Mr. Ciocca discusses competition and mergers in the Italian financial system
Speech by Sig. Pierluigi Ciocca, a Deputy Director General of the Bank of Italy, at a conference
on "La concentrazione nell'industria dei servizi finanziari:aspetti teorici ed esperienze
internazionali" held at the Università Cattolica del Sacro Cuore in Milan on 12/11/98.
Introduction
In the last twenty years there has been considerable consolidation in the credit field. The process
began in the United States, where there have been more than 7,000 bank mergers since 1980. The
United Kingdom was the first country in Europe to see significant merger activity, but it has
spread to other countries, including Italy.
The most frequently cited general cause of consolidation lies in the changes that have occurred in
the external environment: advances in electronic data processing and telecommunications,
provisions aimed at attenuating the institutional separation of intermediaries, and the contraction
in the role of public pension systems. Among other things, these developments have fostered
financial globalization, asset management services, the use of powerful IT systems, and a drastic
reduction in data transmission and communication costs. The repercussions have not been
restricted to international and wholesale markets but have also been felt in local and retail
markets. Banks appear to have seen the larger scale of operations as offering the prospect of
coping with these repercussions better.
In Italy's case, however, a key additional factor has been the increase in competition. The Italian
banking system had entered the eighties with the low level of competition inherited from the
past. The subsequent change was radical and the consequent narrowing of margins stimulated
restructuring and consolidation. From the eighties onwards, the dictum of comparative statics
"more concentration, less competition" has been replaced by the dynamic alternative "more
competition, more mergers". The premise, already tested in analyses carried out by the Bank of
Italy, was that the Italian banking system - traditionally marked by a low degree of
concentration and banks of limited average size with multiple branches - offered not only
plenty of niches for small banks but also considerable scope for economies of scale. This
potential is at last being realized, in the international context I have just described, under the
pressure of the "novelty", at least for Italian banking, represented by the growth in competition
that the Bank of Italy has been pursuing.
In my remarks I shall touch on three aspects of these complex processes, the outcome of which is
still wide open:
a) antitrust action can forestall the adverse effects of consolidation on competition and
reinforce the beneficial effects;
b) the Bank of Italy, both before and after 1990, has pursued a policy aimed at fostering the
efficiency of the banking system through competition;
c) more competition, consolidation and restructuring remain objectives to be pursued, even
though they are only necessary, and not sufficient, conditions for increasing the
competitiveness of the Italian banking system, which is still burdened by high operating
costs.
A high degree of concentration and a small number of large banks that enjoy growing economies
of scale represent a situation that needs to be watched carefully. It is necessary to ensure that
mergers bring benefits for customers and not an increase in market power. The law recognizes
the threat that concentration poses for competition. Nonetheless, the traditional attitude towards
mergers has been attenuated, in view of the positive effects that they are capable of producing.
In Italy, Article 6 of Law 287/1990 defines the scope of antitrust action. The ban on mergers
applies to those that would create or strengthen a dominant position that is detrimental to
competition.
Antitrust law, in turn, can supplement the monitoring of mergers with a range of alternative
instruments. Controlling a firm's behaviour may prevent it from exploiting its position to
discriminate against competitors. Controlling the agreements between competing firms may
prevent such understandings from distorting the play of competition.
In addition, there is the action - which does not derive directly from antitrust law in the strict
sense of the term and which often falls within the scope of several institutions' authority -
aimed at ensuring the contestability of markets, at making it possible for other firms to enter the
market and erode the dominant firm's profits. Freedom to enter the market must be coupled with
freedom to leave the market by keeping down the sunk costs of withdrawing, allowing inefficient
firms to go to the wall, and making it effectively possible for entrepreneurs to sell all or part of
their businesses.
The provisions concerning the abuse of dominant positions and agreements detrimental to
competition, together with control of the effective freedom to enter and leave the market, make it
possible to take a fairly relaxed view of most mergers and acquisitions, bearing in mind that in
particularly serious cases operations hindering competition may be prohibited at law. It should
also be noted in this respect that the parties can be required to dispose of assets or to adopt other
measures like to ensure sufficiently competitive conditions. This practice is widely followed in
the banking sector: in the United States some recent mega-mergers have been waved through
subject to the mandatory disposal of assets equivalent to between 5 and 13 per cent of the
deposits acquired.
The banking industry still has several distinctive features, especially as regards the taking of
deposits and the granting of loans. One important sunk cost is related to the information content
of the customer relationships on which lending decisions are based, an asset that is not easily
marketable. Credit relationships involve an information asymmetry between borrowers and
lenders that results in their not being completely fungible. Small banks that establish particularly
close relationships with their borrowers enjoy an information advantage. This explains why it is
difficult for banks to enter directly into geographical markets in which they were previously
absent; indirect growth by acquiring existing banks or branches is often the easiest way to
overcome this barrier and enter a retail market characterized by information asymmetries.
At the same time this peculiarity is likely to act as an exit barrier, thereby reducing the incentive
to enter the market and the potential competition. Sometimes the authorities themselves
encourage mergers in order to remove inefficient banks from the market without their having to
be put into liquidation, with all the costs the resulting termination of customer relationships
entails. The scope for mergers is accordingly a condition for keeping down market entry and exit
barriers and thereby reducing the probability of collusion. A market for the control and
ownership of banks that works is a necessary condition for the efficiency of banking as a whole.
Mergers also make the financial market's assessment of banks more effective; larger credit
institutions are encouraged to open up their ownership structure to third parties and the stock
market in order to increase their ability to raise equity capital.
On the liabilities side of banks' balance sheets, the demand for deposits and accessory services is
still linked to customers' physical closeness to branches. The evaluation of mergers must
therefore take into account not only imperfect contestability but also the evolution of local
markets and the conditions effectively applied to customers.
Lastly, credit intermediaries are multi-product enterprises and often operate in several markets.
Mergers between diversified intermediaries will have a different impact on the ability to be
present in the various markets - for loans, deposits, payment instruments, securities business,
asset management, leasing, factoring, consumer credit and corporate finance, etc. When
assessing mergers, account therefore needs to be taken not merely of the increase in the degree of
concentration in one market, but also of how competitive conditions change in the other markets.
The Bank of Italy and the promotion of competition
From the end of the seventies onwards the action taken by the Bank of Italy has been aimed at
increasing competition in the banking and financial system. The powers of authorization
assigned by law to the Bank as the body responsible for supervision were exercised from the
twenties onwards according to the principle of competition. In the "Branch Plan" drawn up in
1978 the Bank explicitly announced the objective of fostering competition in the banking
industry: the opening of branches was envisaged primarily in the areas where the concentration
of loans and deposits was highest, and not infrequently monopolistic.
Thus the Bank of Italy placed competition at the centre of its policy aimed at increasing the
efficiency and solidity of the banking and financial system well before it was granted formal
antitrust powers in 1990.
The precondition for the change in the Bank's approach was the abandonment of the idea -
widely held after the crisis of the thirties, not only in Italy and not only among central banks -
that competition, or "excess" competition, caused banking instability and was antinomic with
respect to stability. On the contrary, and especially in the conditions of international openness
typical of the Italian economy in normal circumstances, an inefficient banking system is bound to
be prone to systemic instability, even though oligopoly allows it to be profitable. A powerful
stimulus to achieve profitability and hence a congruous capital base through efficiency could
clearly be detected in the increase in competition in the domestic banking and financial markets.
Increased competition therefore became the key intermediate objective, the fulcrum of the Bank
of Italy's monetary, exchange rate and supervisory policies. Without competition, in the long run
there cannot be efficiency; without efficiency, in the long run there cannot be stability in the
banking and financial industry. A further consideration, rooted in the economic theory upon
laisser faire
which antitrust legislation is based, was that and competition were not the same
thing, that the former could override the latter (especially in an industry with economies of
scale), and that deregulation was likely to be more effective if set within the framework of an
economic and institutional policy aimed at protecting and strengthening competition and
ultimately imposing it on producers who might well not like it. The attribution to the Bank of
Italy of responsibility for implementing antitrust law in the banking field was thus not a break, an
anomaly to be removed later. It was the natural, institutional, recognition of a state of affairs that
had already existed for tens of years. Above all it sanctioned a principle that must be
consolidated and applied more widely: not only are prudential supervision and the protection of
competition not in conflict, but they are rigorously complementary.
The declarations of intent, the strategic decisions, the single acts with which the Bank of Italy
interpreted and applied these general criteria in practice have been many and spread over twenty
years. They cannot all be listed here, but I shall briefly indicate the most important in a series of
summary points:
• the first, absolutely fundamental, step was taken at the beginning of the eighties with the
reaffirmation of the notion of banks, both publicly and privately-owned, as enterprises. In
the wake of the transposition of the EEC's First Banking Directive of 1985, the issue was
finally settled in a judgement handed down by the Court of Cassation in 1989. The
transformation of publicly-owned banks into companies limited by shares followed, as
provided for in Law 218 of 1990;
• between 1985 and 1990, while the amendments to the law that would lead to the new
Banking Law of 1993 were being enacted, administrative measures were adopted
attenuating or eliminating the restrictions in fields such as branching, fund-raising and
lending beyond the short term, and the creation of new banks. The growth of individual
banks was increasingly related, by way of solvency and gearing ratios, to the amount of
capital they were able to bring into play;
starting in the early eighties, the quantity, the quality and the diffusion of the information
•
disclosed by banks to customers and the market were enhanced;
by the end of 1988 the shift from direct administrative instruments to indirect market
•
instruments in implementing monetary policy had been completed;
• in response to the need to place growing volumes of public debt with domestic investors,
steps were taken to create efficient money and bond markets. The share of bank deposits
in households' financial assets fell from 53 per cent in 1979 to 34 per cent in 1990 and
stands at 25 per cent today;
• the removal of exchange controls was started in 1988 and completed in 1990, with the
result that, for the first time in its history, Italy had a fully convertible currency and
complete freedom of both short and long-term capital movements.
All the indicators show that the degree of competition in the Italian banking system increased
significantly in the eighties. Between 1979 and 1989 the average number of banks present in
each province rose from 20 to 27. The concentration of the loan market fell by 15 per cent
nationwide and by 20 per cent in the Centre and South. The differential between the average
bank lending rate and the pre-tax yield on Treasury bills narrowed from 5 percentage points in
1980 to less than 1 point in 1989 and this happened in a period which saw the riskiness of bank
credit increase slightly. The spread between lending and deposit rates also narrowed, declining
initially from more than 9 percentage points in 1980 to less than 7 points in 1989. Inevitably,
these developments resulted in the margins on credit business coming under pressure.
In 1990 the law establishing the Competition Authority (Law 287/1990) made the Bank of Italy
responsible for the antitrust function in the banking sector. The choice was made in view of the
specific technical nature of banking and the complementary nature of prudential supervision and
the protection of competition. In the United States, with its century-long tradition of antitrust
legislation, the situation is similar since the Federal Reserve or the Office of the Comptroller of
the Currency, according to the banks involved, are responsible for evaluating the
anticompetitive effects of mergers. The Department of Justice cooperates with the regulatory
authorities and in extreme cases may bring a legal action against an operation. In Europe, it is
worth mentioning the case of the Netherlands, where, in establishing a Competition Authority at
the beginning of this year, the law provisionally assigned the protection of competition in the
banking and insurance industries to the respective supervisory authorities. Other antitrust
authorities are also beginning to recognize the specificity of the banking sector and, as in Canada,
have issued special instructions for the evaluation of bank mergers.
The growth in competition has continued in the decade that is drawing to a close. Following the
decision taken by the Bank of Italy in 1990 to liberalize banks' branch networks by abandoning
the system of "branch plans", the number of branches increased as never before, rising by
10,000, or more than 60 per cent, to 25,600 in June of this year. At the end of 1989 there were
1,173 banks in Italy, of which 83 were medium-term credit institutions or sections. By the end of
June the number had fallen by more than 20 per cent to 937, of which 120 belonged to banking
groups. In recent years the process of consolidation has involved large commercial banks, partly
in response to the prospect of an integrated European market with a single currency. The average
number of banks present in each province has risen further to 30.
During the nineties the differential between the average bank lending rate and the pre-tax yield
on Treasury bills has tended to remain close to its level at the end of the eighties. But, partly
owing to the rather weak performance of the economy, this decade has seen a sharp increase in
the average riskiness of loans and a deterioration in the quality of banks' assets. Hence, the
stability of the differential between bank lending rates and the yield on government securities is
further evidence of the increasing competition within the banking industry.
The differences between the lending rates applied in the various parts of the country have also
narrowed in the last four years after peaking in the second half of 1994. The difference between
the rates on short-term lira loans in the North and the South is currently around 2 percentage
points for non-financial companies and about 1.5 points for producer households. The gap is
entirely attributable to the greater average riskiness of lending in the South and the longer time it
takes to recover credits there. The ratio of bad debts to total loans disbursed to customers in the
South is 22 per cent, as against 7 per cent for borrowers in the Centre and North. Analyses
carried out at the Bank of Italy show that, after adjusting for the risks that materialized, the
geographical differential disappeared in the early nineties. The spread between lending and
deposit rates has narrowed further and now stands at 4.5 percentage points.
The growth in competition has contributed to a substantial redistribution of banks' shares of the
loan market. The major changes that occurred after the ceiling on bank loans was removed were
followed by further large shifts in the two years 1989-90 and from 1995 onwards. In the last three
years the market shares that changed hands each year were equal to around 4 per cent of the total
loan portfolio on average, excluding the amounts directly affected by mergers. The increase in
competition has led to banks adopting more aggressive supply policies and growth strategies
more closely attuned to demand.
Mergers and acquisitions in the Italian banking system
Between 1990 and 1997 the Bank of Italy, pursuant to the provisions of antitrust law applying to
the banking sector, examined some 300 proposed mergers and acquisitions. The banks in play
grew steadily larger. In the last four years the banks involved accounted for 7 per cent of the
banking system's total assets on average each year. The consolidation process has had a
particularly pronounced impact on the southern banking system, partly as a result of the
acquisition of the control of local banks in difficulty by banks situated in the Centre and North.
In ten cases the Bank of Italy decided to examine proposed mergers in order to verify whether the
operation was likely to create or strengthen a dominant position and prejudice competition. In
four of these cases the go ahead was made conditional on measures aimed at protecting
competition in the market in question.
Another ten examinations concerned agreements suspected of being detrimental to competition.
The investigation of industry-wide standard terms and of payment instruments were especially
important in this respect. In its recently published findings on the rules governing the use of the
PagoBANCOMAT card, the Bank of Italy identified several circumstances that were potentially
anti-competitive and made its approval of the agreement conditional on a number of changes that
will help to make the market more competitive.
The Bank of Italy also investigated five alleged abuses of dominant positions. In four of these
cases the banks were accused of using their exclusive right to provide tax-collection services to
gain undue competitive advantages in neighbouring credit markets. In the fifth case the Bank
took action to prevent the bank from exploiting its dominant position to expand its branch
network abnormally with the aim of obstructing the entry or growth of competitors in the market
in question.
In addition to its normal examination activity, in 1996 the Bank of Italy investigated the
possibility that banks were coordinating their pricing policies, but found no evidence of such
practices. In 1997, in agreement with the Competition Authority, it conducted a general
factfinding inquiry into the corporate services sector.
In the nineties the consolidation of the Italian banking system has proceeded primarily by means
of mergers and amalgamations, of which there had been 265 by the end of 1997. Acquisitions of
the control of banks that subsequently continued to operate as separate entities also played an
important role, with a total of 91 such takeovers. Even where these operations have not yet
significantly reduced operating costs, they have allowed capital to be used more efficiently and
brought tax benefits, increases in fee income and improvements in the quality of the acquired
bank's loan portfolio.
Mergers between banks which are not present in the same markets, or with only limited overlap,
increase competition. By contrast, the "market power" effect tends to prevail over the efficiency
effect where the merging banks both have a large presence in the same market. These findings
confirm the continued importance of the physical closeness of customers to their banks and the
need for the attention that the competition authorities pay to local markets.
Mergers inevitably impact the payment system and the stability of the banking sector. By
diminishing the number of participants in the payment system, they tend to reduce the volume of
transactions to be settled. The setting of operational and technological standards aimed at
exploiting network economies may well be easier. On the other hand, larger banks are likely to
cause more serious problems in the event of insolvency: the overall effect of mergers on the
stability of the payments system will depend on how they affect the riskiness of the individual
banks.
Competition, consolidation and costs
Competition, consolidation and reorganizations have helped to curb operating costs in relation to
the total assets of the banking system. In the three years from 1995 to 1997 this ratio averaged
2.4 per cent, compared with 3 per cent in the second half of the eighties.
Nonetheless, partly as a result of the rigidity of the Italian labour market, the competitive gap
between Italian banks and their counterparts abroad, which is attributable primarily to the greater
incidence of staff costs, has not narrowed in the nineties. In 1997 bank staff costs amounted to 43
per cent of gross income in Italy, compared with an average of 38 per cent in France, Germany
and Spain.
The agreements between employers and the trade unions to reduce the cost of labour, prompted
by the Bank of Italy and promoted by the Government, have not yet been given effect in a new
wage agreement linking earnings more closely to a bank's performance. Significant cost savings,
as well as increased revenues, can be achieved by modernizing structures, reorganizing
production processes and developing innovative distribution networks. Other banking systems
have invested a substantial volume of resources, deriving in part from savings in staff costs, in
technological innovation, thereby acquiring competitive advantages on several fronts.
The increase in competition in banking markets, further intensified by foreign intermediaries
accustomed to operating on a larger scale and with smaller interest rate spreads, has sharply
reduced the profitability of Italian banks' traditional activities. The fall in net interest income,
which began several years ago and will be accentuated by the introduction of the euro, has not
been offset by a lasting increase in revenues from innovative activities: corporate advisory
services and finance, the administration and management of households' savings, and business in
the international securities markets.
In the first half of the eighties Italian banks' return on equity was in excess of 14 per cent, in line
with that of the other leading European banking systems. Since then it has fallen, reaching a low
of around 1 per cent last year. Apart from the level of costs, the large loan losses incurred in the
last few years have made a major contribution to the decline in profitability. The risk-asset ratio
of the Italian banking system is 13 per cent, well above the requirement of 8 per cent established
in the Basle Capital Accord. Only a very few banks are below this limit and the total shortfall is
around 500 billion lire.
The decline in profitability has nonetheless reduced the flow of internally-generated resources
with which to finance growth and merger operations. The larger banks have suffered especially
in this respect: at the end of last year they held less than one third of the free capital of the
banking system, as against 80 per cent of its total assets. The lack of free capital, not tied up in
tangible and financial fixed assets and available for acquisitions, will curtail the scope for
modernizing the system and pursuing efficiency.
The intermediate objective pursued over the last twenty years has been largely achieved; there is
more competition, there have been numerous mergers and a start has been made on
reorganization projects that promise to improve efficiency. Competition has produced its full
effects on the prices of banking products and services, holding them down and making them
more uniform. But other benefits have been, still are, slow in coming: lower costs, international
competitiveness, profits and fresh capital generated by efficiency and the quality of services.
The picture is thus chiaroscuro. Disappointment should only be felt by those who fail to
recognize that competition fosters efficiency but cannot guarantee it where producers lack the
ability to respond - à la Leibenstein - to the competitive stimulus. It is necessary to appreciate
how much inertia has to be overcome in a complex process that is more cultural than juridical or
institutional, in short the "passage" from oligopoly to competition of an industry that is based on
information asymmetries, bilateral customer relationships and the reputation of producers. This
journey was bound to be laborious and slow, especially in Italy's case. The Italian banking
system arrived at the world economic crisis of the seventies after two postwar decades in which
its oligopolistic nature had become deeply rooted, while the economy had enjoyed an
extraordinary boom. The model formulated by Donato Menichella and Raffaele Mattioli had
"worked" in a certain sense; it had met, albeit with the inefficiencies that were the inevitable
corollary, the demand for credit and money of the Italian economy in that buoyant phase. The
subsequent resistance to change cannot be entirely attributed to the reluctance of any industry to
face the forces of competition or to the natural tendency to continue to do things in the same way.
To give way to counterfactual criticism based on hindsight - such as, the injection of
competitive enzymes should have been much larger and more intense - would be not only
sterile but also debatable in theory and risky in practice. It is analytically doubtful whether it
would have been possible, given the context. It is sufficient to mention just one aspect referred to
earlier: the uniform treatment of banks and enterprises and of banks in the public and private
sectors became a part of Italian law - as a result of the judgement of 1989 - ten years after the
supervisory authority had clearly stated the principle. The risk at the practical level is that at this
point banking competition will be seen as a missed opportunity, and that this will lead to the idea
of renouncing it in the future.
The position of the Bank of Italy is to proceed, if possible with greater determination, on the road
taken twenty years ago - not only because the single market, the euro and their rules leave no
option, and not only because the law in force in Italy today mandates this course, but in the belief
that the progress that has already been made is in the right direction, even though competition on
its own, it is worth repeating, does not guarantee an optimal financial system.
The Bank of Italy will devote more resources, a revised internal administrative structure focused
on banking competition, and additional analyses serving to underpin new interventions to the
task of fostering competition in the markets in which banks operate and the mergers they
autonomously plan.
Two changes that are already under way will also produce their effects. Mutually reinforcing,
they should, together with competition in the markets for banking products, stimulate efforts to
achieve the cost reductions and quality improvements that are necessary. The first change is the
privatization of the banks that are still under public control, the second concerns the exit
procedures aimed at preventing moral hazard and the neglect of costs.
The transfer of the ownership of banks to the private sector is the precondition for control to be
contested in the market. In the last few years the process of privatizing public banks has gathered
pace, in parallel with the growth in mergers. Including the operations that are currently being
organized, the share of the banking system's assets in the hands of banks of which the state, local
authorities or foundations own the majority of the capital will shortly fall to 20 per cent, as
against 70 per cent ten years ago. BNL is about to be privatized. The Monte dei Paschi di Siena
foundation, the only one that still owns all the capital of a major bank, has recently decided to
place some of its capital in the market and to seek a stock exchange listing.
The prospect of contestability opened up by bank privatizations has been strengthened by the
changes to the legal framework introduced by the Consolidated Law on Financial Markets, which
came into force in July of this year. The new rules serve to increase the disclosure of information,
enhance the efficiency of the financial markets and the contestability of control - in the case of
listed companies partly through the revision of the provisions governing takeovers. There are 25
commercial banks listed on the stock exchange; they account, directly and indirectly via listed
and unlisted subsidiaries, for 50 per cent of the banking system's total assets. In addition, there
are 10 cooperative banks listed on the stock exchange, accounting for 10 per cent of total assets,
and another 7 banks are listed on the ristretto market.
Although the Community authorities recognize the specific features of the banking sector, their
application of Article 92 of the Treaty to banks tends to be rigorous. The authorization of state
aid to some large European banks has been made conditional on their disposing of assets, parts of
the business and equity interests. The fact that bankers will be able to count less on public
support means they will have to adopt even more stringent criteria of autonomous, sound and
prudent management.
The number of banks in distress that have been consolidated (by means of mergers,
amalgamations and takeovers) or placed under special administration or in liquidation has
increased in the nineties, in both absolute and relative terms. The ratio of the number of such
banks to the total number rose from 1.5 per cent in 1990 to an average of 4.3 per cent in 1996
and 1997; the ratio of their assets to the total assets of the banking system rose from 0.2 per cent
to nearly 6 per cent. The increase in the number of such interventions with respect to troubled
banks has been partly due to the increased emphasis on the preventive nature of supervisory
action. Since the action is taken when the troubled bank still has a net value, it is possible to look
for market-based solutions and hence to reduce the burden borne by the deposit protection
system or the public finances. The proportion of troubled banks subjected to restructuring that
were liquidated rose from 6 to 16 per cent between 1990 and 1997. In terms of their assets, the
ratio rose from just a few percentage points at the beginning of the decade to 11 per cent in 1997.
The potential for the development of the financial sector, in both quantitative and qualitative
terms, that the Italian economy requires and that it can achieve is considerable, probably greater
than in most other European countries. The Bank of Italy rema