Chapter 3 - Market Structures III

1. Chapter 3 - Market Structures III

2. This Lecture This Lecture Financial Systems in Europe • Bank-based systems • Market-based systems • Financial systems in Eastern Europe

3. Why do financial institutions exist? • Traditional explanations • transaction costs • Institutions take deposits and channel funds to individuals and firms; evaluating assets gives rise to fixed costs that intermediaries can share, thereby giving them an advantage over individuals. • asymmetric information • As a rule, borrowers have better information about the riskiness of their financial situation and repayment prospects than do their lenders, and managers know more about the profitability of their firm than shareholders and lenders. Financial institutions have a comparative advantage in screening and monitoring borrowers.

4. Why do financial institutions exist? • In recent years financial intermediation has become less and less restricted to the traditional bank business: • Banks started securitising loans in searching for a way not to keep all the money they lend on their balance sheets, • companies developed their asset management capabilities beyond their core competences and began widening their activities to the financial realm, • most trading of financial instruments takes place among financial institutions without any customers involved at all.

5. Why do financial institutions exist? Some of the changes cannot be explained by traditional arguments. For example, although recent advances in information technology have substantially reduced information costs and asymmetries, the need for financial services has not declined to a similar extent – direct lending is still the exception and not the rule. Another unresolved puzzle is the large share of trades among intermediaries.

6. Why do financial institutions exist? More recent concepts therefore stress the ability to distribute risks as an additional rationale for banks. Financial intermediaries transact at near zero cost and can create a large number of synthetic assets through dynamic trading strategies, allowing them to create products with very safe payoffs and/or with varying degrees of complexity according to their own needs and those of their customers.

7. Synthetic assets • Synthetics are securities that allow combinations of assets to be obtained with low transaction costs. • Examples: • Synthetic stocks can be constructed by buying a stock index future contract and a riskless security. • Synthetic securities – assets or liabilities – denominated in one currency can be constructed by combining a security denominated in another currency with a forward foreign exchange contract of similar maturity and a spot contract. • A forward foreign exchange contract that does not exist can be replicated by using a spot contract combined with borrowing and lending in the two currencies involved. • A synthetic option is built from a set of transactions replicating a portfolio of the traditional financial claims it corresponds to.

8. Synthetic assets • Common to all synthetic assets is that they are so-called redundant securities: • Their cash payoffs may be replicated by a set of transactions in other financial instruments. • Synthetic assets mimic the payoffs, but not necessarily the risk profile of the desired product. • The latter refers to the underlying distribution of returns for various instruments and also to the assumption of continuous price movements and liquid markets that is usually made.

9. Financial market volumes worldwide differ markedly:

10. In Europe, much of this and other financial activity takes place in London:

11. The City of London has • by far the highest number of foreign banks • the highest share of equity turnover, foreign exchange dealing and OTC derivatives trading • it is the most important centre of international bond trading in both primary and secondary markets • there are more corporate headquarters in London than in any other European centre: one-third of Fortune Global 500 companies have their European headquarters there, compared with 9% in Paris, 6% in Brussels, 3% in Düsseldorf and 3% in Frankfurt. • Over 65% of the Fortune Global 500 companies are represented in London – more than in any other European city.

12. However, other European places, too, attract a considerable share of business • and in some market segments are even taking the lead: • exchange-traded derivatives are primarily traded in Frankfurt • the world's second-largest market behind the US of mutual fund management is in France • the insurance industry is largely concentrated in Munich where total premium income exceeds those in both New York and London, the Numbers Two and Three respectively • money and government bond trading is not concentrated in one place • sales teams for non-government bonds and equity sales and M&A, too, are decentralised across the euro area.

13. Traditionally, a distinction is made between bank-based financial systems and market-based systems. In Europe, both can be found: Anglo-Saxon countries have market-based system, while France and Germany are examples of bank-based systems.

14. Financial systems A look at the relative importance of banks and securities markets in the US and Germany shows the difference: In the US, banks are relatively unimportant compared to equities and, in particular, bonds, which play by far the largest role. In Germany, the contrary holds: here, apparently, banks are relatively important and bond and equity markets less so.

15. Financial systems • The data also show that, in the 1990s the importance of bank finance has declined in both systems, while the share of equities has risen markedly. • This indicates a worldwide structural change in financial markets rather than an adjustment or convergence of systems.

16. Bank-based Systems • In countries with bank-based systems, firms' external financial funds are primarily provided by banks with which they have long-term relationships. • As a rule, banks are universal banks allowed to offer a wide range of financial services. • Banks take deposits and lend directly to firms and individuals and, at the same time, trade in equities and provide underwriting services. • The latter is in contrast to market-based systems where more or less strict "firewalls" separating different kinds of financial services such as taking deposits and granting loans on the one hand and underwriting and trading equities on the other exist.

17. Bank-based Systems However, the lines are not clear-cut and the limit of what is allowed or forbidden varies from country to country:

20. Differences in financial systems • As the Table demonstrates, in the mid-1990s the differences in various areas of financial business in and outside of Europe have been considerable. • Many of these differences still persist, although, over recent years, European countries have experienced some convergence in the course of the implementation of the single market program. • Among all bank activities, the most sensitive cases seem to be involvement in real estate business, which is restricted in a large number of countries, ... • and mutual investments, both of banks in nonbank financial firms and vice versa. • For European banks, in contrast to those in the US and Japan, securities trading is widely unrestricted. • Although overall restrictions on insurance are low, they exist among others in the country with some of the largest insurers worldwide, Germany.

21. Bank-based systems A practice which is widespread in bank-based systems – but is not exclusive to them – has become known as relationship pricing: banks offering credit to investment-grade companies tend to charge very little in the hope of being rewarded later with more lucrative work such as underwriting securities. Often banks use this instrument to survive in an ever increasing investment banking competition worldwide. Many of these commitments are based on the assumption that the related costs are low because companies would rather sell commercial paper than draw down credit lines, which are more expensive. However, this way of competing contains a systemic risk: under changing economic conditions, companies may become unable to raise funds in the markets and the demand for credit may rise. In such a situation, repricing - which would be a normal reaction - may be prevented just because the banks find themselves too close to the firms.

22. Bank-based systems • Relationship finance many advantages: • It promotes cooperative behaviour • A firm that defaults on a bank loan risks being excluded from further credit in the future. • Systems risks can be contained by intertemporal smoothing: • In accumulating low-risk, liquid assets, banks reduce the need for cross sectional risk sharing through markets. • In a market-based system, competition from financial markets where risks are actively managed and traded would rule out this possibility. • Banks standing in long-term relationships with their customers are necessarily better informed than stock market investors.

23. Bank-based systems However, these arguments have to be put into perspective: The overall efficiency of a bank-based system depends on the extent to which the advantages are realised. In international debates on investor relations and shareholder value, bank-based systems are usually equated with financial backwardness. By most measures financial markets in the US and UK are more developed than in France, and far more developed than in Germany, raising concerns about corporate governance and control. One example - the German hausbank system:

24. Bank-based systems • The German hausbank system: • there are three kinds of activities not reflected in banks' balance sheets: • control of equity voting rights by the banks • which allows them to considerably influence the outcome of shareholder meetings. The banks derive their strategic advantage in these meetings not only from direct holdings of equity but also from proxy votes from client shareholders. • banks' representation on firms' supervisory boards • the underwriting of new share issues of large listed stock corporations. • In Germany, this is often concentrated in the hands of few big banks that have an informational advantage over potential competitors with no relationships whatsoever to the companies.

25. Bank-based systems • The abuse of these and other instruments of power in bank-based systems is widely held responsible for • outdated structures, • high costs • a great deal of red tape • that deter investment and make venture capital scarcely available, • thereby adding considerably to the structural weaknesses of the economy. • In bank-based systems, corporate governance and control is largely exerted behind closed doors; for example, changes through a stock-market takeover, as in Anglo- Saxon countries, are rare.

26. Market-based systems ... in general, their superiority is reflected in performance:

27. Market-based systems However, again, these arguments have to be put into perspective: Even in market-based systems, shareholders' rights rarely go beyond electing directors, and no mechanism ensures that managers do not pursue their own interests.

28. Market-based systems • Both bank-based and market-based systems have advantages and disadvantages:

30. Bank-based and market-based systems • Inefficiencies are found in both of them:

33. Financial systems • In principle, neither bank-based nor market-based systems exist in pure form.

34. Financial systems • These days, even market-based systems are changing.

35. Financial systems • The most obvious example of system change is the increasing role of institutional investors, ...

36. Financial systems • which is fundamentally altering the traditional environment for corporate governance and control in these systems.

37. Financial systems • Institutional investors are a relatively new phenomenon in market history. • They differ from other market participants above all in two respects: • They are answerable not only to shareholders, but – as they are not as anonymous as other private shareholders – also in a sense potentially to public opinion. • In contrast to other shareholders exit is rarely an option. • As a consequence, they have begun to cultivate a • constant dialogue with the companies (capitalism of voice).

38. Financial systems The debate on bank-based versus market-based systems easily eclipses the fact that in many countries internal finance is still the most important source of funds for firms. In these countries, the nature of the financial system is less important than the overall economic and institutional environment allowing generation of profits that may be used for this purpose. However, studies have shown that this does not necessarily hold true for emerging economies ...

39. Financial systems • Emerging economies are special in that to them • external finance is often more important than internal finance, • and their reliance on the nature and quality of the financial system is much greater than that of developed countries.

40. Financial systems • In May 2004, ten countries became new EU members: • Malta • Cyprus • Poland • the Czech Republic • Estonia • Hungary • Latvia • Lithuania • Slovakia • Slovenia • Bulgaria and Romania are expected to follow in 2007.

41. CEEC financial systems The accession of these countries, in particular those from Central and Eastern Europe (CEEC), is posing huge challenges to Europe's financial markets and currency relations: Their membership will alter rules and regulations in these countries and intensify competition and structural transformations with repercussions on western markets and systems.

42. CEEC financial systems Despite the great progress made over recent years financial systems and markets in the CEEC are still largely underdeveloped:

45. CEEC financial systems • Banking sectors: • transformed from a single-tiered system under the communist rule of the late 1980s, where the state bank had a quasi-monopoly on banking and credit, to a two-tiered one. • Bank legislation along the lines of the EU rules has been implemented everywhere. • In all countries, except Slovenia, major banks have been privatised. • Foreign banks have entered the region's markets, buying domestic banks and stepping up retail networks where these already existed. • In Hungary, Bulgaria and the Czech Republic, foreign banks hold a share of between 60 and 70 percent of total bank assets; in Slovakia the share is even higher.

46. CEEC financial systems • Monetisation and bank penetration: • The degree of monetisation in these countries is low compared to EU standards. In 2002, money in circulation plus deposits in the CEEC as a percentage of GDP was only about two-thirds the EU level. • Bank intermediation, measured as bank claims on the domestic sector as a percentage of GDP, is about one third of the respective EU measure. • The use of bank accounts is less widespread than in western Europe. This is the case for Bulgaria and Romania in particular, where less than 10 percent of the population have bank accounts; even in Poland the share is only 34 percent, while in Slovenia it is close to 80 percent. • The difference between old and new member states is even greater for the total of bank assets. While in the euro area, bank assets amount to 265 percent of GDP, in the CEEC they range from 30 to 100 percent.

47. CEEC financial systems • The role of foreigners: • In contrast to many other countries, in the CEEC, foreign investors control a large part of the banking sectors. • Advantages: import of capital and know-how, • assistance in establishing best practices in bank business, • strengthening of competition, • enhancing of financial sector restructuring and adjustment to international standards. • Disadvantages: in many cases, foreign-owned institutions in these countries have lost important functions in recent years as trading and other key activities were shifted to the investors' headquarters, • danger of disinvestment as a result of a worsening domestic environment or a change in the owner's commercial strategy, as has already occurred in a few cases.

48. CEEC financial systems • Stock markets: • In the first few years of their existence exchanges in eastern Europe showed high market dynamics, • measured as growth in market capitalisation, traded value and number of listed companies they clearly outperformed not only those in developing countries outside Europe but also western European exchanges:

49. 1 World rank in parantheses. • 2 End of 2001. • 3 In dollar terms, percentage increase 1996-2001. • 4 1998-2001. • Source: The Economist (2004): Pocket World in Figures, London.

50. CEEC financial systems Stock markets: However, market capitalisation in the CEEC remained low. The combined annual turnover on the stock exchanges of Prague, Budapest and Warsaw is said to equal that on the Frankfurt stock market in ten trading days. In an international context, only the markets of Poland and, to a lesser extent, the Czech Republic and Hungary, play some role. The dire state of the exchanges makes it easy to forget that before World War II some countries had vibrant financial markets and a long tradition of stock trading: in Warsaw, the first exchange was established in 1817, in Budapest in 1864.