Competitive Strategies In Euroland

As Davidson et al. (1998, p. 67) note with regard to preparations for EMU:

Astonishingly, many banks seem ill prepared. Although they have tackled the IT

and operational challenges raised by a single European currency, they have failed to address the more difficult strategic issues. Put bluntly, they have not considered how they will prosper once a single currency wipes out great chunks of profit in their traditional wholesale businesses of foreign exchange, corporate banking and government bond trading.

In the new Euroland environment Davidson et al. argue that the best opportunities are likely to accrue to only a handful of banks.

Bank revenue growth in wholesale banking following EMU is likely to be mainly in investment banking, which spans areas (such as equities, bonds and M&A) where EU banks will find it difficult to match the scale and expertise of the big US investment banks already operating within the EU. Davidson et al. (1998, p. 69) believe that, overall, 'EMU is likely to create more losers than winners in wholesale banking'. EMU, then, poses many serious threats to banks. For example, the 'typical' European bank could lose around 70 per cent of its foreign exchange trading revenues with the abolition of foreign currencies. In other wholesale banking areas, the threats are also apparently as serious (see ibid., p. 70).

In corporate lending, historically 'cheap' bank loans (facilitated by lending overcapacity and less intense competition) are becoming less sustainable. Banks throughout the EU are having to become more shareholder value orientated, allocating their internal capital to support high-performing assets and correspondingly reducing the proportion of low-income assets on their balance sheet. This is not a specific EMU consequence, although EMU certainly facilitates this kind of environment. Governments throughout Europe are generally keen to improve competitiveness through the discouragement of historic close bank/industry link-ups and state subsidies.

At the same time, a single and more liquid European corporate bond market will facilitate more bond issues by companies. The cost of reserve requirements imposed on Euroland banks by the European Central Bank (ECB) may also be passed on to banks' customers, thereby increasing the cost of bank intermediation. Bank lending volumes and margins will be subjected to downward pressures in this new environment. With increasing securitization, banks may find themselves with a growing adverse selection problem in their own lending.

Deposit and money market business is another area of wholesale banking that will come under pressure. In Euroland, volumes may fall since corporate customers will no longer need to hold deposit accounts in each of the EU currencies in which they trade. At the same time, traders will no longer hold different currency-denominated deposit balances in order to exploit interest rate differentials. A countervailing trend is that a deeper, liquid and more standardized EU money market under EMU should boost competition and increase other opportunities for banks. This increased competition, though, will help to reduce margins on this business.

The wholesale payments area will also come under pressure in Euroland. A great deal of this business comes from correspondent banking, but EMU will eliminate intra-European currency payments. The introduction of TARGET (a payments system for processing wholesale Euro transactions) further lessens the need for traditional correspondent banking services. At the same time, cross-border payments are likely to grow with the increased trade expected to flow from EMU. Nevertheless, banking scale and efficiency are likely to be key competitive ingredients of success in this new market environment.

Government bond trading is another key area of wholesale banking that is likely to be a threat to many Euroland banks. As pointed out earlier, increased fiscal discipline by governments will reduce the volume of government bond issues. At the same time, domestic EU banks will no longer be able to rely on their specialist knowledge of domestic monetary and fiscal policy, national currencies and interest rates to win business. Knowledge of country credit risk will be the more relevant driver of successful government bond business in Euroland; distribution capabilities will also be more important.

These threats, together with the more general and inexorable rise of trends like globalization and securitization, are real and immediate. But there are many good opportunities for wholesale banks in Euroland. The development of a broader, more liquid and deeper European capital market should help to stimulate the cross-border consolidation of many industries, thereby generating more M&A business for banks. The municipal, corporate bond and equity markets should all be stimulated by the single currency environment.

The 'privatization' of government debt may help to promote the municipal bond market, which until recently has been virtually non-existent in Europe. The funding of large public infrastructure projects may transfer increasingly to the private sector. Both equity and bond financing are relevant, but bond finance is especially suited to the kind of revenue streams involved. A US-style municipal bond market might eventually emerge as a replacement for present government borrowing. The privatization of social security and pensions is also likely to boost capital markets, investment management and related wholesale banking.

This brief and select strategic overview of threats and opportunities facing banks in Euroland raises many strategic questions. A leading strategic issue is that there appears to be a premium on bank size, although US experience has also demonstrated that in areas like municipal bonds smaller players can compete successfully with the leading investment banks. However, there does appear to be a general strategic view that size may be particularly critical in many important wholesale banking segments.

All of the foregoing leads to the question of what strategies are likely to succeed. This appears to be a much more complex issue than simply focusing on size per se (and the benefits of size can often be achieved through various alternative routes). Another, more specific question is whether EU banks (and which kinds of bank) can compete successfully in this new, more globalized marketplace. Once again we are in the realms of 'crystal ball' gazing. One also has the strong impression from many US analysts and consultants that only the giant US investment banks can be expected to dominate in this new, apparently more US style of banking in Euroland.

EMU also has important consequences for retail banking. The stronger macroeconomic environment being facilitated in part by EMU has furthered the downward pressure on interest rates and interest margins in many retail markets; this has exerted pressure on bank profitability. During the 1990s, in the US consolidation and increased penetration of regional and local markets by large national and super-regional banks made these retail banking markets apparently more contestable. Yet, smaller financial institutions in the US regional and local markets are 'surprisingly adept at survival' (Walter, 1999, p. 157). There is evidence from the US 'that retail banking clients remain strongly dependent on financial services firms with a local presence, and where there is a high level of concentration this is reflected in both interest and deposit rates' (ibid.).

Local preferences are a strong feature of individual European banking markets and the proliferation of different types of local and regional banking groups is a characteristic feature of these markets. Furthermore, foreign bank entry into the majority of national markets is relatively low and typically restricted to specialized, niche or wholesale activities (ECB, 1999). Another feature of European banking that is likely to affect the evolving market structure is 'the role of state at national, regional and municipal level' (Walter, 1999, p. 159). Walter makes the point that non-joint stock European banks operate under different performance pressures and that 'when public- and private-sector firms meet in the market, competitive outcomes will clearly be affected' (ibid.). The longer-term outcome, however, is unclear; the immediate impact is to help reduce retail banking profit margins in markets where the commercial banks are subject to competition from public sector banks.

Local banks are thought to possess information advantages. Asymmetric information in bank lending will continue to enable banks to target customer segments even as the level of competition increases. Information about customers and the need to have a link with borrowers means that traditional credit activities are likely to remain substantial (de Bandt, 1999). This scenario will hold particularly true for small and medium-sized enterprises and individual customers, who do not have ready access to securities markets. Local knowledge, therefore, can be argued to provide a sustainable competitive advantage for some retail banks. Nevertheless, the different types of European bank face competition from specialist lenders that have taken advantage of technological developments and are providing lower-cost services. De Bandt summarizes the likely effects of EMU on banks' traditional activities as reducing banks' competitive advantages while intensifying the need for asset transformation and uncertainty management.

In Europe, historical characteristics and the existence of asymmetric information provide an opportunity for the co-existence of a relatively large number of small banks serving local and regional markets, while a few large banks service mainly corporate customers at the pan-European level. There are a number of strategic options for small banks in the post-EMU environment. Specializing in niche areas is one. Another is to build alliances with universal banks, either to protect local markets from potential competitors, or to acquire information technology and a larger distribution network. Yet another strategy might be to try to acquire critical mass through the merger route. Nevertheless, mergers are likely to pressure further those small domestic players who are not efficient and strong enough to match the opposition.

The build-up to a wider Euroland is likely to be accompanied by domestic (protective) consolidation in retail banking; this was a feature of the build-up to the SMP (EC, 1997 and Gardener, 1999a). A wider Euroland also appears to increase the potential for cross-border bank mergers, although most analysts argue that the potential cost savings and synergies need to be targeted carefully. Many also believe that these cost savings and synergies will be hard to find and even harder to sustain.

Walter (1999) argues that the present situation in the EU can be compared in some respects with the US prior to its early 1990s' financial sector restructuring. Before it was restructured, the US financial services industry carried too much capital and employment in the production of financial services; both capital and employment were subsequently reduced through consolidation, a process that has just begun in Europe. Yet, there are several notable differences between Europe and the US. Due to the existence of historical differences in bank ownership, retail market consolidation may be slower in Europe than in the US. Furthermore, the ruthless nature apparent in the US consolidation process is relatively less marked in European banking. Nevertheless, competition is expected to intensify in all European retail markets.

New and more innovative distribution channels will be inevitable features of this new environment. Internet and other forms of direct banking in particular also offer the potential of significant cross-border expansion of much smaller retail financial services firms and those without an established (or any) traditional banking franchise. These technology-led developments are likely to be important strategically in the process (slow to date) of globalizing retail financial servces markets in the EU. EMU will facilitate this process through its likely effect of producing a much greater standardization throughout the EU of the institutional market features (including regulation and taxation) within retail financial services.

What is clear is that the EU banking system is currently in a state of unprecedented change. A great deal of M&A activity has already taken place during the past ten years and this has accelerated recently. As with the SMP, some of this has been in anticipation of the new environment facilitated by EMU. The ECB (1999) believes that in the new environment there is room for further consolidation. Two types of merger have been identified:

• strategic mergers - involving at least one large player with the strategic aim of repositioning the merged entity in the EMU market; and

• mergers to remove excess capacity - involving mainly smaller banks and being defensive, with the main aim of the new, larger entity being to realize efficiency gains.

The latter has been a major feature of merger activity in Spain, Italy and France during 1999.

A new and still emergent M&A strategy is also worth emphasizing:

• cross-border mergers between large banks - Dutch-Belgian bank mergers and the Merita-Nordbanken deal is a good example of what might yet prove to be an important stimulus associated (at least partly) with EMU.

This last type of merger is still rare, although several rumours abound and some potential large cross-border mergers have been recently frustrated. Such mergers were envisaged by Cecchini as a product of the SMP. This Cecchini vision has not been fully realized, but EMU may well further promote these types of mergers.

Drawing comparisons of US experiences with bank consolidation and restructuring must be a cautionary exercise. We emphasized earlier that there are many deep-rooted structural and institutional differences between the US banking market and Euroland. Nevertheless, these comparisons are frequently made and they can help to provide useful insight into what might happen in some market segments. The acquisition of the US Bankers Trust by Deutsche Bank is a clear strategic sign that those Euroland banks that aspire to be global banks recognize the need for US-style investment banking expertise.

A recent comparative study by Hurst et al. (1999) reached the following conclusions about the performance of Euroland banks compared with the US:

• Euroland banks generate a relatively low gross revenue stream and have higher costs.

• Despite higher leverage (due to their better average asset quality), the ROE in Euroland during the 1990s is much lower than for banks in the Anglophone countries.

Hurst et al. (1999) point out that costs are not well managed in many European banks. It is also suggested that this apparent poor performance of Euroland banks can be explained through factors like inadequate product mixes and pricing strategies for corporate clients, and the distorted competitive environment.

There are essentially two ways to improve this apparent poor showing by Euroland banks. One is to improve bank performance via the existing management; the second way is to replace management. In this latter context, the M&A route is the common strategic route and it is in this area that US experiences many give some interesting insights.

The US over the past decade has experienced a 'mega' banking-merger wave, with the number of banks dropping by about 30 per cent. An interesting empirical fact is that analysts to date have not been able to find consistent improvements in the post-merger companies: see, for example, Hurst et al. (1999). European bank M&A activity to date (although much smaller than in the US) also seems to support the view that many bank mergers do not lead to longer-term efficiency gains. Of course, there are many problems in interpreting these apparent results. One set of problems concerns the empirical methodologies used to measure merger-related performance. The other concerns the relevance and practical importance of other, less apparent reasons for bank M&A activity.

In their comparative study (of US and Europe), Hurst et al. (1999, p. 99) conclude that Europe in theory 'should see a merger wave much as has occurred in the US'. Many other analysts and students support this view; recent apparent emergent trends in Europe lend empirical evidence to it. Most of the analysis (both theoretical and comparative) seems to lead to the conclusion of post-EMU excess capacity in banking, followed by inevitable restructuring and consolidation in the new Euroland. Furthermore, with increasing securitization and other trends emphasizing the increased importance of investment banking, bank concentration may be expected to increase with the increased capital expenditures that characterize this kind of banking: see, for example, Danthine et al. (1999, pp. 52-4).

All of this begs two questions (at least). First, why hasn't the present EU merger wave attained US bank proportions? Second, can we really expect the kind of mega bank-merger wave experienced in the US, together with the respective rise in bank concentration? In many respects these questions are interrelated. The answers may also bear directly again on structural and institutional differences between the US and Euroland.

Hurst et al. (1999) suggest that there are still many important barriers to restructuring in Euroland compared with the US. Examples include the high level of public ownership of banks and bank restructuring influenced by non-economic motives (such as preserving national champions). EMU may also prompt increased regulatory rigour and reactions to perceived anti-competitive policies. Other Euro-specific factors include the successful use of sharing arrangements (thereby achieving the economic benefits of bigger size) by important EU bank sectors, such as the savings banks. More rigid labour laws in Europe may also slow down cost-cutting and related M&A activity. The EC (1997) study also confirms that there remain important tax and legal differences, together with linguistic and cultural barriers, within the EU that may impact on banking strategies.

The foregoing might suggest that Euroland bank restructuring and consolidation, while significant, is likely to be a slower process and on a reduced scale (at least in the shorter term) than US experiences might suggest. Furthermore, Hurst et al. (1999, p. 101) conclude that most European banks will generally seek to exploit M&A possibilities in national markets before seeking cross-border opportunities. More bank consolidation, then, will be the likely product of EMU, but it 'may well be a very slow process' (ibid.).

Post-EMU strategies of Euroland banks will take many forms. For those handful that aspire to global status, the challenges (especially from the leading US investment banks) are formidable. Building a significant position in US securities is generally accepted as a necessary step for building leadership in investment banking.

Aspirant regional or multilocal players are also likely to be wholesale driven. Davidson et al. (1998) suggest that in the post-EMU environment, these banks have three basic options: sell all or part of their investment banking business; build a purely pan-European presence; or adopt a niche position. These kinds of banks have to examine carefully and exploit customer and product franchises in which they can sustain competitive advantages.

Local players are essentially retail focused; these banks should consider concentrating primarily on retail financial services. One problem here is that during an era of reform of pensions business, such institutions may want to provide mutual fund products and equity brokerage services to their customers. One option for the smaller players might be to form strategic link-ups. Another option for these kinds of players is to focus more strongly on core specialist and niche products. The latter may also be developed cross-border via internet and direct banking distribution channels.

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