First: intensifying competition between financial institutions Whereas financial institutions formerly operated in separate segments of closed economies, they must now compete in financial markets with other financial institutions, both domestic and foreign, regulated and unregulated, as in the case of pension or hedge funds. Financial innovation puts incessant competitive pressure on the providers of financial services which were formerly clearly distinguishable. Credit institutions, investment firms and insurance corporations increasingly offer products that have some similarities in terms of yield or hedging and thus find themselves competing for overlapping customer bases. Competition between financial sectors has also increased in step with technological advances, which have enabled the emergence of new players in the financial sector. E-traders and e-brokers are challenging the dominant positions of banks and brokerage firms. The service providers for outsourced activities peripheral to financial business, such as back-office or custodian services, are also becoming increasingly important. In the future, Internet access providers or telephony companies may well become fully-fledged financial players in their own right. 1  BIS Review 85/2000  Second: stiffer competition between markets The development of information technology and telecommunications has allowed economic agents to move their capital at will. As a result, their investment and borrowing decisions are based on the opportunities available on all markets. •  Domestic exchanges have become mere compartments of the global market and find themselves competing with each other. •  Exchanges must also compete with the extraordinary expansion of over-the-counter markets.

The standardisation of risk management methods and the resulting herd instinct on the part of market-dealers brings with it a number of disadvantages, such as liquidity shortages on certain market compartments, which lead to more volatile prices, credit rationing for certain borrowers and micro-financial contagion whereby “innocent victims” bear the brunt of imbalances stemming from other economies. Such risks have become greater with the development of over-the-counter derivatives markets, which are a potential source of instability for the overall financial system. Liabilities are generally financed with credit, they are based on asymmetric information and risks are concentrated on some of the largest global financial institutions. These institutions may also be tempted to take excessive risks when they come under pressure from heated competition and shareholders’ demands for value. Of course, the prudential authorities approve of high returns on equity, but systematically aiming for returns on equity of 15%, 20%, or more while world growth averages 3% to 5% could make institutions more vulnerable. Actually, the search for profitability should not induce institutions to resort to extreme gearing in which debt replaces capital, or distort portfolio structures by undue focus on high-yield financial assets which also entail a high degree of risk. Nor should it lead them to curtail operating costs excessively, thus reducing the resources devoted to internal control.