sou · GOB311d5 · 2001-01-01 00:00:00 — Insurance activities include underwriting and selling insurance products/services as principal and as Real estate activities include investment, development and management. Unrestricted – A full range of activities in the given category can be c onducted directly in the bank. Permitted – a full range of activities can be c onducted, but all or some must be conducted in Restricted – Less than a full range of activities can be c onducted in the bank or subsidiaries. Prohibited – The activity cannot be conducted in either the bank or subsidiaries. What Is Optimal Financial Regulation? Permissible corporate organizational form in which to conduct selected bank activities in selected EU and G-10 countries* Yes, widely used Yes, widely used Volym D:212 Bilaga 26 Permissible corporate organizational form in which to conduct selected bank activities in selected EU and G-10 countries* Yes & No 6 Italian banks are not directly involved in insurance activities; these must be conducted by insurance companies subject to specific rules. Banks usually act as an agent of insurance companies, selling product through their branches.Only underwriting and custodian services. What Is Optimal Financial Regulation? Permissible corporate organizational form in which to conduct selected bank activities in selected EU and G-10 countries* Source: Office of the Comptroller of the Currency using information provided by bank supervisory authorities in the respective countries. Information as of January 1997. Securities activities include underwriting, dealing and brokering all kinds of securities and all aspects of the mutual fund business. Insurance activities include underwriting and selling insurance products/services as principal and as agent. Real estate activities include investment, development and management. Securities activities fall under the banking activities provisions of Section 1 Act. , such business may be conducted exclusively by a bank. Insurance activities require a license by the insurance supervisory authority (). Insurance activities in may be conducted in the bank as agent but not as principal. Except as agent for insurance companies. Holding companies may own the majority of shares in a Greek bank, but there is no specific legal framework referring to such companies. Only selling insurance products combined with deposits – no insurance risk may be assumed by banks. Excluding investment in bank premises. Only includes selling insurance products and services as agent. Volym D:214 Bilaga 26 Pure holding companies are permitted to incorporate under law, but the statute of a bank holding company does not exist. This type of company is not subjected to any control by any authority. Public debt directly in bank and stock exchange in bank subsidiary. With the exception of selling insurance as an agent, which is commonly conducted directly in the bank. What Is Optimal Financial Regulation? , F. and D. Gale, (1988), Design, Review of Financial Studies, Vol. 1(3), p. , Franklin and . Santomero, (1997), The Theory of Financial Intermediation, , Vol. 21 (11-12), p. , (1996), Settlement Risk in Transactions, Basle, (The Allsopp Report). (1998), Settlement Risk: A Progress Report, Basle, . , ., , . , (1997), Structure, Regulation, and Performance: An International Comparison, Office of the Comptroller of the Currency Working Paper, . 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W., (1984), Financial Intermediation and Delegated Monitoring, Review of Economic Studies, Vol. 51, p. , D. W. and P. H. Dybvig, (1983), , , and Liquidity, , Vol. 1, p. , . and Flannery, ., (1992), Does the Debt Market Assess Large Banks Risk?, Time Series Evidence from Money Center CDs, , Vol. 30 (3), p. 481- 502, . European Commission, Communication of the Commission, : a Framework for Action, October 31, 1998. Fama, , (1985), Whats Different About Banks?, , 15, p. Flannery, ., (1998), Modernizing Financial Regulation (Again), paper presented at a Conference on Financial Modernization and Regulation, of , . Flannery, , Sorescu, Sorin M., (1995), Evidence of in Subordinated Debenture Yields: 1983-1991, , Vol. 50 (2), p. Furlong, , , ., (1987), Risk, of , Vol. 0 (2), p. 20-40, Spring. Furlong, , , ., (1991), Capital Regulation and : A Note, of , Vol. 0 (3), p. 34-39, Summer. Goodfriend, , (1989), Money, Credit, Banking and Policy, in The U.S. : Efficiency Risk and the Role of , edited by D. , Kluwer Academic Press. , G., (1988), Banking Panics and Business Cycles, Economic Papers, Vol. 40, p. , G. and G. Pennacchi, (1990), Financial Intermediaries and Liquidity Creation, , Vol. 45, p. , and A. Santomero, ., (1990), Market Discipline and , , , Vol. 22, (1), p. 119-28, February. Global , (1993), Derivatives: Practices and Principles, Group of Thirty Report. What Is Optimal Financial Regulation? . and . Herring, (1988), Supervision to Manage Systemic Vulnerability, in the Year 2000: Risk and Efficiency, on , , p. Herring, . and . Santomero, (1991), The Role of Financial Structure in Economic Performance, (in Swedish) SNS Forlag, . B., Payments Finality and Risk of Settlement Failure, Technology and the Regulation of Financial Markets, edited by A. and L.J. , : D.C. , 1986, p.97-120. Jacklin, ., (1987), Demand Deposits, Trading Restrictions, and Risk Sharing, Contractual Arrangements for Inter-temporal Trade, Prescott, ., ed. , , ed., Studies in Macroeconomics Series, Vol. 1 , , p. , ., (1995), Three Paradigms for the Role of Capitalization Requirements in Insured Financial Institutions, , 19, p. Kareken, . and , (1978), and : A Partial-Equilibrium Exposition, , Vol. 51 (3), p. and J.M. OBrien, (1990), Market based deposit insurance premiums, on , , p. Litan, R., (1991), The Revolution in , . Herring, . and , (1995), Financial Regulation in the Global Economy, , The Brookings Horvitz, , (1983), after Deregulation, Proceedings of the 9th Annual Conference of the of , . K., (1991), Theory and Practice of the , in C. , eds., Survey of Monetary Economics, Vol. 2, , Blackwell Press. Litan, , (1987), What Should Banks Do?, , . , , (1999), The Economic Rationale for Financial Regulation, Occasional Paper Series 1, : Authority, April. , ., (1989), On the Application of the Continuous-Time Theory of Finance to Financial Intermediation and Insurance, The Papers on Risk and Insurance, Vol. 14, Number 52, , (1990), onomic Performance, , Volume 4, Number 4, (), p. , ., (1995), Do the M&M propositions apply to banks?, , 19 (), p. , ., (1991), The Future of Banking, , . Santomero, ., (1997a), : Do We and Why?, Ekonomia, Vol. 1 (1), p. 1-19, Summer. Santomero, ., (1997b), Effective Financial Intermediation, : East Asian Lessons for Latin and the Caribbean, . Staking, editor, . Santomero, ., (1984), Modeling the , , Credit, and Banking, 16, Part 2, p. Santomero, ., Capital Issue, Financial Regulations and Monetary Arrangements after 1992, M. Fratianni, C. , T.D. Willet eds., Economic Analysis Series, New Press, 1991. Santomero, ., The Regulatory and Public Policy Agenda for Effective Intermediation in Post Soviet Economies, in Financial Sector Reform and Privatization In Transition Economies (7), p. 153-175, J. Doukas, V. Murinde and C. , editors, , 1998. Santomero, . and , Financial Markets, Instruments and Institutions, , 1996, , 1997. Santomero, . and , (1998), in the Retirement Market: Is the News All Bad?, and ChFC, . Santomero, . and . Trester, (1998), Financial Innovation and , , Vol. 35 (1), p. Santomero, . and . Trester, (1997), for a United Europe, , . Volym D: 219 Consolidation and Strategic Positioning in Banking with Implications for Supplement number 27 to the Government Inquiry on the International Competitiveness of the Swedish Financial Sector. Views, suggestions, and opinions expressed in this study represent the personal views of the author and not necessarily those of the Government Inquiry on the International Competitiveness of the Swedish Financial Sector. * , , , Roetersstraat 11, 1018 WB, , The , E-mail: . The author thanks , and participants at the Symposium on the International Competitiveness of the (, 1999). Volym D:220 Supplement 27 Kort sammanfattning (in Swedish) ..................................................... Fundamentals: The Economics of Banking................................ Traditional versus modern banking......................................... Are bank loans special?.......................................................... Securitization: A threat to bank lending? Is relationship banking at risk?............................................... Scale and Scope Issues in Banking............................................. Scope as a Strategic Advantage ................................................. Importance of the competitive environment............................. Is strategic uncertainty special to financial services?............... The Future and Implications for ................................... Relevance of strategic options ................................................ Is national identity important? Consolidation and Strategic Positioning Kort sammanfattning (in Swedish) I bilagan görs en genomgång av de faktorer som anses betydelsefulla när det gäller stordriftsfördelar etc. i bankverksamhet och hur detta påverkar strukturomvandlingen. Olika empiriska undersökningar kring detta refereras också. Avslutningsvis förs mot den bakgrunden en diskussion om utvecklingen i den svenska banksektorn. Bilagan konstaterar att det pågår en snabb struktur- omvandling på bankområdet i nästan alla länder, däribland , med större banker och ökad koncentration som ett viktigt inslag i bilden. Författaren menar dock att denna process bara i begränsad utsträckning kan förklaras med viljan att ta tillvara skalfördelar eller av andra produktionsekonomiska drivkrafter. Den dominerande drivkraften förefaller istället vara en önskan att positionera sig strategiskt i den snabba omvandling som pågår och där osäkerheten om den framtida utvecklingsriktningen och de framtida utvecklingsförutsättningarna är stor. En konsolidering kan här ge ett större manöverutrymme inför kommande faser av strukturförändringar. Volym D:222 Supplement 27 The financial services industry is restructuring and consolidating at an unprecedented pace around the globe. Particularly, in the and Western Europe transactions are numerous and breathtaking. But restructuring is also going on in . Most striking is probably the ever- escalating scale of mergers in banking. In just the last few years, in the US mergers have led to a consolidation of money center banks (e.g. the Chase and merger) and the emergence of regional power houses (e.g., the expansion strategies of BankOne and Nationsbank, and their subsequent mergers with, respectively, First /NBD and BankAmerica). In Europe, mergers have also been prominent. While cross border mergers are relatively infrequent – with exceptions in and the acquisition of the by the Dutch financial conglomerate – mergers between domestic institutions typically involve large banks and are often spectacular. Noteworthy examples include the marriage of and and the announced merger between Général and (and possibly BNP). And in , a spectacular merger has produced the new bank with over $ 700 billion in assets. A parallel phenomenon is the broadening of scope of many banks. Even banks that traditionally followed well motivated focused strategies now seem to give in to this trend. For example, with its activities aimed at the corporate market, now puts itself in the arms of a scope expanding bank (). Scope-expansion also originates from investment banks. Major investment banks are redefining their domain by offering traditional commercial banking products like commercial and industrial loans and by moving into retail brokerage. The union of (investment bank) and (brokerage) within Travelers underscores the scope-expansion in the industry. The spectacular cross-industry merger by Citicorp and Travelers also brings the insurance activities together with bank-oriented financial services. This concept is not really new. Some European banks, – e.g. in the – already engage in bancassurance, that is, combining banking and insurance activities. Similarly, expanded into insurance by acquiring the insurance corporation Winterthur. Consolidation and Strategic Positioning One question is then immediate. Why are banks consolidating so much and expanding scope? The popular financial press points to the increasingly competitive environment of banking as the culprit. As commercial banking becomes more competitive, banks need to examine all possible ways to wring inefficiencies out of their cost structures. One way to do this is to merge with other banks and realize efficiencies of scale through elimination of redundant branches and back-office consolidation. Moreover, the diminishing in commercial banking invite banks to look outside their traditional domain. Some non-banking activities may offer higher and make scope expansion attractive. These higher may come in part from the value attach to "one-stop shopping". However, these popular explanations are inadequate. The empirical evidence on scale and scope economies in banking is far from conclusive.1 It is questionable whether these economies are large enough to justify banking consolidation and scope expansion (see [1997] and , et al. [1993]). Moreover, ample research in corporate finance points at the existence of a "diversification discount". On average diversification does seem to destroy value. There is also evidence that improvements in operating performance and stock returns have been experienced by firms that have refocused (see and Ofek [1995] and Comment and Jarrell [1995]). Therefore, the important question is why are there so many mergers and acquisitions taking place in the industry? This study aims to address this question and other related issues. I will examine the existing empirical evidence on scope and scale economies in banking. A recent survey paper by , Demsetz and Strahan [1999] is of substantial help. An important question is whether the existing empirical evidence can be used to explain the current consolidation wave. While I will conclude that the existing evidence is of some value, I doubt that it is really helpful for understanding the current restructuring in banking. Several issues play a role here. Apart from econometric and sample-selection issues, and possibly fundamental changes in underlying "state-variables", the important issue is that strategic considerations are the driving force behind the current consolidation wave. As I will argue, these considerations may have to do with true scale or scope economies. Rather learning, first-mover advantages and strategic advantages of market power and associated "deep pockets" may explain the current consolidation wave. Strategic positioning might be the rule of the game, and be an optimal response to 1 See and [1991], Cornett and Tehranian [1992], Mester [1992], and Onvural [1996] and [1996]. Volym D:224 Supplement 27 the uncertainties and rapid (and unpredictable) changes facing financial institutions today. Consolidation might then be an evolutionary phenomenon and be followed by a new type of repositioning when the uncertainties become more manageable. This analysis follows recent co- authored work with and (Boot, Milbourn and Thakor [1999]). The organization of this study is as follows. In Section 2, I start out with a discussion of the growing research in the field of financial intermediation. This research - mainly theoretical in nature – sheds light on the costs and benefits of bank funding vis-à-vis direct funding in the financial market. While primarily focused on the funding role of banks and financial markets, it provides valuable insights into the economics of banking. These insights are of great importance for understanding the role of financial institutions in the future. Subsequently, Section 3 discusses the extensive empirical literature on scale and scope economies in banking. Here, I will particularly look at scale and scope considerations that may be important in the future. An important issue in this context is that the literature needs to differentiate more between the various activities (services and products) of financial intermediaries. Section 4 introduces strategic considerations, in particular, the importance of strategic positioning; see the discussion above. Section 5 discusses some political considerations that may impact the restructuring of the financial services industry. In Section 6 I offer some thoughts on the future path of the ongoing restructuring. Foremost, I then address the options and of the Swedish financial services industry. My message is an optimistic one, but one should be prepared for an ongoing extensive restructuring of the Nordic financial services industry. Consolidation and Strategic Positioning 2Fundamentals: The Economics of Banking 2.1Traditional versus modern banking Traditional commercial banks hold non-marketable or illiquid assets that are funded largely with deposits. There is typically uncertainty about the value of these deposits which are often withdrawable on demand. The liquidity of bank liabilities stands in sharp contrast to that of their assets, reflecting the banks' raison d'être. By liquifying claims, banks facilitate the funding of projects that might otherwise be infeasible. The banks' assets are illiquid largely because of their information sensitivity. In originating and pricing loans, banks develop proprietary information. Subsequent monitoring of borrowers yields additional private information. The proprietary information inhibits the marketability of these loans. The access to information is the key to understanding the comparative advantage of banks. In many of their activities banks exploit their information and the related network of contacts. This relationship-oriented banking is a characteristic of value- enhancing financial intermediation. The relationship and network orientation does not only apply to traditional commercial lending but also to many areas of modern banking. One might be tempted to interpret modern banking as transaction- oriented. So does an investment bank (IB) – generally considered a prime example of modern banking – facilitate a firm's access to public capital markets. The IB's role could be interpreted as that of a broker; i.e. matching buyers and sellers for the firms' securities. In this interpretation IBs just facilitate transactions, which would confirm the transaction orientation of modern banking. The IBs' added value would then be confined to their networks, i.e. their ability to economize on search or matching costs. As a characterization of modern banking, this would describe their economic role too narrowly. IBs do more. They – almost without exception – underwrite those public issues, i.e. absorb credit and/or placement risk. This brings an IB's role much closer to that of a commercial bank engaged in lending; the processing and absorption of Volym D:226 Supplement 27 risk is a typical intermediation function similar to that encountered in traditional bank lending. In lending, a bank manages and absorbs risk (e.g. credit and liquidity risks) by issuing claims on its total assets with different characteristics then those encountered in its loan portfolio. In financial intermediation theory this is referred to as qualitative asset transformation (see and Thakor [1995]). Underwriting of an IB can be interpreted analogically; risk is (temporarily) absorbed and is channeled through to the claim holders of the IB. The role of IBs is therefore more than just purely brokerage. Underwriting requires information acquisition about the borrower which is supported by a relationship orientation. A relationship orientation will therefore still be present in investment banking, both in the direction of investors ("placement capacity") and towards borrowing firms. Thus, characterizing financial market funding as transaction-oriented and bank lending as relationship- oriented is too extreme. What will be true, however, is that in investment banking relationships depend much less on local presence 2.2Are bank loans special? Some see public capital market financing as a potentially superior substitute for bank lending. This, however, is unwarranted. Bank lending has distinctive comparative advantages. In particular, it may support enduring close relationships between debtor and financier that may mitigate information asymmetries. This has several components. A borrower might be prepared to reveal proprietary information to its bank, while it would have never disseminated this information to the financial markets (Bhattacharya and Chiesa [1995]). A bank might also be more receptive to information because of its role as enduring and dominant lender. This amounts to observing that a bank might have better incentives to invest in information acquisition. While costly, the substantial stake that it has in the funding of the borrower, and its, hopefully, enduring relationship – with the possibility of information reusability over time – increase the value of information. The bank-borrower relationship is also less rigid than those normally encountered in the financial market. The general observation is that a better information flow facilitates more informative decisions. 2 [1984] introduces intermediaries as delegated monitors. See , and Thakor [1986] for a discussion on information reusability, and [1987] and Lummer and McConnell [1989] for empirical evidence. For a nice illustration supporting the special role of banks, see [1996]. SOU 2000:11 Consolidation and Strategic Positioning Volym D:227 particular, relationship finance could allow for more flexibility and possibly value-enhancing discretion. This is in line with the important ongoing discussion in economic theory on rules versus discretion, where discretion allows for decision making based on more subtle – potentially non-contractible – information. 3 Two dimensions can be identified. One dimension is related to the nature of the bank-borrower relationship. In many ways, it is a mutual commitment based on trust and respect. This allows for implicit – non-enforceable – long-term contracting. An optimal information flow is crucial for sustaining these "contracts". Information asymmetries in the financial market and the non- contractibility of various pieces of information may rule out long-term access to alternative capital market funding sources as well as explicit long-term commitments by banks. Therefore, both bank and borrower may realize the added value of their relationship, and have an incentive to their relationship.4 The other dimension is related to the structure of the explicit contracts that banks can write. Bank loans are generally easier to renegotiate than bond issues or other public capital market funding vehicles. The re-negotiation allows for a qualitative use of flexibility.