Banking With A Single Currency2

Eight impacts are identified and analysed. The first six concern capital markets, including the government bond market and its fast-growing appendix, the interest rate derivative market, the corporate bond and equity markets, institutional fund management, the euromarket, the foreign exchange market, and the competition between the euro and the US dollar as international reserve currencies. The last two effects concern commercial banking with the impact of the single currency on credit risk and on bank profitability in a low-inflation environment.

The Government Bond Market, Underwriting and Trading

The government bond market in Europe is very fragmented, with domestic players capturing a large market share of the underwriting and secondary trading business. This raises the question of the sources of competitive advantage for local banks. With regard to the underwriting and trading of government bonds, Feldman and Stephenson (1988), a Federal Reserve Bank of New York study (1991) and Fox (1992) show that the dominance of local players is the result of three main factors. The first is historical, with local players having privileged access to the public debt issuer. The second is domestic currency denomination, which facilitates the access to a large investor home base, providing a significant advantage not only in placing, but also in understanding, the demand/supply order flows. Finally, expertise in the domestic monetary environment provides information essential for operating on the secondary bond market.

Will these sources of competitive advantage survive with a single currency? As domestic currency denomination, the main source of competitive advantage identified for local banks in the literature, disappears, it is quite likely that we shall observe the emergence of a truly integrated

European bond market. If access to a European-wide investor base does facilitate placement and if access to information on the supply/demand order flows seems essential for secondary trading, then very likely operations on a large scale and at a European-wide level will become a necessity3 and we shall see a consolidation of the government bond underwriting and trading businesses. For instance, both the European Investment Bank and the Kingdom of Belgium have entered the market in 1999 with 'jumbo' issues that can only be underwritten by banks with a large equity base. Bishop (2000) reports that issues of more than one billion euros have increased from 15 per cent to 28 per cent of all euro-denominated issues from the first quarter of 1998 to the fourth quarter of 1999. Moreover, in 1999, the total euro-denominated issue of bonds is 28 per cent larger than the issue of dollar-denominated international bonds.

The Corporate Bond and Equity Markets, Underwriting and Trading

As is the case for government bonds, a key issue concerns the sources of competitive advantage of local institutions in corporate bond and equity underwriting and secondary trading. As explained earlier, customer relations, assessment of credit (business) risk, and currency denomination are critical sources of competitive advantage. The eurobond market presents an interesting case. A report by the Federal Reserve Bank of New York (1991), confirmed in Dermine (1996), McCauley and White (1997) and Harm (1998), reports a strong correlation for non-dollar issue between the currency denomination and the nationality of the lead bank manager. This is illustrated in Table 4.1, which shows that, for instance, French banks are the lead managers 86 per cent of the time for French franc-denominated eurobonds issued by French companies, and 75 per cent of the time for similar bonds issued by non-French borrowers. The domestic currency denomination facilitating access to a home-investor base was a key source of competitive advantage not only for placement but also for secondary trading. Indeed, an understanding of local monetary policy would give a competitive advantage to forecast interest rates and price movements. The leading role of American institutions in the dollar-denominated eurobond market is explained not only by large issues by American companies, by their expertise developed in their home corporate securities markets, but also by the important advantage linked to the dollar denomination of many bonds. Indeed, access to home investors and an understanding of US order flows and US monetary policy provide a decisive advantage in secondary trading as they help to predict price movements.

A single currency in Europe changes fundamentally the competitive structure of the corporate bond and equity markets as one key source of

Table 4.1 Currency and home-country relationship in the choice of the bond bookrunner, 1996 (percentage market share won by bookrunners of indicated nationality)

German bookrunners

French bookrunners

Borrower

Currency

Borrower

Currency

Mark

Other

French

Other

francs

German

44

16

French

86

10

Other

37

2

Other

75

2

All

39

4

All

77

2

UK bookrunners

Dutch bookrunners

Borrower

Currency

Borrower

Currency

Pound

Other

Guilder

Other

UK

40

21

Dutch

83

26

Other

48

3

Other

85

2

All

44

4

All

84

2

US bookrunners

Japanese bookrunners

Borrower

Currency

Borrower

Currency

Dollar

Other

Yen

Other

US

86

46

Japanese

75

46

Other

54

13

Other

87

6

All

64

16

All

84

8

Source: McCauley and White (1997).

Source: McCauley and White (1997).

competitive advantage, namely home currency, will disappear. Indeed, savers will diversify their portfolio across European markets, the exchange rate risk being eradicated. Moreover, a single currency suppresses the secondary trading advantage for domestic banks derived from a better understanding of order flows and monetary policy in the domestic country. Therefore, the two main sources of comparative advantage remaining for local players are historical customer relations and the understanding of credit (business) risk through a better knowledge of the accounting, legal and fiscal (not to mention language) environment. Whenever the business risk embedded in corporate securities can be better assessed by domestic banks, these players will control underwriting and secondary trading.

Local expertise would be particularly valuable for smaller companies, venture capital or the real estate market. However, for larger corporations, worldwide industry expertise will most likely dominate any national advantage. For instance, to serve a Volvo corporation, it is unlikely that Swedish expertise is of great help to local institutions. What is needed is expertise in the global automobile industry.

To conclude this analysis of the impact of a single currency on the corporate bond and equity markets, it seems that customer relations and an understanding of business risk could remain two sources of strength for domestic firms in some segments of the market. But, placing power and trading across Europe coupled with global industry expertise are forces that lead to consolidation in a major part of the securities industry. As a tentative base for comparison, it is symptomatic to observe in Table 4.2 that the top six American underwriters of US debt and equity control 62 per cent of the US market.

Table 4.2 Top underwriters of US debt and equity, January to July 1999

Manager Market share (%)

Merrill Lynch 14.6

Salomon Smith Barney 13.4

Morgan Stanley Dean Witter 9.6

Goldman Sachs 8.4

CSFB 8.1

Source: Thompson Financial Securities Data.

Fund Management

An important segment of capital market business is the fund management industry, pension funds or mutual funds. As Tables 4.3a and b illustrate for France and the United Kingdom, respectively, it is symptomatic to see the dominance of the fund management industry by local firms.4 In view of this extreme fragmentation, especially in comparison with other segments of the capital markets, what is the impact of the single currency on the fund management industry? In this case too, an understanding of the main sources of competitive advantage needs to be developed. These concern the retail distribution network, the home-currency preference, research expertise and the existence of economies of scale (Kay et al., 1994). The first source of competitive advantage in the retail segment is the control of the distribution network, in the hands of local banks in several countries.

Table 4.3a Mutual funds (OPCVM) managers in France, December 1996

Euro bn

Market share (%)

Société Générale

31.30

7.40

Crédit Agricole

25.10

5.90

Crédit Lyonnais

24.10

5.70

BNP

23.96

5.68

CDC-Trésor

18.50

4.40

La Poste

16.30

3.90

CIC-Banque

14.00

3.30

Caisses d'Epargne

12.90

3.10

Banques Populaires

12.30

2.90

Paribas

8.20

1.95

Source: EuroPerformance, AFG-ASSFI.

Source: EuroPerformance, AFG-ASSFI.

Table 4.3b UK league of segregated pension fund managers, 1998

Total assets under management

Euro bn Market share (%)

Mercury Asset Management

105.40

17.4

Schroder Investors

96.10

15.8

Phillips & Drew Fund Management

72.50

11.9

Barclays Global Investors

63.50

10.5

Morgan Grenfell Asset Management

39.70

6.5

Goldman Sachs Asset Management

31.80

5.2

Foreign & Colonial Institutional

20.60

3.4

Hill Samuel Asset Management

20.54

3.4

Prudential Portfolio Managers

20.45

3.4

Fidelity Pensions Management

13.05

2.1

Source: Financial Times, 21 May 1999, compiled by author.

Source: Financial Times, 21 May 1999, compiled by author.

Indeed, domestic control of distribution is protected under the current European legislation framework, which gives national authorities the right to regulate the marketing of funds in their own territory. Obviously the advantage derived from the control of the distribution network applies to retail investors only, as it will not be a barrier to entry in the institutional market. A second source of competitive advantage was the customer preference for home-currency assets, often imposed by regulation. A single currency will of course eliminate this factor and reinforce the need for European-wide portfolios. A large part of these will be provided by index-tracking investment funds. A third source of success is excellence in research-based management. As to the existence of economies of scale and scope in the fund management industry, this is still a subject of debate (Bonnani et al., 1998). If scale seems important for index-tracking funds, it could be less relevant for actively managed funds.

A single currency eliminates the obstacle to international diversification. It is likely that there will be very large low-cost European index-tracking funds competing with smaller research-based funds. On the retail distribution side, domestic banks will keep their competitive advantage as long as the branch network remains a significant channel of distribution.

The Euro-deposit Market

An extremely efficient euro-deposit market was created 30 years ago to circumvent various forms of domestic regulations.5 A first issue concerns the size, coverage and remuneration of the reserve requirement on euro-denominated deposits in the future. Indeed, foreign currency-denominated deposits are not subject to reserve requirements in most countries. In October 1998, a reserve ratio of 2 per cent on deposits with a maturity of less than two years was imposed. However, these reserves will be renumer-ated at the market rate set by the ESCB in its main refinancing operations (Kelly, 1999). A second and more significant issue will be the fiscal treatment of the income earned on these assets in the future.6

Foreign Exchange Markets

A direct effect of the single currency is that not only intra-European foreign exchange transactions disappear, but the competitive advantage of a particular bank in its home currency vis-à-vis third-country currencies changes as well. As an example, a Belgian bank operating in New York is no longer a Belgian franc specialist, but competes with other European banks in the euro/dollar business. As is the case for the government bond markets, for which an understanding of the supply/demand order flows is important to predict the direction of price movements, we are likely to observe a consolidation of the commodity-type low-cost spot foreign exchange business. This conjecture is consistent with the analysis by Tschoegl (1996) of the sources of competitive advantage in the currency market, namely size and the international status of the home currency. Differentiated products based on quality of service or innovations such as options will be another source of competitive advantage.

The Euro as an International Currency: What Are the Benefits for the Banks?

One of the asserted benefits of EMU is that the single currency will become a challenger to the US dollar as the dominant international currency used for units of accounts, store of value and means of payment (Emerson, 1990; Alogoskoufis and Portes, 1991; and Maas, 1995). But in contrast to a national currency which is imposed as sole tender by national legislation, the role of an international currency is fixed by demand and supply on world capital markets. Two questions are being raised. First, is the euro likely to compete against the US dollar in international financial markets? Second, from the perspective of this chapter, what are the benefits derived for banks of having an international currency status for the euro?

Whether we look at the role of the dollar as a unit of account, a store of value, or a means of payment, it is still by far the predominant international currency. For instance, 60 per cent of the foreign exchange reserves of central banks are denominated in dollars, while US exports represent only 12 per cent of world exports. To assess the euro's chance of accelerating the relative decline in the dollar, it is instructive to have a look at history and the relative fall of sterling and rise of the dollar in the international payment system.

In 1914, on the eve of the First World War, the City of London was indisputably the world's leading international financial centre, with the pound sterling the major international currency. According to economic historians, the pound started to weaken during the First World War. The 1914-18 war saw the emergence of large bond financing in the United States. This was coupled with the events of 1931, the insolvency of the Creditanstalt in Vienna and the inconvertibility of the pound. The Second World War increased the status of the dollar, which was confirmed in its international role by the 1944 Bretton Woods agreement.7 We can conclude that the rise of the dollar over a 30-year period was very much helped by the two world wars, and that despite abandoning convertibility into gold in 1971 and continuous devaluation, 25 years later the dollar still retains a leading role as an international currency. Based on the last two decades, which have seen a progressive erosion of the dollar and a slow rise of the Deutschmark, in view of the relative economic size of Europe, and building on the potential for growth in the eastern part of Europe, we can extrapolate and forecast that the euro will replace the D-Mark and be a strong competitor to the dollar. Data for the year 1999 indicate that the euro has closed the gap vis-à-vis the US dollar. The total issue of euro-denominated bonds amounts to 812 billion, compared to 634 billion of dollar-denominated international bonds (Bishop, 2000).

What are the implications for banks of having the euro as an international currency? Three benefits can be identified. The first one is that an increased volume of euro-denominated assets or liabilities will ease the foreign exchange risk management of bank equity. Indeed, a large part of bank assets will be denominated in the same currency as the equity base, easing the control of currency-driven asset growth and capital management. Second, access to a discount window at the European Central Bank (ECB) will make the liquidity management of euro-based liabilities marginally cheaper. Finally, if third countries issue assets denominated in euros or use the European currency as a vehicle, European banks will be well positioned in secondary trading for the reasons mentioned earlier.

EMU and Credit Risk

Many of the channels which have been identified concerned the money and capital markets. An additional impact of the euro is its potential effect on credit risk. There are reasons to believe that the nature of credit risk could change under a single currency. The argument is based on the theory of optimum currency areas and on the objective of price stability inscribed in the Treaty on European Union.

There is an old debate on the economic rationale that leads a group of countries to adopt a common currency.8 The more that countries are subject to asymmetric economic shocks, the more they would appreciate monetary autonomy to cancel the shock. Indeed, with symmetric shock there would be a consensus among the members of a currency union on economic policy, but with asymmetric shocks a central policy may not be acceptable to all the members of the union. Recent economic developments have strengthened the argument. For instance, has the rapid recovery enjoyed by British banks in 1994 not been helped partly by the 1992 devaluation which reduced the bad debt problem? Similarly, the devaluation of the Finnish markka has helped the restructuring of the country after a major recession. How could the introduction of a single currency affect credit risk? If a bank concentrates its business in its home country, and if that country is subject to asymmetric shocks, it is quite possible that a central monetary policy will not be able to soften the shock. Some have argued that the adverse consequences of such shocks could be dealt with at European level and that, in any case, these shocks would be quite rare. Indeed, severe asymmetric shocks could in principle be mitigated by fiscal transfers across Europe. But this is only a possibility, which remains to be verified. As to the argument that asymmetric shocks are rare events, this is indeed the case, but a fundamental mission of any bank risk-management system is to ensure the solvency of financial institutions on precisely those rare but significant occasions. An indirect and interesting corollary of the optimum currency area theory is that for banks operating in a single currency area, the need to diversify their loan portfolio increases the more their home country is likely to be subject to asymmetric (uncorrelated) shocks. This can be achieved through international diversification or with the use of credit derivatives.

A related effect of EMU on credit risk is that the statute of the ECB will prevent inflationary policies. Ceteris paribus, this could increase the potential for losses resulting from default, as we can no longer depend on a predictable positive drift for the value of collateral assets.9 The inability of a country to devalue and the very strict anti-inflationary policy of the ECB imply that, whenever a need to restore competitiveness arises in a particular region, the only tool available will be a reduction of nominal wages and prices. This will change fundamentally the nature of credit risk as firms and individuals can no longer rely on the nominal growth of their revenue to reduce the real value of their debt. This new world calls for innovative techniques to handle potential deflations.10

Banking in a Low-inflation Environment

The last effect of a single currency discussed in this chapter concerns the impact on bank profitability of doing business in a low-inflation environment. Indeed, in the last 20 years, higher inflation and interest rates have provided substantial interest margins on price-regulated deposits. For instance, as is documented in Table 4.4 for the 1980-85 period, interest margins on demand deposits were above 10 per cent in Belgium, France, Denmark and Spain. If new products such as money market funds competed with these deposits, then these demand and savings deposits would still represent more than 40 per cent of client resources collected by banks in Belgium or France (Commission Bancaire, 1996; Banque de France, 1996). As Table 4.4 documents, margins on these products have been seriously eroded with the overall decrease in the interest rate level in recent years. We can safely conclude that an objective of monetary stability and low inflation pursued by an independent ECB will reduce the source of profitability on the deposit funding business.

However, if this effect is quite significant in a large number of countries, two additional effects of a low-inflation environment might soften the impact of lower margins on deposits. The first is that a low interest rate environment usually leads to a much higher margin on personal loans because of the relative inelasticity of interest rates on personal loans. For instance, in France, loan rate stickiness has raised the margin on hire purchase (consumer) loans from 6.3 per cent in 1990 to 10.1 per cent in 1996, a period of

Table 4.4 Interest margins of commercial banks

Belgium

Denmark

France

Germany

Netherlands

Spain

UK

Average margin

on demand deposits*

1980-85 (%)

11.2

16.2

11.7

6.5

5.6

14.5

10.8

1987-92 (%)

8.7

9.0

9.7

7.2

6.8

6.0

7.0

1994-95(%)

5.0

na

6.1

4.8

4.3

3.6

3.6

1996-98 (%)

3.0

na

3.5

3.4

3.4

0.6

3.6

Average margin

on savings deposits*

1980-85 (%)

5.6

8.9

4.3

2.8

2.8

10.7

2.5

1987-92 (%)

3.9

7.0

5.2

2.2

4.7

9.0

2.0

1994-95(%)

1.9

na

1.6

2.9

2.8

5.0

na

1996-98 (%)

0.65

na

0

0.62

1.5

1.4

1.5

Note: *Current short-term rate minus interest rate paid on deposits.

Note: *Current short-term rate minus interest rate paid on deposits.

Source: Data supplied by Organization for Economic Cooperation and Development.

rapidly declining market rates (Banque de France, 1996). A second positive impact of a low-inflation environment is that the so-called 'inflation tax' will be much smaller (Fisher and Modigliani, 1978). A simple example will give the intuition beyond the inflation tax. Consider a case with no inflation in which equity is invested in a 3 per cent coupon bond. After a 30 per cent corporate tax is deducted, the revenue is 2.1 per cent ((1 - 0.3) X 3%). The full profit can be paid as dividend as there is no need for retained earnings and higher capital since there is no growth of assets. If, because of a 10 per cent inflation, the same equity is invested in a 13 per cent coupon bond, the profit after tax is only 9.1 per cent ((1 - 0.3) X 13%), a figure too small to finance a necessary equity growth of 10 per cent. No dividend can be paid in this case and equity holders have suffered an inflation tax.

Therefore, the impact of a low-inflation environment on the profitability of banks will depend on the relative importance of reduced margins on deposits, higher profit on personal loans and on the significance of the inflation tax.

Retirement Planning For The Golden Years

Retirement Planning For The Golden Years

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