A blurred Euro-vision

European banking integration is slow and imperfect

IT BEGAN as a dream in the 1950s to dissuade European countries from ever again contemplating war against each other. The European Coal and Steel Community of 1952 grew into the European Economic Community and, after the Maastricht treaty of 1991, the European Union. Whatever the label, the vision has always been to create a single, borderless economic area with common standards and without barriers.

Given the persistence of patriotism at the national rather than the European level, it is amazing how far the project has come. Most remarkable is the single currency, the euro, which since 2002 has allowed people to travel throughout 12 countries using the same notes and coins. For companies too - such as online shops, travel agents and mail-order firms - a big obstacle to operating in the euro zone was thus removed.

For banks, on the other hand, it was a bitter-sweet experience. Before the euro, they easily handled 15 different west European currencies and interest rates, and made good money out of trading cash, securities and derivatives for customers and for their own book. On January 1st 1999, when 11 currencies were irrevocably fixed against each other (the 12th, the Greek drachma, joined the euro two years later), ten out of 15 currencies vanished from traders' screens. Many European banks lost a chunk of their income.

The consolation was that, at a stroke, wholesale financial markets in Europe became much more integrated and more interesting for non-European investors. This caused much rebalancing of investment portfolios, because shares, bonds, loans and derivatives could be bought across the euro zone without additional currency or interest-rate risk.

On the wholesale side, the integration of European financial markets has been a resounding success. But on the retail side - bank accounts, payments, mortgages, insurance policies and personal investments - the process has hardly begun.

One strong sign that there is little convergence is the scarcity of cross-border banking mergers. So far there has been only one significant one, the purchase of Abbey National, Britain's sixth-biggest bank, by Banco Santander Central Hispano of Spain. One medium-sized French bank, Credit Commercial de France, was bought by Britain's HSBC in 2000, and in the same year Germany's HypoVereinsbank bought Bank Austria. In Italy, another Spanish bank, BBVA, looks likely to succeed in its bid for Banca Nazionale del Lavoro, and ABN Amro of the Netherlands has been battling to take over Banca Antonveneta. Apart from some cross-border bank consolidation in the Benelux and Scandinavian countries, that is as far as integration in western Europe has got.

In central and eastern Europe, it is a different story. Since the early 1990s, large swathes of the banking sector there have been privatised and ended up in foreign hands. That has brought immediate benefits in terms of safety and soundness, fresh capital, innovation and integrity, although some economists are alarmed by the long-term implications.

East, west, home's best

Why the east-west split? Ask the head of a big west European bank why he has not bought up a rival in, say, France, Germany or Italy, and he will give two reasons. First, political and legal barriers to entry act as a disincentive. About half of the French banking system is still in public hands, and a foreigner would find it politically tricky to buy one of the three biggest banks, Credit Agricole Lyonnais, Societe Generale or BNP Paribas. In Germany, an even higher proportion of banks are in public or mutual hands, which means they are simply not for sale. There is a handful of private banks, but their share of the banking market is too small to give a foreign buyer critical mass. In Italy, several of the big banks are theoretically open to takeover, but real or perceived political barriers have discouraged foreign bids until recently.

The second reason for not buying is that, in contrast to domestic mergers, the expected cost savings and economies of scale are rather modest. Domestic mergers benefit from the closure of branches and cuts in the number of employees and other fixed costs. Cross-border mergers are likely to bring only a few savings from the eventual integration of IT systems, back offices and perhaps the design and marketing of some financial products. But in general, even banks that have bought subsidiaries abroad tend to run them as separate banks. For example, Citigroup has not integrated its banking operations in various European countries, and nor have Nordea (the result of a merger of four Scandinavian banks), Deutsche Bank, HSBC or any of the smaller banks with subsidiaries in central and eastern Europe.

Doing their own thing

The reason is simple. When it comes to retail banking, each national banking system, whether inside or outside the EU, is still an island. Tax, ownership, consumer protection and conduct-of-business rules have not been harmonised. Despite the principle of mutual recognition, which is supposed to allow EU banks to operate branches in other EU countries under the supervision of their home regulator, simply opening branches in other countries does not win many retail customers.

Most big European banks have preferred to look for growth in more dynamic markets, such as America or Asia. The smaller ones have headed for central and eastern Europe. Most banking consolidation in the EU so far has taken place within individual member countries, for example in Spain, France and Italy.

A study by Morgan Stanley and Mercer Oliver Wyman, published in February, lays out the arguments in favour of cross-border mergers of European banks. It argues that the banks which are well ahead on IT and on complying with Basel 2 capital rules would be in a good position to buy up those banks that are behind, because they could make the laggards more efficient. The study's authors assume that banking integration in Europe is only a matter of time, because institutions such as the European Commission and the European Central Bank are determined to make it happen.

So what is holding it up? The single European market was supposed to be completed in 1992, but selling services across national borders turned out to need much more legislation and rule-making than expected. In 1999 the European Commission's directorate-general for the internal market drew up a financial-services action plan which was supposed to be completed by 2005. The rules for the wholesale market are more or less ready, but there has been slippage on the retail side.

The second banking directive, passed in 1993, allows for branching under the European passport. A directive on funds that can be sold across Europe has tried to stimulate a market in pan-European investment vehicles. An investment-services directive allows the cross-border selling of insurance and other financial products. But there are snags: countries can still invoke their own consumer-protection laws, and the tax treatment of investments and the legal status of mortgages, even of the ownership of securities, can vary. It is as though foreign tradesmen had been invited into the bazaar, but told they could sell only goods that are identical to the home-produced variety.

This is not true of other things that are sold across borders, such as cars, mobile phones, media or fashion. Is retail finance fundamentally different, or are incumbents unfairly protecting their turf?

The euro was expected to allow easy comparison of prices across all the countries that used it, and stimulate convergence. This has certainly worked for a range of items, from hotels to cars and cappuccinos. But comparing banking services from country to country is fiendishly difficult. A recent study by ING and Capgemini found huge variations in the price of core banking services, ranging from an average of €252 a year in Italy to €34 in the Netherlands. Another study, carried out by Mercer Oliver Wyman for the Italian Banking Association, compared the average price of keeping a current account in various European countries: €133 in Italy, €94 in France, €86 in Spain and €68 in Germany. But over 50% of Italians share bank accounts, which brings down the cost per person, said the study. And British and Dutch banks make much more money than do Italian ones from selling customers extra services such as mortgages and consumer loans.

Consumers in different member countries have different expectations of their banks. The British and Germans are used to getting free current accounts, but paying for cash withdrawals from other banks' ATMs. The French pay for their bank accounts but expect cash withdrawals across the euro zone to be free. Italians pay nothing for keeping a current account but are charged high fees for every transaction. Citigroup, which operates in most European countries, simply adopts the local price structure in each market.

An Italian, say, who wanted to save on bank charges by opening an account in the Netherlands or Spain would be faced with lots of obstacles. As a non-resident, he might be refused point-blank; but even if he succeeded, he would have to watch his step. In theory, any cross-border transfer in euros up to €12,500 should cost the same as a domestic transaction, but the code numbers for the recipient's bank branch and bank account must be given in exactly the right form, otherwise there is an extra handling charge.

Until March this year, French banks were forbidden by law to pay interest on current accounts. This law was overruled by the European Court of Justice last October after a challenge by a Spanish savings bank, and some are now paying interest.

Much of the lack of cross-border action is explained by customers' general unwillingness to change banks. People over 40 in particular hardly ever move their bank accounts, however bad or expensive the service they are getting. They may be missing out on cheaper deals, but most of them have better things to do than shop around for banking bargains. And many customers are proud to bank where their parents and grandparents did. This inertia gives the established banks a comfortable cushion of steady earnings that is only slowly being deflated by competition from internet alternatives, mortgage brokers and consumer-finance companies.

In Britain, various investigations have shown that banks have taken advantage of their dominant position by charging their customers high fees. The Cruickshank report in 2000 criticised the main British banks for overcharging small businesses in the knowledge that businesses in debt cannot easily change banks. Another study, by Stephen Martin and Michael Mainelli of Z/Yen Limited, analysed why big banks with dominant market positions, such as Britain's, may see little value in competing for new customers by offering cheaper and better services. First, customers seldom switch accounts, and if they do it is mostly because they are dissatisfied rather than attracted by something better. Second, the small number of new customers that would be won by offering cheaper and better services would not justify the extra cost. That is why the British market for personal current accounts is stagnant, the study argues. The big four British banks would “have most to lose if there was a culture of change in the personal current-account market”, the study says. It quotes a comment in 2002 by Which?, a British consumer magazine, predicting that change was unlikely until a “critical mass of organisations are willing to question the model of traditional banking and to spend enough money to change national perceptions.”

At least in Britain, as in America, small companies can turn to other sources of funding, such as venture capital and mezzanine finance. In continental Europe, such alternatives are harder to find, especially in Italy, where bank loans make up more than 70% of small-company finance. German and Italian banks traditionally have “house-bank” relationships with their smaller commercial customers. Newcomers seldom have the local knowledge to replace such relationships. But a few foreign banks, led by Royal Bank of Scotland and BNP Paribas, have been making inroads into the corporate-lending market in Germany, prompting complaints from local bankers that their already low margins are being forced down even further.

Germany is generally overbanked, and lending margins have historically been low because of the influence of the savings banks. Germany's savings banks are mostly owned by local authorities and guaranteed by them. Until recently they have been more interested in serving the local community than in making profits. That is changing slowly, mostly because, under pressure from the European Commission, their public guarantees will be phased out from July this year. Funding costs will rise, forcing those banks to charge higher margins.

Brussels theology

As discussed earlier, banks the world over are getting ready for the introduction of a new prudential capital framework, Basel 2, in 2007. The Basel 2 framework is being written into a new European directive that will cover all banks and investment firms within the EU. Its implementation will be as much of a challenge for supervisors as for financial institutions.

The framework rests on three pillars. The first is purely quantitative, assigning risk weightings to different types and maturities of assets, according to the credit rating of the counterparty, and relying on more sophisticated banks to calculate their own capital allocation. The second pillar depends on an assessment of the bank's management and performance by its supervisor, whose skill and competence could make a huge difference to how much extra capital the bank might be asked to hold. The third pillar concerns disclosure and market discipline: again, the ethics and disclosure standards of the local financial market will play a role. Harmonisation of regulatory and disclosure standards will be a nightmare, but European financial-sector regulators have chosen to rely on the principle of mutual recognition, that is, not second-guessing the competence of a bank's home supervisor.

A recent paper by the Centre for European Policy Studies (CEPS) in Brussels, which is partly funded by the European Commission, reinforces the impression that European financial regulation is a chaotic building site rather than the advertised level playing field. It argues that co-ordination between regulators is not developed enough to handle a Europe-wide financial crisis; and that consumers, or those representing their interests, do not have enough say in shaping financial-sector reform.

Faster rule-making, by expert committee rather than through legislation, may be speeding things up, but it favours financial practitioners and other powerful interest groups and risks “regulatory capture ” - -regulators getting too close to some of those they regulate. Four supposedly independent expert groups set up by the European Commission to review progress on the financial-services action plan were “overwhelmingly composed of industry representatives”, says CEPS. It also worries about the consistent implementation of the Basel 2 capital accord across EU states. But despite its criticisms, it is impressed with the European experiment.

Another study, by the Centre for Economic Policy Research (CEPR) in London, asks why progress on European banking integration has been so slow, and suggests that mutual recognition might usefully be complemented by a mechanism for arbitration on a European scale. Others have also suggested a Europe-wide financial ombudsman service for consumers, along the lines of the one operating in Britain.

The CEPR study asks some awkward questions about the pros and cons of cross-border banking integration, pointing out that strong competition from foreign banks could be a two-edged sword. It might allow bad borrowers to shop around more widely for loans, prompting banks to increase their lending rates for all borrowers. Moreover, foreign ownership of local banks may not necessarily be a good thing. “There might be sound economic reasons that justify domestic control of large local banks,” the study says. And it sees a potential problem for countries in central and eastern Europe whose big banks are mostly foreign-owned subsidiaries: “Problems in the parent bank may lead to a very rapid withdrawal of liquidity, jeopardising the entire banking system in the host country.”

Such foreign-owned banks also may be less inclined than locally owned ones to make business decisions that support the national economy, and perhaps more resistant to moral suasion or political pressure. That may be a good thing, leading to more realistic pricing. But then again it may put these countries at a disadvantage relative to some west European countries whose governments continue to exert political pressure on their banks. Still, the question is mainly of academic interest: some eastern European countries had little choice but to invite foreign banks in.

European banking integration is slow and imperfect. Article is part of an Economist survey of international banking.

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