Oxford Economics History Workshop 5 th June 2008 Andreas Mattig University St. Gallen

1. Erosion of Barriers to Entry in the Banking IndustryEvidence from the Impact of the Emerging Financial Markets on the Swiss Banking Structure 1850-1920 Oxford Economics History Workshop 5th June 2008 Andreas Mattig University St. Gallen

2. Organization

3. Idea, Motivation and Central Argument 1

4. Idea and Motivation • „History Motivation“: • Few is known about the banking and capital market in Switzerland. No doubt, the financial system‘s most dynamic period was the post-WW II years, however the bank‘s reputation in the war years had to be have its roots earlier… • „Policy Motivation“: • What happens to the banking industry structure under increased capital openness? We have a set of emerging economies, but the corresponding results are often strongly biased by local political, cultural or legal mechanisms. The analysis of non-regulated market data under similar conditions might be valuable • „General industry structure and Theory Motivation“: • Industry data is often not to easy to be handled and analyzed: Multicollinearity is a permanent issue and in today‘s market efficiency is often too high to really measure structural shifts over time

5. Methodology and Data • This is no empirical paper! The approach relies on inductive theory building and starts with a central argument as „quasi-hypothesis“. The methodology can be grouped into four stages: (1) We observed descriptive patterns and analyzed the existing data set (2) A model (Veloce-Zellner) was applied to describe the economics behind the patterns formally (3) The model was adjusted for the specific conditions and re-solved, resulting in a dominant role of the individual firm‘s cost of liquidity for survival and growth dynamics in the emerging industry (4) The evidence was summarized in four propositions • Data is derived from the Swiss National Bank, various state archives and a first descriptive approach by Ritzmann (1963)

6. Central Argument • The Central Argument in this presentation is that • the emergence of an international capital market in Switzerland came as some kind of an economic shock after the country was turned into a capital lender after producing and exporting surpluses for years • the emergence of an international capital market in Switzerland lead to a re-valuation of asset prices • the role of financial intermediaries changed from foreign agents and asset managers towards transformation of risks and maturities • the value of bank liquidity was sharply increased during this process • new entering banks won a sustainable comparative advantage over the incumbents within a short period of time

7. Evidence I • In the absence of regulatory boundaries, the relative value of input factors are the crucial element in banking, allowing to build absolute cost advantages • The critical element for banks is the price for liquidity, either to be funded by internal (equity or saving) or external (capital market) sources • In the observed time period, saving stocks were initally low and capital demand high • Pre-19th century banking was mostly an equity-story • Access to capital markets and flexibility in balance sheet management prooved to be crititical for success and industry (re-) formation

8. Evidence II • Incumbent banks generally have an advantage over new entrants (existing reputation, customer base, regulatory and technological barriers to entry) • There is evidence that for all bank classes, this incumbent-advantage was replaced by a new-entrant advantage for the period of 1850-1870 • This evidence correlates with the initiation of external capital markets in Switzerland (first capital market financed banks and first stock exchanges) • When modelling the entry formally and controlling for regulatory barriers to entry (that is focussing on absolute cost of capital advantages, the relative cost of liquidity (not capital) for the bank remains as sole explanatory factor

9. Evidence III • The critical role of the cost of liquidity is in line with general expectations: • Capital Markets tend to be more liquid than internal conglomerate markets • Excess Capital Supply due to „openness“ to small and foreign investors • Increased demand for funds (growing middle-class and infrastructure) was more than met by available capital, thus affecting the „price“ of liquidity • But: No evidence for inflation/ capital oversupply • Hint towards increased productivity of capital as financial intermediation innovated from payment transaction and lend lending, towards maturity and risk transformation • General (historic assumption: Harrod-Domar Model – like effect for development; i.e. Capital Increase, but argument for an instutional efficiency effect seems fair

10. „Summary of the Argument“ “A bank holds only that much equity that is required to cover losses or draw backs likely with respect to counterparty and market risks. In an almost closed national banking system (such as the Swiss banking system in the observed period), the endogenous probability of cash withdrawal will be neglectable as the system is, adjusted for some cash hold in the individual households is closed (Jöhr 1940). Total liquidity is thus the individual bank’s levels of liquidity at hand. In a cleared market (CLE equilibrium), it can be assumed that this level equals the amount of ri. ri prooved to be the critical variable for increased competitiveness of new entrants versus incumbents.”

11. Four Propositions: • The relative price of liquidity deteriorated between 1980 and 1910 compared to the decennials prior and after, unveiling a structural beak in the entry dynamic patterns in the banking industry • Bank type specific cost of capital is affected directly depending on the relative elasticity between external markets and their own balance sheet structure • The absolute cost of capital or cost of market entry deteriorated in such an environment for incumbents • Banks with balance sheet structures open to external market instruments enjoyed higher growth rates

12. Theory and Background 2

13. Switzerland in the 18th century French troops invaded Switzerland in 1798, broke the power of the ruling élites there and temporarily destroyed the cantonal system by creating the centralised Helvetic Republic. During the 18th/19th century, great advances were made in scientific agriculture. New industries got off the ground, including clockmaking and textiles. Napoleonic policies („embargo against UK“) allowed to build one of the leading textile industry and manufacturing centres on the continent by taking advantage of a protected (French market) and established capabilities The 19th century was a period of relative peace and prosperity, after the turmoils following the Napoleonic wars had ended Patriotic societies sprang up all over the country. They promoted Swiss national awareness, going beyond narrow cantonal/state boundaries what ultimately lead to a short civil war and the establishment of Switzerland (1848).

14. What determines Market Structures in Banking? • Beyond Capital demand and suppy, banking generally refers to two strings of argumentation when observing changes in market structure in more detail: • Endogenous Factors • Exogenous Factors

15. Demand-Side Aspects Market Power Services Behavioural Arguments Technology Aspects Risk Mgmt. Aspects Meta Risk Int. Systems Systemic Risk Volatility Value Creation Value Recognition Normative Issues Firm- Politics Ethics Compliance What drives banking structures today? Endogenous Arguments Endogenous Innovation in Financial Services

16. What drives banking structures? Exogenous Arguments Law and Regulation MacroEconomic Conditions Exogenous Innovation in Financial Services Technological Advances InternationalizationofMarkets/ Co-Movement in Asset Prices Market Structure/ Competition

17. The Swiss Banking Market Landscape 1850 3

20. A shift in bank types and evidence for attribution of this shift to the entry dynamics of „U“ and „L“ New entry dynamics (Equ.3): Or: How much did the number/size of new entrants advance compared to the total market? U, L and B grew due to improved re-financing cost structures (savings and capital markets S and P as traditional banking forms before 1850 lost ground or grew below market average, whilst at the same time displaying high volatility in their overal balance sheet size Industry growth: Annual Growth rates of Banking Industry Market Volatility: Annual Growth volatility of Banking Industry

21. Structural Breaks • The key idea was to measure at what point in time a specific category/ type of banks enjoyed what level of dynamics compared to its peers. • Structural breaks are those decils wherein one bank type significiantly outperformed its peers in terms of growth rate of new entrants (market entry) • And of growth rates of new entering firms compared to incumbent firms of the same bank type (new entry dynamics)

22. Focus on „Bodenbanken“

23. Focus on „Sparkassen“

24. Focus on „Universalbanken“

25. Focus on Lokalbanken

26. Balance Sheet Structure Shifts

27. Problems, Implication, Future Research • Data Quality and Availability • Implications with respect to emerging capital markets and capital efficiency through institutionalization • Institutionalization moves along fungibility • Stronger Focus on Cummulative defaults statistics • Comparative approaches with other country evidence

28. Alternative explanations An alternative explanation for the structural peculiarity could be seen in the banking crisis that hit especially English Commercial Bank between 1860-1913 (Baker, Collins 2002; Collins 1989). However, this explanation is less likely due to the limited direct exposure of Swiss banks (especially the regional banks) to the UK economy in these days. Other boundaries can be identified when referring to the so far only anectodical evidences. Here, limits can be seen as the observed above normal growth of universal banks might as well be attributed to their reluctance to participate in the money-issuance functions allowed under freebanking conditions. In this respect, Hickson and Turner (2004) showed that early joint-stock banking systems did not equally likely adopt free banking as local branch banking did. Especially these open alternative explanations lead the way to future research in the field. This could be addressed by more detailed modeling and further considerations on the interplay between the relative value of liquidity and the effects on banks – and here beside industry structure also on the effects on the valuation of the asset side of the balance sheet.

29. Globalization of Financial Market’s Impact 4

30. What can be learned from 19th century data for today‘s problem sets with respect to banking market structure? • Problems and Logic of financial intermediation is constant over time • Risk Transformation • Maturity Transformation • Liquidity/ Payment System • But, data availability and industry business modells are not • Data Sets on industrial level are extremely noisy • Industry structure is shaped by conglomerates and intransparent pricing and accounting standards • Nevertheless: 19th century as focus for analysis has advantages • No regulatory impact • Observable start of regulatory work • Slower price/information transmission makes effects more visible over time

31. What can be learned with respect to the current era of globalization? • Globalized markets are in many aspects comparable • Increased Efficiency of Capital Utilization rather than capital oversupply • Therefore institutionalized mechanisms needed • Lack of fungibility/market liquidity ; control problems „Public Debt-to-Equity-Swap in UK as an often used explanation for the start of institutional markets applicable“ „Evidence for foreign investments in 18/19th century only in markets under parliamentary control“ • No global regulation – Free banking Parallels? • Industry Structures in Emerging Economies comparable in terms of capital intensity of textiles and the like?

32. Q&A / Discussion

33. Back-up

34. The Free Banking Idea • The ideabehind „freebanking“ todayisthatthesystemiccostsislowerforself-organizinginstitutionscomparedtoexternalregulation, hencestateregulationis not necessarilyrequired. • Market controlisexcertedthroughdefaultrisk. The proponentsofthetheoryarguethat in absenceof a de-facto stateguaranteeforbanks (asitexiststoday in virtually all maturemarkets) • riskaversion will behigherwithinbanks • monitoringofcounterpartyriskbyotherbanks will bemoresincere • actualcosts- andbenefitsofrisk-taking will bemore transparent (in assetpricesofthebanks

35. Money Markets Mechanisms Geschäftsbanken Notenbank Unternehmungen Private Haushalte Staat Ausland Notenbank Unternehmungen Private Haushalte Staat Ausland Bilanzgeschäft Interbankgeschäft (Geldmarkt im engern Sinn) Geldanlagen bei Banken Geldmarktaufnahmen von Banken Geldmarkteinlagen von Nichtbanken Geldmarktanlagen/ Geldmarktkredite Kundengelder (Bankeneinlagenmarkt) Bankkredite (Bankenkreditmarkt) Geldaufnahmen am Kapitalmarkt Geldanlagen am Kapitalmarkt Ausser-Bilanzgeschäft Trauhandanlagen, Geldmarktpapiere / Geldmarktbuchforderungen Kapitalmarktanlagen von Nichtbanken (Aktien, Obligationen) Andere Finanzintermediäre Anlagefonds Versicherungen, Pensionskassen Finanzgesellschaften Source: M.Lüscher

36. Der Repomarkt: Hauptnutzungsarten und wichtigste Marktakteure Liquiditätsinduziertes Segment: Repoverkäufer Repokäufer (hält Wertpapiere, möchte Kasse (hält Kasse, nimmt Sicherheiten in Form von Wertpapieren Hauptnutzung Kassenkredit zu günstigen Bedingungen Finanzierung von Wertpapier-Kaufpositionen Zugang zu kurzfristiger Liquidität. Hauptnutzung Minderung des Adressenausfallrisikos Eigenkapitalentlastung Diversifizierung Liquide Mittel Wertpapiere (in der Regel GC) Spezifische Wertpapiere / „Specials“ Liquide Mittel Hauptakteure Investmentbanken, Wertpapierhäuser Geschäftsbanken Unternehmen Hauptakteure Zentralbanken Geschäftsbanken Unternehmen Wertpapierinduziertes Segment: Repoverkäufer Repokäufer (hält Wertpapiere, nimmt Kasse als Sicherheit (hält Kasse, möchte Wertpapiere Hauptnutzung Finanzierung von Wertpapier-Kaufpositionen Zusatzertrag aus Portfolio Hauptnutzung Deckung für Wertpapier-Verkaufspositionen Einlieferung in Terminkontrakte Deckung für nicht zustande gekommene Abwicklung Hauptakteure Investmentbanken, Wertpapierhäuser, Inhaber grosser Portfolios (Investmentfonds, Zentralbanken) Hauptakteure Investmentbanken, Wertpapierhäuser EZB - Monatsbericht - Oktober 2002

37. The rise and fall of the Anglo-American wheat trade • The story of the development of the early transatlantic trade, never previously told, makes for fascinating reading in its own right. Britain was a net exporter of wheat until the late eighteenth century, but even for these years a bad harvest meant that the American colonies were looked to in order to make up the shortfall. • The onset of the Industrial Revolution, however, combined with the associated population explosion, meant that domestic production was no longer sufficient. From this point on, the United States was considered an important source for wheat imports. • The ultimate proof for eighteenth-century proto-globalisation is that prices of grain in the United States and Britain influenced each other. As far back as the 1770s, when Britain became a net importer of wheat and large volumes started to be imported from the United States, there is evidence that prices on both sides of the Atlantic were moving together. • A relaxation of the Corn Laws in 1773 ushered in a period of almost free trade in grain, and American wheat began to flood into British ports. But if globalisation might have started at this time, it was soon knocked off course – perhaps not so much by the American War of Independence, but rather by a plague of insects: the Hessian fly (so called because it was commonly supposed to have been introduced to the country in the straw bedding of the hated British Hessian mercenary troops). • These insects devastated the American wheat crop, and it was many years until the wheat export trade began to recover. Even when it did, the Corn Laws turned protectionist again, and it was not until Prime Minister Robert Peel’s famous ”repeal” in the 1840s, that the trade again resumed major importance.

38. 18th century Economic Environment • Eighteenth-century globalisation • The evidence for the early importance of the transatlantic wheat trade comes from two sources.1 First, statistics survive for the wheat trade between the American colonies and the early years of the United States and Britain. These show the beginnings of intercontinental trade in a bulky product, which at the time was a leading component of consumption in Britain. • Second, lending support to the trade statistics is primary evidence, ranging from presentations, to Parliamentary select committees to the correspondence of individual farmers, which all suggests that contemporaries were aware of the significance of this trade. Indeed, by 1800, the British Board of Trade wrote that ‘America be, or is hereafter to be the granary of Europe’, a role which it only fulfilled at the end of the century. • In fact, when the United States did finally emerge as the major supplier of wheat in the 1860s and 1870s, it appears that contemporaries considered this to be a new development, seemingly unaware of the events of the previous century. Their reason for this mirrors the belief that many hold today that globalisation is a modern phenomenon: the early growth in trade was continuously being knocked off course by ‘extraordinary’ events, such as war, politics and even plagues of insects. • Moreover, the trade was finally closed down altogether by the imposition of prohibitive new Corn Laws after the Napoleonic Wars in 1815. That observers had forgotten the importance of this trade after half a century is similar to commentators now often being unaware of the level of globalisation prior to the First World War.