600 saving banks (Sparkassen), with links to local or regional governments. The post office, Deutsche Postbank, also accepts savings from individuals and small firms, which are used to fund finance for the local/regional infrastructure, as well as lending to clients who might be turned away by other banks – hence the guarantee extended to them. There are just under 1800 mutual credit cooperatives. As in Canada and the USA, they are linked to particular professions and trades, and provide basic banking services – accepting deposits and making loans.

There are also privately owned mortgage banks (hypothekenbanken) and mutual building and loan associations (Bausparkassen – some are state owned). Both focus largely on arranging mortgages for home ownership. Just as the UK has recently undergone major reforms, Germany is considering what to do with its Bundesbank, which up to 2000 set monetary policy to achieve price stability.

However, with Germany part of the eurozone, this role is somewhat diminished, though the Bundesbank Governor is part of the ECB interest rate setting committee.

The central banking system in Germany consists of the Bundesbank and nine regional Landeszentralbanken. Until the introduction of the euro, its remit was to maintain price stability. There is a proposal (by the Pohl Commission) to reduce the number of Landeszentralbanken to five. The Bundesbank proposed that BAKred (Bundesaufsichtsamt fur das Kreditwesen), the independent bank supervisor, be subsumed under the reorganized Bundesbank. However, in March 2001, the finance minister called for the creation of a new agency, with responsibility for the supervision of the entire financial sector, including banks.

The Bundesanstalt f¨ur Finanzdienstleistungsaufsich (BaFin – see began operations in May 2002. A legal entity within the Ministry of Finance, BaFin merges the functions of the former offices for banking supervision (BAKred) with the equivalent organisations in insurance and securities, creating a single body with responsibility for supervising all firms in the financial sector, including issues as diverse as solvency and

Top German Banks (by Tier 1 Capital) in 2003

Top German Banks (by Tier 1 Capital) in 2003

consumer protection. BaFin supervises 2700 banks, 700 insurance companies and 800 other firms offering financial services. At the time of writing, it employed about 1000 people, with offices in Bonn and Frankfurt/Main. The Bundesbank continues to represent German interests at the European Central Bank.

There is some uncertainty regarding the future structure and soundness of the German banking system. In 1999 the private banks complained to the European Commission that the public bank sector (Landesbanken, Sparkassen, Deutsche Postbank) had an unfair competitive advantage because they are backed by public guarantees. The complaint was up held by the EC’s Competition Commission. In 2001, the Commission and German government agreed that by July 2005, the loan guarantees for the Landesbanken would be phased out, along with reform of some general guarantees. There is increasing concern about the health of German banks because prolonged recession has forced them to increase their loan loss reserves. Table below summarises the key ratios for the top 5 German banks.

Three of the five are reporting a negative ROA in 2003 and some banks’ cost to income ratios are high by European standards.

Bank structure – France

The French financial system, including its banks, has developed at a relatively slow pace, due partly to the relatively high degree of state interference in this sector. France is characterised by numerous regulations, even though it has recently shed some of its more onerous rules. For example, before 1985, France had no money market to speak of, apart from an interbank market.

The key banks in France are the 400 members of the AFB or Association Fran¸caise des Banques. The system was highly segmented until the 1984 Banking Act. After 1984, AFB member banks became universal banks, offering retail, wholesale and investment banking, together with an intermediary service and investment banking.

The French banking system experienced episodes of bank nationalisation during the last half of the 20th century. The Socialist governments which nationalised banks thought it the only way to offer ‘‘fair’’ banking services to small and medium-sized industries. The more cynical saw it as a means by which the government could control the banking system to meet the industrial goals set by the socialists. The privatisation of banks began after the Gaullists took control of the National Assembly in 1986, but was suspended in 1988. They resumed again in the 1990s, so that by the new century, all the major banks were in the private sector.

There is also a strong mutual and cooperative movement. Typically, they are owned by the depositors, each with a single vote, independent of the size of the deposit. Membership is usually drawn from a particular industry – they can make deposits and apply for loans.

The local offices are members of regional offices, which offer clearing and intermediary facilities. The two national organisations are the Caisse Central de Cr´edit Mutuel, which offers banking services to the regional groups, and the Conf´ed´eration Nationale de Cr´edit Mutuel, which acts as a political lobby for this group. Unlike the UK, these groups are very large. In 2002, Cr´edit Agricole, a mutual organisation, was the largest bank by tier 1 capital; Cr´edit Mutuel was the fourth largest. There is a substantial savings bank movement, the Caisses d’Epargne, which, as a group, represents the fifth largest banking organisation by tier 1 capital. Interest on deposits is tax free, up to a limit. As cooperatives, they offer a full range of banking services to the retail sector. They are not allowed to make loans to commercial or trade concerns. Again, the local banks use regional centres for clearing purposes and two national bodies, one which manages funds collected by the local saving banks and the other which both regulates and represents the savings banks.

The other banks are effectively universal banks. The French banking system has also been subjected to more extensive regulation when compared to other EU states. Though the Banque de France gave up control over lending rates in 1967, restrictions on deposit rate setting, fees and commissions were not lifted until 1996. Even now no interest is paid on current accounts, in exchange, it is claimed, for free bank services. However, as pressure of the single market, particularly in Euroland, increases, it is unlikely that any control over rates will last. For example, in 2000, the Dutch financial group, ING, began to offer interest paying deposit rates on all accounts in credit via the internet. With the implementation of financial reforms, a great deal of consolidation has

Top French Banks (by Tier 1 Capital) in 2003

Top French Banks (by Tier 1 Capital) in 2003

taken place, causing the number of French financial institutions to fall from 2000 in 1990 to just over 1000 at the end of the decade.

Bank structure – Spain54

Spanish depository institutions include banks, mutual savings banks and credit cooperatives.

All of them operate under a similar regulatory regime. There are also ‘‘Specialised Credit Institutions’’ (SCIs), which are confined to granting credit to specific sectors of the economy and may not be funded through deposit taking.

The Spanish banking system was gradually liberalised during the second half of the 1980s. Prior to liberalisation, the financial market was geographically segmented and there was little competition. In 1987, controls on interest rates were relaxed. In 1991–2, credit restrictions and investment targets were eliminated.

These reforms created a very competitive environment; commercial banks and mutual savings banks fought to attract deposits and borrowers by offering very cheap products (e.g. ‘‘la supercuenta’’ and ‘‘la superhipoteca’’). The reforms generated two types of institutions: those focused on growth, and banks which gave priority to increased returns rather than size. There was a wave of mergers and acquisitions among both commercial and mutual savings banks. State owned banks were also affected. Until 1990, state credit institutions depended on the government’s Official Credit Institute. In 1991 the Banking Corporation of Spain, Argentaria, was created by merging the Official Credit Entities: the Banco Exterior de Espa ˜na and the Postal Savings Bank (Caja Postal de Ahorros). Argentaria was gradually privatised between 1993 and 1998, then merged with Banco Bilbao Vizcaya in 1999. The two largest Spanish institutions (see Table below), Banco Santander Central Hispano and Bilbao Vizcaya Argentaria, are the result of mergers between Spain’s bigger banks.

These mergers have increased the degree of concentration in the market. The private commercial banks and the mutual savings banks are the key players in the Spanish banking system. Commercial and mutual savings banks have, respectively, about 49% and 46% of total deposits; credit cooperatives have 5%. In recent years mutual savings banks have progressively increased their share of the deposit market, at the expense of the commercial banks. The change could be due to the restructuring of the commercial banks over the past 10 years, which resulted in the closure of numerous branches (e.g. nearly 600 closed in 2002). At the same time, mutual savings banks have expanded their branch networks.

The major Spanish banks moved into Spanish South America (Hispano-Am´erica). There are cultural and political links between the two regions (common history, language and very similar legal systems), reducing some of the risks normally related to multinational

Top Spanish Banks (by Tier 1 Capital) in 2003

Top Spanish Banks (by Tier 1 Capital) in 2003

banking. Hispano-Am´erica is also a big market (more than 500 million inhabitants), with good growth. Spain plays a leadership role in Hispano-Am´erica – many see Spain as the ‘‘Mother country’’. As a result, the Argentinean financial crisis affected the big Spanish banks with significant exposure in Hispano-Am´erica.

In November 2002, a financial law was passed to modernise the Spanish financial system. The main objectives are to increase the efficiency and competitiveness of the financial system, and to encourage the use of new channels of distribution and technologies in banking, by authorising the creation of e-cash institutions which will issue e-cash, to be used as a means of payment.60 The law also calls for greater protection of the consumers using financial services. The central bank is responsible for bank supervision; and the new law gave its risk agency expanded powers to centralise and supervise financial risks incurred by all financial institutions.

Bank Structure – Scandinavia

Though four independent countries, Norway (not a member of the EU), Denmark, Sweden and Finland make up the region of Scandinavia,61 recent mergers of banks across the region have increased the degree of financial integration between the countries. In fact, it could be argued that this region is closer to achieving a single financial market than the EU as a whole.

The area experienced quite a severe banking crisis in the early 1990s, which led to a large number of mergers, giving this region the most concentrated banking system in Europe. Universal banking is the norm; there are savings and ‘‘union’’ banks, but on a much smaller scale (compared to Germany or France), and no regional banks.

The degree of concentration is quite striking. The five largest banks in each country accounted for, respectively, as a percentage of the banking sector’s aggregate balance sheet, 96% in Finland, 94% in Sweden, 84% in Denmark and 71% in Norway. One example of the increased concentration which crosses national boundaries is Nordea. Nordea is a large universal bank, headquartered in Sweden, which, following a number of acquisitions, became a Scandinavian financial group. In 1993, Nordbanken took over the sickly Gota bank, and shortly after merged with Merita Bank of Finland, to form Merita Nordbanken. Other acquisitions included two Danish banks, Tryg-Baltica and Unibank. It purchased Christianiana Bank og Kreditkasse (K-bank) and Den Norske Bank in Norway, both of which had to be rescued by the government in the early 1990s. Insurance firms were also purchased, reflecting the trend to ‘‘all finance’’ or bank assurance – whereby one bank offers every financial service, from insurance to e-banking.

Scandinavia has some of the oldest central banks in the world, some even preceding the growth of commercial banks, in contrast to the trends in the UK, USA and many European countries, where the central bank was set up after the emergence of a private/public commercial banking sector. The Bank of Sweden or Sveriges Riksbank was created in 1668, replacing the Stockholm Banco, which had been formed to issue bank notes. The Financial Supervisory Authority is responsible for individual bank soundness; the Riksbank controls the payment system and ensures financial stability prevails. The Dansmarks Nationalbank originated as a private bank in 1736, but insolvency led to its nationalisation 37 years later. Though Dansmarks Nationalbank has been independent of government since 1936, its monetary policy is driven by the fixed exchange rate regime it has with the euro, because it is part of the Exchange Rate Mechanism. There is a separate supervisory authority, though both institutions have joint responsibility for financial stability. Soumen Pankki (the Bank of Finland) was formed in 1811, followed by the Norges Bank (Bank of Norway) in 1816. Norges Bank implements monetary policy set by the government. It also controls the investments of the Government Petroleum Fund, which receives the profits from the oil and gas sector. Norway’s banks are supervised by a separate institution, the Kredittilysynett.

In Finland, banks are supervised by a Financial Supervision Group, which is located at the Bank of Finland, but independent of it. Finland has adopted the euro, so its monetary policy is largely determined by the European Central Bank. Finland has 343 banks (1999 figures), which is high compared to other countries in this region. There are just eight commercial banks, and a group of 246 union banks making up Okobank, Merita, a commercial bank, and Leonia, a state owned bank (the product of a 1998 merger between the Postal Bank and the Export Bank). These three banks have 90% of bank assets; 85% of bank liabilities.

There is a fairly strong movement of savings and union banks in Finland – about 130 (out of 152 banks in total) in 2000. In the other countries, these sectors have largely integrated with the commercial banks. There are also some non-bank financial firms in the region, including specialised mortgage banks, state lending firms, investment companies, mutual funds, insurance and pension funds, but most are either subsidiaries or linked to domestic banks, in keeping with the bancassurance approach.

Bank Structure – Italy

The banking structure in Italy underwent major changes in the 1990s, the result of financial reform in preparation for operating in a single market. By 2000, the number of banks in Italy had more than halved due to the 561 mergers and takeovers during the 1990s. The proliferation of large numbers of small, local branchless uncompetitive banks was the outcome of the 1936 Banking Act, which allowed commercial banks to take short-term (18- month) deposits and loans, while investment banks were restricted to long-term finance. No bank could own a commercial concern. The central bank, the Banca d’Italia, had a great deal of power in terms of approving products offered by banks; it also discouraged branch banking. In addition, because of frequent bank failures and crises before and during the 1930s, large numbers of banks were either state owned or run by non-profit organisations, all closely supervised by government.

Given that the Italian industry consists largely of family or state owned firms, there was little demand for finance via an equity market or a more sophisticated banking system.

There was pressure for reform in the 1980s, coming from the banking association itself and groups representing firms and employees. The Banca d’Italia responded by relaxing what restrictions it could, and in 1990 began to encourage mergers and branch networks. The Banking Act of 1993 effectively allowed the formation of bank holding companies, and got rid of the distinction between short and medium-term deposits and loans. Banks were allowed to hold up to 15% of a commercial concern. The outcome was subsidiaries of the BHCs which offered a full range of financial services, including insurance.

From 1993 onward, there was a steady stream of privatisations, beginning with the sale of 64% of the ordinary shares of Credito Italiano followed by Banca Commerciale Italiana, Mediobanca, and in the late 1990s, Banca Nationale del Lavoro, Banco di Napoli and Banca di Roma, among others. By 1999, the share of the banking sector held by the state or organisations supervised by the state had fallen to 12%, from 70% in 1993. The trend has been to form banking groups; in 2000 there were 79 such groups with 267 bank subsidiaries, controlling just under 90% of the country’s assets. There are 8 maggiori or very large banks, and 16 grandi (large) banks. In 2000 there were 284 limited banks with over 20 000 branches, 44 cooperative banks with nearly 5000 branches, and 499 mutuals with just under 3000 branches. Unlike other western countries (with the exception of the USA), the number of bank branches expanded through the 1990s, following the relaxation of the laws by the central bank.

Table below shows the top 5 Italian banks, with some key ratios. As can be seen from the table, despite considerable consolidation, the top Italian banks are much smaller than their British, German or French counterparts in terms of tier 1 capital and assets.

Like the Bank of England, the Banca d’Italia was founded as a private bank in 1893 and given responsibility for maintaining price stability in 1947. It is also the key bank regulator.

Top Italian Banks (by Tier 1 Capital) in 2003

Top Italian Banks (by Tier 1 Capital) in 2003

Directives for a Single EU Financial Services Market

The review of individual bank structure and regulation for a selection of continental European states and the UK illustrates considerable differences in the respective banking systems. In France and Spain, the savings banks are major players; France also has an extensive cooperative movement. Germany is the home of some very large universal banks, but also has some important regional and savings banks. A traditionally fragmented system in Italy is gradually disappearing but has some way to go to match the high degree of consolidation in Scandinavia. The UK and Germany have recently introduced monolithic financial regulators but in Italy, France and Spain, banks continue to be supervised by the central bank. Within this somewhat diverse framework, the EU is seeking to integrate EU financial markets, creating a single market in banking and other financial services. The objective of this is to address the issue of achieving a single banking market in the European Union. The Single European Act (1986) was considered essential if EU markets, including the banking and financial markets, were to become sufficiently well integrated to be called ‘‘single’’ markets. It was hoped the Act would speed up the integration of European markets through the introduction of qualified majority voting and the replacement of harmonisation with mutual recognition. The 1st of January 1993 was designated ‘‘single market day’’, i.e. the day the single internal market was to be completed, in all sectors, including banking. Yet, as this text goes to press, more than a decade later, achieving an integrated banking and/or financial market continues to be an elusive goal.

The Financial Sector Action Plan has set 2005 as the date to achieve a single financial market in Europe. What happened? After reviewing the background to the current state of affairs, the problem of existing barriers to the completion of a single market is discussed.

The internal market: background

The Treaty of Rome (1957) was a critical piece of legislation because one of its key objectives was to bring about the free trade of goods and services throughout EU member states. This was to be achieved through the harmonisation of rules and regulations across all states. However, by the 1980s, it was acknowledged that progress towards free trade had been dismally slow. The Single European Act (1986) was another milestone in European law. To speed up the integration of markets, qualified majority voting was introduced and the principle of mutual recognition replaced the goal of harmonisation. The Act itself was an admission that it would be impossible to achieve harmonisation, that is, to get states to agree on a single set of rules for every market. Instead, by applying the principle of mutual recognition, member states would only have to agree to adopt a minimum set of standards/rules for each market. Qualified majority voting, where no member has a right of veto, would make it easier to pass directives based on mutual recognition.

These acts applied to all markets, from coal to computers. The European directives or laws which were passed to bring about integrated banking /financial markets are reviewed. The First Banking Directive (1977) defined a credit institution as any firm making loans and accepting deposits. A Bank Advisory Committee was established which, in line with the Treaty of Rome, called for harmonisation of banking in Europe, without clarifying how this goal was to be achieved. The Second Banking Directive (1989) was passed in response to the 1986 Single European Act. It remains the key EU banking law and sets out to achieve a single banking market through application of the principle of mutual recognition. Credit institutions65 are granted a passport to offer financial services anywhere in the EU, provided member states have banking laws which meet certain minimum standards. The passport means that if a bank is licensed to conduct activities in its home country, it can offer any of these services in the EU state, without having to seek additional authorisation from the host state. The financial services covered by the directive include the following.

  • Deposit taking and other forms of funding.
  • Lending, including retail and commercial, mortgages, forfaiting and factoring.
  • Money transmission services, including the issue of items which facilitate money transmission, from cheques, credit/debit cards to automatic teller machines.
  • Financial leasing.
  • Proprietary trading and trading on behalf of clients, e.g. stock broking.
  • Securities, derivatives, foreign exchange trading and money broking.
  • Portfolio management and advice, including all activities related to corporate and personal finance.
  • Safekeeping and administration of securities.
  • Credit reference services.
  • Custody services.

This long list of financial activities in which EU credit institutions can engage illustrates Brussel’s strong endorsement of a universal banking framework.

Prior to the Second Directive, the entry of banks into other member states was hampered because the bank supervisors in the host country had to approve the operation, and it was subject to host country supervision and laws. For example, some countries required foreign branches to provide extra capital as a condition of entry. The Second Directive removes these constraints and specifies that the home country (where a bank is headquartered) is responsible for the bank’s solvency and any of its branches in other EU states. The home country supervisor decides whether a bank should be liquidated, but there is some provision for the host country to intervene. Branches are not required to publish separate accounts, in line with the emphasis on consolidated supervision. Host country regulations apply to risk management and implementation of monetary policy. Thus, a Danish subsidiary located in one of the eurozone states is subject to the ECB’s monetary policy, even though Denmark keeps its own currency.

The Second Directive imposes a minimum capital (equity) requirement of 5 million euros on all credit institutions. Supervisory authorities must be notified of any major shareholders with equity in excess of 10% of a bank’s equity. If a bank has equity holdings in a non-financial firm exceeding 10% of the firm’s value and 60% of the bank’s capital, it is required to deduct the holding from the bank’s capital.

The Second Directive has articles covering third country banks, that is, banks head quartered in a country outside the EU. The principle of equal treatment applies: the EU has the right to either suspend new banking licences or negotiate with the third country if EU financial firms find themselves at a competitive disadvantage because foreign and domestic banks are treated differently (e.g. two sets of banking regulations apply) by the host country government. In 1992, a European Commission report acknowledged the inferior treatment of EU banks in some countries, but appears to favour using the World Trade Organisation to sort out disputes, rather than exercising the powers of suspension. Other European directives relevant to the banking/financial markets include the following.

  • Own Funds and Solvency Ratio Directives (1989):The former defines what is to count as capital for all EU credit institutions; the latter sets the Basel risk assets ratio of 8%, which is consistent with the 1988 Basel accord and the 1996 agreement on the treatment of market risk. The EU is expected to adopt the Basel 2 risk assets ratio.
  • Money Laundering Directive (1991): Effective from 1993, money laundering is defined to include either handling or aiding the handling of assets, knowing they are the result of a serious crime, such as terrorism or illegal drug activities. It applies to credit and financial institutions in the EU. They are obliged to disclose suspicions of such activities, and to introduce the relevant internal controls and staff training to detect money laundering.
  • Consolidated Supervision Directives: Passed in 1983 and 1993. The 1993 directive requires accounting reports to be reported on a consolidated basis. The threshold for consolidation is 20%.
  • Deposit Guarantee Directive (1994): To protect small depositors and discourage bank runs all EU states are required to establish a minimum deposit insurance fund, to be financed by banks. Individual EU states will determine how the scheme is to be run, and can allow alternative schemes (e.g. for savings banks) if they provide equivalent coverage.

The minimum is 20 000 euros,66 with an optional 10% co-insurance. Foreign exchange deposits are included. The UK is one of several states to impose the co-insurance, the objective of which is to give customers some incentive to monitor their bank’s activities.

For example, the maximum payout on a deposit of £20 000 is £18 000; £4500 for a £5000 deposit. Branches located outside the home state may join the host country scheme; otherwise they are covered by the home country. However, if the deposit insurance of the home country is more generous, then the out of state branch is required to join the host country’s scheme. The host country decides if branches from non-EU states can join.

  • Credit Institution Winding Up Directive: Home country supervisors have the authority to close an institution; the host country is bound by the decision.
  • Large Exposures Directive (1992): Applies on a consolidated basis to credit institutions in the EU from January 1994. Each firm is required to report (annually) any exposures to an individual borrower which exceeds 15% of their equity capital. Exposure to one borrower/group of borrowers is limited to 40% of bank’s funds, and no bank is permitted an exposure to one borrower or related group of more than 25%. A bank’s total exposure cannot exceed eight times its own funds.
  • The Consolidated Supervision Directives: There have been two directives. The original was passed in 1983 but replaced by a new directive in 1992, which took effect in January 1993. It applies to the EU parents of a financial institution and the financial subsidiaries of parents where the group undertakes what are largely financial activities. The threshold for consolidation is 20% of capital, that is, the EU parent or credit institution owns 20% or more of the capital of the subsidiaries.
  • Capital Adequacy Directives (1993, 1997, 2006(?)): The capital adequacy directives came to be known as CAD-I (1993), CAD-II (1997) and CAD-III (2006?). CAD-I took effect from January 1996 but CAD-II replaced it, adopting the revised Basel (1996) treatment of market risk. It means trading exposures (for example, market risk) arising from investment business are subject to separate minimum capital requirements. As in CAD-I, to ensure a level playing field, banks and securities firms conform to the same capital requirements. Banks with securities arms classify their assets as belonging to either a trading book or a banking book. Firms are required to set aside 2% of the gross value of a portfolio, plus 8% of the net value. However, banks have to satisfy the risk assets ratio as well, which means more capital will have to be held against bank loans than securities with equivalent risk. For example, mortgage backed securities have a lower capital requirement than mortgages appearing on a bank’s balance sheet. This gives banks an incentive to increase their securities operations at the expense of traditional lending, which could cause distortions. The European Commission published a working document on CAD-III in November 2002. Consultation and comments on the document were completed in 2003. The plan is to publish a draft CAD-III in 2004, and by the end of 2006 it should have been ratified by European Parliament and the EU state legislatures. It will coincide with the adoption of Basel 2 by the banks. As was pointed out, the Commission has made it clear that the main text of Basel 2 will form part of the CAD-III directive. In other words, the Basel guidelines will become statutory for all EU states. This means it will be very difficult to adjust bank regulation to accommodate new financial innovations and other changes in the way banks operate. EU banks will have a competitive disadvantage compared to other countries (notably the USA), where supervisors require banks to adopt Basel 2 but do not put it on their statute books.
  • The Investment Services Directive: Passed in 1993, and implemented by the end of 1995. It mirrors the second banking directive but applies to investment firms. Based on the principle of mutual recognition, if an investment services firm is approved by one home EU state, it may offer the same set of services in all other EU states, provided the regulations in the home state meet the minimum requirements for an investment firm set out in the directive. The firm must also comply with CAD-II/III. The objective of the ISD was to prevent regulatory differences giving a competitive edge to banks or securities firms. It applies to all firms providing professional investment services. The core investment products covered include transferable securities, unit trusts, money market instruments, financial futures contracts, forwards, swaps and options. The directive also ensures cross-border access to trading systems. A number of clauses do not apply if a firm holds a banking passport but also meets the definition of an investment firm.

Three other directives are relevant to the operations of some EU banks. The UCITS (Under takings for the Collective Investment of Transferable Securities) Directive (1985) took effect in most states in 1989, other states adopted it later. Unit trust schemes authorized in one member state may be marketed in other member states. Under UCITS, 90% of a fund must be invested in publicly traded firms and the fund cannot own more than 5% of the outstanding shares of a company.

  • Insurance Directives for Life and Non-Life Insurance: Passed since 1973. The Third Life Directive and Third Non-Life Directives were passed in 1992, and took effect in July 1994. These directives create an EU passport for insurance firms, by July 1994. Provided a firm receives permission from the regulator of the home country, it can set up a branch anywhere in the EU, and consumers can purchase insurance anywhere in the EU. The latest Pension Funds Directive was approved by Parliament in late 2003. It outlines the common rules for investment by pension funds, and their regulation. Though silent on harmonisation of taxes, a recent ruling by the European Court of Justice states that the tax breaks for pension schemes should apply across EU borders. States have two years to adopt the new directive, and it is hoped that during this time, they will remove the tax obstacles which have, to date, prevented a pan-European pension fund scheme, and transferability of pensions across EU states. It is also expected that restrictions on the choice of an investment manager from any EU state will be lifted and it will be possible to invest funds anywhere in the Union.
  • Financial Conglomerate Directive (2002): This directive harmonises the way financial conglomerates are supervised across the EU. A financial conglomerate is defined as any group with ‘‘significant’’ involvement in two sectors: banking, investment and insurance.
  • More specifically, in terms of its balance sheet, at least 40% of the group’s activities are financial; and the smaller of the two sectors contributes 10% or more to the group’s balance sheet and the group’s capital requirements. By this definition, there are 38 financial conglomerates in the EU (2002 figures), and most of them have banking as their main line of business. These financial conglomerates are important players, especially in banking, where they have 27% of the EU deposit market; their market share in the insurance market is 20%, in terms of premium income. Market share (in terms of deposits or premium income) varies widely among EU states. The directive bans the use of the same capital twice in different parts of the group. All EU states must ensure the entire conglomerate is supervised by a single authority. The risk exposure of a financial conglomerate is singled out for special attention – risk may not be concentrated in a single part of the group, and there must be a common method for measuring and managing risk, and the overall solvency of the group is to be computed. American financial conglomerates are supervised by numerous authorities, even though the Federal Reserve Bank is the lead supervisor. The US authorities have expressed concern at the plan for an EU coordinator, who will decide whether the US system of regulation is ‘‘equivalent’’; if not, then the compliance costs for US financial conglomerates operating in the EU will increase, leaving them at a competitive disadvantage. A compromise is being sought. Analysts have speculated that the trade-off may be achieved by a relaxation of the Sarbanes–Oxley rules for EU firms operating in the United States. Europe, like Japan, Mexico and Canada, is seeking exemption from parts of the Act.

  • Market Abuse Directive (2002): This directive is part of the Lamfalussy reform of the EU securities markets (see below), and introduces a single set of rules on market manipulation and insider dealing, which together, make up market abuse. The directive emphasises investor protection with all market participants being treated equally, greater transparency, improved information flows, and closer coordination between national authorities. Each state assigns a single regulatory body which must adhere to a minimum set of common rules on insider trading and market manipulation.

Achieving a Single Market in Financial Services

A single financial market has been considered an important EU objective from the outset. A study on the effects on prices in the event of a single European financial market was undertaken by Paolo Cecchini (1988), on behalf of Price Waterhouse (1988). The study looked at prices before and after the achievement of a single market for a selection of products offered by banks, insurance firms and brokers. The banking products studied included the 1985 prices (on a given day) for consumer loans, credit cards, mortgages, letters of credit, travelers cheques /foreign exchange drafts, and consumer loans. Post-1992, it was assumed that the prices which would prevail would be an average of the four lowest prices from the eight countries included in the study. Based on these somewhat simplistic assumptions and calculations, the report concluded that there would be substantial welfare gains from the completion of a single financial market, in the order of about 1.5% of EU GDP. Germany and the UK would experience the largest gains, a somewhat puzzling finding given that the UK, and to a lesser extent Germany, had some of the most liberal financial markets at the time.

Heinemann and Jopp (2002) also identified the gains from a single financial market. They argue that the greater integration of retail financial markets will encourage financial development, which stimulates growth in the EU and will help the euro gain status as a global currency. Using results from another study70 on the effect of financial integration on growth, Heinemann and Jopp (2002) argue growth in the EU could be increase by 0.5% per annum, or an annual growth of ¤43 billion based on EU GDP figures for the year 2000. As was noted earlier, the original objective was to achieve a single market by the beginning of 1993. The grim reality is that integration of EU financial markets, especially in the retail banking /finance sector, is a long way from completion, and any welfare gains are yet to be realised. The Financial Services Action Plan(2000) is an admission of this failure, and sets 2005 as the new date for integration of EU financial markets.

Barriers in EU retail financial markets

Heinemann and Jopp (2002) examined the retail financial markets and identified a number of what they term ‘‘natural’’ and ‘‘policy induced’’ obstacles to free trade. Eppendorfer et al. (2002) use similar terms; ‘‘natural’’ barriers refer to those arising as a result of different cultures or consumer preferences, while different state tax policies or regulations are classified as ‘‘policy induced’’ barriers.

Before proceeding with a review of the major barriers, it is worth identifying an ongoing problem which hinders the integration of EU markets. EU states have a poor record of implementationof EC directives. There are two problems – passing the relevant legislation AND enforcing new laws. The problem is long standing. Butt-Philips (1988) documented the dismal performance of EU states in the period 1982–86, especially for directives relating to competition policy or trade liberalisation. The Economist (1994) also reported a poor implementation rate, though the adoption of directives had improved. For example, in1996 one country was taken to the European Courts before it would agree to pass a national law to implement the Investment Services Directive. It has also been difficult to get some countries to adopt the 1993 CAD-II Directive. The European Commission website has a long list of actions being taken because some EU states have failed to adopt and/or implement a variety of directives.

Heinemann and Jopp identify policy induced barriers, which, they argue, could be corrected by government changes in policies. They include the following.

  • Discriminatory tax treatment or subsidies which favour the domestic supplier. For example, tax relief on the capital repayment of mortgages was restricted to Belgian lenders, which gave them a clear cost advantage. This barrier has since been removed but the European Commission had cases against Greece, Italy and Portugal because of similar tax obstacles. In Germany, pension funds are eligible for subsidy but only if a long list of highly specific requirements are met, which means that any pan-European supplier of pension products faces an additional barrier in Germany. Either the firm will not qualify for the subsidy or compliance costs will be higher than their German competitors, unless the rules imposed by the home state are very similar. If every state has different requirements, compliance costs soar, discouraging the integration of an EU pensions market.
  • Eppendorfer et al. (2002) provide an example of where the principle of mutual recognition creates problems. Banco Santander Central Hispano, Nordea, HSBC and BNP Paribas all reported problems when they tried to extend their respective branch network across state frontiers because of the split in supervision: the home country is responsible for branches but the host deals with solvency issues.
  • Lack of information for customers on how to obtain redress in the event of a legal dispute or problem with a product supplied by an out of state firm.
  • Additional costs arising from national differences in supervision, consumer protection and accounting standards. For example, the e-commerce laws in the EU mean all firms are subject to country of origin rules: if an internet broker is planning to offer services in other EU states, then the broker must follow the internet laws of each state. It is illegal to use a website set up in France for French customers in Germany – a new website has to be created for German customers. Likewise, the EU directive on distance marketing of financial services allows each member state to impose separate national rules on how financial services can be marketed, advertised and distributed. The myriad of different rules makes it almost impossible to develop pan-EU products which can be sold in all states. Nonetheless, Nordea used the internet to successfully capture market share in several Scandinavian countries, which shows the internet can bypass some entry barriers.
  • Conduct of business rules can be used as a way of preventing other EU firms from setting up business in a given EU state. For example, there may be a rule which does not make a contract legally binding unless written in the said state’s language(s). Though there is increasing convergence on the professional markets, this is not the case for retail markets.
  • The ‘‘general good’’ principle is used by EU states to protect consumers, and cultural differences influence consumer protection policy. However, these rules can deter competition from other EU states: the principle is interpreted in different ways across the EU states. The outcome is 15 to 2573 different sets of rules on, for example, the supply of mortgage products, which raises costs for any firm attempting to establish a pan-EU presence. There is a fine line between the use of the general good clause to protect consumers, as opposed to domestic suppliers.
  • There are 15 to 25 different legal systems, each with different contract and insolvency laws, and so on. For example, trying to sell loans across EU frontiers is extremely difficult because of different definitions of collateral across the member states.
  • It is acknowledged that it is much harder to raise venture capital in the EU than in the USA. The Risk Capital Action Plan was endorsed by the European Council in June 1998, to be implemented by 2003. The point of the plan is to eliminate the barriers which inhibit the supply of and demand for risk capital. It will focus on resolving cultural differences (e.g. lack of an entrepreneurial culture), removing market barriers, and differences in tax treatment. However, the plan is ambitious and may prove too difficult to implement.
  • Reduced cross-border information flows can also create barriers. New entrants to state credit markets face a more serious problem with adverse selection than home suppliers because they have less information. In many EU states central banks keep public credit registers, but access to them is restricted to home financial institutions that report domestic information to the central bank. The same is true for some private credit rating agencies. It creates barriers for out of state lenders and even if they do manage to enter the market, it increases the risk of them being caught out with dud loans.
  • Domestic suppliers, especially state owned, often have special privileges. Or, the costs of cross-border operations, such as money transfers, may involve costly identification/ verification requirements. For example, on-line brokers (or any financial service) have to verify the identity of the client they are dealing with. This is done through local post offices, the relevant embassy, or a notary. Such cumbersome procedures discourage the use of foreign on-line broking/financial firms.
  • The existence of national payments systems for clearing euro payments is cumbersome and costly. In July 2003, a new EU regulation requires that the charges for processing cross-border euro payments be the same as for domestic payments up to ¤12 500, rising to ¤50 000 by 2005. The goal is to create a single European payments area. Banks have done well from extra charges for cross-border payments, and one estimate is that this regulation will cause lost revenues of around ¤1.2 billion.
  • Though the integration of EU stock exchanges continues apace through mergers and alliances, clearing and settlement procedures remain largely national. This means, for example, that on-line brokers must charge additional fees for purchasing or selling stocks listed on other EU exchanges (even if there is an alliance), or they do not offer the service. The demand side is also affected: customers are deterred from choosing a supplier in another EU state. The cost of cross-border share trading in Europe is 90% higher than in the USA, and it is estimated that a central counterparty clearing system for equities in Europe (ECCP) would reduce transactions costs by $950 million (¤1 billion) per year.
  • The cost savings would come primarily from an integrated or single back office. A central clearing house for European equities acts as an intermediary between buyers and sellers. Netting would also be possible, meaning banks could net their purchases against sales, reducing the number of transactions needing to be settled, and therefore the capital needed to be set aside for prudential purposes. Real time gross settlement would help to eliminate settlements risk. The plan is being backed by the European Securities Forum, a group of Europe’s largest banks.

  • There are more than 50 related regulatory bodies with responsibility for regulation of financial firms in the EU, and the number will continue to rise as new member states join. This makes it difficult for them to cooperate. This issue will remain while individual states have the right to decide how to regulate home state financial firms. Different reporting rules for companies and different rules on mergers and acquisitions are just two examples of how regulations can create additional barriers to integration. A new directive on takeovers (the 13th Company Law Directive) was supposed to be ratified by the EU Parliament in July 2001. The directive would have brought in standard EU-wide rules on how a firm can defend itself in the event of a hostile takeover bid. Hostile bids would have been easier to launch because it would require management wishing to contest a bid to obtain the support of their shareholders. German firms believed the directive did not give enough protection, and lobbied German MEPs to vote against it. The result was an even number of votes for and against with 22 abstentions, so it was not passed. Though unprecedented, it meant 12 years of work on a directive had been wasted. The failure to ratify this directive has encouraged banks to enter into strategic alliances or joint ventures rather than opting for a full merger. Recent examples include Banco Santander Central Hispano (BSCH) with Soci´et´e G´en´erale, Commerzbank, the Royal Bank of Scotland Group and San Paolo-IMI, and Dresdner Bank with BNP Paribas.

Natural barriers identified by Heinemann and Joppe include the following.

  • Additional costs due to differences in language and culture. For example, the barriers to trade caused by the e-commerce directive were noted earlier. But there are natural barriers arising from the use of the internet as a delivery channel across European frontiers. Fixed costs are created by the need for a specific marketing strategy in each EU state because of differences in national preferences, languages and culture, together with the need to launch an advertising campaign to establish a brand name. IT systems must be adapted for local technical differences and sunk costs can discourage entry. Consumer access to some products may also be limited if certain EU states are ignored because their market is deemed to be too small.
  • Consumer confidence in national suppliers. For example, a real estate firm may refer clients to the local bank for mortgages.
  • The need to have a relationship between firm and customer, which makes location important. This point is especially applicable for many banking products. Relationship banking may be used to maximise information flows, which can in turn, for example, improve the quality of loan decisions.

Heinemann and Jopp (2002) surveyed seven European banks and insurance firms to ascertain how important they considered these obstacles to be, using a scale from 1 (not relevant) to 10 (highly relevant). In retail banking,79 the most important barriers were differences in tax regimes (6.8/10) and regulation (supervision, takeover laws, etc.) 5.8/10. Consumer loyalty and language barriers came next (5.2/10 and 5.1/10), followed by unattractive markets (4.8/10) and poor market infrastructure (3.2/10).

An earlier survey by the Bank of England (1994) reached similar conclusions. About 25 firms, mainly banks and building societies, were surveyed. Cultural and structural barriers were found to be the most difficult to overcome, including cross-shareholdings between banks and domestic firms, consumer preferences for domestic firms and products, governments choosing home country suppliers, and a poor understanding of mutual organisations, which made it difficult for British building societies to penetrate other EU markets. Others included fiscal barriers due to different tax systems, regulatory barriers due to different regulations (e.g. the pension or mortgage examples identified by Heinemann and Jopp), and legal and technical barriers. Note the perception that notable barriers exist has not changed, even though the two surveys (albeit small) were done nearly 10 years apart.

The Lamfalussy report: February 2001

Though this report dealt with EU securities markets, the ratification of its key recommendations by the EU Parliament in February 2002 may have important implications for the future integration of banking and other financial markets. The report made a number of recommendations, most of which were eventually endorsed by Parliament. The key proposal was that rules for EU securities markets would be formulated by expert committees. They consist of a Committee of European Securities Regulators (ESRC), to be made up of national financial regulators. Based on advice from the ESRC, a European Securities Committee (ESC) made up of senior national officials (chaired by the European Commission) will employ quasi-legislative powers to change rules and regulations related to the securities industry. Though these arrangements represent a radical change in the EU legislative process, they are considered essential for Europe to keep up with the rapid pace of change in the financial markets. It normally takes at least three years (an average of five) to have rule changes ratified by the EU Parliament, which undermines Europe’s competitive position in global securities markets.

The Lamfalussy report recommended that the home country principle (of mutual recognition) apply to securities markets, with a single passport for recognised stock markets. International accounting standards should be adopted, with an EU-wide prospectus for Initial Public Offerings.

Lamfalussy also called for the European Commission to act on the failure of certain states to either implement and/or enforce new EU directives. The Committee noted that the failure to integrate the retail financial services sector is preventing the development of a pan-EU retail investor base, which in turn undermines the development of a single securities market.

In February 2002, the European Parliament voted to accept the Lamfalussy report, to ensure a fast track for securities market legislation, even though it undermined their power somewhat. The European Securities Committee can implement legally binding rules, subject to a ‘‘Sunset’’ clause. Each new regulation imposed by the ESC expires within four years unless approved by Parliament. Both Parliament and the Council of Ministers have the right to review any regulation they are dissatisfied with.

Hertig and Lee (2003) are pessimistic about whether the success of the Lamfalussy reforms will work. State members of the ESC will attempt to act in the interests of their home state, and the Council of Ministers or Parliament can always intervene with regulatory decisions. Thus, they predict the ESC will be less powerful than its US equivalent, the Securities and Exchange Commission. For this reason, when the Lamfalussy model comes up for review in 2004, it could be ruled unworkable and ineffective.

These arrangements for the securities markets are important for banking because a similar model could be used to get new rules passed through quickly, to deal with many of the long-standing problems which have inhibited the emergence of a single financial market. However, as was noted earlier, the Commission’s plan to put the main text of Basel 2 (part of CAD-III) through the standard ratification process is a source of concern. Only the Basel 2 annexes will be put on the fast track. Not only will this delay its adoption, it means excessively prescriptive components of Basel 2 will become part of EU law, and therefore, very difficult to change.

Will a Single Market Ever be Achieved?

As was noted earlier, the objective of the Financial Services Action Plan is to achieve a single financial market in Europe by 2005. However, it is open to question whether the plan will succeed. As has been documented, major barriers continue to exist. The question is the extent to which a single market can be achieved in view of the cultural, language and legal differences within the EU, especially now it has expanded to include up to 10 new countries. Application of the Lamfalussy approach to retail financial markets is considered one solution to achieving a more integrated retail financial market, but if Hertig and Lee are correct, it will not succeed.

Instead, perhaps policy makers should concentrate on removing blatant policy induced entry barriers and accept that some markets will never be fully integrated, particularly in the retail banking and some other financial markets. The wholesale financial markets are already global in nature, and a key objective of the European regulators should be to ensure that no legislation is passed which hinders the competitive advantage of Europe’s financial firms operating in wholesale markets. Like in Europe, the wholesale markets are highly integrated, but the retail markets are not. The US insurance sector is regulated by individual states, so insurers face similar problems – there are 51 different sets of rules. It is only very recently that nation-wide branch banking became a possibility. Thus, even though it is one country, parts of retail banking and finance are still highly fragmented. The EU is a collection of 25 independent nations. From 2004, it is 76% bigger than the USA in terms of population, and has a somewhat higher GDP. If a country with just one official language has not achieved a single market in certain sectors, how can the EU, with its many different languages, cultures and legal systems be expected to succeed?

Evans (2000) is one of several experts calling for an increase in the harmonisation of rules across Europe in the banking, capital and securities markets. However, the whole point of the 1986 Single European Act was to introduce mutual recognition because the goal of harmonisation was inhibiting the achievement of internal markets. As the early history of the EU demonstrates, attempts at achieving harmonisation will be even less successful than efforts to bring about a single market through mutual recognition. However, the time has come to recognise that like any country, some markets will be easier to integrate than others.

The European Central Bank

The European Central Bank was formed as part of the move to a single currency within the European Union. The objective of the Maastricht Treaty (1991) was to achieve European M

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