Financial Intermediation in the 21st Century

Financial Intermediation in the 21st Century Edited by Zuhayr Mikdashi

Financial Intermediation in the 21st Century

Also by Zuhayr Mikdashi A FINANCIAL ANALYSIS OF MIDDLE EAST OIL CONCESSIONS, 1901–1965 BANKERS’ AND PUBLIC AUTHORITIES’ MANAGEMENT OF RISKS CONTINUITY AND CHANGE IN THE WORLD OIL INDUSTRY (with others) FINANCIAL STRATEGIES AND PUBLIC POLICIES: Banking, Insurance and Industry INTERNATIONAL BANKING: Innovations and New Policies THE COMMUNITY OF OIL-EXPORTING COUNTRIES: A Study in Governmental Cooperation THE INTERNATIONAL POLITICS OF NATURAL RESOURCES TRANSNATIONAL OIL: Issues, Policies and Perspectives

Financial Intermediation in the 21st Century Edited by

Zuhayr Mikdashi Professor of Banking and Financial Services University of Lausanne Switzerland

Editorial matter, selection and Chapter 25 © Zuhayr Mikdashi 2001 Chapter 5 © Prakash Shimpi 2001 Foreword and Chapter 9 © Institute of Banking and Financial Management (IBFM), University of Lausanne, 2001 Chapters 1–4, 6–8, 10–24 © Palgrave Publishers Ltd 2001 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2001 by PALGRAVE Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N. Y. 10010 Companies and representatives throughout the world PALGRAVE is the new global academic imprint of St. Martin’s Press LLC Scholarly and Reference Division and Palgrave Publishers Ltd (formerly Macmillan Press Ltd). ISBN 0–333–80201–2 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Financial intermediation in the 21st century / edited by Zuhayr Mikdashi. p. cm.

Includes bibliographical references and index.

ISBN 0–333–80201–2

1. Intermediation (Finance) 2. Financial services industry. 3. Banks and banking. I. Mikdashi, Zuhayr M. HG3891.5 .F56 2001 332’.042—dc21 2001021882 10 10

9 09

8 08

7 07

6 06

5 05

4 04

3 03

Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire

2 02

1 01

For a better world

This page intentionally left blank

Contents

List of Figures, Tables and Boxes

xiii

Acknowledgements

xv

Foreword by Jean-Pierre Roth

xvi

Notes on the Contributors

1

Introduction: Financial Intermediation in the Age of Global Capital Gary L. Perlin

PART I 2

3

xviii

1

THE NEW FINANCE ERA: CHALLENGES AND OPPORTUNITIES

Banking in the Twenty-First Century: the View from the Deutsche Bank Rolf-E. Breuer Introduction Current trends in the banking industry Bank strategies for the twenty-®rst century Conclusion: Banking in the twenty-®rst century The Internet and the Commercial Banking Industry: Strategic Implications from a US Perspective William C. Hunter Introduction Recent trends in the US banking industry Technological change and the industrial organisation of US banking markets Recent changes consistent with the predictions of modern industrial organisation theory Strategies for survival in an Internet banking world and the role of local banks Conclusion

vii

7 7 8 12 16

17 17 18 20 21 25 27

viii Contents

4 Three Imperatives to Foster as a Financial Institution in the

Euro Era Jan Huyghebaert First imperative: manage your costs Second imperative: offer your customers a global window Third imperative: develop the skills of your people The case of Almanij Innovation and growth 5

6

29

29

30

30

31

31

Integrating Risk Management and Capital Management Prakash Shimpi The role of corporate capital Capital resources Models of capital structure The changing function of risk management

33

IT and the Pressure to Innovate and Restructure Lars H. Thunnell Globalisation The IT revolution Where is technology heading? Growth ± but still low in¯ation Market change at the micro level Management faces new challenges Strong transformation pressure in the ®nancial sector Sweden at the cutting edge Conclusion

58

33

36

37

55

58

59

60

61

63

64

65

68

72

PART II FINANCIAL MARKETS: FUTURE DEVELOPMENTS 7 Global Finance Beyond 2000: SWX Swiss Exchange's

Challenge Antoinette Hunziker-Ebneter SWX Eurobonds ± the only fully automated platform Eurex Repo based on SWX technology The Internet exchange Easier access ± the new SWX trading system 8

On-line Trading is Changing the Capital Markets Matthias Leclerc The automation of markets Markets in transition

75

75

76

77

77

78

78

79

Contents ix

9

Electronic communication with clients Where will it lead? Summary

81 82 83

ABB as a Major User of Financial Markets Jan Roxendal

84

10 The Transformation of Stock Exchanges in Europe Dirk P. Tirez and Timothy Verhoest Introduction Status report on European stock exchanges Principal driving forces behind the structural change in European ®nancial markets Impediments to the establishment of a truly uni®ed European market Conclusion 11 What is the Future for Nationally or Regionally Based Financial Centres? Alec Tsui Challenges Response of exchanges

88 88 88 92 106 114

117 117 119

PART III REGULATORY/SUPERVISORY AUTHORITIES: STRENGTHENING FINANCIAL INTERMEDIATION AND SYSTEMS 12 The Basel Capital Requirements: a First Step Towards Global Regulation Andrew Crockett 13 New Tools and Risks in Financial Intermediation in Emerging Markets: Should Regulators and Raters Adopt New Methods? The Case of Asia Philippe F. Delhaise 14 The Role of the Financial Stability Institute of the Bank for International Settlements John G. Heimann 15 Switzerland and the Challenges of Globalisation BeÂneÂdict Hentsch

123

128

133

140

x

Contents

16 Does the World Need a New Financial Architecture? Lukas MuÈhlemann Analysis of the 1990s ®nancial market crisis Proposals for a new ®nancial architecture The role of the banks and private creditors Assessment of other reform proposals Switzerland's contribution Conclusion 17 Reform of the Global Financial System: A View from an

Emerging Economy Ali Muhamad Negm Setting better international standards Introducing greater transparency Supervising banking sector soundness The way forward 18 Global Finance Beyond 2000: Implications for Regulation

and the Supervisory Authorities Mikio Wakatsuki Financial globalisation and international cooperation Consolidation and conglomeration The IT revolution and ®nancial innovation

145

145

147

149

152

156

156

158

158

159

159

159

161

161

164

167

PART IV ACADEMICS' AND RESEARCHERS' VANTAGE POINTS 19 Reforming African Financial Markets in the Era of Globalisation Kpate Adjaoute An introductory perspective on African economies The need for further ®nancial market reforms Selected areas of focus Reforms and ®nancial market architecture: issues in

design Concluding remarks 20 Banking Regulation: Administrative Rules versus

Market-based Instruments Robert Bichsel Introduction A rationale for regulation The limitations of an administrative rule The contribution of market-based instruments Conclusion

171

171

173

174

181

184

186

186

187

188

190

196

Contents xi

21 Credit Risk: The New Frontier of Risk Management Didier Cossin The complexity credit risk Dif®culties that arise with ratings Recent theoretical literature on credit risk pricing Credit risk measurement for portfolios Conclusions

198

22 Banking: Is Bigger Really Better? Jean-Pierre Danthine A long, strange trip Why so big? Big egos Scale and scope economies May justify the `big', not the `mega' A Brand new world? Size as a by-product `Conspiring against the public' Conclusion: Is mega too big?

209

23 Turbulence, Crises and Risk Management Salih Neftci Introduction Managing risks Portfolio aspects Measuring the risks of a balance sheet Volatility dynamics and VaR Another tool: extreme value theory Conclusion

220

24 The Quest for the Optimal Portfolio: The Example of

Investment Funds Nils Tuchschmid Investment funds and portfolio management: some

theoretical justi®cations The investment fund industry: the end of a golden age?

PART V

199

201

203

205

208

209

211

212

212

213

215

216

217

217

220

224

227

228

230

233

234

236

237

240

CONCLUSION

25 Whither Financial Intermediation? Managerial and

Regulatory Issues Zuhayr Mikdashi Competition and innovation Corporate strategies

249

249

253

xii

Contents

Risk management Mutations in ®nancial markets Security concerns Public intervention Financial stabilisation Conclusion Index

258

267

274

275

291

300

309

List of Figures, Tables and Boxes

Figures 5.1 5.2 5.3 5.4 8.1 8.2 8.3 20.1 21.1 21.2 21.3 21.4 21.5 23.1 23.2 23.3 23.4 25.1 25.2 25.3 25.4 25.5 25.6 25.7 25.8

Simulation of a ®rm's capital requirement The standard model The insurance model The insurative model Automation of capital markets E-markets Electronic communication with clients Swiss banks: capital ratios, 1989±98 Typical returns from a credit instrument and equity Value of a bond, depending on interest Reimbursement of a zero coupon, depending on the value of assets Payoff for the levered equity E as a function of the value of the assets V Payoff for the credit risky debt D as a function of the value of the assets V A hedged option position Final result of the hedge A reversal Final position The dynamics of competition in a ®nancial space Credit default swap Flow of decisions in the management of a ®nancial ®rm Major stakeholders affecting corporate governance in a ®nancial ®rm External in¯uences on a ®nancial ®rm Components of a risk-management process Main elements in the pricing of a loan Supervision and control

36 38 44 52 79 80 81 190 200 201

256 258 260 262 278

One-year transition matrix Mergers and acquisitions in the banking sector Top 20 US and European banks, as of November 1998 Select survey of cross-country bank ef®ciency studies

202 210 211 214

201 204 205 221 222 223 223 250 252 255

Tables 21.1 22.1 22.2 22.3

xiii

xiv List of Figures, Tables and Boxes

Boxes 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 6.1 25.1 25.2 25.3

Return on equity for company Alpha Return on equity for company Beta Weighted-average cost of capital for companies Alpha and

Beta ROE for companies Alpha and Beta with no insurance if all

assets earn 16 per cent Alternative calculation of insured ROE if all assets earn

16 per cent Uninsured ROE if new assets earn 7 per cent Total average cost of capital (TACC) for insurance model TACC for uninsured companies Alpha and Beta Risk related to capital in the insurative model Relationship of TACC to WACC Steps in determining a ®rm's debt±equity mix Summary of the new technologies that are transforming the

®nancial sector Strategies of a ®nancial ®rm Sources of a ®nancial ®rm's potential risks A new space of stability ± Euroland

40

41

43

46

47

48

50

51

52

54

55

66

254

261

301

Acknowledgements

A constellation of international ®nancial leaders, regulators and researchers have contributed to this original volume, unpublished papers that distil their rich experience and cutting-edge expertise. Their considered re¯ections on past events and their informed views on future developments make for the exceptional and lasting value of this book. The genesis of most of the chapters was a brainstorming dialogue among ®nancial personalities towards the end of 1999 at the University of Lausanne. Besides the gratitude owed to the contributors to this volume, thanks are due to the scores of persons who sustained the efforts of the editor during the realisation of the project, notably the chairman of the IBFM, Dr Jean-Pierre Roth, members of the IBFM Council and faculty, and the editor's graduate assistants ± Veronica Velo and Alexei Pachkov, who helped with the compilation of the documents. Keith Povey's editorial services (with Anne Vickerson and Marilyn Hamshere) deserve particular commendation, along with the surport of Nicola Viinikka at Palgrave. The book is intended for a wide array of readers: policy makers, decision makers, professionals and users of ®nancial services, as well as students and academics. April 2001

ZU H A Y R MI K D A S H I

xv

Foreword

More than ten years ago a group of professors at the Graduate School of Management and Economics, University of Lausanne, decided to expand teaching and research in ®nance. They recognised the central role of ®nance in modern management and the need to provide better education for their students. In this respect they played a pioneering role that was in line with the long tradition of the University of Lausanne as a centre of modern economic thought, with Le on Walras and Vilfredo Pareto as ®gureheads. The Institute of Banking and Financial Management (IBFM) was created on 29 June 1989. It was at ®rst devoted to research and the organisation of seminars for practitioners, but in 1993 it launched a master's degree in ®nance, the ®rst graduate programme of its kind in Switzerland. Since its inception the programme has been widely recognised for its quality. By 1999 some 120 graduate students from the best universities had attended it. All this would not have been possible without the commitment of the faculty members, especially Professor Mikdashi and his successors as director of the Institute, and without the generous ®nancial support of local banks and the University of Lausanne. Professors and sponsors deserve the acknowledgement of generations of students and seminar participants. Following its vocation as a centre of research, learning and exchange in the area of ®nance, the IBFM decided to mark its tenth anniversary by holding a conference at which practitioners and academics could exchange views on the challenges facing ®nancial markets today. The response was extremely positive. Financial leaders representing banks, insurance companies, exchanges, central banks, regulators and international institutions met for a full day to share their experiences and visions in their quiet atmosphere of the campus of the University of Lausanne. Their debates were structured around the three following themes.

The new ®nance era The start of the twenty-®rst century has coincided with major structural changes in ®nancial markets. Worldwide liberalisation has led to globalisation and disintermediation. The free ¯ow of capital and technical progress in telecommunications have eliminated national borders. National ®nancial systems have become parts of global markets, and banks no longer hold an exclusive position as ®nancial intermediaries. Moreover Europe has moved towards monetary union, ten currencies having been replaced by the euro. A large, strong and liquid euro ®nancial market has now emerged. xvi

Foreword xvii

What challenges and opportunities have been created by the new global framework? Will banks survive? How will they compete with other institutions that provide ®nancial services? Will the Internet eliminate bank counters?

Whither ®nancial centres and markets? Global competition for capital as a scarce resource is a clear challenge for ®rms and exchanges. National exchanges are ®nding it dif®cult to maintain their attractiveness. Alliances and mergers are clear signs of the need for restructuring. In Europe, the introduction of the euro has even stimulated rivalry. Temporary competitive advantages are being provided by technological progress in data processing. Is there a future for national exchanges? How will exchanges be able to meet investors' needs in the new architecture? Are alliances long-lasting solutions?

Implications for the regulatory/supervisory authorities Supervision is still a national responsibility, although a move towards international cooperation is observable. Global ®nancial stability remains a major issue for the IMF and central banks. The Basle Committee of the BIS plays a catalytic role as a promoter of sound banking rules. However, given the increasing complexity of ®nancial transactions and the dif®culty of supervising all types of ®nancial institution on the same footing, systemic risks cannot be excluded. How can we protect and strengthen ®nancial systems? Can the BIS rules be implemented worldwide, across ®nancial systems with different levels of development? What are the respective roles of market discipline and regulation? Can global players be supervised by national authorities?

The IBFM wishes to thank all those who took part in the discussions at Lausanne and is pleased to publish the majority of the contributions, as well as speci®c essays written to mark its tenth anniversary. The concluding chapter draws some general conclusions. The IBFM board also expresses its gratitude to Professor Zuhayr Mikdashi, who took on with enthusiasm both the organisation of the conference and editorial responsibility for this book. JE A N -PI E R R E RO T H Chairman of the IBFM Council

Notes on the Contributors

Kpate Adjaoute is Senior Quantitative Analyst in the Quantitative Research and New Product Development Department at Morgan Stanley Capital International. Until 1999 he was Assistant Professor of Finance at the Ecole des HEC, University of Lausanne. He has a PhD in Economics (Finance) and an MSc in international management, both from the Ecole des HEC, University of Lausanne, and a master's degree in ®nancial management from the University of Tunis III. He has been a Visiting Scholar at the Graduate School of Business, Columbia University, Adjunct Assistant Professor of Finance at the City University of New York (Baruch College), and a research and teaching assistant in ®nance at the Ecole des HEC, University of Lausanne. He is also a member of the European Finance Association. Robert Bichsel has been an Economist at the Swiss National Bank and lecturer at the University of Lausanne, Switzerland since 1999, having also been a lecturer at the Universidad de Guanajuato, Mexico. He holds a doctoral degree and a master's degree in Economics from the University of Lausanne. Rolf-E. Breuer is Spokesman of the Group Board at Deutsche Bank AG, which he joined in 1966, ®rst at Karlsruhe Branch until 1969, then at Central Of®ce (Frankfurt), Investment and Trading Department, becoming Senior Vice President and head of the Investment and Trading Department in 1974. In 1985, he became Deputy Member of the Board of Managing Directors and was appointed full Member in 1987. Since 1997 he has been Spokesman of the Group Board. He studied law at the Universities of Lausanne (Switzerland), Munich and Bonn, and obtained a doctorate (Dr. jur.) in 1966. Didier Cossin is Professor of Finance at the Ecole des HEC and Director of the Institute of Banking and Financial Management of the University of Lausanne. He holds a PhD in business economics from the Harvard Graduate School of Business Administration and the Department of Economics, Harvard University. He is a former Visiting Scholar, Department of Economics, Massachusetts Institute of Technology (Fulbright Scholar) and holds DEA d'Economie MatheÂmatique, EHESS-ENSAE; Master's in Econometrics, Paris I, PantheÂon-Sorbonne and Ancien EleÁve de l'Ecole Normale SupeÂrieure (rue d'Ulm), Paris. He is a member of the American Finance Association (AFA) and the Eastern Finance Association (EFA). His research interests are the optimal control of credit risk and guarantees (with applications in corporate ®nance and ®nancial intermediation), ®nancial intermediation and corporate governance. xviii

Notes on the Contributors

xix

Andrew Crockett has been General Manager of the Bank for International Settlements since January 1994 and Chairman of the Financial Stability Forum since April 1999. From 1972 to 1989 he was a staff member of the International Monetary Fund, and from 1989 to 1993 an Executive Director of the Bank of England. In the latter capacity, he was a member of the Monetary Committee of the European Union, Alternate Governor of the International Monetary Fund for the United Kingdom, and a member (subsequently Chairman) of Working Party 3 of the OECD. He is also a member of the Group of Thirty. He was educated at Cambridge and Yale Universities. Jean-Pierre Danthine is Professor of Economics at the Ecole des HEC, Lausanne University, Director of FAME (International Center for Financial Asset Management and Engineering). He has a Licence and Master's in econometrics from the University of Louvain, and an MSc and PhD in economics from Carnegie-Mellon University, Pittsburgh. He is a CEPR Research Fellow and a member of the Executive Committee, a member of the Council of the European Economic Association, a member of the Scienti®c Council of the CFPI (Centre for Professionals in Investment Training), and Associate Editor of the Journal of Empirical Finance and the Revue Finance. Previously he was Associate Professor at Columbia University, Vice-Rector of Laussane University and a member of the Macroeconomic Policy Group, CEPS, Brussels. His research interests are macroeconomics and ®nance, nonWalrasian models of growth and ¯uctuations, ®nancial theory and capital market analysis, with special emphasis on issues raised by asymmetric information. Philippe F. Delhaise was President of BankWatch Asia until 1999. There he headed a team of analysts who monitors over 300 banks in 16 Asian countries for the bene®t of the international investment and ®nancial community. He has produced numerous research papers on banking risk in Asia. His many speaking engagements around the world for various associations and conference groups have con®rmed him as a specialist of ®nancial risk in Asia. For 15 years he worked as a bank manager in Beirut, Tehran, Tokyo, Singapore and Hong Kong before establishing several companies in Hong Kong and Singapore to service the banking industry. Among these was Asia's ®rst regional bank rating agency: Capital Information Services Limited, which became the basis of the Asia division of Thomson BankWatch. He grew up in Belgium, where he obtained degrees in engineering, economics and philosophy. He later earned an MBA at the University of Chicago. John G. Heimann has been Chairman of the Financial Stability Institute of the Bank for International Settlements since 1 February 1999. He assumed this post upon his retirement as Chairman of the Financial Institutions

xx Notes on the Contributors

Group at Merrill Lynch, where he was also member of the ®rm's executive management committee. He began his career at Smith Barney in 1957, and became a founding partner of E. M. Warburg Pincus in 1967. In 1975 he served as Superintendent of Banks for the State of New York and the following year held the position of Commissioner at the New York State Division of Housing and Community Renewal. He was also a member of the board of the New York State Housing Financing Authority and the New York State Urban Development Corporation. While serving as US Controller of the Currency from 1977±81, he was a member of the board of directors of the Federal Deposit Insurance Corporation, serving as Chairman for an 11 month period, and of the Federal National Mortgage Association, as well as serving as the ®rst Chairman of the Federal Financial Institutions Examination Council. He graduated from Syracuse University in 1950 with a BA in economics. In 1979 he received a Doctor of Law degree from St Michael's College in Vermont. BeÂneÂdict Hentsch has been Managing Partner at Darier Hentsch since 1985 and at Hentsch Henchoz in Lausanne since 1989. He spent seven years with J. P. Morgan, working in Brazil and New York. He is a member of various boards and associations, including SAirGroup, Sabena, Swiss Re, the daily newspaper Le Temps and the Geneva private bankers' group. He is also Chairman of the Association of Swiss Private Bankers. He has been actively involved in a variety of local projects, including the construction of the Geneva stadium, the renovation of Uni-Dufour (Geneva) on the occasion of its bank's bicentenary and the plan for the political union of the Vaud and Geneva cantons. He received a degree in economics from the University of St Gallen, Switzerland. William C. Hunter is Senior Vice President and Director of Research at the Federal Reserve Bank of Chicago. He is a member of the Bank's management committee and also serves as Chief Economic Advisor to the bank's President. Prior to joining the Chicago Reserve Bank, he was a Vice President in charge of basic research at the Federal Reserve Bank of Atlanta, where he also managed the ®nancial markets group. He has held faculty positions in many well-known American universities and has consulted with numerous government agencies and private corporations. In 1982 he was a Visiting Professor at the Board of Governors of the Federal Reserve System in Washington, and in 1983 lectured at the NATO Advanced Study Institute, Anacapri, Italy. He has served as a US Treasury Advisor to several monetary authorities in Europe and Asia. He is currently Co-Editor of Research in Banking and Finance and Associate Director of several important academic journals, having published more than 60 articles in leading ®nance and economic journals. He holds a BSc from Hampton University and an MBA and PhD from Northwestern University.

Notes on the Contributors

xxi

Antoinette Hunziker-Ebneter has been Chief Executive Of®cer of the Swiss Exchange SWX and head of the Market Division since December 1997, prior to which she headed the Swiss Exchange's Management Services Division. From 1985 to 1986 she was a currency options trader at Citibank in Zurich and was a member of the Trading User Approval Group in the SOFFEX development phase. She traded the ®rst Swiss interest rate option. Between 1987 and 1992 she worked at Bank Leu, Zurich, where she built up trading and sales in derivative securities products, and integrated these with the trading department for core products equities and bonds. As a member of senior management, she ran the entire securities division, including the issues department. In 1990 she received a Stock Exchange Licence, thus becoming the youngest (and the ®rst female) representative on the Zurich Stock Exchange. From 1993 to 1995 she worked as an independent advisor and instructor for banks and companies in the ®elds of securities trading and sales, derivative products, risk management and electronic exchanges. She received an economics degree from the University of St Gallen, where she majored in banking studies. Jan Huyghebaert has been Chairman and Chief Executive Of®cer of the Almanij±Kredietbank Group since 1991. Previously he was Of®cial Delegate to the Of®ces of the Science Policy (1970±74), an advisor to the Cabinet of Prime Minister Leo Tindemans (1974±78), Alderman for the Port of Antwerp (1978±85), and President of Kredietbank (1985±91). At present he is also Chairman of Kredietbank Luxembourg, CBC Banque, General Biscuits and Alken-Maes Breweries, and member of the board of KBC Bank and Insurance Holding Company, KBC Bank, KBC Insurance, Kredietbank (Suisse), AlcatelBell, Agfa-Gevaert, Gevaert, Bekaert and Sabena, and Vice President of the Flemish Economic Association and the Federation of Belgian Industry. In 1993 King Baudouin conferred on him the title of Baron. He obtained degrees in philosophy and literature from St Ignatius University, Antwerp (1965), and holds a Doctor of Law degree from the Catholic University in Louvain (1968). Matthias Leclerc has been Head of E-Commerce Investment Banking at Dresdner Kleinwort Benson since September 1999. He started his career as Project Manager of a large software development project at Siemens in Munich. After working for a small German bank he moved to Dresdner Bank in Frankfurt, where he spent several years as Head of IT and as Chief Operating Of®cer for Global Markets. He studied mathematics and business administration at the Universities of Giessen, Waterloo (Canada) and Cologne, and is Adjunct Professor at the University of Augsburg. Zuhayr Mikdashi is a Professor at the University of Lausanne. Prior to this he was Research Fellow at the Harvard University Centre for International Affairs,

xxii Notes on the Contributors

Resources for the Future (Washington DC) and The Japanese Institute for Developing Economies (Tokyo); Visiting Professor at the Indiana University Graduate School of Business Administration; tenured Professor at the American University of Beirut; consultant at the World Bank and other international organisations; and Expert-Advisor at the United Nations Center on Transnational Corporations (New York). He also organised international banking and ®nancial colloquia at the Ecole des HEC, leading to the creation of the Institute of Banking and Financial Management in 1989, where he served as Director until 1993. His degrees include a BA and an MA in economics (American University of Beirut), an M.Litt. and D.Phil. in economics and international relations (Oxford University) and a diploma in ®nancial management and control (International Centre for the Advancement of Management Education, Graduate School of Business Administration, Stanford University). Lukas Mu È hlemann is Chairman and Chief Executive Of®cer of the Credit Suisse Group in Zurich and is Chairman of the board of directors of Credit Suisse and Credit Suisse First Boston. From 1973 to 1975 he worked at IBM in systems engineering and marketing. In 1977 he joined the management consulting ®rm McKinsey, where he was elected a Principal in 1982 and a Director in 1986. In 1989 he was made Managing Director of McKinsey's Swiss of®ces, and in 1990 he became a member of the board of directors of McKinsey in New York. He joined Swiss Re in September 1994 as Chief Executive Of®cer and was made Managing Director in November 1994. In November 1996 he was elected Deputy Chairman. At present he serves on the boards of SAirGroup (Zurich), Banco General de Negocios (Buenos Aires), the Tonhalle Foundation (Zurich) and the Zurich Operahouse. He is also President of the Harvard Club of Switzerland. He studied business law at St Gall University in Switzerland from 1969 to 1973, and business administration at the Harvard Business School from 1975 to 1977. Salih Neftci completed his PhD at the University of Minnesota. He currently teaches at the Graduate School, City University of New York and is head of the FAME Certi®cate programme. He also has a visiting appointment at the ISMA Centre, Reading University, UK, and teaches occasionally at the FAME PhD programme. His research and teaching is in the areas of ®nancial engineering, risk management of extreme events and in emerging market asset trading strategies. His latest paper deals with risk measurement using extreme value theory, the notion and estimation of volatility with fat tailed distributions and with contingent capital. He has also published a well known book `An Introduction to the Mathematics of Pricing Financial Derivatives' ± one of the standard texts in university derivatives courses. He is a consultant to various ®nancial institutions and teaches high level courses on cutting edge issues to advanced ®nancial market professionals.

Notes on the Contributors xxiii

Aly M. Negm is Chairman and Managing Director of Delta Bank International, Egypt. He has also served as Governor of the Central Bank of Egypt, Governor for Egypt at the African Development Bank and the African Development Fund, Alternate Governor for Egypt at the International Monetary Fund (Washington), Vice-Chairman and Managing Director of the Arab International Bank (Cairo), Chairman of the Union des Banques Arabes Francaises (Paris), and Chairman of the UBAF±Arab American Bank (New York). He has been widely honoured, receiving an Ordre National de Merite in France, where he was also made a Chevalier dans l'Ordre National de la Legion d'Honneur; a Commendatore Dell'Ordine Al Merito in Italy; and a Commandor's Cross of the Order of Merit in the Federal Republic of Germany. He is an elected Fellow of the International Bankers' Association (Washington DC). He holds a BSc in commerce and an MA in public ®nance from Cairo University. Gary L. Perlin is Senior Vice President and Chief Financial Of®cer at the World Bank. He has overall responsibility for the ®nancial management of the IBRD and IDA. He also chairs the Asset and Liability Management Committee and the Pension Finance Committee. He ®rst joined the World Bank in 1975 under the Young Professionals Programme, serving as an economist from 1975 to 1978. Prior to his return to the World Bank in 1993 (becoming Director of the Financial Section Development Department and the Vice president and Treasurer of the Bank), he served as Senior Vice President of Finance and Treasurer of the Federal National Mortgage Aassociation. He was educated at Georgetown University's School of Foreign Service, the London School of Economics, and Princeton University's Woodrow Wilson School of Public and International Affairs. Jean-Pierre Roth is Chairman of the governing board of the Swiss National Bank. He joined the bank's economic staff in 1979, and for more than 15 years he worked in various sections of the bank in Bern and Zurich. In his capacity as Deputy Head of Department in Bern he was responsible for business involving capital market, banknotes and business relations within the confederation. From 1986 to 1996 he was in charge of the SNB's monetary operations in the foreign exchange and money markets. He studied economics at the University of Geneva, followed by doctoral studies at the Graduate Institute of International Studies (Geneva) and postgraduate studies at the Massachusetts Institute of Technology. After his return to Switzerland he held lectureships at the University of Geneva and the Graduate Institute of International Studies. Jan Roxendal has been President of the ABB's Financial Services Business Segment since 1991. In August 1998 he was appointed Executive Vice President of ABB and a member of the ABB Group's executive committee. Prior to this, in 1973 he joined Skandinaviska Ensiklda Banken (Stockholm) where

xxiv Notes on the Contributors

he received his basic training and gained experience in banking; a period that also included studies organised by the Association of Swedish Banks. From 1981 to 1984 he worked as an Assistant Treasurer at Swedish Export Credit (SEK), which gave him further opportunities to expand his knowledge of international ®nance and global capital markets. At the beginning of 1984 he left SEK to take up a position at ASEA, where he was given the task of building up a modern treasury operation. In 1988, following the merger between ASEA and Brown Boveri, he moved to Switzerland to establish a global treasury organisation as a pro®t centre. During his time at ABB he has served as Chairman of the Board of various ABB companies, and was a member of the board of ABB Norway from 1992 to 1998. Prakash Shimpi is Managing Principal (US) at Swiss Re New Markets, the alternative risk transfer and risk ®nancing division of Swiss Reinsurance. He is Chairman of the division's Strategy Committee and head of product development. He joined Swiss Re in 1995 to form the company's Financial Solutions Group and develop its structured ®nance and capital market activity. The unit, which became part of Swiss Re New Markets in 1997, pioneered the development of insurance-linked securities and other products that re¯ect the convergence of the insurance and capital markets. Prior to joining Swiss Re he was a Managing Director in the Global Insurance Corporate Finance Division of Chase Manhattan Bank, with responsibility for asset and liability management advisory services as well as derivatives transactions. He was also involved in the analysis of leveraged ®nancial transactions. He has also served as Vice President and Manager of the Insurance Portfolio Strategies Group at Drexel Burnham Lambert. He holds a BSc in economics and statistics and an MSc in operational research from the London School of Economics and Political Sciences, an MBA in ®nance and international business from the University of Chicago and is a Fellow of the Society of Actuaries. He also holds a certi®cate in actuarial techniques from the Institute of Actuaries (UK) and is a chartered ®nancial analyst. Lars H. Thunell is President and Chief Executive Of®cer of Skandinaviska Enskilda Banken. From 1977 to 1983 he worked for American Express in New York, reaching the position of Vice President of Financing and Chairman of American Express's Overseas Credit Corp. In 1983 he joined Asea AB, VaÈsteras (Sweden), reaching the position of Executive Vice President, Finance. In 1987 he moved to Asea Brown Boveri in Zurich where he became Executive Vice President and a member of the group's executive management. After returning to Stockholm in 1991, he worked for Nordbanken (as Executive Vice President and Deputy Chief Executive Of®cer), Securum (as Chief Executive Of®cer) and Trygg-Hansa (as President and Chief Executive Of®cer). He is currently a member of the board of several institutions, such as the Swedish Bankers Association, Akzo Nobel SNS, Centre for Business and Policy Studies, and the

Notes on the Contributors xxv

Swedish Industry and Commerce Stock Exchange Committee. He obtained a PhD from the University of Stockholm in 1977, and was a Research Fellow at Harvard University's Center for International Affairs between 1975 and 1976. Dirk P. Tirez is Executive Vice President, General Counsel and Company Secretary of EASDAQ and a Founding Executive of EASDAQ working with the company since its inception in 1996. In 1989 he joined the international law ®rm Cleary, Gottlieb, Steen and Hamilton, working in the New York and Brussels of®ces as an attorney, and was admitted to the New York bar. In 1991 he joined the Brussels of®ce of the Washington DC-based ®rm Covington & Burling and became a member of the Brussels bar. From 1973 to 1996 he was legal advisor to the Cabinet of the Belgian deputy prime minister, minister of ®nance and foreign trade, Philippe Maystadt, in charge of banking and ®nance legislation and the Belgian privatisation programme. He has published a number of articles on European and national ®nancial laws and regulations. He also teaches banking and ®nance laws and regulations at the University of Namur. In 1987 he graduated magna cum laude from the Katholieke Universiteit Leuven, in 1988 from the College of Europe in Bruges, and in 1989 from the University of Michigan, Ann Arbor. Alec Tsui was Chief Executive of the Stock Exchange of Hong Kong from 1997 to 2000. He joined the Exchange in 1994 as Executive Director of the Finance and Operations Services Division, and was promoted to Deputy Chief Executive, Operation Services, in 1996. Between 1989 and 1993 he was General Manager (Finance, Technology and Human Resources), and then Assistant Director (Licensing) and General Manager (Human Resources) of the Securities and Futures Commission. During the previous 12 years he worked for several large private organisations. He is also a member of the Stock Exchange's Listing Committee, Director of the Hong Kong Securities Clearing Company, Director of the Hong Kong Securities Institute, Director of the Financial Executives Institute (Hong Kong) and a member of the Standing Committee on Company Law Reform. He possesses a BSc and M.Eng. in industrial engineering from the University of Tennessee, and has completed the programme for senior managers in government at the John F. Kennedy School of Government at Harvard University. Nils Tuchschmid is Adjunct Director at Banque Cantonale Vaudolse (Switzerland). Previously he was Director of Synchrony Asset Management in Geneva and has been Associate Professor of Finance at the Ecole des HEC, Lausanne University, Director of the MBF programme until August 1999, research and teaching assistant at the University of Geneva, Assistant Professor at the Ecole des HEC at Lausanne University, and a visiting scholar at the Wharton School of the University of Pennsylvania and the ®nance department of the University of Georgia. He is a member of the European Finance

xxvi Notes on the Contributors

Association. His main research interests are portfolio management and asset allocation, performance measurement, and domestic and international asset pricing models. He holds a Licence, Diploma and PhD in economics from the University of Geneva. Timothy Verhoest joined EASDAQ as Vice-President of the Admissions Department in January 2000 having previously been associated with the law ®rm Dieux Geens Cornelis from 1996 to 1999, where he worked in the Brussels of®ce as a member of the Brussels bar dealing primarily with matters of corporate and ®nancial law. From 1998 onwards he has been working as parttime Assistant Professor of the Department of Corporate Law of the Katholieke Universiteit, Leuven, where he is involved in various teaching and scienti®c assignments. He graduated in 1996 cum laude from the law faculty of the Katholieke Universiteit, Leuven and in 1998 magna cum laude from the Katholieke Universiteit, Brussels (advanced degree in corporate law). He is the author of several articles regarding matters of corporate and ®nancial law. Mikio Wakatsuki has been Chairman of the Board of Counsellors of the Japan Research Institute since July 1993. In 1956 he started long and distinguished career with the Bank of Japan, holding numerous positions. He was made Alternate Executive Director of the International Monetary Fund in 1973 and served in that capacity for three years. From 1982 to 1984 he was the Bank of Japan's chief representative in the Americas, headquartered in New York, and then became Director of Research and Statistics. In June 1990 he was made Executive Director of the bank, and in the same year began a three-year posting as Deputy Governor for International Relations, serving as senior advisor to the Governor in May±June 1993. He attended the University of Tokyo and received an LL.B in 1956. From 1959 to 1960 he attended the Graduate School of Economics at Stanford University, where he was a Fulbright Scholar.

1

Introduction: Financial Intermediation in the Age of Global Capital Gary L. Perlin

In order to assess the likely nature of ®nancial intermediation in the twenty®rst century, it is necessary to begin by describing the state of ®nancial intermediation at the close of the twentieth century and the challenges facing it. I suggest we focus on matters of risk rather than on the associated businesses of aggregating funds, processing payments and so on. Most importantly, capital is now global, and this capital is increasingly and irreversibly intermediated through markets, not through bankers' balance sheets. Information and communications engineers have provided capital market participants with immediate access to each other. Financial engineers have provided the instruments with which to transact business through these channels. And policy engineers have developed, typically from their national base, an evolving and increasingly deregulated global system. Unfortunately changes by policy makers and regulators are not often synchronised, introducing a degree of friction and occasionally some tempting opportunities. Regulators often respond only to crisis, to competition and sometimes to fashion. We are blessed with a highly robust system, but one which needs a push to change it now and then. Investment capital often seeks returns through national institutions and in regional markets, but its perspective is global. And unlike the capital that backs bank balance sheets, this capital is not always levered. It represents long-term savings, able to bear more risk than those of banks' balance sheets. It demands, attracts and rewards tradable instruments that become standardised by markets and constitute highly diversi®ed portfolios hungry for risks and their expected returns. Global capital has brought pressure to bear on traditional intermediaries in more ways than one. It has supplanted much of the risk intermediation role formerly played by banks, of course. But global equity capital has also increased pressure on traditional intermediaries to perform. It rewards the promise of sustainable earnings growth rather than impressively sized balance sheets. In turn we see banking institutions voluntarily deploying more of their capital away from longer-term intermediation risks, in which it is dif®cult to 1

2

Introduction

sustain a competitive vis-aÁ-vis ef®cient capital markets. The capital instead goes towards building competitive advantage in human and information capital. This is often associated with increasing returns to scale to reduce costs and support investments in technology. Indeed banks and other ®nancial intermediaries are becoming `portals' to the `internet' of commodity-like, riskbearing markets. Which leads me to the second of the two characteristics I see in ®nancial intermediation; the obvious and possibly inherent volatility of markets. I say `possibly inherent' because of systemic developments and changes in market structure. On the systemic side, we see explosive growth in the volume of crossborder ¯ows, clearly no longer linked to trade. In developing countries we witness not only increasing ¯ows but also a shift in their composition. The postwar development model of transferring capital resources from government to government has largely been replaced by private sector ¯ows to governments and emerging private ®rms. And we have learned how volatile these ¯ows can be, falling by some 60 per cent from a high of $335 billion in net private ¯ows in 1996 to $135 billion in 1999, according to the Institute of International Finance. Direct equity investment held up, but net private credit ¯ows in this same period were expected to fall from a positive $207 billion to a negative $6 billion, with commercial banks being net exporters of funds from the developing countries and portfolio investors providing only $23 billion. It should also be noted that this amount is still larger than net ¯ows from all international ®nancial institutions, including the World Bank. Clearly this reaction has its roots in a changed market structure. Institutional investors now dominate, and although they often place long-term funds they have a very short-term perspective on relative performance, which can encourage large-scale risk taking by competitors who are reassured by the similarity of each other's actions. At the other end of the spectrum, but moving in the same direction, are the individual investors in OECD countries who increasingly participate in savings and de®ned contribution plans, and who are advised to seek long-term returns by increasing their exposure to risk. Taken together, these ¯ows can be very large in relation to the size and institutional capacity of the markets into which they ¯ow. Even more dangerously, however, they may have little information content. Rather than re¯ecting underlying economic fundamentals, they are just as much a product of rapidly changing risk appetites, and therefore risk premia. I am certainly not the ®rst to observe that risk premia seem to decline to their lowest levels just before a crisis. Investors who miss out on the capital gains earned by pioneers in new markets overlook fundamentals in an effort to achieve their return through leverage or excessive risk taking. Indeed it is uncomfortable to suggest that markets can be wrong or inef®cient, but they undeniably have a history of overshooting. In this way they can fool all but the most accomplished of credit analysts. But who is rewarded for ®ghting the

Gary L. Perlin 3

tape? And market structure ± limited two-way liquidity, quickly shifting risk and leverage targets ± breeds the kind of contagion of euphoria and fear we have seen in various measures over the last few years. Against this background, then, what will ®nancial risk intermediation be responding to in the twenty-®rst century? Assuming that capital will remain a global commodity, I would look for the following: First, a reasonably high level of volatility. Those who take risks will need long-term investment horizons (for example individual savers or pension fund managers with young participant populations), or the ability to of¯oad risk in traded markets, or deep pockets and very forgiving shareholders. My educated guess is that the latter will not prevail. Second, I would expect ®nancial intermediation to focus on credit, as market risks will continue to be hedged in commodity-like fashion. This means investing in information, at least as much as ®nancial intermediaries can recover in their pricing of credit. Although many institutions are currently competing for the best credits with new technologies, more sustainable opportunities should appear at both the lower end of the credit spectrum in OECD countries and, perhaps even more attractively, at the higher end of the credit spectrum in developing countries. Creative repackaging of credit through pooling mechanisms and related enhancements will be an important competitive product for successful intermediaries. This is what will make some `portals' succeed where others fail. Third, effective intermediation will require mechanisms that permit regulators and supervisors to manage that which they cannot (or dare not) control. They will have to deal with generalised liquidity events, often arising out of seemingly isolated credit events. They will have to continue to be vigilant about preventing systemic risk, providing time for leveraged borrowers to restructure and for leveraged investors to unwind ± and to do all this according to a formula that does not reward imprudent behaviour. I have no speci®c formula in mind, other than saying that risks are easier to manage before they materialise. Fourth, there will continue to be a place for of®cial credit institutions at the international, regional and national levels. Credits that now appear to be no better than marginal will be crucial to economic growth and to the aspiration I believe we all share to lift out of poverty the 1.2 billion people living on less than $1 a day and the 2.8 billion people living on less than $2. Our joint challenge is to make sure that of®cial credit opens markets rather than distorts them, and that our public institutions complement private ¯ows rather than supplant them. What will ®nancial institutions look like as they deal with the challenges of ®nancial intermediation in the twenty-®rst century? Where will they be located, assuming they are not exclusively on-line? How will they be regulated? On these questions I dare not speculate. The other contributors to this volume are in a better position to do so ± and the decisions are in their hands!

This page intentionally left blank

Part I The New Financial Era: Challenges and Opportunities

This page intentionally left blank

2

Banking in the Twenty-First Century: the View from the Deutsche Bank Rolf-E. Breuer

Introduction Foretelling the future is always a highly speculative task and one that involves many pitfalls. For example there is often a tendency to underestimate the achievements of past generations and to overestimate technological progress, although in today's banking industry the opposite seems to be the case. Another pitfall is to extrapolate existing trends into the future without paying attention to the conditions and circumstances for business. Indeed many forecasts tell us more about the present and the recent past than about the future. Looking back over the twentieth century, one of the main observations is the dominant impact of world politics on banking. By 1899 our greatgrandfathers, armed with ledger books and telegraphs, had managed to create an extensive world capital market. But this succumbed to the political turmoil of the two world wars, the Cold War and long periods of capital control, and was only restored in the 1990s. Of course a view on banking in the twenty-®rst century requires some assumptions about world politics. However it does not seem unrealistic to assume that the politically globalised `one world', with the world-wide dominance of market principles and the trend towards a global rule of law, will continue into the twenty-®rst century. In the banking industry itself, much has changed since the days of the gold standard, although the basics have stated remarkably constant over the last hundred years. However it would be totally wrong to extrapolate this into the twenty-®rst century. Today the Internet and e-commerce pose a dramatic threat to traditional `brick-and-mortar' banking. On the other hand, where there is risk, there is opportunity ± provided strategic decisions are based on the correct information.

7

8

Banking in the Twenty-First Century

Current trends in the banking industry Globalisation, deregulation and disintermediation In the twentieth century, in most countries domestic banking was generally subject to heavy regulation, while international banking had to cope with the restrictions of capital controls. Today the process of deregulation and the world-wide removal of restrictions on international capital movements have led to the integration of global capital markets. The possible removal of the Glass±Steagall Act in the US (which has long been largely ineffective anyway) and the `Big Bang' in the Japanese ®nancial market are evidence of this. The reduction of barriers to trade and ®nance is allowing the rapid dissemination of products and services throughout the world. Also, the world-wide harmonisation of banking supervision law following the Basle process has provided an opportunity to create a level playing ®eld in all markets. In this respect, the current reform of the Basle Capital Accord of 1988 is a great step forward. It aligns supervisory law much more closely with banking practice, the assessment of risk is becoming more differentiated, and regulatory capital is being brought more into line with economic capital, which is really the decisive yardstick for banks. The integration of world capital markets has been accompanied by a shift away from the traditional role of banks as collectors of deposits and granters of loans, to being arrangers of bond and equity issues, that is, investment banking. As usual, the US has been at the forefront of this process. Between 1984 and 1998 the outstanding volume of corporate bonds, CPs and MBS increased from 75 per cent of GDP to more than 120 per cent of GDP. The growth rate of this sector exploded, and the old commercial banks had no means to respond. Today, less than 40 per cent of long-term corporate liabilities in the US is accounted for by bank borrowing, while over 60 per cent takes the form of bonds. In Europe the situation is very different, and in most countries commercial credit from banks is still the predominant form of longterm corporate ®nancing. But Europe has already begun to follow the US, and in 1999 there was an extraordinary increase in corporate bond issues in the new euro-denominated bond market. In both the US and Europe investors are also moving down the credit curve. That is, they are feeling increasingly comfortable with bonds that are rated single A or BBB instead of AAA. And a growing number of investors are also willing to invest in high-yield bonds that are rated below investment grade. The bond markets are now open to almost any issue that provides suf®cient liquidity, though the size of credit spreads will of course always stay volatile due to supply conditions and investor preferences. In addition, illiquid ®nancial assets such as bank loans or mortgages are being bundled together and transformed into marketable securities (CLOs, ABS). Through asset-backed ®nancing even that part of bank lending which cannot be substituted by direct access to the markets can now be `securitised'. And on the deposit side, disintermediation is even more

Rolf-E. Breuer 9

pronounced, with a strong trend away from traditional low-interest bank deposits towards mutual funds and other higher-interest investments and the direct acquisition of securities. Disintermediation and securitisation have obvious consequences for banks' strategies. The more the traditional role of banks as ®nancial intermediaries declines, the more important expertise in investment banking services will become. However it seems clear that in some areas, for example the ®nancing of small and medium-sized enterprises, bank lending is likely to remain the predominant form of outside ®nance. Information technology and e-commerce In the 1990s globalisation, deregulation and disintermediation as the major factors in banking were supplemented by a great leap forward in information technology (IT) and the deconstruction of traditional banking products. A recent article in Euromoney stated that `the internet will do to retail banks what the printing press did to the medieval church'. Today, some experienced analysts even refuse to make any long-term evaluation of banking institutions due to the dramatic changes in the technological environment, and according to Intel chairman Andy Grove, `In ®ve years' time, all companies will be internet companies, or they won't be companies at all.' The initial developments in information technology enabled ®nancial markets to go global. Information ¯ows, trading and investment became independent of time and place. Examples of this are the global integration of foreign exchange markets and the massive short-term shifts in global investments. Real-time trading and settlement became possible, reducing risk and enhancing (technical) market ef®ciency. These initial developments were generally con®ned to the banking sector itself, and had no dramatic consequences for the banking industry. Today's IT revolution is different, since this time the banks' customer relations are under threat. Internet and telephone banking mean that distance is no longer an impediment to the provision of banking services; consequently bank± customer ties will loosen. Instead of geographical presence, quality of service and the reliability of the provider will become the main determinants in interbank competition. A bank's IT expertise has become a crucial competition factor that goes far beyond displaying on the Internet some information on the institution and the services it offers. In some parts of the business, for example in retail investment banking, the traditional role of banks as providers of information has been challenged by an information revolution that has given virtually everybody access to a huge body of information. And commercial banks are no longer needed for the actual investment transaction, since on-line discount brokers can well take over their role. Also, the way this service is provided will change dramatically with the programming of electronic modules that give even retail customers direct access to electronic trading systems in the markets.

10 Banking in the Twenty-First Century

In the future world of virtual market places the traditional branch system will largely lose its strategic importance. Direct banking and Internet banking will not be restricted to on-line payment services or broking. Consumer and mortgage ®nancing, corporate credit and all manner of depository investments will be offered by means of e-commerce (or rather e-business), not to mention asset management, investment banking services and the provision of research. Moreover the Internet easily accommodates different languages, allowing ®nancial service companies to operate across borders. It is also likely that the traditional physical exchanges for stocks, bonds or derivatives as well as OTC interbank dealing (usually done by telephone or IT communication systems) will disappear in favour of global electronic trading systems that are de®ned by the products traded, not by the geographical location of the participants. Of course all this will not happen in a few days. Nevertheless it would be highly dangerous for banks to underestimate the pace of change. Institutional and corporate customers will exert great pressure to receive the quality and perfection of service that is technically feasible. For retail customers, much will depend on habits, fads and fashions. However examples from all over the world show that even this market can be subject to dramatic changes within a short period of time. Deconstruction `Deconstruction' means that the traditional products and services of the banking industry are split into small units. Traditionally, `production', sales and of®ce activities were conducted in the same bank, but today new competitors focus on single elements of this chain of adding value. Previously the costs of market entry in banking were very high due to the necessity of building a branch network. This has changed dramatically with the possibility of on-line or direct banking, so it is no surprise that banks' traditional markets are increasingly being contested by non- and near-banks. In a controversial statement the founder of Microsoft, Bill Gates, even declared that `Banking is essential, banks are not'. This is obviously wrong: even in the era of e-commerce banks are essential providers of advice, clearing and settlement services and risk management. Often the activities of the new competitors are called `cherry picking', in the sense that they `pick' those parts of the business that are most pro®table. However the negative connotation of the term does not seem appropriate. What the `cherry pickers' demonstrate is that cross-subsidisation can no longer be used as a strategy in banking. In Germany, for example, for a long time banks attracted customers by offering current account and payment services at a price that was far below cost, hoping that this would serve as a `door-opener' for other, more pro®table business. Today such a strategy cannot be sustained, since banks will be left with losses from the subsidised product while the other products ± which will have to be made more expensive ± will no longer sell.

Rolf-E. Breuer 11

Examples of new competitors entering the market are already legion. In the US, Charles Schwab is dominating on-line retail investment with just over a quarter of the market, and of the other top 10, three did not even exist in the early 1990s. E*Trade started in 1992 and is now the second-largest on-line broker with 13.5 per cent of the market, Datek Securities is three years old and has a 10.1 per cent share and Ameritrade, established in 1997, has captured an 8.5 per cent market share. Taken together, on-line trading in the US accounts for roughly 30 per cent of all retail trade. In Germany on-line brokerage is still in its infancy, although the IPO of ConSors ± a young on-line broker, temporarily rated among the top ®ve banks in terms of market capitalisation ± has attracted a lot of public attention. Even among the conservative ®nancial community in Japan, the concept of on-line trading has ®nally taken off. About two dozen Japanese brokers offer Internet trading services, along with some new entrants, such as Sony. US on-line brokers such as Charles Schwab, DLJ direct and E*Trade are also establishing themselves in Japan; some are also expanding into various European markets. However activities are not limited to on-line broking. In Britain an Internet bank called Egg ± founded by a big insurance company ± managed to collect deposits worth more than $13 billion ± a market share of about 1 per cent ± within 18 months. In Germany Entrium, a direct bank, was established in 1990 by a big mail-order company and has since become the country's leading ± and Europe's biggest ± direct bank, with 730 000 customers. In France, General Electric Capital, which operates without a branch network, almost drove the big French banks, out of business in the area of consumer ®nancing. Another example of deconstruction is cooperation among banks in respect of payment systems or securities clearing and settlement. One form of this is a joint venture between two or more banks. Alternatively big banks that have developed a technological infrastructure can make it accessible to smaller banks that cannot or do not want to bear the huge costs of developing an IT system. At least in theory, this service can also be provided by non-banks, for example software houses. In my opinion outsourcing (or, alternatively, insourcing) will be a predominant feature in banking in the twenty-®rst century. Customer preferences Changing customer preferences mean that banking will increasingly be driven by demand rather than supply. Customers have become and will become ever better informed and more demanding with respect to quality of service. For both corporate and private customers, it will become commonplace to use the services of several banks simultaneously, and to switch easily between banks. In this environment it will be extremely hard, if not impossible, to maintain the `one-stop-shop' concept. As a consequence banks will have to be alert to changes in customer attitudes. While some customers will simply be looking for a standardised,

12 Banking in the Twenty-First Century

cost-ef®cient service, others will require a wide range of sophisticated products and individual advice on their ®nancial strategy. Even in a world where information can be freely obtained from the Internet, banks are likely to continue to make a pro®t from advisory business. Since many customers will not have the time or the experience to track down relevant information and may need a professional outside view, advice will still be sought from banks and this might even prove a cornerstone of banking in the twenty-®rst century. In terms of the preferred channel of access, advisory business will probably rely on a mixture of standardised information from the Internet and personal advice by telephone, e-mail or personal contact. For the actual transactions, however, it is very likely that most customers will discover the convenience of modern on-line or Internet banking. Even in the twenty-®rst century, customers will prefer to do business with a bank in which they have con®dence. This will apply to all products, although the additional income from a strong reputation in the market ± a brand name ± will vary according to the type of service offered. Especially in the ®eld of nonstandardised products, for example investment banking or advisory services, both of which are increasingly important areas of business, a strong reputation and customer con®dence will continue to be the key to success. A strong brand name will also be important in situations of extreme market turbulence and major bank failure.

Bank strategies for the twenty-®rst century Full competition In the banking sector, as anywhere in business, competition is the main force behind ef®ciency and innovation. For this reason, from an economic point of view the increase in competition that is already happening and will become even stronger in the twenty-®rst century will prove bene®cial for both the economy and the banking industry. However there are some caveats, due to the speci®c nature of banking and to a transitory period of excess capacity and even lower bank pro®tability in many industrial countries. In the extreme, institutions that run into problems because they cannot cope with an environment of stiffened competition tend to `go for broke' ± as the case of American Savings & Loans illustrates. We must ensure that the severe competitive pressures do not lead to excessive risk taking by single institutions and increased fragility of the banking system as a whole. Increasing competition in banking therefore calls for a high level of responsibility on the part of bank management and the supervisory authorities. An important aspect of this is the `moral hazard' problem: if a bank can assume that others (possibly including the central bank) will come to its rescue in the event of severe business problems, this provides an incentive to postpone necessary restructuring, and ultimately encourages the assumption of excessive risk. Especially in Europe, to date most participants have managed

Rolf-E. Breuer 13

to stay in the market, often because of some form of political protection. It is therefore absolutely necessary that in future banks be allowed to fail ± as long as the ®nancial system itself is not endangered. Alternatively, exit from the market can take the form of mergers and acquisitions, as the current consolidation process among Japanese banks illustrates. Strategic options for banks In an environment of increased competitive pressure banks may adopt different strategies. First an active strategy would focus on new ®elds of business (for example Internet banking, ®nancial advisory services), possibly combined with an attempt to expand into other countries. Second a defensive strategy would concentrate on cost-cutting, possibly by means of a defensive merger. A third strategy would be to retreat into certain product niches or ± although less reliable in the long run ± certain geographical niches. What strategy will best suit a bank will depend on its initial position, resources and strategic vision. Of course all strategies have their pitfalls. An intriguing question in the context of the ®rst and second strategies is whether size can be a solution to the problem of competitive pressure. Size cannot be an aim in itself. However in the twenty-®rst century ± even more than today ± size will offer a wide variety of strategic advantages, ranging from the ability to handle what is now a standard lot in underwriting or big syndicated loans, to massive economies of scale in transaction banking, distribution and marketing, asset management or custody. Size also offers the possibility of reallocating capital from one area of business to another, thus reducing the risk of adverse market developments, and of quickly putting a large amount of capital into new areas of business in response to new market opportunities. Finally, cross-selling can only be taken advantage of by suf®ciently large institutions. The big problem, however, is ef®ciently managing and controlling such large entities. In this respect the old approach of universal banking has lost its appeal. During the 1990s the market capitalisation of many continental European banks even shrank. This was partly due to low levels of pro®tability, compared with banks in the US or Britain. However in good part it was due to investors' discontent with the traditional concept of universal banking. Investors ± or more precisely analysts and portfolio managers ± believe that large conglomerates ± unlike small specialists ± still tend to cross-subsidise unpro®table parts of their business and to postpone necessary restructuring. For this reason the valuation of continental European banks in the markets is suffering from `conglomerate discount'. The third strategy ± retreat to a niche ± is often ridiculed. This is by no means justi®ed: niche players have an excellent chance of outperforming almost any competitor in their ®eld of excellence, and can easily be highly pro®table entities. For a big bank the challenge is to combine the concept of specialisation and the virtues of a niche player with the abovementioned

14 Banking in the Twenty-First Century

advantages of size. Put into practice, this means that the old conglomerate must be split into single specialist activities, each of which must be fully pro®table and able to compete with the best specialists in the ®eld in terms of quality and customer satisfaction. Mergers and acquisitions as a strategic answer? Further consolidation among banks is one way of achieving gains in ef®ciency. The current, extraordinary merger wave can therefore be expected to last well into the twenty-®rst century. The big deals in the US (Citicorp/Travelers, Bank America/Nations Bank), in Japan (Dai-Ichi/Fuji/Industrial, Sumitomo/Sakura) and in Europe, triggered by the introduction of the euro, are likely to continue until substantial consolidation has taken place. The recent wave includes a growing number of cross-border mergers (probably still far too few) and a fair share of mergers of equals as opposed to hostile takeovers (though both can be a valid strategy, depending on the circumstances). Whether a merger proves successful in terms of ef®ciency gains and higher pro®tability depends on many factors, and various studies have pointed out that only about one third of all mergers are successful in the long run. But in general there can be no doubt that further consolidation would make economic sense. Therefore it is deplorable that a number of countries still prohibit certain types of transaction. Mergers and acquisitions among banks should be subject only to market conditions. The strongest form of political protection against this is, of course, public ownership of banks. The economic costs of public ownership go far beyond the typical inef®ciencies of the public sector. The whole industry ± and consequently the economy ± is negatively affected, due to distortions in competition and the prevention of an otherwise meaningful and economically necessary consolidation process among banks. In my view it is high time that public-sector interference in the banking industry be restricted to areas where there is a clear and well-de®ned role for public-sector banks that cannot be performed by private-sector institutions. Banking in Euroland In principle globalisation, disintermediation. IT and competition from nonand near-banks ± the prime sources of radical change in banking ± would also have affected banks operating in the Euro-11 had there been no single currency. This is obvious from a comparison between any of the Euro-11 countries and the rest of the world. However the single currency posed another challenge to European banks: it removed the currency barriers that had provided substantial protection to domestic markets. The euro has also led to greater transparency with regard to prices and conditions, and hence to the further enhancement of competition. For a big bank operating in the euro area, the euro has made the development of an EMU-wide distribution network seem advantageous, if not necessary. Due to the size of the market, however, signi®cant cross-border

Rolf-E. Breuer 15

consolidation in retail banking would require an extremely large investment. Therefore strategic partnerships can be a valid alternative to actual mergers. Unfortunately, even with the advent of the euro the single market for banking has not been fully realised. Whereas the euro has been a success in ®nancial markets ± with a high degree of convergence in bond markets, the equity market and payment systems ± and for Europe's corporate sector in general, pan-European banking is still facing many obstacles. If substantial progress is to be made in this ®eld ± (which would doubtless help banks to cope with the challenges ahead ± a couple of additional political initiatives will be required. On paper the harmonisation of banking regulations in the EU, due in particular to capital adequacy and banking directives, should have been accomplished by 1993. However, despite many changes signi®cant number of regulatory impediments to cross-border activity ± contrary to the single market principle ± remain in place in the European ®nancial markets. The reality is even more in contradiction to the idea of a level playing ®eld in all markets in the practice of banking supervision. Since bank regulators will have even more discretionary scope under the new Basle proposal, it is extremely important to ®ll this gap. In my view the need for Europe-wide banking supervision ± possibly via the creation of a European supervisory agency ± is therefore selfevident. Non-regulatory barriers constitute another group of impediments to cross-border banking in the euro area. Examples are differences in the taxation of interest income and between the tax systems and legal differences, for example the lack of some form of European corporate law. The fact that Euroland is not a single market for banks can also be observed from merger and acquisition activity. To date, in most cases consolidation in banking, unlike in other industries, has clearly been aimed at creating `national champions' rather than concentrating on cross-border Mergers. Of course there are obvious reasons why national mergers are more attractive: the cultural and language barriers are much lower, especially in retail banking, and many customers still prefer national banking customs and habits. Still, creating national champions may lead to regional monopolies, and in wholesale or investment banking the need for pan-European, cross-border mergers is even more evident. The predominance of national mergers is partly due to political in¯uence. Mergers in banking need the approval of the national banking supervisory authorities. In most European countries, however, the rules for mergers and acquisitions in banking are not clearly speci®ed, and the lack of legal and administrative transparency leaves ample scope for political decisions. Recent cases in France, Italy and Portugal have shown a strong political in¯uence, and one case even provoked formal protest by the European Commission. In my view, either the national authorities must learn to accept cross-border market forces, or a European set of rules must be speci®ed. In this respect the complete transfer of banking supervision from member states to the European level would be the optimal solution.

16 Banking in the Twenty-First Century

Conclusion: banking in the twenty-®rst century Of course any speculation about the future of the banking industry is bound to be highly uncertain. However it can be argued that the bank of the future will look radically different from any banking institution of the past. Some observers suggest that banks will come to resemble software ®rms or ®nancial business consultancies. Obviously banks will come rely more heavily on IT than ever. It can also be safely argued that the Internet and e-commerce will soon become important parts of the business, and that the provision of advisory services, including research, to private and business customers will probably become ever more important. The next century will also see a further reduction in the importance of branch networks. Of course, personal contact will always be essential in some parts of the business (for example to some extent in the advisory business, in evaluating real estate or in areas of corporate and investment banking). However, these highly specialised tasks can probably be better provided by experts who are geographically mobile than through of a dense network of of®ces. In the future, banks will operate without geographical restrictions. They will also be extremely ef®cient specialists or multispecialists rather than big conglomerates. Banking has always been a fascinating business ± but rarely have changes in the industry been so fascinating as they are at the start of the twenty-®rst century.

3

The Internet and the Commercial Banking Industry: Strategic Implications from a US Perspective1 William C. Hunter

Introduction The banking industry provides an interesting and important case study of how changes in technology and regulation in¯uence competitive structure, business strategy and industrial evolution. Indeed a narrow focus on traditional bank products and performance measures conditioned on the rapid pace of technological change confronting the industry would lead one to conclude that banking is essentially a declining industry. In fact, according to some observers the commercial bank ± an institution that conducts the twin activities of accepting deposits payable on demand and originating loans ± has outlived its usefulness. Such a focus, however, misses most of the true innovations that have taken place in the industry in recent years ± most notably the move towards off-balance-sheet and information-based activities. A broader perspective shows banks evolving in ways that are enabling them to provide the same basic functions as before, but in new, more ef®cient ways. In the past most banks thought of themselves as delivering a set of speci®c, largely unrelated products to different sets of customers. Today, as a result of technological change and competitive pressures, many banks are pursuing strategies that aim to strengthen their ability to perform various functions, including, for example, ®nancial planning for retail clients and raising capital for middle-market companies, which tend to cut across old product lines. As a result, and in contrast to most industrial ®rms, many banks are offering a more diversi®ed range of products and services than ever before with the aim of exploiting potential synergies among those products. Much of this has been made possible by the recent advances in technology, typically associated with the so-called electronic banking revolution and spurred on by the rapid development and application of the Internet. The economic rationale for banks' past existence relates directly to their two core activities ± taking in deposits payable on demand and providing non17

18 The Internet and the Commercial Banking Industry

marketable loans. It seems clear that both activities essentially require the institution to come up with cash at short notice ± that is, to provide liquidity. Economy of scale in the provision of liquidity thus explains why both activities are provided by the same entity. Deregulation and technological innovations have served to increase competition in the ®nancial services industry, which has forced commerical banks to concentrate on the essentials of liquidity provision. This is why the outward nature of bank activities has changed signi®cantly for both retail and wholesale customers. For example banks around the globe often sell their loans instead of holding them on their balance sheets, offer consumers unsecured personal credit lines through credit cards and provide back-up lines for commercial paper instead of extending loans. Despite these different types of activity, it should be obvious to the astute observer that the underlying economic rationale for these activities ± the provision of liquidity ± has not changed. Beneath the surface of the dramatic changes in ®nancial products and services, the fundamental banking business of liquidity provision seems alive and well. Moreover, in the course of performing their traditional activities banks have acquired competencies that enable them to perform a variety of other ®nancial and non-®nancial activities that deregulation and innovation have opened up to them.

Recent trends in the US banking industry Since the 1970s, what is commonly called the commercial banking industry in the US has evolved into two distinct and, for the most part, differently focused industries: the `global banking industry' and the `community', `local' or regional banking industry. As might be expected, banks operating in the global banking industry or market compete in national and international markets while community banks compete largely in local markets. This is at least partly because global banks have large corporate customers with special ®nancing and information requirements compared with consumers and small businesses. Thus US global banks face competition from different sources than those faced by community banks. For example global banks face competition from the commercial paper market, investment and merchant banks and major foreign banks, all of which compete in national or international markets. Consequently the geographical market for many of these global bank customers and services is at least national in scope but is more often global. In contrast, the geographical market of the community banking industry is still largely local, approximated by metropolitan statistical areas (MSAs) or non-MSA counties.2 The preference of consumers and small businesses for local banks is presumably due to the lower information and transaction costs relative to their funds and may also re¯ect the information costs facing nonlocal ®nancial ®rms. Whatever the reason, it is apparent that US bankers are

William C. Hunter 19

keenly aware of this preference and treat community or regional banking as a very localised activity that often requires a local presence.3 For example the number of bank branches in the US increased by about 74 per cent between 1970 and 1990, even as the number of banks and banking organisations declined. For many years it has been apparent that community banks are signi®cantly in¯uenced by local market conditions that may in¯uence only some, if any, of the activities of global banks. This has provided support for the view that local banking is a separate industry from the global banking industry. This view is also supported by studies of the cost structure of the US banking industry. Many of these studies have found that global and community banks do indeed operate on different long-term average cost curves, that is, these banks operate in different industries.4 While ®rms in both of these industries operate as ®nancial intermediaries, offer insured deposits and the other standard packages of services, local banks have traditionally served a distinctly separate class of customer and competed in fairly protected local markets. As a result it has been generally assumed that developments in the global banking industry will only marginally affect community or regional banks. However, with the advent of dramatic technological change in the form of various electronic or Internet banking developments and the increase in the minimum ef®cient size of banks as a result of technological developments, local banks can no longer assume that their local markets will remain unattractive or inaccessible to global banks and their global networks. Thus local and regional banks should be aware that their market share is at risk. This is easy to see given that the overlap between these two industries is limited in an important way that is indicative of the basic difference between the two industries. Speci®cally, while banking organisations that operate in the global banking industry can and do operate in the community or local banking industry, the reverse does not hold. That is, community and local banks tend not to operate in the global banking industry. However, just as technological developments represent a threat to the long-term viability of community banks, when used appropriately they also present an opportunity for these banks to access the global banking market through the electronic networks offered by members of the global banking industry. Two interesting avenues for examining technological change and its in¯uence on the banking industry are (1) regulation and the legal environment resulting from changes in banking technology, and (2) changes in the competitive environment facing ®nancial institutions. Regarding the regulation of Internet banking and related changes induced by technology, the current consensus among US banking scholars seems to be that market arrangements for electronic money and Internet banking should be allowed to evolve unencumbered by regulation and government intervention. This should remain the case as long as the safety, soundness and stability of the payments and ®nancial system are not impaired by these developments.

20 The Internet and the Commercial Banking Industry

This essentially means that regulatory intervention in electronic money and internet banking will take place in a parallel fashion to the regulation that already exists for non-electronic non-Internet banking. That is, if the paper equivalent of an electronic transaction is regulated, then so should the electronic transaction. In this environment, regulatory attention is focused on evaluating the threat of those electronic transactions which have no paper equivalent to the safety and soundness of the payments and ®nancial system. Many concerns have also been expressed about the nature and structure of the US banking industry in the next 20 to 30 years; in particular, whether local and regional banks will be able to compete with the larger global banks and whether banking services will continue to be owned by traditional bankers or by software developers or telecommunications ®rms. As should be clear from this introduction, there is reason to believe that banking services will continue to be provided by banks (both global and regional), albeit in a much more competitive environment.

Technological change and the industrial organisation of US banking markets The impact of technological change on the banking industry (both globally and locally), particularly the development of Internet banking, is best examined using the tools of modern industrial organisation theory. Though many banks might eventually offer combinations of electronic cash and electronic money, the decision to become a fully ¯edged provider of electronic or Internet banking services involves irreversible investment and output decisions. This irreversibility, combined with uncertainty about customer demand for electronic banking services, implies that banks (and other ®rms for that matter) will typically face a precommitment decision when deciding whether to enter the Internet banking business and the scope of such involvement. This decision will uniquely in¯uence the environment surrounding the emergence of an electronic or Internet banking technology. Given these elements of irreversibility and demand uncertainty, if banks are pro®t-maximising ®rms we can expect incumbent or dominant banks (typically the large global banks in the US) to act strategically when deciding the scope of their involvement in Internet banking. Hence they can be expected to undertake entry-deterring investments to the extent that the marginal bene®t of such investments (the pro®t that ¯ows from reduced future competition) exceeds their current cost. Investment in excess capacity is one such strategy. Whether or not investment in excess capacity constitutes a credible threat by dominant ®rms depends on what potential entrants think the post-entry regime will be, on whether or not there are economies of scale and scope in the provision of electronic and Internet banking services, and on the size of minimum output relative to the market. Whether incumbents ®nd investment in excess

William C. Hunter 21

capacity pro®table depends on their certainty that such investment will deter entry, and perhaps on the possibility of free-riding by other incumbent ®rms. Investment could also be used as a way of responding to entry rather than as a device for precluding entry. If customers incur costs by switching from their current bank to a new provider of ®nancial services, then incumbents or dominant ®rms may strategically expand output to attract customers and make entry more dif®cult. This involves some sacri®ce of short-term pro®ts and should be considered as a strategic investment in the customer base. It is clearly costly for incumbent or dominant ®rms to carry excess capacity or to make other strategic investments to deter entry. If incumbents can raise the costs incurred by actual or potential rivals while suffering smaller cost increases themselves, they will generally ®nd it pro®table to do so. The existence of signi®cant demand uncertainty also implies that dominant ®rms ®nd it worthwhile to engage in predatory or entry-limiting behaviour in order to create and maintain a reputation as a ®rm that will ®ght entry, or as a low-cost ®rm. Although such a strategy may be unpro®table in the particular market in which it is carried out, it does discourage entry into other markets and thus may be optimal for dominant ®rms from an overall point of view. Barring the success of the above strategies, cooperation (as opposed to collusion) may emerge as a key force behind the evolution of electronic and Internet banking. Such cooperative arrangement are commonly referred to as strategic alliances or joint ventures.

Recent changes consistent with the predictions of modern industrial organisation theory Two developments are responsible for the interest and growth in electronic and Internet banking around the globe. These developments are signi®cant for both global banks and community and local banks in the US and elsewhere. First, computing costs have dropped steeply in recent years; second, electronic telecommunications innovations have simultaneously increased the capacity for communication usage in ®nancial services and reduced the importance of geographically based ®nancial services. Historically, both global and local bankers viewed themselves as owning customers. They provided a range of services to customers, including current and savings accounts, credit cards and settlement and clearing procedures. Customers only had to choose a bank, deposit their money and withdraw it in whatever form they chose at some future date. In many countries, and especially the US, the types of service that banks and other ®nancial ®rms could offer customers were restricted by law ± for example, until recently US ®rms that issued securities were not allowed to accept deposits. In addition there were statutory restrictions on the types of entity that could accept customer deposits. A prime example of this was the US Bank Holding

22 The Internet and the Commercial Banking Industry

Company Act, which prohibited companies from owning banks if the parent company was engaged in activities that were not closely related to banking. The deregulation of banking and bank deposit activities has brought deposit rates to competitive levels in most banking markets. Indeed, with the depositor's cost of telephoning or e-mailing competitors falling to zero, banks have had to rethink their deposit and retail business. While synergies remain in liquidity provision, all banks enjoy this synergy, so the challenge is to build a competitive deposit business in ways that create rents for the bank. In fact there are only a limited number of ways in which long-term pro®ts can be made. The holy grail for all banks (both global and local) continues to be captive customers who are price-insensitive, that is, have inelastic demand curves. In the absence of this, banks must innovate continuously or ®nd scale economies that enable them to become low-cost producers. It helps, of course, if there is substantial ®rst-mover advantage in a product so that the pro®ts from innovation or scale can be reaped over a longer period. In the days when a customer had to be physically present to undertake most banking activities, proximity to a bank branch was important. A bank's customers were those who lived closest to the branch. Higher prices could be charged or lower interest rates paid to their customers because the customer's costs of switching to another bank were high. But today it is no longer clear which customers a bank should target. The geographical reach of any given bank has increased as a result of lower communication costs. At the same time the cost to the customer of switching banks has fallen. Banks, both global and regional, have one big advantage when deciding who to target, how to bring them in and how to increase their switching costs: so-called customer inertia. Many customers have been slow to use the phone or other telecommunications media to reach other ®nancial service providers ± there seems to be considerable inertia and the learning curve is apparently steep. For example, while the number of ATMs in the US went up from 13 800 in 1979 to about 187 000 in 1998, the number of bank branches also went up over the same period. Many customers in the US still prefer to use bank branches for such activities as depositing cheques despite the fact that ATMs can do the job just as well as tellers in manned branches. Local branches provide some human interaction, and hence are less technologically intimidating. Moreover bankers (at least in the US) have been seen as more trustworthy than other ®nancial service providers, such as stockbrokers and insurance agents. Some bankers correctly view their branch network and current depositor base as an opportunity. Their idea is to use the branch as the gateway through which the depositor can access the entire ®nancial system. They would like to convert the physical contact and trust they currently enjoy with depositors into high switching costs so that when depositors become more technically sophisticated, or when access costs diminish further, they are not tempted to switch banks.

William C. Hunter 23

There are a number of ways in which ®nancial service companies can increase switching costs. Providing personal advisory services may be the costliest approach, but it also has the most potential to build personal bonds that are hard to break. Another approach is to offer a variety of services and to integrate them so that they appear seamless to the customer. For instance a bank that can offer to the customer mortgage, credit card and insurance services can link all these accounts to the deposit account, as well as to overdraft facilities and home equity loans. Within limits, authorised payments can be made automatically, if necessary by borrowing on behalf of the customer at the least-cost rate. The bank can also provide a consolidated statement to the customer at the end of every month. The advantage of being the sole access point is that the cost of switching to a different access point increases with the number of services provided (and if the customer uses software, with the degree of specialisation of the software needed to gain access). Clearly this strategy is so designed that convenience is the most important feature, but this raises an interesting question: should the bank offer access to more than its own products and services? It should, and not simply because it will become more attractive as an access point if it is able to offer the best services. By offering other ®rms' services, it can also promise its customers that they will not be overcharged, ripped-off or gouged later if they lock themselves into the bank (economists call this technique a second sourcing). Moreover the bank that controls access is in a position to extract rents from the other service providers because it controls the prime asset: captive customers. This approach has been successfully followed by the discount broker Charles Schwab, and by Intuit Home Banking. For example Schwab's mutual fund provides its customers with access to over 1100 mutual funds from over 100 fund families, consolidating all fund statements into one statement for the customer. The market power gained by Schwab through its customer control access is evident in Fidelity's decision to withdraw most of its popular funds from this scheme. Innovation Innovation is clearly one way in which a ®nancial institution can differentiate itself from the pack. But most successful product innovations on the retail side are easily imitated (except those based on proprietary technology). One way to build sustained advantage is to use innovation to build a captive customer base. In a sense this is what Charles Schwab has done. It was one of the ®rst brokers to allow customers to trade electronically. In the process it cross-sold a variety of products, including information services and mutual fund services that locked the electronic customer into a relationship with Schwab. At the same time these customers give Schwab the necessary scope to pursue further innovation. Another kind of innovation is to identify activities with high transaction costs and to reduce those costs by internalising the transactions. To the extent

24 The Internet and the Commercial Banking Industry

that there are ®rst-mover advantages to this approach, a bank can build a longterm franchise. For example Citibank recognised that there were still very high costs involved in making cross-border payments. By setting up a global network of branches and developing tremendous expertise in foreign exchange transactions it succeeded in internalising cross-border payments. The savings in transactions costs coupled with the very high volume of transactions have made this a very pro®table franchise. Moreover other banks are unlikely to challenge this franchise because of the high cost of setting up a competing network and the formidable position now occupied by Citibank. Technology It is clear that nothing beats being a low-cost ®nancial services provider and that automation is a proven way to reduce costs. For example the real cost of an electronic deposit in the US fell from four times the cost of processing a cheque in 1979 to less than half the cost in 1998. Since automation requires a substantial investment, large global banks have a competitive advantage. Indeed this may also explain the large-scale consolidation taking place in the US banking industry. In recent years the percentage of assets in banks with over $100 billion (1994 value) more than doubled between 1979 and 1998 while the percentage of assets in small banks dropped by more than 50 per cent. Most economic analysts of the payments business suggest that it is a large®xed-cost business. Thus the economics of the situation require the service provider to maximise its customer contacts in order to spread these ®xed costs over a larger base. Since variable costs are low, maximising the customer base maximises pro®ts. Hence the private provider will be motivated to control a larger and larger share of the market. This could lead to increased market concentration and market (monopoly) power, with adverse consequences for small community and regional banks. Given that there are large sunken costs in the business, standard economic theory implies that the incumbent provider will be able to sustain its monopoly position, that is, market forces will not keep the ®rm from exploiting its monopoly position. Being in a business that is subject to mild increasing returns to scale ± that is, the larger the ®rm the cheaper its average cost of producing electronic ®nancial services ± dominant ®rms will naturally seek to become larger and will engage in entrylimiting and/or pricing behaviour to limit competition. Again, this implies that small regional banks will ®nd it dif®cult to compete. Finally, electronic payments systems are subject to signi®cant network externalities, scope economies and economies of sequencing. A dominant ®rm with the industry standard software or hardware will have a de®nite competitive advantage over all new entrants, which must adopt this software or hardware in order to offer complete access. The dominant ®rm is thus able to exploit scope economies and gain access to additional customers, again leading to increased market share and power. The business also has elements

William C. Hunter 25

of economies of sequencing, which are present if an integrated technology is more productive than separate technologies. Economies of scale and scope Scale and scope economies typically have important implications for the structure of an industry. If such economies are substantial, ceteris paribus an industry will tend to be relatively concentrated and entry will be dif®cult. There is a large body of literature on scale and scope economies in the commercial banking industry in most developed countries. Most of this literature focuses on data for banks with under $1 billion in total assets, which in essence are part of the community or regional banking industry. The evidence suggests that scale economies (especially in US banking) are quite modest and are exhausted at low levels of output. This bodes well for the competitive viability of smaller regional and community banks. On the other hand, more recent studies of larger global-type banks show that signi®cant scale economies are possible for these banks.5 This raises questions about the viability of local and regional banks throughout the developed world. What is one to make of these mixed ®ndings? Since the 1970s, with the onset of deregulation, increased expansion and new electronic technologies, questions have been raised about the competitive viability of small and regional banks. A fairly wide range of empirical evidence suggests that small banks are both viable and pro®table.6 For example it has been argued that the scale economy research ®ndings imply that smaller banks are able to compete on an equal footing with large global banks, or at least with respect to basic banking services. Moreover, recent research on managerial inef®ciency in US banking suggests that these types of inef®ciencies dominate those identi®ed with inef®cient scale.7 If one believes these ®ndings, small community and regional banks do indeed have a continuing role to play in the industry. Nonetheless there is reason to believe that small and regional banks will continue to be threatened by developments arising from technological change. Studies of the impact of technological change in the US banking industry suggest that the minimum ef®cient size of banks (especially in the US) has increased as a result of technological change.8 This combined with the probable impact of electronic or Internet banking on the structure of the industry, strongly suggests that regional and small local banks will have a tougher time competing in the future.

Strategies for survival in an Internet banking world and the role of local banks Even though fundamental competencies have not changed, in order to compete, global banks and community and regional banks can pursue different strategies in the world of Internet banking. Banking scholars have identi®ed several strategies to deal with the technological revolution in the

26 The Internet and the Commercial Banking Industry

®nancial services industry. These strategies involve serving different customer segments in a variety of ways. Strategic decisions involve both operating decisions and product decisions and can be made locally on a decentralised basis or on a centralised basis. Decentralised operating and product or service decision making has the advantage of keeping local bank decision makers in close proximity with the customer and local information. The disadvantage of this approach is that senior management may not have complete control over the operations side, while on the product or service side the bank may miss opportunities to exploit economies of scope and scale. By default, this strategy is a natural one for small community and regional banks, given their size and/or lack of extensive branch networks. However some small banks have attempted to mitigate the disadvantages of the strategy by outsourcing back of®ce operations and joining large electronic networks to enhance their customers' access. However, in attempting to circumvent the weaknesses of the decentralised strategy these banks may have to share a substantial proportion of the pro®ts from their customer base with the access providers, and they also risk their customers being captured or stolen by the access providers. Clearly the decentralisation strategy will pose signi®cant risks and problems for small banks in the future as geographical location becomes less important in de®ning a bank's customer base. A strategy of decentralised operational decision making and centralised product and service decision making makes sense for banks that possess special localised knowledge about their markets, but recognise that retail customers (in all but the most remote and isolated markets) in an Internet banking world will have fairly low switching costs. It will also be dif®cult for banks to make signi®cant pro®ts from traditional products that come to be offered on a commodity basis. Thus, it will become important for banks to offer customers a wide choice of a products and services (which emerge from a centralised product and services strategy) and to offer local or decentralised pricing differences and advice only for those products that are deemed to be of high value-added. A strategy of centralised operational and product and service decision making recognises the growing standardisation of banking products generally, though not exclusively. Such a strategy also implies more uniformity in operations and products regardless of location, since location is less relevant in an increasingly electronic world. Like the ®ndings of studies on the cost effectiveness of banks using decentralised and centralised decision making more generally,9 it is likely that a totally centralised strategy will not be optimal for most banks. Such a strategy seems to work for the McDonald restaurant chain but it probably will not for most banks, given their special competency in local information gathering and processing. Based on this discussion, it seems fairly obvious that a totally decentralised strategy, especially on the retail side, will become less and less pro®table as we

William C. Hunter 27

move into a more integrated electronic and Internet banking world. Customers will become more sophisticated, they will move up the learning curve, and the cost of electronic hardware and software will continue to decline, making this mode of transacting even more cost effective relative to paper and face-to-face contact. To be sure, no one knows exactly how long this will take, so the strategy may be pro®table in the short run. A global strategy, on the other hand, is likely to be beyond the means of most small and medium-sized banks. For most banks, then, a strategy that exploits local market-information advantages and product synergies, scale economies and innovation seems most appropriate.

Conclusion There are several key questions that bank managers around the world should consider carefully before making any decisions about the adoption of an electronic or Internet banking strategy:

. Will the bank be required to reroute its existing customer base through a mandatory switch or will its customers be able to access the menu of services by coming directly into the bank in a seamless fashion? Will the bank control the customers' access to the global electronic market? . Will the bank be able to choose its ®nancial partners (insurance, securities, brokers and so on) under its chosen electronic (hardware and software) arrangement? . Can the bank's customers reach the bank from any device, over any channel? . Will the bank maintain brand independence and direct contact with its customer base?

Clearly the answers to these questions will determine the bank's overall

electronic or Internet banking strategy, including the particulars of the

strategy. These particulars include:

. . . .

The decision to outsource front-end processing.

Customer switching costs.

The extent to which the bank will or will not be tied into proprietary networks.

Whether the technology invested in is supported by all the network

partners with which it chooses to af®liate. . Whether it can choose its own strategic partners. . Whether its customers will continue to identify with the bank as their bank of choice. Continued technological change in the banking and ®nancial services industry and in electronic or Internet banking are inevitable. While these

28 The Internet and the Commercial Banking Industry

changes pose great challenges to regional and local banking organisations and global banks alike, they also provide these banks with an enormous opportunity. If global and local banks are smart and work in a cooperative manner with each other and with strategic partners, they will not only strengthen their customer relationships but also create a variety of new revenue sources. Notes 1. The views expressed in this chapter are those of the author and not necessarily those of the Federal Reserve Bank of Chicago or the Board of Governors of the Federal Reserve System. 2. See I. Walter, Global Competition in Financial Services (1988), Cambridge, MA: Ballinger/Harper and Raw Pavel and C. J. McElravey, `Globalization in the Financial Services Industry', Economic Perspectives, vol. 3 (Federal Reserve Bank of Chicago, May/June 1990). 3. The importance of a physical local presence is suggested by the apparent need for even global banks to have a physical presence near major corporate clients located in foreign countries (see Walter, Global Financial Competition, op. cit. 4. See, for example, William C. Hunter, Stephen G. Timme and Won Keun Yang, `An Examination of Cost Subadditivity and Multiproduct Production in Large U.S. Banks', Journal of Money, Credit, and Banking, vol. 22 (November 1999), pp. 504±25; Allen Berger, William C. Hunter and Stephen G. Timme, `The Ef®ciency of Financial Institutions: A Review and Preview of Research Past, Present, and Future', Journal of Banking and Finance, vol. 17 (April 1993), pp. 221±49; William C. Hunter and Stephen G. Timme, `Technological Change in Large U.S. Commercial Banks', Journal of Business, vol. 64 (July 1991), pp. 206±45; William C. Hunter and Stephen G. Timme, `Technical Change, Organizational Form and the Structure of Bank Production', Journal of Money, Credit and Banking, vol. 18, no. 2 (May 1986), pp. 152±66. 5. See Allen Berger and Loretta Mester, `Inside the Black Box: What Explains Differences in Ef®ciency of Financial Institutions?' Journal of Banking and Finance, vol. 21 (July 1997), pp. 895±947. See also Hunter and Timme, Technological Change, op. cit., for a futher review of this literature. 6. See, for example, Donald Fraser and James Kolari, The Future of Small Banks in a Deregulated Environment (1985) Cambridge, MA: Ballinger Publishing 7. See Berger, Hunter and Timme, `The Ef®ciency of Financial Institutions', op. cit., for a comprehensive review of the issues. 8. See Hunter and Timme, `Technical Change' and `Technological Change', op. cit., 1991) for a discussion of the impact of technological change on the minimum ef®cient size of banks in the US. 9. See William C. Hunter, `Internal Organization and Economic Performance: The Case of Large U.S. Commercial Banks', Economic Perspectives, vol. 19 (September/October 1995), pp. 10±20.

4

Three Imperatives to Foster as a Financial Institution in the Euro Era Jan Huyghebaert

The euro has been transforming and will continue to transform the ®nancial industry in Europe. It has had the impact of a tidal wave hitting the shore: forex margins in the euro-zone are gone, lending margins are under pressure and so on.

First imperative: manage your costs The challenges and opportunities brought by the euro are in general the same as those brought by any market-broadening event. To some degree, the gradual removal of the Glass±Steagall Act will have similar effects in the US. Consolidation will accelerate, customers will become more demanding, distribution channels will proliferate. All these effects will increase the pressure signi®cantly to lower costs. The need to manage costs in general and the cost income ratio in particular is the ®rst imperative observed here: the need for cost reduction in order to keep pace as an incumbent ®nancial institution. New attackers from within the industry, Internet-related such as ConSors and DAB or not, or from outside the industry, such as retailers and telecom operators, often enter the industry with tailored propositions at very low cost. The existing ®nancial institutions are faced with matching the new offering while maintaining the existing offering. This matching does not imply the same value at the same price, but the essence of a competitive offering should be present in terms of cost/ bene®t. This is the core of the multichannel strategy, and the resulting complexity makes a low-cost position very dif®cult to achieve. It represents a new development compared with previous years' when there was a trend to make better use of IT and to move to bigger branches to deliver a full service at acceptable costs. Besides the tidal wave of the euro there are less visible but more powerful forces at work in the ®nancial industry: technological change, regulatory issues, globalisation and demographics. 29

30 Three Imperatives to Foster

Second imperative: offer your customers a global window One particular implication of globalisation is that ®nancial institutions will increasingly concentrate certain activities in `hot spot' ®nancial centres such as London or New York because they offer access to a larger pool of talent, and there are no hurdles in the Internet age against serving customers from these centres. This is what happens in advisory investment banking, in custody and increasingly in brokerage. This implies that all ®nancial institutions will be forced to rely upon the talent pool of those centres and to open shop there. These centres are very competitive markets, and it may take years to establish a good position for newcomers, given the risks of trying to move forward. On a more general note, globalisation will increasingly change the ®nancial industry because technology and deregulation facilitate trade. For years the total value of international trade has been growing at a multiple of the growth rate of world GDP, and the advent of e-commerce will only accelerate this trend. Increased global trade, the growth of business and personal travel, and the seamless information ¯ow through classical and new media such as the Internet are causing a paradigm shift. The typical local banking customer ± even a small business or a well-experienced individual ± will increasingly demand a window on the world within the local banking relationship. Financial institutions therefore need to offer this to virtually all customers. Offering a global service with a local rooting is a new paradigm for the industry and those who can deliver this have the best chance of retaining their customers. At this point disintermediation can stop: if customers receive cost-effective, quality advice the ®nancial institution can claim the relationship. The question facing all ®nancial institutions is how to implement this global/local strategy.

Third imperative: develop the skills of your people Demographics are a second powerful current of change. There will not only be a much older population, which traditionally owns the majority of all savings, but lower birth rates will concentrate wealth over generations through the mechanism of inheritance. So customers will be fewer, more af¯uent and in need of advice. Retaining customers, who will be faced with a seamingly endless choice of ®nancial institutions, will be the key for growth. Hence the increasing power of brand as a vehicle to inspire and maintain customer attention and loyalty. Secondly, these customers will be very sensitive to the quality of service and advice, including a clear appreciation of the risks they are facing. But quali®ed advisors will be scarcer: not only will the proportion of the working population shrink, but all industries will compete with the ®nancial industries for the talent available. The pressure on ®nancial institutions to engage in productivity improvement and skill development will be tremendous. Financial institutions will be forced to invest even more in the quality of

Jan Huyghebaert 31

their people, because these people will be the key advisors to customers, and therefore their quality will be the institution's quality.

The case of Almanij In Belgium, Almanij and its group companies have been relentlessly striving to meet these imperatives. The creation of KBC is a good example of this.

. The creation of KBC has met the ®rst imperative of cost reduction, because

the merger of the former Kredietbank with CERA Bank allows it to rationalise its distribution network in Belgium without losing coverage. This is a tedious process, since the net present value of merger bene®ts can only be captured after meeting the costs of integration. Secondly, such a merger needs to be well prepared, manage the organisational culture and maintain the growth momentum of the initial positive goodwill from the public's reaction. Fifty per cent of all mergers fail on one or more of these criteria. However Almanij is con®dent that it can successfully conclude this integration, given the track record of the former Kredietbank. . The creation of KBC has also signi®cantly strengthened Almanij's capital base, creating options for international expansion. This is helping the Almanij Group to meet the second imperative: to create a window on the world in a local relationship. Needless to say, many things still need to be done. The merger enabled the Almanij Group to strengthen its position in Belgium (its home market), to ®nance its expansion into Central Europe, and to maintain or improve its position in certain niche markets, such as trade ®nance. The concept of a second home market is still under investigation. The key challenge is to preserve its focus in its growth process. . Finally: embracing the bancinsurance concept is helping the Almanij Group to develop new skills in product development and marketing.

Innovation and growth There is a common theme at the core of meeting these three imperatives. It has to do with growth and innovation. The importance of innovation is well known, and meeting the three imperatives only stresses its importance:

. Reducing costs while expanding the availability and quality of customer service requires innovation.

. Opening a window on the world and making it available to all local customers requires new ways of leveraging technology and alliances.

. Achieving new standards of productivity and skills for bank personnel

requires innovations in working methods, the use of computers and the training of employees. Growth is essential to offer these people a career, to retain them and to preserve the investment made in them.

32 Three Imperatives to Foster

The importance of growth is equally clear. Growth is necessary to broaden the earnings base and to motivate good people. However, organic growth opportunities in traditional markets are limited. Capital markets' expectations for earnings growth are exceeding the business growth rate. Consequently growth raises the issue of size in the ®nancial industry. Almanij's decision to create KBC is a good illustration of how it thinks about this issue. Almanij believes that shareholder value is the result of many factors, of which scale is only one. But it recognises that scale and size make a huge difference in certain lines of business, for example in most activities in investment banking and custody. In other lines of business, the jury is still out. An example here is asset management, where some players prosper by going after scale, while others specialise and equally prosper. Other businesses are much more skill- and reputation-driven. Private banking is an example. Almanij believes in the importance of scale in any line of business, in¯uenced by factors such as regulation and technology. Constant evaluation of position in terms of size is necessary in any line of business, as is assessment of the potential of business unit leaders and the quality of customer service. Almanij and its group companies realise that growth and innovation lie at the core of competition. Not all innovations, though, have the nature of a breakthrough: some are small and even barely visible, but can help to meet the imperatives described above. The following are a few examples:

. Almanij developed a strong position in the ECU trading market, a market that has now gone but gave Almanij some quality business over a number of years.

. Almanij pioneered new mutual funds with embedded options for its af¯uent customers and gained a signi®cant market share.

. It expanded into new markets, including Eastern Europe, for their growth potential. Such expansion takes time, although there is a limited opportunity to enter such markets and it can soon be too late, as in China. Almanij's initial hesitation to enter unknown territory has been compensated by a pace of development that time exceeded expectations. . It developed new types of collaboration between employees in bank branches and independent specialist exclusive agents in insurance in order to increase service quality. . It was the ambition of one of the founders of IBOS, an international network for cash management and payment services, to start building more international service line. Of course growth and innovation have no limits. Therefore Almanij must aggressively seek all growth opportunities and explore all ways to innovate. However the reality is that any advantage will be short-lived, and that there is a price to pay for innovation, which occasionally makes coming in second just ®ne.

5

Integrating Risk Management and Capital Management1 Prakash Shimpi

Capital management and risk management are two sides of the same coin but conventional ®nance theory treats them separately. Capital management focuses on delivering the optimal balance sheet (composed of equity and debt) that minimises the cost of capital. It is the domain of the chief ®nancial of®cer (CFO). Currently the term risk management refers to the roles of the risk manager and treasurer, working separately in the insurance and capital markets to manage the ®rm's operational and ®nancial risks. Simple intuition tells us that capital and risk are related. With a multitude of forms of capital and rapidly developing risk management techniques, it is natural to treat capital management and risk management as two distinct topics. This simpli®cation comes at a price: by considering capital structure and insurance strategies in isolation, we fail to account for important connections between them. To capture this interrelationship requires a framework that incorporates both. Additionally, this framework needs to apply equally to techniques that straddle both the insurance and the capital market. In this chapter we develop such a framework ± the insurative model.2 We start with a general discussion of the role of corporate capital and the relationship between capital and risk. Next we consider two conventional models of corporate capital ± one dealing with debt and equity and the other with insurance ± and combine them to produce the insurative model. This exercise requires us to delve into ®nance theory, but we have tried to make the subject accessible to anyone with a basic knowledge of ®nance. There are, however, several new concepts introduced here that should interest even a seasoned corporate ®nance specialist.

The role of corporate capital Why does a corporation need capital? A ®rm can be thought of as a collection of activities that entail risks. To conduct these activities and respond to their risks, the ®rm needs capital. In other words it needs capital primarily to fund 33

34 Integrating Risk and Capital Management

its operations, to cushion it against adverse ®nancial results and to assure observers of its ®nancial soundness. A ®rm's capital can be de®ned as the sum of three items:

. Operational capital . Risk capital . Signalling capital Operational capital This is the capital required to ®nance corporate activities. If a ®rm undertakes only risk-free projects, this will be the minimum capital it needs to stay in business. The cost of operational capital for a risk-free project should re¯ect only the time value of money. Risk capital Corporate activities generate risks. A ®rm requires capital in addition to its expected operational capital to cover the ®nancial consequences of these risks. The amount of risk capital depends on the risk tolerance of the ®rm. It is calculated as the capital needed to keep the ®rm's probability of ruin below some de®ned level. For example, suppose a statistical analysis of a ®rm's risk exposure shows that its expected operational capital is $500 million, but there is a 5 per cent chance that it will need $750 million and a 1 per cent chance that it will need $1 billion. In this case, risk capital of $250 million would correspond to a 95 per cent survival probability and $500 million would correspond to a 99 per cent survival probability. The cost of this component of capital should be a combination of both the time value of money and the riskiness of the ®rm. The sum of these two items is the economic capital of a ®rm: economic capital ˆ operational capital ‡ risk capital Signalling capital Often it is not suf®cient that only the managers of a ®rm be satis®ed with the adequacy of the capital they have to cover their risks. Investors, suppliers, regulators, rating agencies and analysts, for example, need to be satis®ed as well. They do not have the same risk analysis tools as the ®rm's managers, and cannot be as familiar with all the risks that the ®rm has undertaken. Instead they have their own, more generic risk assessment tools, which are keyed off a short list of items from the ®rm's ®nancial results. These tools not only measure the adequacy of a ®rm's capital but also enable a comparison of its ®nancial soundness relative to other ®rms. Since these tools cannot be as precise as a ®rm's internal ®nancial model, they tend to be conservative, overstating its capital needs.

Prakash Shimpi 35

Rather than argue the point, managers hold the additional signalling capital to reassure outsiders that the ®rm is indeed as strong as the managers know it to be. A small amount of such capital is not detrimental, but too much can create a noticeable drag on a ®rm's ®nancial performance. Managing risks, particularly those that are the focus of external evaluators, can help reduce the amount of signalling capital a ®rm needs. The required size of signalling capital for any ®rm depends on a number of factors, such as ownership structure, market credibility and industry sector. For highly regulated companies such as banks and insurers, which are subject to risk-based capital requirements, signalling capital may be large. On the other hand a privately owned manufacturer not subject to the same type of scrutiny may need none. Capital and ®rm risk For a ®rm to operate in the marketplace, it needs suf®cient capital to meet the ®nancial obligations arising from its activities (economic capital) and its position in the market (signalling capital). The capital required by a ®rm, therefore, is made up of the following components: capital required ˆ economic capital ‡ signalling capital ˆ operational capital ‡ risk capital ‡ signalling capital From the preceding discussion, we recognise that a ®rm's capital requirement depends on the ®rm's risks. Let us de®ne the function f `risk' to indicate the amount of capital necessary to cover some given risk. If we use ®rm risk to denote the risk of the entire ®rm's activities, so that f `®rm risk' is the amount of capital necessary to cover ®rm risk, then it is related to the ®rm's required capital in the following way: capital required ˆ f …firm risk†

ˆ capital needed to cover firm risk

Figure 5.1 illustrates this relationship for a hypothetical ®rm3 When the ®rm runs a simulation of its operations it generates probable future scenarios and determines, for each scenario, the amount of capital it will need to stay in business. The ®gure shows the capital required on the horizontal axis and the number of scenarios on the vertical axis. It shows that the minimum capital it will need to operate is $500; that amount is considered its operational capital. In only 1 per cent of the scenarios is the capital needed greater than $1500. This means that the economic capital of the ®rm is $1500, of which $1000 is risk capital. Although the ®rm's business does not have any other risks, there is a very real risk of not being able to demonstrate capital adequacy to interested third parties. The capital effect of this risk needs to be added on. If this signalling capital amounts to $50, then the capital required is $1550.

36 Integrating Risk and Capital Management

Number of scenarios

99%

1%

500

Risk capital

Operational capital

Capital required $ 1500 Economic capital

Figure 5.1 Simulation of a ®rm's capital requirement

Capital resources So far we have not discussed the ®nancial instruments that constitute a ®rm's capital. Let us refer to the capital resources utilised by a ®rm as ®rm capital. It is easy to think that capital is limited to equity and various classes of corporate debt, that is, paid-up capital that appear on the ®rm's balance sheet. Indeed most of the corporate ®nance literature focuses on these forms of capital. There are, however, more capital resources available to a ®rm. A ®rm also has the ability to access off-balance-sheet capital, that is, capital that does not appear on its balance sheet, in order to ful®l the same objectives as it does with paid-up, on-balance-sheet capital. There are two ways to do so. The ®rst is to buy the right to access capital in case it is needed. One example is a bank line of credit. It does not form part of the ®rm's on-balance-sheet capital since it has not yet been paid to the ®rm. A fee is paid for the credit line. If the ®rm utilises the line and borrows from the bank, the loan at that time is treated as on-balance-sheet capital. This is a cost-effective way for a ®rm to postpone putting capital on its balance sheet until it needs to. Of course such a bank facility comes with several terms and conditions that limit its availability and in¯uence the cost.

Prakash Shimpi 37

The second way to access off-balance-sheet capital is to transfer risks to other ®rms, thereby altering the retained risk pro®le and the consequent capital structure of the ®rm. For example, by paying a premium to an insurance company a ®rm can eliminate its exposure to property damage at its manufacturing facilities. The ®rm does not have to keep any paid-up capital to cover this risk, except for some operational capital to pay the on-going insurance premium. All losses arising from that risk are borne by the insurer. The distinction between these two off-balance-sheet capital resources is fairly straightforward. With the ®rst, the ®rm still owns the risk, and can raise paid-up capital at some later date if it needs to. With the second, the ®rm no longer owns the risk, and therefore does not need to raise any paid-up capital to cover it. Now that we have introduced the concepts of retained risk and transferred risk, we can de®ne them here. Transferred risk refers to that subset of ®rm risk for which losses are borne by another party. The ®rm pays only the cost of transferring this risk. Retained risk refers to those risks for which losses are borne by the ®rm. To summarise, once a ®rm's capital needs have been identi®ed, the capital instruments have to be put in place and consequently the ®rm's risks are either retained or transferred, as the following two relationships show: firm capital firm risk

ˆ paid-up capital ‡ off-balance-sheet capital ˆ retained risk ‡ tranferred risk

The preceding discussion allows us to relate the capital resources that a ®rm has put in place to its required capital, which is a function of its risks, f (®rm risk):

. If ®rm capital equals required capital, the ®rm is adequately capitalised. . If ®rm capital exceeds required capital, the ®rm is overcapitalised and is likely not to meet investor expectations.

. If ®rm capital falls short of required capital, the ®rm is undercapitalised and taking risks beyond its stated tolerance exposes it to insolvency.

Understanding the role of corporate capital, both on- and off-balance-sheet, and its relationship to the riskiness of a ®rm's activities provides the foundation upon which to build a common framework that ties in both the insurance market and the capital market.

Models of capital structure Traditionally there are two models of a corporation ± the standard model and the insurance model. By combining these two, we develop the common framework that we call the insurative model.

38 Integrating Risk and Capital Management

The standard model The standard model is the conventional corporate ®nance approach to developing a ®rm's capital structure. The ®rm's risk is not explicitly speci®ed. Instead the starting point is a statement of the ®rm's paid-up capital requirement. The objective is to construct a combination of equity, mezzanine (or subordinate) debt and senior debt that an investment or commercial bank can sell to investors or syndicate to lenders. Normally the distinction between these forms of capital is understood in terms of priority to claims on corporate cash ¯ows while the ®rm is operating, and on corporate assets if the ®rm is liquidated. There is another way to describe this model, one that relates to risk. This model refers only to risks that are retained by the ®rm. It addresses only onbalance-sheet, paid-up capital. If the ®rm uses only equity capital, then the shareholders are fully exposed to the ®rm's retained risks. By introducing senior and subordinate debt, the model distinguishes between the forms of capital by their exposure to the ®rm's risks. The standard model strati®es all the ®rm's risks and speci®es that capital providers share those risks sequentially. The senior debt providers are the least exposed, and the equity investors are the most exposed (Figure 5.2). In effect the standard model equates the paid-up capital of the ®rm to the amount necessary to cover its retained risk. It ignores the possibility that other forms of capital may be utilised to cover this risk. Using the function f (risk) introduced earlier, we can write the following relationship:4 paid-up capital ˆ f …retained risk†

ˆ capital meeded to cover retained risk

Low

High Senior debt

Priority of claim

Mezzanine finance

Exposure to risk

Equity

Low Retained risks of corporation

Figure 5.2 The standard model

High

Prakash Shimpi 39

The difference in cost between each form of capital re¯ects the difference in risk exposure. It is in the ®rm's interest to introduce debt, since debt can enhance the risk-return pro®le of the shareholders. Just how much debt the ®rm should have is discussed at length in most corporate ®nance texts.5 It is suf®cient for our purposes to highlight, in an abbreviated form, two measures of interest to management. The ®rst is return on equity (ROE) and the second is the weighted-average cost of capital (WACC). We shall de®ne and discuss these below. Before proceeding any further, it is important to recognise two fundamental milestones in corporate ®nance theory from the seminal work of Modigliani and Miller (MM).6 MM Proposition I states that, in the absence of taxes, transaction costs and other market imperfections, a ®rm cannot change the total value of its securities just by splitting its cash ¯ow into different streams. This is because the ®rm's value is determined by its real assets, and not by the securities it issues. So long as the ®rm's investment structure ± and therefore the cash ¯ows it expects from its operations ± is taken as given, the ®rm's capital structure is irrelevant. In addition, MM Proposition II states that the expected return to shareholders of a ®rm that has debt will increase in proportion to its ratio of debt to equity. This increase is linear as long as the debt is risk-free. However if the level of borrowing makes the debt risky, then the debt holders will demand a higher return, leading to a slower increase in the expected return.7 The following numerical examples describe the calculation of ROE and WACC, and illustrate the MM propositions (Box 5.1). Alpha Corporation needs no more than $1500 in capital 99 per cent of the time. It has an expected operational capital need of $500. It is not concerned with holding any additional signalling capital. It purchases insurance at a price (insurance premium) of $10, which relieves it of having to raise $500 in paid-up capital.8 We refer to this amount of paid-up capital relief as (insurance capital). (Note that insurance capital is not the amount of insurance protection purchased ± a point we shall discuss later.) The ®rm's gross income, de®ned as revenues minus operating expenses, excluding debt interest and insurance premium, is $160. Its net operating income is $150, which is gross income minus the insurance premium. Its net operating earnings, de®ned as net operating income minus the debt interest, is also $150, since Alpha does not have any debt. With the standard model, Alpha's balance sheet relationship does not explicitly re¯ect the value of its insurance arrangements. It shows only its paid-up capital as $1000, which is assumed to be fully deployed in the ®rm's productive assets. Although the assets earn a gross income of $160, the paid-up capital earns a net operating income of $150. Irrespective of its ®nancing sources, the ®rm's assets earn a gross income of $160. We de®ne the return on assets (ROA) as the ration of gross income to the book value of assets. Alpha's ROA is 16 per cent ($160/$1000). If its

40 Integrating Risk and Capital Management

Box 5.1

Return on equity for company Alpha

Operating capital Risk capital Signaling capital Capital required Less capital met by insurance Paid-up capital

$ 500 1000 0 1500 500 1000 ˆ book value of assets

Gross income Insurance premium Net operating income Debt interest Net operating earnings

160 ˆ earned on assets 10 150 ˆ earned by paid-up capital 0 150 ˆ available to shareholders

Return on assets: gross income ROA ˆ ˆ assets

160 ˆ 16% 1000

Return on paid-up capital: net operating income ROP ˆ ˆ paid-up capital

150 ˆ 15% 1000

Return on equity: net operating earnings ˆ ROE ˆ equity capital

150 ˆ 15% 1000

®nancing decisions do not affect the ®rm's projects, then, in the absence of market imperfections, its return on assets should remain unchanged. Similarly we de®ne a new measure, the return on paid-up capital (ROP), as the ratio of net operating income to the book value of paid-up capital. Alpha's ROP is 15 per cent ($150/$1000).9 Alpha does not believe in leverage, the use of debt. Its capital is composed entirely of $1000 in equity. The entire net operating income of $150 is available as earnings for shareholders. The return on equity (ROE), de®ned as the ratio of net operating earnings to the book value of equity, is 15 per cent ($150/$1000), which is exactly the same as its ROP. Now consider Beta Corporation, which has exactly the same characteristics as Alpha except that it is willing to borrow (Box 5.2). Beta's management feels that the operational capital is a stable number, so they therefore raise $500 in debt and $500 in equity. The interest on debt for Beta is 10 per cent, so it takes a charge of $50, assuming no taxes.10 The income available to

Prakash Shimpi 41

Box 5.2

Return on equity for company Beta

$ Paid-up capital ˆ 1000 Debt capital ˆ 500 Equity capital ˆ 500

$ Net operating income ˆ 150 Interest on debt ˆ 50 Net operating earnings ˆ 100

Return on equity: net operating earnings $100 ROE ˆ ˆ 20% ˆ equity capital $500 shareholders, its net operating earnings, is now only $100 ($150±$50). However, since there is less equity the return on equity is higher than Alpha's, at 20 per cent ($100/$500). Beta has reduced its equity and increased the return on that equity by borrowing. This increased return is due to the increased burden of risk that the shareholders take relative to the debt providers. It should be clear from the preceding discussion that ROE is a pro®tability measure based on the book value of equity. We turn our attention now to measuring a ®rm's cost of capital, which is based on the market value of that capital.11 Were corporate debt not risky, it would be reasonable to assume that it would be available at the same rate to all ®rms. In reality we know that debt is risky and there is a spread over a risk-free interest rate that corporate borrowers have to pay. That spread is a function of the riskiness of the debt. The return that equity holders demand also depends on the risk associated with a ®rm. The standard measure of the cost of these sources of capital is the weightedaverage cost of capital, WACC. In the standard model, which is a model of paid-up capital, WACC refers only to the average cost of debt and equity. The cost of debt (COD) can be determined fairly easily. It is the ®rm's current borrowing rate on debt; it re¯ects the expected return of debt holders. One way to compute it is ®rst to project the expected interest expense that the ®rm expects to pay on its outstanding debt each year. The cost of debt is then the discount rate that equates the present value of this stream of expected interest payments to the debt value, the market value of debt. To illustrate, if we assume that the expected interest payment is the same each year in perpetuity, then: Cost of debt ˆ expected annual interest payment=debt value The cost of equity (COE) requires some thought. Like the cost of debt, it re¯ects the expected return for shareholders. Unlike the cost of debt, the cost of equity is dif®cult to determine precisely, although several methods are

42 Integrating Risk and Capital Management

available to calculate an approximate value. One method, based on the capital asset pricing model (CAPM), calculates the cost of equity as the sum of the riskfree rate and the expected risk premium on a ®rm's shares. The expected risk premium is based on the sensitivity of a share's price to overall stock market movements. Another method, known as the Gordon growth model, is similar to the method used above for the cost of debt. It calculates the cost of equity as the discount rate that equates the present value of future shareholder dividends, assumed to grow at a constant rate, to the equity value, the market value of equity.12 For our purposes, we use the following simple method to determine the cost of equity. We assume that, in an ef®cient market, shareholders known what a ®rm's activities are expected to earn for them over some future period. The cost of equity is the discount rate that equates that stream of earnings to the market value of equity. For example, if this expected net operating earnings is constant each year in perpetuity, then: Cost of equity ˆ expected annual net operating earnings=equity value Once we have determined the cost of debt and the cost of equity, WACC is simply the average of these costs, weighted by the respective market values of debt and equity: WACC ˆ cost of debt  …debt value=‰debt value ‡ equity valueŠ† ‡ cost of equity  …equity value=‰debt value ‡ equity valueŠ† Let us consider companies Alpha and Beta again. For ease of exposition, assume that market values of debt and equity equal the book values, and that the ®rms will continue to earn the same amounts in perpetuity. The cost of equity is calculated using the above formula (Box 5.3) The cost of equity for Alpha is 15 per cent. Since it has no debt, its WACC is simply the cost of equity of 15 per cent. The cost of equity for Beta is 20 per cent, re¯ecting the added risk that shareholders of a leveraged ®rm have to bear. As predicted by MM Proposition I, the WACC for Beta is 15 per cent, the same as for Alpha. Of course we have made several simplifying assumptions here. We made the calculation of cost of equity appear trivial; in reality it is more dif®cult. Furthermore we made the assumption that when a company borrows, its shareholders are able to demand the appropriate additional return to compensate them for the additional risk. This should be so in ef®cient markets. However there is a view that markets are not as ef®cient as required for the MM propositions to hold. In that case, there is an optimum level of borrowing that does not increase the required ROE as much as predicted by MM, thereby lowering WACC. For example, if the shareholders of Beta feel that the additional risk they take relative to shareholders of the comparable unleveraged ®rm, Alpha, requires 3 per cent additional return, then Beta's COE will be 18 per cent instead of the predicted 20 per cent, producing a WACC of 14 per cent.

Prakash Shimpi 43

Box 5.3

Weighted-average cost of capital for companies Alpha and Beta

WACC ˆ cost of debt 

debt value debt value ‡ equity value

‡ cost of equity 

equity value debt value ‡ equity value

WACC for Alpha: expected annual net operating earnings $150 COE ˆ ˆ 15% ˆ equity value $1000 Since debt value ˆ 0, WACC ˆ COE ˆ 15% WACC for Beta: expected annual interest payment $50 ˆ 10% ˆ COD ˆ debt value $500 expected annual net operating earnings $100 ˆ ˆ 20% COE ˆ equity value $500 WACC ˆ 10% 

$500 $500 ‡ 20%  ˆ 15% $500 ‡ $500 $500 ‡ $500

The insurance model It is not common to consider insurance in a corporate ®nance setting. Nevertheless doing so provides some insights ± we show this in the examples below. In the insurance model, risks are speci®ed explicitly. Risks are either transferred through insurance and hedging or retained by the ®rm. Transferring risks changes the ®rm's retained risk pro®le. As a consequence insurance has a direct impact on corporate capital structure. It is worth brie¯y noting the difference between transferring a risk in insurance form and in capital markets (derivatives) form. Risk transfer using insurance indemni®es the ®rm from losses arising from that risk ± the ®rm can only collect if it actually incurs a loss. Also, before the ®rm can buy the insurance protection it has to demonstrate that it has an insurable interest, that is, it is actually exposed to losses from the insured risk. Risk hedges in capital markets are not indemni®cation contracts. Payments are made irrespective of whether the ®rm incurs a loss. The ®rm can purchase the hedge (generally a derivative) whether or not it is exposed to the underlying risk. For this discussion the term `insurance' I refers both to insurance contracts and to capital market forms of risk transfer. Figure 5.3 shows that insurance is off-balance-sheet capital that covers the risk transferred by the ®rm. Like debt and equity, different insurance contracts can be constructed to cover separate

44 Integrating Risk and Capital Management

Near-the-money/ first loss layers

Insurance and derivatives

LOW Out-of-the-money/ excess of loss layers

Exposure to risk

High Firm’s risks

Transferred

Retained

Figure 5.3 The insurance model

layers of a risk. Exposure to risk is highest for the ®rst loss layers of insurance (or `near-the-money' options), covering losses that occur with a high frequency but have a low severity. Least exposed are excess of loss layers (or `out-of-the-money' options), covering low-frequency events that can have a high severity of losses. In effect the insurance model equates the off-balance-sheet capital of the ®rm to the amount necessary to cover its transferred risk. Using the function f (risk) again, we can write: off-balance-sheet capital ˆ f …transferred risk† ˆ capital needed to cover transferred risk The insurance model focuses only on the risk being transferred and the cost of doing so. It does not address the capital released by transferring that risk. To do so we need to develop a corporate ®nance view of the insurance model. This is an important intermediate step on the way to developing the insurative model. In our examples above the insurance cover would probably be stated as protection for losses up to, say, $1000 (the insurance limit) at a premium rate of 1 per cent, or an insurance premium of $10. As stated earlier, such a premium is appropriate for a high-severity, low-probability risk. The premium rate,

Prakash Shimpi 45

expressed as a percentage of the insurance limit, does not provide the true cost of insurance as a capital resource, because the insurance limit does not signify the capital relief provided to the ®rm through insurance. (As mentioned earlier, by buying insurance the ®rm is relieved from raising some paid-up capital, hence the term `capital relief'.) The capital relief is likely to be less than the insurance limit. The insurance limit de®nes the maximum loss payable, but it does not re¯ect the probability of such a loss occurring. The insurance premium of $10 does represent the probability-weighted average of all possible losses, from the ®rst dollar payable to the full insurance limit.13 It is possible, therefore, that the probability of a full insurance limit loss occurring is less than 1 per cent. In other words, with a probability of 99 per cent the loss under the insured risk is less than $1000. If a ®rm de®nes its probability of ruin threshold to be 1 per cent, then the capital relief provided by the insurance cover is also less than the insurance limit of $1000. Let us go one step further and assume that the ®rm has a number of insurance policies in place. Then the insurance premium of $10 and the limit of $1000 are, respectively, the sums of all the ®rm's insurance premiums and limits. In this case it is more than likely that the capital relief will be less than $1000, since the probability of full-limit losses occurring simultaneously under all the policies is remote. After conducting a risk mapping analysis the company recognises that this insurance programme removes the need to raise paid-up capital of $500. Without insurance the ®rm would have to raise $500 of equity (since equity and not debt is more appropriate to stand behind such risk). In the previous section we de®ned this amount of capital need, replaced by insurance as the insurance capital. The total capital resources available to the ®rm is the sum of debt, equity and insurance capital. The ®rst two are paid-up capital and the last is off-balance-sheet capital. The following relationships describe the capital resources in the insurance model: firm capital ˆ paid-up capital ‡ off-balance-sheet capital ˆ debt capital ‡ equity capital ‡ insurance capital Conventionally the insurance model makes no statement about the shareholders' return on equity or the corporation's weighted-average cost of capital. Recognising now that insurance is a component of corporate capital, how will these two measures be affected? We consider ®rst the impact on ROE and then on WACC. For both Alpha and Beta the mere recognition of insurance has no impact on ROE, since the earnings and the equity amounts are unchanged. The calculations in Boxes 5.1 and 5.2 remain the same. However the recognition of insurance as a capital resource could change the amount of insurance that the ®rms have relative to debt and equity.

46 Integrating Risk and Capital Management

Does ROE remain constant if the ratio of insurance to equity, for instance, is changed? We saw that leverage produced a higher ROE for Beta than Alpha. Therefore changing the amount of insurance is likely to change ROE. To verify this, consider Alpha's decision to drop its insurance programme and replace it with new equity (Box 5.4) First, dropping its insurance programme saves $10 in expenses. Second, its equity capital increases to $1500. The additional $500 is assumed to be deployed fully in the ®rm's activities and is able to earn the same return on assets, which we know is 16 per cent. The ®rm earns 16 per cent on assets of $1500, which is $240. This entire amount is available to the shareholders, since there are no other providers of capital. ROE is therefore 16 per cent as well, an increase from the 15 per cent calculated earlier. This analysis could lead one to believe that the shareholders of the uninsured ®rm earn an additional 1 per cent return for taking over the risks that would otherwise have been insured. This reasoning is ¯awed. To appreciate the ¯aw, suppose that Beta also decides to drop its insurance programme and replace it with $500 of new equity. As with Alpha, the new assets earn 16 per cent, leading to a net operating income of $240 on assets of $1500. Subtracting the interest on debt of $50 leaves net operating earnings of $190 on an equity of $1000. Beta's ROE is now 19 per cent, which is 1 per cent less than the 20 per cent calculated earlier. Surely the shareholders of the uninsured Beta are not giving up 1 per cent in return for taking on the additional risks. To understand the true dynamics, consider the change in return caused by converting $500 of off-balance-sheet capital (insurance) to $500 of paid-up capital (equity). Dropping the insurance programme saves a premium expense of $10, or 2 per cent of $500. Raising the new equity increases revenues by $80,

Box 5.4 ROE for companies Alpha and Beta with no insurance if all assets earn 16 per cent ($)

Old paid-up capital New equity capital Return on all assets Net operating income Interest on debt Net operating earnings Total equity capital

Alpha 1000 500 16 240 0 240 1500

Beta 1000 500 16 240 50 190 1000

Uninsured ROE Insured ROE Change in ROE

16% 15% ‡1%

19% 20% �1%

ˆ old assets ˆ new assets

Prakash Shimpi 47

or 16 per cent of $500. The net change in return is the sum of these two amounts, which is $ 90, or 18 per cent of $500. Alpha's ROE with insurance is 15 per cent. The additional $500 equity brings a higher return of 18 per cent. The new ROE is therefore increased to 16 per cent. On the other hand Beta, with insurance, has an ROE of 20 per cent. The additional $500 of equity brings a lower return of 18 per cent, leading to a lower ROE of 19 per cent (Box 5.5). The preceding discussion con®rms that insurance does indeed have an impact on the ROE of a ®rm. We were able to demonstrate this using two simplifying assumptions. These assumptions are embodied in the statement that the new assets can earn the same return on assets (ROA) of 16 per cent as the old assets. Without these assumptions, the impact of insurance on ROE is likely to be even more pronounced. The two assumptions are:

. Available investment projects . Ef®cient markets The ®rst states that the ®rm will be able to deploy fully the additional $500 of equity in new projects to achieve a 16 per cent return on assets. In reality the ®rm may not have suf®cient projects to enable it to do so. More importantly, though, the ®rm may have to underinvest this capital in order to maintain a

Box 5.5 Alternative calculation of uninsured ROE if all assets earn 16 per cent Income due to new equity capital ˆ insurance expense savings ‡ new asset income ˆ …2%  $500† ‡ …16%  $500† ˆ 18%  $500 Return on new equity capital of $500 ˆ 18%

Alpha:

Return on old equity capital of $1000 ˆ 15%

Uninsured ROE ˆ

15%  $1000 ‡ 18%  $500 ˆ 16% $1500

Beta:

Return on old equity capital of $500 ˆ 20%

Uninsured ROE ˆ

20%  $500 ‡ 18%  $500 ˆ 19% $1000

48 Integrating Risk and Capital Management

certain level of liquidity to meet the risky events normally covered by insurance. Instead of earning a 16 per cent return on the additional $500 of assets, the ®rm may only be able to achieve, say, 7 per cent. The second assumption is one of ef®cient markets. In contrast to the securities market, where there is a lot of information about the value of securities traded in an open and transparent manner, the insurance market is one of bilateral negotiations, customised risk portfolios and, at best, opaque pricing. The very existence of the insurance industry indicates that moving risks from the balance sheet of a corporation to that of an insurance company creates value. Unfortunately it is dif®cult to get a ®x on that value. However this value creation does imply that the ®rm's shareholders would not be able to get that same value by replacing insurance with more equity. Once again, instead of earning a 16 per cent return on the additional $500 of assets, the ®rm may only be able to earn, say, 7 per cent. Box 5.6 shows that if the new assets are only able to earn 7 per cent, then Alpha's ROE falls from 15 per cent to 13 per cent in the absence of insurance. Similarly Beta's ROE falls from 20 per cent to 14.5 per cent. We now turn our attention to the cost of capital. How does one construct the WACC in this case? The standard model would look at the cost of debt and equity only. For the companies in our examples, the standard model produced a WACC of 15 per cent. That cannot be the true cost since it ignores insurance. An alternative way to calculate the cost of capital is to develop a true WACC Box 5.6

Uninsured ROE if new assets earn 7 per cent

Income due to new equity capital ˆ insurance expense savings ‡ new asset income ˆ …2%  $500† ‡ …7%  $500† ˆ 9%  $500 Return on new equity capital of $500 ˆ 9%

Alpha:

Return on old equity capital of $1000 ˆ 15%

Uninsured ROE ˆ

15%  $1000 ‡ 9%  $500 ˆ 13% $1500

Beta:

Return on old equity capital of $500 ˆ 20%

Uninsured ROE ˆ

20%  $500 ‡ 9%  $500 ˆ 14:5% $1000

Prakash Shimpi 49

that incorporates both on- and off-balance-sheet capital. We call this the total average cost of capital (TACC). The numerator is the sum of the cost of insurance and the costs of debt and equity. The denominator is not just the value of paid-up capital but the total value of ®rm capital, including insurance. If we de®ne the total value of ®rm capital to be ®rm value, then: firm value ˆ debt value ‡ equity value ‡ insurance value

ˆ paid-up value ‡ off-balance-sheet value

and TACC ˆ cost of debt  …debt value=firmvalue† ‡ cost of equity  …equity value=firm value† ‡ cost of insurance  …insurance value=firm value† Two terms in the equation have not yet been de®ned: insurance value and cost of insurance. We shall address each in turn. We have already de®ned insurance capital as the capital relief provided by insurance. Now we need to determine the value of this capital relief, which we de®ne as insurance value. Unlike debt value and equity value, insurance value is not directly observable in the ®nancial markets. We propose that the best estimate of the value of insurance to a ®rm is the current amount of capital relief that insurance provides. At any point in time, if the ®rm decides to replace insurance with paid-up capital it will have to raise new equity. By de®nition the amount of new equity will have to equal the capital relief provided by insurance at that instant. At the date of issue the book value of new equity equals its market value. Hence the value of the capital relief (book value) is equal to the insurance value (market value). The cost of insurance (COI) is de®ned as a ®rm's current insurance rate for its covered risks, measured as a percentage of insurance capital. It is the discount rate that equates the present value of expected insurance premiums to the insurance value. The next step, therefore, is to estimate the future stream of insurance premiums that the ®rm is likely to pay. When insurance protection is provided in capital market form (for example derivatives) the insurance premium is determined as the current trading price of the cover. When it is provided through an insurance contract the current insurance premium is not always observable, but it is possible to get indicative quotes. If we assume that the expected insurance premium is the same each year in perpetuity, then: cost of insurance ˆexpected annual insurance premium=

insurance value

For both Alpha and Beta the insurance value equals the capital relief of $500. If the expected annual insurance premium stays at the current amount of $10, then cost of insurance is 2 per cent ($10/$500).

50 Integrating Risk and Capital Management

We now have all the values necessary to calculate the TACC for Alpha and Beta (Box 5.7). The total value of the ®rm's capital resources, including insurance, is $1500. Both ®rms pay the same insurance premium ($10) and the same expense on paid-up capital ($150) for a total of $160. This gives a TACC of 10.67 per cent for each ®rm. We showed that under the standard model the WACC of the unleveraged ®rm, Alpha, equals its cost of equity. In the insurance model it is clear that TACC does not equal cost of equity. This is because insurance is recognised explicitly in the calculations. If the ®rm had no insurance, would the TACC be equal to cost of equity? Under the idealised assumptions of the MM propositions, the answer is absolutely yes. In Box 5.4 we showed that the net operating earnings of Alpha without insurance are $240. As before, if the market value of equity is assumed to be its book value of $1500, then the cost of equity is 16 per cent ($240/ $1500). Substituting into the formula in Box 5.7 gives a TACC for uninsured Alpha of 16 per cent. In Box 5.8 the TACC for uninsured Beta is shown to be 16 per cent as well, as predicted by the MM propositions. If we relax these idealised assumptions and assume, as before, that the new equity for an uninsured ®rm can only earn 7 per cent instead of 16 per cent, then it is not reasonable to use the costs of equity of 16 per cent and 19 per cent for uninsured Alpha and Beta. The shareholders would actually earn a lower return, and would adjust their expectations downward. The underutilised equity capital becomes a drag on earnings. It is notable that the TACC of the insured ®rm is lower than the TACC of the uninsured ®rm. Clearly this need not always be so. A poorly constructed insurance or hedging programme may not provide the necessary capital relief to a ®rm. However if it is structured appropriately the reduction in capital costs can be signi®cant. The conventional focus on WACC in the Standard Model misses this point entirely. Box 5.7

Total average cost of capital (TACC) for insurance model

TACC ˆ cost of debt  debt value=firm value ‡ cost of equity  equity value=firm value ‡ cost of insurance  insurance value=firm value Alpha: TACC ˆ 10%  Beta: TACC ˆ 10% 

$0 $1000 $500 ‡ 15%  ‡ 2%  ˆ 10:67% $1500 $1500 $1500 $500 $500 $500 ‡ 20%  ‡ 2%  ˆ 10:67% $1500 $1500 $1500

Prakash Shimpi 51

Box 5.8

TACC for uninsured companies Alpha and Beta

TACC for uninsured Alpha: Cost of equity ˆ

$240 ˆ 16% $1500

Since debt value ˆ 0 and insurance value ˆ 0, TACC ˆ COE ˆ 16%. TACC for uninsured Beta: Cost of equity ˆ TACC ˆ 10% 

$190 ˆ 19% $1000

$500 $1000 $0 ‡ 2%  ˆ 16% ‡ 19%  $1500 $1500 $1500

In summary, the conventional insurance model does not consider ROE and WACC explicitly, but it is not too much of a stretch to take a corporate ®nance view of insurance. The insurative model The next step is obvious. Combining the effects of the standard model and the insurance model gives us a simple generalised framework with which to consider the effects of on- and off-balance-sheet capital, accessing both the insurance and the capital market. We call this the insurative model. In effect the insurative model equates all ®rm capital to the amount necessary to cover all ®rm risks, both retained and transferred. Using the function f (risk) as before, we have: firm capital ˆ f …firm risk†

ˆ capital needed to cover firm risk

or: paid-up capital ‡ off-balance-sheet capital ˆ f retained risk ‡ f …transferred risk† This is structurally richer than merely combining the standard model and the insurance model. Recall that in the standard model paid-up capital only referred to retained risk, and in the insurance model off-balance-sheet capital only referred to transferred risk. In the insurative model paid-up capital can be used to cover some of both retained and transferred risks. Likewise off-balancesheet capital can be used to cover some of both those risks as well (Box 5.9).

52 Integrating Risk and Capital Management

Box 5.9

Risk related to capital in the insurative model

If paid-up capital (PC) covers the proportions p of retained risk (RR) and q of transferred risk (TR), and off-balance-sheet capital (OC) covers the rest,

then:

PC ˆ p  …RR† ‡ q  …TR†

OC ˆ …1 � p†  …RR† ‡ …1 � q†  …TR†

Summing both sides of these equations gives:

PC ‡ OC ˆ …RR† ‡ …TR†

Or ®rm capital ˆ ®rm risk

This framework captures the economics of conventional insurance and corporate ®nance instruments, as well as the new integrated products. What implications does this model have for our picture of corporate capital structure? Figure 5.4 shows just how rich the diversity of corporate capital resources can be, and how necessary it is to develop this generalised model of corporate capital and risk. First, we can identify those resources that provide paid-up capital to the ®rm. If these cover risks retained by the ®rm, then they are the familiar Off-balance-sheet

Paid-up

Contingent capital

Senior debt

Mezzanine finance

Equity

Insurance-linked securities

Low

Insurance and derivatives

Firm capital

Exposure to risk

High Firm’s risks

Transferred

Figure 5.4 The insurative model

Retained

Transferred

Prakash Shimpi 53

varieties of equity and debt as well as some forms of ®nite risk reinsurance. If they cover risks that are being transferred away from the ®rm then they are new instruments such as insurance-linked securities that embed insurance risks in corporate bonds. Second, we can identify those resources that release the ®rm from immediately raising paid-up capital. If they cover risks that are being transferred away from the ®rm, then they are insurance or derivative contracts. If they cover risks that are retained by the ®rm, then they are new instruments such as contingent capital. In addition we can consider the effect on corporate capital of transferring the risks of discontinued businesses off-balance-sheet using run-off facilities. We coined the term `insurative' to refer to any corporate capital resource, be it debt, equity, insurance, derivative, contingent capital or any other. The insurative model embraces all of these instruments and allows us to evaluate their effectiveness in a consistent framework. The standard model's exclusive focus on debt and equity ignores the range of capital resources available to a corporation. This can distort the view of a ®rm's capital cost and its return on equity. In particular, minimising WACC under the standard model may not lead to minimising the TACC of the corporation. As we saw in the previous section, if the mix of insurance, debt and equity remains unchanged, there should be no change in ROE under the expanded model. The generalised framework then states the ROE equation as: ROE ˆ net operating earnings=equity capital where net operating earnings is the amount available to shareholders after paying all the costs of other paid-up and off-balance-sheet capital, and equity capital is a book-value measure. In this model, TACC considers all sources of capital. The numerator includes the costs of both on- and off-balance-sheet capital. The denominator is not just the value of paid-up capital but the total value of the capital resources of the ®rm, that is, ®rm value. As stated earlier, the TACC formula is: TACC ˆ cost of debt  …debt value=firm value†

‡ cost of equity  …equity value=firm value†

‡ cost of insurance  …insurance value=firm value†

The sum of the ®rst two terms is the proportion of TACC due to paid-up capital, and the last term is the proportion of TACC due to off-balance-sheet capital. As shown in Box 5.10, WACC, the cost of paid-up capital, is only one component of the true capital cost of the ®rm. If we de®ne paid-up value as the value of paid-up capital, then: paid � up value ˆ debt value ‡ equity value

54 Integrating Risk and Capital Management

Box 5.10

Relationship of TACC to WACC

TACC ˆ cost of debt  debt value=firm value ‡ cost of equity  equity value=firm value ‡ cost of insurance  insurance value=firm value Adjust the ®rst two terms: debt value paid � up value  paid � up value firm value equity value paid � up value ‡ cost of equity   paid � up value firm value insurance value ‡ cost of insurance  firm value

TACC ˆ cost of debt 

Combine the ®rst two terms: TACC ˆ WACC  paid � up value=firm value ‡ cost of insurance  insurance value=firm value This allows us to restate TACC in the following way: TACC ˆ WACC  …paid-up value=firm value†

‡ cost of insurance  …insurance value= value†

Although the examples in this chapter have separately considered debt, equity and insurance (of both insurance risks and capital markets risks), the insurative framework is general enough to consider risk management techniques that combine facets of all these elements. This framework shows us that a ®rm's decisions on insurance and risk retention can be just as important as its decisions on its debt±equity mix. Determination of a ®rm's optimal debt±equity mix is only the last in a series of capital structure decisions that its management must make. As we show in Box 5.11, the preceding steps include decisions on risk retention, risk transfer and the amounts and structure of paid-up and off-balance-sheet capital. It is worthwhile to highlight a point touched on in the previous section. Financial statements of corporations do not adequately disclose all offbalance-sheet facilities. In particular, insurance protection is not clearly described. Financial managers do try to give an accurate account of their capital costs and return potential. However, being familiar with the standard model they focus on ROE and WACC. The insurative model shows that this does not give the true picture: no distinction is made between companies that are well-insured (or hedged) and those that are not.

Prakash Shimpi 55

Box 5.11

Steps in determining a ®rm's debt±equity mix

1. 2. 3. 4.

Identify the ®rm's risks. Calculate the capital required to cover those risks. Determine the risks to transfer and to retain. Determine the required amount of paid-up capital and off-balancesheet capital. 5. Structure the off-balance-sheet capital. 6. Structure the paid-up capital, which includes the decision on debt± equity mix.

The insurative model allows us to compare the impact of derivatives strategies, multiline insurance covers, contingent capital facilities, ®nite risk reinsurance, insurance-linked securitisation, asset-backed securitisation and various forms of debt and equity in one consistent framework. The prerequisites for making such comparisons appropriately are by no means trivial; they require a thorough understanding of the ®rm's risks, their interactions and their impact on ®nancial performance. On top of this, the structural, features of the insuratives must be modelled and their impact on the ®rm assessed. Then the ®rm must determine the decision criteria for selecting a particular capital structure and put the appropriate capital resources into place. We now turn our attention to how the interaction between risk and capital management is changing the function of corporate risk management.

The changing function of risk management This analytical framework was developed to help describe some of the changes that are taking place in corporate risk management. The risk manager and treasurer are entrusted with managing operational and ®nancial risks within the framework of a given capital structure, the composition of which is the responsibility of the CFO. Besides avoiding or reducing risk, the risk manager has traditionally had recourse to the insurance markets to transfer risk to third parties, and the treasurer has had recourse to the capital markets to transfer risk and (separately) obtain ®nancing. The CFO has viewed the capital markets as the primary vehicle for maintaining or transforming capital structure. As the capital and insurance markets converge, progressive organisations have started to develop risk management tools that incorporate features of both. For example one of the new integrated risk management products provides a single block of insurance capacity that protects against a broad set of risks, both those that are traditionally insured and those that are hedged in the

56 Integrating Risk and Capital Management

capital markets. It may be inef®cient to purchase insurance and ®nancial loss protection separately, because the corporation may be overprotected on the ®nancial side and underprotected on the insurance side, or vice versa. By purchasing an integrated cover that protects both insurance and ®nancial exposures, the corporation is assured that capacity will be available irrespective if the source of the loss. And, of course, no matter what the source of the loss the ultimate effect on the bottom line is the same. Another consequence of the convergence of insurance and capital markets is the development of tools that combine risk transfer and ®nancing. For example ®nite risk reinsurance products combine ®nancing and risk transfer in a way that allows corporations to achieve in a single transaction the bene®ts of both insurance and debt ®nancing. The revolution in risk management techniques has implications for the CFO as well. Any policy regarding capital structure con®guration is predicated on an assessment of the risks confronting the corporation. As we saw in the insurative model, a company's risk pro®le may change as a result of the implementation of new risk management instruments, with a consequent change in corporate capital needs. Instead of simply optimising the balance of debt and equity, the CFO now has at least three instruments to use: debt, equity and insurance. In addition there are techniques that directly address the capital structure issue. Given that equity capital is an expensive source of long-term ®nancing, and that the risk pro®le of a ®rm determines its required amount of equity capital, substitutes for paid-up equity capital have the potential to offer signi®cant economies. Contingent capital products, for example, promise to infuse the company with capital precisely when it is needed ± in the event of a catastrophic loss. These products eliminate the need to hold expensive onbalance-sheet equity capital for those rare events that may in¯ict severe ®nancial harm on a corporation. An off-balance-sheet contingent capital facility (almost insurance, but not quite) can be cost effective. These examples show that the CFO, treasurer and risk manager need to recognise that integrating corporate risk management can take place at several levels. At its most basic, the integration can occur within the separate worlds of the treasurer and the risk manager. At the next level, integration can occur across the two markets. A further level of integration takes place with the inclusion of the CFO's domain of corporate capital structure. Finally, all these forces can lead to fundamental structural changes in the markets for risk capital. Notes 1. This chapter is an excerpt from Prakash A. Shimpi (ed.), Integrating Corporate Risk Management (Swiss Re New Markets, 1999) London and New York, ch. 3. 2. Prakash Shimpi, `Economics of Insuratives: Working Papers', University of London, August 1999.

Prakash Shimpi 57 3. In effect, Figure 5.1 is a representation of the function, f (®rm risk), since the simulation calculates the capital needed under various outcomes of the ®rm's risks. 4. The same function, f (risk), is used for this discussion to denote that there is a functional relationship between a risk and the capital required to cover it. The actual functional relationship between any particular component of ®rm risk and the capital required to cover it may be different. 5. For example Richard A. Brealey and Stewart C. Myers, Principals of Corporate Finance, 5th ed. (New York: McGraw-Hill, 1996), chs 16±19, discusses dividend policy and capital structure. 6. Franco Modigliani and Merton Miller, `The Cost of Capital, Corporation Finance and the Theory of Investment', American Economic Review, vol. 48 (1958), pp. 261±97. See also France. Modigliani and Merton Miller, `Corporation Income. Taxes and the Cost of Capital: A Correction', American Economic Review, vol. 53 (1963), pp. 433±43. 7. See any standard corporate ®nance text, such as Brealey and Myers, Principals of Corporate Finance, op. cit., for a full treatment of the Modigliani and Miller propositions. 8. Such a premium is reasonable for a catastrophic loss event that has a low probability of occurrence. 9. Note that in standard ®nance texts, insurance costs are included in the operating expenses, in which case the gross income would be equal to a net operating income of $150. This would make the ROA = ROP = 15 per cent. Replacing ROP with ROA in all the equations in this section would deliver the familiar equations seen in corporate ®nance textbooks. 10. If we assume that the ®rm is able to deduct its borrowing costs from its taxes, then that tax shield reduces its effective borrowing cost. See Brealey and Myers, Principals of Corporate Finance, op. cit., ch. 18, for a full discussion. 11. When we refer to capital resources in this chapter, we use the convention that `value' refers to the market value of the capital. For example equity value is the market value of a ®rm's equity. We also use the term `cost' to refer to the percentage cost of a capital resource, based on its market value. For example cost of equity is the cost of equity as a percentage of equity value. 12. Brealey and Myers, Principals of Corporate Finance, op. cit., chs 4 and 8, discuss these methods of determining cost of equity. 13. The insurer pays when losses exceed a minimum threshold. In insurance markets that threshold is known as the attachment point.

6

IT and the Pressure to Innovate and Restructure Lars H. Thunell

The ®nancial sector will face tremendous challenges in the coming years. Globalisation and information technology are the twin forces transforming the industry ± indeed the world economy ± at a pace never experienced before.

Globalisation It might sound like a clicheÂ, but we are in the midst of the greatest economic transformation in the history of mankind. Since the early 1980s, thanks to new technology and globalisation, around one billion people have been lifted from abject poverty to some kind of global middle-class status. Globalisation has proceeded in steps: via freer trade, deregulation of the capital markets to today's rapid transformation and diffusion of technology to all corners of the world. As a result the old trade-off between quality and quantity is changing. Some decades ago, when deciding on their production base global companies could choose between high-cost, high-quality production in industrialised countries and cheap, low-quality production in Third World countries. Today, however, courtesy of globalisation, new information technology and the collapse of communism, it is quite possible to produce high-quality goods and services in emerging economies ± and much more cheaply than in industrialised countries. This of course means more rapid global growth, but also new challenges to the industrialised world and its old companies. For the small and open economies of this new world there is no control room in the Ministries of Finance, where ministers can push buttons or pull levers and feel certain of controlling their national economies. As a matter of fact most national economies are merging into a single, comprehensive global economy. In this new global economy the Anglo-Saxon free market model has triumphed over the planned economy, and also over the welfare state and the Asian model. Hence there is increasing pressure for deregulation and free markets in just about all countries. Tax structures are converging as tax bases become more mobile. The number of independent currencies is diminishing, 58

Lars H. Thunell 59

due to currency unions, currency boards and dollarisation. New fashions and cultural trends are spreading rapidly via new media, global television, fax machines and the Internet ± even to the remotest villages. Young people are increasingly in¯uenced by global trends and by other young people all over the world, rather than by their local elders. We are truly becoming one world.

The IT revolution In this global environment a new revolution is taking place in information technology, a revolution that is in turn helping to propel both growth and globalisation. In my opinion the IT upheaval is a third industrial revolution ± following the ®rst industrialisation process, based on the steam engine, and the second wave, based upon the electrical motor and the internal combustion engine. There is of course no scienti®c or exact de®nition of what constitutes an industrial revolution. However economists and historians seem to agree that one important characteristic is the development of a generic technology, which is then exploited and employed in numerous sectors, creating spin-offs and `developmental blocks' in important ways that were totally unforeseen by the original innovators. We all know the story of the dynamo and the electrical motor; how it started as a big, clumsy machine at the centre of the factory ¯oor but gradually evolved over decades to become more ef®cient, smaller and universal. Today there are literally hundreds of electrical motors in each home, in our kitchen appliances, vacuum cleaners and other gadgets that have transformed everyday life. The same is true of the internal combustion engine, which radically transformed transportation, distribution, housing and living. And in time the manufacture of cars, the construction of houses and the production of television sets, refrigerators and so on created economic growth and mass prosperity on an unprecedented scale. I believe the same thing will happen again as a result of the IT revolution. Its symbol is the silicon chip and the glass-®bre cable. Some 20 years ago, when computers started to be used in industry, they were rather bulky and slow and were usually handled ± in closed-off rooms ± by men in white coats, speaking unintelligible techno-lingo. The productivity effect was low or hardly discernible. I guess we all remember Solow's quip: `Computers are everywhere but in the productivity statistics'. Now, however, computers are literally everywhere and the man±machine interface is much easier to handle, and when millions of computers are interconnected through high-speed cable the productivity effects are much greater. They are bound to be even greater in the future. While the engines of the earlier industrial revolutions simpli®ed physical human work or replaced it with machines, the chip and the cable will replace or simplify mental and intellectual work. In doing so they will transform our lives in ways we cannot imagine today.

60 IT and the Pressure to Innovate and Restructure

The ®nancial industry will be exposed to this transformation more rapidly than many other sectors. Why and how is the topic of this chapter.

Where is technology heading? The technical change brought about by the IT revolution has just begun. Over the next few years we will see rapid development in several areas.

. Moore's law (exponential growth of computing capacity) will apply at least

.

.

. . .

.

.

for the next couple of years. Processors will be faster, and memory capacity will rapidly increase. Computers and chips will become even smaller and smarter. Bandwidth will expand. The sending and receiving of immense amounts of information via the Internet is increasing much more rapidly than was thought possible only a couple of years ago. The bottleneck is the last thread out to the individual household, but here also experimentation and innovation are moving fast. The man±machine interface will become even simpler and easier to handle. We have become used to a screen, a mouse and a keyboard, but in the near future we will be able to interact with the computer through speech (or even via sensors applied to our bodies). The screens will be thinner, bendable or foldable and transportable. This means that e-mail and Internet connections will be easier to handle and will function faster from any place in the world with the help of a number of gadgets. All this opens up true interactivity. Not only will we be able to interact sequentially, but together we will be able to work on the same project or design, in real time, irrespective of where in the world we are. The communication explosion will propel the rapid development of ®lters, screening and push technologies. IT will, in simpler and less conspicuous ways, become embedded in all kinds of products and processes, which will become `intelligent' or at least self-regulated, like thermostats). We can already see this in durable consumer goods, for example antilocking brakes and automatic traction systems in cars. In the ®nancial markets we can see it in automatic trading programs and their various selling and buying orders. In manufacturing, electronics are being gradually linked to electromechanical micromotors with sensors and switches, which work in a mechanical environment in machines and products of all kinds. Huge resources are being spent on combining such techniques with medical technology. Self-regulating medication and medical treatment, even operations, via remote control is already here. Simulations and similar technology can also be utilised to revolutionise education. In manufacturing and the service sector it is increasingly possible to mass produce tailor-made products, paradoxical as that may sound. Computerised

Lars H. Thunell 61

control of production, inventories and supplies is being used already and is spreading to more and more industries. Generally, means of group communication and communication over large distances will be more widely available and easy to use, as well as more sophisticated.

Growth ± but still low in¯ation All of this has already affected the macro economy, and it will have an even greater impact in the future. In the words of Joseph Schumpeter, earlier revolutions started long waves of growth and credit expansion. The pattern is not completely clear, and it has repeatedly been disturbed by external shocks (wars and political disruption) and internal boom±bust cycles. Nonetheless, beneath the surface of day-to-day events it is quite possible to see a secular trend. Consequently, part of the rapid growth of the postwar period can be explained by the transformation of society through commercialisation of the electrical motor and the internal combustion engine. The gradual economic retardation during the 1970s and early 1980s was partly due to external shocks (oil crises) and politics (de®cit ®nancing and in¯ation), but it can also, or at least partially, be explained by the fact that these technologies had matured to such an extent that they had lost much of their creative and transforming effects. If the hypothesis about a third industrial revolution proves correct, we are now on the threshold of a new period of growth, but nobody knows how lasting or how strong it will be. Even though there will certainly be setbacks every now and then, I believe that it will take decades for the new technologies to make enough breakthroughs to lose their power. If such optimism is justi®ed, we will see a better-functioning economy for several years in the western economies:

. Technical development will cut costs.

. Consumers will be stronger, better informed and more likely to shop

around for the best buy.

. Quality of information and the more rapid processing of information will help cut transaction costs.

There is a clear possibility that the next decade will be characterised by strong growth and low in¯ation in many countries outside the US. It is impossible to quantify the growth effect, not least because statistical aggregates have a hard time capturing the development of the service sector. In particular, national accounts tend to underestimate improvements in the quality of goods and services. This is crucial to the knowledgebased economy that is now emerging. Nonetheless it is a good bet that

62 IT and the Pressure to Innovate and Restructure

growth in Europe and elsewhere will be stronger in the ®rst decade of the twenty-®rst century than it was during the last 25 years of the previous century. Furthermore there is a fair chance that in¯ation will stay low. Central banks have become more independent and they are likely to continue their in¯ationbashing. They will be supported in this by the breakthrough of new costcutting and competition-enhancing technologies. More rapid productivity growth, improved market transparency and globalisation all speak in favour of low in¯ation. It is true that serious and stringent academic economists are uncertain of the quantitative effects, telling us sternly that this is not really a retardation of in¯ation rate per se, but rather a one-off effect on the price level. They may be right ± in theory. But in real life it will take years for these one-off effects to make their full impact, and to any non-economist, therefore, they are naturally interpreted as a lower rate of in¯ation. All practical businessmen see the effects in real life in the increasing dif®culty of raising prices. We can no longer push cost increases onto the consumer; instead we have to increase productivity. It is dif®cult to see this trend being reversed in the foreseeable future. The combination of tight monetary policies, rapid industrial transformation (the scrapping of obsolete capital) and stiffer competition will also transform wage formation and labour markets, not least in Europe. The labour market will become more fragmented as union power decreases. Salaries are being set according to productivity rather than determined by distribution or egalitarian quarrels. Clearly, cost pressures from the labour market will tend to decrease as a result. All in all it is fair to assume that growth can be strong without in¯ation picking up as a result. This does not necessarily mean that a `new economy' is replacing an `old' economy or that old economic laws have suddenly stopped working. Rather, old patterns are being stretched somewhat because of the great number of technological and structural changes. There is nothing strange about that. It should be stressed that the effects of these new technologies, although bene®cial at the global level, will not be perceived as bene®cial by some people. Schumpeter aptly coined the term `creative destruction' to depict the turbulent forces that tear down and build up in one single process. Rigid companies will be severely hit by industrial transformation. Regions that are highly dependent on such old companies will experience increased unemployment. On average, people with poor or old-fashioned educational backgrounds will fare worse than highly educated people. Wage differentials will change as new professions are created and old ones become obsolete. The leaders and stars of the new markets and technologies will be able to heap huge rewards, while others fall behind. Equity valuations will soar ± and crash, as they always do during period of intense innovation and creative destruction. Of course, this will cause strains ± for individuals as well as for elected

Lars H. Thunell 63

politicians. There is a risk of political turbulence and short-sighted political reactions.

Market change at the micro level In many respects the micro effects on individual markets will be more farreaching than the macro effects. Many markets will function more ef®ciently. As already stated, improved information and lower transaction costs will make it possible for consumers to shop around, choosing suppliers in a more ef®cient way. But beyond that it is interesting to note that markets in the communication and information sectors often tend to show more fundamental changes. In this new `network economy', markets often show four characteristics:

. Products are more valuable if many people have access to them. A single

phone or fax is not worth anything. But the more common they are, the more valuable they become since they can be linked to each other and communicate. This is a fascinating example of how the traditional textbook rule of declining marginal utility is turned on its head ± utility actually increases sharply as more machines are linked to the network. . Economies of scale cause unit costs to drop in several of these markets. The ®rst product (software program, musical recording, computer game and so on.) is expensive to manufacture, whereas mass production ± that is, digitally copying the ®rst product ± is extremely cheap. Here also the traditional hypothesis about decreasing returns seems to be wrong. . In order to enable users of fax machines, computers, cellular phones, pagers and so on to meet and communicate, the various products and systems must be able to communicate with each other. Thus industry standards must be established, spontaneously or through regulation. . All this creates strong incentives for the emergence of (perhaps temporary) monopolies. Individual companies that conquer a dominant market position can set market standards and hence make it virtually impossible for any competitor to challenge them. This makes it pro®table to act extremely aggressively in order to gain market share as fast as possible. It can be said that the supply and demand relations of network markets are different from those prevailing in ordinary markets. If the value of a product increases with the number of people who have access to it, the demand curve is upward sloping. Consequently large economies of scale mean that the slope of supply curves may be negative. Some analysts see these peculiarities as so important that we should accept a `new economy' paradigm ± alas with a new economic theory as well. Most economists, however, see such network markets as special cases of the all-encompassing traditional micro theory of economics.

64 IT and the Pressure to Innovate and Restructure

I am not all that keen on this taxonomic in®ghting. I leave that to the learned academics, even though my gut-feeling is that the old rules probably still apply in the new economy; at least, that is what the recent stock market fall tells me. But irrespective of whether you see the old laws as relevant or not, it is a fact that competition will be razor sharp in most of the new network markets. Certainly the motivation is often to conquer a monopolistic position, but I believe that such positions tend to be short-lived, as the next technological breakthrough creates a new threat to the dominant monopolistic company.

Management faces new challenges Obviously, these huge changes will have a profound impact on management. Developments in information technology will affect the very core of management as well as the company itself. Information is a decisive factor for client relations, brand name and the value chain of production. Until now information on the corporation and its products has primarily been embedded in the products themselves. But as the electronic networks evolve, information can be decoupled from the physical content and location of the products. This entails new business opportunities as information and products can be separated and reconnected in new combinations. In management literature this is called `unbundling'. The traditional value chain is broken up and put together again in new ways. In this respect the IT revolution constitutes a disruptive change to existing business on a scale never seen before. One effect is that the success and market capitalisation of ®rms can undergo sharp swings. In times of rapid change, new technologies and new products can suddenly ruin even very wellmanaged and successful companies, which just happen to be on the losing side of the new technologies. The other side of the coin is that upstarts that happen to be at the right place at the right time can suddenly be extremely successful and rewarded with a market capitalisation that ± at least for a while ± looks downright ridiculous. Such evaluations need not be long-lived; in this uncertain world new information rapidly has an effect on market capitalisation. But even though stock market valuations are volatile, the long-term economic and social effects of the new technology remains ± as do the effects on business models and management. There are many consequences for management emanating from these facts. One glaringly obvious conclusion is that hierarchical companies will tend to become less ef®cient. On the other hand ¯at organisations with a rich ¯ow of information in easy-to-access networks will foster creativity; independent and small business units are the natural building blocks of the modern corporation. But the link between the corporation and its clients will also be affected. It is possible to provide more customers with information all over the world, irrespective of where production takes place

Lars H. Thunell 65

or the products are sold. Consequently the role of the middleman or intermediary has abruptly changed. The customer and the supplier can ®nd each other faster and easier, provided the information system can screen, ®lter and select. Traditional wholesale middlemen will soon be a defunct species unless they transform themselves into electronic information specialists and navigators. However, if they are successful in this, there is a new, booming market to catch. One extremely important aspect of the new information technologies is the possibility of `data mining', that is, exploiting all the new possibilities to learn about the customer. Intelligent data information systems make it much easier to collect information about clients' needs and purchasing patterns, making it possible to customise advertising, target special offers and adjust the product mix in an ever-more fragmented world. It also opens the possibility of price differentiation, which is all the more important in a world of cut-throat competition. Given the high costs of information systems and the emergence of (albeit short-lived) technological monopolies, there are high risks involved in being locked into dependence on systems that become both costly and obsolete far more rapidly than expected. The obvious conclusion is to avoid such a locking-in. As product cycles get shorter it is also important to be more ¯exible in as many areas as possible. It is quite dangerous to put all one's eggs in one basket; ®rms that are dependent on a single technology are extremely vulnerable. The conclusion is that experimentation is vital. The ®rm must test many solutions and be prepared to incur losses in the process. It must allocate resources to make such experiments possible. To encourage creativity and overcome resistance from established departments, it is often advisable to set up special units to develop and test new technologies. This should be done even if they compete head-on with the (former) core activities of the ®rm.

Strong transformation pressure in the ®nancial sector The ®nancial industry is one of those sectors that will see the greatest and most rapid upheavals. The reason is obvious. The sector's bread and butter is to process information and the IT revolution makes it easy to unbundle its products. The new technology makes it possible not only to change old patterns, but also to create totally new products and channels of distribution. Retail banking is facing huge changes. Yesterday's banking was a vertically integrated value chain, where a number of different products were packaged, distributed and sold via a system of branch of®ces. This has been changed by electronic banking. It is seen by many as mainly a new and cheaper channel of distribution. But if my description of the trends facing us is correct, the changes will be much greater.

66 IT and the Pressure to Innovate and Restructure

As the networks grow and become more sophisticated, more customers will be able to access information through new channels and to choose more freely among various services. The supply of personal ®nancial management software is rapidly improving, while at the same time advanced analysis and updated information in real time is available more or less free from several sources, often via the most popular portals. It is probably only a question of time before alliances are formed between software producers, portals and other Web-sites on the one hand, and a number of banks and ®nancial institutions on the other. Free software and direct access to banks, as well as streaming video and audio will make it possible to see and listen to different ®nancial advisers on the Internet ± and to compare their advice. This makes the customer's freedom of choice much more real. The customer will soon be able to choose all sorts of services on the Internet. Until recently the general perception was that the market would be segmented into two main groups: cheap and quick transactions via the Internet; and more sophisticated, personalised and expensive ®nancial advice, sold for a (hefty) fee in special, plush branch of®ces. However, the borderline between these markets is becoming increasingly blurred as clients are demanding to pick and choose between services and combinations of services. It seems as though all big players must be able to provide their customers with all kinds of Internetbased services. Consequently the most sophisticated ®nancial advisory services are being subjected to intense pressure to transform themselves. Commercial banking and corporate banking have already experienced great changes. Previously stable relations between banks and corporate clients have been severed as disintermediation and niche strategies have fragmented the markets. E-commerce is creating new channels for corporate clients of all sizes, which can now ®nd each other easier and faster without traditional intermediaries. Box 6.1 Summary of the new technologies that are transforming the ®nancial sector

. Three enabling techniques. Advances in the performance and costef®ciency of three interrelated technologies (computing power, data storage and data transmission bandwidth) are dramatically reducing the cost of collecting and processing information. . Exploding connectivity and plummeting transaction costs. The fall in the cost of information is reducing transaction costs and increasing the demand for improved connectivity, creating a self-reinforcing cycle of reducted transaction costs. . Substitution of information for hierarchy. The falling cost of delivering information instantaneously throughout the organisation is resulting

Lars H. Thunell 67

.

.

.

.

.

.

.

. .

in formal organisational hierarchies giving way to more nimble, decentralised, network-based structures. Interactive customer relationships. The plummeting cost of interaction and connectivity is enabling companies to capture unprecedented amounts of data on their customers and to deliver increasingly individualised value propositions. Transformation of value chains to value webs. Lower transaction costs, increased connectivity and open standards are reducing coordination costs among multiple, disparate entities; as a result the traditional value chain is being replaced by web-like structures of coordinated, value added activity. Scale economies are increasing ± and decreasing. Increasing connectivity, increasing information intensity of production factors and declining transaction costs are undermining traditional scale economies in marketing and distribution, while increasing economies of scale in digital production. Network effects and serial monopoly. There is an increase in the prevalence of network effects, which exist when the utility that a user derives from the consumption of a good increases with the number of fellow users, leading to monopolistic business systems ± until replaced by rival product systems with displacing network effects. Digitial substitution and unbundling. The Information component of physical (or analog) products and services is being replaced by digital substitutes, often with radically different development trajectories, cost structures and distribution capabilities. Disintermediation and reintermediation. Some middlemen (retailers, agents and distributors) are being disintermediated or displaced by direct (typically electronic) buyer±seller trade; others are reintermediating markets by expanding their role as third-party information brokers or market makers. Channel disruption. Traditional physical or personal sales channels are being disrupted by lower-cost e-commerce alternatives and by consumers' increasing preference for scattering purchase activities across multiple channels. Infomediation. Traditional sales and distribution intermediaries that exploit information asymmetries are being replaced by electronic intermediaries that provide information and match buyers and sellers. Demand aggregation. The Internet and other information networks are enabling buyers to aggregate individual purchasing and `put out to bid' transactions, transferring pricing power to the demand side and transforming suppliers into explicit price takers.

68 IT and the Pressure to Innovate and Restructure

Trading is obviously undergoing similar changes due to the introduction of electronic trading. Markets have become more transparent and information is ¯owing more freely, so traditional full-service brokers have become increasingly squeezed. As a result of these changes ± and of low interest rates and low in¯ation ± it has become more dif®cult to make a pro®t on payments systems, using the ¯oat. Instead credit analysis is becoming more important as low in¯ation puts pressure on interest rates and corporate restructuring takes giant leaps.

Sweden at the cutting edge My country, Sweden, has gone through some very troubled times in the past decades. From the mid 1970s to the mid 1990s growth was poor, in¯ation was high and we encountered numerous budget and currency crises. Time and space do not allow me to dwell on the reasons for this ± suf®ce it to say that we possibly succumbed to hubris in the 1960s after decades of rapid growth. Politicians started to think that Swedes were God's own chosen people and that we could break all the laws of economics by expanding the public sector and imposing far higher taxes (the maximum marginal rates in some cases exceeded 100 per cent!) and handing out higher subsidies than any other country (sick pay was hiked to 100 per cent). Alas the cost was high. But fortunately economic policy has undergone a U-turn. The main reasons for this are exactly the forces I have been discussing here: globalisation and new technologies, which have forced Sweden to modernise and adapt. Gradually we Swedes have come to realise that the laws of economic reason cannot be violated. In the 1990s numerous structural reforms were carried out, albeit often grudgingly. The central bank has been made independent and given a clear-cut target of holding back in¯ation. A tax reform has slashed the worst excesses of the tax system. A budget reform has put a cap on public spending. Wage formation has become more decentralised. We have become members of the EU. There are many things that remain to be done, such as joining EMU, introducing additional tax reforms, modernising the labour market and soon, but Sweden's economy now looks much healthier. One aspect of this is Sweden's ± and the Nordic region's ± rapid adoption of information technology. The successes of Ericsson and Nokia are well-known, and numerous small software companies are sprouting up. Internet penetration is extremely high, as is ownership of mobile phones and PCs. E-commerce is advanced and the public sector is reasonably mature in IT. When market researchers and economists attempt to quantify the position of different countries as regards the use and ef®ciency of IT, Sweden and Finland are regularly ranked as world leaders, along with the US and Singapore. Denmark and Norway are also ranked high, although not quite as high as their two Nordic neighbours.

Lars H. Thunell 69

These facts have made the Nordic countries a testing ground for many of the new information technologies, not least in the ®nancial sector. The Nordic banks are regarded as world leaders in the ®eld of Internet banking. The proportion of customers actively using the Internet for banking services is far higher than anywhere else. This offers a great opportunity for Nordic banking. The SEB's experience The Skandinaviska Enskilda Banken (SEB) has undergone a rapid transition during the past few years. It has traditionally been the dominant commercial bank for large Swedish exporting companies, as well as the bank of choice for many wealthy Swedes. It is the biggest trader of currencies, bonds and securities in the Nordic region, and consequently is at the centre of the current reshaping of the ®nancial markets due to globalisation and the IT revolution. In terms of size, it is large by Nordic standards but small in global or even panEuropean terms. The pressure to transform is extremely strong and the SEB is facing this pressure head-on. It has embarked on a path of rapid technological renewal and transformation, concentrating on the booming savings markets and the possibilities offered Internet banking, in which area it intends to exploit its expertise in a European perspective. The bank's Nordic focus is visible in the sense that it has acquired the Swedish insurance company Trygg-Hansa (and then divested the non-life operations) and Gyllenberg, a Finnish private bank. It entered Denmark through an alliance with Codan, an insurance company, and expanded into the Baltic region through ownership of three banks in the three Baltic countries, and recently also by acquiring a Polish bank. As a result its assets under management have more than trebled in three years, from SEK 190 billion in 1996 to SEK 950 billion in the third quarter of 2000. At the same time the number of Internet clients has increased 70-fold, from 10 000 to almost 700 000. This last development illustrates the SEB's relentless pursuit of technological advancement, new distribution systems and new products. To a large extent its acquisitions have been prompted by its wish to channel its new products into new markets, for instance it is busy setting up an Internet bank in Denmark. It has also bought BfG Bank, the ®fth largest privately owned bank in Germany, which the SEB hopes will create a platform for rapid expansion into Internet banking in Europe. This is well in line with its (albeit short) Internet tradition. The SEB was among the very ®rst to set up an independent Internet bank (in December 1996), although to a certain extent it cannibalised existing business and the retail branch of®ces. It was deliberately created as a separate entity to ensure its independent growth and aggressive expansion, even at the expense of other business of the bank. This re¯ects the experience in other areas, where new, disruptive technologies can threaten the entire business unless new units are allowed to be creative and to experiment, even though their activities seem to be at odds with the rest of the organisation. Now that e-banking is well

70 IT and the Pressure to Innovate and Restructure

established and more mature, it is being integrated into the different business areas more fully. The SEB e-banking activity offers a complete range of banking and insurance services to private clients and small businesses alike ± from account information to bill payment mutual funds and stock brokerage. The results have exceeded the bank's expectations. The bank now has more customer visits on the web than in its branch network in Sweden. Even in the Baltic region, which is very small and has a far lower average income than Scandinavia, there has been a surprisingly rapid increase in e-banking. This demonstrates the possibility of starting from a `low' technological base and moving directly to the most modern forms of production and distribution, that is, skipping a few of the normal steps of technical development and going straight for the frontier. Encouraged by these events, and in order to sharpen its focus even further, the bank has set a high goal for its Internet service: it intends to have 5 000 000 Internet clients by 2005. This may sound overly optimistic; but the point is that setting such a seemingly impossible target will force the entire organisation to rethink its full range of processes and products. It will foster creativity, since it will demonstrate that the old ways of doing business will not suf®ce if the bank is to survive, let alone thrive, in the new global economy. One example of the bank's high-tech approach is the development of an Internet Trading Station. This is an on-line service directed at all corporate clients, but perhaps is most bene®cial to medium-sized trading clients that lack large ®nancial departments. Physically, this is simply a computer terminal, but the client has access to all of the SEB's research, trading services and facilities. When using the Trading Station the customer can be certain that deals will be automatically passed to clients' ®nancial systems via a common system interface. Decision support and the execution of deals are available globally through one channel, the Internet. Controlled deal entry enables clients to let administrative staff execute trades. As a result, human errors are reduced and costs are cut as realtime ®nancial information is provided to all users within the company at low cost. In effect the Trading Station moves the bank's trading ¯oor ± the largest in Northern Europe ± right into the of®ce of the client. Here, growth has been even more spectacular than in private banking. After only two years, the Internet accounts for some 50 per cent of total FX transactions in Sweden. Great interest has been expressed by other banks in franchising this service. During my 25 years in ®nance I have never seen technological breakthrough as rapid as this one. According to analysts the SEB is one of the world leaders in the use of modern IT in banking and ®nancial services, and it intends to maintain its technological lead. One obvious task is to launch its IT distribution model in Europe. This can be done through mergers and acquisitions, using acquired ®rms as vehicles to spread the bank's knowledge. It can also be achieved through organic growth. Both these strategies are currently being used.

Lars H. Thunell 71

From bank to portal All these activities are tied together in a long-term e-centric strategy. The breakthroughs in IT are applicable on a global scale, whereas the existing banking systems and client bases are still largely local. The SEB's aim is to link global technological change to local clients by introducing new technologies through several channels. It intends to create a standardised Internet platform with three main characteristics:

. An Internet bank that offers private clients a wide range of services ± payments and transactions, savings and borrowing, advice and investment.

. An interface that is easy to use, takes advantage of the bank's global technological expertise and is adapted to local needs.

. Technical solutions to payment and transaction systems tied to local/ national payments systems.

This means that the bank's global system must be standardised and able to cope with local solutions, which may initially look different. Local solutions and interface, linked to data mining, will reduce customer acquisition costs and lead to long-term growth of the client base. Technically the process is intended to move from the local to the global as banking and ®nancial markets become more integrated. In a somewhat longer-term perspective, one task is to evolve from a service channel to a valuable portal, supplying clients with investment services, online banking and advisory services, but also leveraging the bank's valuable client base to other services and providers, ®nancial as well as non-®nancial. This process has already started. The bank has launched a `travel square' on its Web site as a ®rst step. It is based upon a partnership with the Amadeus booking system and supplies its Internet banking customers with the opportunity to search, book and pay for travel on-line. It offers the bank the possibility of broadening its client base, it provides clients with additional services, and it provides airlines with the possibility of selling more tickets, not least excess capacity tickets, to an attractive customer segment. The bank's clients enjoy lower-priced tickets, and both the bank's and the booking system's client bases become more valuable. This is seen as only the starting point. More services will be added, and the bank plans to cooperate more closely with a number of other service providers, leveraging each other's services. New technology and the links to existing client groups will be used to create new af®nity groups, where the bank's will act as an entry point for special client groups to gain access to numerous other service providers. One example of this is the recent creation of a `Senior Net' for older clients with special needs and demands in respect of housing, travel, medicine and so on. Another aspect of the recent developments is the increasing speed and accessibility of services. Currently, most electronic transactions go via PCs, but

72 IT and the Pressure to Innovate and Restructure

an increasing amount of business will soon be carried out via cell phones. The new WAP technology will make it possible to use mobile phones not only for conversation, but also for e-mail, automatic market updates and the transmission of buy and sell orders to stockbrokers. It will soon be easy to program WAP phones to carry out just about everything that a top-of-therange PC with modem can do today, no matter where you are in the world. At this point the trading ¯oor will have moved not only to the of®ce of the corporate client but also to the coat pocket of private customers ± the branch of®ce and the portal to many other services will literally be in the client's pocket!

Conclusion Financial markets will undergo tremendous changes in the next few years, driven by globalisation and new technology. Clients will bene®t from stiffer competition and increased transparency. To us in the business, the IT revolution is both heaven and hell. It is hell for those who are slow to adapt and whose business might be destroyed by disruptive technologies. It is heaven for those who are skillful and lucky enough to be ¯exible and on the frontier, and thus able to reap the rewards of technological leadership.

Part II

Financial Markets: Future Developments

This page intentionally left blank

7

Global Finance Beyond 2000: SWX Swiss Exchange's Challenge Antoinette Hunziker-Ebneter

In a number of years there will be one electronic order book for each publicly traded security in the world. Via the Internet, the in¯uence and power of investors and issuers is becoming so potent that they will ultimately succeed in having their needs met. These investors and issuers want a simple means of obtaining the best possible price to be had, and this in a transparent, secure and well-supervised pool of global liquidity. But whether this pool of liquidity will be spread among ®ve global securities exchanges or concentrated in a single, virtual `world exchange' ± or even whether this liquidity pool will be called an exchange ± is an open question. The word exchange is useful because a securities exchange is something more than just a systems provider. A securities exchange is also responsible for ensuring that appropriate disclosure is made, that market transparency is maintained and that supervision is carried out at all levels of activity. SWX has deliberately not integrated the English word stock into its name, rather it simply calls itself the Swiss Exchange because it trades other ®nancial instruments than just stocks, for example bonds, Eurobonds, warrants and repos and this on a fully electronic basis. In 1999, when SWX and German colleagues successfully inaugurated Eurex ± which has since become the largest options and futures exchange in the world ± it was absolutely clear that even stocks would at some point be traded on jointly conducted or interconnected platforms. SWX wants to remain a pool of liquidity even in a world with one order book and just a small number of exchanges. For that reason it has settled on a strategy of product diversi®cation. In addition to its traditional strengths in the cash equities market and, more recently, the SWX New Market, this strategy builds on new, fully automated areas of investment such as SWX Eurobonds.

SWX Eurobonds ± the only fully automated platform As of 1 April 1999 the Swiss federal parliament freed foreign investors from having to pay stamp tax on Eurobond transactions, thus laying the basis for 75

76 Global Finance Beyond 2000

the expansion of SWX Eurobonds. Since then the trading turnover on SWX Eurobonds has increased and the number of transactions has grown in tandem. Spreads for liquid Eurobonds currently stand at around 15 basis points, while those for less active issues are between 25 and 50 basis points. The CSFB was the ®rst institution to engage in market-making activities on this revolutionary trading platform. In the meantime three additional banks have started quoting ®rm bid and asking prices on SWX Eurobonds. For SWX, this is a signi®cant breakthrough. With four active market-makers, even the large London-based bond dealers will not be able to avoid taking a close look at the prices being put up on SWX Eurobonds. Investors, too, will be keeping a close watch on SWX's bond market, which is the only Eurobond market in which ®rm bids and asks are quoted. Furthermore the only Eurobond trades anywhere to `hit the tape' are those executed on SWX. Put simply, only on SWX does an investor have the chance to double-check the price at which his or her order was executed. On top of this the combined force of SIS SegalnterSettle and SWX Swiss Exchange made it possible to set up links to Cedel and Euroclear, enabling market participants to choose their preferred clearing organisation.

Eurex Repo based on SWX technology The SWX Swiss Exchange and Eurex agreed to integrate SWX Repo into Eurex as of 1 October 2000 under the name of Eurex Repo. SWX acts as service provider and sees to the technical support and continuing development of the repo platform. This strategy, which combines SWX's modern trading technology with Eurex's customer-oriented marketing throughout the world, will further enhance Switzerland as a ®nancial marketplace as well as strengthen the leading position of SWX and Eurex in electronic trading. Swiss and foreign participants can now carry out their Swiss franc funding and collateral management operations directly on the interbank market as well as at the almost daily auctions of the Swiss National Bank, thereby also facilitating their intraday liquidity management in Swiss francs. The settlement takes place on a fully automated basis via SIS Segalntersettle, with a direct link to SIC Swiss Interbank Clearing. All of these aspects are milestones in the automation of the ®nancial markets. Eurex is building up a pan-European, euro-based repo market with a fully automated value-adding chain; trading via Eurex Repo, clearing via Eurex Clearing AG, and electronic links to leading settlement organizations. SWX diversi®ed into new products such as Eurobonds and repos because considerable changes are set to take place in stock trading. The basis upon which this strategy was built was SWX's time-tested competence in developing and implementing fully electronic securities trading systems.

Antoinette Hunziker-Ebneter 77

The Internet exchange In the future, access to retail customers will take place largely via the Internet. Thanks to this new medium and a young generation totally at ease with it, a body of investors is emerging that obtain their information from the Internet and use it to place orders. For example about 12 per cent of all SWX transactions are currently attributable to Internet traders who are automatically routed to the SWX Swiss Exchange via discount brokerage houses. Thus SWX is already an Internet exchange. SWX has to offer its products as cheaply as possible, and to win it is necessary to demonstrate the greatest liquidity. Customers want to go where spreads are smallest and market depth greatest.

Easier access ± the new SWX trading system In response to market needs, SWX has developed a new version of its trading system. The TNA (Trading New Architecture) is a trading technology based on Windows and Internet standards and compatible with other of®ce applications such as Excel and Access. The launch of TNA spells much lower infrastructure costs, making it attractive for smaller companies to participate on the SWX trading system. Exchange participants in Switzerland and abroad are to trade via a public line or the Internet. In the coming years many new investment instruments will become tradable on securities exchanges via the Internet, and here too SWX intends to continue to make its mark.

8

On-Line Trading is Changing the Capital Markets Matthias Leclerc

The effect of the Internet on the economy, and in particular on various retailoriented industrial sectors, has been widely discussed and analysed. It is, however, the capital markets where we might see the greatest changes. Technology allows us dramatically to change business models and to establish bene®ts for institutional clients and wholesale markets alike. The purpose of this chapter is to highlight some of these changes.

The automation of markets Electronic markets are not a particularly new phenomenon. The wholesale foreign exchange markets have traded electronically for some year's now. The success of Eurex has resulted in a clear tendency towards the electronic trading of exchange traded derivatives. Very few of the major futures exchanges worldwide still trade in the pits. This trend towards market automation has also caught on in national stock exchanges. Electronic communications networks (ECNs), which are now growing in the US, are part of this phenomenon. Several initiatives have been made to move bond markets onto an electronic platform. These markets have tended to resist such a move and have mainly relied on telephone-based communications, but they are now starting to go on line, in particular the government markets. Other markets are still in the infancy of automation. However some consortia-owned platforms are currently under development and a few VCfunded start-ups are trying to gain critical mass in this area. On the origination side, Web-based IPOs are an established channel to access a speci®c client group. In particular, in respect of collecting information about investor groups, this is particularly attractive for the issuing ®rm and its investment bank alike. Bond origination over the Web is not as common in retail due to bonds' lower importance for this investor group. In January 2000 a number of issuers and investment banks issued bonds that could also be subscribed over the Web; for these bonds the issuer could follow the book building process on-line via a dedicated Web page. 78

Matthias Leclerc 79

For dealing with institutional and corporate clients banks are moving towards electronic deal execution. Already more than 40 per cent of American institutions deal US treasuries electronically, and this ®gure can be expected to rise to around 80 per cent by the end of 2000. Leading banks are already executing double-digit percentages of their FX deals with clients via the Internet. The same can be expected to happen for equities, European government bonds and exchange traded derivatives. As in the wholesale markets, automation of the OTC and corporate debt markets will take longer. The retail sector has been moved into automation very quickly by on-line brokers. New ®rms are mushrooming, and there is a race to provide more services at even lower costs. Figure 8.1 summarises the situation.

Markets in transition The traditional exchanges have been criticised by market participants for their slow pace of consolidation and their perceived failure to become more ef®cient and more responsive to speci®c market needs (for example the extension of trading hours). In the US this need has led to the emergence of so-called electronic communications networks (ECNs). ECNs promise:

. . . .

More transparent pricing and order books. After-hours trading. Less legacy (rules, corporate structures). Cross-border operation.

Wholesale

Institutional clients

Reality

Reality

Reality

Reality

Evolving

Evolving

Reality

Attempts

Evolving

Evolving

Evolving

Origination

FX Equities Bonds

Credit ETD

OTC

Attempts

Attempts

Reality

Reality

Attempts

Attempts

Figure 8.1 Automation of capital markets

Retail

80 On-Line Trading is Changing the Capital Markets

The hope is that ECNs will lead to simpler and more client-friendly trading. At present they are mainly domiciled in the US. In Europe the most pressing need is to create a single market for the most liquid (several hundred) stocks. Tradepoint is one exchange that hopes to deliver this. Apart from the need to create a pan-European stock market there is the parallel necessity to create a pan-European settlement system. In its absence a trading platform will not be able to deliver full value. Creating such a platform will be relatively easy, organising a pan-European settlement system will be a far more formidable task. Figure 8.2 depicts the current landscape. The rationale for banks to invest in these initiatives varies from case to case but can be categorised as follows:

. Invest and hope. Banks invest in the hope that the ECN (or exchange) they

are backing will become either a market or a commercial success, or both. In the former case they will be a shareholder of the most liquid, most successful market, in the latter case the investment will be highly pro®table for the investor or at least when looked at from today's market valuations of some contenders). . Invest and hedge. The current income models are threatened, and many people expect them to be overcome. Investing in an ECN at least lets investment banks participate in future dividends resulting from business generated through the ECNs (instead of through a broker).

Retail

ConSors

Schwab

E*Trade

E*Trade Comdirect

Optimark

Tradeweb

Exchanges

Market makers

Credit Trade

Instinet

bondclick

Broker tec

Archipelago

Island

Trade point

Euro MTS espeed

Market Xt

US equities Figure 8.2 E-markets

European equities

US bonds

Core deal

Xetra

European bonds

Creditex

E-crossnet (Institutionais only)

Institutionals

Matthias Leclerc 81

. Invest and learn. No one can claim a full understanding of future market

models and the technology involved. Equity participation in new start-up initiatives gives the shareholder more insights into new business models and technologies in an environment totally unrestrained by corporate politics and business legacies.

Electronic communication with clients

Types of employment

Banks will need to extend the electronic revolution of the capital markets to their clients. This is taking place in four stages (Figure 8.3). Stage 1. The marketing channel is being used by every major institutional in a more or less professional manner. It is, however, unidirectional in nature. Stage 2. The next step is to automate existing products and client relationships. This opens a further channel, facilitates new services and makes existing, ones more ef®cient. As an example take FX spot trading with corporate clients. Previously clients had to call the bank repeatedly to ask for a price. When they executed, they would input the deal characteristics in to their own computer, as would the salesperson at the bank. Electronic links now allow clients to see a price, execute on it and now the deal data electronically fed into their system. On the bank's side the deal will be creditchecked automatically and transmitted to the bank's FX position-keeping system and from there into the settlement system. If the bank has a single (though globally managed) credit and market risk position, centralised settlement and booking, this process achieves the utmost ef®ciency. Of course this model can be applied to many other products if they are suf®ciently standardised, for example equities, government bonds and

New

business

models

Buyer’s agent Market places

New

ways of

cooperation

New products/

services

Further

information

channel

Distribution platforms

Portalhierarchy

Seller’s agent

Sales of intemet products

Marketing

Marketing

Bank

Bank

Bank

User

Client

Client

Bank 3rd parties

Types of Interaction

Figure 8.3 Electronic communication with clients

Client

82 On-Line Trading is Changing the Capital Markets

exchange traded derivatives. Even the plain vanilla interest rate derivatives fall into this category. Some leading banks have achieved this process optimisation through diligent work over the last few years: many of their processes are centralised, uni®ed and streamlined. Whilst this is bene®cial to a bank that does not intend to offer electronic services to its clients, it is absolutely crucial for those which intend to offer Internet-based services. It thus provides a sound basis for the new electronic era. Only if processes are fully streamlined, and if transactions can be handled at minimal cost, will electronic transactions be pro®table. Stage 3. The framework for grouping services into a comprehensive suite is the concept of the portal. Here we can clearly distinguish between general portals (such as Yahoo, Excite and soon) and application-speci®c, vertical portals. Investment banks will aim to offer their clientele vertical portals that cater for their speci®c needs. Some have already developed and brought to the market a portal containing news, research and intelligence links, as well as a platform for access to their trading tools. The simplest form of portal is the `seller's agent' which aggregates all of a bank's electronic services and makes them accessible through a single entry point. Stage 4. The next development step is the `buyer's agent' portal. This collects the products of several normally competing ®rms at one Website, which enable clients to compare the ®rms' offers and prices. Buyer's agents are already available, particularly in bonds markets, where other initiatives are also under development. This applies both to the secondary and to the primary markets.

Where will it lead? It is hard to predict what will happen in the future, especially when such rapid changes are taking place. Nevertheless a few trends are already perceivable. First the borders between the client-oriented and wholesale markets will blur. Automation will standardise the price difference between the electronic wholesale market and the direct client environment. Different spreads will be based mainly on credit and cost considerations, although the latter might be overruled by the desire to capture ¯ow. In any event the consequence will be automated, quasi-direct access to liquid capital markets or at least for orders within a certain threshold). This will result in the defacto disintermediation of banks and brokers for these products, reducing their role to managing the remaining credit risk and collateral, and providing a technical channel to the wholesale markets. Second, work¯ows will industrialise. A direct consequence of the automation of markets will be the further streamlining of banks' internal and external work¯ows. Various industrial initiatives have already been started to create standards for this purpose. These standards will in turn help the trend towards

Matthias Leclerc 83

decomposition of the value chain, allowing more ef®cient ®rms to in-source from less ef®cient ones. Only if products can be manufactured at the lowest prices will it make sense for ®rms to offer them. Third, liquid products will move away from exchanges. Since the early 1980s two product categories have moved away from the exchanges: FX and bonds. After Rule 390 has been dropped in the US this trend will extend into the ®eld of equities. In future the most liquid shares will be mainly traded off-exchange. Exchanges will in turn consolidate to concentrate liquidity and ease access for their clients. They will be fully automated and work for pro®t.

Summary The capital markets are undergoing dramatic changes at the moment. These changes are the result of the ongoing automation of wholesale and clientdriven markets using the technologies of the Internet. The changes will continue, leading to an even higher disintermediation of banks and challenging them to revisit their business models.

9

ABB as a Major User of Financial Markets Jan Roxendal

ABB (www.abb.com) serves manufacturing, process and Consumer industries, utilities, and the oil and gas sector, with 160,000 people in more than 100 countries. In 1998 ABB reported total revenues of about $31 billion and a net income of 1.3 billion. ABB was formed in 1988 through the merger of ASEA of Sweden and BBC Brown Boveri of Switzerland, each of which had a history of more than 100 years in its home country. Until very recently, shares in ABB could only be bought indirectly through the two founding parent companies. No fewer than six classes of shares or securities were quoted on seven stock exchanges. This situation led to unnecessary complexity for investors and overly low liquidity in the respective share classes, and it put constraints on ABB to use equity in capital market transactions or in connection with merger and acquisition activities. Another complication was the fact that ABB's shares represented four different voting powers. After many years of preparation ABB managed to ®nd a solution to its shareholder structure, and in the summer of 1999 it successfully introduced a single share structure with one share one vote. Shareholders were asked to exchange their old shares for shares in the new ABB company. The offer was very well received by the market, with a positive response of 98 per cent of the total votes. With the single class share ABB expected an increase in the liquidity of its shares, improved transparency and enhanced ®nancial ¯exibility. Today the capital structure of ABB consists of 300 million registered shares at a nominal value of CHF 10. Every day around one million shares change hands. ABB is listed on the Swiss Exchange and on the Stockholm, Frankfurt and London Stock Exchanges. It intends to add New York to that list in the near future. In today's world, where shareholder value drives more and more organisations, it has become increasingly important to make ownership as easy as possible without unnecessary complications. This is best achieved by meeting shareholders' demands in respect of transparency, costs and liquidity. 84

Jan Roxendal 85

It is not up to the managers of a company to decide where, when and how the company's shares should be traded. Investors will buy and sell shares in the market place that offers the best combination of their speci®c requirements. If a company does not make trading in its shares attractive, investors may simply sell their shares or reduce the weighting of that company in their portfolios. More and more investors are allocating their investments according to sector rather than diversifying their portfolio according to market or country in the traditional way. In the global economy investors like to trade on equal terms, independent of base currency and time zone. ABB has, since the introduction of the single share structure, been a Swiss company, but its shares are listed in three different currencies. The US dollar has been adopted as the reporting currency, but that does not mean that the company is dollar based. As a Swiss registered company the share capital is paid in Swiss francs. When it reports its results the various group companies' results are converted into dollars ± a global currency for global companies ± to make it easier for the investment community to compare ABB's performance with that of other companies. How does ABB see the future trading of its shares developing? Today, two thirds of share turnover takes place in Zurich and one third in Stockholm. Is there likely to be a further concentration of trading in Zurich or will more trading move to London, New York or maybe an Asian stock exchange? This will probably depend on who owns the stock and where these investors feel most comfortable in executing their exchange orders. The decisive factor will be which exchange can provide the most effective execution at the lowest possible cost. ABB is not only dependent on an ef®cient market for raising equity, it is also a major user of various ®nancial markets. Most of this trading activity is conducted by ABB's Financial Services Group, which employs some 900 people in about 20 countries. Its total assets exceed $20 billion and in 1998 its pretax income was $400 million. The group is made up of four different businesses: treasury, insurance, structured ®nance and the project development unit, equity ventures. ABB's yearly trading volume with the banking community exceeds the company's annual turnover several-fold. The bulk of this trading takes place in 14 Treasury Centers, which operate as the ABB Group's internal bank. ABB is a very decentralised company and is located in many countries. It is the Financial Services Group's job to make sure that ABB companies around the world operate with suf®cient funding and provide attractive investment returns, as well as to provide hedging solutions in foreign exchange. In addition to the Treasury Centres, ABB also owns a reinsurance company, which means that its ®nancial performance is very much related to how it manages its insurance reserves in the bond and equity markets. All this ®nancial activity makes a high demand on ABB's bank suppliers to provide it with high-quality service in many different areas and markets around the world.

86 ABB as a Major User of Financial Markets

ABB's main concern in the ®nancial market is the credit quality of its counterparts and the liquidity of the instruments it trades. As an active market participant, ABB is exposed to many different market risks so it must have a high level of con®dence in its trading partners. In the same way that banks expect ABB to honour its side of a transaction, ABB expects others to meet their obligations to it. For many years the company has had an in-house credit risk system, where all its on and off-balance-sheet exposures are measured monthly against an allocated limit. Trading volume is basically related to the commercial and ®nancial activities of the ABB Group. Transactions related to the company's borrowing, cash investment and foreign exchange are normally executed in cash against delivery. A big part of its business, however, is done by using derivative instruments. This is particularly true for transactions that relate to hedging or risk management. In fact the company's derivative volume is ten times bigger than its cash volume. The derivative volume can be split into over-the-counter contracts (OTCs) and exchange-traded products. Today, trading volume is shared equally between the two classes. ABB works with many banks around the world but it is also an active user of exchanges in Europe and the US, plus the Sao Paulo and Tokyo exchanges. What speaks in favour of exchange traded products is that credit and settlement risk is mitigated and liquidity is often better than in the OTC market. The OTC market, on the other hand, makes it possible for ABB to have products customised for its needs. As a very decentralised group with more than 500 operating companies it can sometimes be an advantage to obtain a market quote that matches ABB's exposure instead of hedging through a standard exchange traded contract. Over the last couple of years there has been a concentration of OTC traded volume to around 20 global banks. The reasons for this are the globalisation of the banking industry and the fact that very few banks have the ability to serve an international organisation in all corners of the world. One-stop shopping reduces the number of business calls. Another reason may be that banks are now much more restricted in how they use their own risk capital. Banks are more and more reluctant to use their balance sheet to support customers' trading limits. As a consequence ABB has entered into netting agreements for off-balance-sheet products with its most active trading partners. This has led to a reduction of up to 80 per cent of gross exposure with some banks. Many people in the ®nancial services business are busy thinking about how the Internet will change the way in which the ®nancial market will work in the future. ABB's experience in Internet trading is limited to just one bank and so far this activity has been restricted to foreign exchange. The result has, however, been very encouraging and it is hoped that more banks will offer the same kind of service in the future. The Internet will certainly change the way

Jan Roxendal 87

in which ABB conducts its bank business and it is likely to have a major impact on how it develops its business model. The pace of change will accelerate substantially and the fast movers will set new standards for all market participants to follow. Globalisation of the ®nancial services industry and new technology such as the Internet will lead to increased competition between various market alternatives. As in many other industries, competition will lead to fewer but more global and perhaps more specialised market leaders, but there will still be room for local suppliers and niche players. Different time zones, currencies and other local features will provide enough incentive for ABB to conduct part of its ®nancial business on a local or regional basis. Ultimately the market winner will be the market place that can provide the best liquidity and transparency at the lowest cost for both investors and capital users.

10

The Transformation of Stock Exchanges in Europe Dirk P. Tirez and Timothy Verhoest

Introduction Many European stock exchanges currently face important challenges, the response to which will determine their survival in the near future. There exists a broad consensus that the present European landscape of ®nancial markets, which is characterised by extreme fragmentation on the one hand and obsolete regulatory and technological framework on the other, cannot be maintained much longer. Competition between ®nancial markets is fostered by European integration, be it through monetary uni®cation (the advent of the euro as a single currency) or through the slow process of regulatory harmonisation. Alliances are being formed (in some cases only to be dismantled shortly thereafter), platforms with pan-European aspirations are being announced and smaller traditional stock markets are crumbling under the pressure of increasing cross-border competition. The new environment in which ®nancial markets need to operate is gradually transforming traditional `mutualistic' national institutions into borderless electronic trading platforms. The survival of these traditional institutions will depend on their capacity to adapt speedily. This chapter aims to elaborate on the driving forces behind the current developments and to focus on the objectives that ®nancial markets of the twenty-®rst century will need to ful®l. It will also survey the legal impediments to the establishment of a truly uni®ed European ®nancial market.

Status report on European stock exchanges The demise of the old model of the national stock exchange ± an introduction For a long time stock exchanges were mutualistic institutions that were protected by national laws from outside competition, but due to increasing European and global liberalisation they have gradually been forced to reckon 88

Dirk P. Tirez and Timothy Verhoest 89

with outside competition. The Investment Services Directive of 11 May 1993, which came into force on 1 January 1996, was probably the most decisive factor in this development. As soon as investment ®rms were free to offer their services across national borders, stock exchanges were exposed to competition from rival markets. This increased competition put pressure on the transaction costs charged by traditional exchanges. The elimination of the currency risk and the emergence of new Internet trading technologies to break down national boundaries have led to the emergence of new markets (such as EASDAQ) or trading platforms (Tradepoint) that attract domestic companies away from their traditional domestic markets, thus acting as a new element of competition for traditional stock exchanges. The new markets can also bene®t fully from the rapid growth of the European equity culture among retail investors, and from the shift of the bigger institutional investors to sectoral, cross-border investment strategies rather than diversi®ed national portfolios. The above factors will be discussed in more in later sections. We focus ®rst on the effects that these changes have had on the traditional national exchanges in Europe. Reorganisation of European stock exchanges National stock exchanges have recently adopted several measures to counter competition from other national markets and from new players such as EASDAQ:

. The merger of exchanges and related services (such as clearing and

È rse, 1993; Amsterdam settlement) in the same ®nancial centre (Deutsche Bo Exchanges, 1997; Brussels Exchanges, 1999; Paris-Bourse-SBF, 1999); these mergers have usually been aimed at increasing the pro®tability of the exchanges and creating a one-stop facility for market participants. . Cooperation agreements of between various exchanges, such as: ± the creation of EUREX (1996) as a result of the merger between the German and Swiss derivatives market; ± the creation of Tradepoint in the UK, a screen-based, electronic-orderdriven exchange (`UK Regulated Exchange') that trades most of the LSE securities as well as other European Securities on a proprietary electronic trading platform, where orders from quali®ed institutions and intermediaries are automatically matched on a price/time priority basis. Tradepoint has teamed up with the Swiss exchange (SWX) to create `Virt-x', expected to the launched in the ®rst quarter of 2001. ± the creation of Jiway by OM Gruppen, the owner of the Swedish exchange, and Morgan Stanley Dean Witter of an Internet trading platform based in London for small retail investors (through on-line brokers), designed to trade 6000 European shares, which was launched in November 2000;

90 The Transformation of Stock Exchanges

± the signing of a letter of intent between eight exchanges (London, È rich, Amsterdam, Brussels, Milan and Madrid) Frankfurt, Paris, Zu announcing the constitution of a pan-European electronic platform (May 1999); this project, however, has been abandoned because of differences between the eight members (for instance regarding the choice of the trading system) that have paralysed the project; ± several interconnection arrangements between exchanges to enable cross-membership and cross-access (such as the Benelux alliance and the È rich±Milan alliance) and, in the case of the more far reaching Paris±Zu agreement between Stockholm, Copenhagen and Oslo (NOREX), the sharing of the same trading system and the same trading rules. . The reduction of transaction costs, liberalisation of commissions, centralisation of orders and further automatisation. . The demutualisation of traditional exchanges in order to attract new shareholders and to organise the internal organisation according to the rules of a commercial company (for instance the London Stock Exchange), in some instances leading to the ¯otation of the commercial company that È rse and by manages the stock exchanges (as announced by the Deutsche Bo the new Euronext exchange ± Brussels±Amsterdam±Paris ± for the ®rst half of 2001). . Greater ¯exibility in exchanges' traditional admission requirements in order to attract high-growth companies in new economies away from speci®c high-growth exchanges with a different set of rules; it appears, for instance, that both the Amsterdam example and the Premier Marche of the Paris Bourse grant exemption to applicants from the Listing Particulars Directive requirement that companies seeking admission to an of®cial stock exchange must have an operating history of, and ®nancial accounts for, at least three years. Such lists of new initiatives and alliances run the risk of being outdated very fast. In March 2000 the exchanges in Amsterdam, Brussels and Paris announced their intention to merge by the end of the year under the name `Euronext'. Promising to offer a single trading platform with a single set of rules and a single clearing and settlement system, this new exchange is preparing itself for competition with the London Stock Exchange and the È rse. The merger was prompted, especially in the case of the Deutsche Bo smallest of the three partners in Euronext (BXS), by increasing concerns about liquidity, volume and general disinterest on the part of private and institutional investors. For the biggest partner, the Paris Bourse, the merger can be viewed as the acquisition of two smaller regional players; their roles in Euronext are likely to be limited. Euronext has declared that its initiative is open to additional partners and the exchanges of Luxembourg and Portugal have already shown some interest, while Frankfurt declined the invitation. Although the merger of these traditional continental exchanges will lead to an

Dirk P. Tirez and Timothy Verhoest 91

increase in volume and a possible reduction of certain overhead costs, placing Euronext in a better competitive position, it still has to prove that its trading platform, both from the regulatory and the technological side, is able to face the challenge of the evolving European ®nancial market place. This recent trend towards consolidation has not resolved the traditional distinction between `order-driven' exchanges (all continental exchanges and the London-based Tradepoint) and Anglo-Saxon `quote-driven' exchanges (such as the London Stock Exchange and EASDAQ). The debates on cost ef®ciency and differences in liquidity in both types of market have yet to be resolved. Academic studies comparing the order-driven New York Stock Exchange (an `auction' market) and the quote-driven NASDAQ market (a `dealer' market) have not led to conclusive ®ndings. In recent years the execution costs on the NASDAQ market have been lowered substantially because of lower spreads, due in part to the emergence of electronic communication networks (ECNs). ECNs, which currently account for approximately 30 per cent of turnover on NASDAQ, provide alternative markets for the NASDAQ shares by electronically matching buyers' and sellers' orders, thereby eliminating the need for intervention by a human broker. The appearance of these alternative trading systems and their relative importance have transformed NASDAQ into a quote- and order-driven market, where market makers still account for the bulk (70 per cent) of the transactions. Without entering into the debate on the ef®ciency of the two market types, it is clear that the order-driven system only provides suf®cient liquidity if there is a certain critical mass of orders and if the share is suf®ciently mature to foster continuous investor attention. For high-growth companies, the establishment of a suf®cient degree of liquidity necessitates the intervention of market makers that display bid and ask offers and execute transactions at the displayed quotes. Once a market in a certain stock reaches a certain critical level, it will probably bene®t from the introduction of certain order-driven mechanisms, such as those provided by ECNs. As a result, more and more hybrid market systems are likely to appear that combine the bene®ts of orderand quote-driven markets. Current status of European exchanges In the immediate future, Europe is expected to see a consolidation of exchanges around three major poles ± Frankfurt, Paris Euronext and London ± and further merger and cooperation agreements that will eliminate the smaller exchanges. The Scandinavian markets seem to have chosen to remain independent for the time being. This ®rst wave of consolidation will undoubtedly be followed by a second wave that will further reduce the fragmentation of the European ®nancial markets, such as the arrival of NASDAQ in Europe. In addition some of the new initiatives (EASDAQ, Jiway) are expected to play an increasing part in the ®nancial market in Europe.

92 The Transformation of Stock Exchanges

The winners in the struggle for dominance in the European ®nancial markets will, however, not only be determined by the possibility of attaining critical mass through mergers and other forms of cooperation, but will also depend on the ability of these exchanges to modernise and unify their regulation systems, as well as their trading, clearing and settlement systems. While the traditional exchanges are thus gearing up for the twenty-®rst century and competition from new entrants (Virt-x, Jiway, EASDAQ), some external factors are provoking drastic and rapid changes in the structure of the ®nancial markets, making it dif®cult for market participants to predict which market or which system will ultimately prove victorious. In the next section we present an in-depth review of the driving forces behind the development of the ®nancial markets, starting with the important regulatory initiatives in the European Union.

Principal driving forces behind the structural change in European ®nancial markets The evolving European regulatory framework Undoubtedly, the legislative effort to harmonise and liberalise the ®nancial services market in the European Union (EU) is one of the principal driving forces of the integration and consolidation movement in Europe today. This chapter provides an overview of the European regulatory framework, which is designed to enhance competition between the various European market participants. The principal documents in this respect are the Investment Services Directive (ISD),1 the Second Banking Directive (SBD),2 the Listing Particulars Directive3 and the Prospectus Directive.4 A prerequisite for the creation of a pan-European ®nancial market is the existence of a uni®ed ± or at the very least harmonised ± set of rules governing the provision of ®nancial services in the EU, the supervision of regulated ®nancial markets and the legal structure of companies across the national boundaries. The European legislator has, since the enactment of the Treaty of Rome in 1957, adopted legislation and announced various initiatives to promote harmonisation in the three aforementioned areas, with varying degrees of success or concrete results, especially where the structure of corporate entities is concerned. The European Council has mainly focused on the provision of ®nancial services (where harmonisation is easier to obtain), and a consistent although not exhaustive pan-European framework has been adopted. The credit institutions and investment ®rms of the EU member states have been granted considerable freedom to provide investment services within the EU. The instruments that have contributed most to this include:

. The European Economic Community Treaty (hereafter the treaty) of 25 May 1957, which enshrines the basic freedoms of `establishment', `provision of services' and `capital'.

Dirk P. Tirez and Timothy Verhoest 93

. The Second Banking Directive (SBD) of 15 December 1989, which coordinates

laws, regulations and administration for the business of credit institutions.

. The Investment Services Directive (ISD) of 10 May 1993, which facilitates investment services in the securities ®eld, particularly cross-border.

. The Prospectus Directive of 17 April 1989, which coordinates requirements for

the drawing up, scrutiny and distribution of the prospectuses that are required to be published when transferable securities are offered to the public. . The Listing Particulars Directive of 17 March 1980, which coordinates requirements for the drawing up, scrutiny and distribution of the listing particulars required for the admission of securities to of®cial stock exchange listing. The following subsections look at how these various instruments have contributed to the free provision of investment or ®nancial services in the European Union. The treaty: fundamental freedoms and restrictions by member states On the basis of the freedoms of establishment and cross-border provision of services referred to in the treaty, investment ®rms established in one of the EU member states are, in principle, authorised to provide investment services in the other member states. The relevant provisions are:

. Article 52, which prohibits any direct or indirect discrimination or

impediment with respect to the conditions of establishment of subsidiaries, branches or agencies of a company from one member state in any of the other member states. . Article 59, which prohibits such discrimination or impediment with regard to the (cross-border) provision of services. The treaty allows any business established in one of the member states to set up a branch or subsidiary, as appropriate for the development of its activities, or to provide services on a cross-border basis, within the EU. Whilst being restricted by certain exceptions, these freedoms have been broadly interpreted by the European Court of Justice (ECJ).5 Furthermore Articles 52 and 59 have been found by the EC to be directly applicable.6 This enables individuals to invoke such provisions before their national courts. The provisions stem directly from community law, and so confer rights on individuals independent of national law. These community law rights are to be protected by national courts. The basic freedoms thus proclaimed by the treaty enable ®nancial institutions and investment ®rms to offer their services to nationals of other member states, either directly or through the establishment of a branch or subsidiary in another member state.

94 The Transformation of Stock Exchanges

The second banking and investment services directives: the `European passport' for the provision of investment services by credit institutions and investment ®rms Objectives of the SBD and ISD. Key elements of the European legal framework in respect of freedom of establishment and the provision of ®nancial services are the provisions in the SBD and ISD relating to credit institutions and investment ®rms. Through the mechanism of a mutually recognised single license granted by the home state (`the European passport') and the method of home state control adopted by the SBD7 and ISD8 , the EU has adopted the necessary legislation to give effect to the fundamental freedoms contained in Articles 52 and 59 of the treaty. Both directives have similar objectives and are largely comparable in their approach. The SBD is applicable to all credit institutions, that is `undertakings whose business is to receive deposits or other repayable funds from the public and to grant credits for their own account',9 while the ISD applies to `any legal person the regular occupation or business of which is the provision of investment services for third parties on a professional basis'. The ISD further provides that undertakings that are not legal persons may be treated as investment ®rms if `their legal status ensures a level of protection for third parties' interests equivalent to that afforded by legal persons, and they are subject to equivalent prudential supervision appropriate to their legal form'. Investment services activities are de®ned as the receipt, transmission and execution of orders for ®nancial instruments (including transferable securities),10 the management of portfolios of investments for third parties and the underwriting or placing of issues of such investments. The SBD was adopted to effect the harmonisation necessary to ensure that EU credit institutions are granted a single license that is recognised throughout the EU and in principle, to submit them to the exclusive, prudential regulatory supervision of their home member state. It applies to all credit institutions, with the exception of the member state's central banks and certain speci®ed institutions (which are listed in Article 2.2 of the SBD). The three guiding principles provided for in the SBD, and which therefore apply to credit institutions as de®ned, are:

. The mutual recognition principle (the `European passport').

. The home country control principle.

. The single banking license principle.

The same basic principles are applied, with variations in detail, to investment

®rms, pursuant to the ISD. In addition both directives contemplate the

provision of services on a cross-border basis. The ISD further states:

by virtue of mutual recognition investment ®rms authorised in their home Member States may carry on any or all of the services covered by this

Dirk P. Tirez and Timothy Verhoest 95

Directive for which they have received authorisation throughout the Community by establishing branches or under the freedom to provide services. The result of this principle of mutual recognition of investment ®rms is that once these ®rms are authorised in one member state, under the supervision of that home state, they may set up branches or conduct business on a cross-border basis. This may be done without further authorisation in any other member state. However it does not exclude compliance with host state rules established in the interests of the general good (for example code of conduct rules). The provisions for the general good, however, do not represent a further layer of prudential regulation, in addition to that of the home state. This freedom from intervention by the regulators of states other than the home state is commonly referred to as the `European passport'. Authorisation and supervision by the home member state in accordance with the SBD and ISD. Any credit institution intending to operate in one of the EU member states must obtain authorisation prior to commencing its activities. The granting of such authorisation is subject to the following conditions:

. The credit institution must have initial capital of at least ®ve million euro; member states may, however, grant authorisation to credit institutions with initial capital of less than that amount, provided that the latter is not less than one million euro and that the conditions referred to in Article 2 of the SBD are met. . The credit institution must disclose the identity of any shareholders with substantial holdings and the competent authorities must be satis®ed as to the suitability of such shareholders.

The prudential supervision of any duly authorised credit institution is exercised by the competent authority in its home state. The home state is de®ned as the member state where the authorisation has been granted. Member states where such institutions have set up branches or provide services may, in certain circumstances, maintain some degree of control.11 Similarly the ISD requires every investment ®rm to be duly authorised by its home state ± that is, the state in which its registered of®ce is located or, if under its national law it has no registered of®ce, the member state where its head of®ce is situated.12 Such authorisation is subject to the following four conditions:13

. The investment ®rm must have suf®cient initial capital to comply with the rules laid down in the Capital Adequacy Directive;14

. The persons who effectively direct the ®rm must be of good repute and suf®ciently experienced.

96 The Transformation of Stock Exchanges

. The identity of partners or shareholders in the investment ®rm must be disclosed.

. The investment ®rm must present a programme of operations setting out at least the type of business contemplated and its organisational structure.

As with credit institutions, duly authorised investment ®rms are subject, on a continuous basis, to the exclusive prudential supervision of the competent authorities in the home state. Obtaining the European passport. A credit institution authorised in one member state may carry out the banking activities listed in the annex to the SBD. These activities may be carried out either via the establishment of a branch or through the provision of services on a cross-border basis in any other member state. This may be done without further authorisation. However the ®rm must notify the competent authority in its home state of its intention to set up in another member state, or to provide cross-border investment services in accordance with Articles 19 and 20 of the SBD. The procedures are, in summary, as follows:

. In order to provide cross-border investment services in another member

state: (a) the ®rm must indicate to the competent authority in its home state the activities it intends to carry out; (b) the competent authority should transfer this information to the competent authority in the host state within one month; (c) where necessary, the competent authority in the host state should relay any conditions (including rules of conduct to be complied with by the ®rm, in the interest of the general good) within two months. . In order to set up a branch in another member state: (a) the ®rm must indicate to the competent authority in its home state: the member state where it intends to set up; a programme of operations, which must set out the types of business envisaged and the organisational structure of the branch; the address in the host state where documents can be obtained; the persons responsible for the management of the branch; and if a credit institution, its own funds and solvency ratio; (b) the competent authority in the home state should transmit this information to the competent authority the host state within three months; and (c) the competent authority in the host state should relay any conditions (including rules of conduct to be complied with by the ®rm in the interest of the general good) within two months.

Dirk P. Tirez and Timothy Verhoest 97

However, as the EU Commission notes, with the growth of electronic trading and as `more services are provided without any physical movement, the less the noti®cation will be used'.15 Articles 17 and 18 of the ISD in turn enable every duly authorised investment ®rm to be established in any of the member states, or to provide investment services on a continuous basis within the EU. This may be done without any further authorisation. The procedure for setting up a branch is the same as for credit institutions, except that no indication of own funds or the solvency ratio needs to be given. Access to the regulated market and the concept of remote membership. The three guiding principles ± mutual recognition, home country control and the single banking license ± all relate to the freedom of establishment and provision of services enshrined in the treaty. Together they are the main novelty implemented by the SBD. In order to maximise the freedom of movement of both services and capital, and to enable credit institutions and investment ®rms to have direct access to stock exchanges located within the EU, the European Council introduced the concept of a `regulated market'. This concept is the main innovation in the ISD. If a stock market appears on the list of regulated markets compiled by its home state, it may function throughout the member states without satisfying additional regulatory requirements. Inclusion on such a list is therefore the passport to recognition by the other member states. In this way each member state retains its sovereign right to set the requirements for the creation and organisation of a market within its territory. Investment ®rms that are authorised to provide the investment services referred to in Section A.1(a) and (b) of the ISD (the reception and transmission, on behalf of investors, of orders relating to ®nancial instruments listed in Section B, as well as dealing for their own account in such instruments) must be given access, ± via a branch or a subsidiary ± to an EU-regulated market. However such a ®rm must comply with:

. The capital adequacy rules laid down by the Capital Adequacy Directive and any additional capital requirements of the host state.

. The rules of the market ± relating to its constitution and administration, the execution of transactions and the clearing and settlement system.

. The professional standards imposed on the staff operating on and in conjunction with the market.16

To qualify as a regulated market (as set out in Article 1.13 of the ISD), a market must satisfy the following requirements:

. Securities traded on the market must be securities referred to in the ISD. These securities include transferable securities.

98 The Transformation of Stock Exchanges

. The market must appear on the list prepared by the EU member state which is that market's home state.

. The market must function regularly. . The market must have a set of rules governing its operation, access to the

market and conditions governing either admission to listing (if the Listing Particulars Directive, as amended, applies) or, if it does not apply, the conditions to be satis®ed by a ®nancial instrument before it can be traded on the market. These rules must be approved by the competent authority in the member state where the market is located. . The market must comply with the minimum reporting and transparency requirements of Articles 20 and 21 of the ISD. The important concept of cross-border or remote membership is linked to the right of a regulated market to offer the necessary facilities for that market to operate, without further authorisation,17 in the home state of a foreign ®nancial intermediary. This covers, in particular, the right of a regulated market to locate computer screens with such ®nancial intermediaries. As a result, a regulated market is exclusively subject to its home state regulator, without further regulation by the host states where the screens are situated. The mere fact that the screens of a regulated market are located in another member state does not trigger the public offering rules and regulations of those states. Furthermore the ISD does not require as a condition to qualify as a regulated EU market that the trading and settlement platform be located in one of the EU member states. However direct and undiscriminatory access should be available to EU members of such a regulated market. Every member state must submit to the EU Commission (as well as to the other member states) the list of regulated markets for which it is the home state.18 In the context of strong competition between exchanges within the EU, it is important for a stock market to qualify as a regulated market within the de®nition set out above, as it enables those exchanges to broaden their membership structure internationally. Regulated market status should enable such exchanges to attract retail and institutional investors throughout Europe and further a®eld. Code of conduct-rules. Credit institutions and investment ®rms, subject to the SBD and ISD respectively, must at all times comply with the conduct of business rules laid down by the member states. In this respect Article 11 of the ISD aims to ensure, as minimum requirements, that a ®nancial intermediary:

. Acts honestly, fairly and in the best interests of its clients and the integrity of the market.

. Acts with due skill, care and diligence.

Dirk P. Tirez and Timothy Verhoest 99

. Has and employs effectively the resources and procedures necessary for the proper performance of its activities.

. Seeks information on its client's ®nancial situation, investment experience and objectives.

. Makes adequate disclosure of relevant material information in dealing with its clients.

. Avoids con¯icts of interests or, if necessary, ensures that such con¯icts are fairly treated.

. Complies with any applicable rules and regulation. Where the ®nancial intermediary is providing services on a cross-border basis, it is the responsibility of the member states where such services are provided to ensure compliance with their applicable conduct of business rules. However it would be contrary to the principle of freedom of services enshrined in the treaty if the code of conduct rules of two or more member states applied to a single cross-border transaction. A member state where an investment ®rm provides cross-border investment services, or decides to set up a branch, is authorised to enforce compliance by the ®rm with local rules additional to those of the SBD and ISD if such rules are in the interest of the general good. However no precise de®nition of `general good' is provided in the directives. The term `general good' is applicable not only to credit institutions and the provision of banking services, but also, in general, to securities and investment services. Because of this lack of clarity and resulted dif®culties, a public discussion of the issue was instigated by the EU Commission. This resulted in the publication by the Commission of a ®nal communication, the Interpretive Communication, in 1997.19 The `general good' doctrine derives from ECJ judgments relating to the fundamental freedoms of the treaty, notably of establishment and of the provision of goods and services. It was held that a product that complies with its home state regulations and is produced lawfully can be sold in another member state even if it does not comply with the regulations of that state.20 In this way the presumption of mutual recognition and of the superiority of home state regulations gained currency. The general good exception to these presumptions was also recognised by the ECJ. More speci®cally, the rules of conduct imposed on any passported institution that provides investment services in a host state must:

. be for the general good;

. be non-discriminatory in its application in the state where the service is

provided;

. not duplicate any home state rule; . be proportionate to the host state's aim;

100 The Transformation of Stock Exchanges

. be objectively necessary:21 . fall within an area not currently the subject of legislative harmonisation. As an alternative a host state may rely on the argument that the regulation is itself a non-discriminatory measure which that state is entitled to enforce in the context of a broad and mandatory set of requirements, such as taxation or consumer protection.22 In this case, however, the proportionality principle applies if the member state instates such a requirement. The purpose of the harmonisation by the SBD and ISD can be summarised as streamlining the applicable standards with those of the home state taking priority. Both authorisation and prudential supervision are the prerogative of the home state in the approach taken by the SBD and ISD. An increased burden will only fall on the service provider if the additional standards that are imposed by the host state satisfy the `general good' criteria mentioned above. Article 13(1) establishes that both authorisation and prudential supervision are the prerogative of the home state. This also extends to enforcement in cases where there is a violation of host state legislation by a service provider, the authority over which rests with the host state (Article 21). The prospectus directive and the listing particulars directive The Prospectus Directive applies to securities that are offered to the public for the ®rst time in any EU member state, provided these securities are not listed on a stock exchange operating in that member state.23 The following aspects of the Prospectus Directive should be noted:

. It generalises the obligation to publish a prospectus where securities are to be offered to the public for the ®rst time in one of the member states.24 However there are a limited number of circumstances where exemptions (in whole or in part) from this obligation may be provided for in the domestic legislation of the member states.25 . If securities to be offered to the public are to be listed on an of®cial stock exchange operating with in the EU, then the prospectus has to be drawn up in compliance with the Listing Particulars Directive.26 . In other cases, public offering prospectuses should be drawn up according to the Prospectus Directive. Such prospectuses should contain all the information necessary to enable investors to make an informed judgment about the assets and liabilities, ®nancial position, pro®ts, losses and prospects of the issuer, and the rights attached to the securities offered. . In all circumstances the Prospectus Directive requires the publication of at least the minimum information referred to in Article 11.2 of the directive. In this respect the member states may permit the issuer to draw up a prospectus, the contents of which is determined in accordance with the Listing Particulars Directive instead of the Prospectus Directive.27 This is subject to adaptations that are appropriate to the circumstances of the

Dirk P. Tirez and Timothy Verhoest

101

public offering. The existence of such a facility is important in view of the conditions under which mutual recognition of prospectuses may be granted. . Articles 20 and 21 of the Prospectus Directive provide for the mutual recognition of public offering prospectuses within the European Economic Area (EEA). This is applicable when a prospectus is approved by the competent authority in one of the EU member states and the securities are to be offered in other member states. Basically, if a prospectus is drawn up in compliance with the Listing Particulars Directive because: (1) there is an intention to list the securities on one of the of®cial EU stock exchanges, or (2) the issuer has been authorised, pursuant to Article 12 of the Prospectus Directive, to draw up its prospectus in compliance with the Listing Particulars Directive, and the prospectus is approved by the competent authority in one of the member states, then this prospectus must be recognised as complying with the laws of the other member states where the securities are offered. Such recognition does not require any further authorisation from any other member states. Member states are not, however, obliged to recognise public offering prospectuses that do not comply with the minimum information requirements of the Listing Particulars Directive and contain only the minimum information referred to in Article 11 of the Prospectus Directive. In circumstances where mutual recognition applies, the member states in which recognition is sought may require the prospectus to be translated into their national language. In addition, information that is speci®c to their market and relates to the taxation system, ®nancial organisations acting as paying agents and the method by which notices are given to investors may still be required to be included in the prospectus on a state-by-state basis.28 The creation of the European Monetary Union On 1 January 1999 the euro became the of®cial currency of 11 of the EU member states (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Portugal, Spain and the Netherlands ± collectively known as the Eurozone). The introduction of the euro has enabled cross-border trading within the EU without exchange risks and costs and has therefore increased competition among the ®nancial markets in Europe. The single European market was hampered by the use of 15 or more trading currencies, exposing investors to additional currency risks and rendering interexchange sectoral comparisons dif®cult. The euro has acted as a catalyst for a market-driven modernisation of the EU ®nancial markets, inter alia through the consolidation of payment and securities settlement systems (thereby substantially reducing the costs of these services). The introduction of the euro, together with the implementation of the Capital Liberalisation Directive of 1998 and the second Banking Directive,

102 The Transformation of Stock Exchanges

which came into effect on 1 January 1993, has also increased competitive pressure between banks and investments ®rms, provoking a trend towards consolidation in the ®nancial sector. While the banking industry was predominantly national until recent years, there has since been a wave of cross-border mergers and takeovers. The euro has stimulated competition between ®nancial institutions for various reasons:

. It enables cross-border comparisons between the fee structures of crossborder competitors.

. The liquidity risks traditionally involved in medium-term loans in foreign currencies has disappeared.

. The arrival of the euro as a political symbol of unity and the disappearance of the foreign exchange risk has lowered the barrier against bank customers soliciting the services of non-domestic banks. . The regulatory differences that still segregate national markets tend to stand out in a single currency market, thereby accelerating the harmonisation process. . The introduction of the euro, in general, has forced many domestic banks to internationalise their corporate and retail business. The consolidation and internationalisation of banks within the EU through the introduction of the euro is strongly intertwined with similar movements in the European ®nancial markets, and both movements tend to stimulate each other. The advent of new technologies in the securities industry and the regulatory problems involved The creation of a single market for ®nancial services, with a minimum number of hurdles to cross-border trading between member states, lies at the heart of the EU directives on investment services, banking and insurance. But the Internet has already created a single global market of its own. Its impact on ®nancial services provision has been vast, as have the legal issues raised by it. The main methods of providing information over the Internet are:

. The Worldwide Web: a network of sites (also known as Web pages) that can

be visited by readers, who may use any of the interactive facilities offered by the site/page but can not amend its contents. . Bulletin boards (also referred to as newsgroups or message boards): these are not the creation of a single entity but allow users to post messages and responses to such messages at a particular location and on speci®c topics. . E-mail: this is similar to traditional means of correspondence and can be sent to a particular recipient, groups of speci®ed recipients or to large numbers of recipients. It is one of the most popular forms of Internet usage,

Dirk P. Tirez and Timothy Verhoest

103

due partly to its speed and cost, both of which compare very favourably with traditional methods.29 Information disseminated via the Internet can be quickly and easily communicated to a wide audience, regardless of geographical location. The range of new opportunities provided by the Internet for communications and commerce is clearly vast. But the often unfettered accessibility (subject to modes of encryption) that the Internet provides to an increasingly online society brings with it some critical legal and regulatory issues. The regulators are aware that they are struggling `in the race to keep up'30 with the innovations of the Internet. These often do not ®t readily into the existing paper-bound and geographically based regulatory framework. Protection and con®dence The protection of investors and the maintenance of con®dence in all ®nancial services markets must remain paramount. To this end in February 1999 the SEC, for example, put on its Web site a trading tips document cautioning investors about the use of ®nancial services Web sites. The Securities and Investments Board in the UK (now the Financial Services Authority) issued press releases alerting investors to the dangers of bogus or copy-cat Web sites after an investor was cheated out of £20 000 by a fraudulent Web site.31 Such documents aim to increase investor awareness of unregulated sites, or those masquerading as legitimate sites, and to prevent cyber-cheats from defrauding investors. The Australian ®nancial regulator has posted spoof investment advertisements on the Web, as both a warning and an educational device, to highlight for investors the potential risks of on-line investing.32 Whilst it is imperative for the Internet market place to be made secure by regulation to protect users and providers alike, this must be done in a way that does not restrict its potential. Initial public offerings on the Internet The Internet makes it possible to announce or promote shares and other investments to a potentially global public. In 1998, for example, it was estimated by the Computer Industry Almanac that the Internet was used by more than 147 million people worldwide.33 Methods of controlling the widespread distribution of Web-based information need to be considered. There is no speci®c regulation of cyberspace, however the basic principles of the Public Offering Directives34 apply to Internet offerings in the member states. The distribution of securities can only be made by banks and investment ®rms with a European passport. Any prospectus used must be approved by a competent authority, with the potential provided for in the Prospectus Directive for mutual recognition. Restrictions on national solicitation and advertising will also apply as Web site postings may breach

104 The Transformation of Stock Exchanges

restrictions on advertising. Regulators are facing the challenge of applying existing requirements to a new context. These principles have been applied in the context of private offerings and electronic road shows. For example a British company that put its share offer on the Internet expected it to be seen by 20000 people, whereas a hard copy prospectus for a similar placing and offer of a comparable company would, in general, only be seen by approximately 2000 people. In this case it was possible to review the prospectus on-line, and the application form could be printed off and returned with a cheque by post.35 Once brokers are properly equipped it will be possible to make payments by credit card over the Internet, although the issue of cyber-cash security is still being addressed. Facilities such as these raise additional questions not only about the mechanics of regulation, but also about the need for geographical demarcation of the material available on the Internet so that questions of jurisdiction can begin to be addressed. It may be necessary to control the availability of such information. For example in the Internet Bookshop offering cited above, only potential investors with a UK postcode could access the document as the offering was not authorised to be made in any other jurisdiction. Although the Internet market may be global, legal jurisdiction is not. Accordingly, in the context of Internet offerings the following issues may need to be considered over and above those currently addressed by the European regulatory framework:

. Geographical considerations:

(a) The establishment of an effective system for ascertaining the country of origin of an individual who attempts to open an account to purchase securities. (b) Clear indication should be given that these securities are not being offered in that member state (disclaimers and warnings). (c) No targeting of persons outside speci®ed member states (for example no translation into their of®cial language, no applicable currency or zip code option). . Offeree restrictions: (a) Password protection. (b) The restriction of access to pre-approvated persons (quali®ed institutional buyers or accredited investors). (c) Attention to the lack of clarity arising from institutional investors' exemptions differing from member state to member state (no Rule 144A in Europe). (d) Virtual road shows should only be made accessible by password to sophisticated investors to whom actual road shows are directed. . Offering disclaimers: (a) Warnings or conditions of use that require the user to af®rm, when accessing information for example, the governing law of the site.

Dirk P. Tirez and Timothy Verhoest

105

(b) Such af®rmation may persuade a court, in the event of subsequent dispute, that the user has in this way actively agreed to a particular jurisdiction. . Regulation of hyper-text links: (a) Attitude of regulators towards information obtained from a hyper-text link to another site. The SEC, for example, has decided that this material is contained in the same `envelope' as that on the issuer's Web site, and therefore the standards and rules governing the offering apply to such linked information. . Relationship between Web sites and other marketing: (a) For example, verify prospectus and road show content but query veri®cation status of Web site and any linked information sites. (b) Ascertain the legal position governing disclosure obligations of free shares given away on Web sites prior to an offering to generate interest in the company and the stock. The secondary market on the Internet Key issues relating to the creation of a secondary market on the Internet once again relate primarily to questions of geographical location and jurisdiction. For example:

. Noti®cation of authorities in the member state where the offer of crossborder services originates.

. Regulation of any marketing or promotional material, in particular the . . . .

question of whether accessing a company's Web site might not satisfy the regulations governing marketing materials. Breaches of any national codes of conduct applicable in a host state. Security of ordering or investing by e-mail. Security of use of cyber-cash. Impact of regulations on cold-calling and canvassing.

The Internet also provides great scope for traditional securities violations that regulators seek to combat. Manipulation of the secondary market is a particular problem, as false or misleading statements can readily be made and received on the Internet. Multiple messages promoting a particular stock, for example, can be used to create a misleading impression of the market for speci®c shares.36 Successful regulation of a secondary market raises different concerns from those speci®cally addressed by the existing regulations. If a ®nancial services provider, for example, is required to tailor its Web site to satisfy the multiplicity of requirements by different member states, this might ultimately hinder accessibility and reduce the cost bene®ts of the owner of the site. If not, each member state may attempt to enforce its own requirements governing the use of the Internet and an unworkable system of overregulation could easily result. The increasing use of the Internet and other forms of electronic communication, together with the regulatory problems mentioned above, is

106 The Transformation of Stock Exchanges

increasing the pressure on regulators and ®nancial markets alike to promote harmonisation and uni®cation in this area. A borderless community of Internet users is hardly compatible with nationally fragmented ®nancial services legislation and practice. Development of a European equity culture The last important generator of change in the traditional ®nancial services landscape is the growing European equity culture among retail investors. Investment in securities in Europe has long been monopolised by large banks and other institutions, plus a limited number of wealthy individuals, but European citizens are now turning away from savings accounts and secured bonds towards active participation in the trading of stock (although this increased interest is cyclical by nature and is largely driven by the overall performance of ®nancial markets). It is clear that the European mainland does not have the long tradition of equity investment found in the Anglo-Saxon world, especially the US. For instance in 1997 the market value of equities in the EU amounted to 18 per cent of the total in the ®nancial system, compared with 39 per cent in the US. There is evidence, however, that an equity culture is slowly growing in the EU, for a number of reasons. First, investors are drawn to the stock exchange in periods of low in¯ation and low interest rates, when the more traditional investment vehicles are much less rewarding. Second, the advent of the Internet has enabled private individuals to gain access to information and online trading, which has stimulated their participation in the equity markets. Third, companies on the European mainland have been in¯uenced by their Anglo-Saxon counterparts and have gradually overcome their traditional unease about opening up to the public. Young, high-growth companies in particular have realised that the stock exchange is both an inexpensive way of raising capital and a unique means of gaining (inter)national exposure. More established companies (`blue chips') which on the European mainland have traditionally been closely held by families, banks and certain other institutional investors, are following in their footsteps. These three factors are creating a dynamic that will further increase the participation of individual and institutional investors in equity markets. The growing equity culture is increasing the overall turnover on the market and attracting new competitors that speci®cally cater to the needs of retail investors.

Impediments to the establishment of a truly uni®ed European market Despite the current trend towards harmonisation and concentration, major impediments remain to the creation of a single, pan-European market for ®nancial services, including:

Dirk P. Tirez and Timothy Verhoest

107

. Incomplete harmonisation in the areas covered by directives due to options

being left open to national legislators and the lack of a European passport for public offerings across Europe. . Differences between company legislation in member states. . Market-speci®c differences regarding individual income and corporation tax regimes, paying agent services, and the ways in which notices to investors are published in the member states. . Lack of a European equivalent to the Securities and Exchange Commission (SEC) in the US, which harmonises the supervision and conduct of companies and markets. Some speci®c examples of these are provided in the following subsections. Lack of a uni®ed set of rules due to options available under the directives Issues unresolved by the EU directives The freedom of movement and the European passport referred to in the treaty and the ISD have to some extent liberalised the provision of investment and/ or ®nancial services within the EU. However serious problems relating to the Prospectus Directive and the mutual recognition process are preventing the completion of a truly effective, pan-European distribution of equity securities. The main problems are due to the fact that member states may or may not have taken advantage of the options available to them when drafting legislation to implement the harmonising directives. In this respect the following problems should be noted. First, certain regulators require the publication of a prospectus in the event of a private placement because the securities are to be admitted to trading on a domestic exchange. Second, domestic law and/or regulators may require a full translation of the prospectus in order for it to be mutually recognised and used on a cross-border basis. Third, domestic regulators may require a prospectus to have different layouts in order to meet speci®c national requirements. Fourth, domestic law and/or regulators may require the prospectus to include burdensome country-speci®c information. Fifth, a prospectus is not required for the distribution of euro-securities that are not the subject of a `generalised campaign of advertising or canvassing',37 but no precise de®nition of this is provided. Member states have individually determined their requirements so there has been no uniform application of the provision. Euro-securities are de®ned in the Prospective Directive as: Transferable securities which:

. are to be underwritten and distributed by a syndicate, at least two of the members of which have their registered of®ces in different States, and; . are offered on a signi®cant scale in one or more States other than that of the issuer's registered of®ce; and

108 The Transformation of Stock Exchanges

. may be subscribed for or initially acquired only through a credit institution or other ®nancial institution.

However it appears that certain member states have arti®cially restricted the de®nition of euro-securities, which violates the Prospectus Directive and the principle of freedom of services referred to in the treaty as de®ned by the ECJ. Such a range of approaches means that the harmonisation envisaged by the directive has not been achieved. The problem for issuers is that their prospectus must be tailored to satisfy these different requirements, thereby increasing the cost of cross-border offerings. EASDAQ's experience: key dif®culties in the creation of a pan-European market Amongst the dif®culties that need to be addressed to enable cross-border panEuropean offerings to take place successfully, EASDAQ, as Europe's ®rst panEuropean stock exchange, has identi®ed certain key issues.38 The lack of an adequate framework for private placements. First, Articles 2(1)(b), 2(2)(l) and 3(f) of the Prospectus Directive should in theory, provide an adequate regulatory framework for the placing of securities that are not subject to a generalised advertising campaign or canvassing and may only be subscribed to or initially acquired, by credit institutions or other such ®nancial institutions. Second, the current lack of uniformity in the domestic laws and regulations of the member states in connection with the construction and implementation of the euro-securities provisions39 has prevented the creation of an ef®cient EU private placement market, unlike that which has been achieved with Rule 144 in the US. It might be asked whether a similar rule should be applied in the EU. The lack of a common de®nition of the concept of public offering. In the absence of common de®nition of the concept of public offering, and due to the fact that the member states have their own sets of public offering requirements, a cross-border securities offering cannot be contemplated in a simple and cost-effective manner. In the long term, harmonisation of these rules should be sought and a common de®nition of the concept of public offering found. In the short term the issuer should only have to adhere to one set of domestic rules when making a cross-border offering. The issuer could then choose between the rules of the member state in which it is incorporated, those of the member state where the prospectus is approved, or those of the member state where the markets are located and the securities are to be listed/admitted to trading. Differences in domestic requirements for information to be included in the prospectus. Article 21.1 of the Prospectus Directive requires a prospectus to contain information that is speci®c to the market where the offering is being made. This requirement applies to the member state's tax system, the ®nancial

Dirk P. Tirez and Timothy Verhoest

109

intermediaries retained to act as paying agents and the way in which notices to investors are published in the member state. When securities are to be offered in several member states the insertion of this information is clearly burdensome and extremely expensive for the issuer. Such information is, to a large extent, not tailored to the transaction, so why should it not be made available to investors/®nancial intermediaries via public sources in each of the countries concerned, as well as via the Internet? No prospectus approved by a competent authority should ever be subject to additional information requirements. Article 21.1 of the Prospectus Directive should be amended accordingly. The requirement for the prospectus to be translated into the national language of all the countries where the securities are to be offered to the public. This is clearly not cost-effective, and perhaps not even appropriate in a single market context. Even if a summary prospectus in the languages concerned is produced, it should not be subject to any further regulatory approval and/or authorisation. Individual investors appear to be adequately protected by the conduct of business rules referred to in Article 11 of the ISD, which are applied on a state-by-state basis.

Another impediment to the establishment of a uni®ed ®nancial market is the unequal or partial implementation of the ISD by the various member states, as revealed by a survey conducted by the European Venture Capital Association in May 1998.40 Its overview of the situation indicates that the harmonisation ideal driving the directives is too ambitious. In part this is a function of member states treating the uni®cation of markets as a question of easy and ef®cient distribution of securities. In addition the regulators in each member state are nationalistic and keen to retain the full scope of their powers. The harmonisation steps laid down in the directives do not seem adequately to take into consideration the role that a pan-European stock market could play in this respect. The efforts made by FESCO towards further harmonisation In view of the international differences outlined above it is questionable whether there currently exists a truly European market. To address this issue the Forum of European Securities Commissions (FESCO) was established. Its members are drawn from 17 EU/EEA states and it has set itself the challenge of devising and agreeing standards. These are intended to be over and above the minimum required by the directives and they target areas where the implementation of these minimum standard has lack of clarity and additional costs for issuers. The following are under consideration:

110 The Transformation of Stock Exchanges

. . . .

Standards for regulated markets. Standards for the participants in offerings. Improvement of mutual recognition. Harmonisation of rules of conduct.

FESCO has also produced a Multilateral Memorandum of Understanding (hereafter the memorandum), which re¯ects the intention of the competent authorities in the member states concerned to exchange information on such matters as market manipulation and insider dealing. The principle underlying the memorandum is `to establish a general framework for co-operation and consultation between the Authorities' (de®ned as any member of FESCO) `in order to facilitate the ful®lling of their supervisory responsibilities' (Article 1). The main aims are as follows: `in the ®nancial ®eld . . . co-operation . . . between the competent authorities of the Member States for the purpose of carrying out their duties, `the increasing internationalisation, harmonisation and interdependence of European Financial Markets due, for example, to the use of modern technology, closer co-operation between the European exchanges and the completion of the Internal Market for ®nancial services'; and `the strengthening of cross-border co-operation in order to enhance investor protection, to promote the integrity of ®nancial markets and more generally to facilitate performance of the supervisory functions and effective enforcement of the laws and regulations governing the markets'. The espoused bene®ts of establishing a common standard, specifying shared targets and exchanging relevant information highlight dif®culties that the directives have so far failed to resolve. The memorandum also highlights the problem regulators have in applying the minimum requirements of the directives, as opposed to agreed standards. On 10 May 2000, Fesco issued a consultative paper `A ``European Passport'' for issuers', suggesting certain regulatory changes in order to facilitate cross-border offerings in the European Economic Area. Difference in national laws on companies The creation of a single European ®nancial market will remain an unattainable ideal as long as the member states continue to have widely divergent views on the structure of corporate entities, their reorganisation and the way in which they ought to be governed. The EU has long perceived the need for more harmonisation in this area. The ®rst company directive of 9 March 1968 set uni®ed minimum standards for limited liability companies within the EU. However, a number of proposals that are considered vital to the establishment of a uni®ed ®nancial market have failed to reach a consensus among the member states. In order to achieve a single European market for ®nancial services, in May 1999 the European Commission released its `Action Plan Implementing the Framework for Financial Markets' (hereafter `the action plan'). Some months

Dirk P. Tirez and Timothy Verhoest

111

earlier the European Council had recognised that certain legislative initiatives had fallen victim to a protracted political deadlock:

. the two proposals on the winding up and liquidation of credit institutions and insurance companies;

. the proposal for a thirteenth company law directive on takeover bids; . the European Company Statute. Closely linked to these issues are the varying corporate governance requirements and practices within the EU. Differences in corporate governance requirements give rise to legal or administrative barriers that might frustrate the development of a single market (such as practical arrangements for the exercise of voting rights by shareholders in partner countries), and therefore need to be streamlined. The differences in company law (as well as in tax law) between the various member states are an important impediment to further uni®cation of the European ®nancial markets. Decision making by the European legislator on these issues, which has been painstakingly slow in recent years, needs to be speeded up drastically if a truly uni®ed ®nancial market is to be established. On 17 July 2000, ECOFIN established a Committee of wise Men on the Regulation of European Securities Markets to assess the current conditions for the implementation of the regulation of securities markets in the European Union. The committee, chaired by Alexandre Lamfalussy, issued its preliminary proposal in November 2000 and its ®nal report in February 2001. Lack of a uni®ed supervisory authority The goal of creating a regime under which securities listed on an exchange in one member state will automatically be entitled to a listing in any other member state has not been entirely achieved, for the reasons mentioned above. It is worth considering whether the differing implementation of directives aimed to harmonise indicates the need for a European body akin to the American SEC. As the markets in Europe are regrouping, certain national supervisory authorities have already been forced to cooperate at a higher level or to rede®ne their responsibilities. The creation of Euronext for instance, will certainly diminish the role and responsibilities of the Belgian and Dutch supervisory authorities in favour of the French COB. Although this kind of spontaneous cooperation from below, together with the achievements of European organisations such as FESCO, is a form of harmonisation, it is clear that European legislative action is called for to increase the speed of this harmonisation. The closer coordination of supervisory authorities has therefore been identi®ed as essential by the European Commission. As the standards set by the European supervisory authorities differ on numerous items, such as the use of accounting standards, language requirements and forward-looking statements (to mention just a few), issuers

112 The Transformation of Stock Exchanges

incur unnecessary costs when obtaining intra-EU multiple listings or when raising capital through public offerings in various member states. As the European Commission has realised and stated in its action plan: `There is now a greater need and a willingness to engage in an open discussion on the structures that will be needed to ensure appropriate regulation and supervision of a single ®nancial market.' Existing protective measures Despite the regulatory efforts that have been made, many member states have retained protective legal provisions that constitute violations of the principles and provisions of EU law. Europe's ®rst pan-European exchange, EASDAQ, has actively been promoting a Pan-European securities trading environment and is vigilant about the use of discriminatory measures to protect and promote national interests. It has ®led two complaints with the European Commission against Italian and French initiatives that did not comply with the treaty, and in November 1998 the European commission formally requested that the French and Italian governments provide explanations of the non-compliance of their ®nancial laws with the treaty. The provisions under investigation are as follows:

. In France a number of statutory provisions provide tax bene®ts to certain

types of insurance contract (contract d'assurance-vie DSK). The favourable tax treatment applies if the unit of account of these contracts is a share of the unit of a collective investment company that invests 50 per cent of its capital in shares of French companies, of which at least 5 per cent of the assets are held in shares of non-quoted companies. . In Italy a number of provisions provide for a reduced tax rate for companies that intend to have their shares listed for the ®rst time on an Italianregulated market. These provisions violate the principle of non-discrimination laid down in Article 6 of the treaty. They also contravene treaty provisions on the free movement of services and capital within the EU (Articles 59±66) as they restrict cross-border trading. These national provisions also violate the prohibition on state aid (Articles 92±4) by offering a discriminatory advantage to the French and Italian markets. The French and Italian initiatives can be applauded for attempting to facilitate and promote the development of capital markets, but they should apply to all EU-regulated stock markets, including EASDAQ, pursuant to the non-discrimination principle enshrined in the treaty. EASDAQ has also sought to ensure that French companies that trade or are seeking to trade on EASDAQ, together with French ®nancial intermediaries and French investors, will bene®t from the increasing interest shown for the `contracts d'assurance-vie DSK'. EASDAQ is committed to promoting the pan-

Dirk P. Tirez and Timothy Verhoest

113

European trading platform of its market for the bene®t of its issuers and members. In addition, the French government was required, subject to certain conditions, to extend the scope of the regulation in order for it to apply to a contract d'assurance vie, relating to high-growth company stock, wherever traded in Europe. In April 1999 France and Italy agreed to amend their laws on the above-mentioned tax bene®ts in order that they apply to all shares quoted on any regulated market in the EU. In February 2000 EASDAQ also ®led a formal complaint with the Belgian minister of ®nance based upon provisions of Belgian law that discriminate EASDAQ, a ®nancial market regulated by Belgian law, in comparison with the Brussels Stock Exchange (BXS) or that discriminate (non-Belgian) companies that are listed on EASDAQ. EASDAQ has identi®ed the following counts of direct or indirect discrimination by Belgian law:

. Belgian citizens who invest in shares of the company for which they work

.

.

.

.

(or its parent company) are entitled to a tax reduction. This reduction, however, only applies to shares of Belgian companies and therefore violates EU law. Belgian citizens can bene®t from a tax reduction on deposits with recognised pension funds, provided these funds invest at least 30 per cent of their resources in shares of Belgian companies or in bonds of Belgian companies and not more than 10 per cent in shares of foreign companies listed on a Belgian exchange. This discriminatory practice is a prohibited form of state aid to the Brussels exchange. The company that manages the Brussels Stock Exchange is exempt from corporate tax but this is not the case for EASDAQ, the only other company to manage a stock exchange in Belgium. This too is a blatant violation of EU law and a prohibited form of state aid. Dividends that are redistributed by the receiving company to a Belgian company can normally only bene®t from the Belgian participation exemption if the conditions for that participation would be met if the original distributor of dividends would pay them directly to the Belgian company, unless (1) the redistributor is a Belgian company or a company located in a country with which Belgium has entered into a double taxation treaty, or (2) the redistributor company is listed on an of®cial stock exchange within the EU. Because EASDAQ is considered to be a regulated market and not an of®cial stock exchange (see above), companies listed on EASDAQ are not able to bene®t from the exemption mentioned above. No withholding tax is due on dividends paid by a Belgian company to a Belgian investment fund. However this exemption is conditional, inter alia, upon the investment fund investing at least 75 per cent of its assets in Belgian companies. This is also a prohibited and discriminatory form of state aid.

114 The Transformation of Stock Exchanges

. The contribution of capital in a company is exempt in Belgium if the shares

of that company are listed on a Belgian stock exchange. Although EASDAQ is incorporated as a stock exchange in Belgium, the tax administration is of the opinion that this exemption only applies to the Brussels stock Exchange, which also constitutes a violation of EU law.

EASDAQ has requested the Belgian minister of ®nance to take prompt action to eliminate these discriminatory practices, in accordance with Articles 12 (prohibition of discrimination on the basis of nationality) and 56 (prohibition of restrictions on the free movement of capitalt) of the EU treaty.

Conclusion The current trend for market mergers across Europe has been driven by the demand for greater value for investors and institutions. As a result, previously monopolistic exchanges are being required to cut costs, reduce regulatory separatism and harmonise their markets. If they do not they will come under increasing threat from the growing number of cost-cutting Internet brokers. As the competition between stock exchanges continues to intensify a new model of transnational and borderless stock exchange is needed. Such an exchange should:

. be able to facilitate cross-border trading (through a single set of rules); . be able to provide ef®cient, low-cost execution (through an advanced . . . .

technological platform and competitive rates for clearing and settlement); be able to provide direct access from anywhere in Europe; have strong admission and regulatory standards; be fully integrated and offer European settlement; be technologically advanced in order to compete with highly ef®cient electronic OTC markets.

EASDAQ was incorporated speci®cally to ful®l the above, and during its four years of existence it has provided investors and market participants with a platform that is able to meet the ®nancial market challenges of the twenty-®rst century. EASDAQ is also striving for the abolition of nationalistic protective measures and for this uni®cation of ®nancial markets and ®nancial services within the EU through persistent regulatory reform. Notes 1. Council Directive 93/22/EEC of 10 May 1993, on investment services in the securities ®eld. 2. Second Council Directive 89/646/EEC of 15 December 1989, on the coordination of laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institutions and amending Directive 77/780/EEC.

Dirk P. Tirez and Timothy Verhoest

115

3. Council Directive 80/390/EEC of 17 March 1980, coordinating the requirements for the drawing up, scrutiny and distribution of the listing particulars to be published for the admission of securities to of®cial stock exchange listing, as amended. 4. Council Directive 89/298/EEC of 17 April 1989, coordinating the requirements for the drawing up, scrutiny and distribution of the prospectus to be published when transferable securities are offered to the public, as amended. 5. European Court of Justice, Reyners, 21 June 1974, Rec., 631; van Binsbergen, 3 December 1974, Rec., 1299. 6. Case 26/62, Van Gend en Loos [1963] ECR 1. 7. The SBD states that the directive is envisaged as an `essential instrument for the achievement of the internal market, a course determined by the Single European Act . . . from the point of view of both the freedom of establishment and the freedom to provide ®nancial services, in the ®eld of credit institutions'. It describes how `the approach which has been adopted is to achieve only the essential harmonisation necessary and suf®cient to secure the mutual recognition of authorisation and of prudential supervision systems, making possible the granting of a single licence recognized throughout the Community and the application of the principle of home Member State prudential supervision'. 8. The intended purpose of the ISD is to effect the essential harmonisation necessary and suf®cient to secure mutual recognition of authorisation and of prudential supervision systems, making possible the grant of a single authorisation valid throughout the Community and the application of the principle of home Member State supervision. 9. First Council Directive 77/780 EEC of 12 December 1977, on the coordination of laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institutions, referred to as the First Banking Directive. 10. See Sections A and B of the Annex to the ISD. 11. See Article 18 of the SBD. 12. See Article 3 of the ISD. 13. See Articles 3.3 and 3.4 of the ISD. 14. Council Directive 93/6/EEC of 15 March 1993, on the capital adequacy of investment ®rms and credit institutions. 15. European Commission, interpretive communication, `Freedom to provide services and the interest of the general good in the SBD', SEC (97) 1193 ®nal (20 June 1997). È rkland `The Scope of the General Good Notion in the Highlighted in Mattias Bjo Second EC Banking Directive according to recent case law', European Business Law Review, July/August 1998, p. 231. 16. See Article 15.1±3 of the ISD. 17. See Article 14.4 of the ISD. 18. See Article 16 of the ISD. 19. European Commission, interpretive communication, `Freedom to provide services and the interest of the general good in the Second Banking Directive', SEC (97) 1193 ®nal (20 June 1997). 20. See judgment of Case 120/78 Rewe±Zentral AG v Bundesmonopolverwaltung fuÈr Branntwein (1979), ECR 649. 21. Case 205/84, Commission v Germany (1986), ECR 3755. 22. For full discussion of these principles please see `The Scope of the General Good Motion in the Second EC Banking Directive According to Recent Case Law' by

116 The Transformation of Stock Exchanges

23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40.

Mattias Bjo È rkland, European Business Law Review, July/August 1998, p. 227 and following. See Article 1 of the Prospectus Directive. See Article 4 of the Prospectus Directive. See exemptions referred to in Articles 5.6 and 13 of the Prospectus Directive. See Articles 7±11 of the Prospectus Directive. See Article 12 of the Prospectus Directive. See Article 21.1 of the Prospectus Directive. As highlighted and further detailed in IOSCO, `Report on Enforcement Issues Raised by the increasing use of Electronic Networks in the Securities and Futures Field' (Madirid: IOSCO) September, 1997. SEC Chairman, Arthur Levitt, 7 November 1996. PN/SIB/33/97, 21 August 1997. James Mackingtosh, `Spoof internet adverts may warn of fraud', Financial Times, 29 May 1998. Quoted at http://cyberatlas internet.com/big.picture/geographics/cia.htm/. The ISD and the Prospective Directive. Offering on the Internet Bookshop, reported in The Lawyer, 11 March 1997. See IOSCO, `Report on Enforcement Issues' op. cit. See Article 2(2)(1) of the Prospectus Directive. EASDAQ, `A Pan-European Passport for Public Offers Throughout the European Union' (Brussels: EASDAQ, October 1998). Indeed, most of the Member States have restricted the euro securities provisions of the Prospectus Directive to bond issues. In addition, no common de®nition has been provided with respect to the concept of `restricted circle of persons'. Europe Private Equity Special Paper, `IPOs in Europe: EASDAQ and other Markets', edited by S. J. Berwin & Co. in association with EASD and the European Venture Capital Association.

11

What is the Future for Nationally or Regionally Based Financial Centres? Alec Tsui

The early stock exchanges were usually developed to serve the needs of market users in particular geographical areas. In larger countries, several exchanges often emerged to serve different parts of the country. Over time, one of these become dominant and served the country as a whole. National exchanges thus evolved in most parts of the world, and are still largely in place. As the twentieth century progressed the role played by stock exchanges in national economies grew enormously. Today there are many millions of individual investors placing a large part of their savings in the stock market, either directly or through mutual funds. The value of their pension funds or life insurance policies often depends on the market. As facilitators of capital formation, stock exchanges have emerged as the most ef®cient means yet of directing equity capital to its most productive use. The market determines which enterprises receive the funding, and the cost of their capital. Thus stock exchanges have assumed a central role in the macroeconomics development of nations. Despite the important role played by stock exchanges they are not immune from challenges, including those posed by advanced technology, increasing investor demand and globalisation.

Challenges The impact of technology Technological developments have made it simple to trade stocks outside the border of the home country. Discount brokers and Internet-based trading have slashed transaction costs in the developed markets. The traditional function of stockbrokers as the access point to a market is rapidly becoming obsolete; investors can access exchanges or trading systems directly through the Internet. New networks are springing up to compete directly with the market-making functions of exchanges. These are called electronic communication networks 117

118 Nationally or Regionally Based Financial Centres

(ECNs), examples of which are Instinet and Island in the US, and Posit in the UK. They can collect, route and match orders and perform a large part of the trading functions of an exchange. The advantages of ECNs over traditional exchanges are that they can focus on one activity to minimise overhead costs and trade in the most actively traded stocks or the larger-ticket deals. Hence they offer signi®cant competition to traditional exchanges in the most valuable parts of their business. Some large securities houses even handle a suf®ciently large volume of orders to be able to match buyers and sellers in-house, thus bypassing the of®cial exchanges. Stock exchanges are able to compete with ECNs as they still constitute the largest pools of liquidity. However a competing market can drain off liquidity much more quickly than previously, as was seen when London captured market share from Frankfurt at the beginning of the 1990s, only to lose it a few years later. In principle there is nothing to stop ECNs doing the same thing if they are able to attract suf®cient investors to create an orderly and ef®cient market. Many investors are suf®ciently sensitive to transaction costs to be willing to switch. Globalisation The growth of worldwide, cross-border investment during the 1990s was as remarkable as it was unforeseen. Overseas portfolio investment by US residents in 1998 totalled $89 billion and the ®gure for Japan was $100 billion. Asian countries were signi®cant recipients of these capital ¯ows. In Hong Kong, more than 30 per cent of trading volume in 1998 was generated overseas. The top 14 securities houses, nearly all of which are international ®nancial conglomerates, accounted for over 39 per cent of the turnover. One consequence of globalisation is that individual stock markets have become more volatile. This has placed a premium on the risk-management capability of exchanges and their associated clearing houses. The market operator's ability to monitor closely the ®nancial position of its members and intervene when necessary is also key to its surviving the impact of global capital ¯ows. Another consequence of globalisation is increased competition between exchanges for trading and listings. Exchanges in one country can now reach across borders and take turnover and liquidity from another, thanks to technology, differentials in transaction costs and the invention of new instruments such as ADRs and GDRs. This competition between exchanges has been at its most intense in Europe and North America, but it is now beginning to spread to Asia. Increasing investor demand Many exchanges are now able to provide real-time trading information to investors. Through the Internet, investors also have access to a vast amount of company and trading news. They can instantly obtain detailed information

Alec Tsui 119

on certain stocks at a very low cost, and even place their orders on-line. Clearly investors are in a much stronger position in respect of obtaining the necessary information to make their channels investment decisions and choosing their investment channel (both the market and the intermediary). As investors become more sophisticated they demand more direct and upto-date information from the market, so it is very important for exchanges to continue to develop effective and ef®cient channels to satisfy this demand.

Responses of exchanges Faced with such severe challenges, stock exchanges have both individually and collectively formulated their responses. A common response is to do what they normally do, but more effectively and at a lower cost, and to add value to the services they provide to the users of their markets. Let us look at some of these ideas. Ef®cient execution, clearing and settlement The exchanges that will be able to compete best will be those than can offer maximum liquidity and guarantee safe and ef®cient execution, clearing and settlement. The ef®ciency of the trading and settlement operations, will increasingly depend on investment in trading and settlement technology. This can often represent a very large gamble, and only big institutions will be able to afford to take the risks associated with it. Some exchanges are currently moving towards real-time clearing and settlement. Product development and open market access To a large extent, liquidity in a market depends on its attractiveness to investors, so exchanges need to offer a larger variety of products to meet investors' needs. To this and, exchanges can develop new products in-house or form alliances with other exchanges and trading systems with dual listings and trading. Another way to increase the competitiveness of an exchange is to offer market access to practitioners, which helps to minimise transaction costs while maximising liquidity. Mergers and alliances There is a global trend for stock exchanges to merge with each other or with a derivatives exchange, and to establish strategic alliances with other exchanges or trading systems. This is leading to the emergence of several competing networks, each offering an integrated global service. The advantages of this strategic arrangement include the ability to trade in different time zones and in different stocks, and to raise company pro®les in other countries. Merged exchanges or exchange alliances are in a better position, compared with individual exchanges, to invest in technology and develop trading and settlement facilities that allow them to compete.

120 Nationally or Regionally Based Financial Centres

Demutualisation To meet competitive threats, exchanges are increasingly being driven to behave like commercial enterprises ± becoming highly cost-ef®cient and focusing on the need to satisfy their customers. For many exchanges this calls for a major change of organisational culture. For those which are still based on a traditional membership structure, constitutional reform is also necessary. Ownership of an exchange by members who enjoy exclusive trading rights has proved to be an inef®cient model. The concern of members to maximise their pro®ts and protect themselves from competition increasingly con¯icts with the interests of the exchange as a business. Reluctance to reform its business can only lead to the demise of an exchange. For this reason, numerous exchanges in Europe and elsewhere have gone through a process called `demutualisation' ± separating the ownership of the exchange from the right to trade on it. Some exchanges, such as the Australian Stock Exchange and the Stock Exchange of Hong Kong, have listed or planned to list the exchange on itself. This will complete the process of turning the exchanges into commercial entities, able to tap public funding on equal terms with ECNs and other providers of services similar to those of exchanges. A commercial orientation and the availability of funds for development are key for exchanges to compete.

In conclusion, no matter how exchanges evolve, one thing is certain: the economic function that exchanges perform will continue to be needed because securities markets will continue to play a role in the formation and allocation of capital within national economies.

Part III Regulatory/Supervisory Authorities: Strengthening Financial Intermediation and Systems

This page intentionally left blank

12

The Basel Capital Requirements: a First Step Towards Global Regulation Andrew Crockett

When they were ®rst introduced in 1988, the Basel Capital Requirements were a major step forward in at least two respects. First, and substantively, they were a basis for strengthening the international banking system by raising the amounts of capital banks were required to hold. In so doing they contributed to a more level playing ®eld for internationally active banks. Second, and procedurally, they represented the ®rst time that national regulators had agreed on the application of a set of international minimum standards for bank supervision ± a ®rst step towards global regulation. It is important, however, not to exaggerate what was achieved in 1988. In the ®rst place, nobody pretended that the minimum capital requirements were other than a very crude re¯ection of the riskiness of a bank's portfolio. Second, the coverage of the 1988 accord was limited. It was deliberately designed to apply only to internationally active banks headquartered in the countries represented in the Basel Committee ± the G10. No attempt was made to address the problem of regulating banks with purely domestic business, or headquartered in other jurisdictions. Several developments have taken place since the introduction of the 1988 capital regulation regime that could not have been fully foreseen at the time. First, the combined effect of peer pressure and market forces meant that the Basel rules were adopted much more widely than initially expected. Although backed by no international treaty, the Basel capital standards came to be generally accepted in the industry and amongst supervisors: an interesting example of the powers of `soft law'. Secondly, and perhaps more predictably, banks began to rearrange their portfolios in order to reduce the constraints implied by regulatory capital requirements. New instruments and the securitisation of assets made it possible for a bank to achieve more or less any desired level of risk in its portfolio, while still observing the required cushion of regulatory capital. Let me say a few words on how supervisors have responded to these dynamic developments in the banking industry. The fact that supervisors outside the G10 have shown a desire to use and apply the rules developed by 123

124 The Basel Capital Requirements

the Basel Committee has changed the committee into a de facto global standard-setting body. This has created the need to be more responsive to the concerns of regulatory authorities outside the G10 and conditions in their banking industries. One approach to dealing with this issue has been to create regional groups of supervisors to provide a channel by which regional concerns can be brought to the attention of the Basel Committee. A global meeting of bank supervisors, held every two years, provides another vehicle for the transmission of information. By the mid 1990s, however, it was becoming apparent that merely facilitating the exchange of information was not suf®cient. A more structured approach to broadening the coverage of the Basel rules was needed. After some discussion it was decided to develop Core Principles for Banking Supervision. By comparison with the existing corpus of guidelines from the Basel Committee, the core principles represented an extension in at least three ways. First, the principles were comprehensive rather than selective. Whereas the previous rules simply covered points where the G10 supervisors felt a harmonisation of practice was desirable, the core principles aimed at covering all aspects of banking supervision, from initial licensing, through ongoing supervision, to merger and closure procedures. Second, the core principles were designed to apply to the supervision of all banking institutions in all countries, and not simply to the supervision of internationally active banks of industrial countries. This, too, introduced a much wider range of supervisory concerns than were covered in the original Basel Accord. Third, the core principles were developed with the active involvement of supervisors from non-G10 countries. This responded to the need for both realism and legitimacy. Core principles were unlikely adequately to cover supervisory concerns in emerging markets unless supervisors with ®rst-hand experience of those issues were directly involved in preparing supervisory guidance. And the acceptability of new rules would be greater if those bound by them had a share in their preparation. The promulgation of the core-principles in 1997 was an important step forward. It provided the basis for a harmonised approach to supervision on the basis of global best practices. However there is a limit to what the core principles, by themselves, can achieve. Even with the support of the recently drafted methodology (for assessing compliance with the core principles), these principles are a kind of checklist of supervisory best practice, not a blueprint that can be mechanically applied. Much remains to be done to translate the broad principles embodied in the document into implementable guidelines. It is for this reason that the Bank for International Settlements (BIS) established the Financial Stability Institute. It is hoped that this will develop into a forum for supervisors to exchange ideas and to learn from each other the practical techniques needed to put the core principles into effect. Another development during the 1990s was consolidation in the ®nancial sector, including the blurring of boundaries between banks, securities issuers

Andrew Crockett 125

and insurance companies. This has necessitated greater international cooperation among supervisors, both geographically and across market segments. The international associations of supervisors in the securities and insurance industries have grown in importance. Through the Joint Forum they have established a vehicle for cooperation with each other and with the longer established Basel Committee. In some countries, notably Japan and the UK integrated supervisory agencies have been established to deal with the entire ®nancial sector. These developments can be viewed as steps toward global regulation. However in my view it is unlikely that they will lead to the creation of a global super-regulator in the foreseeable future. In the ®rst place, national legislatures are unlikely to surrender their sovereign responsibility for regulation in their home jurisdictions. Second, in some countries, the US for example, the separation of regulatory responsibilities among different bodies is too wellentrenched to be quickly changed. What this means is that the globalisation of regulatory standards, which is an inevitable consequence of the globalisation of the ®nancial industry, will be achieved through the intensi®cation of cooperation among different regulators, rather than through the cross-border consolidation of formal regulatory authority. This is a less tidy approach, but not necessarily less effective. There are some advantages to a measure of regulatory competition, provided it does not compromise the goal of adequate supervision. And the need for international debate and agreement on regulatory initiatives is an important constraint on excessive regulatory zeal. Let me now pass on to some of the substantive issues raised by capital adequacy regulation and how they can be dealt with. As is well known, the original 1988 accord required minimum capital holding of 8 per cent of risk assets. Approximately half of the minimum capital requirements had to be represented by shareholders' funds, the remainder being allowed to be in various subordinated debt instruments. Risk assets were classi®ed into four categories, with most carrying a 100 per cent weighting. However the sovereign debt of the OECD countries carried a zero risk weight and most interbank lending a 20 per cent risk weight. Any approach that divides assets into different risk buckets is open to at least three types of objection. First, the risk weights do not differentiate suf®ciently between assets of different quality in the same risk class. Second, certain assets with lower risk weights may have higher intrinsic risk than some with higher risk weights. And third, the approach does not make any allowances for the risk enhancing/reducing features of concentration or diversi®cation in portfolios. There is no good answer to these objections, so long as supervisors themselves accept responsibility for assigning risk weights. They could of course use a more `granulated' approach, multiplying the number of risk buckets and using techniques to differentiate more ®nely amongst the risk

126 The Basel Capital Requirements

characteristics of different claims. But this takes supervisors in the direction of substituting their judgement for that of bankers, with all the moral hazard and ef®ciency objections that this entails. A more promising approach is to use banks' own internal credit ratings. There can be as many risk buckets as banks' grades (the average is 12±15 in most sophisticated banks). One can even imagine regulatory capital being a continuous function of expected default frequencies (EDFs) and loss given defaults (LGDs). In practice the Basel Committee's recently published consultative paper1 embodies three approaches, called the three pillars of the new approach. The ®rst, which has attracted the most comment, though in my opinion it may not be the most important, is based on the assignment of risk weights to the assets in banks' books. It offers two options: the standardised approach, which deals with some of the more glaring anomalies of the existing risk weights, and the more promising internal-ratings-based approach. The second is to use supervisory oversight to assess the quality of banks' internal credit assessment and allocation of economic capital. This is a potentially fruitful approach that could eventually lead to much greater reliance on banks' internal models of credit portfolios. And the third is to develop ways of exposing banks to greater market discipline, through transparency and more effective ways of allowing the market to express its view on institutional soundness. Certain elements of these last two approaches, about which I will have more to say shortly, are extremely promising, but are not yet at a stage where they are ready for practical implementation. Concerning the standardised approach, the new proposals tackle some of the elements that were most heavily criticised in the 1988 accord. Under the 1999 proposals it will become possible to assign a risk weight of 20 per cent (instead of 100 per cent) to the highest quality commercial credit. Sovereign and interbank credit will attract risk weighting based on a more objective assessment of credit quality. The old `club rule' whereby OECD members countries had a zero risk weight while all other sovereign credits had a 100 per cent weight will be abandoned. In the internal-ratings-based approach, banks will be allowed to use internal ratings for credits if the supervisors accept that they are adequately rigorous. The second pillar of the 1999 document is the use of supervisory judgement. It has always been assumed that supervisory judgement will complement capital ratios, for example by requiring additional capital for institutions with excessive risk concentrations or inadequate credit appraisal systems. Under the new approach, supervisory discretion will play a growing role. Through this approach, credit risk modelling techniques, which are not yet suf®ciently advanced for the calculation of regulatory capital, can be tested and improved as risk management and supervisory tools. The third pillar of capital adequacy regulation is market discipline. If institutions are suf®ciently transparent about their risk pro®les and appetites, their counterparties will be in a position to discipline excessive risk taking.

Andrew Crockett 127

Some proposals from academics for in¯uencing capital holding aim to exploit market discipline in a more formal way. One suggestion is that banks be obliged to issue subordinated debt, whose secondary market value would provide an objective measure of investors' assessment of the institution's creditworthiness. Another suggestion is that banks should `precommit' an amount of capital based on their own assessment of value at risk. Penalties would apply when actual losses were greater than assumed value at risk. Neither the precommitment nor the subordinated debt proposal has yet attracted suf®cient support to provide the basis for capital adequacy regulation. Indeed each has a number of important technical ¯ows that need to be overcome. But both are examples of the search that is now under way to give a greater role to market forces in capital adequacy. Note 1. This refers to the ®rst consultative documents, issued in June 1999. A second consultative document, incorporating amendments in response to comments received, was published in January 2001.

13

New Tools and Risks in Financial Intermediation in Emerging Markets: Should Regulators and Raters Adopt New Methods? The Case of Asia Philippe Delhaise

The Asia crisis has revealed a number of weaknesses in the supervision of ®nancial institutions in Asia. Coincidentally, this has taken place at a time when supervisors in mature economies are confronted with new risks and are revising their approach. By and large, Asia's ®nancial intermediaries still operate as fairly unsophisticated moneylenders and rely on antiquated risk management tools. While the new ®nancial tools that are presently the focus of supervisors and raters in mature economies have yet to pose a serious threat to the balance sheets of Asian ®nancial institutions, enough of those tools have become accessible to them for Asian supervisors to take notice. But this matter in fact represents considerably more of a danger in Asia than in regions with advanced banking systems, simply because there is, among Asian ®nanciers, a general lack of skill in risk management and control. This chapter brie¯y examines how regulators misread the signs of an impending ®nancial crisis in the early 1990s and how new ®nancial tools and broader access to international ®nancing have compounded the problem. The chapter will touch on the sorry state of risk management in Asia, on the failure of many local authorities to rehabilitate the banking system and on why simple but drastic solutions are disregarded. Moneylenders are highly geared companies that enjoy the recognition of and a degree of protection from supervisors in exchange for the provision of ®nancial services to the community under strict rules. The rules take the shape of capital and liquidity ratios, while a number of regulations affect the risk pro®le of the ®nancial institutions' assets, especially their loan assets. On that front alone, supervisors made considerable mistakes in Asia prior to the 1997 crisis. Perhaps would it be useful at this point to clarify that the 1997 crisis was in reality a market panic that, through the transmission belt of exchange rates 128

Philippe Delhaise 129

and stock market valuations, served to reveal the weaknesses of many Asian countries. But the banking crisis started well before the 1997 panic. Japan's banking crisis started in 1991. The Korean banking system was on its knees as early as 1993 or 1994. The liquidity pro®le of Thailand's banks was so fragile that by 1995 a major rating company ± Thomson Financial Bank Watch ± took the unprecedented step of gathering the 15 Thai banks for tea and cookies to tell them that a major crisis would hit them sooner or later. That the banks survived until the July 1997 crisis is simply a miracle. Malaysia was less of a problem, and the misallocation of capital would only have hit the country in about 1999, if not for the 1997 contagion. The same goes, paradoxically, for Indonesia where the local banks, for all their mistakes and the ¯outing of some prudential rules, were not in immediate danger. The Philippines banking system was not scheduled to crash until the year 2000. Taiwan had ± and still has ± a remarkably fragile banking system in an otherwise healthy economy. Most banks in China, Vietnam and the Indian subcontinent have been happily operating with negative equity for years. How did the regulators fare? The regulators' job is to keep the banks on the straight and narrow. They must catch delinquent institutions before their mistakes start to costin¯ict depositors, creditors or taxpayers. When a privatesector bank is about to lose its last chunk of free equity, it should be forced to mend its ways and inject fresh capital funds. Should it fail to do so, the authorities should step in, force a reduction of capital and, if no fresh investment funds can be located, nationalise the institution partly or entirely. It comes as a surprise that, after the mid 1980s when Malaysia acted that way in respect of three small banks, no Asian country used such powers to clean the banking system until Thailand made a belated attempt in 1998. The regulators failed in their duties, but in all fairness it should be stressed that politics went into play and they were largely prevented from doing their job. Beyond control by the ratios, the regulators failed in another way: they disregarded the all-important risk management and control. This is where the new tools ± the new toys is perhaps a more appropriate description ± came into play: derivatives and large international risk-taking activities. It would be possible today for relatively small ®nancial institutions to go bankrupt within two weeks, and there would be little the regulators could do. But it would also be possible for them to collapse suddenly under the weight of accumulated mistakes that no external observer could have foreseen. Managers themselves often fail to acknowledge the existence of such mistakes. Beyond the ratios, regulators should be able to gauge the skills and the tools of the risk managers in the ®nancial institutions they control. If the managers of a bank adequately control the bank's risks, there should be no need for external supervision, beyond basic ratios. If the bank managers know what they are doing, there should be no risk ± except at the tail end of the risk spectrum ± that they could not manage and contain. A major weakness of the Asia banking systems in recent years is that ®nancial institutions have been allowed to take risks that

130 New Tools and Risks in Financial Intermediation

they do not understand and have been unable to control. From Thai banks borrowing short-term dollars to ®nance long-term baht investments in unneeded real estate, to tiny Korean merchant banks lending dollars to unsafe Brazilian or Indonesian corporate borrowers, to Hong Kong-based banks lending to Malaysian companies for risky investments in the steel industry of the Philippines, the list is long of obvious mistakes in risk management. The huge losses posted by many banks in the aftermath of the 1997 crisis should have at least prompted the authorities to take a fresh look at those matters, and to start a new era of better controls, beyond traditional ratio monitoring. But here also the countries have failed: the rehabilitation of the banking systems has been far from harmonious. Governments and bank regulators across much of Asia have been desperately trying to ®x banking systems that in many cases are arguably beyond repair. Efforts to date amount to little more than creative accounting techniques designed to mask insolvency. Regrettably, received wisdom has centred on the principle of merging unsound banks with those perceived to be sound, with the expectation that reducing their number will somehow give rise to miracles. I would suggest that, to the contrary, now is the time to allow the creation of brand new commercial banks across the region. A case could be made that it would be best to create new banks rather than rehabilitate moribund ®nancial institutions. Asian governments, swayed by international trends in the consolidation of banking systems, do not seem interested in the idea, but that is another story. The capital funds that are presently missing from commercial banks represent between 15 per cent and 45 per cent of GDP, depending on the country. It is simply not realistic to expect that the missing capital funds can be easily found. So banks must cook the books. In truth, using stringent international accounting practices, most banks in Thailand, Indonesia and Korea would exhibit negative capital ratios. In many cases they are beyond repair. This has a number of implications. From an investor's point of view, it would theoretically be more appropriate to start a new bank rather than to invest in a bankrupt ®nancial institution and see the best part of the fresh injection of capital devoted to writing off bad loans. From the bank owner's point of view, there is nothing more to lose. With no more downside risk, moral hazard is at its highest. The temptation exists to increase both reward and risk. Little fresh lending is likely to be directed at safe borrowers. From the regulator's point of view, it is preferable to let the owners of the ailing banks make an attempt at rehabilitation. This is because liquidating the bank at this stage would carry social and perhaps political implications. Once the capital funds are exhausted, depositors, creditors and taxpayers will share the cost of the failure. It is often the case that a bank operating as a going

Philippe Delhaise 131

concern, in the hands of those who wrote the credits in the ®rst place, is likely to be more successful than liquidators in pursuing recalcitrant borrowers. It is also likely to be more successful than government bodies taking over such assets. The Basle Committee's approach to capital ratios, in its original 1988 form and with subsequent revisions, may exhibit some weaknesses, but it is an important step forward. Its adoption in Asia, however, has become a source of creative accounting for banks in that, since it is the focus of all rehabilitation gauging, no effort is spared to fake solvency. The valuation of assets is inaccurate and the regulators often conspire with banks to conceal the extent of the damage. Banks post in¯ated capital ratios. Loan losses are concealed that, if recognised, would eat away at Tier I, the most precious part of capital funds, as opposed to the more fuzzy capital attracted under Tier II. Now that capital funds have become acutely restricted, the banks will, for the ®rst time in Asia, face trade-off decisions between various risks that may lead them to lending decisions that could become socially undesirable or economically suboptimal, simply because they have lost the power to choose. Meanwhile problem loans in aggregate have reached catastrophic levels and created a huge gap in equity. Compounding this dif®culty is the very manner in which problem loans are identi®ed. The classi®cation of problem loans is not only changing, being lenient and inconsistent across the region, but is also often subject to unwholesome in¯uence by authorities. The same problem applies to the provisions that these banks need to put aside against such loans. Provisioning decisions seem to be dictated not so much by prudence or the recognition of loan defaults, but by what banks can afford without recording embarrassing losses. Banks have traditionally hidden huge amounts of non-performing loans simply by rescheduling the terms of their interest and/or principal payments, despite the bleak future prospects of such repayment. There can, of course, be, valid situations in which borrowers have legitimate cause to seek a restructuring of their obligations. In Asia, however, such reasons are generally rare. Rescheduling allows banks to skimp on prudent provisions while simultaneously recording interest income that never was, and is never likely to be, earned. This explains why a bankrupt bank can often look pro®table. While acknowledging that improving economic conditions could restore the cash ¯ows of some distressed borrowers and their ability to service their debt obligations, the banks' practices remain an unacceptable gamble. Another expedient ± and more acceptable ± practice involves the transfer of non-performing loans to asset management companies. The main characteristic of such ®nancial vehicles in Asia is that, beyond the liquidation of loans in a more ef®cient manner, they ensure the transfer of wealth from taxpayers to banks in a discreet and seemingly painless way.

132 New Tools and Risks in Financial Intermediation

Most banks in South Korea, Thailand, Indonesia and Malaysia are now at the mercy of their governments for their very survival. Either the governments own the banks outright, or they have a moral obligation to support them, sometimes as a price paid to the banks for their help in rescuing the weaker constituents of the ®nancial system. Such Faustian arrangements are not new to Asia. The governments of Indonesia, South Korea, the Peoples' Republic of China, Vietnam and the countries of the Indian subcontinent have long controlled most of the larger commercial banks. Under government control, banks can more easily fake solvency. They conceal bad loans. In lieu of capital, government bonds are lodged on the books. The aforementioned practices are merely accounting illusions. At best they allow banks to post the minimum regulatory ratios to keep them alive, so that they can ful®l their role as moneylenders. At worst they perpetuate mediocrity and moral hazard. However viewed the present efforts to rehabilitate banks in Asia are but a transfer of enormous wealth from the many to the few. The major shareholders and managers of failed banks have not only escaped just punishment generally but often pro®t from the arti®cial rescue of their banks. Clearly the regulators have been forced to go along with expedient decisions dictated by political and often practical considerations. Beyond capital ratios, there are many pressing problems to ®x in the ®nancial systems throughout Asia; namely credit culture, transparency, disclosure and corporate governance. More important still, Asia should pay more attention to the development of its capital markets. Meanwhile substantial efforts are needed for a quick resolution of the present credit crunch. Asia needs ruthless regulators and supervisors who will not allow private sector banks to resume their wild chase for market share or elusive pro®ts. One possible development would be the creation of brand new banks, an option to which nobody gives serious consideration. The sad truth, perhaps, is that the lessons of the painful Asian crisis will not translate into any substantial improvement in the way banks are supervised.

14

The Role of the Financial Stability Institute of the Bank for International Settlements John G. Heimann

In 1998, turbulent and inadequately supervised ®nancial systems threatened global instability. Since the height of that concern the G-7 has supported a number of actions to put in place disciplines to promote greater stability, and the worlds economic growth prospects are now substantially better. To some degree a sense of complacency has grown that should cause concern. We must not forget that the instability of 1998 saw the fastest growing economies in East Asia suffering contractions in output that were even greater than that experienced during the Great Depression of the 1930s; Russia going into default beneath its cloud of corruption; in the US, the mounting of one of the biggest ever emergency re®nancings, not for a bank but for a hedge fund; free enterprise Hong Kong taking publicly owned stakes in all of its private companies; and Japan nationalising its banks. The causes of the problem, about which there is general agreement, include excessive indebtedness, both public and private; the inappropriate nature of that indebtedness, with its tilt towards short-term maturities in non-domestic currencies; high levels of leverage, not just in the ®nancial system, but also in the debt to equity ratio in the industrial sector; and the nearly universal weakness of developing nations' domestic ®nancial systems. It is almost impossible to pick up a newspaper or magazine these days without confronting another set of proposals to reform the `international ®nancial architecture', proposals that sweep the horizon of reform and include:

. The creation of an international deposit insurance corporation (George Soros).

. The formation of an international bankruptcy courts (Jeffrey Sachs). . A rethink of the generalised antipathy towards controls on capital out¯ow (Paul Krugman).

. Chilean-style controls on in¯ows (Barry Eichengreen). 133

134 The Role of the Financial Stability Institute

. The creation of a single global super-regulator of ®nancial markets and institutions (Henry Kaufman).

. The creation of a world central bank with responsibility for overseeing a new global currency (Jeffrey Garten).

. The selection of the IMF to perform the functions of a lender of last resort, a

suggestion packaged along with a wide range of improvements to the existing structure of the international ®nancial institutions (IFIs) (Stanley Fischer).

The Council on Foreign Relations created a task force (of which the author was a member) and recently published its ®ndings in a report entitled `Safeguarding Prosperity in a Global Financial System: The Future International Financial Architecture', which put forward seven key recommendations:

. The IMF should lend on more favourable terms to countries that take . . . . . .

effective steps to reduce their crisis vulnerability, and should publish an assessment of these steps so that the market can take note. Emerging economies with fragile ®nancial systems should take transparent and non-discriminatory tax measures to discourage short-term capital in¯ows. The private sector should promote fair burden sharing and market discipline. Emerging economies should reject pegged exchange rates. The IMF should adhere consistently to normal lending limits and abandon huge rescue packages. The IMF and the World Bank should revert to their basic historical roles. Political support for ®nancial reform should be generated.

Most of these schemes have fatal ¯aws. Some suggestions, ranging from the unrealistic to the surreal, are politically infeasible given the absence of a supranational legal authority; some could substantially increase costs to lenders or add protection for borrowers, and thus would lead to a sharp contraction of capital ¯ows to developing nations; and those that shift risk away from creditors, thus leading to an increase in capital ¯ows, are likely to be followed by a wave of greater risk taking, followed by another wave of defaults. It seems to me that all these suggestions possess bits that could be recalibrated and, if taken together, would be helpful in designing solutions. However any attempt to ®nd a sweeping one-size-®ts-all answer is bound to fail. After all, each situation is different and needs to be evaluated in light of its particular circumstances. In my view solutions must be designed on a case-by-case basis, combined with smaller packages from the IFIs and accompanied by a reduction of bailout expectations (the moral hazard issue); more private sector involvement early on with terms that incentivise the private sector to participate; the recognition

John G. Heimann 135

that solutions cannot be forced, since countries make their own decisions, the acceptability of which are priced into the market; and limit restructuring to the most dif®cult cases when insolvency threatens. There is of course considerable disagreement about any and all of the solutions save one the need to strengthen the ®nancial sector of developing nations. All commentators, all committee reports, public and private, agree that this is key to ®nancial stability. Since the mid 1970s we have seen time and time again that:

. Poor macroeconomic policies coupled with a weak ®nancial sector is a recipe for disaster.

. Even when a country has a reasonably decent macro policy mix, if it has a weak ®nancial sector any external shock is quickly transformed into disaster. . A country may have a poor macro policy mix, but if it has a strong and vibrant ®nancial sector there may be big problems, but disaster is averted.

The ®nancial sector should be a stabilising in¯uence, but as we have seen in Asia, Russia and elsewhere it has acted as a multiplier, making bad problems worse. Since there is general agreement that strengthening the ®nancial sector is critical, there is an unfortunate tendency within the of®cial community to assume that suf®cient attention and resources are being paid to ®xing this problem. Some efforts along these lines have been made in the past and are being made by a variety of central banks and international ®nancial agencies ± but not nearly enough. Improving the ®nancial sector fundamentally requires substantial upgrading of ®nancial supervisory systems. Theoretically, change could and should be implemented by the private sector in recognition of best practice and in response to competitive pressures. But this has not happened. Many reasons have been cited ± including structural and cultural issues, which are usually used as an excuse for not meeting best practice ± for their inability to change. The fact remains that those institutions wished to enjoy the bene®ts of global markets without accepting global standards. In recognition of the need to improve the functioning of ®nancial intermediation, the Basel Committee on Banking Supervision (BCBS) adopted the Core Principles of Banking Supervision, which were designed to guide supervisors on the standards they should require when examining a bank in order to judge the safety, soundness and prudent management of that institution. Since the private sector had abdicated the role of selfimprovement, the ®nancial supervisors recognised that it fell on their shoulders to become the agents of change. Upgrading ®nancial supervision in any country is a long-term project, one that will take years of diligent implementation to succeed. In the US it takes

136 The Role of the Financial Stability Institute

about ®ve years to train a good bank examiner. And good bank examiners are exactly what are needed. On-site supervision is key to determining the strength or weakness of any individual ®nancial institution, and on-site means on-site bank examiners. Off-site examination, favoured by some, is only valid if off-site is the sum of skilled on-site examination. If it is not, then off-site calculations are often corrupted by incomplete and often misleading information. In many of these countries there is an overwhelming shortage of trained and experienced bank examiners. Furthermore many of these supervisory agencies are starved of the ®nancial resources needed to provide a competitive wage for professional staff and purchase support mechanisms such as information technology. These agencies do not receive the necessary political support, which precedes ®nancial support, to upgrade their capacity to do the job. Many of the G10 central banks and banking supervisory agencies have been active in training bank examiners from developing nations. This has been helpful, but not all the G10 banking supervisory agencies have a similar view on the techniques needed to implement the core principles. Furthermore the training provided has been coloured by the practices and procedures used in the country in question. As a result, hundreds of men and women have been sent back to their home countries with some element of training but, as a group, without a common understanding of techniques and goals. It is imperative that we create a broad set of international standards that are accepted, implemented and enforced across the global ®nancial system. We need a common understanding of the root meanings of the Core Principles and a common measure for their implementation and enforcement. It is to be hoped that this will be furthered by the ®nal adoption of the Core Principles Methodology by the BCBS. The Financial Stability Forum (FSF), under the chairmanship of Andrew Crockett, the general manager of the BIS, and in cooperation with the IMF and the World Bank, has begun to collect data on the various training courses being offered to banking supervisors. Prior to this effort, no compendium of courses was available. This is an important ®rst step in the process of providing assistance for ®nancial supervisory improvement. The IMF has agreed to undertake, in the course of its Article IV consultations, a review of the state of ®nancial supervision. That should prove to be enormously helpful, but much more is needed. Identi®cation of problems is an important ®rst step towards their correction, but it must be accompanied by sources of education, training and assistance to which countries can turn in order to improve ®nancial supervision. It is towards this end that the Bank for International Settlements (BIS) and the BCBS created the Financial Stability Institute (FSI) of the BIS. The FSI's mandate is to help improve and strengthen ®nancial intermediation in the developing nations and those in transition. For the most part this means working with banking supervisors, since ®nancial intermediation in these

John G. Heimann 137

countries is heavily concentrated in the commercial banking system. For the most part capital markets are virtually non-existent or are only in the earliest phases of development. The FSI is pursuing this task through a variety of symposia, meetings and workshops for the leaders of ®nancial supervisory agencies. Leadership is key. We know that we must convince the agency heads of the validity and timeliness of our programmes so that they will encourage, even order, their associates to attend the courses that have been designed for them. An integral part of the FSI's programme is the holding of workshops and meetings, many of them regional, for middle-level members of the supervisory agencies ± the men and women who are responsible for the examination process. The programme began with the leadership, but it must reach out to professional staff so that they too can receive the bene®t of FSI programming. At the very heart of the FSI's work will be the Core Principles and the Core Principles Methodology, when ®nally adopted by the BCBS. This is particularly important since the IMF's Article IV consultation will include an assessment of adherence, implementation and enforcement of the methodology. During 2000 the FSI held a series of workshops on methodology in Basel and the regions. It has also offered workshops on fraud detection, consolidated supervision, governance, asset and liability management, information technology, ®nancial innovation, deposit insurance, capital ¯ows and, last but not least, risk management, credit risk, and market risk. It is the FSI's practice to use supervisors from around the world to lecture on subjects that are primarily supervisory in nature, and for the private sector to provide the lecturers for subjects that are directly market related. The FSI recognises that at this stage much of what it is doing is somewhat experimental. Early in its existence it sent a survey to the heads of supervision and the central bank governors of all the non-G-10 countries to ®nd out what they needed. Most encouragingly, it received a response rate of slightly over 75 per cent. This impressive result overwhelmingly indicated the need for assistance. The programme for 2000, which focused on risk management, consolidated supervision and core principles methodology, re¯ected their priorities. Prior to 2000 the FSI had held four workshops, attended by 129 persons from 74 countries. Their level of sophistication and experience was broadly spread from a very few with near state of the art capacity to those who had just begun seriously to improve their supervisory skills. Nearly all of those with whom the ESI has been in contact have been seeking a substantive upgrade for their agencies. They wished to have the same basic competence as that which presently exists within the G10. And they realistically recognised that it would take some time to get there. Therefore the task of the FSI is twofold: to give supervisors a grasp of the end result they wish to achieve; and to provide them with the tools that will help them to achieve that goal, not only in the long term but in the short term as

138 The Role of the Financial Stability Institute

well. It is not good enough just to outline the landscape of the promised land of banking supervision. They have continuing responsibilities and must examine and pass judgement on banks tomorrow. The FSI must provide them with the necessary tools to help them manage their ongoing responsibilities as they travel the long road to the promised land. This is easier said than done. Whatever is suggested for immediate implementation must be in concert with long-term, presently unachievable goals. The FSI is attempting to resolve this dilemma by stressing basics, coupled with techniques for an immediate assessment of an institution's ability to meet minimum standards. The FSI's course on market risk explains the bene®ts of and the techniques for stress testing and measurement tools such as VaR ± all of this done by private sector experts, complemented by supervisors with this particular expertise ± and simultaneously provides them with questions that will help them to determine the scope and reach of an institution's market risk management. In many countries, supervisors simply do not have enough trained professionals to evaluate the more sophisticated techniques designed by the G10 supervisors. Therefore the questions the FSI gives them are designed quickly to reveal the state of management's capacity to manage risk without requiring the supervisor to ®eld an army of experienced examiners backed up by state of the art technology. For example, at the beginning of an examination the examiner could ask the CEO the following questions (there are follow-up questions depending upon the answers):

. What is the tolerable level of loss your board of directors has agreed is an acceptable level of risk?

. Please show me how you decompose your pro®t and loss statement

between risk- and non-risk-related activities. Also, may I see your log of extraordinary gains and losses for the past six or 12 months with the accompanying explanations?

These questions are simple but not simplistic. If the board of directors has not set a tolerable loss limit, the supervisor knows there is a basic governance issue. If the pro®t and loss statement is not decomposed and if there is no log of extraordinary gains and losses, then the supervisor knows there is no effective risk management in that institution even if a risk management box appears on the organisation's chart. Since most supervisors have the power to inspect the institution's records, including board minutes, the answers given are easily veri®ed by inspection. The FSI recognises that the path to global improvement of ®nancial supervision is long and arduous. Most nations with which it has been in contact seem serious about improving their ®nancial supervisory capacity. But no doubt some of those who say they are will not commit the necessary resources to accomplish the task. Adherence to principles is not necessarily

John G. Heimann 139

compliance with principles. The FSI does not prejudge the motives of any nation in this respect. Over time it will become apparent to the FSI and the international ®nancial community which nations are seriously trying to improve and those which are just paying lip service. As that becomes apparent, and it surely will, then international ®nancial institutions and the capital markets will take progress, or the lack of it, into account and act accordingly.

15

Switzerland and the Challenges of Globalisation BeÂneÂdict Hentsch

Much has been written or said on the subject of globalisation since the advent of new technologies enabled the development of information superhighways, bringing people closer in a way hitherto unknown in the history of humanity. To mention the challenges that await Switzerland and its citizens is to touch upon, discuss and raise doubts about facts or even myths and it is dif®cult to bring such a discussion to a satisfactory conclusion. The exercise Switzerland was forced to carry out to resolve the problem of the unclaimed Jewish assets revealed how dif®cult it is to analyse the past, especially when this is communicated to us by our predecessors: honest and conscientious people who are convinced they acted in the interest of future generations. To question myths is therefore a delicate matter. It is even more so today because time seems to ¯y ever faster and there is less and less of it available for re¯ection and the development of ideas. In 1989, when I joined the Board of Swissair as a young man of 40. I was told that `Joining the board of Swissair is somewhat like joining a religious order; you are now entering the realms of mythology ± Swiss mythology. There are three icons in this country the Matterhorn, the Knie circus and Swissair! Woe betide those who question them: as such historical monuments, they reign majestically, unassailable, unquestionable.' Just for the record, the person in question recommended that, in view of my very young age, I should not take the ¯oor during the four years of my ®rst term in of®ce ± a question of becoming acquainted with the mysteries of this strange religion, namely the supervision of a historic monument! I did not really follow his advice but I am still on the board, which in 10 years has been slimmed down from 32 to nine members. For me this reduction is very symbolic and it brings me the subject of this chapter ± the challenges facing Switzerland and how we should tackle them. Without rewriting history, I would like to return to a date that I see as the turning point for Switzerland, after which everything changed course towards a new world ± one for which Switzerland was totally unprepared. The date was 140

BeÂneÂdict Hentsch 141

9 November 1989. The place was Berlin. The event was the tearing down of the Berlin Wall. Why do I consider this date to be so geopolitically crucial for Switzerland and its future? At the risk of appearing to historians as simplistic and reductionist, I think that postwar Switzerland has suffered the after-effects of the way the world was organised at Yalta. At that point the world became bipolar and was set on course for a cold war between two superpowers that neutralised each other for more than 45 years as each had the nuclear means to destroy the other. For more than four decades the US and the Soviet empire confronted each other, and their confrontations by and large took place in Switzerland, whose political neutrality was accepted by both parties and allowed it to play host to this politico-diplomatic seesaw. During this time our gift, as Swiss, was to act as mediator between these sworn enemies, with their diametrically opposed values and visions of the world. Following the star wars initiative by President Reagan, the Soviet empire was incapable of ®nding the economic means to continue the technological race and was therefore obliged to lay down its arms and accept the end of its dominance over half the world. Since then Pax Americana has reigned supreme. The world is no longer bipolar and it will take generations for China to rival American power, despite the fact that it has given human kind many of its greatest inventions. As for Europe, it is still in the cradle. The biggest challenge facing Switzerland can be illustrated by paraphrasing a graf®ti written on walls in Prague when the Russian tanks rolled into the city: `Wake up, Lenin ± they've gone mad!' In our case it is `Wake up, Switzerland ± the world is changing!' So let us take a look at the challenges facing us. I shall deal with the main ones, those that seem to me to be the most essential. I do not claim to have solutions for them, but I shall try to provide some food for thought. The ®rst challenge is to abandon Swiss neutrality. At one time this concept was as much wanted by Swiss citizens as it was desired by external forces, and as long as it was really useful both domestically and externally it worked extremely well. However we have to face the fact that it is no longer useful today. Switzerland's procrastination over the war in Kosovo is a good example of the extent to which the Swiss idea of neutrality (which is, moreover, an armed neutrality) has become completely out of touch with the reality of what is needed. What is worse, it might cause Switzerland to be seen as sel®sh if it carries on standing on the sidelines and shows a lack of solidarity with the events surrounding it. Switzerland has to recognize that the world has become unipolar. It must enter the ring and take an active political and diplomatic part in the adventures of the world of which it is a part. It can no longer be just a spectator, content to offer an umpire's advice to ®ghters who do not really care. This means joining both the UN and NATO, which should rapidly become an organisation serving Europe and not the US.

142 Switzerland and the Challenges of Globalisation

The second challenge is to reorganise Switzerland's institutions. The Swiss political system is like a three- or four-stage rocket, looking after the destiny of a population of seven million inhabitants ± half the population of Paris ± and it seems particularly unsuitable for putting us into orbit for the third millennium and ill-adapted to modern requirements for running the state. There is no question of doing away with direct democracy, which is and must remain the basis of the country's institutions. The living proof that this system works well can be seen at the municipal level. Close relations between those governing and the citizens, except in the big cities, is the guarantee of good administration and so it is rare that problems are not resolved swiftly by the electorate (known in Switzerland as the souverain). The most one could envisage at this level is greater rationalisation of the communes by reducing their number. Without endangering these close relations, is it really reasonable and necessary to maintain over 3000 communes in order to safeguard cultural differences? The cantonal level is the second stage of the rocket and, in our opinion, the one that poses the biggest problem. Indeed it is becoming increasingly dif®cult to run a confederation made up of 26 mini states, all with sovereign powers and jealously guarding their independence but ®nding it increasingly dif®cult to handle and coordinate affairs for which they should no longer be responsible. One example of this is economic promotion, where cantons are ®ghting each other over Swiss or foreign companies. We feel that this is not in keeping with the rules imposed by globalisation. It is absurd and even counterproductive. The cantons now understand this as the discussions on intercantonal collaboration have intensi®ed and are increasingly taking the shape of agreements. This gives us a fourth institutional level, although it is not very democratic as it completely escapes the electorate's control and sanctions and, politically, no parliament has any hold over this kind of agreement. I am among those who believe that Switzerland must redraw its cantonal boundaries, which is why I have contributed to, and will continue to be involved in the Vaud±Geneva Uni®cation project. Finally, the federal level should be completely rethought. The issue of the Holocaust-related dormant accounts was the ®rst crisis Switzerland had faced since the Second World War. It proved to be a very serious one and revealed our system to be leaderless and incapable of handling a crisis. It didn't even see it coming ± Wake up, Switzerland, the world is changing! This was all the more surprising as in the business sector, in which Switzerland excels, it is common knowledge that you need someone in charge when things are going badly. Moreover there are also managers for times when things are going well. So why is it that in politics it is acceptable to dilute power to such an extent that no one knows who holds it ± about from, perhaps, some mandarins or civil servants in Bern. What is even more strange is that our founding fathers fully understood the importance of a

BeÂneÂdict Hentsch 143

leader, as in times of war the country appoints a general as supreme leader. This is why, without creating a presidential system, it would be shameful to return to our magical formula and hope once again to sleep the sleep of the just. Tightening up the leadership, ®xing main objectives, redistributing power in order to be prepared for the new responsibilities the government will be facing ± these are the greatest tasks facing our institutions. The debate must be resolved before we can go knocking at Europe's door as a self-con®dent, politically prepared, Switzerland, ®t to board the ship and perhaps even quali®ed to copilot its voyage. The third challenge is to reconcile the business and political worlds, and this beyond the political divides. In a country with an antimilitia culture it is very odd that the business and political sectors look daggers at each other What has not been said to damn the business and banking communities, making them shoulder the responsibility for all ills? What has not been said about mergers, shareholder value and unemployment? So how is it that this country of seven million inhabitants has produced some 15 companies that are all world leaders in their ®elds? How is it that they, and our country, are so prosperous? We have to ®nd a way to communicate and work with the political world, all parties together and without ulterior motives. It is not neoliberalist to talk about ef®ciency and competitiveness. It is not incompatible to be at once prosperous and united, humanitarian and rational. The last challenge can be summarised in three words: values, vision and responsibility. Values: In a global world, where one of the most dif®cult risks is loss of identity, the most important thing for a country and its citizens is to be able to express themselves and agree on a number of common values. Moral, ethical and cultural principles among peoples and a positive attitude towards prosperity, solidarity and tolerance are the essential foundations on which all societies should be built, and no matter what happens it is our responsibility to pass on these values to the next generations. On this point I am optimistic and con®dent. Vision: Switzerland lacks vision because its consensual system is incapable of producing it. `Ask a committee to design a horse and it will produce a camel'. The same goes for vision. Ask seven wise men to de®ne a vision for Switzerland and the result will inevitably be a kind of muesli, perfectly edible but not very exciting. The very purpose of a vision is to stimulate, motivate, stir up crowds, sweep young people off their feet. It has to provide a reason for our actions and our lives. Youth is not in itself a political programme. It is a moment in life that we can feel at any age. Victor Hugo said, `Why was youth given to the young?' In saying this he was aware that there is something vibrant in young people that begs to be taken seriously. Never forget that we do not inherit the earth from our parents, we borrow it from our children.

144 Switzerland and the Challenges of Globalisation

Responsibility: This is why it is our responsibility, as descendent generations, to bequeath to those who will take up the torch a Switzerland that is selfcon®dent, unite the world around it and freed from the annoying habit of always wanting to perfect everything to extremes, thus appearing fossilised and incapable of visionary fervour. To live is to act. To act is to be stirred. To stir others is to conquer.

16

Does the World Need a New Financial Architecture? Lukas MuÈlemann

At regular intervals throughout the 1990s, major events shook the foundations of the international ®nancial system. After each crisis calls were made for measures to prevent the same thing happening again, culminating in demands for an entirely new ®nancial architecture. This chapter argues that a totally new ®nancial architecture is neither necessary nor feasible at present. What is needed and what should be undertaken, however, is a targeted reform of the existing system to improve its functioning. The chapter is divided into ®ve sections. The ®rst provides a brief analysis of the most recent ®nancial crisis, which affected Asia, Russia and Latin America: remedies can not be prescribed until we understand what happened, why it happened and the interplay of the various effects of the crises. The second section assesses the various proposals for a new, farreaching ®nancial architecture, while the third looks at possible reform measures, focusing on the role of the banking sector and private creditors. The fourth section takes a critical look at the contributions made by other players, arguing that only by acting in concert will it be possible to improve the stability of the international ®nancial system. The ®nal section spells out concrete possibilities for Switzerland.

Analysis of the 1990s ®nancial market crisis Except for the Great Depression of the 1930s, no other crisis has been so exhaustively described and analysed. What actually happened? Four phases can be identi®ed, each with its own driving force. First, ¯ight from the emerging markets. It all began in the summer of 1997 with investor ¯ight from the currency and equity markets, ®rst from Asia and later from Latin America. In the six Asian emerging markets most severely hit by the crisis, shares fell by 60±75 per cent, and in the ®ve leading Latin American economies they fell by 50±75 per cent. Second, ¯ight from equities. Apart from some short-term reactions, the stock markets of the industrialised countries were not affected at ®rst. On the 145

146 A New Financial Architecture?

contrary, they bene®ted from the revaluation of risks. In the second half of 1998, however, the industrialised nations hit by a ¯ight from equities to ®xedincome instruments, and between the end of July and the beginning of October the DJI lost a maximum of 14 per cent, the FTSE 21 per cent, the DAX 33 per cent and the SMI 37 per cent. Third, ¯ight into security and quality. In mid August crisis point was reached. The situation in Russia caused investors to seek refuge in security and quality. Government bonds from industrialised countries with the best ratings and liquid capital markets were the preferred choice. As a result, other borrowers found it dif®cult to ¯oat any issues at all, and spreads widened considerably. For example the yield differential between US treasury bonds and Brady bonds ± both dollar-denominated ± for Latin American borrowers soared from 500 basis points to 2500. The spread between government bonds of AAA-rated Germany and AA-rated Italy ± both members of EMU ± widened from 30 basis points to over 50. On the highly liquid US capital market, the gap between treasury bonds and high-yield bonds expanded from 440 to 730 basis points. Both the bond markets and the equity markets saw volatility increase sharply after 17 August 1998. Fourth, ¯ight to liquidity. At the peak of the crisis in September/October the global ®nancial system ± and also the real economy ± was facing a potentially dangerous ¯ight to liquidity. Even the best rated government bonds were cold shouldered. In the course of a single day, yields on government bonds rose by 24 basis points in the US, 28 points in Germany and 36 in the UK ± a clear indication of widespread risk aversion and a deep crisis of con®dence. The situation was exacerbated by the near collapse of the LTCM hedge fund. Hot on the heels of all this the dollar fell 7.4 per cent against the yen within the space of an hour, and the nosedive on the equity markets accelerated yet again. Courageous action at the right moment ± clear interest rate signals and a signi®cant relaxation of the monetary reins ± diffused the threat of a systemic crisis. So what were the causes of the events that brought the world's ®nancial markets to the brink of crisis? Part of the answer lies in the real economy and part in the markets themselves. The ®nancial markets in southern Asia found themselves in crisis in 1997 because the authorities had overvalued their currencies for too long and pushed domestic interest rates up massively in support of these currencies. As a result growth collapsed, and this in turn worsened the long-term problem of overcapacity. Investors then expected the currencies to lose value and so shifted funds out of these countries. The fact that debt had become extremely short term in most countries further exacerbated the situation. The confusion started to affect the equity markets of the industrialised countries in summer 1998 as two facts became apparent; that the Asia crisis was going to last longer than anticipated; and that Japan was not in a position to shore up either the Asian economy or the international economy because it

Lukas MuÈlemann 147

had reached an impasse in terms of economic policy and was having to deal with shrinking domestic growth and the risk of de¯ation. In addition, it was widely felt that the US was facing a marked economic slowdown. As a result, pro®t expectations, which had been underpinning the equity markets, came under pressure. But it was the crisis in Russia that tipped the balance. A combination of factors ± massive devaluation, domestic state bankruptcy and a foreign debt moratorium, in tandem with a political vacuum that meant it was practically impossible for international lenders and institutions to ®nd competent negotiating partners ± had an overwhelming impact on the risk behaviour of investors. The example of Russia made it clear ± in the strongest manner possible ± that during a solvency crisis affecting a major country even government paper could drop by as much as 80±100 per cent. It was the lack of political leadership at the global level that ultimately drove investors to seek shelter in liquidity. This point is taken up again in the section on measures that need to be taken.

Proposals for a new ®nancial architecture Against this backdrop an unprecedented number of suggestions for reform have been put forward ± ideas for what is effectively a new ®nancial architecture. These are based on the following considerations. Numerous ®nancial institutions are active today all over the world, and globalisation has meant that the ®nancial markets are becoming increasingly integrated. As a result crises are less and less likely to be con®ned within local or regional boundaries: the risk of infection is substantial. Institutions ± governments, central banks, regulators ± that still have a very strong national orientation or are only just beginning to participate in the international arena are having to cope with this new environment. Given this scenario, the call for the creation of global institutions seems very pertinent. But what does a closer examination reveal? Three of the suggestions are assessed below. First, Henry Kaufman, former chief economist of Salomon Brothers and Wall Street expert/guru, advocates a central regulator for ®nancial institutions and ®nancial markets ± a sort of super regulator. It would, of course, be a good thing if supervision functioned according to the same high standards throughout the world. Market players are ®ghting a continuous battle for a level playing ®eld. But the idea of a central body is unrealistic. Many of those involved would be deprived of substantial areas of responsibility. This is clearly illustrated by the current situation in the US, where yet another attempt at comprehensive reform of the ®nancial sector ± the long overdue abolition of the Glass±Steagall Act±threatened to fail, this time because of opposition from the various regulators involved. An attempt to reach agreement on a global scale would be tougher still, but such action is not really necessary in any case. Admittedly, national regulators always lag behind developments to a certain

148 A New Financial Architecture?

extent, but in the last ten years an enormous amount of progress has been made in terms of international cooperation. The BIS, the securities markets regulators (IOSCO) and the insurance regulators (IAIS) are cooperating with each other to an ever greater degree and are also harmonising standards within their own ranks. This is the right road to take, and therefore there is no need for a super regulator. Second, Jeffrey Garten, Dean of the Yale School of Management and former Undersecretary of Commerce for International Trade, proposes the creation of a world central bank. Such a body would be responsible for the global stability of the ®nancial markets and would act as a true international lender of last resort. Apart from the dif®culty ± in the absence of a single currency ± of ®nding a policy acceptable to everybody, the problem of sovereignty would again be the major stumbling block. And here we can learn from the example of the EU. Although economic and monetary union is a reality and the European Central Bank is up and running, even in this economic zone ± which is highly homogeneous compared with the global economy ± the ®nancial markets are alert to the smallest sign of a difference of opinion between the national central bank presidents. As for the Swiss, they would certainly ®nd it extremely problematic if the Swiss National Bank were to become tied to a sort of world central bank. Third, the idea of a single global currency, ¯oated by Harvard economist Richard Cooper, Former Undersecretary of State for Economic Affairs and Former Chairman of the Federal Reserve Bank of Boston, in the 1980s, has been dusted down again. It is certainly true that neither ®xed nor ¯exible exchange rate regimes are perfect and that exchange rate ¯uctuations are a substantial headache for us all ± even bankers. But to impose a single currency worldwide would really be a kill-or-cure remedy. EMU ± which is, after all, still in its infancy ± cannot simply be extrapolated to cover the entire globe. Apart from economic considerations and the question of sovereignty, the psychological reaction of people to the loss of their national currencies has to be taken into account. Under certain circumstances the Argentineans, for example, might cope with their economy being `dollarised', but would the US ever be prepared to give up the dollar? In this respect the people of the US and Switzerland are probably very similar. In addition to these three main proposals for a new ®nancial architecture, other suggestions have been put forward, two of which are looked at below. These do not involve the whole building being pulled down, just couple of rooms being added. The architect of one of these plans is ®nancier and philanthropist George Soros. He would like to see the creation of an international debt insurance agency. Taking the existing protection for bank deposits as a model, such an agency would effectively stop borrowers panicking and thus prevent them from following their herd instinct and making debt restructuring more dif®cult or even impossible. A number of practical questions need to be addressed here. At what point would we cap

Lukas MuÈlemann 149

insurance for lending or bonds? How high would the insurance premiums be? Instead of an of®cial body, would private solutions also be possible? In fact it is already possible to insure corporate loans, particularly in Europe, but the `moral hazard' problem is the main objection to the idea of more-or-less comprehensive insurance cover. Generous solutions will tempt lenders to act carelessly, while solutions that are not generous enough will not offer the hoped-for protection in times of crisis. The creation of an international bankruptcy body for government debt is the brainchild of Harvard economist Jeffrey Sachs, among others. This would be comparable to existing national bodies that are able to defer payments for companies with ®nancial problems, thereby facilitating debt restructuring or, if necessary, initiating liquidation. I am not at all sure that agreement could be reached on such an arrangement. For decades now Switzerland has been trying to develop a debt collection and bankruptcy law for the ®nancial sector that would really make a difference. And the EU has already attempted a number of times, without success, to ®nd an acceptable cross-border solution. Logically, a supranational bankruptcy court would be able to remove the government of a country in crisis in the same way as this can be done for the management of a bankrupt private company. Can you imagine what this would mean! Apart from all this, government borrowers already have the power unilaterally to declare a debt moratorium. The example of Russia is fresh in our minds. The various suggestions outlined above prompt the following questions. To whom would such a super-organisation be answerable? Would it be possible to ensure that such a body did not degenerate into a paper tiger or a cumbersome bureaucracy? How could checks and balances be guaranteed? Furthermore it is highly unlikely that there would be suf®cient political agreement to create an organisation that would be superior to national bodies and would therefore severely restrict national sovereignty. The idea of going back to the drawing board and creating something absolutely new is certainly tempting. However, although a move to a completely new building would perhaps be good, the number of players and different interests involved would be too large for success to be guaranteed. Although the situation was suf®ciently serious during the crisis ± and to some extent still is ± to warrant a look at widerranging ideas and some long-term approaches, it is time to come back down to earth and consider what is both feasible and necessary. The next section assesses the adjustments that should be made to the ®nancial architecture, focusing on the banking sector.

The role of the banks and private creditors The ®rst question here is why ®nancial institutions were taken by surprise by the most recent ± Asia-led ± crisis and why they were so severely affected by it. The answer lies in the fact that the banking sector had a very strong belief in the future of the emerging markets. The momentum in Asia, the revival in

150 A New Financial Architecture?

Latin America in the wake of the `lost decade' and the fresh start in Eastern Europe all contributed to the positive mood. Many banks made clear strategic decisions and focused more ®rmly on these regions. In the case of Russia, for instance, the Credit Suisse Group wanted to enter the market right from the start ± and as one of the key players. It was clear from the beginning that this represented a long-term commitment, and Credit Suisse's successes lulled it into a false sense of security. In the case of Russia, this was encouraged by the fact that the G7 countries, at the urging of Chancellor Helmut Kohl, accepted Russia into their ranks in May 1998. We all know that it is easy to be wise after the event. Credit Suisse paid rather dearly for its experience and immediately went back over the books. Lessons were learnt not only by Credit Suisse but also by the whole ®nancial system. In most cases steps were taken ± as a sort of emergency measure ± to dampen investors' appetite for risk. Although this could only ever be a temporary solution it was necessary to stabilise business. In addition other, more fundamental measures were identi®ed. These have either been implemented or need to be analysed in greater detail. Five key points should be borne in mind. First, the monitoring and management of risks must be improved. Risk management is viewed as an ongoing process. A watertight, infallible system simply does not exist. Credit Suisse's experience led it to make further improvements to what was already a wide-ranging, multilevel risk management system. In particular stress tests (catastrophe scenarios) were tightened up and risk concentrations of all types reduced. Second, for some time now banks have been working intensively on the improvement of performance measurement. Here the assessment of future risks has a dual aim: to make the pricing of services more realistic, and to change the internal incentives system. Entrepreneurial thinking and conduct are being strongly encouraged at all levels. Staff who generate high earnings on the strength of their know-how and commitment will be rewarded accordingly. However, one of the problems with the incentive system generally in use today is that losses that occur at a later point in time have no impact on the level of bonus payments. Credit Suisse has made important adjustments in its proprietary trading departments, but it would be unrealistic to impose these changes across the board. The market is completely heartless on this point, and Credit Suisse's competitors would simply cream off its people ± and the best people at that. The President of the FBC recently ¯oated the idea that the banks should create a quasi-cartel for this purpose. Quite apart from the fact that the many agreements in this sector rightly belong to the past, a new cartel can scarcely be the solution. On the other hand, something does need to be done. Therefore, within the context of an internationally coordinated ruling, this problem will probably be at least discussed and analysed in more detail. Whether this will produce a solution remains to be seen. Third banks need to have detailed information on the situation of their debtors ± without state-of-the-art, coherent and comprehensive ®gures,

Lukas MuÈlemann 151

high-quality risk management is a chimera. Thus the banks have a substantial interest in improving the relationship between debtors and creditors. Business partners who talk to each other regularly in good times are more likely to ®nd solutions that are acceptable to both sides in times of crisis. In Credit Suisse's Swiss lending business, the dialogue between clients and the retail bank has been intensi®ed to a signi®cant degree ± with excellent results across the board. It must be possible to do something similar with debtor countries. Indeed Mexico is setting a good example in this respect. The form that this dialogue might take is clearly up for discussion. Lenders will be interested in macrodata such as GDP, balance of payments, foreign debt, important dependencies and so on, while up-to-date ®gures on various capital ¯ows will also be welcome. In addition, certain aspects of economic policy will need to be clari®ed. Players could meet about once a quarter or once every six months, or more frequently in dif®cult phases or crisis situations. Fourth, more active involvement of the private sector in crisis management appeals to banks. In concrete terms this means involving creditors ± including bondholders ± in debt restructuring programmes. At present this is generally a very tedious process because it usually involves a large number of creditors. Collective action clauses would make it possible to simplify and facilitate opinion-forming and decision making between bondholders: this would minimise the risk of individual creditors preventing a restructuring that would otherwise have gained majority approval. In terms of credibility, the G10 could lead by example when launching such issues. However we must not ignore the fact that spreading the crisis management net wider in this way would have its price. If bonds were no longer protected in the case of restructuring, investors would pay even more attention to borrower quality. And although this would be desirable, it would tend to make capital-raising ± particularly for not so high-quality borrowers ± more expensive. Fifth, from the point of view of the ®nancial sector, suggestions that are designed to improve the debt management of the emerging markets by offering innovative ®nancing solutions need to be looked at carefully. On the one hand, debtor countries need to be supported in their efforts to prevent a burgeoning of short-term, foreign-currency-denominated debt. Chile, for example, now requires portfolio investments to be held for a minimum of one year ± those held for a shorter period are subject to a higher rate of tax. On the other hand, new ®nancing instruments can enhance ¯exibility, as in the case of structured notes, where payments are tailored to certain economic conditions, such as the price of crude oil. Other key ideas in this respect are rollover options for foreign-currency-denominated debt, partially guaranteed debt and refraining from the use of put options and cross defaults. Opinionforming in this area is still largely in its infancy, but one thing is already clear: all these alternatives will have their price. In some circumstances they could even result in the effective exclusion of debtor countries from the international ®nancial markets.

152 A New Financial Architecture?

In this connection the issue of moral hazard arises: banks and other private creditors enter into higher risks because they assume that in a crisis the IMF and other public institutions will pick up the tab. This means that pro®ts are essentially privatised while losses are borne by the taxpayer. Demands for burden sharing ± that is, greater involvement on the part of the private sector ± are therefore being heard. This argument leaves something to be desired, however. Although the danger of a moral hazard cannot simply be dismissed, the private sector does not get off scot-free and the most recent crisis is a prime example of this. Estimates indicate that the crises in Asia and Russia cost private investors around $350 billion on the ®nancial markets and in bank credits. On top of this there is lost economic growth of at least $250 billion. These losses will be partially offset by bilateral and multilateral public sector commitments of almost $150 billion. Experience suggests that these will be paid over a period of three to four years. So there should be no talk about the burden being borne by only one of the sides in the equation, not to mention the fact that no bank decides to enter into a commitment because it thinks that the IMF will come to the rescue in an emergency.

Assessment of other reform proposals This section considers the contribution that banks could make to the stability of the international ®nancial system, as well as reform proposals levelled at other players. The sheer number of issues that need to be addressed is overwhelming. Some of these are already in an advanced stage of discussion, others require more detailed clari®cation. First, the demands on debtor countries are particularly large, and there are no catch-all solutions. The implementation of concrete proposals has to be looked at on a case-by-case basis. Nonetheless there are a couple of common elements. Regular dialogue with creditors at an early stage and improvements in debt management have been mentioned earlier. Using South Korea as an example, in December 1996 short-term international debt outweighed debt with maturities of over one year, while today only around a third of international debt is short term. The following points are also important. As a priority, exchange rate regimes need to be reviewed. For emerging economies the link to the US dollar or to a basket of currencies can clearly bring advantages. But the arti®cial exclusion of exchange rate ¯uctuations also carries major risks. If capital can be raised in the dollar zone with no exchange rate risk and then invested at higher interest rates domestically, no one can be blamed for wanting to pro®t from this. But when this leads to an escalation in foreign debt and a melting away of currency reserves as uncertainty increases, this is surely a high price to pay. Locking in a currency makes sense only in the context of a properly conceived and functioning currency board or where the fundamental operating conditions allow it.

Lukas MuÈlemann 153

Where imbalances already exist, they are only exacerbated by a ®xed exchange rate system. In a world of disin¯ation, de¯ationary pressure and excess capacity, devaluation can make sense because it shifts demand from foreign to domestic producers. A further weak spot in the majority of cases is the fact that the domestic ®nancial sector cannot keep pace with the opening up of the markets. Many banking systems are still extremely fragmented. The creation of more ef®cient units is crucial, not least to enable countries to keep abreast of foreign competitors. A number of countries have initiated reforms in this area, although free market solutions rather than politically motivated new groupings or forced marriages, such as those witnessed in Malaysia, would have been preferable. Improvements in banking regulation are a priority, but these countries cannot be expected to apply the high standards of the industrialised countries overnight. Nonetheless a move in this direction is urgently needed. Next comes the need for internationally accepted standards of disclosure and governance. The idea is to create greater transparency at all levels. Borrowers who do not meet these standards will have to accept that they must pay higher risk premiums or quit the market. And given that analyses are only as good as the data on which they are based, better and more rapidly accessible data on debtor countries is essential. We cannot have another South Korea, where what was thought to be short-term debt of $50 billion amounted, after numerous corrections, to more than $100 billion. And ®nally there is a need for social reform ± a huge amount of catching up needs to be done almost everywhere. Those who are already disadvantaged have to be prevented from going under in times of crisis. One could argue ± and this argument has its proponents ± that in such situations the IMF should relax the conditions to which its ®nancing is tied, as these are the real root of the problem. But anybody who makes funds available must be con®dent that these are not being poured into a bottomless pit. Whether or not the IMF has sometimes demanded a little too much in the past can certainly be discussed. However supporting debtor countries in their social reforms is primarily the task of the World Bank. The industrialised nations share the latter obligation, and have a duty to support debtor countries in their efforts to improve their institutional frameworks. Using the most recent ®nancial crisis once again as an example, three further requirements should be mentioned. First, the industrialised countries ± together with the international organisations ± must, particularly in dif®cult times, demonstrate one key thing: leadership. The fact that Japan said it was prepared to make available substantial funds for South-East Asia but at the same time failed to tackle suf®ciently systematically the reform of its own banking system ± a decisive factor in the stability of the region ± did little to inspire con®dence. The same is true of the US, where demands for a new facility from the IMF were counteracted by the fact that existing commitments had not been honoured.

154 A New Financial Architecture?

The EU was taken by surprise by the instability in Russia and showed a marked reluctance to make decisions. And ®nally, the central banks were clearly at a loss for quite some time. It is true that it was later possible to make good some of this, but in future those involved must act in a coordinated and systematic fashion to ensure that the con®dence of market players in the orderly and reliable functioning of the ®nancial markets remains intact. Second, the industrialised nations would do well to improve their own statistics. At ®rst sight this may sound a little presumptuous, but it is absolutely in their own interest. Rapidly accessible, systematic data on ®nancial ¯ows in the emerging markets are important. This would also make it easier to check the plausibility of the data delivered by debtor countries. Banks ± which already report a great deal of information to the Bank for International Settlements ± are called upon to contribute, but the main gap is in terms of those players who are not yet covered by the statistics, namely institutional investors. Third, Western governments must, as an emergency measure, make funds available to cancel the debt of the poorest countries. Happily, moves are already being made in this direction. This is obviously an extremely delicate situation: on the one hand these countries can hardly push ahead with development if they are handicapped by debt; on the other hand the prospect of debt remission could tempt them to be less careful than they might otherwise be in deploying their funds. As regards the role of the IMF, the following two comments from the banking point of view should be emphasised. First, the demand voiced in one or two quarters for the abolition of the IMF on the ground that it was responsible for provoking the crises in the ®rst place was fairly wide of the mark, as was the suggestion that instability on the global ®nancial markets could be avoided solely by putting together ever larger ®nancing packages. The focus should be on ensuring that, in the future, the IMF can increasingly act in a preventative capacity. Second, in tandem with a strengthening of the IMF's monitoring activity there has to be a more liberal publication policy with respect to the ®ndings of this surveillance. There is obviously a danger of either setting off a false alarm or leaving the ®nancial markets in uncertainty for too long. However, if the private sector is to be involved more closely in burden sharing the insider privilege enjoyed by the IMF in terms of sensitive information will have to be radically rethought or even abandoned. A repeat of the situation has to be prevented where, more than a year before the turbulence on the ®nancial markets, the IMF criticised Thailand's economic policy and demanded targeted reforms, with the public knowing nothing about it. There remains the question of international regulation and of the further liberalisation of the ®nancial markets. In respect of regulation, the following two points are especially important. First, regulations lay down guiding principles but they can never provide for all eventualities, and there is also a

Lukas MuÈlemann 155

risk that they might create false incentives. The fact that short-term lending is subject to less stringent capital adequacy requirements than long-term commitments has attracted criticism for this reason, for example. But this ruling can be looked at in one of two ways. On the one hand it can be said that there is generally less risk of default in the case of money that is lent for a short period, and this is why banks usually demand less interest than for a loan that will not be paid back until the more distant future. On the other hand there is clearly a danger that borrowers are thus encouraged to take out short-term loans. An answer to this will need to be found in the context of the current overhaul of the BIS regulations. Second, the attempt to make hedge funds responsible for the recent round of ®nancial crises is not valid. Such funds play an important role in today's ®nancial markets. Nonetheless there needs to be greater transparency in respect of their activities, particularly with regard to their borrowing. Information that can be used for the assessment of counterparties is of central importance to banks. This leads to the issue of free movement of capital. Here, people tend to hold one of two extreme opinions. On the one hand it is argued that the Asian crisis would not have reached the proportions it did if the markets had been liberalised to a greater extent: regulation prevents capital from being used in the most productive fashion, affects the liquidity and ef®ciency of ®nancial markets, restricts personal rights and fosters corruption. The alternative argument is that the market's regulatory mechanisms have failed and that comprehensive controls and restrictions on the movement of capital ± at least in times of crisis ± must be introduced. Because investors have too little information they often act to support the business cycle. This causes the markets to over-or undershoot, resulting huge costs to the real economy. Princeton economist Paul Krugman is surely right when he states that in times of economic crisis the sudden out¯ow of foreign capital only allows for two equally unattractive responses: either interest rates have to be hiked massively to support the exchange rate, which damages the domestic economy; or the exchange rate is left to fend for itself, which increases foreign debt and the risk of bankruptcies ± consequences that are just as bad. Economic collapse can only be prevented by keeping interest levels low and thus stimulating the economy. This is why Krugman argues that controls on the transfer of capital represent the lesser of all evils in a real crisis. This argument is especially opt it a total lack of restrictions on capital ¯ows goes hand-in-hand with institutionally weak national ®nancial systems. But such restrictions should de®nitely not be seen as a cure-all. They must be limited to genuine crisis situations since irresponsible use of this instrument is not without its consequences. Market players must be able to predict when capital restrictions will be imposed. Otherwise they will look elsewhere for their investment opportunities.

156 A New Financial Architecture?

Switzerland's contribution As a country with both a long free market tradition and a banking sector with very strong international ties, Switzerland has a particular interest in a stable global ®nancial system. What Switzerland can contribute to this is the subject this section. This ®rst issue is Switzerland's participation in the IMF. Nowadays this is taken for granted, thus begging the question of why Switzerland did not become a member of the Bretton Woods institutions a long time ago. The Swiss Federal Department of Finance provided an excellent overview of the principles of Swiss policy vis-aÁ-vis the IMF in a position paper published in March 1999. It is particularly important for the IMF to achieve greater transparency and to help foster good government. Switzerland wants the IMF to focus on the social and environmental acceptability of economic development. This is without doubt a worthy goal, but one which will by no means be easy to realise across the board. From a banking point of view, it is important that the ®nancial sectors of the emerging economies are strengthened ± what needs to be done in concrete terms has been covered above. As a country with a major ®nancial centre, Switzerland can do much by way of developmental collaboration on a number of levels. Its regulatory and supervisory system, as well its many years of experience in both national retail banking and international business, if case much to offer in showing others the way forward. The Credit Suisse Group already does a great deal in terms of providing advisory services for states and institutions in emerging markets. Banks have a very clear long-term goal: the emerging markets cannot escape globalisation, so they must open up their ®nancial markets to a greater extent. However the crisis has shown that we need to exercise patience. Rapidly opening up markets without at the same time developing local operating frameworks and structures is no good.

Conclusion The problems currently being faced are certainly not serious enough to overcome strong political opposition to a radical change of course or the creation of a fundamentally new ®nancial architecture. In any case, the present system is by no means all bad. Since the early 1980s the emerging economies have developed strongly, and the industrialised countries of the world have bene®ted from this. The best chance of progress therefore lies in the gradual strengthening of the individual pillars of the existing system. Not a new building, but targeted renovation. What is needed are more comfortable rooms in the sense of improvements in the standards of institutions and economic policy. The basement needs to be extended so that greater market depth can be gained. The architects will also need to use more glass to achieve the necessary transparency. And a

Lukas MuÈlemann 157

common space is needed so that players can talk to each other more often and more regularly, instead of communicating over the garden fence in an emergency. It is of particular importance that everyone who lives there becomes involved, and that the renovation work is not only planned but also executed. Crises and the attendant ®nancial turbulence cannot be prevented from happening in the future, but measures can be taken to improve their predictability and management, thus ensuring that they are less severe the next time round. For this reason the most recent crisis should quite clearly be viewed as presenting an opportunity.

17

Reform of the Global Financial System: A View from an Emerging Economy Ali Muhamad Negm

In the late 1990s the world economy faced one of its most extensive and harshest ®nancial crises. This crisis stemmed from excessive credit expansion, ®nancial sector weaknesses and other structural shortcomings, and was not entirely homegrown. What the global economy faced was a systemic problem, a crisis of the international ®nancial system, a system that did not develop fast enough to satisfy the needs of all the participants: investors seeking new opportunities, emerging market economies seeking resources for investment, and governments seeking to ensure that markets were operating safely and ef®ciently. The crisis generated many calls for change and reform of the international ®nancial system was seen as a must. Since then many steps have been taken. Lessons have been learnt, but the reform has just begun and every idea shared can make a big difference.

Setting better international standards Although a considerable number of standards for ®nancial practices already exist, more effective standards should be introduced and implemented, especially in developing countries. The World Bank, the IMF, regional development banks, the BIS and the banking supervisory community are increasing their efforts in the banking and ®nancial areas. The 1988 Basle Capital Accord has been successful in arresting the decline of major banks' capital ratios and promoting a harmonised approach to the setting of capital requirements by national regulators. Nonetheless the accord has a number of shortcomings, including credit risk models, optimum capital requirements and other factors that are now being reviewed and discussed worldwide. The Basle Committee's Core Principles for banking behaviour and supervision illustrate the importance of introducing better international standards. 158

Ali Muhamad Negm 159

The adoption and implementation of internationally agreed standards and rules does not mean that all national practices have to be identical, but they should be judged according to their compliance with a common set of international standards.

Introducing greater transparency The availability of accurate information is essential for well-functioning ®nancial markets and market economies. This applies to all the major players in the world economy: public and private ®nancial markets, multilateral institutions and above all governments: any national effort must be transparent in order to be credible and successful. Governments must announce all steps and actions to the public and avoid favouritism. Furthermore, timely and detailed information can prevent the accumulation of problems by forcing governments to take appropriate measures at the right time.

Supervising banking sector soundness The Asian crisis showed how weak banking systems can damage the economy as a whole. Many banks had engaged in excessive short-term foreign-currency borrowing, and this dangerous build-up of debt had been made possible, in part, by inadequate regulation of banking activities, compounded by cozy relations between governments and bankers. The swiftness and size of the crash showed that the banking systems of the countries in question were built on crumbling foundations. Unfortunately this was not a unique situation. Many developing countries have far too few supervisors to monitor their fragile banking sectors, and this situation will continue for some time to come. For the past few years every major ®nancial crisis has been either caused or intensi®ed by banking sector weaknesses. A sound international ®nancial system must rest on sound and strong national systems. And these must be monitored according to transparent and consistent standards.

The way forward Many positive steps have been taken, and yet the world remains ®nancially fragile and another crisis is not hard to imagine. How can we best protect and strengthen the global ®nancial system? First, governments must take decisive action to deal with banking problems, including the shutting down of insolvent institutions and the taking over of others. Bank restructuring is a complex, long-term process that involves a dif®cult balancing of institution-by-institution reforms with major aspects of the broader economy.

160 Reform of the Global Financial System

Second, there must be an increasingly important role for regional surveillance, with policy discussions involving policy makers from all countries in the region. Third, governments and national authorities must demonstrate full ownership of all aspects of the restructuring effort. Adjustment programmes often include legal and regulatory improvements. A judicial and legislative framework is essential for reform efforts and has to be developed. Fourth, resolution of a banking crisis is inevitably linked to resolution of a corporate sector crisis. If corporate restructuring is slow, then bank reforms will be hampered. By the same token, resolution of corporate indebtedness requires a well-functioning banking system. It is crucial to identify ®nancial vulnerabilities and risks that have the potential to generate regional and international spillovers. The valuation of bank assets in the face of severe market conditions and an economic downturn is dif®cult, but necessary, because the bad debts ultimately will have to be dealt with. Fifth, to bolster their banking systems, countries should adopt international practices that will unify banking governance across markets. They should also focus on the development of independent oversight of banks. Strengthened supervision of banking systems will reduce the likelihood of wide and deep systemic crises in the future, but it will not eliminate the threat. Finally, healthy ®nancial institutions should take advantage of good times to build up a capital cushion to tide them over bad times. This should be a primary goal of government regulators, who should encourage banks to focus on stronger capital-adequacy ratios, collateral margins and general loan-loss provisioning.

18

Global Finance Beyond 2000: Implications for Regulation and the Supervisory Authorities Mikio Wakatsuki

Changes in the ®nancial industry have been rapid and far-reaching in recent years and will accelerate even more in the future. The factors creating and promoting change are complex and diverse, but they have one common element, namely global implications: progress in globalisation in the aftermath of the Cold War, the triumph of the creed of Anglo-Saxon capitalism (market mechanisms, competition, deregulation, small government and so on), developments in the IT revolution, the accumulation of ®nancial assets in preparation for the aging society, huge cross-border ¯ows of capital and so on. This rapid and far-ranging change has inevitably created a new environment and poses new problems for the regulatory±supervisory authorities. In particular three interrelated three developments can be identi®ed as having important implications for the prudential authorities:

. Financial globalisation and international cooperation. . The consolidation and conglomeration of ®nancial institutions. . The IT revolution and ®nancial innovation. The impact of these developments on national regulatory and supervisory authorities will differ, re¯ecting the diversity of their ®nancial and economic systems. But because of the global nature of the changes, the authorities' response to them requires international cooperation and consistency.

Financial globalisation and international cooperation As ®nancial globalisation proceeds and ®nancial interdependence deepens, it is increasingly recognised that ®nancial regulation and supervision needs to take into account the impact of globalisation and its implications for ®nancial activities. The BCCI case in the 1980s, for instance, clearly underlined the 161

162 Global Finance Beyond 2000

importance of global supervisory cooperation and coordination. The recent ®nancial crisis in Asia and other emerging market countries demonstrated that crisis is highly contagious in a globalised market and may threaten the stability of the ®nancial markets in the world at large. The Asian crisis was initially thought to be due largely to the failure of the macroeconomic policies and rigid exchange rate arrangements of the countries involved, or to social and cultural factors such as `crony capitalism' and corruption. But it was gradually recognised that a more fundamental cause of the crisis was related to ®nancial globalisation. In other words the underlying cause of the crisis was the fact that the emerging market countries were too eager to enjoy the bene®ts of ®nancial globalisation and failed to pay due regard to the risks arising from it. The international ®nancial institutions may have been too hasty in preaching the virtues and bene®ts of ®nancial liberalisation in the age of globalisation and too lax about pointing out the need for caution. Consequently, in the wake of the ®nancial crises of 1997±98 the need was widely recognised for a strengthening of ®nancial systems and the promotion of ®nancial stability in the globalised market. The building of a new international ®nancial architecture has become a major issue of international concern. One key area in this undertaking is the strengthening of prudential regulation of ®nancial institutions and of regulatory enforcement to deal with the increased risks stemming from ®nancial globalisation. The task has two aspects: building strong and effective national regulatory systems, and strengthening the international supervisory framework and international cooperation. In the G10 and other developed countries, cooperation in the strengthening of regulatory systems has quite a long history. The approach they adopted was basically to rely on national regulatory models, establishing general standards and principles through agreement, but leaving actual devices and implementation to the individual countries. This was a realistic approach, as the diversity of cultural and historical backgrounds would have made it dif®cult to set up and enforce a uniform regulatory system. Even in the euro-zone countries, where monetary uni®cation is completed, there is no enthusiasm for greater formal centralisation through the European Central Bank of policies relating to prudential supervision, even though the Maastricht Treaty provides for the possibility. Yet the globalised market has come to accept that national supervisory bodies should adopt common rules and standards. Moreover the G7 minister and governors have stressed the urgent need for a framework for the multilateral surveillance of national supervisory systems among the developed countries. Likewise, because the ®nancial turmoil in the emerging market economies shook the whole world, the strengthening of ®nancial and prudential systems in those countries has become an important aspect of the new ®nancial architecture. Here, as in the case of the developed countries, a one-size-®ts-all regulatory system will not work. But at least the emerging market countries are to be required to establish ®nancial and regulatory systems that incorporate

Mikio Wakatsuki 163

common international rules and standards of best practices. In this context, the need to develop such rules and standards has been underscored. Assistance to the emerging market countries in building robust and effective systems is being provided by international ®nancial institutions and through various forms of international cooperation. As regards the supervision and surveillance of the international ®nancial system, a number of international frameworks and arrangements have been set up to this end. International ®nancial institutions such as the IMF, IBRD and BIS are sharing the work and the responsibility. In addition, sector-speci®c international groupings such as the BCBC (Basle Committee on Banking Supervision), IOSCO and IAIS have been playing an important role in their respective areas. Against the background of these arrangements, in 1998 the G7 ministers and governors asked Hans Tietmeyer to prepare a report on ways to improve international cooperation and coordination in the ®eld of ®nancial market supervision and surveillance. In his report, submitted in February 1999, Tietmeyer pointed out some limitations of the sector-speci®c approach to global ®nancial integration, although the approach has already produced some remarkable results. The report identi®ed three problems: (1) the need to overcome the separate treatment of micro-prudential and macro-prudential issues; (2) the need to bring together the major international institutions and key national authorities concerned with ®nancial sector stability; and (3) the need to integrate emerging markets more closely into the framework. Tietmeyer's prescription for these problems was to convene the Financial Stability Forum (FSF), consisting of representatives of the national and international authorities responsible for questions of international ®nancial stability. He carefully avoided the idea of making sweeping institutional changes to realise the improvements, presumably to avoid a proliferation of international institutions. No doubt this was a very realistic and constructive step forward. Nevertheless the challenges of the globalised market may require a stronger response than this prescription, such as establishing a kind of a global regulator by turning the FSF into an independent institution. The rationale for this idea is that several aspects of the FSF, in its present form, have room for improvement. For instance:

. The present arrangement of two meetings a year will not be enough to deal with the complex and diverse problems arising from the rapidly changing global market. To increase the frequency of meetings while the FSF remains in its present form would be very dif®cult. . The current number of members is too large for wide-ranging problems to be handled in a timely and ¯exible manner. . The interests of developing countries are not suf®ciently represented, though additional representatives are expected to be invited to participate

164 Global Finance Beyond 2000

at a later stage. However the addition of these extra members to an already large forum may make it even more unwieldy. . Many of the tasks referred to the FSF may require corps of permanent staff and experts, who are not subject to or in¯uenced by political considerations. . There are many new areas in the globalised market that national regulators are not well-prepared to oversee, and new information technology will create new frontiers that will require careful international monitoring. The answer to these problems is an independent institution for international prudential matters. The following is a broad outline of the revamped FSF. The FSF will be an independent international institution, run by a managing director and an executive board comprising several national representatives. It will have a secretariat of permanent staff with expertise in ®nancial supervision and auditing, supplemented by outside experts mobilised from the public and the private sector as the need arises. The institution is not intended to replace or supersede national supervisors or regulators. It will basically cover those areas that national supervisors and regulators ®nd it dif®cult to cover, such as cross-border ®nancial activities and non-regulated ®nancial entities. The mandate of the new institution will be similar to that of the present FSF, but it will be carried out on a regular and systematic basis rather than in the present ad hoc manner. Speci®cally, it will:

. Conduct the surveillance of global ®nancial vulnerability, including the pooling of information.

. Assess the need for regulation of non-regulated entities and, if necessary,

engage in the surveillance and monitoring of the activities of those entities and off-shore centres from the standpoint of global ®nancial stability. . Strengthen and encourage the development and implementation of international best practices and standards, and assist developing countries to incorporate them into their ®nancial and supervisory systems. . Assess the need for regulation of cross-border cyberspace banking (that is, Internet banking, electronic money and fund transfers, and so on). The establishment of a global regulator also involves such delicate issues as sorting out relations and turfs with sector-speci®c groupings. But as the global regulator is expected to have authority over all types of ®nancial function, the activities of the sector-speci®c groupings should eventually be brought under the authority of the regulator.

Consolidation and conglomeration The consolidation and conglomeration of ®nancial institutions is proceeding in the major industrial economies. The background for these developments

Mikio Wakatsuki 165

is manifold: intensifying competition stemming from globalisation and deregulation in domestic and international markets; a consumer demand for integrated and comprehensive ®nancial services (one-stop shopping); and technological progress that makes it easier to realise the bene®ts of synergy between different ®nancial services. In addition to these common factors there are country-speci®c factors. In the US the de facto repeal of the Glass±Steagall Act in recent years has made cross-industry mergers and alliances easier. In Europe the introduction of the single currency has prompted ®nancial institutions to seek partners and alliances in order to prepare for the expected intensi®cation of competition. In Japan an attempt to reform the ®nancial system, dubbed `Japan's Big Bang', triggered almost revolutionary changes by drastically reducing the separation between ®nancial industries prescribed by Article 65 of the Securities Transactions Act, among other legislation. The lifting of various barriers to new entrants to the ®nancial services industry and the complete abolition of exchange controls have intensi®ed competition in both the domestic and the foreign sector. Mounting market pressure to expedite the consolidation of bad loans and to improve pro®tability, backed by the of®cial push for mergers in order to reduce the degree of over-banking, have increased the incentive to merge and form a kind of conglomerate. The recent surge of mergers and alliances in Japan has produced new varieties of merger: mergers between different industries and categories, for instance of banks with securities houses or of commercial banks with longterm credit banks and insurance companies; mergers under a holding company between super-regional banks; and mergers between banks and insurance companies belonging to different keiretsu groupings. New entrants to the ®nancial services industry include non-banks, trading ®rms and even manufacturers. A leasing company is now moving into Internet banking and the insurance business. This propensity for conglomeration will inevitably create a need for closer cooperation among the supervisors of the different ®nancial services. However, as the demarcation blurs between separate industries, the traditional institutional approach has become inadequate for the overseeing of merged entities, especially conglomerates. As a result supervisors have recognised the need to take a functional approach to the emergence of ®nancial hypermarkets, and to the possible emergence of cross-border hypermarkets. In response to such developments, many countries are taking steps to create a uni®ed or single regulator, or at least to combine some of their regulators. In Japan a uni®ed regulator known as the Financial Supervisory Agency (FSA) has been created, partly in response to developments in the ®nancial markets and partly as a remedy for the failure of the old system. Under the old system the various supervisory functions were allotted separately to the relevant bureaus, such as the banking and securities bureaus of the Ministry of

166 Global Finance Beyond 2000

Finance. Since the ministry was responsible for practically every aspect of the ®nancial industry, including the functions of regulator, supervisor and even guardian of the industry, it was prone to con¯ict, of interest between those functions. The incompatible combination of regulation/supervision and protection of the industry was regarded as one of the causes of procrastination when dealing with the bad loan problem. Thus, as part of the Big Bang reform programme, the Japanese FSA was established as a separate and independent organisation from the Ministry of Finance. The new organisation integrates all the supervisory functions of the ministry over banks, securities, insurance and other ®nancial services. The trend for conglomeration and the creation of a single regulator have led to a questioning of the role of the central banks as supervisor and stirred up the debate on the `separation approach'. Quite a few central banks still maintain some supervisory role on the grounds that prudential information is necessary for maintaining the soundness of the ®nancial system and that there is no serious con¯ict of interest between monetary and prudential policies. In Japan the recently amended Bank of Japan Law lay down the basis of the supervisory functions and the Bank of Japan continues to oversee banks and securities houses that have accounts with the bank. The law also gave the bank responsibility for safeguarding the integrity of the ®nancial system in the case of ®nancial exigencies, including emergency lending to ®nancial institutions. Against these legal requirements, the bank claims that microprudential information is essential for the maintenance of the ®nancial order and the safety of the settlement system. The bank maintains that the lender-of-lastresort function would not be in any serious con¯ict with monetary policy since the function is not meant to provide an unconditional and unlimited supply of liquidity. The emergence of giant ®nancial conglomerates and alliances between banks and other types of ®nancial institution is a development for which the bank was not prepared. The bank will have to extend its overseeing activities to include other functions of these conglomerates, to the extent that they affect the stability of the ®nancial and settlement systems. But it will become even more essential for the bank to cooperate closely and exchange information with the FSA. As suggested by chairman of the Federal Reserve Board in a recent speech, it will almost certainly become necessary for the Bank of Japan to develop more sophisticated or even customised prudential policies and procedures to be applied to these giant ®nancial organisations, instead of using the one-size®ts-all approach. The problem of duplication in supervision needs to be minimised. For this reason the two authorities are trying to differentiate their responsibilities in respect of the observance of legal requirements, corporate governance issues and risk management.

Mikio Wakatsuki 167

The IT revolution and ®nancial innovation Along with globalisation, consolidation and conglomeration, ®nancial innovation, backed up by the IT revolution, is dramatically changing the pro®le of entire ®nancial services industry. Financial products created in recent years, such as ®nancial derivatives, are the offspring of technological progress, which has made it possible to unbundle risks and reallocate them in a highly sophisticated way. The sharp reduction in data processing costs has led to advances in data-based customer services. The introduction of Internet banking and e-money is expected to change the delivery channels of banking services and eliminate geographical distance. These developments clearly indicate that success in the ®nancial business in the future will depend largely on an ability to combine money, information and technology in the most effective manner. The sophistication and complexity of ®nancial products and businesses have forced ®nancial institutions to develop equally sophisticated and complex risk management models. The conglomeration of ®nancial businesses has made risk pro®ling and risk management even more complex, and to grasp the whole picture has become a really demanding task. In order to cope with these developments, the regulatory and supervisory authorities must keep pace with the increasing sophistication of the ®nancial institutions. They need to understand and assess the adequacy of the private sector's risk management models, which requires up-to-date knowledge and expertise. Communication between the authorities and the private sector is also very important for mutual understanding. In Japan, both the ®nancial sector and the authorities are in the catching-up stage in terms of the IT revolution and its utilisation, the use of sophisticated risk-management models and the accumulation of expertise. The recent wave of mergers and alliances makes the task even more urgent and complex. The FSA is recruiting experts in ®nancial engineering, auditors and certi®ed public accountants from the private sector to enhance the expertise and know-how of its corps of examiners. The Bank of Japan has set up a special team to develop knowledge and tools for the new frontier of ®nancial engineering and risk management. Apart from these efforts by the supervisory authorities, the importance of private market regulations has been emphasised in recent years. In the rapidly changing globalised market, and in the face of ever advancing ®nancial technology, the supervisors' work needs to be supplemented by market discipline. If private market regulation is to be effective, market discipline supported by appropriate public disclosure should play a central role. More elaborate disclosure standards may need to be established. Market infrastructure, such as legal and accounting systems, needs to be developed with suf®cient clarity and global consistency. Conformity with an internationally agreed code of conduct and best practice standards will also support effective private market regulation.

168 Global Finance Beyond 2000

In tandem with private market regulation, statutory regulation needs to make more use of market discipline. The `incentive-compatible' approach, which relies to a greater extent on assessment by market participants, will considerably reduce the workload of supervisors. Use of the `precommitment' model, based on the incentive-compatible approach, may need to be encouraged. Eventually the major task of the supervisors will be to assess banks' internal risk-management systems. In Japan, neither the supervisory authorities nor the private sector are ready for such an approach, and at present they rely chie¯y on disclosure, along with regulation according to objective numerical standards. However it is almost certain that the incentive-compatible approach will form the basis of their future model. The rapid progress in IT and ®nancial innovation requires that the regulatory authorities carefully and vigilantly monitor ®nancial market developments. But premature and excessive regulation of the new ®nancial frontiers may frustrate the efforts to innovate and to develop greater sophistication. The legislative structure for regulation and supervision also needs to be ¯exible in order to cope with the rapid changes in the ®nancial industry in a timely and effective manner. Cyberspace banking and ®nancial services, for instance, are an area where a balance between timely regulation and appropriate support for innovation needs to be struck. Likewise, while regulation and supervision should aim to secure as much business freedom as possible, they should balance this objective with the need to protect the interests of consumers and investors.

Part IV

Academics' and Researchers' Vantage Points

This page intentionally left blank

19

Reforming African Financial Markets in the Era of Globalisation Kpate Adjaoute*

This chapter discusses selected key aspects of African ®nancial systems. It begins with an introductory perspective on African economies today and throws some light on the most salient features of the continent's economic standing. Important steps have been taken since the mid 1980s to promote a more sustainable ®nancial system as a masterpiece in a private-sector-led economy. The second section outlines some areas where reforms are still needed, as well as discussing the positive developments that have taken place since the wide adoption of structural adjustment programmes. The third section goes into the speci®cs and touches on aspects such as external liberalisation and foreign exchange operations, money market development and monetary policy options, issues in banking supervision and the challenges represented by global banking regulation. In many cases the reforms of the formal ®nancial sector have been paralleled by a gain in share of the informal ®nance sector. The fourth section looks at the role of rural ®nancial markets and how ®nancial market fragmentation is at work in African countries, discusses the mission of micro®nancial institutions in this context and highlights further avenues for more integrated ®nancial markets. The ®nal section offers some guiding principles for ®nancial market reforms.

An introductory perspective on African economies In their paper on African economies, Collier and Gunning (1999) identify several reasons for the poor economic performance of the continent as whole and of the Sub-Saharan African countries in particular. These countries have the highest poverty rate, underlain in many cases by a population growth rate that is not commensurate with economic performance. The following are among the leading causes of poor economic performance.

. Endogenous growth factors such as a lack of openness to trade. Indeed Sachs

and Warner (1995) suggest that the openness indicator for Sub-Saharan African countries is 0.04, compared with 0.37 for other developing countries. 171

172 Reforming African Financial Markets

This lesser degree of openness is accompanied by de®cient public services and a lack of ®nancial depth, as measured by the ratio of monetary aggregates to gross domestic product. . Lack of social capital, as households and ®rms have not yet been able to create social institutions that promote growth. . Weaknesses in the product and factor markets due to inappropriate regulation and a high-risk environment, which have constrained the development of ®nancial markets. . High dependence on international aid: whereas aid is relatively marginal for developing countries as a group, the ratio of aid to gross national product is ®ve times higher for the Sub-Saharan African countries. The combined impact of these factors is a lower rate of return on investment, which in turn has triggered massive capital ¯ights. The severe economic depression experienced by many African countries during the 1980s called for economic liberalisation schemes, mostly under the guidance of the International Monetary Fund and the World Bank. Two of the premises of the structural adjustment programmes (SAPs) that were put in place were the promotion of sound ®nancial systems and the mass privatisation of state-owned enterprises. African economies have long been characterised by repressive ®nancial systems that have not been able to provide suf®cient credit expansion to the entire economy. The heavy involvement of the state in the operation of many business segments has also meant the use of directed credit schemes and ®nancial institutions ± mainly banks ± to ®nance severe ®scal imbalances. Developments in government ®nance have often been accompanied by two-digit in¯ation ®gures that have subjected businesses to credit squeeze as in¯ation rises. Credit rationing essentially leads to overinvestment in low-return sectors that are deemed to be of priority and to underinvestment in sectors that offer better opportunities but are seen as less important. The failure of the ®nancial systems to perform their two basic functions ± intermediating between savers and investors, and administering the country's payments mechanism ± has resulted in the emergence of a signi®cant informal ®nance sector with devices to circumvent the many impediments imposed by the formal ®nance sector. Fry (1995) identi®es a few distinctive features of developing country ®nancial systems. The ®rst characteristic of such systems is the predominance of commercial banks, with limited scope for insurance and pension assets, as well as for commercial bond and equity markets. Second, these ®nancial systems tend to be heavily taxed in the sense suggested by Bailey (1956) and Friedman (1971), through in¯ation that erodes the value of savings and bank reserves and provides the government with a source of revenue. The evidence also suggests that banks' required reserve ratios in developing countries are much higher than those in the developed world, thus exacerbating the in¯ation tax effect. Another factor in African ®nancial systems is the

Kpate Adjaoute 173

prevalence of ceilings on deposit and loan interest rates, commonly referred to as ®nancial repression, which constitutes an additional source of taxation borne by depositors and other private sector agents that are obliged to hold non-reserve assets that yield net returns below the world market interest rate. At the empirical front, there seems to be a positive relation between ®nancial and economic development, in the sense that repressive and stunted ®nancial systems are found in stagnant economies with low per capita income. Against the background described above, a consensus has emerged between African countries and their main partners and international development assistance organisations of the need to promote more sound ®nancial systems that will enable ef®cient mobilisation of domestic savings and attract more foreign direct investment. According to the ®ndings of the second Tokyo International Conference on African Development (TICAD II), if absolute poverty is to be reduced by half by 2015, an estimated annual growth rate of 7 per cent is needed. A conservative estimate of the necessary physical investment needed to attain such a growth rate is 33 per cent of GNP, which is far beyond the current level of 15 per cent. The rest of this chapter discusses the main areas of African ®nancial market reforms and outlines the results achieved by the liberalisation programmes. Such reforms are needed more now than ever before to attract foreign direct investment and increase the mobilisation of domestic savings. In addition, micro®nancial institutions are evaluated in terms of design, pace and how they ®t in with and complement the overall ®nancial system.

The need for further ®nancial market reforms Concrete progress has been recorded in a number of areas due to the reform efforts; however there remain weaknesses in other areas that need to be tackled it the reforms are to produce coherent results and an effective ®nancial infrastructure. Mehran et al. (1998) identify the following problem areas in Sub-Saharan African ®nancial systems. Only limited autonomy is granted to the central bank in most African countries, so that in many cases the central bank cannot properly perform its monetary and supervisory functions. Hence price stability and sound banking systems cannot always be achieved because of government interference in credit extension and bank licensing. Signi®cant entry barriers to foreign banks result in a lack of competition, and the absence of a level playing ®eld discourages private banks. In addition the large share of non-performing loans, the crowding out of the private sector, high administrative costs and high reserve requirements are at the root of large discrepancies between deposit and lending rates. Similarly the large non-performing loans on the balance sheets of large government-owned banks are impeding the development of interbank markets because sound banks are unwilling to deal with weaker ones. As indicated above the excessive use by governments of bank

174 Reforming African Financial Markets

resources to ®nance ®scal imbalances pushes up interest rates and discourages productive investment. An important limitation is the absence of the complete array of ®nancial instruments that are necessary for the conduct of indirect monetary policy ± this limits the ability of the central bank to absorb liquidity from and inject liquidity into the economy as market conditions dictate. Conventionally, the maintenance of macroeconomic stability is deemed to be the principal focus of ®nancial reforms, but decisive steps are also needed in other areas, as discussed below.

Selected areas of focus External liberalisation and foreign exchange operations At the beginning of the 1980s most African countries had stringent foreign exchange restrictions, which were counterproductive to ± among other things ± the privatisation programmes that were underway to promote private-sectorled growth with minimal government interference. Foreign investors are only interested in privatisation programmes if there is some guarantee of international capital mobility. The external liberalisation reforms have produced positive results, but further efforts are needed to strengthen the policy mix with respect to macroeconomic balance, bank soundness and political stability. This is critically important in the face of the increased integration of the ®nancial markets, which makes uncontrolled liberalisation potentially detrimental. As an illustration of the above argument, private capital ¯ows to the developing world reached a record $235 billion in 1996 (Finance and Development, December 1997). This favourable development in international capital ¯ight has been due in part to structural changes in both developing and industrialised countries, and as such these ¯ows are expected to have a lasting impact (the argument might not fully carry to the Sub-Saharan African countries, where uncontrolled democratic transitions have raised concerns about country risk). The institutionalisation of savings ± namely pension fund and insurance assets and the quest for international portfolio diversi®cation ± has been the driving force of such ¯ows. At the same time the realisation that emerging markets may represent a different asset class with a potentially attractive risk-return trade-off, and that the terms and conditions governing market access in these countries may suddenly change in response to changes in the business cycle, has increased the risk of sudden ¯ow reversals. Precisely because capital ¯ows to emerging markets are mostly due to the institutionalisation of saving in OECD countries, unexpected stock price declines will trigger important portfolio readjustments by institutional investors that will be detrimental to developing countries. It thus appears that while increased access to the global ®nancial markets is associated with substantial bene®ts, many countries have been subject to

Kpate Adjaoute 175

some vulnerability to sudden changes in investor sentiment and attacks on their currencies. For instance speculative currency attacks on the Thai baht, the Mexican peso and the Czech koruna are perfect illustrations of the dangers of external liberalisation when there are weaknesses in the ®nancial system or the exchange rate arrangement. In the African context, the South African rand crisis is a leading example. Speculative attacks usually involve a net short position in the domestic currency for settlement at some future date, say in one month, and the bank that is serving as counterparty to the speculator has to spot buy the foreign currency to cover the position. The main issue, then, is to identify the defence strategies available to the central bank to contain a speculative currency attack. Given the mechanics of currency speculation and the fact that the central bank can be a customer in the forward exchange market, one possible means of defence is for the central bank to initiate forward purchases of the domestic currency. If these forward purchases match the short forward position of some other customer, then this intervention will offset spot sales of the domestic currency. The intervention scheme described above requires the central bank to acquire some expertise in the use of currency derivative products, or at least the very basic ones, such as forward contracts. For African countries, forward contracts are probably the most simple ®nancial instrument to engineer and transact. Therefore the basic skills and infrastructure needed to deal in this market must be developed. Essentially, the engineering of forward contracts only requires the ability to borrow and lend both in the domestic currency and in the foreign market, so that even if forward contracts are not formally offered they can be synthetically replicated through short-term borrowing and lending. At the policy level, then, what are needed as additional steps in the reform mix are the removal of obstacles to interbank trading and ef®cient payment systems in order to establish the systemic resilience required to withstand the ®nancial crisis inherent in ®nancial volatility. One important element in sustainable foreign exchange liberalisation is the exchange rate regime. The existing exchange rate arrangement may or may not lend the system to speculative attacks. As discussed above, currency speculation almost always involves short selling the currency under consideration. In perfectly ¯exible markets such as stock markets, short selling bears the risk of an unexpected equity price surge that will hurt the short seller. In the case of foreign exchange speculation, this risk is limited if the existing exchange rate regime is not overly ¯exible. In the case of African countries, very few have an exchange rate regime that can withstand speculative attacks. According to Mehran et al. (1998), not all African countries have chosen foreign exchange arrangements on the basis of their structural characteristics and the nature of the external shocks affecting them.

176 Reforming African Financial Markets

Money market development and monetary policy options Distinctive features of African ®nancial markets before the reforms were the prevalence of quantitative controls and the imposition of nominal limits on interest rates. As a result of interest rate ceilings and credit rationing, negative real interest rates were the rule rather the exception, and as a consequence inef®cient investments were commonplace. In fact, in the face of negative real interest rates, borrowers were granted subsidies on ®nancing costs and were more likely to engage in investment projects that yielded below market rates. These negative interest rates, coupled with the impossibility of certain projects to ®nd the required resources because of credit rationing, paved the way for the development of a signi®cant informal ®nance sector with high interest rates. The liberalisation of interest rates was primarily aimed at achieving economic ef®ciency, in the sense that savings resources would be directed to more productive investment opportunities. At the same time the classical framework for the conduct of monetary policy became inappropriate and monetary policy instruments consistent with the new environment were called for. While there has been no change in philosophy with respect to the primary objectives of the monetary authorities, it has been recognised that the instruments used to pursue such objectives have differing degrees of ef®ciency. One area of consensus, however, is that monetary policy can be more easily conducted if the target elements are part of the central bank's balance sheet, but the effectiveness of such an option in in¯uencing aggregate demand and in¯ation is open to question. With respect to the management of bank liquidity, traditional means such as central bank discount windows have become inappropriate. Indeed, because of the political sensitivity of this rate, upward adjustments are often made too late to have any useful effect. A more ¯exible way of liquidity management entails the removal of automatic borrowing from the central bank at posted interest rates. Money market instruments should be given preference and a large number of corporate borrowers could access short-term ®nance without intermediation cost. Deeper money markets permit more competitive banking because banks are no longer required to hold excessive liquidity as a hedge against unexpected customer demand, which can be met by taking appropriate positions in the money market. The absence of money markets in most African countries impels banks to hold more liquidity than is necessary, as documented by Caprio and Honohan (1990), who assert that banks in developing countries are exceedingly liquid. Over a set period of time and given reliable forecasts of system liquidity, a variety of instruments can be used to supply or drain liquidity. Among these instruments are outright purchases or reversed transactions (repos) in domestic securities and the foreign exchange market. The availability of a market for treasury securities or central bank bills can be important in this respect. The use of foreign exchange swaps for liquidity management is often

Kpate Adjaoute 177

constrained by the size of the market and the number of participants, which are in many cases limited. Moreover, since currency swaps imply the spot purchase of the currency and a contract to sell it at later date, monetary authorities are not immune from potential devaluations, and they also need to be familiar with forward transactions. With respect to the promotion of the money market in the perspective of adequate monetary policy conduct and liquidity management, one can offer the following four guidelines. First, the central bank should take the necessary steps to ensure that the payment system is suf®ciently trustworthy, and to enhance the standing of the instruments available in the money market, especially with respect to default risk. Second, concerning the instruments themselves, treasury securities are often the preferred choice precisely because of their low probability of default. Central bank securities are valid alternatives but they offer very limited scope for ®nancial market deepening. In fact trading in central bank bills is restricted to bank participants, and that is clearly at odds with the necessity to enlarge the participation base as a precondition for an active ®nancial market. For the available securities, the central bank should also provide book-keeping and transfer facilities to support trading. Third, it is equally important that, at any point in time, there are dealers willing to transact the eligible securities. These dealers ± not brokers ± should be licensed by the central bank and have a suf®cient capital base to bear the risks inherent in securities trading. Finally, a revamp of the way in which the domestic debt is managed is needed since ®scal imbalances are no longer ®nanced by extracting bank resources. In this respect the central bank usually has a mandate from the Ministry of Finance to issue the required securities. For the central bank to supply the securities in the right amount and maturity, there is a need for coordination between the central bank and the Ministry of Finance. Without such coordination a misguided supply of treasury securities will result in erratic behaviour by interest rates and a high cost of ®nancing the ®scal imbalance. Issues in banking supervision Healthy and dynamic ®nancial institutions are at the heart of an ef®cient ®nancial system and supervision is the necessary device to ensure bank soundness. Three ingredients are required for effective supervision. First, there must be banking laws where supervision is inscribed, detailing the duties and powers of the supervisory entity, and a clear indication of how potential con¯icts between the supervisory body and the government will be resolved. Second, the supervisory entity must be endowed with suf®cient human and ®nancial resources to perform its tasks properly. Finally, there must be credible accounting and reporting standards to ensure consistency and equal treatment across the ®nancial institutions under scrutiny. For structural reasons and owing to the nature of the banking systems, banking

178 Reforming African Financial Markets

supervision In sub-Saharan African countries was questionable before the implementation of the reforms. Because the system was predominantly state-owned or foreign-owned, formal supervision was hardly a priority. First, for local state-owned banks the heavy involvement of the state meant that there was limited questioning of bank management and reporting practices. This explains why some banks with highly questionable loan portfolios remained in business. Outside Africa, the examples of the BCCI (Bank of Credit and Commerce International) and The Meridien Bank, which continued to operate despite non-compliance with supervision standards, are more than illuminating in this respect. On the other hand, even when foreign banks were not subject to formal supervision, their management was usually subject to good reporting, so there was no real need for close monitoring. Furthermore these foreign banks were subject to adequate auditing by their headquarters, and compliance with sound business rules was presumably ensured. Following the privatisation of major banks and the diminished share of foreign banks, and hence a change in shareholder composition, interest in formal supervision as way to ensure banking system soundness has grown, along with broader reforms. Thus in respect of formal recognition of supervision in banking laws, signi®cant advances have been made in almost all African countries. Only in a few countries have such advances proved controversial. For example in Zambia and Zimbabwe the question has been raised as to whether the government should retain some discretionary power to override the decisions of the supervisory body. Such disputes are inevitable, particularly when it comes to bank licensing and closures, which are usually politically sensitive. In the majority of cases, however, there has been a political will to give supervision a more strong legal basis. This tendency has been recently reinforced by the developments under the OHADA single business law, which sets the foundations for the harmonisation of business laws in Africa. The choice of supervisory body varies, but in most cases it is the central bank, where experienced manpower and ®nancial resources are available. Other countries, such as the CFA countries, have elected for supervisory bodies outside the central bank, although there are tight connections with the central bank. Regardless of the formal set-up, the body must have the appropriate power and adequate resources to perform both on-site and off-site inspection. Finally, with regard to accounting and reporting standards, practice is more or less based on the accounting systems of the former colonial powers. The recent move in industrial countries towards more standardised norms, such as the International Accounting Committee norms, has been seen as inappropriate for Africa because of the nature of the shareholder structure. But the opening of the economies and the desire to attract more foreign direct investment has led some countries to review their reporting requirements. The West African French-speaking countries, for example, have recently adopted the SYSCOA

Kpate Adjaoute 179

(SysteÁme Comptable Ouest Africain), which is more in line with international standards. To summarise, the idea of bank supervision has gained in popularity, at least at the formal level. But the biggest challenge facing supervisory bodies in Africa is to summon the political will to enforce painful decisions when necessary. An additional impediment to effective supervision is the scarcity of people with the necessary expertise. To overcome this the eastern and southern African countries intend to provide collective training for supervisors. This is certainly an example to be followed by other countries. One device that will certainly help African banks is increased adherence to the Basle Core Principles on banking supervision. The challenges of global banking regulation The Asian and Russian ®nancial crises, coupled with the fragility of most developing countries' banking systems, have led to renewed attention being paid to the prudential regulation of banking and ®nancial institutions. This preoccupation is understandable, bearing in mind how detrimental the contagion effect can be. In fact all countries, developed or not, are exposed to the contagion of ®nancial crises. A consensus has thus emerged to establish a common regulatory framework whose principal purpose is to prevent ®nancial crises or contain them if they emerge. It is undisputed that banking regulation must be consistent with the basic functions of ®nancial intermediaries. At the global level, however, ensuring consistency between ®nancial intermediaries' functions and regulation presents a considerable challenge because of the signi®cant variation in the functions and structures of ®nancial institutions throughout the world, and no single regulation can be perfect for all. The traditional theory of ®nancial intermediation is ®rmly rooted in the idea that transaction costs and informational asymmetries call for the existence of intermediaries to provide particular services ± collecting deposits and expanding credits in the case of banks. The ®nancial disintermediation that characterised the 1980s in the wake of massive deregulation translated into the decline of traditional banking/insurance services. This decline was accompanied by revived interest in direct intermediation via ®nancial markets and the emergence of new ®nancial agents, conventionally known as non-bank banks. In the face of this threat, banks in the developed world responded with innovative product lines and increased securitisation. Consequently the structure of the assets and, in particular, the liabilities of banks has fundamentally changed. If users no longer have recourse to banks for traditional services, one might expect that the decline in transaction costs and the burgeoning of the information age would trigger a move away from traditional products such as mutual funds. In fact it might have been predicted that, given lower transaction costs, investors would themselves manufacture these standard ®nancial products for diversi®cation purposes. However interest in mutual

180 Reforming African Financial Markets

funds as an investment vehicle has instead been growing and despite the possibility of direct intermediation investors always refer to banks when it comes to handling risk management issues. This evolution in the functions and use of banks motivated Merton's (1993) theory of ®nancial intermediation. This new theory, better known as the functional approach to ®nancial intermediation, relies on the assumption that the ®nancial systems will provide services such as the transfer of economic resources over time. This view of ®nancial intermediation is in sharp contrast to the old paradigm, where the emphasis is put on the institutions themselves, such as banks. The functional approach is particularly appealing in the sense that the focus is on functions, which over time are much more stable than institutions. It then follows that the functional needs of a given economy are almost invariant over time, but the way in which these services are constructed and delivered changes fundamentally. At the minimum, banking regulation has to be in line with the technology that underlies the production and delivery of services, and offer containment of the pitfalls that may arise in the packaging and delivery processes. In theory this is easily achievable in an environment where there is consensus about the services to be expected from the ®nancial system and about ef®cient means of production. It appears obvious from the preceding analysis that the ®nancial system is in some sense a mirror of the underlying economy, and this is where one faces the biggest challenge to the global regulation of banks. The banking systems of developing countries have production and packaging processes that are radically different from their counterparts in the developed world. This difference follows from the differences in the underlying economic structures. Moreover banks in emerging countries are subject to contingencies that are little known to the global regulator. For instance banks in developing countries are little diversi®ed, if at all, and rely heavily on a limited number of export products. This in turn implies that they face an excessive portfolio concentration and a high exposure to international commodity markets given the volatility of commodity prices. Another subtle component of banking in emerging economies is the shareholder structure, which does not always guarantee consistency in strategic choices, and thus represents another source of (idiosyncratic) risk. In this context of dual ®nancial systems (developed versus emerging), clearly the regulator will not ®nd it easy to ®nd a remedy that ®ts all. The BIS tackles this issue by offering guidelines (core principles), and it follows that the sustainability of the global ®nancial system will depend critically on how the North and South translate these guiding principles into an effective regulatory framework in line with the activities of the banks and the underlying economic structures.

Kpate Adjaoute 181

Reforms and ®nancial market architecture: issues in design The rural sector The rural sector plays a central role in Africa, providing nearly 90 per cent of per capita income and making an equally important contribution to gross domestic product. Yet the attitude towards ®nancing rural farmers has been mixed, especially with respect to the ®nancial infrastructure available to the rural sector. With farming formally identi®ed as a priority sector, farmers should in principle be able to rely on ®nance provided by development banks or custom-made institutions especially set up for the sector. As discussed previously, such specialised institutions often lack the ®nancial sustainability and operational ef®ciency needed to accomplish their mission. On the other hand African commercial banks and the like have a ®rmly rooted tradition of collateral-based lending, which obviously represents a high credit-market entry barrier to the small-scale farmer. Consequently an informal ®nancial sector, commensurate with the size of the demand for funds, provides an alternative solution. However informal ®nanciers are likely to act as monopolists and charge higher interest rates, since their clients are constrained from entering the formal ®nancial sector. Initial steps to develop the so-called rural ®nancial markets focused on the development of bodies; such as credit unions, which have had remarkable success in Sub-Saharan Africa but failed in Latin America. Similarly, informal ®nancial groups such as rotating savings and credit associations (ROSCAS) and money-keepers appear to be much more prevalent in Africa. The essentially spontaneous emergence of these groups is part of the reason for their sustainability. The success of these groups depends on their structural form: their self-selected and voluntary participation, autonomy and selfreliance combined with particularly convenient service delivery, ¯exibility and trust. Furthermore group collateral seems to be more effective for monitoring credit risk. In fact peer pressure on defaulting members tends to guarantee higher recovery rates. Despite these attractive features, informal ®nance suffers from quite a few limitations. Such arrangements do not allow savings to be mobilised from more than a small group of individual who are well known to one another, and they have spatial limitations in terms of outreach. Moreover they barely provide term ®nance since there is hardly any term transformation. Because of these limitations, the reforms that were undertaken were partly aimed at reducing the weight of this informal sector in favour of a more dynamic formal one. If this move was correct, the more progress a country made towards ®nancial liberalisation, the less signi®cant the informal ®nancial sector should have become. However this was not the case and the reforms have led to greater fragmentation of the ®nancial markets in Africa.

182 Reforming African Financial Markets

Financial market reforms and fragmentation Because of credit rationing, many potential investors are excluded from access to investible money despite the expected pro®tability of their projects. The assumption is that the liberalised ®nancial sector will meet the demand for funds at market clearing conditions, and eventually on formal and informal credit costs will converge. Have the ®nancial reforms in Africa been accompanied by a consequent decline in the role of the informal ®nance sector? The available cross-country evidence does not seem to support the above conjecture. The World Bank's 1994 Policy Research Report explicitly acknowledged that ®nancial reforms have not always brought about the expected deepening of ®nancial markets. Instead, where improvements have been recorded in the ef®ciency of the formal ®nancial sector, these improvements have largely been matched by signi®cant growth in the activities and assets of informal ®nancial institutions, as documented by Aryeetey et al. (1997). Indeed these authors report that the capital base of moneylenders in Nigeria grew by as much as 264 per cent between 1990 and 1992 and that of savings and loan companies by 148 per cent. A similar pattern has been observed in Tanzania and other African countries. From the perspective of modern ®nancial intermediation theory, it would be interesting to know whether the coexistence of formal and informal institutions corresponds to ef®cient specialisation aimed at serving different market segments. Assuming that this is so, then the interest rates on the two markets should re¯ect the differences in the elements of a loan contract: orgination cost (information acquisition and processing in particular) and, most importantly, credit risk. Standard arbitrage arguments imply that if the interest rate differentials do not exactly re¯ect the difference in cost and risk components, there is room for riskless arbitrage pro®t for any agent who can simultaneously transact on the two market segments. However, African ®nancial markets seem to be more characterised by some degree of fragmentation, where the observed differences in interest rates cannot be fully accounted for by risk and cost characteristics, and it is also generally not possible to exploit discrepancies by arbitrage dealing. In the study conducted by Aryeetey et al. (1997), loan administration costs were generally found to be lower for informal ®nancial institutions, ranging from 0.1 per cent of the loaned amount for rural credit unions in Malawi to a maximum of 4.4 per cent for urban credit unions in Ghana. On the other hand, formal banks incurred substantially higher costs in loan administration, topping at 18.9 per cent of the loans made to large-scale enterprises in Nigeria. Despite the comparative advantage enjoyed by informal ®nancial institutions in this respect they were found to charge signi®cantly higher interest rates, with moneylenders charging at least 50 per cent more than the formal bank rates. This is in line with the monopolistic behaviour that can be expected

Kpate Adjaoute 183

when clients are preselected on speci®c grounds and there is limited or no mobility between market segments. Micro®nance as the unifying link In the face of increased market fragmentation, most African countries are trying to establish so-called micro®nance institutions, which are intended to ®ll the gap between the segments represented by formal and informal ®nancial entities. Because the formal sector is largely collateral-based and the informal sector focuses on small-scale investors, there exists an intermediary class of investors who cannot satisfy the collateral requirement of formal banks, but whose project size is beyond the capacity of informal ®nancial institutions. Micro®nance entities are intended to service this market. The National Micro®nance Bank (NMB) in Tanzania is a prime example of how micro®nance is gaining in pace and importance. The Bank of Tanzania has even gone one step further and set up a directorate with sole responsibility for strategic thinking on better avenues to support the micro®nance sector. Micro®nance institutions are expected to ®ll the service gap left by the formal and informal sectors. But at best, one can expect the reforms to lead to some sort of specialisation where three types of ®nancial intermediary exploit three different niches. The evidence so far seems to be biased towards fragmentation, with little interconnection between market segments. Market fragmentation impedes the ef®ciency of monetary policy since transmission cannot be ensured properly. In this sense it may be useful to rethink the type of supporting strategies that are likely to facilitate ®nancial market deepening. In order to handle the ®nancial market fragmentation outlined above, Adjaoute (1999) offers very useful advice on how securitisation can be used in the pursuit of more integrated ®nancial markets. The type of securitisation suggested relies upon packaging selected assets of the formal banking sector, micro®nance institutions and eligible informal ®nancial institutions and can be summarised as follows. Initially, securitisation trusts would be set up by a credible institution, possibly with the involvement of the central bank. The trust would then buy loans from banks, micro®nance institutions and informal ®nanciers (who would remain the originators) and package them into asset-backed securities. The packaged assets would be sold to an underwriter for retail to investors. Finally, the trust would collect the ¯ows associated with the original loans and pass them on to the ®nal investor. The credit quality of the trust could be enhanced by some form of guarantee or insurance ± state or international organisations that support development ®nance would be useful in this respect. The guarantee would be needed to cover possible delinquent losses from the original loans so that the ultimate investor would have ®rst class security with respect to credit risk. There are many advantages of the securitisation suggested here. First and foremost, illiquid assets could be initially transformed into liquid and tradable

184 Reforming African Financial Markets

ones. Because the primary intermediary could sell the loans to the trust the loan origination costs would probably be lower, because the originators could save on collection costs. The possibility of selling the loans would ease the liquidity constraints of the originators and release the pressure on the central bank discount window. The trust would complement the market in a very useful way in that it would be acting at the national level, offering a range of products that would not have been available otherwise. Additionally, because the trust would be a formal entity that interacts with the various segments of the ®nancial market, the transmission of monetary policy would be enhanced. This observation is fully in line with the World Bank's (1994) opinion that policy should explicitly incorporate the informal sector if it is to have a positive impact. Although there might be technical problems in implementing the securitisation scheme outlined here, the opportunity really exists to link the three segments of the African ®nancial system. Securitisation has been instrumental to the success of the mortgage and other markets in industrialised countries, and the lessons learnt from their experiences can be very valuable for African countries.

Concluding remarks This chapter has outlined the reforms of ®nancial systems in African. While there is a general consensus that such reforms are a necessary step towards a more dynamic, private-sector-led economy, there is more than one path to a sustainable ®nancial system. Hence the reforms have varied in nature, scope and pace from one country to another and have produced different results. Based on the success or failure of ®nancial reforms in other developing countries (Asia, Latin America), the following are necessary to the ef®ciency of ®nancial markets in Africa. First, the reform efforts should be primarily directed at increasing deposits, and to this end it is crucial to maintain positive real interest rates on both loans and deposits. Second, emphasis should be put on the viability of ®nancial intermediaries through appropriate loan recovery schemes. The sustainability of loan programme should be especially targeted, avoiding the use of the ®nancial system to allocate subsidies or act as a ®scal agent. Past experience also suggests that directing loans to speci®c groups, enterprises or areas can be particularly counterproductive. The evidence from rural ®nancial markets also indicates that concessionary rediscount lines should not be used to fund rural credits. In fact a supply of cheap loans discourages savings and deposit mobilisation and undermines the viability of the ®nancial system. Finally, the ®nancial system will be better able to accomplish its mission if the current market fragmentation is dealt with by tying all the components together. Note * This chapter was started while I was with the ®nance faculty of the HEC, Universite de Lausanne, and completed during my early days with the Quantitative Research

Kpate Adjaoute 185 Department at Morgan Stanley Capital International in Geneva. The views expressed here do not re¯ect those of the HEC or MSCI and I take full responsibility for any errors. Special thanks go to professor Z. Mikdashi for initiating the project and for his kind advice.

References AdjaouteÂ, K. (1999) `A Selective anatomy of some aspects of African ®nancial markets', BIS Conference Paper, Monetary and Economic Department. Aryeetey, E., H. Hetting, M. Nissanke and W. Steel (1997) `Financial market fragmentation and reforms in Sub-Saharan Africa', World Bank Technical Paper, no. 356 (Washington, DC: World Bank). Bailey, M. (1956) `The welfare cost of in¯ationary ®nance', Journal of Political Economy, vol. 64, no. 2. Caprio, G. and P. Honohan (1990) What is excess liquidity? (Washington, DC: The World Bank). Caprio, G. and P. Honohan (1991) `Monetary policy instruments for developing countries', World Bank Symposium. CEA-ONU (1999) Rapport eÂconomique sur l'Afrique. Collier, P. and W. Gunning (1999) `Explaining African economies', Journal of Economic Literature, vol. X X X V I I . Friedman, M. (1971) `Government revenue from in¯ation', Journal of Political Economy, vol. 79, no. 4. Fry, M. (1995) Money, interest and banking in economic development (Baltimore, MD: The Johns Hopkins University Press). IMF Research Department Staff (1997) `Capital ¯ow sustainability and speculative currency attacks', Finance & Development, December. Ledgerwood, J. (1999) Micro®nance handbook: an institutional and ®nancial perspective (Washington, DC: The World Bank). Mehran, M., et al. (1998) `Financial sector development in Sub-Saharan African countries', IMF Occasional Paper, no. 169, (Washington, DC: IMF). Merton, R. C. (1993) `Operation and regulation in ®nancial intermediation: a functional perspective', in P. Englund (ed.), Operation and regulation of ®nancial markets (Stockholm: Economic Council). Sachs, J. and M. Warner (1995) `Natural resources and economic growth', Development Discussion Paper, no 517a (Harvard Institute of International Development). Thillairajah, S. (1994) `Development of rural ®nancial markets in Sub-Saharan Africa', World Bank Discussion Papers, no. 219 (Washington, DC: World Bank). Turner, P. J. Van't Dack (1996) `Changing ®nancial systems in open economies: an overview', BIS Policy Paper, no. 1 (BIS). World Bank (1994) `Adjustment in Africa: reforms, results and the road ahead', Policy Research Report (Washington, DC: World Bank).

20

Banking Regulation: Administrative Rules versus Market-Based Instruments Robert Bichsel1

Introduction The recent Mexican, East Asian and Russian crises and the LTCM debacle severely shook the world's ®nancial markets. Goodhart et al. (1998) report that since 1980, of the 181 members of the IMF, 41 have had banking crises and 108 have encountered serious banking problems, a situation not experienced since the Great Depression. In the early 1990s, for example, national idiosyncratic shocks hit the Nordic countries and the Swiss banking sector. According to Calomiris (1999), since the start of the 1980s there have been nearly 100 national ®nancial crises, with losses of at least, the magnitude of those sustained during 1931±33 in the US. These records point to the potential instability of ®nancial systems in general and of banks in particular. They also highlight the limitations of banking supervision; stability is no higher under the current regulated banking system than it was under an unregulated system, such as in Scotland and in the US2 during the nineteenth century. In particular, the current banking supervision framework seems unable to prevent crises. The decline of the Asian economies in the 1990s, notably Japan, were accidents waiting to happen, particularly because the banks were in such bad shape. Traditionally, banking supervision has relied on administrative rules. While this approach may have been adequate to deal with relatively unsophisticated and slowly evolving ®nancial intermediaries, it is not satisfactory in today's rapidly changing environment. Danthine et al. (1999), for example, report that the worldwide annual number of bank mergers has increased by a factor of eight since the beginning of the 1990s, leading to a completely new, continuously evolving picture of the banking sector worldwide. The recent agreement between the US Congress and the White House to repeal the Glass± Steagall Act, that is to break down the regulatory barriers between banks and securities ®rms, will further stimulate competition and lead to new develop186

Robert Bichsel 187

ments and mutations in this sector. Markets are becoming more complete and working better than they used to. In this new environment the regulatory authorities should, whenever possible, use market forces to serve public interests. Various interesting proposals have recently been made in this area. Instruments that rely on market forces ± that is, incentive schemes rather than administrative rules ± have been developed. Among these are the use of external rating agencies or internal models to assess banks' riskiness, the use of junior debt to create market discipline, and the development of a new bankruptcy procedure. These instruments are theoretically appealing and may signi®cantly improve banking supervision, leading to a safer and more ef®cient banking system in the future. Some of them have actually been included in the new framework proposed by the Basel Committee on banking regulation.3 However, as will become clear, there are many unresolved problems. The next section brie¯y presents the main arguments for banking regulation. The third section discusses some characteristics and drawbacks of current regulation, based on administrative rules. The fourth section describes some new instruments aimed at improving banking regulation, highlighting both their virtues and their drawbacks.

A rationale for regulation Several characteristics of the banking industry provide the rationale for speci®c regulation, two of which are particularly important. First, banking systems that rely on fractional reserves are inherently unstable. Second, ®nancial intermediaries, being highly leveraged, have an incentive to take more risk than is socially desirable. The cause of bank instability and the associated inef®ciency is to be found in a speci®c characteristic of the ®nancial intermediation activity: maturity transformation. Banks rely on fractional reserves. As consumers have random needs for liquidity, a ®nancial intermediary can offer a liquidity insurance while holding in cash only a fraction of the amount deposited and investing part of the deposit in longer-term and relatively illiquid projects. This may increase the welfare of depositors but it can also cause instability. If the depositors are con®dent, such a system is stable. However if their con®dence is lost for some reason (justi®ed or not) and they think that other depositors will withdraw their money, then it becomes individually (though not socially) optimal to do likewise. This would lead to a breakdown of the banking system. The same mechanism applies at the country level. The ®nancing of highly illiquid projects (for example infrastructure) on the international markets relies on relatively short-term debt, and a run of creditors may lead a country into deep trouble even if it would otherwise have had no problems in servicing its debts. The crisis that hit Korea in 1997 is an example of this phenomenon.

188 Banking Regulation

The bias towards excessive risk taking in the banking system is partly due to the improper monitoring of banks. While a bank essentially relies on debt to ®nance its activities,4 it is largely controlled by its shareholders. The bulk of its money thus comes from small depositors who lack an incentive properly to monitor the bank's activities. On the other hand shareholders, who have more incentives and instruments to monitor the bank, tend to take excessive risks because they fully bene®t from gains and cannot lose more than their initial investment. This bias towards risk taking is worse the closer a bank is to failure (insolvency), that is, the lower the potential loss for shareholders. Another source of excessive risk in the banking sector is to be found in the costs of bank failure. First, most assets of banks usually consist of loans, the value of which greatly depends on private information acquired and held by the bank. As this information capital, based on the long-term lender±borrower relationship, is lost when a bank fails, these assets lose their value. Second, when a bank fails its dif®culties may spread over the entire economy. This contagion may be due to information diffusion: the failure of one bank may spell bad news for another bank with a similar portfolio and trigger its failure. The contagion may also be due to the domino effect, through the interbank market with interruption of the clearing process and risk of failure in interbank settlements, or through liquidity problems.5 As the stakeholders of a bank ± creditors and shareholders ± only bear a fraction of these costs, the degree of risk taking and the resulting number of failures are too high as compared to the socially desirable levels. These factors suggest that there are potential social gains to be had from careful regulation of the banking industry. This regulation has to be established at the supranational level as technological innovations and declining transaction costs are making the distinction between domestic and foreign markets irrelevant.

The limitations of an administrative rule The Basel Committee on Banking Supervision was created in 1974, under the auspices of the Bank for International Settlements (BIS), in the aftermath of serious disturbances in the international currency and banking markets. It was mandated to formulate international standards for prudential regulations and supervision. In the early 1980s the committee became concerned that the capital ratios of the main international banks were deteriorating at a time when international risks were growing. To halt this erosion of capital standards they worked out a weighted approach to risk measurement. This would allow the establishment of a minimum capital requirement that would re¯ect each banks' risk exposure. Since 1988 this approach has been progressively introduced in virtually all countries with active international

Robert Bichsel 189

banks and the minimum capital requirements have become the centrepiece of worldwide banking regulation. The requirement that a banks' capital should correspond to at least a given fraction of its risk exposure constitutes a multipurpose instrument. First, the cost of risky investments is increased, thus lowering the equilibrium risk exposure of the bank. Second, the consequences of a loss from a particular investment are limited since the capital stock serves as a buffer. Third, for the same reason the probability of a bank run and thus of bank failure are reduced. Under an ideal risk-based capital system, any increase in a bank's risk would be accompanied by an increase in capital. This implies that the riskbased capital standards should explicitly link changes in required bank capital with changes in exposure. The implementation of such an instrument unfortunately raises many problems, making it dif®cult to design a capital requirement rule that really meets its objectives. The measurement of banks' assets and risk exposure, together with the choice of optimal risk exposure, are problematic. Measuring the risk of a bank, for example, is becoming increasingly dif®cult because ®nancial intermediaries now use sophisticated procedures, policies and tools for risk management that are based on relatively recent ®nancial theories. The 1988 Basel Accord's capital requirements do not re¯ect this degree of sophistication. The required capital level is computed using a rather administrative distinction between bank and non-bank, collateralised and uncollateralised, OECD and non-OECD loans. Banks must hold a capital ratio amounting to at least 8 per cent of their assets, weighted according to this simple categorisation. Such a rule may provide wrong incentives for various reasons. First, as the risk weights do not accurately re¯ect the true risk of an asset, banks have an incentive to arbitrage both between and within risk categories, eventually increasing their exposure. Second, by ignoring the bene®ts of portfolio diversi®cation, the risk-based capital standards do not differentiate between changes in asset composition that hedge risk and those which increase risk. In addition the current risk-based capital standard does not account for interest risk. Hence a capital-de®cient bank can, at the margin, improve its risk-based capital ratio by substituting interest-sensitive, low-credit-risk assets such as long-term government bonds, for shorter-term, higher-credit-risk assets such as commercial loans. This may increase the bank's interest-rate and portfolio risk, while reducing its required capital level. Changes in capital and changes in risk may thus be negatively rather than positively correlated. Figure 20.1 illustrates one possible consequence of capital standards based on an administrative rule. As can be seen, the capital ratio of the Swiss big banks, weighted according to the Basel Committee standards (BIS ratio), rose steadily from 1994, reaching 15 per cent in 1998, well above the 8 per cent rule set by the 1988 accord. On the other hand the non-weighted capital ratio of

190 Banking Regulation

16.0 14.0 Big banks (BIS ratio) 12.0 10.0 Big banks (non-weighted) 8.0 Regional banks (non-weighted) 6.0 Cantonal banks (non-weighted)

4.0 2.0 0.0 1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

Sources: Les banques suisses, 1993±98 (non weighted capital ratios); the Basel Committee on banking

supervision (BIS ratio).

Figure 20.1 Swiss banks: capital ratios, 1989±98

these banks fell from more than 8 per cent to less than 4 per cent. Thus, together with the downward trend in credit ratings,6 indicates that these banks were taking more risks than previously. As can be seen from the trend for regional and cantonal banks, the downward trend in non-weighted capital in Switzerland is speci®c to big banks, suggesting that sophisticated banks are more prompt to react to adverse incentives. Given the general rise in sophistication and the increased competitiveness that prevail in the banking industry, one fears an increase in risktaking if the regulatory framework remains unchanged.

The contribution of market-based instruments The inability of the current rules to prevent crises has led various academics and politicians to submit fresh proposals aimed at strengthening banking supervision. These include alternative ways to assess risk and/or reduce exposure in the banking sector: external ratings, internal risk models, the precommitment approach and the subordinated debt approache, as well as new bankruptcy procedures. A general theme in these proposals is greater reliance on market-based instruments.

Robert Bichsel 191

External rating agencies As already mentioned, the minimum capital requirement is a sound instrument to discipline the banking sector. One of the main dif®culties for the regulator when setting a minimum capital requirement is measuring a bank's riskiness. In order to avoid this dif®culty the use of external ratings has been suggested. This approach links the capital requirement ± that is, the amount of capital a bank should hold against the assets of speci®c companies, ®nancial institutions and countries ± to a risk assessment provided by an external rating agency such as Moody's Investors Service, McGraw-Hill's Standard & Poor's or the Anglo-American Fitch IBCA, thus relying on the market for the data needed for appropriate regulation. This method represents a real improvement over the simple categorisation proposed by the 1988 Basel Accord as it allows for an increased number of risk categories and ensures that these categories are linked to some objective measure of risk. However the approach has several limitations and drawbacks. First, rating agencies (like regulators) do not have access to the private information banks have on their creditors and thus usually fail to provide an accurate estimate of banks' riskiness. Second, the number of risk categories considered by rating agencies, while higher than under the Basle Accord, is lower than the number of categories of risk with which a bank is actually confronted. Moreover the discrimination between different risk categories is arbitrary, which creates undesirable incentives. For example, according to a proposal by the (1999), Basel Committee in the safe part of the rating spectrum the proposed risk weighting strongly discriminates between borrowers in two different classes that are not very different in terms of risk. This gives investors an incentive towards the lower risk rate category to bene®t from a reduction in capital requirements. On the other hand, in the risky part of the rating spectrum, claims with the same capital requirements offer very different risk premiums. This provides an incentive for banks to choose riskier claims among the same category of capital requirements, so as to bene®t from higher returns without being subject to heavier capital requirements. Third, while rating agencies currently have an incentive to provide accurate ratings to investors because this is what investors demand, this may change if the capital requirements are set according to these ratings. Banks that are interested in saving capital may pressure the rating agencies to rate their assets favourably. The agencies may then compete for customers by adjusting their assessments in favour of the banks, which in turn may lead to a race to the bottom. This will especially be the case if the banks ask the rating agencies to rate their non-traded assets: such assets are owned exclusively by the banks and there is no pressure by the market to get the right rating, as is usually the case for assets with a large investor basis.

192 Banking Regulation

Finally, external ratings are volatile as they follow market perceptions of a country's or a company's likelihood of default. Internal models and the precommitment approach Pro®t-maximising banks have a strong incentive closely to monitor their risk exposure and they have access to private information that enables them to do so. As a consequence the information they have about their risk exposure, in particular on the credit book, is much more accurate than that provided by the regulator or the rating agency. A good regulatory scheme would thus base the capital requirement on this private information, that is, assess a bank's riskiness using the bank's own model of risk evaluation (VaR)7 or its selfassessment (the precommitment approach).8 One problem is of course that banks have no incentive to deliver accurate information on their risk exposure, particularly if they know that their capital requirement will be based on this. Banks have an informational advantage over their supervisors when assessing the risk of a loan, and they may be tempted to exploit this advantage by systematically underestimating their risks in order to reduce their capital requirement. Another problem is that internal risk models, while appropriate for market risk assessment, do not yield satisfactory results when used to estimate credit risk because market data on credit risk are not available for most borrowers, and because defaults are rare and cyclical events. A penalty scheme may give banks the incentive to release this private information or to reveal their effective riskiness. Banks can be allowed to choose their holding of capital freely, if the regulator sets both a loss limit (the maximum loss level tolerated given the capital holding of a bank) and a penalty scheme (the ®nancial ®ne, the additional capital requirements or other sanctions to be taken if the loss exceeds this level). Similarly banks can be allowed to choose between different VaR models, provided a penalty scheme is introduced to penalise those banks whose VaR models fail to pass a back-testing procedure.9 Unfortunately, while the back-testing procedure is suitable for market risk, it is far more dif®cult to apply to credit risk. As a consequence there is no `best practice' that can be followed to establish the quality of the models. Furthermore, if the principal limitation of these models is lack of data, considerable time will be needed to build a reliable VaR model and a reliable back-testing procedure. As credits often represent the bulk of a bank's assets, underestimation of the credit risk may endanger the existence of the bank. In such a context a trial and error approach to penalties may prove very costly. In addition, as shareholders do not care about ®nes when the bank's losses exceed its capital, that is, when the bank is insolvent, ex-post penalties may be useless (or even counterproductive) if the bank is severely undercapitalised. Finally, a problem arises if banks are free to choose between internal ratings and the administrative rule. Banks holding very risky assets will tend to prefer

Robert Bichsel 193

the standard approach if the internal ratings approach calls for a higher capital requirement than that imposed under the standard approach. Hence a scheme that allows banks freely to choose which approach to use will lead to a deterioration of the capital coverage of risks. On the other hand, if the choice is not left to the banks but is decided at the regulatory level, sophisticated banks will tend to reduce their high-risk business, for which the internal rating sets a higher capital coverage, while unsophisticated banks will specialise in risky assets as they are at a comparative disadvantage in low-risk business, resulting in the concentration of risky business among less quali®ed institutions. Junior debt requirement A third proposal is to rely more heavily on market discipline by forcing banks regularly to issue junior debt. Market discipline can operate through two channels: indirectly, whereby supervisors monitor the market yield of junior bonds to determine the risk exposure of a bank and set the capital requirement accordingly; and directly, through the discipline imposed by junior creditors. Bank depositors are unlikely to penalise their bank for excessive risk taking, either because they are explicitly insured or because of depositor preference laws. Secondary market rates and spreads on these debt instruments would thus be inadequate measures of a bank's risks. On the other hand the holders of junior debt are least likely to be bailed out in the event of bank failure and thus are most likely to require full disclosure of a bank's situation. Unlike shareholders, subordinated debt holders do not participate in the gains associated with risk taking. Hence the secondary market spreads on subordinated debt should be particularly sensitive to the level of the bank's risk. Banks may be free to choose their risk exposure as long as the spread does not exceed a particular threshold, but the supervisor may intervene when the spread exceeds that threshold, creating an incentive to limit risk taking. Investors gather information about a bank's risks and consider that information when making their decisions. Uninsured debt holders ask for higher returns or higher capital whenever a bank suffers losses and/or faces increased risk. If junior debt holders and depositors share the same risk aversion, banks will refrain from excessive risk taking and the necessity for direct regulation of risk exposure will tend to disappear. Banks already use subordinated debt, but they tend to reduce their issue in dif®cult times when this source of ®nancing becomes more costly. As suggested by Calomiris (1999), to ensure that banks hold a suf®cient level of junior debt for the mechanism to operate properly, they should be asked to issue risk-sensitive debt on a regular and frequent basis, renewing a fraction of the stock of debt every month or so. This is particularly important as ®nancial and technological innovations are allowing banks to change their ®nancial condition rapidly.

194 Banking Regulation

In spite of the many advantages of this method compared with the traditional risk assessment approach used by regulators, many problems remain. First, it is not clear that secondary market indicators provide information that the supervisor does not already have. Second, markets will tend to underassess the effective riskiness of banks if they believe that banks in dif®culty will be bailed out or recapitalised. Third, the yield spreads may go in the wrong direction when a bank is in deep trouble. When the value of junior debt gets close to zero, junior creditors (like shareholders) may prefer a risky investment strategy that will restore the value if successful, rather than demand prudent behaviour. Fourth, like all the proposals that aim to increase market discipline, subordinated debt requirement may generate some additional instability in times of stress. When the markets are under stress because the economy is deteriorating, or when the bank itself is in ®nancial dif®culty, the cost of issuing risk-sensitive securities is likely to increase, and at such times the forced issuance of subordinated debt is particularly costly. However this effect is attenuated if only a fraction of the global junior debt is to be renewed immediately. Finally, if the rate of return on subordinated debt required by the markets is set before a bank effectively chooses the risk level for the next period, the bank will tend to increase its exposure to risk to compensate for the increase in its capital cost. As a consequence the bank may be encouraged to take more risk under a junior debt requirement scheme than when creditors are insured and have no incentive to monitor. New bankruptcy procedure Instruments based on market forces are primarily designed to deal with large sophisticated banks, which cannot be regulated adequately using a simple administrative rule for capital requirements. Because of their size, these banks often present a systemic risk for the domestic economy, and hence are likely to be rescued in the event of failure. This presents an important problem; regulatory instruments based on market forces are ineffective if market participants believe that some banks are too big too fail. First, the use of internal models and the precommitment approach may work effectively only if a credible punishment scheme can be implemented, that is, if banks know they will not be bailed out in the event of trouble. Second, the junior debt approach can meet its objectives only if junior creditors actually fear the possibility of bank failure and the associated loss. The higher the likelihood of public rescue, the lower the spread on junior bonds and the lower the incentive for junior creditors (together with other creditors) to monitor the bank. This spread is thus informative for the regulator provided the markets do not judge the bank as too big too fail. The ef®ciency of the bankruptcy procedure plays an important part in that judgment. During bankruptcy proceedings, creditors do not usually act in a valuemaximising way. First-ranked creditors generally push for liquidation, leading

Robert Bichsel 195

to an inef®cient ®re sale. On the other hand junior creditors wish the bank to stay in operation as this increases the probability of their being repaid, but it also risks bigger losses. In addition bankruptcy proceedings are often an administrative matter, for example in Switzerland they are under the control of the Federal Banking Commission. The commission decides whether a troubled bank is to be closed, and if so, how its assets will be sold and the creditors compensated; or whether the bank should be recapitalised or bought by another bank. This can lead to inef®cient outcomes as the receiver lacks relevant information. These inef®ciencies render bankruptcy proceedings very costly. And the higher the cost of a failure, the greater the likelihood that the failure of one bank will spread throughout the banking system, and thus the more likely it is that the government will bail out the troubled bank. Hence some banks are too big too fail only because the bankruptcy proceedings are inef®cient. One method of solving this problem relies, again, on market incentives.10 The bankruptcy procedure can be designed in such a way that participants are provided with an incentive to maximise the bank's value. This can be done by splitting the bank's assets and liabilities: debt rights are transformed into participation rights that have precedence over common shares (making creditors the new owners of the bank).11 The conversion of debt rights into participation rights can be done in such a way that con¯icts of interest between creditors disappear while the priorities of different creditor classes are respected. The new owners can then decide what to do with the bank: sell it to a single bidder, sell it in parts to a group of bidders, or retain ownership, depending on which alternative will maximise the value of their property rights, and thus of the bank. While supervising the procedure, the authorities stay in the background. They decide when to start bankruptcy proceedings, monitor the managers, disclose the bank's characteristics and organise the auctions and decisionmaking processes. The crucial decisions ± whether and under what conditions the bank is is to be rehabilitated or sold ± are taken by those who will bear the consequences. In Switzerland the quest for an ef®cient bankruptcy procedure is particularly important. While the systemic risk for Switzerland as a whole is likely to be relatively low, the failure of one of the two major banks might lead the whole banking sector into deep trouble. In such a situation the bankruptcy procedure must be suf®ciently ef®cient for the markets to be convinced that these banks are not too big too fail. One problem with this proposal is that while it is important for a bank to remain in operation during the proceedings, this will only be possible if (protected) depositors leave their money with the bank. There is no guarantee that they will do so. Nor is it clear what the managers should be allowed to do during the proceedings and how the bankruptcy authorities can successfully monitor them.

196 Banking Regulation

Conclusion The rapid evolution of the ®nancial sector has rendered the task of the regulator both more dif®cult and more necessary. Tougher competition in the banking sector is putting managers under greater pressure and this may lead to increased risk taking. New and more sophisticated ®nancial tools require new and more sophisticated supervisory tools. As a consequence, the cost of an inadequate regulatory framework, based on administrative rules, is growing. Under certain conditions, particularly when insolvent banks are not systematically rescued ± that is, when an ef®cient bankruptcy procedure exists ± instruments such as a junior debt requirement, internal models and external ratings may signi®cantly improve banking regulation. However instruments that rely on market forces and incentive schemes should be seen as complements to rather than substitutes for administrative regulatory rules. Market-based instruments are still imperfect and markets tend to be volatile. It would thus be dangerous to base banking regulation ± particularly in respect of reducing banks' exposure to risk ± exclusively on such instruments. Nonetheless the regulatory authority should see market forces as an aid to the meeting of public interests. As Goodhart et al. (1998, p. 141) put it: `the wise regulator will use the market as an agent of risk control wherever possible'. And the proposals made by the Basel Committee for the new capital adequacy framework are a ®rst step in that direction. Notes 1. The author is grateful to Jean-Pierre Roth for helpful comments. 2. See White (1984) and Rolnick and Weber (1989), cited in Rochet (1999). 3. `A New Capital Adequacy Framework', consultative paper issued by the Basel Committee on Banking Supervision, June 1999. 4. The capital to asset ratio is typically 4±8 per cent, compared with 30±40 per cent in industry and commerce. See White (1991), cited in Dewatripont and Tirole (1994), p. 23. See also Figure 20.1. 5. As in the LTCM case. 6. According to the Fitch IBCA ratings, the average rating of the three big Swiss banks, while still high, declined continuously between 1990 and 1998, passing from A to B. See Bank for International Settlements, Quarterly Review, August 1999. 7. In 1996 the Basel Committee accepted the principle of commercial banks using their internal models (for example the value at risk model of J. Morgan). 8. See Kupiec and O'Brien, cited in Rochet (1999). 9. As noted by Rochet (1999), internal models and the precommitment approach are in fact the same under certain conditions. It is for instance possible to design a penalty scheme for both cases that leads to the same choice of capital. 10. See Aghion et al. (1992) for a detailed analysis. See Birchler and Egli (1999) for application to Switzerland. 11. Small depositors are represented by a deposit insurer.

Robert Bichsel 197

References Aghion, Ph., O. Hart and J. Moore (1992) `The economics of bankruptcy reform', Journal of Law, Economics, and Organization, vol. 8, pp. 523±46. Bank for International Settlements (1999) Quarterly Report, August (www.bis.org). Basel Committee on Banking Supervision (1999) `A new capital adequacy framework', consultative paper (www.bis.org). Birchler, U. and D. Egli (1999) `Ein Bankenkonkursrecht fu È r die Schweiz', mimeo (Swiss National Bank Zurich, Switzerland) Calomiris, C. (1999) `Building an incentive-compatible safety net', Journal of Banking and Finance, vol. 23, pp. 1499±1519. Danthine, J.-P., F. Giavazzi, X. Vives and E.-L. von Thadden (1999) `The future of European banking', Monitoring European Integration 9 (London: CEPR). Dewatripont, M. and J. Tirole (1994) The Prudential Regulation of Banks, Walras-Pareto Lectures, Ecole des Hautes Etudes Commerciales, Universite de Lausanne (Cambridge, Mass: MIT Press). Goodhart, C., P. Hartman, D. Llewellyn, L. Rojas-Suarez and S. Weisbrod (1998) Financial regulation: Why, how and where now? (London and New York: Routledge in association with the Bank of England). Rochet, J.-C. (1999) `Solvency regulation and the management of banking risks', European Economic Review, vol. 43, pp. 981±90.

21

Credit Risk: The New Frontier of Risk Management Didier Cossin

The art of market risk measurement and control has reached a state today that is impressive by any standard. Recent academic developments (notably based on option pricing), new tools (VaR and its variations), new instruments (with the continuously renewed derivative contracts), new institutions (for example the importance assumed by risk management departments in banks) have all converged to provide a remarkable understanding and mastery of market risk, whether interest rate, foreign exchange or stock markets. Of course our deepened understanding has also con®rmed what we cannot understand ± forecasting and asset pricing have particularly been under stress. But overall the advancement of ®nance in market risk is both obvious and a guarantee of further advancements in the ®eld, and other the clear promise of rocket science discoveries continuously to upgrade our knowledge and techniques. It is thus unfortunate that what is arguably the largest single risk class in volume today ($4.6 trillion of public debt in the US in 1996 alone and easily $2.9 trillion in corporate loans in the same country) and arguably the major risk for all economic agents in the business world ± the risk of default ± is far from being as well understood. Credit risk is also very pervasive. Most of the huge derivatives markets, for example, are OTC (over-the-counter) contracts and as such present a credit risk ± the possibility of default by one counterparty. Banks have had to manage credit risk (risk of default on the loans they provide) for centuries. The fact that they are much less sophisticated at doing this than they are at managing their (comparatively more recent) FX or interest rate exposures, and also lack advanced techniques and instruments to do so, may therefore come as a surprise ± but actually it should not do so, as we shall show in this chapter. Credit risk is a complex topic that requires all our intellectual, technical and institutional abilities, and even then it does not lend itself to easy solutions. What should also be clear is that hoping to manage risk without managing credit risk is hopeless. This is the risk to manage. It pervades all ®nancial contracts and it perverts market risk, for example a portfolio believed to be fully hedged with swap or forward 198

Didier Cossin 199

contracts against an FX or an interest risk may suddenly ®nd itself at risk again because of credit risk. What we propose to do here is to give a sense of why credit risk is so dif®cult to apprehend, what traditional methods are telling us, how modern techniques, inspired by the most advanced market risk techniques, are being used to look at the problem from a new angle, and how new instruments and new institutions are emerging that may help us to manage credit risk better in the near future.

The complexity of credit risk Credit risk is extremely complex and presents a greater challenge than both market risk (one needs to understand market risk in order to predict when and under what conditions a counterparty might default) and purely exogenous risks such as operational risk. Indeed credit risk depends on market risk, but while market risk can be made homogeneous by category (interest rate, FX and so on), credit risk is deeply fragmented. First, credit risk is fragmented by product. For example banks hold loans while mutual funds hold bonds on what might appear to be the same credit risk (a company) but it actually leads to a very different outcome in the event of default (technically, while the probability of default may be similar across products for a one company exposure, the loss given default, and thus the credit risk that is a combination of these two dimensions, will differ widely and is usually not well determined ex ante but a consequence of complex negotiations). Second, credit risk is fragmented geographically. Most institutions lend and invest primarily in their own back yards. Global players, and those trying to design management techniques that will be applicable worldwide, have long discovered that default in the US, default in Switzerland and default in Japan are three very different things, with different economic outcomes and different uncertainties about the outcome, not to mention the complex interaction between the credit risk of the country and the credit risk of the company. Third, credit risk is fragmented in time. On the investor's side it is fragmented by maturity horizon. Bank loans often mature within ®ve years, while life insurance companies invest in 10- to 30-year bonds. These exposures are usually analysed by means of the same long-term rating system. The relationship between credit risk and time is not well understood, but as we shall see later, credit risk can increase or decrease with maturity, in a highly non-linear fashion. This fragmentation can lead to excessive risk taking and inef®cient pricing. If one adds to this fragmentation the proliferation of credit enhancement methods (from collateralisation to AAA subsidiaries via credit risk insurance), which make the issue even more confusing, the problematic heterogeneity of this risk starts to become evident. On a more technical note, most market risk models (such as asset selection and the ef®cient frontier, the CAPM and other asset pricing models, and more

200 The New Frontier of Risk Management

recently most of the models in the option pricing literature) are based on an assumption of normal distribution. Unfortunately this assumption (and the rather simpli®ed mathematical conclusions it produces) does not carry well for credit risk. A holder of a credit instrument such as a bond can expect to receive the principal plus interest if the instrument is held until maturity, or even to have a limited upside if the credit instrument is upgraded in rating. The downside occurs, usually with a low probability, when either the obligor defaults or the instrument is downgraded in rating. Therefore the return from a credit instrument is highly skewed. In contrast the return from an equity instrument is fairly smooth and symmetrical and can be assumed to be normally distributed. Figure 21.1 shows the difference between the returns from equities and there from credit instruments. Because of the highly skewed nature of returns from credit instruments, the calculation of value-at-risk (VAR) requires a different approach from the traditional market risk methods (from derivative pricing to VaR), where a normal distribution of returns is assumed. Note that this difference in statistical behaviour is linked to the relationship between credit risk and market risk and to the nature of credit risk itself. One way of looking at credit risk, which those used to option theory will recognise, is to plot the pro®le of a bond that is subject to credit risk versus the value of the assets of the ®rm. The pro®le differs between a bond that is subject to interest rate risk and the reimbursement value of the same bond, depending on the capacity of the ®rm to honour its commitments (Figures 21.2 and 21.3) To these conceptual issues we have to add a practical consideration: lack of data. While there are some data on ratings, these are not frequently updated, nor are they necessarily a good representation of default probability. They have no explanatory power for loss, given default. Yields on publicly traded

Frequency

Typical credit returns

Typical market returns

Portfolio value Source: CIBC.

Figure 21.1 Typical returns from a credit instrument and equity

Didier Cossin 201

Bond

Interest

Figure 21.2 Value of a bond, depending on interest

Recovery (%) 1

Value of assets Face value Figure 21.3 Reimbursement of a zero coupon, depending on the value of assets

instruments can be observed but they are instrument-dependent. Also, unlike with market risk, the correlation between the returns on credit instruments is not directly observable, which makes it dif®cult to calculate the credit risk of a portfolio. The current lack of data (something that could be partly remedied by effort on the part of banks and regulatory bodies) thus makes a conceptually dif®cult task even more problematic. It is therefore to the credit of those working in the ®eld that our knowledge and techniques have advanced dramatically since the late 1990s. Before examining these techniques we shall look at the dif®culties that arise with the most frequently used traditional instrument: ratings.

Dif®culties that arise with ratings Traditionally ratings have been used as the starting point in credit risk analysis. Ratings are a simple way to transform a discrete event (default) into a more continuous variable (rating changes). It is well known that continuous

202 The New Frontier of Risk Management

variables are easier to handle and to obtain the dynamics of than discrete events. This transformation is thus welcome if it is valid. The following brief example illustrates the functioning of ratings. Suppose you have a long position in a bond that is rated AA. The risk you face is that of being downgraded. Hence to calculate the credit risk of your position you need to calculate:

. The probability of a downgrade.

. The bond's value in the event of a downgrade.

. The recovery rate in the event of the ultimate downgrade: default.

Hence the use of transition matrices (Table 21.1), which plot the probability of moving to another rating. They are useful for measuring and managing credit risk in that they can be used to ascertain the dynamics of ratings over time. The transition matrices can be calculated from past data by calculating (over a period of 15±20 years) the number of AAAs that have remained AAA, the number of AAAs that have become AA, and so on. More recent work tries to integrate the credit cycle instead of using only historical data, but obvious challenge of the methodology is its dependence on the latter (and its failure to consider outside factors such as macroeconomic variables). How good are ratings at capturing credit risk information? Several researchers have addressed the problem, with mixed results. For example Lucas and Lonski (1993) analysed the ratings of 6000 issuers over the period 1970±90 and found that ratings are not stable, and that even their instability is not stable. Ratings volatility doubled from 6 per cent of changes per calendar year in the 1970s to 12 per cent in the 1980s. There was a clear downward trend in quality that makes credit risk analysis all the more important today. The ratio of downgrades to upgrades went from 1.17 (almost balanced) to 2.17 for long-term debt over the period in question, that is there were twice as many downgrades than upgrades at the end of the period. Table 21.1 One-year transition matrix (per cent) Initial rating AAA AA A BBB BB B CCC

Rating at year-end AAA

AA

A

BBB

BB

B

CCC

Default

90.81 0.70 0.09 0.02 0.03 0.00 0.22

8.33 90.65 2.27 0.33 0.14 0.11 0.00

0.68 7.79 91.05 5.95 0.67 0.24 0.22

0.06 0.64 5.52 86.93 7.73 0.43 1.30

0.12 0.06 0.74 5.30 80.53 6.48 2.38

0.00 0.14 0.26 1.17 8.84 83.46 11.24

0.00 0.02 0.01 0.12 1.00 4.07 64.86

0.00 0.00 0.06 0.18 1.06 5.20 19.79

Source: Standard & Poor; Credit Week, 15 April 1996.

Didier Cossin 203

Some authors defend the idea that there is no useful information to be obtained from ratings as they are too slow to adjust and re¯ect rating agencies' management as much as true credit changes. Others have strongly defended ratings as the only true source of information available. Hite and Warga (1997) show, using a sample of 1500 industrial ®rms during the period 1985±95, that there is little information content in rating upgrades (all the information has already been incorporated into market prices) but there is some in rating downgrades. This study shows that neither the antirating nor the prorating lobbies are right ± the reality is more complex. Several studies (for example Cantor et al., 1997) have shown that neither of the two agencies (S&P and Moody's) truly dominates the other as far as the information content of their ratings goes. Indeed, if one considers split ratings (which are much more frequent than had been thought ± 2000 out of 4399 issues between 1983 and 1993 were split), it can be shown that taking into consideration the two ratings has more information content than taking either one. Finally, Nickell et al. (2000) have addressed stability (or instability) of rating migrations and established a methodology to adapt rating migrations to changes in the business cycle, the country or the industrial sector. In short, the information content of credit ratings is minimal at best, even in the US, where ratings are extensive. Note that credit risk depends not only on the probability of default (captured to a certain extent by ratings) but also on the recovery rate (or conversely the loss, given default), and information on this variable is even hardly to crime by Altman and Kishore (1996) have found that there are huge differences across industries ± for some industries the recovery rate can be as high as 80 per cent while for others it barely goes over the 10 per cent mark. Different recovery rates should lead to different credit risks, a fact not well represented in ratings and for which we lack even the most basic information, especially in Europe. From a practical viewpoint, the usual instruments of credit risk measurement seem limited and their relationship to actual pricing is dif®cult to assess as complex, non-linear relationships are sure to be present.

Recent theoretical literature on credit risk pricing During the last few years, academic research has shed new light on the complexity of the credit risk problem and on ways to approach and treat it. Two major lines of research have evolved (with some overlap): the contingent claim approach and the reduced form approach. The ®rst approach was pioneered in 1974 by Robert C. Merton (who won a Nobel Prize in 1997). Merton proposed that in a simple setting (a ®rm with only one issue of zero-coupon debt) the stock of the ®rm can be seen as a call option on the assets of the ®rm and hence the credit risk on the debt issue can be compared to a short position on a put option. Thus contingent claims analysis (option pricing) can be used to value the component parts of a ®rm's

204 The New Frontier of Risk Management

liability mix. In general, the value of each component will depend upon the stochastic variables that determine the evolution of the ®rm's asset value, the evolution of the interest rate, the payouts (dividends, coupons and so on) to the various claimants, and the division of the ®rm at any point of reorganisation (for example bankruptcy). The method makes it possible to analyse and measure the impact on credit risk spreads of a change in asset volatility, a change in interest rate volatility, different maturities of debt and so on. Figures 21.4 and 21.5 illustrate the structure. The payoff structure for levered corporate equity is isomorphic to the one for a call option on a share of stock where the maturity date of the ®rm's debt, T, corresponds to the expiry date of the option, the promised payment on the debt, B, corresponds to the exercise price of the option and the ®rm's value, V, corresponds to the underlying security. As a consequence the terminal payoff to debt is functionally equivalent to owning the assets of the ®rm and being short a call option on those assets with an exercise price of B. (Alternatively the debtholders can be considered to have lent money risklessly at face value B and gone short a put option on the assets of the ®rm with an exercise price of B.) We can thus use option pricing to value credit risky bonds. The theory provides for interesting and unexpected consequences, such as the fact that volatility and credit spreads may be two contradictory measures of credit risk (they may rank instruments differently as to their risk) and the fact that in high-yield debt, longer maturity may be associated with a lower credit risk, all else being equal. The methodology has been extended in various ways to take into account non-constant interest rates, several debt issues, more complex instruments (including credit derivatives), the presence of collateral, the presence of gaming when there are bankruptcy costs and so on, but it becomes very dif®cult to handle mathematically when these different complexities are

E(V,T )

V(T ) – B

45° 0

B

V

Figure 21.4 Payoff for the levered equity E as a function of the value of the assets V

Didier Cossin 205

D (V,T )

B

45˚

0

B

V

Figure 21.5 Payoff for the credit risky debt D as a function of the value of the assets V

cumulated. It is nonetheless a full theory of credit risk with, notably, an endogenous recovery rate. The reduced-form approach is quite different. Although it focuses on arbitrage-free models (and thus differentiates itself from the plain actuarial ratings-based approach), it treats bankruptcy as an exogenous rather than an endogenous process. From a theoretical point of view this is not a welcome departure, but it does allow for easier treatment of practical cases (with the weakness of ignoring the ®nancial economics behind the determination of the bankruptcy process). Many recent papers have followed this assumption. The papers allow for somewhat easier pricing of complex instruments. They also allow models to be ®tted in a clean way to past data. On the other hand the models are limited to exogenous times to default and exogenous recovery rates. Although very sophisticated mathematically and of great use in practice, the models do not provide a full theory and thus may be taken to be at fault in a highly unstable environment. Put together the two theories give us a much better picture of what credit risk is about and how this risk moves with different variables. They allow for a more precise pricing of credit risk and should prove highly useful as the market for credit risk evolves (notably with credit derivatives such as credit default swaps).

Credit risk measurement for portfolios Financial institutions are required by the regulatory authorities (The Bank for International Settlements and the national governing bodies) to hold a certain amount of funds in reserve to cover the risk of their assets. Determining the amount to be held is an important regulatory challenge, but knowledge of the amount of risk an institution is exposed to helps the managers of banks to

206 The New Frontier of Risk Management

manage their portfolio and risks. Since the ®nancial performance of a company is in¯uenced to a large extent by market conditions, the credit risk of the company (the possibility of downgrade or default) depends on market conditions. Simply adding together market risk and credit risk may lead to double counting. At the same time a sudden increase in the riskiness of large `market makers' can in¯uence the overall market conditions. Ideally, therefore, in order to quantify the amount of risk there should be a holistic approach to risk measurement, capturing both aspects. Since the theoretical models for this are too complex for easy implementation, ®nancial institutions are using separate models to evaluate the two aspects of risk. Of the many models available to evaluate credit risk, the following four are dominant. Creditmetrics Creditmetrics, which was initially promoted by J. P. Morgan and is now marketed by an independent company (Riskmetrics), measures changes in the value of an asset due to the migration of its credit rating. It starts by assigning a credit rating to an asset/obligor. The range of changes in the value of the asset is calculated on the basis of the probability of the asset changing its credit rating or defaulting over a certain period. Than the value at risk at a given con®dence level is derived as the value of the return on the asset at that con®dence level. Credit rating agencies such as S&P and Moody's publish data on the credit ratings of assets, their transition probabilities and the recovery rates in case of default. CreditRisk‡ Credit Suisse's CreditRisk‡ is derived from the model used by insurance companies to evaluate their risks and relies on a two-state model of an asset ± the asset is either in default or not in default. In this sense it is close to reducedform models. The model does not consider risks due to the downgrading of the credit rating of the obligor. No assumption is made about the causes of default: obligor A is either in default, with probability PA or is not in default, with probability 1 � PA . Losses (exposures, net of recovery) are divided into bands, with the level of exposure in each band being approximated by a single number. Default rates, their volatility and the recovery rates of obligors are obtained from the credit rating charts published by rating agencies or the ®nancial institution itself. To calculate a loss due to the default of a portfolio of assets, the model divides the assets into bands, based on exposures. The total portfolio is then regarded as a portfolio of these bands. Value at risk at a certain con®dence level is then calculated as the expected loss due to default at that con®dence level.

Didier Cossin 207

Credit Monitor model The Credit Monitor model is based on Merton's option model of a ®rm, where both the stockholders' and bondholders' claims on the ®rm's assets are considered as options. If the volatility of a ®rm's equity is known, its value and the ®rm's capital structure, value of the ®rm's assets and its volatility can be calculated. The value of the risky debt can then be calculated using the option pricing model. Using historical data on the behaviour of defaulting ®rms, the creditmeasuring company KMV has concluded that the critical threshold for default (The `default point') is not the point where the value of a ®rm's assets falls below the value of its liabilities, but where the ®rm's value reaches the par value of current liabilities to be serviced over a time horizon plus half its longterm debt. The model then computes the index, distance to default (DD) as the number of standard deviations between the mean of distribution of the asset value, and the default point. Unlike the Creditmetrics model, where ®rms with the same credit rating are expected to have the same default and transition probabilities, which are equal to the average historical rate, the Credit Monitor model allows us to look at the default probability of a speci®c ®rm. Also, since rating agencies take time to upgrade and downgrade the credit ratings of ®rms, the default rates they report may not accurately re¯ect the actual default rates. In fact there are examples of the EDF (expected default frequency) becoming the leading indicator of default or a tall in the creditworthiness of obligors. Creditportfolio The CreditPortfolio model (promoted by McKinsey & Co.) incorporates macroeconomic factors into the calculation of default rates and the probability of credit rating transitions. The probability of default is calculated as a function of various macroeconomic factors and the speculative grade of the obligor. Provided there is enough historical data to calibrate the model ± that is to establish coef®cients for the in¯uence of a particular factor on probability ± this model can be used to calculate the riskiness of assets in any country or industry. The econometric consistency of the model thus becomes essential, but its theoretical base is weaker than those of the other models.

It should be noted that none of these models can deal with market risk at the same time as credit risk (for example none can deal with non-constant interest rates) and none can deal with non-linear instruments such as options, hence they are very limited. However, they do represent an important advance on the usual practices. For example they allow for portfolio optimisation of highyield portfolios, something that has not been done before. When new instruments to manage credit risk emerge, such as credit derivatives, knowl-

208 The New Frontier of Risk Management

edge of how to manage portfolios and transform their exposure to credit risk will offer a major competitive advantage as the ¯exibility of exposure management becomes increasingly important. The most widely used credit derivatives (credit default swaps ± basically default insurance ± and total return swaps, whereby a safe return is swapped for a credit risky return) as well as new instruments (default spread options and futures) will render the credit risk exposure of ®nancial intermediaries more ¯exible than they have ever been. Understanding what they want in terms of credit exposure and the value of that exposure are thus becoming essential concerns for ®nancial intermediaries in respect of competitiveness.

Conclusions Measuring credit risk is a complex matter, although it has been essential to banks' operations for generations. New insights are emerging, particularly from theoretical literature on the subject. These new insights are revolutionising the approach to credit risk management. The current economic boom may lead some to believe that credit risk is no longer the primary risk to consider and that market risk should be the focus of all attention. Nonetheless, good management of credit risk may provide a competitive advantage that will turn out to be a lifesaver in the event of a downturn (as well as in a new regulatory context). References Altman, E. and V. Kishore, 1996, `Almost Everything You Wanted to Know About Recoveries on Defaulted Bonds', Financial Analysts Journal, November/December, pp. 57±64. Cantor, R., F. Packer and K. Cole, 1997, `Determinants and Impact of Sovereign Credit Ratings', Financial Analysts Journal, December, pp. 76±91. Hite, G. and A. Warga, 1997, `The Effect of Bond-Rating Changes on Bond Price Performance', Financial Analysts Journal, May/June, pp. 35±47. Lucas, D. J. and J. Lonski, 1992, `Changes in Corporate Credit Quality 1970±1990', Journal of Fixed Income, no. 2, March, pp. 7±14. Nickell, P., W. Perraudin and S. Varotto, 2000, `Stability of Ratings Transitions', Journal of Banking and Finance, no. 24 (1±2) pp. 203±27.

22

Banking: Is Bigger Really Better? Jean-Pierre Danthine1

`A long, strange trip' On both sides of the Atlantic the banking industry has undergone two decades of spectacular transformation and the consolidation process does not seem to be slowing down, particularly in Europe. For academics, sceptical by profession, the trend towards ever bigger banking institutions is puzzling as in their studies they can ®nd no con®rmation of the rhetoric adopted by practitioners and consultants to justify their actions or rationalise their strategies. In this chapter we review the arguments and counter arguments. The facts are striking and indisputable. The movement was initiated in the US at the beginning of the 1980s, a `long, strange trip'2 that saw the number of commercial banking organisations in the US fall from 12 463 to 7926 between 1979 and 1997. The clean-up was concentrated among the smallest institutions: in this period the number of banks with total assets in excess of $100 billion actually increased from three to six; the number of medium-sized banks (with total assets in the range $100 million to $100 billion) remained relatively stable, falling from 2446 to 2284; while the number of banks with total assets below $100 million fell from 10 014 to 5636.3 Bankruptcies (numbering 1475) played only a relatively small role in this development and were concentrated among the smallest banks (1148 out of 1475): most of the consolidation was due to mergers and acquisitions (M & A). Between 1980 and 1994, on average there were 423 mergers per year, and during this period about one in two of the US banks that existed in 1980 (43 per cent) took part in an M&A transaction. Eighty of the 142 mergers involving large banks were interstate.4 Table 22.1 shows the data for the US and Europe. It underscores the fact that the potential for change was not exhausted by the early 1990s, rather M&A activity accelerated in the second part of that decade.5 The move towards consolidation started later in Europe and developed at a relatively slow pace until 1996, but it then exploded, as the data for 1997±8 attest. 209

210

Table 22.1 Mergers and acquisitions in the banking sector1 Value of transactions

Number of transactions

In billions of US dollars

As a % of all sectors2

1991±92 1993±94 1995±96 1997±98

1991±92 1993±94 1995±96 1997±98

1991±92 1993±94 1995±96 1997±98

United States Japan Euro area4 Belgium Finland France Germany Italy Netherlands Spain Sweden Switzerland United Kingdom

1354 22 495 22 51 133 71 122 20 76 38 47 71

1477 8 350 18 16 71 83 105 13 44 23 59 40

1803 14 241 20 7 50 36 93 8 27 8 28 25

1052 28 203 21 7 36 45 55 9 30 8 22 17

56.8 0.0 17.5 1.0 0.9 2.4 3.5 5.3 0.1 4.3 1.1 0.4 7.5

55.3 2.2 14.6 0.6 1.0 0.5 1.9 6.1 0.1 4.5 0.4 3.9 3.3

114.9 34.0 19.1 0.5 1.2 6.5 1.0 5.3 2.2 2.3 0.1 1.0 22.6

362.4 1.1 100.4 32.5 4.3 4.0 23.2 30.1 0.4 5.9 2.1 24.3 11.0

18.7 0.3 8.3 14.1 22.3 4.3 6.5 15.6 0.2 13.5 3.8 9.5 6.5

9.0 18.8 9.3 7.0 21.7 1.0 7.6 17.7 0.5 21.5 2.0 43.4 3.4

10.6 21.6 11.2 4.9 7.4 9.8 3.7 24.9 17.5 14.1 0.3 2.4 10.4

18.2 4.1 27.1 34.8 77.5 4.1 45.5 63.3 0.8 26.6 7.1 78.3 4.0

Total banks

2098

2032

2162

1360

84.7

83.2

200.8

534.2

11.7

8.5

11.0

18.9

Total non-banks, 2,723 ®nancial

3,267

3,973

5,156

63.7

122.2

189.9

534.2

8.8

12.5

10.4

19.4

Notes:

1 Classi®ed by the industry of the target; only completed or pending deals; announcement date volumes.

2 Of mergers and acquisitions in all industries.

3 As of 30 October 1998. 4 Excluding Austria, Ireland, Luxembourg and Portugal. Source: BIS.

Jean-Pierre Danthine 211

Why so big? There is no shortage of factors to explain the launch of this process: deregulation (culminating in the US with the end of the prohibition on interstate banking and in Europe with the advent of the euro) and technological progress being foremost among them. The fundamental characteristics of the process are not in question either: the effect of deregulation was to expose banks to the winds of competition, and as a consequence of this and of technical progress a large number of banks appeared to be inef®ciently small, poorly managed and insuf®ciently diversi®ed. The disappearance of the smaller banks through bankruptcies, mergers or absorptions, the major manifestation of this process, is thus no puzzle at all. What it is more dif®cult to explain is the constitution of megabanks such as those making up the top 20 (Table 22.2). Note that most of the institutions listed this table are recent entities or have been involved in an M&A transaction in the last few years. Noteworthy of the consolidation activity after to November 1998 was the formation of the largest bank in terms of assets with the acquisition of Bankers Trust by Deutsche Bank, followed by the merger between Deutsche Bank and Dresdner, the emergence of the largest Hispanic institution (BSCH, resulting from the merger of Banco Santander with Banco Central Hispanoamericano with assets of $300 billion), the BNP± Table 22.2 Top 20 US and European banks, as of November 1998 ($ billion)

1. UBS 2. Citigroup 3. Deutsche Bank 4. ABN-Amro 5. Hypovereinsbank 6. HSBC 7. Credit Suisse 8. Dresdner 9. ING Group 10. SocieÂte GeÂneÂrale 11. Barclays 12. Chase Manhattan 13. Banque Nationale de Paris 14. Commerzbank 15. National Westminister 16. JP Morgan 17. Bank America 18. First Union 19. Lloyds TSD 20. San Paolo-IMI Source: Goldman Sachs & Co.

Total assets

Market cap

749 702 693 501 492 487 477 462 456 418 406 357 346 343 311 299 264 235 234 200

69.2 107.0 33.4 31.8 31.1 55.5 46.4 24.7 55.2 18.2 35.6 48.7 14.6 13.8 30.2 16.6 99.9 57.4 64.8 12.0

212 Is Bigger Really Better?

Paribas deal in France and the acquisition of NatWest by the Royal Bank of Scotland.

Big egos One provocative view is that there is nothing rational about this race for size. `Megamergers', those leading to the establishment of banks with assets exceeding $100 billion, are not in the interests of shareholders or society at large. In the absence of rational motives, they can only be explained by the private motivations of managers, be they compensation packages or their aspiration to rule over ever bigger institutions. In other words Megamergers are the unfortunate outcome of the empire building ambitions of managers or their desire to maximise their private bene®ts. In this view the search for size in the 1990s (which of course was not limited to the banking industry) is reminiscent of the conglomerate fallacy of the 1980s. The conglomerate build-up in the 1980s was almost uniformly criticised in academic circles on the grounds that stockholders could diversify at much lower cost, via their portfolio choices, than managers through mergers or acquisitions and that this would prove to be a passing and costly fad. Fifteen years later the victory of academics is sweeping as managers are proclaiming the virtue of being focused and are often applying this new conviction to the break-up of the very conglomerates that were put in place in the earlier period. Indeed, one cannot exclude that the merger game of the 1990s was the result of a similar fallacy and that blind, fashion conscious or self-motivated managers were preparing for another victory by scientists over `practical men'!

Scale and scope economies The standard, natural line of reasoning espoused by managers to justify their M&A strategies builds on the presumed existence of economies of scale and/or scope in banking, that is, on the possibility that average cost will fall as ®xed costs are spread over a larger volume of activities. Scale economies in banking can come from a variety of sources. There are ®xed costs associated with maintaining a branch network ± administrative and back-of®ce operations, information technology ± or running investment banking or asset management operations. Scope economies can also be signi®cant because combining different product lines (such as banking and insurance products) may increase the relationship value of banking while decreasing average marketing costs. Note, however, that even within the industry there are as many opponents of the one-stop shopping concept as there are proponents. Combining different product lines may also help relax some regulatory constraints (by meeting the demand with a product that is subject to less stringent regulation).

Jean-Pierre Danthine 213

Some of these economies of scope, those arising between commercial and investment banking, are the source of what some see as the comparative advantage of universal banks over specialised institutions. A bank, through its commercial banking activities (executing payments and soon), establishes long-term relationships with ®rms and is in possession of valuable information on their ®nancial structure. A commercial bank is thus in a privileged position to know whether a ®rm may be prepared to shift its funding sources. Similarly, through its branch network a commercial bank has a comparative advantage in tapping the retail market to distribute the bonds, shares and commercial paper issued by ®rms. There is also some evidence of economies of scope between corporate ®nance activities and distribution in the recent history of the investment banking industry. Investment banks that were strong in distribution but weak in corporate ®nance, and thus had limited relations with corporate clients (Cazenove, BZW, NatWest, James Capel), gradually disappeared from the market. The survivors are either purely corporate advisors (such as Rothschilds and Wasserstein Perella) or fully integrated houses (such as Goldman Sachs and Morgan Stanley). If corporate relations and distribution are important, commerical banks should be in a privileged position to enter the investment banking industry by transforming themselves into universal banks. May justify the `big', not the `mega' There is a puzzle, however, in that the very signi®cant number of studies that have attempted to measure standard returns to scale or scope in banking have concluded that they are exhausted at a relatively small scale and are not the source of a very large cost advantage. Speci®cally, most studies have failed to ®nd evidence of scale economies for banks above $25 billion in asset size and they have generally found differences in unit costs attributable to sizes smaller than 10 per cent. (Results for the US can be found in Saunders, 1996; Berger and Mester, 1997); Berger et al., 1998). Table 22.3 show, the results from a number of recent studies, focusing on European data. In addition to standard economies linked to scale or scope, size may offer better diversi®cation opportunities (in the deposit base, investments and loans).6 The risk dimension is understandably relevant for institutions such as banks and it provides a pointed illustration of the dif®culty of estimating production frontiers. Indeed recent studies contend that the failure properly to correct for the risk dimension has led to signi®cant underestimates of the optimal bank scale. Diversi®cation improves the expected return±risk trade-off a bank faces. But the lower cost of risk management of a larger and better diversi®ed bank allows it to take on more risk (and even increase the probability of insolvency). Cost savings therefore may not be detected if the tendency of better diversi®ed institutions to take on more risk is costly. Hughes et al. (1998) have found that the bene®ts from consolidation increase

214

Table 22.3 Select survey of cross-country bank ef®ciency studies Study Allen and Rai (1996)

Ruthenberg and Elias (1996)

No. of Banks 194 65

Bank type

Source

Countries

Results scale (in billion)

Commercial

Compustat

A, AUS, B, CH, CN, D, DK, ES, F, FIN, I, JP, S, UK, US

60

5 largest

Of®cial

B, CH, D, DK, ES, F, FIN, GR, I, IRE, ISR, NL, POR, S, UK

50 0.6

Schure and Wagenvoort

1974

Credit institutions

(see their de®nition)

BankScope

EU-15

Sheldon (1999)

1783

Commercial and

saving

Fitch-IBCA Bankcorp

EU, Norway, CH

Vander Vennet (1994)

1504

No investment

IBCA

B, D, DK, ES, I, L, NL, POR, UK

3±10

Vander Vennet (1999)

2375

No investment

?

A, B, CH, D, DK, ES, F, FIN, GR, I, IRE, L, N, NL, POR, S, UK

5±50

Sources: Sheldon (1999); Schure and Wagenvoort (1999).

0.5±1.5

Jean-Pierre Danthine 215

(improved pro®tability and production ef®ciency, and lower insolvency risk) when consolidation widens the geographical spread of the bank. Geographical diversi®cation appears to offset the tendency of larger banks to take on more insolvency risk (controlling for diversi®cation). Overall, and controlling for risk taking, Hughes et al. (1996) have found evidence of large economies of scale that increase with asset size and conclude that the `largest banks may not have been observed yet'. On the face of it, this ®nding might be seen as providing academic support for the constitution of megabanks. This is not clearly the case, however; not only because the approach and the results stand out in the literature and are in need of con®rmation in the face of a larger stream of studies with opposite ®ndings, but also because the gains from risk diversi®cation that are associated with the geographical expansion of commercial banks across the US hardly provide the rationale for most of the big mergers in Europe, which have often taken place within national borders.7

A brand new world? The world of banking has changed so much that there is cause to argue that academic studies tell a tale of the past. The 1980s and 1990s were decades of swift technological change, mostly driven by the advance of computing power, and of major progress in ®nancial techniques, triggered by the work of Merton (1973) and Black and Scholes (1973). Information technology is considered to offer substantial scale economies: at normalised quality, the marginal cost of servicing a larger bank is small, possibly zero.8 Furthermore telecommunications have abolished distance and permitted the exploitation of scale economies on a global basis. Globalisation and EMU, viewed as fostering a convergence of client needs and ®nancial practices across the world or the European economy, make it desirable to do so. Similarly ®nancial engineering makes it possible to extend the range of banking services and in many instances to replace personal services with products. These often require a substantial development investment but have close to zero marginal cost. They thus contribute to the transformation of banking, traditionally based on relationships (retail and corporate lending), into an activity mostly based on knowledge. Knowledge is free to disseminate and use across a given institution; it is a public good, or at least locally (within a ®rm). Knowledge-based activities have inherent economies of scale. It is thus conceivable that during the 1980s scale and scope economies in banking became more important than ever before, and that merging ®rms were, and still are, trying to capture the bene®ts. Major technical and ®nancial innovations, however, take time to produce measurable results in terms of a bank's production function, which is what econometric studies attempt to estimate. The cost of adapting to the new world of banking are very high and mask its bene®ts for several years. It should therefore come as no surprise that empirical studies based mostly on data from the 1980s fail to detect the `new'

216 Is Bigger Really Better?

scale economies. While there is a ring of plausibility in this line of defence, it should be noted that some of the studies we have cited make use of data from the 1990s and so far they have con®rmed the earlier estimates of optimal scale. Another line of defence in the same spirit contends that estimating production frontiers is a dif®cult task and that the typical study fails to encompass the entire set of activities covered by institutions that call themselves banks. Even economies of scale that appear modest in the aggregate might be signi®cant once they are properly attributed to a speci®c line of business. Modest economies of scope between that particular line of business and the rest of a bank's activities might be suf®cient to validate bigger size. This line leads Walter (1999) to admit that `it seems reasonable that a scale-driven pan-European strategy may make a great deal of sense in speci®c areas of ®nancial activity even in the absence of evidence that there is much to be gained at the ®rm-wide level'.

Size as a by-product There is another, different, argument to justify the constitution of big or mega banking entities. It has to do with management performance. Empirical studies report very large disparities in cost structures among banks of similar size. The order of magnitude of these so-called X-inef®ciencies is around 20 per cent. Schure and Wagenvoort (1999) estimate that the weighted average of X-inef®ciencies in the EU-15 declined from 20 per cent in 1993 to 16 per cent in 1997, the extremes being represented by Greek (59 per cent in 1997) and UK banks (measured to be fully ef®cient in the same year). These estimates seem to indicate that much bigger ef®ciency gains can be achieved by improved management than by optimising along the size dimension. However there seems to be a positive correlation between size and X-ef®ciency. This is paradoxical because one of the arguments against size is the increasing dif®culty for managers to control and monitor ever bigger organisations, and one key argument against mixing different lines of business is the dif®culty of resolving the con¯icts between different corporate cultures. One plausible interpretation of these facts is that size per se has nothing to do with managerial ef®ciency and is not what is sought in the consolidation process. Size is only the (unfortunate) by-product of the process by which the market enforces managerial ef®ciency, that is, by which the strong exploit the pro®t opportunities arising from the presence of poorly managed institutions. Banks that are poorly managed are tempting targets for those which are better managed, and in the process two smaller institutions may merge into a bigger one. This argument is valid at all scale levels. Indeed the relative weakness of the old UBS and the Bankers Trust is likely to have precipitated the emergence of (what were at the time of the mergers) the two largest banks in the world. Note that this argument leads to the prediction that divestment is likely to follow the consolidation phase. Once value has been created via an increase in

Jean-Pierre Danthine 217

managerial ef®ciency, the handicap of excessive size may prevail and the natural solution will be to divest non-core businesses or to break up the organisation into smaller, specialised banking units. Indeed some of this has been going on, although very timidly, in the case of the new UBS.9

`Conspiring against the public' One last argument, rarely invoked but probably ever present, is the intention to to use consolidation as a way to relax the intensity of competition and increase market power. The `politically correct' form of the argument is that it is motivated by the need to reduce excess capacity in distribution networks (over-banking). Also, and particularly relevant in the European context, consolidation may provide ways to cut excess labour if this is dif®cult to achieve otherwise: by inducing deep reorganisation, of®ce relocation and so. These are all situations where the interests of shareholders and society at large may diverge. Value may be created for the former but not the latter. This is clean by the case where a concentration of market power results from the consolidation process. Antitrust policy is the mechanism by which society protects itself against such developments. This mechanism appears to have worked satisfactorily in the US, where concentration levels have not increased since the early 1980s. There is more reason to worry in Europe. The current tendency to consolidate within national borders is producing high concentration levels, in some casses much higher than would be tolerated in the US (see Neven and von Ungern-Sternberg, 1998). It is possible that this trend has run its course and that the advent of the euro in particular will foster cross-country consolidations (Danthine et al., 2000), but the current evidence is far from conclusive. In any case, one can argue that utmost vigilance should be exercised by competition authorities: the time of banking being off-limits to competition policy should de®nitely be over (Danthine et al., 1999).

Conclusion: is mega too big? There is a distinct possibility that the megabank and the big and wide bank will underperform in the coming years and that the tendency to constitute mammoths will be short-lived. Indeed the rationale for what we are currently observing could be found in the results of X-inef®ciency studies and the hypothesis that size is the by-product of the process by which the market enforces managerial ef®ciency; divestment and refocusing will then follow. We may also be witnessing the consequences of economies of scale in some speci®c line of business ± investment banking, where only a few global players are likely to survive, is the prime candidate, asset management is another, more doubtful one. Again, the divestment of non-core businesses will follow the consolidation phase, designed to achieve the required size in investment banking or asset management.

218 Is Bigger Really Better?

If size itself emerges as a trump card for banking concerns, this will be for reasons not currently supported by academic research and the lessons will be farreaching. They may have to do with the Internet (whose impact on the industry is cloaked in uncertainty), with a new role for brand names in banking (a development we have not witnessed so far) or possibly with economies of scope between investment banking and commercial banking, coupled with the requirements of a global presence in the former. The nature of these economies of scope are well understood but attempts to exploit them have always failed, and to this day the problems inherent in merging different corporate cultures and managing huge organisations have systematically prevailed. Notes 1. This chapter relies heavily on, and at times borrows from, research coauthored with Francesco Giavazzi, Ernst-Ludwig von Thadden and Xavier Vives; see in particular Danthine et al. (1999) and Danthine et al. (2000). While entitled to my deep gratitude, they are in no way responsible for the opinions expressed here. 2. Berger, et al. (1995) 3. The ®gure on the net reduction in the number of US banks understates exit from the industry. During the same period, 3111 new US commercial banks entered the industry. The data are from Berger et al. (1995). 4. See Rhoades (1996.) 5. This is particularly true in terms of value, less so in terms of the sheer number of transactions. 6. See Diamond (1984). Cerasi and Daltung (1996) show how diversi®cation in a debt®nanced bank lessens the agency problem and improves the incentive of a banker to monitor projects when internal agency problems put limits on the size of a bank. 7. Danthine et al. (1999) argue that diversi®cation possibilities are better in European countries than in the US. The gains from international diversi®cation are superior, however, and it is therefore dif®cult to rationalise large intra-country-mergers if risk diversi®cation is the only or main motive for consolidation. 8. Bauer and Hancock (1995) found that the (real) cost of processing an electronic deposit for an average American bank fell by 85 per cent between 1979 and 1994.

References Allen, L. and A. Rai (1996) `Operational ef®ciency in banking: An international comparison', Journal of Banking and Finance, vol. 20, pp. 655±72. Bauer, P. W. and D. Hancock (1995) `Scale economies and technological change in Federal Reserve ACH payment processing', Federal Reserve Bank of Cleveland Economic Review, vol. 31. Berger, A. N., R. S. Demsetz and Strahan, P. E. (1995) `The Consolidation of the Financial Services Industry: Causes, Consequences, and Implications for the Future', Journal of Banking and Finance, vol. 23, pp. 135±94. Berger, A. N., A. K. Kashyap and J. M. Scalise (1995) `The transformation of the U.S. banking industry: what a long, strange trip it's been', Brookings Papers on Economic Activity, 2 (Washington, DC: Brookings Institution). Berger, A. N. and L. J. Mester (1997) `Inside the black box: What explains, differences in the ef®ciencies of ®nancial institutions?', Journal of Banking and Finance, vol. 21, pp. 895±947.

Jean-Pierre Danthine 219 Black, F. and M. Scholes (1973) `The pricing of options and corporate liabilities', Journal of Political Economy, vol. 81. Cerasi, V. and S. Daltung (1996) `The Optimal Size of a Bank: Costs and Bene®ts of Diversi®cation', London School of Economics, Financial Management Group, Discussion Paper no. 231, London. Danthine, J. P., F. Giavazzi, X. Vives and E. L. von Thadden (1999) The Future of European Banking, Monitoring European Integration 9 (London: CEPR). Danthine, J. P., F. Giavazzi and E. L. von Thadden (2000) `European Financial Markets after EMU: a First Assessment', DEEP working paper (University of Lausanne). Diamond, D. (1984) `Financial intermediation and delegated monitoring', Review of Economic Studies, vol. 51. Hughes, J. P., W. Lang, L. Mester and C. G. Moon (1996) `Ef®cient banking under interstate branching', Journal of Money, Credit and Banking, vol. 28. Hughes, J. P., W. Lang, L. Mester and C. G. Moon (1998) `The dollars and sense of bank consolidation', Working Paper 10, Federal Reserve Bank of Philadelphia. Merton, R. C. (1973) `Theory of Rational Option Pricing', Bell Journal of Economics and Management Science, 4, Spring 1923, pp. 141±83. Neven, D. and Th. Von Ungern-Sternberg (1998) `The competitive impact of the UBS±SBC mergers', Chaiers de recherches eÂconomiques du DEEP 9805 (Universite del Lausanne). Rhoades, S. A. (1996) `Bank Mergers and Industrywide Structure, 1980±94', Staff Study 169 (Board of Governors of the US Federal Reserve System) Washington, DC. Ruthenberg, D. and R. Elias (1996) `Cost economies and interest margins in a uni®ed European banking market', Journal of Economics and Business, vol. 48, pp. 231±49. Saunders, A. (1996) Financial Institutions management, 2nd edn (Burr Ridge, III.: Irwin). Schure, P. and R. Wagenvoort (1999) `Economies of scale and ef®ciency in European banking: new evidence', Economic and Financial Reports, vol. 99, no. 1. Sheldon, G. (1999) `Ef®ciency, competitiveness and the changing structure of European Banking', mimeo (University of Basle). Vander Vennet, R. (1994) `Concentration, ef®ciency and entry barriers as determinants for EC bank pro®tability', Journal of International Financial Markets, Institutions and Money, vol. 4, pp. 21±46. Vander Vennet, R. (1999) `Cost and pro®t dynamics in ®nancial conglomerates and universal banks in Europe', mimeo (University of Ghent, May). Walter, I. (1999) `Financial service strategies in the euro-zone', European Investment Banks Papers, vol. 4, pp. 145±68.

23

Turbulence, Crises and Risk Management Salih Neftci

Introduction Balance sheets are opaque concepts. In more than one way, the individual instruments in a balance sheet have no meaning by themselves. What is more, most large ®nancial institutions carry a very large number of diverse instruments on their balance sheets, in many different branches and subsidiaries around the world. Even a careful analysis of ®nancial tables and balance sheets will not show the exact positions and exposures the ®nancial institution has taken. This is even before one can ask how one would value these positions. Quantitative methods of risk management are perhaps the only reasonable way of assessing the potential losses institutions may face in the event of ®nancial turbulence. In this introduction we illustrate why this is so by discussing the dif®culties of managing risks using non-quantitative approaches. We do this using two examples, both of which relate to options. Options exist in explicit and implicit form. They are often implicit in very common contracts that never draw attention. For example, annuity contracts often contain signi®cant optionality. Another case in point is bonds, most of which usually come with call or put options. Call loans on the other hand, are loans that contain complex implicit options. Looked at from this angle, explicit options that are either written over the counter or traded in organised exchanges are an exception. All these aside, some of the more popular derivatives that have attained a huge volume contain options. Caps, ¯oors and swaptions form the largest part of derivatives books in ®nancial institutions. They are basically options on interest rates. Selling or buying an option appears to an outsider as a very risky activity. After all, the seller of a call on interest rates or currencies faces the (gross) payoff at expiration. The situation of a buyer is shown in Figure 23.1. Clearly it looks as though the trader who is short faces very high risks and may lose unlimited sums if the interest rates move against him or her! Yet this 220

Salih Neftci 221

12

10

8

6

Cs = slope C•

4

• 2

rr0

0

r

Long

r

•

– Cs = slope Short

Figure 23.1 A hedged option position

222 Turbulence, Crises and Risk Management

• r

Figure 23.2 Find result of the hedge

way of looking at option risks is misleading. As soon as a trader sells an option he or she buys an appropriate amount of the underlying asset. For example in this case he or she buys Eurodollar futures, whose value is: Ft ˆ 100…1 � 0:25rt † where rt is the three-month Libor for example. If the contract is entered into when, say rt , ˆ r, then this position looks like the one shown in Figure 23.2. Here the slope of the payoff is 0.25 times the number of futures contracts sold, which in general is equal to C0s =0:25, the slope of the option position at point C0 . Accordingly, if the rt increases by
r then the option position gains by:
Ct =
rt while the futures position loses:
r…Ct =rt † The two quantities are approximately equal, especially if
r is small. This means that the option buyer (seller) has hedged his or her risk. Hence if we look at the balance sheet of this institution we will see a long position in options, which we may think is risky. We will also see a short position in the underlying asset, which we may also ®nd risky. But put together these risks cancel out. Does this mean that the positions are not risky? Nothing could be further from the truth. The option holder faces volatility, or vega risk. If the actual volatility in the market turns out to be less than expected, the trader may lose money. In Figure 23.3 we show a reversal. The trader is long the underlying asset, he is long an at-the-money put and short an at-the-money call. Considered separately, the instruments appear to be very risky and the trader has a high probability of losing money. But put together the position is not risky at all. In fact traders use these types of riskless positions to arbitrage between markets. They will `buy' an instrument and, using appropriate call and put options, `sell' it at a higher price. The spread is their pro®t. Their position is not any riskier than the activity of a new car dealer.

Salih Neftci 223

S′ S0 Sell

S′

Buy

Sr

S0 S′

Figure 23.3 A Reversal

Yet suppose the prices move as in Figure 23.4 and the trader mistakenly sells the put, which has become pro®table. Then the whole position reduces to a short put, which carries unlimited risks. This shows that the closing of a position may affect the risks of other assets in the portfolio.

224 Turbulence, Crises and Risk Management

S′ S0

Final position

Figure 23.4 Final position

How can the institution tell whether such indirect exposures are created by the thousands of transactions carried out on a given trading day? Clearly this is not an easy operation. This chapter discusses the current methods of risk management and provides one answer to the above questions. The chapter is organised as follows. First we describe the main concepts and tools. The next section discusses some standard ways of measuring risk. This is followed by a discussion of the types of assets ®nancial institutions deal with and their relevance from the point of view of risk management. The next two sections deal with the complications that one may encounter when applying these tools, and with the new avenues.

Managing risks Risk management can be seen as having two broad branches. The ®rst, and the one with which we are mainly concerned in this chapter, is market risk management. The second, and equally important, is credit risk management ± we shall comment on this rapidly developing domain as well. We begin by considering a simple example in order to de®ne the basic concepts, which are essentially the same across markets and credit risk management. Consider a default-free zero coupon bond with price B0 with maturity T and yield RT . This could be a treasury bond, or more exactly a STRIP. Because

Salih Neftci 225

the bond is default-free the holder of this instrument is guaranteed to receive 100 units of a certain currency at T, which for simplicity we assume is the US dollar. Assuming that the future default-free short rates are given by …rt ; t ˆ 0; 1::; T � 1†, the arbitrage-free price of this bond will equal:   100 B0 ˆ EP …1 ‡ r0 †…1 ‡ r1 †::…1 ‡ rT�1 † where P is the risk-neutral probability measure. This price can also be written in terms of the corresponding yield: B0 ˆ

100 …1 ‡ RT †T

Here the RT ; rt and the exchange rate, eT , between the US dollar and some relevant variables will alter the value of the asset in question. Market risk has to do with losses that may be caused by changes in these market risk factors. There are in fact three major ways in which changes in risk factors can affect the value of a portfolio. We shall discuss these within the context of the same example. The ®rst effect is the portfolio or asset's delta. The yield, RT , is a random variable and it will change by
RT as time t passes. This change can be large and may cause signi®cant drops in the value of the bond. Taking the standard derivative, the change can be written as:   100
B0 ˆ � T
RT

…1 ‡ RT †T‡1

In a portfolio that has long bonds, the losses will be proportional to increases in RT . This proportion (called the delta of the instrument) will be greater the longer the maturity of the bond, that is, the T:   100

DELTA ˆ � T

…1 ‡ RT †T ‡1 Here we see the ®rst type of market risk, namely the ®rst order price risk of the bond portfolio, and this is clearly caused by random movements in the riskfree yield. The secondary effects of movements in risk factors is the gamma effect. An institution that is long (short) the bond, or some other instrument, may have hedged the delta risk, however. This can be done by selling (buying) T-bonds, T-bills or other appropriate interest rate futures. But in some cases, such as Eurodollar futures, the futures price is a linear function of the interest rates, whereas the bond price is a non-linear function of RT , as can be seen from the formula above. Thus the institution may have exposure to the second derivative with respect to yield:

226 Turbulence, Crises and Risk Management


B20 ˆ 100


R2

T T‡2

T 2 ‡ T

…1 ‡ RT †

This risk is called the gamma risk and is another type of market risk created by the inability of a linear instrument to hedge fully for the nonlinear effects of random changes in the risk factor RT . Note that in this particular case the gamma risk is of the opposite sign to the delta risk. Hence if one has exposure to a particular delta, ignoring the gamma risk will be equivalent to adopting a conservative approach. The third category of market risk is more complicated. If the yield, RT , remains the same, the price, B0 , does not move from one period to another:
B0 ˆ 0 Yet, suppose the volatility of RT changes. Then any institution that has taken a position in default-free options written on this bond may suffer losses. In this case, although the price of the bond remains the same, the price of the corresponding options may move adversely. Letting F…RT ; t† denote the price of these options at time t we have:
F ˆ F
T where T is the volatility of the yield, RT . This is another major form of the market risk called the vega risk, where vega is given by: Vega ˆ F This illustrates the main forms of market risk, which consist of the changes in the ®rst and second order movements of market risk factors as well as by random changes in the volatilities associated with these market risk factors. Hence there are potentially two sources of randomness, one emanating from the market risk factors, the other from the corresponding volatilities. This distinction is subtle and non-trivial for an institution with options books, even though the two sources of randomness will eventually be present in a history of observed data on market risk factors. Credit risk Credit risk management proceeds along similar lines to a certain point, but then major differences (and dif®culties) emerge. We use the same example discussed above. First we need to consider a zero-coupon bond with non-zero default probability. Let the price of this bond, with maturity T, be B0 and denote the risk yield as RT . This new bond is issued by either a corporate credit, a sovereign credit or an international bureacracy. As a major departure from the previous case, because the bond is now defaultable the holder of this instrument is not guaranteed to receive 100 units of currency at maturity T.

Salih Neftci 227

Hence we now have the corresponding variables of interest: RT ˆ RT ‡ sT rt ˆ rt ‡ st where …st † denotes the important notion of credit spreads. Note that in addition to the term structure of default-free yields, RT , we now have a term structure of credit spreads, sT . The price of this bond is given by:   Y…X† B0 ˆ EP  …1 ‡ r0 †…1 ‡ r1 †::…1 ‡ rT�1 where P is the same risk-neutral probability measure as before, and Y(X) is the payoff at maturity. Unlike the case of the default-free bond, the value of this payoff is not constant at 100 and depends on a variety of random events, summarised by the vector X. We thus have:  100 if no default with probability p Y …X† ˆ f …X† if the bond defaults with probability 1 � p where f(X) is called the recovery value. This price can again be written in terms of the corresponding yield: B0 ˆ

^† Y…X …1 ‡ RT †T

^ ) is the expected payoff at maturity. where Y (X Clearly this setup is quite similar to that which we had before, except that we now have two different risks in the risk factors RT ; rr ; et , namely default-free risk factors plus the credit spreads (st ). The notions delta, gamma and vega can be de®ned for credit risk factors as well, but it is customary to separate these two branches of risk management.

Portfolio aspects Before we can de®ne the notion of value-at-risk (VaR) we need to add some portfolio aspects to the de®nitions above. We assume that there is no credit risk and concentrate on market risk. We complicate the setting and deal in continuous time, t. There are now two assets, whose prices at time t are given by F1t and F2r . These assets depend on three market risk factors, Xt ; Yt ; Zt . The dependence on market risk factors is written in a speci®c form: F1t ˆ F1 …Xt ; Yt † F2t ˆ F2 …Xt ; Zt †

228 Turbulence, Crises and Risk Management

The market risk factors are stationary random variables with a joint distribution function, f(X, Y, Z), which is not necessarily normal but is time independent. Again for simplicity, suppose market risk factors are serially uncorrelated and uncorrelated with each other across time. They can, however, be correlated contemporaneously. We can de®ne portfolio Pt as a linear combination of these two assets: Ft ˆ 1 F1t ‡ 2 F2t 1 , and 2 are portfolio weights. They may depend on the partial derivatives of Ft . Short selling is allowed, and portfolio weights can be negative. As t changes the price of the two assets will ¯uctuate randomly around a (time dependent) mean. Such ¯uctuations are caused by random changes in the risk factors. Thus in order to proceed further one needs to assume some dynamics for the risk factors. In continuous time the risk factors are assumed to follow the stochastic differential equations given by: dXt ˆ aX …Xt ; t†dt ‡ …11 dW1t ‡ 12 dW2t ‡ 13 dW3t † dYt ˆ aY …Yt ; t†dt ‡ …21 dW1t ‡ 22 dW2t ‡ 23 dW3t † dZt ˆ aZ …Zt ; t†dt ‡ …31 dW1t ‡ 32 dW2t ‡ 33 dW3t † Here …ij ; i ˆ 1::3; j ˆ 1::3† are the variances and covariances of new sources of randomness represented by Wiener processes …W1t ; W2t ; W3t †. We can form the covariance matrix using the restriction: tj ˆ ji A major task in risk management is estimating or calibrating the values of these parameters. Starting from the dynamics of risk factors, using Ito's lemma we can obtain the dynamics of the asset prices. For example for F1t we obtain:  dF1t ˆ F1X dXt ‡ F1Y dYt ‡

 1 1 F1XX x2 ‡ F1YY y2 ‡ F1t ‡ F1XY x y dt 2 2

and similarly for other assets. It is important to emphasise two points. First, the partials …E1x ; Fiz ; Fty ; i ˆ 1; 2; 3†, are nothing other that the deltas mentioned earlier. The …Fixz ; Fixz ; Ftyy ; i ˆ 1; 2; 3† are the corresponding gammas, but the vegas are not present in this equation. This is due to an assumption that the new randomness in risk factors can emanate only from the additive Wiener processes and ij is random to the extent that it depends on the risk factors only.

Salih Neftci 229

Measuring the risks of a balance sheet Value-at-risk (VaR) is the amount of money an institution can lose on its trading portfolios during a given time period and in rare circumstances. In order to calculate VaR a reference period needs to be de®ned and the meaning of a rare event has to be quanti®ed. Let  be the probability that movements in risk factors will cause a loss larger than the capital currently set aside by the institution. Then, value-at-risk at  con®dence level is given by the (time dependent) upper bound K such that: Prob…
Pt  K † ˆ  where 0 <  < 1. For example suppose we chose,  ˆ 0:01% then, during 99 per cent of the time periods speci®ed by
, the decrease in the portfolio's value will be below the critical limit K . Hence, if the institution holds K units of capital, for 99 per cent of the time there will be suf®cient money to cover the losses. In other words, the portfolio holder will not lose more than its capital 99 out of 100 days if
is selected as 1 day. How to calculate the VaR We begin the discussion of VaR calculations using the example of the risk-free bond introduced in the previous section. Suppose the balance sheet of the institution consists of N dollars' worth of the T period default free bonds B0 discussed earlier. We know that a movement in the relevant risk factor RT will translate to a change in value given by:   100
B0 ˆ � T
RT

…1 ‡ RT †T‡1

In order to obtain the VaR we need to implement the following steps: 1. First, de®ne what a `rare' day is. Let  ˆ :01. This means that we would like to have enough capital to cover losses that occur on 99 per cent of the trading days. 2. Next, we need to obtain the critical level K:01 . To do this we need to have the probability distribution of
RT ®rst. This can be done in two ways.  We can either assume a model for the relevant probability a priori,  or estimate this density in a non-parametric way. We will return to non-parametric methods later. We will proceed by

230 Turbulence, Crises and Risk Management

selecting a closed form, parametric model. Assume that
RT is distributed normally with:
RT  N…;  2 † where  is the volatility of the risk factor. Once the assumption of Normality is made, we use the equation Prob…
Pt  K:01 † ˆ :01 to determine the K:01 . We know from standard normal tables that: K:01 ˆ 2:79 Given the , we can get a value for the critical loss level K:01 3. The next step is the estimation of . This can be done using appropriate econometric methods. 4. Having obtained the Ki:01 , the VaR of the bond portfolio will be given by: h 100 K:01 V a R ˆ �N T …1‡R †T ‡1 T

Or, we write this is the form: h i 100 V a R ˆ �N T …1‡R 2:79^ †T ‡1 T

the ^ being the estimated volatility. Note what this last equality says. In order to obtain the VaR, we use the delta and multiply this by a critical level that de®nes a particular tail of the distribution for the risk factor
RT .

Volatility dynamics and VaR VaR calculations can be made signi®cantly robust by taking into account second order effects and by working with non-parametric densities instead of standard distributions. The modi®cations that would incorporate the gamma effects are straightforward and do not require a recalculation of the variances and covariances. The complications introduced by volatility estimation are much more subtle, but can also be handled reasonably well in many cases. In fact, one can use non-parametric estimates of volatilities and signi®cantly broaden distributional assumptions. Non-parametric volatility Suppose rt represents a risk factor that obeys the SDE: drt ˆ …rt ; t†dt ‡ …rt ; t†dWt where Wt is a Wiener process. We can assume that the drift and diffusion functions are general functions of rt . We can, for example, use a generalized

Salih Neftci 231

parametric speci®cation and de®ne the general drift and diffusion components as: …r; t† ˆ 0 ‡ 1 rt ‡ 2 rt2 ‡ 3 =rt …r; t† ˆ 0 ‡ 1 rt ‡ 2 rt 3 and then try to estimate the parameters using a continuous time estimation. We can also use explicitly non-parametric methods. In fact, the density function can be estimated directly using Kernel estimation. De®ning a Kernel function by K…u† and assuming a standard Normal Kernel, we can estimate the non-parametric density directly: f …xi † ˆ

N 11X xi � ri K… † bn n bn iˆ1

where, the {ri } denotes the observed values of the risk factor, the xi is the point at which we want to estimate the density and where K…u† is the Kernel function: r 1 �1u2 K…u† ˆ e 2 2 The parameter bn controls the window of the Kernel and is a critical number that may not be very easy to select. The f (x) obtained this way will resemble a smooth histogram that can be used in place of the known closed form probability models such as Normal, Student's-t, F and so on. It is known that the Kernel estimator has good properties, that it is not sensitive to the type of Kernel one is applying. The selection of bn , is on the other hand fairly critical. The Kernel density estimated this way will provide an alternative to obtaining the K parameter. In fact, once the density of rt is estimated by Kernel methods, the K used in VaR calculations can be determined by: Z



K

f …x†dx ˆ 

With given , this is one equation, in one unknown K . K having been obtained this way, we can then let: V a R ˆ N…delta†Ka : Clearly this way of proceeding is not dependent on restrictive functional forms. Instead, the probability distribution is obtained directly from the observed sample. This approach may go a long way to answering many criticisms that can be raised against the standard VaR calculation. But, it still does not answer at least one critical issue.

232 Turbulence, Crises and Risk Management

The vega risk Empirical work indicates that volatilities of ®nancial data exhibit signi®cant time-variation. Equally importantly, the correlations across risk factors are also likely to change suddenly. If this is indeed the case, then VaR calculations used in the standard approach, and discussed above, may be quite inaccurate depending on the extent and acuteness of movements in volatility, and correlation parameters. There are several possible ways one can model such time-varying volatility, and improve the VaR estimates. GARCH models, are time series models that allow volatilities to change depending on observed shocks and on the past volatilities. A simple GARCH(1,1) is given by: t2 ˆ 0 ‡ 1 t2�1 ‡ 1 t2�1 where t2 is the variance of the relevant risk factor, and the t is a shock, or disturbance. However, GARCH models introduce rather restrictive dynamics into the volatility. The non-linearity is `mild' in the sense that the serial correlation in the volatility will be linear. Sudden correlation and volatility changes cannot be accommodated. Also, GARCH models impose a symmetry on the up-and down-side movements. Extreme market optimisms would be modelled the same way as extreme market pessimisms. Volatility and correlation parameters not only change over time, they may change suddenly and by large increments. These changes can also be asymmetric, in the sense that volatility may go up suddenly, yet it may go back to normal only gradually. The LTCM example is a case in point. Some of these obstacles can be overcome by generalizing the GARCH even further. For example, such models permit more general non-linearities and asymmetries to be introduced in volatility dynamics. In place of the simple GARCH (1,1) model introduced above we can write: t2 ˆ 0 ‡ 1 ‰1 t�1 ‡ 2 t�2 Š2 and we can let the data tell us what the parameters i ; i are. Because this model allows for the cross-product of t s to affect the system without violating the non-negativity constraint, it will permit modelling asymmetric behaviour in asset price volatilities. It is also more likely to generate sudden jumps than a GARCH (1,1) model would allow for. However, these more complicated volatility dynamics would be lacking in one important aspect. The vega risk that we discussed above cannot be fully captured by the above models. It turns out that the volatility parameters may vary because they may have random components speci®c to themselves.

Salih Neftci 233

Stochastic volatility models To be more satisfactory, volatility needs to be modelled as a continuous time stochastic process: dt ˆ a…t ; t†dt ‡ b…t ; t†dVt where Vt is another Wiener process, possibly correlated with the original Wt , and where the a(.) and b(.) are the drift and volatility parameters of the  itself. To preserve non-negativity of volatilities one can adopt the mean reverting model and use: dt ˆ … � t †dt ‡ t dWt Here,  will represent long-run mean and the  will be the adjustment rate of volatility observed as of time t, to this long run mean. The problem with this type of volatility movement is more severe than the other issues raised. If the volatilities under consideration are stochastic, then in current global conditions, we have incomplete ®nancial markets and arbitrage pricing cannot be applied. Another way of putting the same issue is to say that with stochastic volatility, we may not have the necessary instruments to hedge our positions. Clearly, the VaR approach would then need to be modi®ed to take into account this important point. In fact, the latest ®nancial upheaval may be an example of such stochastic volatility and may show the vulnerability of the standard approach.

Another tool: extreme value theory We begin by considering some simple facts about exchange rates. When we study continuous time data, we see considerable evidence concerning: 1. Signi®cant time variation in volatility, something that we already discussed above. 2. Leptokurtic behaviour of Log-differenced exchange rate data. This effect is very strong. For example, daily data on $/DM has a kurtosis coef®cient around 13. Monthly data gives 4.2. These ®gures are considerably above the Normal, which should be 3. 3. An inverse relationship between excess kurtosis and the length of the holding period, a point which is quite important to a risk manager, since risk is supposed to be managed daily. 4. Some skewness that may exist in daily exchange rate data. Of these characteristics, the most important seems to be Leptokurtic behaviour, which indicates that the performance of the risk factors may be farther away from Normal distribution, especially at the tails. The extreme

234 Turbulence, Crises and Risk Management

value theory and the tail estimation may provide one answer to these problems. We now turn to exchange rates. Let, Pt be the exposure to an exchange rate xt , and let the Ht�1 ˆ fdx1 ; . . . :; dxt�1 g be the History of percentage exchange rate changes observed until time t � 1. Exchange rate is assumed to be the only risk factor. The capital that one needs to put aside for this exposure will be calculated as in the standard approach, using VaR formula: Ct ˆ H  Pt where H can be calculated parametrically or non-parametrically using the frequency distribution implied by Ht�1 . This was discussed earlier. There are two possible problems here. First, the behaviour of extremes may not be similar to that of data during normal times. That is to say, there may be a structural breakdown as we observe more and more extreme values. Second, the standard calculation of H will not take into account the probability of extremes that have yet to occur. Application of extreme value theory may improve the results in both of these accounts. For example, Generalized Pareto Distribution provides an alternative way of calculating the K used in VaR calculations. Let the random variable x denote an extreme of a relevant risk factor. Then, extreme value theory shows that asymptotically, that is to say, as we observe more and more extreme values, the distribution function of x will be given by: x F…x† ˆ 1 � …1 �  †� 

x0 < x

where  is a distributional parameters and where the 0 <  is similar to the volatility parameter of the standard approach. We can only use the distribution F (.) in estimating the tail of the probability density for a risk factor. From this point we can calculate the K parameter and plug it into the VaR formula. This way of proceeding would avoid mixing extremes and normal values, and hence will be a much more robust estimate of the underlying risk for VaR calculations during rare events. The case of extremes that have not yet occurred can also be handled in a more satisfactory way with this theory. There are two possible ways of proceeding. One can impose Bayesian priors on the extreme value distributions, and hence include in VaR calculations the possibility of as yet unobserved extreme movements, or one can use cross section data in estimating the VaR. Some problems Application of extreme value theory to risk management is not without problems. Without going into the details, we brie¯y describe some of these.

Salih Neftci 235

First, there are some outliers in continuous time forex data that are due only to reporting errors. Information providers and banks do not pay much attention to storing past data. If data errors have not been resolved, this may present signi®cant problems for applications of extreme value theory. Clearly such data have to be eliminated, but how do we chose which outliers are erroneous and which are true extremes? Second, because we are dealing with extremes, by de®nition extreme value theory may have to be used with small numbers of observations. This makes inference more dif®cult.

Conclusion There is no doubt that VaR and associated methodologies constitute a signi®cant leap forward compared to the traditional descriptive methods used by risk managers only ten years ago. Yet, there is still a long way to go if we consider managing risks associated with big ®nancial crises, rather than daily measurement of value at risk. Most of the characteristics one associates with ®nancial crises violate the basic assumptions of standard risk management tools. Fortunately, new tools are emerging. Extreme value theory and volatility dynamics are two such avenues. References 1. Ait-Sahalia, Y., 1996 `Non-Parametric Pricing of Interest Rate Derivative Securities,' Econometrica. 2. JP Morgan, 1996, `CreditMetrics', Technical Document. 3. Duf®e, D. and Pan, J., 1997, `An Overview of Value at Risk', The Journal of Derivatives. 4. Edwards, F. and Neftci, S. 1989, `Extreme Movements in Futures Prices', Journal of Futures Markets. 5. Embrechts, P., Kluppelberg, C., Mikosh, T., 1997, Modelling Extremal Events, Springer. 6. Jorion, P., 1997 Value at Risk, Irwin. 7. Pickands, J., 1975, `Statistical Inference Using Extreme Order Statistics', Annals of Statistics. 8. `RiskMetrics', 1996, Technical Document, 3rd edn.

24

The Quest for the Optimal Portfolio: The Example of Investment Funds Nils Tuchschmid

The assets managed by the investment fund industry have grown considerably since the 1970s. Consider the example of equity mutual funds in the US, which represented some $37 billion in managed assets in 1976 but in early 1990 exceeded $166 billion. Switzerland has experienced the same phenomenon. From a modest CHF 20 billion in managed assets ± including funds domiciled in Luxembourg ± in 1988, the total capitalisation of Swiss investment funds amounted to more than CHF 160 billion in 1994. This trend has not yet stabilised. The CHF 77 billion invested in Swiss investment funds at the end of 1991 had increased to more than CHF 320 billion by the end of 1998, which corresponds to an annual growth rate of more than 20 per cent. This trend, has not been limited to Switzerland and has affected all ®nancial markets, including the US, in spite of the strongly rooted equity culture among the general American public. At the end of 1998 over 30 000 funds were managing total assets of almost $9200 billion. The reasons for this resounding success are easy to understand. The investment fund industry perfectly illustrates the advantages of ®nancial intermediation. All parties involved bene®t from allowing market access to smaller investors: ®nancial intermediaries are remunerated for their services, while investors gain access to new investment opportunities that would otherwise be unavailable to them. This simple acknowledgement explains the fund industry's success and justi®es the existence and activity of ®nancial intermediaries. If one combines that with a strong overall stock market performance in recent years (crashes notwithstanding), widely reported even in the mainstream media, it is easy to understand why investment funds keep attracting new investors eager to make pro®ts. Does this mean that this growth in managed assets will continue in a market where performance seems to be essentially driven by new fund offerings unconditionally accepted by avid investors? Obviously it would be too straightforward to answer in the negative by simply stating that, as available savings are limited, the same is bound to apply to consumer demand for investments. That is not the aim of this chapter. 236

Nils Tuchschmid 237

Indeed there are a lot of other reasons for believing that this industry is currently enjoying its golden age and that it will have to change in the coming years. Investment funds, as we know them today, are successful for two predominant reasons. First, the cost of market access is often prohibitive for small investors.1 Second, the costs of acquiring and processing information are always high, both for assessing the credit rating of securities issuers and for monitoring and managing portfolios.2 However everything seems to indicate that the importance of these two factors will decline over time. Therefore the need to develop and sell standardised products, such as investment funds, is also likely to diminish. The latter observation is reinforced if one notes that the famous concept of `market portfolio', which often serves as a theoretical justi®cation of the fund industry, can easily be thrown off balance.3 The structure of this chapter is as follows. Based on modern ®nancial theory we ®rst review the importance and interest of investment funds in portfolio management. We then discuss the inherent limitations of these standardised products, illustrating them with a few simple but telling examples. Finally, referring by analogy to the development of ®nancial derivatives, we demonstrate the need for new portfolio management techniques to meet each investor's speci®c requirements. In this context the current structure of investment funds should appear obsolete or, at the very least, inef®cient.

Investment funds and portfolio management: some theoretical justi®cations Our aim is not to analyse in a few lines the investment fund industry from the viewpoint of ®nancial intermediation, the advantages of which were brie¯y considered above. Intermediaries are known to be the best agents for handling the needs of small investors because they are better positioned to deal with asymmetrical information problems and they bene®t from substantial economies of scale. However, beyond the scope of the investment-fund industry, this argument equally applies to all areas of ®nance, be it corporate or market-related. If one is seeking to establish a clear and speci®c theoretical justi®cation for investment funds, modern portfolio theory appears to be a natural reference point. Indeed one can ®nd very few examples in ®nance where the development of an economic activity is so closely correlated to a purely theoretical concept. To demonstrate this we can brie¯y restate the well-known mean-variance criterion developed by Markowitz. According to this universally acknowledged criterion the investor seeks, for a given level of expected return, to minimise the risk of the portfolio, measured by the standard deviation of returns. By applying this approach to all possible or required levels of expected return it is possible to derive the famous `ef®cient frontier', along which, starting from the minimum variance portfolio, we can ®nd all combinations of assets, that is, all the portfolios that can be rationally selected.

238 The Quest for the Optimal Portfolio

More precisely, and based on this normative criterion, investors are able to de®ne, for every level of expected return, the combination of ®nancial assets that should be contained in a portfolio in order to minimise its risk exposure. Where, however, is the link between the result of this model and the investment fund market? One could imagine that each point on the ef®cient frontier corresponds to an existing investment fund with a return pro®le that matches the requirements of a speci®c investor. However this representation is obviously erroneous, although it is true that by de®nition an investment fund is a portfolio, since a fund must satisfy the requirements of the greatest possible number of investors. In other words one should be able to achieve various return and risk pro®les on the basis of a few funds common to all investors. In fact, even though the evidence is not immediately striking, the development of the mean-variance criterion enables us to justify the use of investment funds for asset allocation purposes. Indeed it can be mathematically demonstrated that it takes only two ef®cient portfolios to reproduce the frontier in its entirety.4 In other words, only two ef®cient investment funds would be required in the market to manage investor portfolios and reproduce all investment opportunities, corresponding, in the present case, to all ef®cient portfolios. This reasoning may, however, be taken further by referring to the famous separation theorem developed by James Tobin in 1958, which clearly offers the required analytical framework. To do so we shall revert to the meanvariance criterion and assume the existence of a risk-free asset. The investor's choice now lies between his or her portfolio, situated on the initial ef®cient frontier, and a risk-free investment. By slightly formalising our argument we can characterise the investor's behaviour by postulating that the latter seeks to maximise the utility function of his or her ®nal wealth, as described by the following formula: ~ † ~ Š � A Var…W Max ˆ E‰W 2 N where E[.] is the operator of expectation, Var(.) symbolises the level of variance and A is the parameter measuring the investor's risk aversion.5 By de®nition the level of wealth at the end of the period will be: ~ ˆ N 0 P~ ‡ …1 ‡ Rf †m W where N is the vector in which each element is the number of risky securities held by the investor, P is the vector of the end-of-period values of these risky (stochastic) securities and m is the amount invested at the risk-free rate of return, Rf Once the utility is maximised, subject to the budget constraint de®ned above, it is possible to derive the optimal demand for risky assets: Nˆ

1 �1  … � ‰1 ‡ Rf ŠP† A

Nils Tuchschmid 239

where  is the variance-covariance matrix and  is the vector of expected prices (E[P]). One can thus observe that the composition of a portfolio made up of risky ®nancial assets is independent of the agent's preferences. Only the fraction of wealth invested in the portfolio depends on the investor's speci®c risk aversion. To make this argument clear we need only to consider the ratio of optimal demands between two ®nancial assets, Ni =Nj In the latter the investor's risk-aversion parameter has disappeared. In other words the relative weighting of two assets is not determined by the investor's tastes. The portfolio is therefore universal insofar as the portfolio is the same for all investors. Only the proportion of wealth that the latter agree to invest in it will depend on their attitude towards risk. Graphically, the remarkable aspect of Tobin's result lies in the fact that the ef®cient frontier becomes a simple straight line, which simpli®es to the extreme the issue of asset allocation. In order to be located on any given point along the ef®cient frontier, an investor merely needs to distribute his or her wealth over two funds: the risk-free asset and the `tangent' portfolio, namely the portfolio located on the old frontier at the intersection with the new ef®cient frontier, the composition of which is directly derived from the previous result and equal to6 �
�1  � ‰1 ‡ Rf ŠP As with our initial result, we observe that two funds are suf®cient to reproduce the set of investment opportunities offered in the ®nancial markets. How, then, is it possible to reconcile the separation theorem with the fact that there are thousands of investment funds? Even if we disregard simple market competition, how is it possible to say that a single company will offer dozens of different funds, from equity funds to bond or money-market funds, not to mention real estate funds or funds-of-funds, when two funds are apparently enough? Again, ®nancial theory offers an explanation. By somewhat generalising the separation theorem we have to recognise that the tangent portfolio contains all available ®nancial risky assets. If, in the extreme, we wish to reason in terms of market equilibrium and admit that investors' expectations are homogeneous, the latter will invest part of their wealth in this tangent portfolio, which in this context will automatically become the famous market portfolio.7 The latter is thus composed of all assets making up the economy. Every investment fund could thus be considered to represent a fraction of this market portfolio and investors, by distributing their savings over each of these funds, will only synthetically reproduce it. Obviously the two funds separation theorem might seem restrictive in that the derivation of the result is based on too simplistic a hypothesis. However, it is possible to generalise the result and imagine, for example, a process generating returns for ®nancial assets characterised by K-factors. In this case all investors will hold a combination of K-funds, excluding their investment in the risk-free asset. Hence even if the problem lies in the determination of these

240 The Quest for the Optimal Portfolio

K-factors, the principle remains unchanged in terms of portfolio management.8 In any case ®nancial theory offers, from the simplest approach to the most sophisticated models, a clear and precise justi®cation of the existence of investment funds. To manage a portfolio by means of a few standardised investment funds would indeed enable the reproduction of all investment opportunities and the construction of the optimal portfolio for each and every investor.

The investment fund industry: the end of the golden age? As mentioned above, investment funds are without doubt generators of added value. They allow market access to investors who would otherwise be prevented from investment opportunities, and they offer a professional asset management service to individuals who do not have the required infrastructure to monitor their investments. We have also noted that it is always possible to replicate all investment opportunities by means of a limited number of portfolios. Investment funds thus perfectly illustrate the separation concept enabling each investor, according to his or her desired level of market-risk exposure, to distribute his or her wealth over the various funds offered by investment professionals. Does this imply that the investment fund industry will last or even continue to prosper in its present form? In fact, as stated in the introduction to this chapter, everything seems to indicate the contrary. To state that this industry is currently at its peak and will be subject to fundamental changes in the medium term does not seem particularly far-fetched or even bold. To justify this statement, we do not propose to use the somewhat commonplace argument of repeated absence of effective performance, namely that with an equivalent risk exposure, investment funds cannot systematically generate returns that are higher than those of a reference index. Indeed, although this argument seems to be empirically veri®ed, it will not automatically motivate investors to ¯ee such investment vehicles as long as the achieved performance is in line with the stated objectives. Neither do we propose to highlight the lack of transparency that prevents investors from knowing the precise level of market risk the fund is exposing them to. It can indeed be observed that the classi®cation of funds into different management types, such as growth or income funds, does not constitute a reliable source of information.9 Stated differently, knowing a fund's `category' does not permit identi®cation of its asset management style. Consequently it is dif®cult for investors to know which product they are buying and in which market(s) they are effectively investing. This argument pleads in favour of simpli®ed access to information, but it does not really question the usefulness of investment funds. Finally, we shall not base our reasoning on the fact that it is always dif®cult, if not impossible, to quantify and compare the effective costs inherent to different funds. In the absence of a clear and universal standard of

Nils Tuchschmid 241

presentation, even careful investors are faced with a dif®cult choice. Again, this is open to discussion, but it will not weaken the investment fund industry. To justify the thesis of an in-depth change the argument needs to be of another order. In fact we believe that the investment fund market will have to change radically or disappear simply because portfolio managers will have to match investors' requirements as closely as possible, and that it will be dif®cult to do so by means of the investment funds currently available. Indeed it is highly improbable that determination of an optimum investment policy could simply involve `distributing' the pro®le of each investor, according to his or her risk aversion, along an ef®cient frontier in order to select adequate funds: growth funds on one side of the frontier for those investors willing to bear the market's risks, and bond or money-market funds on the other side for risk-averse clients who ®nd the returns offered by a simple savings account insuf®cient. Of course this analysis, based on the ef®cient frontier concept, is not wrong even when simpli®ed to the extreme. In a certain sense we are merely reiterating the points developed previously. Investment funds enable clients to invest in different classes of ®nancial asset and the allocation of their wealth depends on their speci®c attitude towards risk. However this analysis is based on a number of implicit arguments. In particular it is grounded on the crucial but often neglected hypothesis that the market is not only perfect but also complete.10 The assumption of completeness thus implies that the investor's wealth is subject to no other source of risk than that of the market. This perception is not only simplistic, it can also lead asset managers to offer investment funds that are at complete odds with their clients' actual needs in terms of their risk/return pro®les. In fact even without admitting the existence of idiosyncratic risks it is easy to demonstrate that classical asset-allocation solutions are often far from optimal. To do so we merely need to assume the existence of a source of risk other than, and correlated to, that inherent to ®nancial markets. Two examples should be enough to illustrate this point. Let us consider the case of a young dynamic executive employed by a pharmaceutical company. He has accrued suf®cient savings to consider investing them in the ®nancial markets. In view of his young age it is very likely that he will be advised to invest a substantial part of his assets in an equity fund because he can expect an interesting long-term rate of return with minimal risk exposure. If the reference currency is the Swiss franc, it is almost certain that these assets will be invested in a Swiss equity fund. Obviously this allocation strategy can be criticised on several counts. First, a long-term investment in equities is neither automatically more pro®table nor less risky than an investment in bonds or other classes of ®nancial asset.11 Second, the investor is exposed to the pharmaceutical industry's substantial risks. More precisely, the investor is now subjected to two sources of risk: one derived from his ®nancial investment and the other related to his employment income. Unless his salary is guaranteed

242 The Quest for the Optimal Portfolio

for life, it can be reasonably stated that the main source of risk for this investor comes from the sector in which he works. The investment proposed by his ®nancial advisor therefore compounds the investor's risk exposure, as market risk is inherent to the pharmaceutical sector.12 Put differently, the portfolio is clearly not well diversi®ed if we reason in terms of the investor's total wealth, namely when we include human capital in the reasoning, where human capital is the sum of the present value of future wages. Let us now take the example of an owner of a mortagaged house who has modest savings and would like to invest pro®tably in the ®nancial markets without taking too much risk. Here again we can imagine that this investor will be advised to invest in the bond or money market. If at ®rst sight this strategy appears to be perfectly conventional and risk-averse, it soon becomes clear that it is inadequate. If interest rates were to rise, the bond investment fund would lose value and the interest on the investor's mortgage debt would increase. De facto the investor is twice exposed to interest-rate risk. Of course we can argue that these two examples do not call into question the investment fund industry as such, but rather the asset-allocation policies followed by fund managers.13 Nevertheless it is true that separating investment funds from such asset-allocation issues is increasingly dif®cult, for two reasons. First, funds are frequently chosen when the assets to be invested are deemed insuf®cient, even though the notion of `insuf®cient' has never been clearly de®ned. Second, it has become commonplace for asset managers to involve funds in the management of their investors' assets, even if these investors' wealth is considered suf®cient. Indeed this policy reduces the costs inherent to monitoring investment portfolios and remains widely accepted, provided asset managers put their investors' money into funds directly or indirectly managed by the institutions where the managers are employed. Hence resorting to investment funds seems to be the rule rather than the exception. Based on this statement, standardisation, and in many cases the poor transparency of investment funds, adds to the problems highlighted in both our examples. The use of investment funds makes it impossible or extremely dif®cult to manage a portfolio other than in strict accordance with traditional asset allocation rules. It is therefore the standardised nature of investment funds that, in our view, will force the industry to modify the range of products currently on offer. Indeed the incompatibility between the use of a standardised product and the speci®c needs of an investor cannot easily be resolved. In this sense the investment fund industry is bound to adjust. With regard to adaptation, the derivatives market and its development over time provides the best example of the path the investment fund industry should follow. The 1970s saw the emergence of ®rst-generation standardised products, such as futures and option contracts, the structure of which has remained fundamentally simple. This ®rst wave was followed by secondgeneration products, which may be seen as combinations of the ®rst ®nancial

Nils Tuchschmid 243

derivatives. One could, for example, include swaptions or future options in this category. Than came today's extensive range of structured products, created by ®nancial engineering, which can be viewed as the third generation of derivative products.14 This trend can be easily explained. With the initial standardisation of derivative instruments, markets were able to guarantee suf®cient liquidity and thus reduce transaction costs, while credit risk was minimised or kept under control. As market interest mounted and traders' skills improved, more complex instruments could naturally be introduced. This evolution was made possible by, among other factors, the reduction of costs and the use of technical and quantitative tools to value these instruments, manage their risk and monitor their position. It is therefore possible to imagine that modern portfolio management will follow, in the medium term, a trend comparable to that of derivatives and that the investment fund industry will rapidly be forced to transform itself. Indeed many factors in the ®nancial markets are helping to make this development possible. The relentless reduction in the cost of market access, the progress achieved in information technology, the rise in computing capacity, the availability of adequate quantitative tools and recent developments in ®nancial theory are bound in the medium term, to bring portfolio managers closer to the real needs of investors.15 We can also imagine that this new environment will favour the emergence of new competitors who, with betteradapted work structures, will be able to offer professional asset management services even to modest investors. In this respect the investment-fund and asset-management markets will be radically transformed. The guaranteed income available to some banking institutions by the mere existence of a captive investor base will lose its importance. Soon investors will focus as much on a strategy's cost as on a hypothetical performance. We can indeed imagine that performance will no longer be the determining factor in the selection process since, owing to the speci®c characteristics of asset management, it will already be integrated into the product. Cost and quality will therefore become the only relevant selection criteria. Of course we do not forecast the complete disappearance of standardised investment funds. Nevertheless it seems clear that their importance will diminish over time and only a minority of funds will be capable of remaining in existence. One naturally thinks of funds where the initial investment remains prohibitive for the vast majority of investors.16 One can equally imagine that pure management products, including index funds, will remain important investment vehicles. Indeed, whatever the replication technique used, their risk ± return pro®les are known as their composition exactly re¯ects the risk ± return pro®le of the underlying index. On the basis of these products, asset managers can thus construct any given strategy chosen by their investors. If we revert to our example of the young executive, it is possible to eliminate the risk exposure to the pharmaceutical sector by adding a very

244 The Quest for the Optimal Portfolio

limited number of derivative instruments to the index portfolio. Similarly the use of index funds will enable the establishment of (1) risk ± return pro®les that will meet the requirements of each investor and (2) the creation of highly active sector or country strategies. Owing to their transparency and the clarity of their objectives, these funds will serve as the basis for the development of structured products. Whether these tools will still be known as investment funds or whether they will be transformed into exchange-traded certi®cates will be resolved naturally, depending on the cost imposed by the regulations speci®c to each of these investment vehicles. In any case the nature of the investment fund industry will certainly change profoundly. From opaque funds and uncertain promises, we should see the emergence of adequately pro®led products, where cost minimisation and risk control will be key factors in success. Notes 1. It is worth noting that without suf®cient capital the unitary cost of some stocks jeopardises any attempt ef®ciently to diversify a portfolio. 2. We deliberately neglect a third factor the relative rarity of quali®ed specialists capable of ef®ciently managing investment portfolios. Indeed, if fund management is an economically viable activity, it must inevitably attract the human resources required to meet the demand. More importantly, it is also arguable that as long as end users do not dispose of adequate assessment tools, the lack of suf®cient training among fund managers will be dif®cult to identify. This latter point adds strength to the previous argument. 3. Obviously we do not propose to address this issue exhaustively in a few pages. Rather we shall outline a number of ideas that we hope will be deemed suf®ciently relevant to justify our argument. 4. Strictly speaking this statement is not true if investment constraints, such as shortsale restrictions, are added into the optimisation model. We choose here to neglect this point. 5. We therefore adopt the hypothesis that the investor seeks to maximise a linear function that is growing in terms of mean and decreasing in terms of variance. This function represents an investor who, for example, can be characterised by a negative exponential utility function and whose wealth is normally distributed. 6. It may be noted that this reasoning does not crucially depend on the existence of a risk-free investment. Indeed it can always be assumed that the investor holds a fraction of his or her wealth in an asset that is so liquid as to generate no returns. Given zero or non-stochastic in¯ation, the previously derived result remains the same. 7. The fact that investors have homogeneous expectations does not mean that they all act and invest in the same way. As in the game of roulette, we all have the same expectations regarding the probability of a given result's occurrence, but, we all play differently. 8. One could, for example, consider macro- or microeconomic factors, such as interest rate spreads, industrial production, price-earnings or book-to-market ratios, size and so on. One might also reason in terms of state variables affecting the ®nancial assets' return and risk parameters. We would, however, obtain the same type of separation, with as many replicate portfolios (funds) as there are variables, to which one would have to add the tangent portfolio.

Nils Tuchschmid 245 9. See Brown and Goetzmann (1997). 10. In his speech to the American Finance Association, Sanford Grossman (1995) proposed a very elegant distinction between market completeness, as exposed in the Arrow±Debreu model, and a completely securitised market. However this point is not developed here. 11. See Bodie (1995) for an illustration of this statement. One may also note that if this argument were always true it would raise another question: why do investors still want to invest in ®xed-income assets? 12. This is particularly obvious if one assumes that this investor is a Swiss national and that he will therefore choose an equity fund invested in Swiss stocks, as the weighting of the pharmaceutical sector in the Swiss Performance Index (SPI) exceeds 34 per cent. 13. In particular they highlight a faith in the concept of market portfolio. Indeed, as Grossman (1995) underlines, even if standard valuation models are not really successful in explaining the price behaviour of ®nancial assets, their implications in terms of portfolio management policy appear to remain important and universally accepted. 14. Of course this breakdown is schematic and does not include the successive stages where one range of products replaced its predecessor, and all types of derivatives, from the simplest instrument to the most sophisticated combination, coexist in the markets to this day. The characteristics of the overwhelming majority of current investment funds correspond to those of ®rst-generation ®nancial derivatives. One could possibly categorise umbrella or hedge funds as second-generation instruments. In the case of the former, investors can `navigate' between different markets at apparently very low cost, offering undisputed portfolio management ¯exibility. The latter, if we limit ourselves to their strict hedge-fund appellation, could be considered ef®cient instruments to modulate, in combination with other funds, a degree of risk exposure. 15. Not to mention, of course, the use of derivatives in allocation strategies, allowing the realisation of classical risk ± return pro®les at lower cost. 16. In this category, real estate funds naturally come to mind. One cannot construct a portfolio suf®ciently diversi®ed to eliminate the speci®c risk component without investing a considerable amount of money.

References Bodie, Zvi (1995) `On the Risk of Stocks in the Long Run', Financial Analyst Journal, May/ June, pp. 18±21. Brown, Stephen and William Goetzmann (1997) `Mutual Funds Styles', Journal of Financial Economics, vol. 43, no. 3, March. Grossman, Sanford (1995) `Dynamic Asset Allocation and the Information Ef®ciency of Markets', Journal of Finance, vol. 50, no. 3, July, pp. 773±87. Tobin, James (1958) `Liquidity Preference as Behaviour towards Risk', Review of Economic Studies, no. 67, February, pp. 65±86.

This page intentionally left blank

Part V

Conclusion

This page intentionally left blank

25

Whither Financial Intermediation? Managerial and Regulatory Issues Zuhayr Mikdashi

The ®nancial landscape is undergoing a substantial transformation, with growing cross-border capital movements, ongoing consolidation in the banking and ®nancial services industry, and new functions and methods in ®nancial intermediation. Many factors are contributing to this transformation: the dismantling of certain government restrictions, the acceleration of competition, new customer needs or behaviours, innovations in ®nancial products and staggering advances in information technology. This chapter has two main objectives: (1) to identify, and re¯ect on, the key challenges encountered by decision makers at the helm of ®nancial intermediaries (banks, securities ®rms and insurance ®rms), ®nancial market platforms or channels, and technical infrastructures; and (2) to review important regulatory issues. In particular it addresses selected aspects of competition and innovation, corporate strategies, risk management, mutations in ®nancial markets, public intervention and ®nancial stabilisation.1

Competition and innovation The actors in the ®nancial services industry are becoming increasingly diverse. On the supply side, the so-called traditional banks (notably the deposit-taking institutions) are faced by an array of competitors from various backgrounds: newly established ®nancial ®rms, industrial enterprises that have developed ®nancial functions to cater for third-party needs, information technology and software companies, consumer product distributors and so on. These newcomers have been drawn in by the attractive opportunities in the ®nancial sector and their entry has been facilitated by tumbling entry barriers (Figure 25.1). Barriers to competition consist of multiple factors whose relative importance varies considerably between markets and over time for individual ®nancial products or services. These barriers arise inter alia from scarce talents and skills, expensive technology and infrastructure, differences in culture or business practices, legal±regulatory controls, monopolistic constraints and 249

250 Whither Financial Intermediation? Entry of new intermediaries

Potential barriers: • Scarce talents and skills • Costly technology and infrastructure

• Differences in culture or business practices • Legal–regulatory hurdles • Monopolistic constraints (e.g. on know-how and data flows) • Fiscal burdens

Closeness of substitute

products or services

Market power of intermediaries

Financial space:

Market power of users

Factors in competitive attractiveness*

Transaction terms * See list in main text.

Figure 25.1 The dynamics of competition in a ®nancial space

®scal charges.2 Strategically positioned ®nancial intermediaries can thus impose barriers in the form of onerous conditions governing the transaction of ®nancial operations, and constraints on the ¯ow of know-how or data. A number of factors contribute to a ®nancial space's comparative attractiveness in terms of competition, notably for investors, creditors and users of funds. The principal factors are as follows:

. . . . .

A wide choice of ®nancial products and services. A broad and diverse customer base. Market liquidity. Innovativeness. Proper use of risk management and control techniques.

Zuhayr Mikdashi 251

. . . . . . .

Truthfulness and transparency of key data on accounts and operations.

Ef®cient and strong intermediaries.

Safety nets.

Lively competition.

The availability of high-quality managerial±technical talents and skills.

A sound and effective legal±regulatory system.

Macroeconomic and ®nancial stability.

Several of the foregoing characterise developed market economies, such as

those of the US, Western Europe and Japan.

Traditionally the principal function of banking has been to transform depositors' funds (callable on demand or at short notice and at their face value) into longer maturity loans. The management's expectation is that the longer the maturity of a loan, the higher the interest margin obtainable, other things remaining equal. The banker of the past was therefore essentially a deposit taker and a credit originator, keeping loans until their maturity. Banks have increasingly enlarged the range of their products and services in response to the more diverse and complex needs of the modern economy, and to defend their markets vis-aÁ-vis other enterprises with ®nancial intermediation activities, such as mutual funds, pension funds, insurance companies, brokers/dealers, and department stores or supermarkets that offer ®nancial products. Among the diverse functions that banks currently have, six are very likely to remain important:

. Accepting savings in the form of deposits.

. Originating credit or guarantees.

. Providing payment services and transferring assets between economic

agents.

. Providing liquidity to holders of sight deposits and bene®ciaries of standby lines of credit.

. Identifying, separating, packaging, retaining and selling the components of

risk (the latter is generally de®ned as the uncertainty associated with an event or an outcome). . Providing information, advice and certi®cation on the quality of assets or projects. Innovations in ®nancial products and progress in information and communication technology have promoted business expansion, heightened competition and reduced costs. In the ®eld of ®nancial innovation, derivatives have enjoyed spectacular growth. The value of these ®nancial products is derived from or determined by an underlying asset (stocks, bonds or commodities), a reference rate (interest rates, exchange rates) or an index (re¯ecting the collective value of various ®nancial products or commodities). Standardised

252 Whither Financial Intermediation?

derivatives are usually traded through organised exchanges, while custommade derivatives are privately negotiated and transacted outside the exchanges or over the counter (OTC). Among the recent promising developments are credit derivatives. The latter involve swap and option contracts whose function is to transfer all or a portion of the credit exposure of a ®nancial asset over its lifetime (or a shorter period), while the institution buying the protection retains the title of the asset, thereby maintaining the existing relationship of lender± borrower. A standard `master agreement' has been issued by the International Swaps and Derivatives Association (ISDA) to facilitate OTC or exchange-traded transactions. One example is `credit default swap', in which the buyer of total protection receives the face value of a debt upon default by the borrower,3 or the so-called `credit event' (Figure 25.2). The buyer of the protection is insured against the credit event (default) by paying a premium (a lump sum or ®xed periodic payments) of the loan's face value to the seller of the protection. PROTECTION SELLER

PROTECTION BUYER Bank A

Premium paid: x basis points of N

Agreed payment upon

credit event (i.e. default

on the reference asset N)

5 year note N

Loan

Reimbursement of

principal + interest

CORPORATE BORROWER

Figure 25.2 Credit default swap

Bank B

Zuhayr Mikdashi 253

When appropriately used as coverage instruments, derivatives allow economic agents, including banks, to neutralise or at least moderate their risk of exposure. Some institutions or individuals use them as instruments for speculation. They may multiply the effects of the reward (or loss) through debt ®nancing (the leverage factor). Naturally the market will penalise unreasonable behaviour by any party. Recent developments in ®nancial derivatives have been useful in improving the negotiability of ®nancial assets, and in raising the liquidity and depth of ®nancial markets. The liquidity provided by derivatives has, however, proven to be procyclical, in that these instruments are readily available during boom periods but in short supply during periods of crisis. Accordingly their utility in offering protection in the management of risk disappears in times of crisis, when the few ®nancial intermediaries that control the market are loath to issue such instruments.4

Corporate strategies The process of globalisation has enlarged economic actors' choices and opportunities. This applies particularly to ®nancial ®rms, whose ability to diversify their portfolios has improved considerably. Some have even strengthened their ascendancy over speci®c markets, frequently by means of alliances, joint-venture strategies, acquisitions or mergers. Indeed, with the liberalisation of ®nancial markets, ®nancial intermediaries have been able to extend the spectrum and reach of their activities. Business strategies can rationally be founded on any of the following considerations: risk diversi®cation, economies of scale or scope, utilisation of human and other resources, maximisation of opportunities and optimally servicing customers. Guided by the ultimate interests and objectives of their dominant stakeholders (notably capital providers, key promoters or top management), ®nancial ®rms may choose either of the following strategies or hybrids thereof: (1) a strategy of core or niche businesses, focusing on one central activity or a few related activities at which they are best; or (2) a strategy of `multidimensional expansion', aimed at building a sizeable ®nancial institution that offers a wide array of products and services to a large number of markets and a variety of customers. To avoid duplication, the global ®nancial ®rm tends to centralise the design of its basic ®nancial products, leaving it to the management of its business units to adapt these products to local market needs and regulations in the most ef®cient and judicious manner (Box 25.1). Traditionally interest margins (the spread between interests on loans and deposits) have been the major source of income for banks. Depositors and borrowers are increasingly ®nding attractive opportunities in capital markets, a phenomenon referred to as bank `disintermediation'. This has prompted banks to develop various fee-bearing activities, posted off their balance sheet.

254 Whither Financial Intermediation?

Box 25.1 Strategies of a ®nancial ®rm: conglomerative and extensive versus selective

. Geographical span: one market versus several markets, regions or countries.

. Range of customers targeted: branches of economic activity, small or big

institutions, high-net-worth persons, wholesale operations, retail customers, government agencies and so on. . Array of products or services provided: deposit and ®duciary accounts, credit, corporate ®nance, project ®nance, cash management, foreign exchange, underwriting and trading in securities, derivatives, guarantees, trust and investment funds, asset management, insurance, brokerage, M&A, LBO, IPO, equity participation in non-®nancial ®rms, custody, counselling, e-commerce and so on.

The optimal strategy for a particular ®rm is that which enables its management to have the `right' mix of lines of business and countries in order to produce superior risk-adjusted results. The latter are often judged by reference to pro®tability, stable earnings, growth of turnover, signi®cant market share and staying power. Benchmarks for the foregoing are usually set according to four yardsticks: targets pre-established by management, recent performance of the ®rm, the ®nancial sector's mean results, and the leading competitors' results (Figure 25.3). Improved performance is management's declared reason for the adoption of a particular strategy. In the case of a strategy of merger and acquisition (M&A), the expected bene®ts are one or more of the following: the creation of new business opportunities, complementarity of existing activities, economies of scale and scope, technological and operational ef®ciency, sharing information on customers, career opportunities for staff, joint research and ultimately higher earnings. Compared with expansion from within, an acquisition is generally deemed a more rapid means of growth, assuming the acquiring ®rm has a suf®ciently strong capital base. If a ®rm has a relatively high market capitalisation, however, this might dampen the desire of an interested acquirer to bid for that ®rm. Empirical studies have shown that management has often sought larger size for reasons of market power or egotism. A strategy of merger or takeovers presents a number of challenges, notably in the areas of integrating information technology, corporate culture and organisational streamlining. The success of a merger will heavily depend on a shared vision by the business leaders concerned, and on analysing very carefully, objectively and in suf®cient detail the foregoing issues. Moreover mutual understanding and

Zuhayr Mikdashi 255

Objectives • Profitability • Growth

• Stability • Market share

• Staying power

Strategies

Implementation Major resources • Capital • Knowledge • Technology

• Planning and budgeting • Organisation, delegation, communication, motivation of personnel • Product marketing (pricing, distribution channels, advertising) • Corporate governance Benchmarks used

Periodic reviews and adjustments

Control and evaluation of results

• Pre-established targets • Recent performance of the firm • Sector’s mean results • Leading competitors’ results

Figure 25.3 Flow of decisions in the management of a ®nancial ®rm

trust among the top executives of the merging ®rms, their management style, their abilities and their commitment to work together to complete the process of integration are fundamental to outperforming competitors. Duplication or overlap of functions, bureaucracy, poor coordination, management in®ghting and the demoralisation of personnel are sources of reduced ef®ciency.5 Such problems can open the way for the poaching of top staff by competitors and can undermine the strength of the new combined enterprise. Ultimately, dif®culty in integrating the parties concerned can prevent the consummation of an intended merger or acquisition. The foundering in April 2000 of the proposed Deutsche±Dresdner Bank deal is one illustration of a botched merger.6 Shareholders and investors can have reservations about a policy of outright diversi®cation if it leads to an overextension of scarce managerial talent and yields a lower return than a more focused approach. The management of a ®rm

256 Whither Financial Intermediation?

generally strives to ensure that the remuneration paid to its shareholders is at least in line with that received by the shareholders of similar-risk ®rms. If a bank has a risky pro®le, this will discourage the providers of funds unless they are enticed by commensurately higher remuneration. Well-managed small and medium-sized ®nancial ®rms, by applying their expertise to selected activities, can achieve high levels of cost effectiveness and performance. Figure 25.4 identi®es the main interests of a ®nancial ®rm's stakeholders. The latter comprise the board of directors and senior management, share-

Senior management Customers Optimal satisfaction of users’ needs for services/funds/know-how: • Cost–price relations • Duration of facilities • Quality of products and services • Reliability of financial firm in periods of difficulty

• Compensation packages • Perks • Power • Continuity • Autonomy • Personal security

Public authorities • Efficient mobilisation and allocation of savings • Monetary compliance • Prudential standards • Fiscal obligations • Competition rules • Social and ethical considerations Suppliers and subcontractors • Equipment • Software • Other materials • Services

Board of directors corporate governance rules

Shareholders • Maximisation of value (appreciation of shares and dividends) • Influence on business policies and management • Negotiability of shares • Majority versus minority groups’ interests • Time horizons (short versus longer term)

Depositors and other creditors • Yield • Security • Liquidity • Convenience • Flexibility of terms

Personnel • Salaries and incentives • Training • Security of employment • Work conditions • Fair evaluation process • Equal opportunity • Advancement

Figure 25.4 Major stakeholders affecting corporate governance in a ®nancial ®rm: a con®guration of key interests and objectives

Zuhayr Mikdashi 257

holders (big and small), creditors (including depositors), employees, customers, suppliers, subcontractors and public authorities. Good corporate governance in a bank sets guidelines for rules and relationships among the stakeholders of the ®rm, aimed at optimising wealth creation. They cover various areas: strategy, ef®cient assignment of responsibilities, proper incentives, control systems, avoidance of con¯icts of interest, adequate transparency and protection of depositors' interests. The board of directors ± ideally comprising competent and independent persons ± normally has the crucial task of supervising senior management with a view to protecting the prosperity and ensuring the survival of the ®rm. The evaluation of the performance of a bank cannot be restricted to the sole criterion of risk-adjusted ®nancial reward to shareholders. A comprehensive evaluation from the standpoint of all stakeholders is needed, based on the following principal groups of factors:

. Financial solidity, which comprises the bank's earning capacity, capital

adequacy, asset quality, liquidity and operational ef®ciency, measured over the long-term. . The quality of the management, evaluated by reference to vision, a clear and coherent strategy, innovativeness, control of risks and judicious judgement. . Social responsibility and ethical conduct of business. . Respect of the physical environment with regard to the bank's own activities and those of customers using the bank's resources. Researchers have identi®ed two major corporate governance models: the AngloAmerican model, in which shareholders' interests are paramount; and the traditional German±Japanese model, in which not only the owners' interests but also those of employees, customers, partners and the community have a signi®cant effect on corporate decision making.7 The general current trend in corporate governance privileges two areas: raising shareholder value; and enhancing managerial resources (®nding, developing, rewarding and retaining executive talent). The management's drive to create shareholder value needs to have a longer-term perspective, insofar as short-term pro®t pressures can inhibit investment in the development of new products or entry into new markets. The external environment of a ®nancial ®rm in¯uences its strategic choices, and eventually its results. The external factors are diverse and can be classed into two broad (but interrelated) categories: market conditions, and governmental frameworks. Governmental frameworks cover regulatory ± supervisory standards, safety nets and macroeconomic policies. Market conditions comprise customers needs, competitiveness by the providers of ®nancial services, diversity of products and services, business facilities and expertise, demography and socioeconomic structure, economic growth and cycles, authenticity and transparency of accounts, and sociopolitical stability (Figure 25.5). Both categories vary among countries or over time.

258 Whither Financial Intermediation?

Risk management Banks' credit relationship (originating, holding and monitoring loans until

their ultimate recuperation) is changing. Loans and their risk elements are

increasingly tradable. This trend has helped to enhance the liquidity of

®nancial markets ± with one adverse consequence: potentially higher

volatility. Financial crises or turmoils have heightened the interest of ®nancial

®rms in risk management, especially with respect to:

. Improving risk diversi®cation.

. Optimising the funding or the liquidity of the ®rm.

. Holding selected risks that the ®rm is capable of managing pro®tably

(involving a positive risk ± reward analysis) and transferring the other risks. . Setting equity capital at a level that maximises the ®rm's market value.

Regulatory conditions

Market conditions

Prudential rules

Customer needs

Rules of competition and ethical behaviour

Competitiveness Diversity of products and services

Supervisory frameworks Disclosure of key risk information

Business facilities and expertise

Strategies, implementation and results*

Safety nets Deposit insurance Asset insurance Last-resort financing Management of crises Macro policies Monetary, fiscal, labour, other

* See Box 25.1 and Figure 25.3.

Figure 25.5 External in¯uences on a ®nancial ®rm

Demography and socioeconomic structure Economic growth and cycles Authenticity and transparency of accounts and operations Socio-political stability

Zuhayr Mikdashi 259

Risk dynamics In a dynamic world characterised by unending and unexpected change, the management of risk is a continuous process. It starts with the identi®cation and measurement of risk elements, and with ascertaining their linkages. Accurate measurement is crucial to the appropriate pricing of risk elements. Other functions of risk management include forecasting the behaviour of risk factors over a given time horizon, speedy reporting and monitoring, internal control and audit, internal and external rating of exposure positions, independent evaluation and eventual adjustments for risk mitigation (Figure 25.6). Since the risk pro®le of a ®nancial ®rm changes rapidly, the risk manager has to be forward looking when assessing the impact of past and current decisions and practices, and when giving advice on the potential risks/ rewards of future strategies and decisions. This responsibility entails continuous vigilance: in identifying areas of risk, and in improving measurement tools under the supervision of top management. The latter's primary concern is to choose those risks it can manage pro®tably and to transfer the others. The array of risks encountered by the management of a ®nancial ®rm is varied. A taxonomy is proposed in Box 25.2, which identi®es ®ve major categories of risk ± credit risks (debtors or counterparties), portfolio concentrations, market volatility and liquidity risks, legal risks and operational risks ± and extraneous problems, including governmental mismanagement. A ®rm's chief risk of®cer has to grapple with various risk elements using a holistic approach. This enterprise-wide risk management acknowledges (1) the fact that risks are interconnected, and (2) the need to gauge risk exposures more accurately in order to quantify the economic capital needed. Some risk elements are very dif®cult to measure, for example those linked to payment systems and reputation.8 The important elements in the pricing of a ®nancial product are graphically represented in Figure 25.7 by reference to a single loan transaction. Banks use different debt rating models, which vary with respect to methodology and the choice of key qualitative and quantitative factors to assess the probability of default by a borrower and to estimate the average loss on a homogeneous portfolio of borrowers.9 Statistical techniques are applied to historical data to identify, measure and price the risk factors. These techniques are also used to assess the risk impact (reduction, increase or neutral) of adding another product, for example a new loan to a particular credit portfolio. Credit scoring is one method of estimating the relative creditworthiness of a customer within a given category of borrowers.10 Such a method is, however, retrospective in that it focuses on how parties have handled their loans in the past, while current loans are extended against future income. Therefore credit scoring has to be supplemented by other, forward-looking evaluations.

260 Whither Financial Intermediation?

Oversight by board of directors and senior management

Identification of risks and analysis of linkages

Adjustments and risk mitigation

Independent evaluation

Internal and external rating systems

Measurement techniques Assumption of selected risks, within prudent limits

Risk trading, or risk transfer to 3rd parties

Internal control and audit

Forecasting models and time horizons

Pricing methods

Information reporting and monitoring

Figure 25.6 Components of a risk-management process

Helped by their long experience, diverse exposure and sophisticated expertise, large global banks are developing reliable analytical and predictive tools to assess the riskiness of customers, counterparties, products and facilities

Zuhayr Mikdashi 261

Box 25.2

Sources of a ®nancial ®rm's potential risks

Creditworthiness of customers:

 Financial capacity and willingness to honour obligations

Concentration of activities with reference to:

 Single customer or counterparty  Geographical region  Related entities  Product  Currency  Branch of economic activity Market risks:  Volatility of ± interest rates ± currencies ± equities ± commodities Legal risks:  Contracts invalid or unenforceable  Non-compliance with laws and regulations Operational risks:  Inef®cient organisation  Improper accounting, inadequate procedures and absence of independent controls  Ignorance or incompetence on the part of managers  Remuneration structure encourages excessive risk taking (e.g. bonus of traders) Extraneous problems:  Interference by rulers or pressure groups  Economic turbulence or shocks  Sociopolitical disturbances or military con¯icts

 Lack of liquidity and suitable funding  Negotiability constraints in respect of instruments/assets

 Inapplicable laws  Lawsuits and adverse judgements

 Negligence by or lack of motivation among personnel  Accidents and crimes  Payment and settlement risks  Reputation risks  Fraud, concealment, insider trading and self-dealing

 Ecological disasters  Corruption and money laundering  Systemic or contagion risk

262 Whither Financial Intermediation?

F E D G C

B

A

Notes: A: cost of funding the loan by the lending institution; B: operating costs attributable to the loan; C: market risks (e.g. volatile interest rates); D: credit risks (e.g. default); E: other risks (e.g. possible operational problems); F: opportunity cost of the equity capital needed to underwrite the loan; G: gross margin. These elements are presented on a stand alone basis for a speci®c loan transaction, that is, without taking diversi®cation into consideration.

Figure 25.7 Main elements in the pricing of a loan

across regions, industries and time. These statistically based debt rating models are used by credit of®cers and risk managers to judge loan applications and decide concentration limits, to estimate loss forecasts and to allocate economic capital to various exposures. Risk models have to be continuously re®ned and adjusted in response to new information on risk conditions and advances in ®nancial theory. Key variables have to be properly tested by reference to their explanatory power.11 The evaluation of governmental ± also known as `sovereign' ± borrowing and of the related `country risk' are also subject to quantitative and qualitative analysis. Country risk is generally considered a particular case of credit risk. It refers to the potential losses creditors and/or investors may sustain on their claims (including contingent liabilities, irrevocable credit lines and derivatives instruments) on debtors in a foreign country. The reasons for such losses are varied. They include, besides the usual creditworthiness factors pertaining to an individual borrower, the following:

. Default by sovereign (governmental) entities. . Financial turbulence, leading to a sharp fall in exchange rates or asset prices. . Restrictions on the transfer of funds, possibly leading to the nonconvertibility of the domestic currency.

. Breach of contract and other arbitrary governmental actions, such as expropriation, con®scation, punitive ®scality, bureaucratic exactions,

Zuhayr Mikdashi 263

corruption, forced liquidation of assets or interruption of business, denial of needed products or services, failure to honour contractual obligations. . Political and social disturbance, and armed con¯ict. The rating of a ®rm whose activities are con®ned to one country is capped by the rating of that country.12 Accurate measurement techniques are fundamental to the process of understanding and managing risks. In the ®nancial sector the accounting conventions followed in certain countries do not command general acceptance. Many queries remain, for example should market value be used in lieu of historical cost accounting for all of a bank's items (on as well as off the balance sheet)? Should assets with no active secondary market be recorded at an imputed market valuation? Would a market valuation of non-tradable assets introduce greater uncertainty into the calculation of the net worth of a bank, and would it call on the bank's management frequently to readjust its economic or regulatory capital base? Do market valuations under volatile market conditions invariably represent the true or fair value of an asset or liability? A number of countries use the standards set by the International Accounting Standards Committee (IASC). These standards are being updated to re¯ect the latest best practices (for determining values and for the disclosure of risk exposures) and to achieve coherence and consistency. The Basle Committee on Banking Supervision recommends two different accounting treatments for derivative instruments. If these instruments are used to hedge assets or liabilities held until maturity, these instruments are carried at amortised cost. If these instruments are part of the bank's trading portfolio, they are carried at fair cost.13 It is worth noting here that ®nancial analysts have generally focused on short-term earnings. This approach could hurt the market valuation of the traded stocks of a bank whose management has a longer-term perspective and chooses not to sacri®ce long-term asset quality.14 Risk mitigation Banks and other ®rms use various risk-management techniques. The techniques used to mitigate credit risk include:

. The syndication of large loans or exposures among several ®nancial ®rms. . The sale by a ®rm of a given category of loans (such as accounts receivable

or promissory notes) to a specialised ®nancial institution known as a `factor'; the latter usually buys the ®nancial assets in question on a nonrecourse basis and at a discount that re¯ects the interest charge and the risk of default by the debtors. . Asset-backed securitisation, that is, the sale of a given portfolio of a ®rm's standardised loan assets to specially created, separate legal entity or specialpurpose vehicle whose securities are issued for placement with private or institutional investors.

264 Whither Financial Intermediation?

. The total or partial transfer of credit risk to underwriters or insurers. . The use of ¯exible interest rates on loans to allow for repricing or the transfer of changes to a bank's funding costs (for example interest on deposits) to the loans, thereby maintaining stable interest margins for the bank concerned. . Hedging market and credit risks through the use of derivative instruments such as futures and options traded on regulated exchanges, and OTC swaps, options and forwards (see Figure 25.2); . Selective approval at origination of credits and other exposures to optimise concentrations.

An increasingly greater number of the risks encountered by a ®nancial ®rm or its clients can now be mitigated. This can be done inter alia for computer breakdown and for political risks. The former can be transferred for a fee to an IT services vendor, who assumes responsibility for computer maintenance and back-up. Political risk insurance is provided by private underwriters (for example Lloyd's and Zurich-American), national agencies (in the case of the richer trading nations of the OECD) and multilateral agencies. Multilateral political insurance agencies are af®liated to intergovernmental development institutions such as the World Bank, the Inter-American Development Bank and other regional development banks. The function of the Multilateral Investment Guarantee Agency (MIGA) of the World Bank is to encourage the ¯ow of funds for productive purposes to its 127 developing member countries, mainly through the issuance of investment guarantees against political risk. This international insurance market has grown considerably in coverage capacity, with increased cooperation among insurers to share risks (by reinsurance or coinsurance) and to draw on each other's special capabilities.15 Value-at-risk Several models have been developed to measure and control risk. None, however, has proven foolproof. Notable among these models is the value-at-risk (VaR) model, which purports to show the maximum loss (say x) a ®nancial ®rm might incur on an asset or a portfolio of exposures. It assumes (1) immediate liquidation of the portfolio, (2) a given probability or con®dence level (for example 99 per cent), (3) a given time horizon or holding period (for example 10 working days) and (4) suf®cient data on the ®rm's recent experience. This means that, on average, in 99 holding periods out of 100 the loss on the portfolio under consideration will not exceed x. Put differently, in one 10-day spell out of 100, the portfolio will, on average, sustain a loss greater than x. However the VaR does not provide information on the timing or the size of the loss in excess of x. For ®nancial ®rms, in principle it is possible to design market-risk VaR models for the trading book (trading portfolio) and credit-risk VaR models for the

Zuhayr Mikdashi 265

banking book (loan portfolios). The existence of a large volume of empirical data on securities prices and the availability of this data on a daily basis have enabled ®nancial ®rms to develop VaR trading-book models and to evaluate their reliability. Similar information is not readily available for VaR banking-book models, so researchers use bond data as a substitute for loan performance. Although most VaR models integrate the effects of diversi®cation and hedging, the prudent manager should not overlook a detailed risk analysis of signi®cant individual positions within the portfolio under scrutiny. The limitations of these models arise, inter alia, from the following:

. Price changes are distributed normally, thereby understating the probability of large price declines (and consequently the probability of large losses).

. Too small a number of correlations between price changes are used. . The historical data used may understate risk, especially illiquidity risk during periods of crisis.

. The composition of the portfolio is assumed to be ®xed during any one day. . The probabilities of price changes used as certainties are in fact statistical estimates.16

The future will not, however, replicate the past, upon which the VaR models are based, so risk analysts complement their evaluation with the scenario approach, which predicts how the ®rm might be affected by a complex chain of events, including a worst case scenario. However few analysts are able to imagine the full range of nightmare scenarios. This was the case with the UBS, whose post-tax loss reached CHF 659 million in 1997 and CHF 987 million in 1998 (over $1.1 billion in these two years). The loss in 1997 was attributed to problems with its global equity derivatives business, the main elements of which were risks resulting from the use of an inappropriate model on its `worst of dual asset call spread options' (CHF 120 million), loss on its Japanese convertible bonds (CHF 275 million), an `adverse' change in the UK's ®scal legislation (CHF 80 million) and high volatility in the international shares market (CHF 150 million). The UBS's loss in 1998 resulted from participation in a large hedge fund, the Long Term Capital Management (LTCM), and a nonhedged credit to the LTCM.17 The LTCM, founded in 1994, had on 31 August 1998 $125 billion in assets on a capital of $4.8 billion at the beginning of that year ± that is, a 25:1 leverage ratio. Fourteen of the large banks and securities ®rms who were creditors of the LTCM in 1998 failed to enforce their own credit risk management standards. Although large and sophisticated, the UBS did not have documentation on the execution and supervision of its transactions with the LTCM, and failed to identify or properly to evaluate major risks.18 The lax behaviour of senior bankers can be partly explained by the following factors:

266 Whither Financial Intermediation?

. The `halo' bestowed on the LTCM by virtue of the fact that three of its

principals had outstanding credentials: a former vice chairman of the Federal Reserve Board and two Nobel laureates. . The attractive past performance of the LTCM and other hedge funds created an infatuation with these funds, even on the part of sophisticated ®nancial ®rms, and there was a degree of herd-like behaviour. . The generally favourable economic conditions in 1995±97 prompted over optimism by bankers It was established that the analytical tools used by banks and by securities and futures ®rms to assess the LTCM's risks were ¯awed: they did not question the fact that the LTCM's strategy across markets was uniform, that is, it lacked appropriate differentiation. Furthermore they underestimated the size of potential shocks in world markets, and the constraints on the rapid liquidation of the LTCM's positions. The role of judgement Risk models, no matter how sophisticated, cannot encompass all risks and their linkages. Furthermore, they are subject to human error. Hence they should be looked upon as aids to ± not substitutes to ± the making of judgements. Independent expert control of risks should exist within the ®rm on a continuous basis to assist top management to assess the risks taken by its managerial staff, including traders. Chief ®nancial market traders can receive bonuses of 10±15 per cent of their group's pro®ts, and consequently are motivated to scout around for ®nancial ®rms that are willing to take risks in order to make outsize gains. One such trader personally earned some $15 million over four months while operating in the investment banking unit of the Credit Suisse Group. Other ®nancial ®rms have chosen to reduce the level of risk their trading of®cers can take.19 The remuneration package of the latter does not incite them to focus solely on short-term gains, thereby neglecting longerterm positive results for the bank. The Swiss Federal Banking Commission has found that bonuses can reach several times the annual salary of a trader, and that these are linked to short-term gains, even though they are only partially realised. Usually banks bear the losses alone, some of which arise in the medium or longer term.20 For banks that have invested heavily in information technology, data on exposure can be obtained in real time. In the management of risks, better informed senior executives can thus make their decisions on sounder bases and exercise control without costly delay.21 Several private rating agencies are in the business of judging the capacity of companies or countries to honour their ®nancial obligations. The leaders are Moody's Investors Services (a unit of Dun & Bradstreet) and Standard & Poor's (of McGraw-Hill). They are followed by Fitch-IBCA Duff and Phelps, and BankWatch. These agencies are accredited by various regulatory authorities.

Zuhayr Mikdashi 267

Their ratings are usually made at the demand of borrowers, who pay the agencies for their services. In recent years, major rating agencies have started to publish `unsolicited ratings', reportedly to counter the tendency of debt issuers to shop around for the lowest fees among the agencies and/or for better ratings.22 Credit-rating agencies have occasionally failed to identify looming risks and to warn investors about the increased vulnerability of borrowers, for example in the case of the Asian crisis in 1997±8.23 Certain risks cannot be reasonably measured or anticipated, particularly systemic risk (the risk of failure of the ®nancial system). This refers to the domino-like transmission of disruption of default risk (of a ®rm, a market segment, a payment and settlement system, and so on) to other institutions and/or countries. Contagion spreads to institutions or countries that are perceived by investors or creditors to have similar problems or to be economically vulnerable to the collapse of the ®rst victim. The impact of the Asian crisis, which broke out in Thailand in the second half of 1997, was estimated by the IMF to have halved world economic growth in 1998 and 1999 from a projected 4 per cent to 2 per cent. The management of systemic risk and other macroeconomic risks is the responsibility of the public authorities, and individual banks need not hold capital against the possibility of an overall ®nancial breakdown.24 Nevertheless the more capital a bank has, the higher the losses it can absorb, including those that arise from systemic risk. The central bank, in its responsibility as lender of last resort, normally protects sound and solvent banks against a liquidity crisis in the event of massive transfers or cash withdrawals by panicky depositors. Otherwise a forced liquidation of assets could lead banks ± hitherto sound and safe ± into insolvency and default. Such default can also affect debtors, whose credit lines are cut, and cascade-like breakdowns can become systemic, with a chain reaction of ®nancing problems affecting many economic agents and disrupting payments, savings and credit distribution channels.

Mutations in ®nancial markets Over the past few decades, large business enterprises in developed market economies, led by US ®rms, have been successfully tapping the securities markets for lower-cost funding than that obtainable from banks. Begining in the 1980s various ®rms, including banks, started to unload selected portfolios of standardised credits through securitisation. The latter enables the bank to shift the credit risk and the funding of these portfolios to investors, enticed by the attractive terms of asset-backed securities. Banks that securitise portfolios of loans seek to generate fee income upon performing certain functions: originating and distributing credit, risk assessment, monitoring borrowers, collecting interest and capital reimbursements, and various accounting and administrative services.

268 Whither Financial Intermediation?

In more recent years, smaller enterprises have been able to turn to ®nancial markets to satisfy some of their funding needs. Even development capital and start-up equity can be partially raised through various specialised stock exchanges or trading platforms. The opportunity to issue stocks and other securities has been enhanced by the willingness of individual and institutional savers to channel a signi®cant portion of their wealth into tradable ®nancial instruments. Exchanges Exchanges are organised markets that have traditionally focused on the trading of equity shares and commodities. In more recent years derivatives and ®xed-income securities (such as corporate bonds and commercial papers) have become tradable on exchanges, mostly electronically: in early 2000 the Swiss Exchange, for example, traded some 40 per cent of the Eurobond retail volume, valued at euro 541.12 billion (the wholesale market was over 10 times larger).25 In 2000 the largest electronic trading system for European government bonds, Euro MTS, accounted for over 30 per cent of all trading volumes (14 billion euros worth of transactions a day) in these securities.26 Venture capitalists and high-growth companies are increasingly able to raise capital through exchanges geared to their needs, at conditions more favourable than bank ®nancing. With the globalisation of ®nancial markets gathering momentum, competition has been building up among exchanges at the national and international levels to raise fresh capital for all kinds of business enterprises and for trading in various ®nancial instruments. Exchanges have been competing for the custom of users by enhancing the utility of their services through a variety of novel approaches. NASDAQ27 is one example of an exchange based on an electronic communication system, whereby market makers display the prices at which they are willing to buy or sell stocks for their own account or for their customers. It has pioneered the provision of capital access to budding hightechnology and/or high-growth companies, such as those in information technology. In contrast the New York Stock Exchange (NYSE) is based on the traditional auction system. It has stricter listing requirements for ®rms with respect to size, equity, shareholding and performance, including those seeking an initial public offering (IPO).28 Furthermore it has erected protective barriers, for example it denies other exchanges the right to trade in the stocks it lists. A few exchanges have also limited the ¯ow of data and routing orders, thereby constraining the growth of electronic systems. Under the aegis of governmental regulatory entities, most exchanges are authorised by the jurisdictions in which they operate to be self-regulated. This covers the control of market manipulations and the supervision of broker/ dealer conduct. Besides operational ef®ciency, the challenge for interconnected exchanges and the Internet is to agree generally accepted regulatory rules to protect the markets from false information.

Zuhayr Mikdashi 269

The opening of new exchanges in competition with established ones has yielded signi®cant advantages in terms of improved service and lower charges. Emulating NASDAQ, several new exchanges have helped young start-up and high-growth companies (mostly in the high-tech ®eld) to raise ®nance by overcoming the stringent listing of traditional exchanges. For IPOs the latter normally require an operating history, and set minimum conditions in respect of pro®tability or sales over recent periods, as well as minimum levels of capital and assets, and a minimum number of founding shareholders with lock-up periods (that is, with the obligation of keeping their shares over pre-agreed minimum periods). In 2000 the European exchanges for innovative companies comprised the Brussels-based Easdaq, the Alternative Investment Market (AIM) in London and the Euro NM alliance of ®ve continental European exchanges (Amsterdam, Brussels, Frankfurt, Milan and Paris). The latter enables investors in these ®ve exchanges to transact shares listed in any of the partner exchanges, using the same trading and settlement system.29 The proliferation of independent exchanges has, however, the potential to fragment liquidity pools. Such fragmentation could be overcome by alliances or mergers of exchanges aimed at creating common platforms with shared rules for the cross-border listing, margining, transaction, clearing and settlement of trade. Alliances or mergers might be prompted by a number of expected bene®ts: extension of the distribution network and client base, improved division of labour, economies of size (for example through joint research or shared investment in new technologies), cross-trading arrangements and an improved competitive position for the cooperating parties vis-aÁ-vis rivals. In the ®eld of derivatives, one example of a successful international alliance is Eurex, a common electronic trading system set up by the Frankfurt and Zurich exchanges. Eurex has also entered into an alliance with the Chicago Board of Trade, the Helsinki Exchange and others with the objective of connecting international derivatives markets. Its major competitor in the derivatives sector is the Globex Alliance, which links the Paris Bourse, the Chicago Mercantile Exchange and the Singapore International Monetary Exchange, joined later by the Montreal and Brazilian exchanges. Other examples include the merger (with their respective ownerships) of the French (60 per cent), Dutch (32 per cent) and Belgium (8 per cent) stock exchanges in early 2000, driven by pressure to reduce costs. The Paris, Amsterdam and Brussels exchanges thus became a single exchange called Euronext, with one membership, one rule book (including listing) and one clearing ± netting and settlement system. Euronext handles equities, options, derivatives and commodities. The London Stock Exchange and the Deutsche È rse followed suit in May 2000 to form the biggest European co-owned Bo exchange. The latter intended to become a global trading platform through alliances ± notably with NASDAQ to be effected through cross-shareholding. However, the deal collapsed later that year.

270 Whither Financial Intermediation?

Technological advances can be illustrated by reference to electronic trading systems, which are replacing the ¯oor-based, open outcry method. The latter (also known as pit trading) consists of a public auction at a centralised exchange, where ®nancial instruments are traded by authorised ¯oor participants who make bids and offers to each other verbally or through hand signals. In contrast electronic trading systems, commonly referred to as electronic communications networks (ECNs), are screen-based: they allow authorised investors (institutions and persons) to use computer terminals ± regardless of geographical location ± anonymously to enter bids and offers into a host computer, which matches orders and executes operations. These operations cover order-routing, clearing and settlement, and allow investors to trade after hours at the major traditional exchanges. ECNs have several advantages: they reduce the market impact of transactions; they eliminate bid/offer spreads or dealer±broker commission; and they are neutral. Some ECNs, such as Island, anonymously display all limit orders (those in which investors specify the purchase or sale price at which they are willing to transact) in a format available on the Internet at no charge. ECNs are also important to NASDAQ's trade, accounting for about 30 per cent. By trading on ECNs, institutional and private traders reduce their reliance on market makers. Some stock exchanges (for example the Deutsche Bo È rse and the Paci®c Exchange) have also combined their equity and ®xed income operations with ECNs (Market XT and Archipelago respectively). Investors and traders thus receive multiple bene®ts: extended trading hours, access to information and stocks from several exchanges, regulator oversight, high-speed electronic trading and access to more opportunities. Other exchanges have announced similar plans. Greater market transparency can be achieved by requiring the full range of investor limit orders received by competing exchanges, electronic systems and stand-alone dealers to be displayed. This would permit all market participants to ascertain the extent of supply and demand for any stock, and it would enhance the liquidity of ®nancial markets.30 E-trading On-line business via the Internet ± by means of personal computers and mobile devices ± has proliferated and enjoyed spectacular growth. By easing access to markets, cutting trading costs and broadening the range of investment opportunities, on-line brokers have attracted millions of investors. Some brokers are independent while others are af®liated to diversi®ed ®nancial ®rms. A few on-line brokers may not be guided by professional practices and ethics, notably the rules of `suitability' and `know your customer' observed by traditional ®rms that offer judicious advice aimed at protecting investors from inappropriate ®nancial risks.31 Beyond distributional advantages, investment bankers ± thanks to their research capabilities ± can offer large institutional investors quality advice.

Zuhayr Mikdashi 271

Electronic commerce (often referred to as e-commerce) is bound to expand with customer adaptation to change, ready access to technology, transparency of costs and prices, and assurances about the protection of privacy.32 Relationship-based ®nancial transactions are increasingly being replaced by automated operations. `Over the counter' instruments (equity, debt, derivatives, indices and so on) ± hitherto with prices quoted privately ± will thus become increasingly available on-line, not only for institutions but also for savvy individuals. Investors all over the world can now directly access actively traded instruments in the secondary market and newly launched securities such as IPOs in the primary market at negligible marginal cost. Investors are likely to reap certain advantages by trading with electronic brokers via the Internet, rather than with traditional dealer/broker ®rms. The following advantages can be realised, subject to the judicious choice of an ef®cient and neutral broker (that is, without its own portfolio to compete with its customers):

. Lower cost structure and lower fees and commissions (for transaction, clearing, settlement and so on). Direct electronic access to major stock exchanges, and global reach. Instantaneous trade execution, with speedy settlement and clearance. Extended trading hours (24-hour access to brokers). Greater transparency through real-time prices, up-to-date news, performance measurement and charting. . Better prices (except after normal trading hours, when the bid±ask spreads are larger, the choice of stocks is smaller, the information is less complete, volumes are smaller and prices are more volatile).33

. . . .

The trading-hour constraint is rapidly disappearing with the creation of alliances among stock exchanges in different time zones, notably the exchanges in America, Asia and Europe. Investors thus have 24-hour platforms of active trading. Furthermore competition has prompted on-line stockbrokers to expand their range of activities. One rapid means of expansion is by takeover, as was done in early 2000 by E*Trade (buying Telebank Financial, the Internet banking group) and Charles Schwab (buying US Trust, a ®nancial ®rm in investment management, private banking, estate planning and ®duciary services). One of the world's largest electronic brokerages ± Reuters' Instinet ± caters for institutional investors and equity brokers. In 2000 it expanded its offering to include ®xed-income securities and retail business. Through a single brokerage vehicle, Instinet offers its customers access to the major marketeconomy exchanges, thereby providing them with a large pool of liquidity, global opportunities and lower transaction costs. In addition to its brokerage business, it offers trading research and analytics to its institutional customers.

272 Whither Financial Intermediation?

Its participation interests span over other independent electronic trading platforms, such as Tradepoint in the UK and Archipelago in the US. A continuous stream of current data and the ability to trade on a real-time basis are increasingly available not only to ®nancial ®rms and their traders, but also to private investors. Sophisticated, high-speed order routing and execution systems enable investors and traders to be linked directly (that is, without an intermediate ®rm being involved in routing orders) to other traders and to market makers in various stock markets. Transactions are executed within seconds of traders placing their orders, against the payment of fees for computer and electronic services. On-line traders and investors do not, however, have the bene®t of the advice normally provided by a full-service broker/ dealer on the suitability of a particular trade.34 Banking and IT developments Notwithsanding the spectacular growth in ®nancial markets instruments, bank credit remains important for two categories of borrower: individuals and small enterprises that are unable to access the ®nancial markets, and institutions that need custom-made advice and ®nancing, for example for major projects such as energy generation or mining. Standard bank products (such as consumer lending and mortgages) with transparent terms can increasingly be purchased via e-channels. The latter are cost ef®cient for commoditised credit products and for simple high-frequency bank services such as bill payments, fund transfers, information provision, stock and mutual fund trading, personal planning modules and so on. Compared with individual investors in corporate bonds, banks have four major comparative advantages in handling credit risks. First, banks have the means and the expertise to monitor and assess the wealth, income, spending behaviour and debt servicing of their customers. Second, they enjoy economies of scale in their credit operations because of the large number of transactions. Third, they are capable of achieving a higher degree of diversi®cation among borrowing customers. Fourth they can obtain on a continuing basis from their borrowing customers speci®c information that is not readily available to investors since the borrowers know that their bank, for competitive reasons, will protect proprietary information from public disclosure.35 Banks are increasingly at the forefront of using state-of-the-art information technology to protect their market share in the ®nancial services industry against encroachment by new players. Their jump into cyberspace has been spectacular: from dispensing cash and accepting deposits through automatic teller machines from the late 1960s, to the current provision of Internet banking to corporate and individual customers. Financial ®rms' considerable investments in IT are aimed at tapping a very large potential market for a wide array of standardisable products or services, such as credit cards, debit cards, stored-value cards, consumer or mortgage loans, fund transfers, foreign exchange, cash and/or asset management,

Zuhayr Mikdashi 273

trading in mutual funds and ®nancial instruments, insurance policies, bills payment, corporate research, portfolio evaluation and advice. Modern banks' activities are based fundamentally on processing information. In this respect their methods of servicing their customers have generally progressed through ®ve stages, beginning in about 1960:36

. The automation of the `back of®ce' and the reduction of paper-based, manually processed operations.

. The provision of self-service banking via ATMs inside or outside the bank premises.

. The provision of banking services via the telephone to customers in of®ces, shops or at home.

. The provision of Internet banking, further easing customers' access to

banking services and allowing new ®nancial service providers to enter the market. . The delocalisation of the traditional bank±customer relationship with the arrival of mobile devices that enable customers to interface with their banks and other ®nancial market participants whenever and wherever. The use of the Internet for transactional purposes has increased considerably for the following reasons: ease of entry by service providers and customers; cost effectiveness (about one tenth of the cost of a transaction in a traditional bank of®ce); and improved transparency in the terms of the products and services offered by banks, including prices. The Internet has also allowed the rise of independent `information providers', who search for and aggregate the terms of products and services offered by ®nancial ®rms. Independent distributors have also sprung up on the Internet, thus widening customers' choice in respect of various products and services, such as mutual funds, deposits, mortgages, consumer credit, life insurance, stockbrokerage, credit cards and so on. Banks are adding to their traditional function of ®nancial intermediation the novel function of facilitator of e-commerce. In the latter capacity they are currently developing a variety of services, notably:

. Internet portals: these `supersites' are open to many providers of products or

services. They provide potential buyers with an opportunity to view, compare and choose. Offerings need not be limited to ®nancial products or services. . Certi®cation of identity: each bank certi®es the identity of its own account holders, and acts as a channel for its customers to verify the identity of account holders at other banks. . Assisting small businesses: banks court the custom of small enterprises by offering to set up Web sites for them. These Web sites have interactive transactional capabilities.

274 Whither Financial Intermediation?

. Electronic billing: within the framework of their cash management services,

banks can offer to companies that send large volumes of bills to their customers an electronic billing and remittance-processing service through the interbank payment system. . Facilitating e-commerce: banks have an interest in offering technology for electronic business-to-business commerce in order to automate the ¯ow of transactions relating to procurement, the distribution of goods and related services. Besides generating fee income from that activity, they expect a positive fallout for other activities, such as cash management. . Electronic money: with the availability of computers equipped with smart card readers, banks are able to provide electronic money that can be stored on these cards for use on the Internet. In addition, electronic cheques are being designed for use by businesses or individuals. The ongoing cybernetic revolution implies heavy investment by ®nancial ®rms to strengthen their relationship with existing customers, create new opportunities and fend off competition from other ®nancial and non®nancial ®rms, including technology companies. Yet, potentially pro®table IT developments are dif®cult to identify with certainty, and there is a danger of committing resources to an IT channel that turns out to be economically unviable. In this case the ®rms concerned could loose substantially in non-amortisable investments and reduced market share or turnover.37

Security concerns E-commerce is particularly vulnerable to technological problems (for example the breakdown of individual computers or networks), and imposters or other parties seeking to harm users or providers. Attacks could include:

. Stealing important information, such as credit card numbers and other personal data.

. Damaging or destroying computer ®les and contaminating computer systems by planting viruses.

. Illicit operations, such as unauthorised transfers of funds. . Denying service by maliciously congesting targeted Web sites. Unless computer security and law enforcement are improved, e-brokerage business ± which was estimated to account for about 16 per cent of all stock trade in the US in 200038 ± and other e-commerce could be hurt. Various users of the Web, including the operators of interbank transfer systems, could be equally hurt by cyber-terrorism. This calls for identi®cation of the Internet's weak links, and for continuous upgrading of security systems in areas such as encryption, digital signatures, ®nger-print scanning and coding, traf®c ®lters

Zuhayr Mikdashi 275

to ascertain legitimate users, and the rerouting of traf®c from logged computer servers to others. For the unfettered growth of Internet operations, of®cial security certi®cation at the international level and the prosecution of offenders are essential. Besides raiders illegally cracking into ostensibly heavily protected computer systems, individual Internet users can be vulnerable to those seeking to embezzle unsuspecting and credulous persons through the use of such claims as `Get rich quick', `Free stock' and `Exceptional high returns', as well as pyramidal schemes and other scams. Internet fraudsters are being pursued at the international level, and national agencies in 28 countries are monitoring suspect Web sites. The US Federal Trade Commission is spearheading the global sweep, with the help of international agencies. A permanent data base is being established to store information on fraud site operators, their physical locations and the victims of their misdeeds. Fraudulent operators on the Internet are thus increasingly being tracked down.39

Public intervention Motivation Protection of the banking system is of particular concern to the public authorities in modern economies in view of the fact that the banking system is at the centre of the payment and settlement system, the mobilisation of savings, the allocation of credit and the creation of money. Indeed banks provide most of an economy's stock of money through the extension of loans to households and companies. The payment and settlement system is a fundamental infrastructure in a modern economy in that every economic transaction necessitates a payment. Besides the legal tender ± that is the banknotes and coins produced by the monetary authorities ± bank deposits lodged by individuals and institutions are a major source of payment funds. Since bank deposits are a leading liquid asset for individual and institutional depositors, banks offer payment services linked to these deposits, and hence they have assumed a central role in the payment system. The failure of banks ± in view of their central role in the payment and ®nancial intermediation systems ± thus has a stronger adverse effect on the real economy than the failure of other ®rms. An ef®cient ®nancial sector is essential to the growth and stability of modern economies at the national, regional or international levels. Public intervention in the ®nancial sector is therefore prompted by the objective of (1) setting the requisite conditions for the safe and ef®cient operation of the banking/®nancial system, and (2) forestalling payments crises. Such crises produce considerable ill effects, such as recession, disruption of production, social con¯ict and loss of property or life. This is readily illustrated by the many crises that hit several countries in various parts of the world during the

276 Whither Financial Intermediation?

1990s. The vulnerability of ®nancial intermediaries ± and notably banks ± derives largely from ®ve inter-related factors:

. Banks prefer to rely on third-party funding (or debt) in lieu of owner's

. .

.

.

funding (or equity) because of the lower ®nancial cost of debt ®nancing compared with equity; debt charges are furthermore treated as expenses before the assessment of corporate taxation, which is not the case with dividends. Consequently banks tend to minimise the cushion of equity or risk capital. Banks depend for a signi®cant portion of their third-party resources on depositors' funds, which have to be repaid at their face value and on demand (or at very short notice). Banks transform liquid or short-term resources into illiquid or longer-term assets in the expectation of reaping higher interest margins. Furthermore they tend to keep a small fraction of their callable deposits in liquid assets, since these assets produce only modest or no income. Banks are highly interdependent owing to their intertwined business relations (interbank lending, syndicated loans, joint clearing and settlement mechanisms, counterparty operations, agency relations, joint ventures and so on). The losses of a defaulting bank spread through the payment and settlement system, and are thus bound to affect other banks. Depositors are likely to panic if adverse rumours spread, in view of the maturity mismatch between banks' liabilities and assets and in view of the opacity of information on risks that banks disclose to the public. Depositors are therefore prone to rush to withdraw their funds, not only from unsound or unsafe institutions, but also from solvent institutions.

The principal aim of legislation on and regulation of the ®nancial sector is to protect general welfare and improve market ef®ciency, notably with respect to consumer protection, transparency, systemic risk and moral hazard. First, consumer protection is needed against the possible abuse of market power by dominant ®nancial intermediaries. Intermediaries have sought to increase their size for multiple reasons, notably to achieve greater ef®ciency and higher returns through (1) economies of scale (since the initial cost of setting up a ®nancial activity is relatively very large and the cost of an additional unit of product or service is very low or nil), and (2) economies of scope (through the synergy created by offering multiple products to satisfy various complementary needs of customers). Regulators have to ensure that the abovementioned economies bene®t consumers. Second, the ®nancial sector is characterised by information asymmetry, indicating that the parties to a transaction do not have the same information. Indeed depositors have incomplete information on their depository bank. Regulators can require the latter to disclose the information needed to enable depositors and other users of ®nancial services to make sound decisions. Small

Zuhayr Mikdashi 277

depositors often lack the willingness, time, skills or resources to identify and analyse the risk of ®nancial intermediaries, delegating that function to the public authorities, which are in a better position to obtain the required information and to impose appropriate penalties on intermediaries that transgress the rules. Third, regulation can eliminate or moderate systemic risk. The latter results from the potential chain effect of the failure of one intermediary in a given country triggering ± through the payment system ± liquidity and solvency crises for other intermediaries in the same country, as well as in other countries. The rapid transmission of risk can be explained by the fact that banks are closely interconnected. Solvent intermediaries can be faced by a massive, irrational run by panicking depositors subject to herd-like behaviour and can ± in the absence of adequate funding ± be obliged to effect a `®re sale' of ®nancial assets. This will set in train a series of price declines and insolvencies unless the regulators and monetary authorities intervene appropriately and in the early stage of the problem. Fourth, safety nets are put in place to prevent or quell runs on banks that might spread rapidly from weak banks to strong ones. They are normally available through three standby arrangements: (1) a lender-of-last-resort service for solvent banks; (2) deposit guarantees ± and in some situations an explicit (or implicit) bail-out promise ± to individual institutions (notably big ones); and (3) intra-day credit from the clearing authorities (viz. the central bank) to participating banks, normally against collateral. Safety nets carry with them the seed of `moral hazard'. The latter means that ®nancial institutions and their customers expect central banks, deposit insurance institutions, other governmental agencies and multilateral international organisations to intervene to prevent the failure of a ®nancial intermediary in the event of a ®nancial crisis ± a situation which fosters mismanagement (as discussed below). Public protection and market discipline Financial crises and their costly aftermath have prompted public authorities to improve their regulatory framework and provide safety nets. The results of this are distorted competition and weakened market discipline. In particular safety nets (1) reduce the incentive of depositors and other creditors to monitor their bank and to charge that bank in accordance with its risk pro®le; (2) induce depositors to entrust their funds to banks at lower interest rates than would be acceptable in the absence of deposit insurance; (3) reduce bankers' prudence by enticing them to take greater risks (in the expectation of higher returns) in the knowledge that the funds provided by creditors are secured by deposit guarantees; and (4) enable banks to ®nance customers at interest costs that are not commensurate with the risk posed by these customers, thereby leading to a suboptimal misallocation of economic resources. The propensity of management to neglect professional rigour can be counteracted by the effective enforcement of prudential regulations (such as

278 Whither Financial Intermediation?

rules focusing on adequate liquidity, exposure limits and risk-adjusted capital), and by imposing appropriate penalties on banks and their managers for irresponsible behaviour. Bank management would accordingly be required continuously to enforce the observance of various laws and regulations, including prudential rules. This could be veri®ed by ef®cient control and audit systems within the ®rm, under the supervision of designated public agencies and accredited independent external auditors (Figure 25.8). Deviant or fraudulent actions by top management should be subject to appropriate punishment. This could start with a reprimand and ultimately lead to the temporary or permanent withdrawal of operating permits,40 or jail sentences for executives if warranted.41 The involvement of public authorities in regulatory and supervisory functions and safety nets does not mean that market participants can assume risks without bearing the consequences of their actions. In protecting the

Enforcement of rules set by the regulatory authorities and the financial firm

Entities external to the firm

National or international governmental agencies: • Monitoring • Surveillance • Inspection

Accredited Independent auditors and rating agencies

Board of directors:

Organs within the firm

• Policies and directives • Internal audit

Management: • Internal organisation • Controls and compliance rules • Procedures and models

Figure 25.8 Supervision and control

Power to: • Publicly censure • Impose fines • Oust managers • Withdraw authorisation or support • Prosecute

Zuhayr Mikdashi 279

public interest, bank regulators act as agents for two principals: the taxpayer, who is shielded against the eventuality of being called upon to share the cost of a bank failure; and the customer (whether debtor or creditor), who is safeguarded against exploitation and the misuse of his or her ®nancial resources by unscrupulous parties within or without the bank. Regulators, as the agent for the taxpayer, do not invariably act in the best interests of the latter as they are supposed to do. Indeed they may be tempted to delay addressing the problems of troubled banks under their jurisdiction in order to cover up past mistakes or oversights in the hope of an improvement in the circumstances of the banks. They are comforted by the fact that insured depositors are protected and that an insolvent bank can continue to operate for a long period. The delay in closing an insolvent bank, with operational losses still accruing, will increase the cumulative losses sustained by the bank. This will in turn increase the cost to the taxpayer, who will be called upon to absorb the losses suffered by insured depositors (known as the principal/agent problem).42 A bank's risks can change rapidly and thus render existing information obsolete. For troubled banks it is recommended that thorough on-site examinations be conducted more frequently than is the case for sound banks. This type of inspection would, however, be costly in terms of the labour of quali®ed persons assigned to that function, as well as burdensome for the banks being examined as their day-to-day operations would probably be disrupted. Low-risk banks should therefore be subject to a less intensive supervisory programme. Off-site surveillance complements on-site examination by offering an appreciation of the bank's circumstances on an ongoing basis. This can take the form of (1) a series of ratios, known as `supervisory screens', calculated from the ®nancial accounts of a bank ± problems can be detected when the ratios diverge from the standard values established on the basis of past experience; or (2) econometric models based on selected ratios that produce a single number that re¯ects the degree of solidity of a bank. Econometric models are considered to be more useful than supervisory screens in detecting problems with safety and soundness. Judgement remains, nevertheless, an important element in detecting problem situations.43 In view of (1) the delays in reporting mishaps by the management of troubled banks to the regulatory authorities, (2) the inadequate or imprecise measures currently available for assessing bank risks, and (3) the lags in corrective measures or sanctions by the regulatory authorities, it is advisable to resort to market signals to trigger managerial rigour, and thus contain or moderate moral hazard. Governmental entities (such as the Federal Deposit Insurance Corporation, FDIC, in the US) cannot readily recognise changes in the risk pro®les of deposit-taking banks. Indeed deposit insurance cannot involve actuarial methods similar to those used, for instance, by the life insurance business. The

280 Whither Financial Intermediation?

latter offers a reliable statistical calculation of the risks (for example health risks and mortality tables) and premia needed to build a fund capable of absorbing predictable future losses. However bank failures cannot be accurately forecast: they occur irregularly and very occasionally in large numbers. If the governmental deposit insurance ± which substitutes the credit standing of a private bank for that of the central government ± undercharges for risk, the bank will in effect be bene®tting from a concealed subsidy.44 Bearing in mind the above considerations, it is essential for the soundness and ef®ciency of the banking system to price as fairly as possible the risk exposure of each bank. Towards that objective, transparency of information on a bank's operations enables rational market participants with money at stake to produce a collective judgement on the riskiness of the said bank, and the premia they will require for channelling their savings to it. Markets can evaluate the risk of widely traded ®nancial instruments belonging to entities whose operations are suf®ciently transparent. Market discipline will have been exercised when lending charges (including premia on risks) increase and credit availability decreases in parallel with the increase in the borrower's risk pro®le. If a bank assumes excessive risks, depositors have the possibility of withdrawing their funds if they doubt the bank's solvency. In the case of default, management and the shareholders should fully bear the brunt of the losses, followed by subordinate creditors. The orderly liquidation of an insolvent bank bene®ts the economy in the long term as it prompts the management of other banks to exercise prudence. This principle should apply to all institutions, regardless of the size and scope of their activities. In the absence of an international framework for handling insolvencies, a professional association of operators and regulators from the ®nancial sector has offered recommendations for the speedy handling of the insolvency of global ®nancial institutions.45 Market signals could be built into the safety nets to ensure that participants in the ®nancial system have a strong incentive to behave prudently. Such signals are premised on the existence of transparency (that is, the dissemination of reliable, detailed and up-to-date data on risk exposures), on the ef®cient functioning of a competitive market place, on rational behaviour by market participants on both the supply and the demand side for funds, and on prompt reaction by all parties concerned. Various measures for the promotion of market signals have been proposed, including the following:

. Regulations could require all banks to issue, besides their share capital,

subordinated debt for public subscription. Investors are normally sensitive to a bank's `prudence and performance' record. The lower the prudence, the higher the cost of placing subordinated debt with potential investors. More generally, the disclosure of a bank's risk-based capital (including information on innovative, complex and hybrid capital instruments) will enable market participants to judge the bank's capacity to absorb ®nancial losses.

Zuhayr Mikdashi 281

This information needs to be complemented, for the bene®t of investors, with disclosure on various risk exposures.46 . A governmental deposit insurance safety net should carry a coinsurance element (for example 20 per cent), whereby each depositor shares in the risk by accepting an element of self-insurance and bearing a tranche of the eventual loss on her/his deposit. This coinsurance would encourage depositors, especially large ones, to demand greater transparency from their deposit-taking bank so that they could assess their bank's safety and soundness: they would discipline risky institutions by withdrawing their funds or demanding higher interest rates on their deposits. Should a bank deny its depositors the requisite information, it would be shunned or obliged to pay a risk premium for its opacity. . Partial private insurance or reinsurance of a proportion (say 5 per cent) of a bank's deposits could also be used. Risk-assessed premia on deposits charged by the private sector would then act as a supplementary market signal. A rise in such premia should trigger regulatory action, in the same way as would an increase in the spread required by investors on the subordinated debt of a bank, over and above a risk-free rate (for example that of a governmental security).47 A governmental deposit insurance entity ± besides using market signals to price its protection of bank deposits ± would need the authority to inspect banks and the means to make banks comply. These means could include:

. . . .

Penal insurance rates.

The dismissal and replacement of inef®cient or miscreant executives.

Denying deposit insurance to a delinquent bank.

Ultimately, the closure of a bank.

The central role of equity The solidity of a bank in the long term is based on three main pillars: earning capacity, prudence and equity. Prudence calls on management to maintain appropriate liquid reserves to meet unexpected withdrawals of funds, and to avoid excessively risky operations. The survival of a ®rm in periods of dif®culty is dependent on the relative size of equity or owners' capital at risk. Owner's capital demonstrates three characteristics: permanency, a residual status in the distribution of income or assets, and initial responsibility for absorbing eventual losses. Capital's functions are primarily fourfold:

. To cover unexpected losses (expected losses can be integrated into the

charges levied on individual products and services, or can be absorbed by speci®cally constituted loss provisions). . To ®nance ± in an environment of uncertainty ± the start-up costs of a bank's activities (including those relating to physical infrastructure or the

282 Whither Financial Intermediation?

acquisition of know-how and talents), and the expansion of these activities over time. . To secure depositors by increasing the owner's stake in the bank; this serves to moderate the interest paid on deposits and third parties' funds, . To ensure that the level of capital requirement moves in tandem with the overall risk of a bank's activities. In view of the fact that equity capital generally costs more than borrowed funds, the ®rm's top management endeavours to constitute adequate equity base capable of maximising the value of their enterprise. By comparison, public regulators of banks, in prescribing minimum capital requirements, are primarily concerned with protecting the public interest ± notably that of ensuring a safe and sound banking system capable of serving all concerned parties ef®ciently. The ®rst attempt by central bankers and regulators to institutionalise their cooperation in the ®eld of prudential standards was the creation of the Basle Committee on Banking Supervision at the end of 1974. The membership of this committee currently comprises senior representatives of the monetary-supervisory authorities of the major ®nancial centres.48 The committee has no supranational supervisory authority: its task is to recommend best practice standards and guidelines. The committee was established in the wake of the foreign exchange turbulences in 1974 that culminated in the collapse of Bankhaus I. D. Herstatt, which defaulted on more than $600 million in claims. The German banking authorities announced its failure at 4 pm (German time) on 26 June 1974. More than 12 US-based banks that had paid out Deutschmarks to Herstatt were unable to get US dollars in settlement at the opening of the clearing system in New York at 10.30 am as Herstatt's had been closed before its dollars could be credited to its foreign counterparties, which suffered considerable losses. The ensuing unsettlement in the interbank trading market hurt other banks, which were charged onerous risk premiums of 2 per cent for six weeks. This type of cross-currency settlement risk is a time-zone-induced credit risk in spot forex transactions and has come to be referred to as the `Herstatt risk'.49 Prompted by the objective of ensuring both prudent behaviour and the convergence of regulatory standards among banks, over the years the Basle Committee has formulated a series of guidelines for national bank regulators. With the approval of the G10 central bank governors, the committee proposed the application of a framework for minimum regulatory capital, beginning in 1988. Banks operating transnationally were asked to cover four categories of bank loan exposure with minimum capital charges, rising in accordance with their estimated riskiness. These charges were set at 0 per cent (OECD governments),50 1.6 per cent (banks in OECD countries), 4.0 per cent (residential mortages) and 8.0 per cent (all other loans) of the face value of the respective claims. Capital was de®ned as consisting of two tiers: tier 1 or core capital, comprising common shares and

Zuhayr Mikdashi 283

retained earnings; and tier 2 capital, comprising mostly medium- to longterm subordinated debt instruments. In 1997 the committee enlarged the minimum capital requirement for banks to cover market risks, notably with respect to banks' trading portfolios. Equity standards were adopted in 1988 after a negotiated compromise among the committee members. These standards have proved too simplistic, and often arbitrary or inconsistent. For example, in the case of bank credit the rules assign to the best-rated corporations (AAA) the same minimum regulatory capital coef®cient as that for lower-rated corporations, that is, 8 per cent of the face value of such loans. Such rules encourage banks to operate perversely by reducing assets whose risks and capital charges are overestimated by the regulators, and increasing assets whose risks and capital charges are underestimated by the regulators. Use of the static, `one-size-®ts-all' approach also fails to address differences in the nature of banks' businesses. The standardised uniform weights have not been con®ned to credit risk, but have also been used in the case of market risks. Indeed in 1997 the committee introduced a regulatory capital charge on the trading account of banks, set at a ®xed minimum multiplier of three for valueat-risk (VaR), plus an `add-on' of one to make a total of four VaR, when the banks' internal models and their stress testing prove to be inaccurate. Stress testing estimates the potential loss resulting from the large changes in key risk factors that can occur in periods of extreme dif®culty. During 1999±2001 the Basle Committee embarked on a revision aimed at ®ne-tuning its regulatory capital framework, guided by four objectives:

. . . .

Safety and soundness in the ®nancial system.

Competitive equality among banks.

A comprehensive approach to addressing risks.

Generalised coverage for all banks (the 1988 recommendations were

intended solely for internationally active banks) in view of the liberalisation of domestic ®nancial markets.

The committee's 2001 proposals also underline three major requirements: (1) expanding capital requirements to cover additional risks (such as operational and interest-rate risks); (2) giving regulators additional power to raise (above the general minimum of 8 per cent) a bank's capital adequacy if warranted by the risk encountered by that bank; and (3) the disclosure of more details to the general public in order to encourage market participants to differentiate among banks by reference to safe and sound banking practices. The committee has also recommended greater reliance on independent credit rating agencies and on banks' own risk-management models and internal ratings (instead of the preassigned standard ratios imposed by the regulators). The latter recommendation is premised on the assumption that management has full and ready knowledge of the risks of its operations on a continuous

284 Whither Financial Intermediation?

basis, and that its models are capable of identifying risk variables and of accurately calculating their weights and behaviour. One can argue that the committee's approach poses several challenges, notably the following:

. The validation of internal models by the regulatory authorities requires a

. . .

. .

coherent approach to assessing these models, not only within a single country but also across several countries that might use different accounting methods. It is possible that certain current or prospective credit rating agencies could supply, in response to demand by or pressure from rated entities, better ratings than would be warranted by strictly objective criteria. Credit rating agencies are not likely to have full and immediate knowledge of a bank's rapidly changing risk circumstances. The proposed weights for risk exposure, though an improvement over those of 1988, are still rough and static estimates and are often the product of negotiated compromises reached at a given point in time by representatives of the bank supervisory authorities. Banks may continue to practice `regulatory arbitrage' by favouring activities whose regulatory capital requirement underestimates their effective risk. The committee has yet to address each individual bank's risk diversi®cation by reference to its full range of portfolios, both on and off balance sheet. Such enterprise-wide calculations for a ®nancial institution can produce an overall risk pro®le, which can be higher or lower depending on the correlations for defaults and/or credit losses within and across different credit risk concentrations.

Researchers are exploring new avenues for assigning capital charges to assets held by ®nancial intermediaries. They include:

. Precommitment of capital (PCA) to the trading portfolio of a bank. The

management of the latter would be asked to choose a level of capital to back the said portfolio over a given period of time. Should the cumulative losses exceed the capital cover at any time during that period the regulators would ®ne the bank ex-post. The PCA approach could well prompt most banks to develop accurate models and to communicate the results truthfully to the regulators. The task of the regulators would be to choose an appropriate structure of penalties to induce bank managements to moderate their risk levels or provide an additional capital cushion. The stiffer the penalty, the greater the prudence of management in terms of risk taking. PCA would have the advantage of reducing regulators' involvement in the setting of capital requirements by putting the onus on individual bank managements.51 . Rewarding banks that avoid losses with a reduction in the standard capital charges. Banks could moderate their risk pro®le by various means, such as

Zuhayr Mikdashi 285

acquiring safe assets, resorting to hedging, disposing of assets (sell-downs or securitization) or enhancing internal controls.52 . Introducing contingent liability for bank stockholders upon the default of their institution. `Double liability' was applied to national banks in the US from 1863 to 1933. Contingent liability could also be imposed on the managers of failed banks.53 Expanding the reach of regulation The gradual dismantling of barriers in ®nancial intermediation and markets has led to greater interdependence at the global level, thereby presenting both opportunities and challenges for competition and risk control. National regulators and supervisors are reluctant to surrender their prerogatives. In the absence of a supranational global regulatory and supervisory entity, which is unrealistic in light of the current and prospective state of world affairs, it is imperative that the various parties in the international ®nancial community enhance their cooperation in order to avoid systemic risk and preserve a sound and resilient global ®nancial market. International regulatory cooperation has increasingly focused on: (1) The observation of uniform principles for healthy risk management and harmonised safe capital requirements; (2) common accounting plans that allow for accuracy and transparency in the reporting of the economic circumstances of ®nancial institutions, and for comparability of reporting techniques across time and space; (3) the auditing of the consolidated activities of an enterprise; and (4) the appointment of an accredited regulatory agency to act as primary supervisor or principal coordinator of all national regulatory agencies concerned with the world-wide supervision of diversi®ed, transnational ®nancial groups. Governments interested in boosting their economies have deliberately exonerated from regulation all or selected activities of ®nancial ®rms. These exonerations vary considerably among jurisdictions. Moreover, regulatory and informational gaps exist even in advanced market economies that are deemed to be well regulated. This is the case, for example, in the US, where the Securities and Exchange Commission does not have the authority to monitor and regulate unregistered af®liates of broker/ dealers and futures commission merchants. These companies have large positions in OTC derivatives and are major contributors to hedge funds.54 Information gaps exist when risks are not identi®ed and assessed industrywide for the bene®t of regulators and operators. Such gaps can well be the source of ®nancial troubles. Indeed this has been the case with the US regulatory system, which does not have a mechanism for pooling information on the risks assumed by ®nancial ®rms in relation to a speci®c customer. Industry-wide aggregation of the risks per customer might have alerted the regulators to the excessive leverage of the LTCM, which in 1998 managed to distribute its liabilities among 14 large ®nancial ®rms. The exposure to the LTCM assumed by

286 Whither Financial Intermediation?

each ®nancial ®rm was not among its largest, and this is the reason why US regulators did not recognise the potential threat posed by the LTCM.55 Several European countries have well-established agencies for centralising risk assessment. Their functions are to aggregate the exposures assumed by ®nancial providers vis-aÁ-vis individual customers, be they business enterprises or consumers, and to share the aggregated information with the ®nancial ®rms concerned. In order to protect their independence and neutrality, these agencies are not af®liated to any particular private ®nancial ®rm and usually operate under the aegis of the central bank. The supervisory authorities and the ®nancial ®rms are therefore able to obtain aggregated information on the size of exposure of an individual customer. With such information, each ®rm is then able to ascertain the comprehensive exposure its customer has assumed vis-aÁ-vis the ®nancial services industry, and is in a position continuously to monitor its own exposure and judiciously manage its relationship with that customer. Aggregated information on customers' exposure, which is increasingly available on-line to ®nancial ®rms, can be of great help in averting the excessive concentration of risks on individual customers within the ®nancial services industry, and in taking timely corrective action. Moreover, under the aegis of the European Central Bank, transnational cooperation among several European risk assessment agencies is expanding the reach of the agencies concerned.56 Within the ®nancial sector, the hedge-fund branch is generally under no obligation to disclose risks in its portfolios. The majority of these funds are highly leveraged investment pools (also known as highly leveraged institutions, HLI). Their participants are a few ®nancial institutions or wealthy individuals ± no more than 100. They are often organised as limited partnerships and so far have no disclosure requirements. The general partners risk their own money and are responsible for day-to-day management. The limited partners provide their funds for investment by the general partners and do not become involved in management. The latter follow aggressive investment strategies, and take long and short positions with full use of market derivatives. Recent failings in sophisticated ®nancial ®rms' models and risk management make vigilance by the supervisory authorities all the more necessary if crises are to be averted or forestalled. In late September 1998 the US Federal Reserve regulators, fearing that a systemic risk might result from the nearcollapse of the LTCM, urged that additional ®nancing be provided to this fund by its creditor±investor ®nancial ®rms. The abrupt and disorderly unwinding of large positions and the liquidation of collaterals held by counterparties would have further strained the ®nancial markets and compounded the dif®culties of all participants in the globally interconnected markets.57 To limit the ability of ®nancial ®rms to evade prudential regulation and to close the gap between international supervisory practices, cooperation among

Zuhayr Mikdashi 287

the regulators and supervisors of different countries is necessary. For ®nancial ®rms operating internationally, it appears reasonable to have as main supervisor the agency from the country where the ®rm has its central headquarters. It is legitimate for a country to bar the entry of a ®nancial ®rm if its home country does not have an adequate regulatory±supervisory framework. The Basel Committe called on lender banks to seek both quantitative and qualitative disclosure from borrowing HLIs on their investment risks.58 Some transparency is needed if market participants are to anticipate excessively risky situations and avoid aggressive ®nancial strategies that could lead to the collapse of large HLIs, disrupting national and international ®nancial systems. The US authorities favour such a policy for HLIs with capital in excess of $1 billion (less than 20 out of about 2500 funds in the US). The possible failure of any of these large HLIs is deemed to be a source of systemic risk. It was proposed that they report to the US Federal Reserve their total assets, leverage ratios and market risks, for release in due course to the public. Such legislative disclosure is also espoused by the Financial Stability Forum (FSF), which was created in 1999 by the G759 to forestall crises similar to the Asian and Russian ones of 1997±98 (see the section on ®nancial stabilisation below). The disclosure requirements could generate market discipline on the part of hedge funds and their counterparties, eventually leading to safer conduct. Should this fail, further legislative action may be needed. The impact of national legislation, even in a major ®nancial centre such as the US, will be limited unless it is emulated by other ®nancial centres. Otherwise fund managers could move offshore in order to maintain secrecy about investment strategies that they consider `proprietary'. If a large player discloses its strategy, it could be taken advantage of by counterparties or other players, especially when it needs to liquidate its positions.60 The Basel Committee on Banking Supervision and its sister bodies the Committee on the Global Financial Systems and the Committee on Payment and Settlement Systems, which operate within the BIS, focus on sound, safe and ef®cient practices for banks, ®nancial markets and payments systems, respectively. The regulatory aims are shared by other global rule-setting bodies, such as the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS). All are concerned with contributing to global ®nancial prudence, and therefore stability. State support and mega-institutions It is reckoned that a few governments of developed market economies that profess to espouse a policy of free and competitive markets in fact follow contrary approaches, offering favourable treatment to certain categories of ®nancial institutions. Recently the debate in Europe has centred on Germany, where the 12 state-owned Landesbanken have been capitalised by regional governments at favourable conditions not available to their competitors and

288 Whither Financial Intermediation?

continue to bene®t from explicit or implicit state guarantees. This has given these banks higher credit ratings and the possibility of raising funds more cheaply, thereby undercutting their privately owned rivals and allowing them to expand their activities. Such privileges create an uneven playing ®eld at the expense of competitors in national and international markets.61 As a result of this governmental support some of the Landesbanken have become very sizeable, including the Westdeutsche Landesbank. The latter is backed by the regional government of North-Rhine Westphalia through unlimited state guarantees and subsidies in the form of property transfer. The European Commission has estimated that the government subsidy amounts to 1.6 billion Deutschmarks and is asking for its return to the authorities, along with 0.6 billion Deutschmarks of accrued interest. Governmental support has enabled the Westdeutsche Landesbank to outgrow its regional bank status and become a major commercial bank with of®ces in 37 countries. It has taken risky exposures, notably in investment banking and lending to emerging markets, such as those in Asia.62 Governments in other major market economies have equally failed to maintain a level playing ®eld in their ®nancial markets. In the US, two of the biggest government sponsored ®nancial institutions, the Federal National Mortgage Association and the Federal Home Loan Mortgage Association (dubbed Fannie Mae and Freddie Mac respectively), were set up by the federal government in 1938 and 1970 respectively and were later transformed into privately owned, pro®t-making enterprises. Both enjoy certain privileges not available to other private lenders, large or small. In particular they are exempt from state and local corporate income tax, banks can invest in the securities of the two institutions without limitation (that is, the risk concentration rules have been waived), their capital requirements are about one third of those applying to large banks, they bene®t from the patronage of the US president who appoints ®ve members of their boards, and the US Treasury provides them with an emergency credit line of $8.5 billion. Their quasi-public status enables them to obtain lower-cost funding in ®nancial markets, estimated in 1996 at $6 billion a year on their $1 trillion debt. It is thought that one third of the subsidy is not passed to mortgages but handsomely bene®ts shareholders, top executives and employees. The implicit government guarantee is a source of moral hazard, and the borrowing costs of these two institutions do not re¯ect their risk pro®le. Without such a guarantee it is likely that they would refrain from extending lower-quality loans: in 2000 some of their borrowers paid a meagre down payment of 3 per cent and allocated 50 per cent of their income to servicing their mortgages (at a time when the standard percentage was a maximum of 36 per cent for housing and other credit expenses). Loans with low down payments are, by statutory requirement, subject to private mortgage insurance. The two institutions were nevertheless held responsible for sti¯ing competition from other private lenders, and for aggravating the credit bubble

Zuhayr Mikdashi 289

through their aggressive expansion, thereby putting the US taxpayer at risk if post-bubble dif®culties had called for rescue by the government.63 It is pertinent to note that large national banks ®nance mortgages with consumer deposits insured by the government-owned FDIC. Unlike Fannie Mae and Freddie Mac, these banks are not constrained by federal charters to ®nance domestic housing solely; banks can diversify their activities by offering ®nancial products and services in various markets and countries.64 The ongoing consolidation of the ®nancial industry in various parts of the world is producing several large and complex ®nancial ®rms that engage in a variety of activities. They seek to satisfy the needs and serve the convenience of their customers by offering a broad range of products and services, so-called `one-stop shopping' (see Box 25.1). Yet these institutions pose challenges to public policy with respect to (1) their dominant position in selected products and markets and the antitrust implications of this, and (2) governments' reluctance to close institutions whose soundness and safety are in doubt lest their action provokes a systemic risk. The existence of `too big to fail' (TBTF) institutions has often resulted in public authorities giving implicit guarantees to non-insured depositors and other creditors of these institutions. This policy is bound to de¯ect from market discipline in the management of megainstitutions.65 Large ®nancial institutions have, furthermore, risk exposures in multiple products and sectors, and in extensive geographical areas. Characterised by increasing complexity and diversity, these institutions are accordingly not amenable to standardised rules of risk control. Each needs to construct speci®cally designed risk models to assess its risks and capital requirements. In view of their potential impact on national or international systemic risks, their operations have to be scrutinised on a continuous basis by a team of highly quali®ed inspectors. Financial conglomerates now have a greater opportunity to develop in the US market, thanks to the Gramm±Leach±Bliley Act of 1999. The Act effectively dismantled the functional barriers previously imposed on ®nancial providers by the Glass ± Steagall Act of 1933. The latter had segregated the ownership and operation of investment banks (securities ®rms or merchant banks) on the one hand, and deposit-taking institutions (notably commercial banks) on the other. Furthermore the replacement of the Pepper±McFadden Act of 1927 by the Riegle±Neal Interstate Banking and Branching Ef®ciency Act of 1997 has eliminated geographical barriers to bank extension within the US. Financial regulatory agencies in certain countries continue to focus on risks and sound practices in their assigned areas in the ®nancial sector: banks, mutual funds, securities and derivatives markets, and insurance. In the US they include the Federal Deposit Insurance Corporation, the Federal Reserve System, the Of®ce of the Comptroller of the Currency, the Of®ce of Thrift Supervision, the Securities and Exchange Commission, the state banking authorities, and insurance regulatory agencies. US bank regulators

290 Whither Financial Intermediation?

have joined in the Shared National Credit Program to assess the risk posed by large syndicated loans to participating banks.66 The programme does not evaluate other risks. US regulators have not yet properly addressed risks interrelationships across the various segments of the ®nancial sector.67 In a few countries all ®nancial services (banking, pensions, insurance, securities and derivative trading, and asset management) fall under a single regulatory ± supervisory agency (for example the Financial Services Authority, FSA, in the UK). First introduced in Norway in 1986, integrated ®nancial control was adopted by Denmark in 1988, Sweden in 1991, the UK, Australia and Japan in 1998 and Iceland in 1999. Other countries are preparing similar legislation.68 Integrated ®nancial regulation and supervision recognises that the formal separation between ®nancial intermediaries and their products and services is becoming increasingly blurred, especially in view of the growth of ®nancial conglomerates and the increasing substitutability of ®nancial products and services. A single, comprehensive regulatory agency can identify and assess industrywide risks more easily than a fragmented system of multiple agencies, each focusing on different categories of ®nancial services companies. Moreover the centralisation of regulatory functions in one institution yields economies of size and ef®ciency, and facilitates the recruitment and retention of quali®ed personnel. From the standpoint of enterprises, large ®rms with diverse activities are better off under a single regulatory agency as they avoid having to deal with a multiplicity of agencies. Small ®rms, however, fear being faced by an overbearing and bureaucratic mammoth to which they have to submit regardless.69 The regulation of ®nancial conglomerates poses important challenges with respect not only to setting appropriate prudential rules, but also to avoiding possible con¯icts of interest between the different units of conglomerates and their customers, who are entitled to fair and impartial treatment. Greater transparency and timely disclosure of information enables experienced ®nancial customers and analysts to evaluate the terms of the products and services offered, and to assess the risks and results of ®rms, including their constituent units. Market participants are then able to value shares, subordinated debts and other ®nancial instruments more realistically, thereby prompting management to focus continuously on sustaining productivity and earnings. However at the moment market participants are not fully informed, and some investors may set more store on short-term than on longer-term performance. Beyond the supervision of risks, public authorities have to concern themselves with the protection of customers of ®nancial conglomerates in two principal areas: consumer privacy and oligopolistic power. With regard to the former, consumers may be concerned about ®nancial ®rms' legal right to pass on or sell their personal data without prior consent to af®liated or

Zuhayr Mikdashi 291

associated companies. The latter include unaf®liated enterprises that perform services for or function on behalf of a ®nancial ®rm, and joint mechanisms between two or more ®nancial ®rms for the marketing of ®nancial products and services. The information disclosed can cover, inter alia, the customer's assets, liabilities, sources of income, spending patterns, insurance coverage, retirement plans and even health matters.70 The dominance by a small number of ®nancial ®rms in selected products or markets has been strengthening. The effect of such a concentration could well be to drive up the margins, commissions or premiums that ®nancial conglomerates impose on their services. Moreover such oligopolist control could eventually lead to a reduction in the choices offered to consumers, and increase the opacity of the information available to market participants. The foregoing calls for constant vigilance on the part of the regulatory authorities which is not always the case. In the UK, for example, the authorities have reportedly tolerated the bending of free market rules. In particular, regulators have allowed the big four UK banks ± which control the payment system and about 70 per cent of the personal market ± to inhibit competition. These banks' practices included (1) locking in customers by means of high barriers against defection; (2) interbank agreements aimed at discouraging potential entrants; (3) imposing excessive charges that are unrelated to the costs, for example when customers use other banks' cash dispensing machines; (4) charging excessive fees to retailers that accept credit and debit cards; and (5) charging excessive fees for bundled products and services. These practices have produced excessive pro®ts compared with those made by other enterprises.71 Furthermore the chairman of the banking review, Don Cruickshank, deemed that the `over-cosy relationship' between the UK big banks, the government and the regulators was unwarranted for systemic reasons, such as possible bank runs.

Financial stabilisation Sources of instability Greed, irrational exuberance and negligence are generally deemed to be at the root of ®nancial crises. According to this interpretation, herd-like euphoria causes decision makers to underestimate risk and/or overestimate returns.72 A sudden shift in market expectations and loss of con®dence ± triggered by a particular adverse event ± can lead to the opposite process of overestimation ending in a paroxysm of gloom, investor panic and ®nancial contagion. Crises can also be provoked or exacerbated by unsound or incoherent macroeconomic policies. Alternatively they can be averted, moderated or mastered by judicious policies. To illustrate, a crisis in an open economy can be provoked by an excessive ®scal de®cit. The latter will generate a vicious circle of rising domestic demand and prices, followed by the further swelling of public indebtedness. To stabilise domestic demand, the government may

292 Whither Financial Intermediation?

inappropriately resort to monetary measures such as raising interest rates. This will in turn attract foreign hot money, or cause domestic ®rms to engage in less expensive foreign borrowing: capital in¯ows will then create additional upward pressure on domestic prices, and lead to an overvalued exchange rate. Deterioration of the country's current account and an increase in its foreign debt will follow. To maintain the exchange rate and the ¯ow of foreign capital, interest rates are raised further, forcing more and more domestic borrowers into liquidity and solvency problems and eventually leading to a cascade of collapses in various sectors and a recession in the domestic economy. This will be accompanied by capital ¯ight and the collapse of the exchange rate. The end result is likely to be a banking crisis. The globalisation phenomenon, while increasing diversi®cation opportunities, has led to a higher degree of uncertainty, deriving inter alia from the enormous ®nancial resources that can be used for cross-country speculation, potentially leading to destabilisation. The rising interdependence between ®nancial ®rms and markets has also contributed to an increase in the transmission of risks across institutions and markets. All crises have particular elements of their own. Fundamental to the Asian ®nancial crisis, which hit Thailand, South Korea, Indonesia and Malaysia in 1997±98, was the conjunction of certain international events with domestic policy and structural distortions, including, notably, the following interrelated factors:

. Banks and corporations in these four countries had resorted to excessive

short-term borrowing in US dollars for their local-currency, long-term loans. In the absence of hedging, these banks became vulnerable to the depreciation of national currencies, and to liquidity crises because of their inability to roll over their foreign short-term debts. (The current Basle Capital Adequacy rules appear to have induced banks to favour short-term interbank loans to emerging economies, instead of more appropriate longer-term maturity loans.)73 . Given the limited absorptive capacity the Asian national economies faced in the mid 1990s, with a massive in¯ux of foreign capital in search of more attractive opportunities (compared with the yields then obtaining in capital exporting countries) the prices of domestic shares and real assets in the capital-importing countries were allowed to rise considerably, thereby presaging a bust after the boom. . Domestic banks imprudently channelled their lending to certain business sectors of dubious productivity and pro®tability, including sectors suffering from excess capacity. Furthermore loan reimbursements were not rigorously enforced by bank management, thanks to rampant self-dealing, nepotism, cronyism and corruption. Private projects of high risk or poor pro®tability bene®ted from subsidies, cheap credit, authorised monopolistic practices (for example under the aegis of conglomerates) and explicit or

Zuhayr Mikdashi 293

implicit government guarantees. State-owned companies (including banks) were extensively used as sources of political patronage. . With rising domestic prices and national currencies effectively pegged to an appreciating dollar, the four economies suffered a reduction in export costcompetitiveness, which in turn reduced their capacity to earn suf®cient foreign exchange to meet their foreign-currency-denominated ®nancial obligations on time. Their export earnings suffered further from the stagnation of the Japanese economy, and from competing exports by China, partly boosted by the 50 per cent devaluation of the Chinese currency in January 1994.74 Regulatory frameworks and enforcement of the prudential rules governing domestic ®nancial intermediaries proved inadequate. Indeed, regulators condoned and covered up ¯agrant violations of laws or standards by in¯uential or politically linked executives who had falsi®ed accounts to conceal abuses and losses. In an environment of corruption and bribery, law enforcement of®cials thus allowed domestic banks to operate with negative capital ratios and ¯out various other rules.75 Early diagnosis of a ®nancial crisis would enable those responsible for its management to produce an appropriate remedy. Some authors have called on the IMF to base its diagnosis on a purely logical, mathematically formalised and econometrically tested model. Such a model would include the interconnections between the factors responsible for the crisis, and the instruments capable of restoring both the soundness of the ®nancial system and economic growth.76 One should nevertheless be cautious about relying solely on mathematical models based on past experiences to predict future crises and/or prevent their outbreak. Some judgmental discretion may well be needed to reach an innovative or creative approach to interpreting novel situations. The current supervisory standards in developing and emerging economies need to be improved, guided by proper prudential principles.77 Financial supervision should be carried out by competent independent examiners whose authority and judgement rests to a signi®cant degree on the integrity of the ®nancial sector. Both external examiners and risk managers of ®nancial ®rms will need to be provided with appropriate ®nancial and occupational incentives (such as attractive pay and adequate job security) if they are to carry out their functions ef®ciently. Moreover bankruptcy procedures should be diligently enforced on insolvent institutions. The developed, richer economies of North America, Europe and Japan have an important role to play in global ®nancial stability. They are the world's major creditor and capital exporting countries, ®nancing inter alia the heavily indebted developing economies. If foreign currency debts and related economic data are fully disclosed without delay by creditor and debtor countries, market forces will be able to alert investors/creditors in time, as well as the supervisory agencies, thereby enabling them to reach sounder decisions.

294 Whither Financial Intermediation?

This will help to forestall crises or at least moderate their impact.78 The opacity or scarcity of up-to-date reliable information on changing economic conditions in individual countries (and notably emerging economies) have prevented ®nancial markets from functioning ef®ciently and providing optimal solutions before crises strike. Creditor countries therefore need to improve the supervision of their ®nancial intermediaries' exposure to emerging or developing economies. Facilitating access by the products of poor, heavily indebted developing countries to the markets of developed economies (by waiving duty and quota restrictions) should enhance the ability of these debtor countries to honour their ®nancial commitments and attenuate the intensity of debt crises. In this respect, a proposal was made by the World Bank and the IMF for government ministers to meet within the Development Committee in April 2000 under the joint auspices of the two institutions. The US trade representative would not, however, countenance this approach.79 Towards global stability Intergovernmental institutions such as the International Monetary Fund (IMF), the World Bank and the Bank for International Settlements (BIS) play an important role in promoting global ®nancial stability. The leading governmental members of these institutions represent the world's major ®nancial markets. Crises have prodded these governments to cooperate more closely in respect of (1) the exchange, pooling and dissemination of information pertinent to the ef®cient functioning of world ®nancial markets, (2) greater coordination between national and international regulatory bodies, and (3) the implementation of international best standards and practices.80 The foremost multilateral institution in terms of monetary ®nancial cooperation is the IMF. Established in 1945, it works towards various goals: collaboration on international monetary problems, balanced expansion of international trade, exchange stability and the elimination of foreign exchange restrictions. It also provides temporary support to correct maladjustments in members' balance of payments. Synergetically with the IMF's objectives, the Financial Stability Forum (FSF), established by the G7 in 1999, functions as a coordinator for various institutions with the aim of reducing the risk of global ®nancial instability. It focuses on ®nancial intermediaries, ®nancial markets and payment infrastructures. The FSF does not have an operational mandate and seeks a concerted approach by international organisations and standard-setting entities (for example the BIS, the IMF, the World Bank and the OECD), along with national regulatory agencies, ®nance ministries and the central banks of the G7 and non-G7 countries with major ®nancial centres.81 In view of its status as the global intergovernmental monetary institution (183 countries), the IMF has been entrusted with the major responsibility of promoting global ®nancial stability. Its main role is to help member countries

Zuhayr Mikdashi 295

to shore up their balance of payments by providing stand-by facilities, subject to certain rules. Notable among the latter are ®rst, a ceiling of borrowing based on the relative economic weight of the member country) and second, strict enforcement (monitored by the IMF) of an agreed-upon economic programme. These policies aim to promote macroeconomic stability over the long term within the framework of an open market economy. Governments that experience ®nancial distress often call on the IMF after the fact instead of asking for assistance at the inception of the problem, when the help provided can be more effective and can moderate some of the high economic and social costs of adjustment. In administering its limited resources the IMF has not invariably abided by its own rules. Moreover it has been directly in¯uenced by its major funders, notably the US, which is the largest contributor to the IMF's resources (17.35 per cent of the total subscription).82 One example concerns the 1994±95 ®nancial debacle in Mexico, which led to the exchange rate of the peso plummeting by some 50 per cent on 21 December 1994. At the urging of the US government, the IMF agreed to a stand-by arrangement for Mexico of up to $17.8 billion immediately after President Clinton announced that the US would provide ®nancial assistance of $20 billion. The total assistance package was raised to $47.8 billion when Canada and the BIS offered additional aid, beefed-up by a supplementary funding commitment of $2.8 billion by the World Bank. Several of the member countries complained that the IMF executive Board had not been adequately consulted on the Mexican rescue operation. Moreover the IMF's ®nancing amounted to 688 per cent of Mexico's subscription quota. The statutory cumulative limit for ®nancial support is about 300 per cent of the member's quota, and is subject to detailed negotiation and agreement between the IMF and the debtor country. The latter normally makes a commitment to reform its macroeconomic and ®nancial policies (with a timetable for targets) in order to ameliorate or eliminate its external payments problem. The US government was concerned ± it is pertinent to note ± about the negative externalities of the Mexican ®nancial crisis, notably:

. The threat posed to US trade, employment and immigration interests.

. The threat of contagion posed to other countries.

. Solidarity vis-aÁ-vis a fellow member of the North American Free Trade

Agreement (NAFTA, comprising the US, Canada and Mexico).

. Concern that Mexico's move towards a market-oriented economy and political democratisation (to be emulated by other emerging economies) could be thwarted.

Critics within the US administration, the US Congress and other creditor countries (the G10) contested the above and further invoked the moral hazard factor as a possible contributor to Mexico's ®nancial crisis. That factor already

296 Whither Financial Intermediation?

existed because of the ®nancial assistance provided by the IMF and various creditor nations during Mexico's foreign debt crisis of August 1982. This ®nancial rescue operation could have encouraged Mexico and other emerging capital importing countries to follow risky macroeconomic and ®nancial policies, and unduly encouraged foreign investors or creditor banks to relax their monitoring of risks.83 Public funds were thus used during the ®nancial rescues of Mexico (1995), South Korea (1997) and Russia (1998) to repay shortterm debt to private parties, despite the fact that these parties had enjoyed high interest rates when they chose to ®nance these countries. Foreign banks and investors might, on the basis of past bailouts by the IMF and creditor nations, anticipate similar treatment and therefore take more risks. The IMF's promise to provide ®nancial support to ®nancially distressed member countries therefore entails a moral hazard factor. National deposit insurance mechanisms in creditor counties, which explicitly or implicitly provide banks and their depositors with government guarantees, add to the moral hazard factor. However, no guarantees are cost-free, and several investors and lenders (domestic and foreign) have sustained large losses during past ®nancial crises regardless of the IMF's and creditor nation's support to member governments. To reduce moral hazard and enhance market discipline, lenders and investors should be made to share the cost of crises they have been involved in causing, thus providing them with an incentive to engage in prudent behaviour. Of®cial and private entities have raised several important questions about the optimal future role of the IMF, including the following:84

. Should the IMF act more like a central regulatory authority by extending its

surveillance function over member countries to cover (1) macroeconomic reforms and stabilisation, and (2) banking and ®nancial market regulation and supervision? . Should it assist member countries in their endeavour to anticipate, avoid or resolve ®nancial crises, thereby acting as a quasi international lender of last resort for countries hit by creditor panic and currency ¯ight? . Could the IMF act as an international deposit insurance entity for member countries that borrow on the international ®nancial markets, by levying differentiated premia in accordance with its rating of the creditworthiness of the members concerned? Is it realistic to assume that the IMF has suf®cient knowledge and political backing to carry out that function, which would include management of the ®nancial reserves accumulated from such premia? . Should the IMF be con®ned to the function of a mediator between creditors (sovereign and private entities) and debtor countries in times of ®nancial distress, and help both parties by facilitating speedy negotiations and workable solutions to settle claims, thereby replacing the ad hoc meetings between public sector creditors (known as the Paris Club) or private sector

Zuhayr Mikdashi 297

creditors (the London Club) and the defaulting debtor countries?

. Should the IMF continue to address poverty alleviation (mostly through the

Poverty Reduction and Growth Facility, and the Heavily Indebted Poor Countries debt relief) or should this be left to its sister organisation, the World Bank, and similar institutions? . Should the IMF maintain its longer-term lending programme (which extends up to 10 years) in order to ®nance structural reforms in member countries, or should it instead focus on temporary, short-term lending to countries that encounter payment and liquidity problems? A few critics have questioned the IMF's failure ± despite its oversight and conditionality prerogatives ± to detect irregularities in member countries, leading to a failure to enforce policy changes and to the misuse of the IMF's resources.85 They also question the ability of the IMF to forewarn governments about looming crises. IMF of®cials acknowledged in 1999 that they had failed to obtain timely information on some countries that had faced ®nancial distress, although, they had managed to alert certain countries (for example Thailand in early 1997) of an impending foreign exchange crisis, to no avail as it turned out. In the case of Thailand, the IMF's warning was reportedly not made public in order to avoid precipitating the very crisis it was aiming to prevent (the Thai debacle eventually broke out in July 1997).86 Moreover crises can deepen or become protracted if appropriate solutions are not adopted in time, or if governments renege on their commitments under the IMF support programmes. Several entities (of®cial and non-of®cial) have called on the IMF to require greater transparency from member countries so that problems can be identi®ed before they turn into crises.87 Some holders of high of®ce in government or ®nance have put in doubt the effectiveness of the IMF's oversight and rescue measures: they consider that its advice is more relevant to past crises than to unfolding ones. For doctrinal reasons or reasons of national interest, very few have called for the outright abolition of the IMF.88 Most critics suggest that the IMF needs to be more focused and should function primarily as lender of last resort in order to contribute effectively to global ®nancial stability.89 The emphasis on short-term support to member countries is espoused by the current managing director of the IMF, Horst Ko È hler, and the US Treasury. Both believe that long-term lending should be primarily the concern of the World Bank.90 Last-resort lending, as a safety net (see the section on public protection and market discipline above), carries with it a moral hazard risk. To cope with the latter, the IMF needs to ensure the proper observance of certain prerequisites:

. The members in question are eligible for suf®cient last-resort lending,

subject to policy conditionality on macroeconomic matters and prudent

298 Whither Financial Intermediation?

regulation of their ®nancial sector, with rigorous enforcement of rules and standards. . Lending is made at a penalty rate to limit the demand by countries actually or potentially facing a liquidity crisis, or those susceptible to systemic risk, and on condition that these countries are in a position fully to honour their obligations; for poor countries with no prospect of repaying a loan, aid is more appropriate. . The private sector should carry out its own risk analysis, monitoring and self-regulation; thus capital exporters (creditors and investors), along with capital importers, should have to bear the brunt of the consequences of their risky behaviour by sustaining losses or ultimately being forced into bankruptcy. . The application of reliable accounting, monitoring and regulatory standards, namely those set up by the Basle Committee on Banking Supervision, the IMF Special Data Dissemination Standard, and IOSCO. By enhancing the quality of the available information and assuring the transparency of key data, regulators and markets can more ef®ciently monitor ®nancial players in the global market. An embryonic, very modest international lender of last resort facility was started up in April 1999 when the IMF launched its Contingent Credit Lines (CCL) facility for a two-year trial period. The CCL provides member countries with short term-®nancing (up to two years) to protect them against contagion risks. IMF support of this sort is intended to send a message to the international ®nancial community about its con®dence in a member's economic policies. The criteria for approval for such support are stringent, and include the prerequisite that `the member must be implementing policies that make it unlikely it will need to use the resources [sic] and it must not already be facing balance of payments dif®culties as a result of contagion'. The CCL support is capped at 500 per cent of the member's quota in the IMF and is subject to a surcharge of 300 basis points in the ®rst year, plus 50 basis points per six-month extension.91 Before the IMF can play a genuine lender of last resort role in the world economy the leading creditor countries (the US, the EU and Japan) have to reach a consensus on the IMF's strategy and structure. In particular they have to agree on whether the IMF can substantially increase its members' quota subscriptions and its of®cial borrowing from capital-exporting countries, notably the major industrial countries (the G10). The IMF has yet to tap private sources in the world ®nancial markets directly. As a universal, multilateral organisation the IMF is likely to have a greater degree of objectivity or neutrality in evaluating data and recommending appropriate policies and reforms than national institutions (although the abovementioned creditor countries will continue to wield considerable in¯uence). It is more realistic in a world of sovereign states and great diversity

Zuhayr Mikdashi 299

to approach global ®nancial cooperation in a gradualistic manner than to attempt a rapid overhaul of the existing web of institutional relations. Sequencing liberalisation Developing countries can expect higher growth in the long run through the gradual liberalisation of their capital accounts, subject to their having sound macroeconomic policies and a solid and well-regulated ®nancial sector. International capital ¯ows are prompted by diverse aims and motives, ranging from productive investment to short-term speculative gains and money laundering. Unfettered and erratic short-term capital movements can destabilise an economy, especially when the ¯ows are massive in relation to the absorptive capacity of the domestic economy. Some countries, for example South Korea, liberalised short-term ®nancial ¯ows in the mid 1990s while retaining restrictions on long-term capital movements. Such sequencing is deemed inappropriate.92 Indeed debt, unlike equity, carries with it the risk of default if debtors fail to pay interest or reimburse capital on time. Moreover debt with a short maturity entails a higher degree of volatility. It is accordingly more rational for governments of developing economies to give priority to the liberalisation of direct investment, followed by equity portfolio investment. Furthermore long-term debt ± in contrast to short-term debt ± has to be judiciously structured to avoid the bunching of reimbursements. Charges aimed at discouraging hot capital in¯ows (that is, short term and speculative) could take the form of ®scal levies or non-interest-earning deposit requirements. These charges would be waived for foreign funds employed over longer periods, thereby providing an incentive for additional productive investment. Capital controls (through ®scal charges or other restrictions) on international ®nancial transactions are prompted by a variety of aims, including:

. Marshalling national savings for domestic use by restricting the outward ¯ow of capital in search of safety or higher returns abroad.

. Enhancing macroeconomic (monetary, exchange rate, growth and so on) . . . .

stability by moderating the size of foreign pools of capital that can precipitately leave the country. Changing the composition of capital in¯ows, for example by favouring those with longer maturity. Reducing the impact of capital in¯ows on currency appreciation (with its adverse effect on exports) or on monetary expansion (with its in¯ationary pressures). Protecting domestic ®nancial ®rms until they attain maturity (for example through economies of scale and scope). Favouring certain domestic economic activities and/or protecting nationally owned enterprises from foreign acquisition.

300 Whither Financial Intermediation?

Capital controls carry administrative costs, generate corruption, create distortions and institute rigidities in the domestic economy, which then looses the bene®ts of free trading in assets. These bene®ts include risk-sharing, diversi®cation, growth, technology transfer and enhanced competitiveness.93 Prior to the liberalisation of capital movements, developing countries in an interdependent world economy therefore need to introduce appropriate structural reforms (for example reforms aimed at strengthening the ®nancial sector) and macroeconomic policies that are capable of mobilising domestic savings for productive investment in a market-oriented economy. As summarised by one well-documented source, `External ®nancial liberalisation should not be considered an isolated or primary goal, achievement of which automatically raises the sophistication and resilience of the domestic ®nancial system. Rather, it should be part of a concurrent, integrated and comprehensive policy approach to macroeconomic and structural reform with individual elements of this policy package reinforcing each other.'94 Even if they have carried out appropriate structural reforms, small and medium-sized economies will continue to fear the adverse effects of massive (measured in proportion to gross domestic product) and speculative crossborder capital ¯ows. They therefore need international organisations to provide some assurance of support in times of trouble if they are fully to liberalise short-term capital movements. The moral hazard such assurance would induce in the behaviour of various economic actors, notably ®nancial ®rms, has to be weighed against the bene®t of preventing the propagation of systemic risk.

Conclusion At the beginning of the twenty-®rst century the landscape in major ®nancial markets is characterised by (1) relatively open ®nancial markets with rising interdependence among economies, institutions and market participants, (2) an increase in the average size, geographical reach, scope of product offerings and complexity of operations of ®nancial ®rms, (3) structural changes in intermediation, driven by deregulation, innovation and technology and (4) pervasive uncertainty and rapid turnarounds. The recent experience of crises and successes in the ®nancial sector has provided a wealth of lessons. First and foremost, a stable sociopolitical environment, sound macroeconomic policies and a solid regulatory framework are sine qua non for current and prospective prosperity. Second, a highquality top management team is fundamental to the enduring success of an enterprise: a ®rm can survive and prosper if it continues to develop, recruit and retain talented and entrepreneurial persons. Third, transparency and the timely provision of accurate information to management, regulators and market participants contribute to more rational decisions and greater ef®ciency. Fourth, the liberalisation of ®nancial markets has opened up

Zuhayr Mikdashi 301

opportunities for gain, but with the concomitant risk that unsound policies or strategies will contaminate other countries. Fifth, judicious cooperation or integration aimed at protecting the shared interest of stability and growth are needed (see Box 25.3). The survival of a ®nancial institution depends to a great extent on the ability of its leadership to anticipate and manage challenges and opportunities with

Box 25.3

A new space of stability ± Euroland

The euro95 has eliminated currency risk, increased the liquidity of ®nancial markets and consolidated the securities settlement industry (transfer of funds, delivery of securities and custody). Competition in ®nancial intermediation within Europe has considerably intensi®ed, aided by technology. This has led to a reduction in the price of some ®nancial products and services. In order to sustain pro®ts, several leaders of ®nancial groups have sought economies of scale ± for example by standardising ®nancial products and services, and through mergers, acquisitions or alliances. Thanks to the strength of the European Union (EU) in world trade, the euro is endeavouring to challenge the US dollar's ascendancy. The Euro's stability should help it to become highly demanded as a monetary reserve, a standard of measurement for international transactions and a means of investment. Europe needs to further the process of free internal trade, privatisation, ®scal harmonisation and ultimately greater economic±political union in order to anchor its monetary union more ®rmly. Asymmetric growth among the EU countries can only be prevented by budgetary allocations or more open and ¯exible markets (including the labour market). The European ®nancial services sector remains segmented (for example in respect of pension schemes) owing largely to national protectionism and/or inertia.96 Euroland has yet to devise a central regulatory authority for issuers and ®nancial intermediaries to enforce standard rules, impose ®nes and communicate violators' names for prosecution. European securities regulators have been endeavouring to harmonise their activities ± through the Forum of European Securities Commissions (FESCO, established at the end of 1997) ± by recommending improvements in stockmarket listing and prospectus requirements.97 The euro is generating momentum for the establishment of a level playing ®eld, the coordination of policies and the creation of central institutions in the areas of ®nancial regulation and supervision, crossborder payments, money and capital markets, liquidity assistance, deposit insurance, systemic-risk management and crisis resolution.98

302 Whither Financial Intermediation?

vision, appropriate strategies, professional competence, observance of prudent standards and healthy judgement. Decision makers and analysts are not, however, able to identify or accurately assess all the endogenous or exogenous causes of incipient ®nancial distress, nor the interaction of these causes. Moreover, recommendations aimed at preventing a crisis or containing the damage it causes cannot be solely guided by the lessons of the past. Crises have indeed differed with respect to (1) their genesis, intensity, propagation and duration, (2) the principal players (such as commercial banks, institutional investors, non-®nancial corporations, governmental entities), and (3) the role of key variables in the ®nancial market (for example interest or exchange rates) and the commodity market (for example energy prices). In the search for solutions to avert or control future ®nancial problems, discernment is needed by policy makers, regulators and executives, as well as improved methods and techniques to anticipate crises and manage risks. It will be useful to keep in mind those lessons of the past that appear relevant, but it is necessary to seek new solutions to problems that bear little or no relation to those of the past.99 Painful lessons recede from memory over time, often leading to lapses in risk management and to unreasonable behaviour. Notes 1. Certain aspects of these themes are examined in various chapters of this book. 2. See K. H. Eika, `The competitive environment in the banking industry ± driving forces and trends', Economic Bulletin (Norges Bank, Oslo, 1998/4), pp. 368±80. 3. See `International Banking and Financial Market Developments', BIS Quaterly Review, Bank for International Settlements, Basle, November 1999, p. 27; J. T. Moser, `Credit derivatives: Just-in-time provisioning for loan losses', Economic perspectives (Federal Reserve Bank of Chicago, fourth quarter 1998), pp. 2±11. 4. See United Nations, World Economic and Social Survey (New York: United Nations, 1999), pp. 227±8. 5. See `Financial mergers ± complex equations', The Economist, 5 June 1999, p. 89; S. Kwan and R. A. Eisenbeis, `Mergers of Publicly Traded Banking Organizations Revisited', Economic Review, (Federal Reserve Bank of Atlanta, fourth quarter, 1999), pp. 26±37; John Plender, `European banks ± why American-style consolidating mergers destroy value', Financial Times, 10 February 2000, p. 12. 6. See Emilio Botin, `Merger is not the only route', The Banker, April 2000, pp. 16±18. 7. See W. R. Emmons and F. A. Schmid, `Universal Banking, Control Rights, and Corporate Finance in Germany', Review (Federal Reserve Bank of St. Louis, July/ August 1998), pp. 19±42. 8. See Pamela Martin and Kathleen M. Beans, `Enterprise-Wide RM', The Journal of Lending & Credit Risk Management, March 2000, pp. 22±6. 9. See Basel Committee on Banking Supervision, Range of Practice in Banks' Internal Rating Systems (Basel, January 2000), p. 42. 10. See Leretta J. Mester, `What's the Point of Credit Scoring', Business Review (Federal Reserve Bank of Philadelphia, September±October 1997), pp. 3±16. 11. See Bryce Ferguson (Citigroup), `A consistent, Global Approach to Risk', The Journal of Lending & Credit Risk Management, February 2000, pp. 20±4.

Zuhayr Mikdashi 303 12. See Svein Gjedren and Harald Bohin, `An Evaluation of Emerging Markets as an Investment Alternative for the Petroleum Fund', Economic Bulletin (Oslo: Norges Bank, June 1999), pp. 187±96. 13. Basel Committee on Banking Supervision, Report to the G7 Finance Ministers and Central Bank Governors on International Accounting Standards (Basel, April 2000), 37 p. 14. Kevin M. Blakely (RMA chairman), `Be Careful Dancing to the Analysts' Music', The Journal of Lending and Credit Risk Management, February 2000, p. 6. 15. See Gerald T. West (Senior Advisor at MIGA), `Political Risk Investment Insurance', Credit Lyonnais International, no. 3 (1999), pp. 38±40. 16. See Daniel A. Nuxoll, `Internal Risk Management as a Basis for Capital Requirements', FDIC Banking Review, vol. 12, no. 1 (1999), pp. 18±29; UBS Financial Report 1998 (Zurich: UBS), pp. 33±5. 17. Swiss Federal Banking Commission, Rapport de gestion 1998 (Bern, April 1999), pp. 138±44, and Rapport de gestion 1999 (Bern, April 2000), p. 206. 18. Ibid. 19. `Risk Bets Pay Off Handsomely at First Boston', Wall Street Journal Europe, 22 March 2000, pp. 13, 24. 20. Swiss Federal Banking Commission, Rapport de gestion 1999, op. cit., pp. 203±4. 21. See Nicholas Dunbas, Inventing Money (New York, Chichester: John Wiley, 2000), p. 262. 22. See `U.S. Ends Probe Into Moody's Without Action Against Firm', Wall Street Journal Europe, 12±13 March 1999, p. 20. 23. `Credit-rating agencies ± On watch', The Economist, 15 May 1999, pp. 90±1. 24. See Alan Greenspan, `The Role of Capital in Optimal Banking Supervision and Regulation', Economic Policy Review (Federal Reserve Bank of New York, October 1998), pp. 163±8. 25. See `E-bonds, licensed to kill', The Economist, 15 January 2000, pp. 79±80; `London Banks Take Key Role At Swiss Bourse', Wall Street Journal Europe, 24 January 2000, p. 16. 26. `Electronic bond system accuses banks of sabotage', Financial Times, 12±13 February 2000, p. 1. 27. The National Association of Securities Dealers Automatic Quotations, NASDAQ, is the stock market of the US National Association of Securities Dealers (NASD), whose membership exceeded 5500 at the end of 1999. 28. `NASDAQ Closes Above 3000, a Triumph for Technology'. Wall Street Journal Europe, 4 November 1999, pp. 1, 12. 29. See Amaya Guillermo, `Dotcoms go to market', Connectis (Paris, May 2000), pp. 29±32. 30. `SEC Chairman Wants Dealers to Disclose Fixed-Price Orders', Wall Street Journal Europe, 17±18 March 2000, p. 18. 31. See `Among Big Changes, Where Is The SEC?', Wall Street Journal Europe, 12 October 1999, pp. 1, 7. 32. See L. J. Radecki and J. Wenninger, `Paying Electronic Bills Electronically', Current Issues in Economics and Finance (Federal Reserve Bank of New York, January 1999), p. 6. 33. `After-Hours Trading May Cost More and Yield Less for Retail Investors', Wall Street Journal Europe, 10 February 2000, p. 18. 34. US General Accounting Of®ce, Securities Operations ± Day Trading Requires Continued Oversight (Washington, DC, February 2000), p. 39.

304 Whither Financial Intermediation? 35. See D. W. Diamond `Financial Intermediation and Delegated Monitoring', Review of Economic Studies, July 1984, pp. 393±414; Per Lilja, `Structural changes in the banking sector ± driving forces and consequences', Quarterly Review, no. 4 (Stockholm: Sveriges Riksbank, 1999), pp. 43±63. 36. See Marco Martini, `The impact of information technology on the banking and ®nancial industry', Review of Economic Conditions in Italy (Rome: Banca di Roma, May±August 1999), pp. 203±23; John Jordan and Jane Katz, `Banking in the age of information technology', Regional Review, (Federal Reserve Bank of Boston, 4th quarter, 1999), pp. 24±30. 37. See John Wenninger, `The Emerging Role of Banks in E-Commerce', Current Issues in Economics and Finance (Federal Reserve Bank of New York, March 2000), p. 6. 38. See `Computer Attacks Increase Anxiety of Online Investors', Wall Street Journal Europe, 11±12 February 2000, p. 11. 39. See `Worldwide sweep for internet fraudsters', Financial Times, 24 March 2000, p. 1; `SEC Plans to Scour Internet for Crime', Wall Street Journal Europe, 29 March 2000, pp. 25, 32. 40. This was the case with three of the Credit Suisse Group's af®liates in Tokyo, which the Financial Supervisory Agency of Japan found guilty of the following offences: window dressing the accounts of Japanese banks, non-observance of the separation rules for certain banking activities, obstructing of®cial investigations by destroying or hiding documents or making false declarations, allowing de®ciencies in the organisational structure and failing to act in compliance. Swiss Federal Banking Commission, Rapport de gestion 1999, op. cit., p. 204±5. 41. Recent examples include the former chairman and CEO of the failed Banesto Bank (Mario Conde) being sentenced to 10 years and two months in jail in Spain for embezzlement and fraud, and three senior collaborators receiving sentences ranging from four to 13 years; and a 30-month prison sentence being imposed on the former chairman (Tsugio Yukihira) and president (Atsuo Miki) of Japan's Yamaichi Securities, who jointly concealed losses of ¥233±72 billion (over $2 billion) and distributed illegal dividends of ¥6 billion by falsifying ®nancial reports between 1994 and 1996. The president was also found guilty of paying a racketeer and making other illegal payoffs. `Jail sentences for executives of failed broker', Financial Times, 29 March 2000, p. 4. 42. See George Hanc, `Deposit Insurance Reform: State of the Debate', FDIC Banking Review, vol. 12, no. 3 (1999), pp. 1±26. 43. See R. A. Gilbert, A. P. Meyer and M. D. Vaughan, `The Role of Supervisory Screens and Economic Models in Off-Site Surveillance', Review (Federal Reserve Bank of St. Louis, November ± December 1999), pp. 31±56; B. J. Hirtle and J. A. Lopez, `Supervisory Information and the Frequency of Bank Examinations', Economic Policy Review (Federal Reserve Bank of New York, April 1999), pp. 1±19. 44. See Kenneth Jones and Barry Kolatch, `The Federal Safety Net, Banking Subsidies, and Implication for Financial Modernization', FDIC Banking Review, vol. 12, no. 1 (1999), pp. 1±17. 45. Group of Thirty, International Insolvencies in the Financial Sector (Washington, DC, 1998). 46. Basel Committee on Banking Supervision, A New Capital Adequacy Framework: Pillar 3 Market Discipline (Basel, January 2000). 47. See G. H. Stern, `Managing Moral Hazard With Market Signals: How Regulation Should Change With Banking', The Region (The Federal Reserve Bank of Minneapolis, June 1999), pp. 28±33, 60±62.

Zuhayr Mikdashi 305 48. Known as the Group of 10 (G10): Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, United Kingdom and United States (Luxembourg and Switzerland subsequently became full members). 49. See Benton E. Gup, Bank Failures in the Major Trading Countries of the World (Westport, CT: Quorum, 1998), pp. 28±9; Stuart I. Greenbaum and Anjan V. Thakor, Contemporary Financial Intermediation (Orlando, Fl: The Dryden Press, 1995), p. 655. 50. The OECD (Organization for Economic Cooperation and Development) then consisted of 24 industrial, developed, market-oriented economies. 51. See A. Daripa and S. Varotto, `Value at Risk and Precommitment: Approaches to Market Risk Regulation', Economic Policy Review (Federal Reserve Bank of New York, October 1998), pp. 137±43. 52. For example Patrick Parkinson, `Commentary', in Economic Policy Review (Federal Reserve Bank of New York, October 1998), pp. 155±9. 53. Hanc, `Deposit Insurance Reform', op. cit., p. 11. 54. US General Accounting Of®ce, Long-Term Capital Management: Regulators Need to Focus Greater Attention to Systemic Risk (Washington, DC, October 1999), p. 3 (hereafter GAO/GDG-00-3). 55. US General Accounting Of®ce, Risk-Focused Bank Examinations: Regulators of Large Banking Organisations Face Challenges (Washington, DC, January 2000), pp. 43±4 (hereafter GAO/GGD-00-48). 56. Zuhayr Mikdashi, Les banques aÁ l'eÁre de la mondialisation (Banks in the Era of Globalisation) (Paris: Economica, 1998), pp. 266±73; Bank of France, La centralisation des risques bancaires (Paris, October 1999). 57. See Bank for International Settlements, 69th Annual Report, 1 April 1998±31 March 1999 (Basel, 1999), pp. 99±102; GAO/GDG-00-3, pp. 10±12. 58. See Basel Committee on Banking Supervision, Banks' Interactions with Highly Leveraged Institutions: Implementation of the Basel Committee's Sound Practices Paper (Basel, January 2000). 59. The G7 is an economic grouping of seven industrialised nations whose aim is to coordinate monetary, ®nancial and ®scal policies to promote a more stable world economic system. It comprises France, Germany, Japan, the United Kingdom, the United States (the G5), Canada and Italy. 60. See, for example, `Pending U.S. Regulations Don't Worry Hedge Funds', Wall Street Journal Europe, 29 March 2000, p. 16; `Hedge funds may face direct regulation', Financial Times, 27 March 2000, p. 4. 61. See `Germany's System of Bank Guarantees Challenged', Wall Street Journal Europe, 23 December 1999, p. 22; `Germany's protective wings', The Economist, 22 May 1999, pp. 101±2. 62. See `EU Sues Germany over Subsidies to WestLB', Wall Street Journal Europe, 12 April 2000, p. 2; `Public-sector banks: To court', The Economist, 15 April 2000, pp. 90±1. 63. See `America's home-loan worry', The Economist, 15 April 2000, pp. 15±16, 89±90; `Worries about Risk Rise as U.S. Agencies Grow', Wall Street Journal Europe, 26 April 2000, pp. 13, 18. 64. See John Buckley (SVP of Communications, Fannie Mae), `America's mortgages', The Economist, 29 April 2000, p. 4. 65. See T. H. Hoenig, `Financial Industry Megamergers and Policy Challenges', Economic Review, (Federal Reserve Bank of Kansas City, third quarter, 1999), pp. 7±13. 66. GAO/GGD-00-48, p. 42.

306 Whither Financial Intermediation? 67. GAO/GDB-00-3, p. 3. 68. See Michael Taylor and Alex Fleming, `Integrated Financial Supervision ± Lessons of Scandinavian Experience', Finances & Development (Washington, DC: IMF, December 1999), pp. 42±5; and Financial Services Authority, Annual Report 1998/ 99 (London: FSA, 1999), p. 52. 69. Don Cruickshank, Competition in UK Banking, report to the chancellor of the exchequer (London: HMSO, 2000; www.bankreview.org.uk). See also `Tremors in the City', Financial Times, 7 April 2000, p. 14. 70. J. D. Hawke (Comptroller of Currency), speech before the Consumer Federation of America, 2 December 1999; FDIC, Privacy of Consumer Financial Information (Washington, DC, 28 February 2000). 71. `Too close for comfort' and `Bank bondage', Financial Times, 21 March 2000, p. 16. 72. See Svein Gjedrem (governor of the Central Bank of Norway), `Financial Stability ± Experiences and Challenges', Economic Bulletin (Oslo: Norges Bank, 1999/4), pp. 389±395. 73. `Recent approaches to involving the private sector in the resolution of international debt crises', Deutsche Bundesbank Monthly Report December 1999, (Frankfurt, 1999), pp. 33±48. 74. See also Richard Brealey, `The Asian crisis: lessons for crisis management and prevention', Quarterly Bulletin (London: Bank of England, August 1999), pp. 285±96; Timothy Lane, `The Asian Financial Crisis ± What have we learned?', Finance & Development (Washington, DC: IMF, September 1999), pp. 774±7. 75. See Philippe F. Delhaise, Asia in Crisis ± the Implosion of the Banking and Finance Systems (Singapore: John Wiley, 1998), p. 280. 76. See Mario Sarcinelli `What future for the IMF?' Review (Rome: Banca di Roma, September±December 1999), pp. 373±430. 77. The Basel Committee on Banking Supervision has already issued a `Core Principles Methodology' (Basel, October 1999). 78. See Andrew Large, The Future of Global Financial Regulation (Washington, DC: Group of Thirty, 1998). 79. `US blocked trade perks for poor nations', Financial Times, 7 April 2000, p. 6. 80. Hans Tietmeyer, `Evolving Cooperation and Coordination in Financial Market Surveillance', Finance & Development (Washington DC: IMF, September 1999), pp. 20±23. 81. See Andrew Crockett (chairman of FSF), `A pillar to bolster global ®nance', Financial Times, 22 March 2000, p. 13; `Recent approaches to involving the private sector in the resolution of international debt crises', Deutsche Bundesbank Monthly Report (Frankfurt, December 1999), pp. 33±48. 82. See, `The IMF needs a new focus as well as a new boss', The Economist, 13 November 1999, pp. 89±90. 83. See US General Accounting Of®ce, International Financial Crises ± Efforts to Anticipate, Avoid, and Resolve Sovereign Crises, (Washington, DC, 7 July 1997). 84. For example see ibid. 85. See `IMF comes under new scrutiny following Ukraine allegations' Financial Times, 18 February 2000, p. 4; `US seeks culprits for misuse of IMF loans', Financial Times, 28 March 2000, p. 8. 86. Bijan B. Aghevli, `The Asian Crisis: Causes and Remedies', Finance & Development (Washington, DC: IMF, June 1999), pp. 28±31. 87. See Ariel Buira, An Alternative Approach to Financial Crises, Essays in International Finance (Princeton, NJ: Princeton University Press, 1999).

Zuhayr Mikdashi 307 88. See George P. Shultz, William R Simon and Walter R. Wriston, `Who Needs the IMF'? Wall Street Journal Europe, 4 February 1998, p. 10, `Close the World Bank and the IMF', Wall Street Journal Europe, 13 April 2000, p. 10; `Summit of Head of States (G77): Fidel Castro calls for the ``demolition'' of the IMF', L'AGEFI (Lausanne); 13 April 2000, p. 5. 89. See Jane Little, `The IMF Under Fire: It must be doing something right' Regional Review (Federal Bank of Boston, 2nd quarter, 1998), pp. 9±15. 90. `New chief wants IMF to focus on short-term lending', Financial Times, 29 March 2000, p. 16; `Koehler Backs Greater IMF Autonomy', Wall Street Journal Europe, 29 March 2000, pp. 1, 4. 91. IMF, Survey Supplement (Washington, DC, September 1999), p. 16. 92. Sarcinelli, `What future for the IMF?', op. cit., p. 382. 93. See Christopher J. Neely, `An Introduction to Capital Controls', Review (Federal Reserve Bank of St. Louis, November/December 1999), pp. 13±30. 94. United Nations, World Economic and Social Survey 1999, op. cit., pp. 240±5. 95. Adopted by 11 countries: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands and Portugal ± known as the euro area or Euroland. 96. See `European pensions ± Dear Prudence', The Economist, 11 December 1999, p. 74. 97. See `European ®nancial regulation: No SECs please, we're European', The Economist, 21 August 1999, pp. 62±3. 98. See Alessandro Prati and Garry J. Schinasi, Financial Stability in European Economic and Monetary Union, Princeton Studies in International Finance (Princeton, NJ: Princeton University Press, 1999). 99. See William R. White, `What have we learned from recent ®nancial crises and policy responses?', BIS Working Papers, Bank for International Settlements, Basle, (January 2000).

This page intentionally left blank

Index

ABB Group 84±7

Adjaout, K. 183

Africa 171±84

economic performance 171±3 need for ®nancial market reforms 173±4; banking supervision 177±80; exchange rate regimes 175; external liberalisation 174±5; fragmentation and 182±3; micro®nance institutions 183±4; money market developments 176±7; rural sector 181 agriculture 181

aid programmes 172

Almanij Group 31±2

Alternative Investment Market

(AIM) 269

Altman, E. 202

Ameritrade 11

Archipelago 272

Argentina 148

Aryeetey, E. 182

Asian ®nancial crisis 128±32, 133,

145±7, 149, 152, 154, 159, 162, 186,

267, 292±3

asset-backed securitisation 263

Australia, stock exchange 103, 120

capital of 8, 123±7, 131, 158, 188±90,

191, 281±5

community banking 18±19, 25

competition in 10±11, 12±13, 19,

102

corporate off-balance-sheet capital

and 36

crises see ®nancial crises

customers 9, 11±12, 22±3, 30, 66

decentralisation 26±7

deconstruction of banking

services 10±11

deregulation 8, 18, 22, 211

disintermediation 8±9, 67, 253

employee development 30±1

European single currency and 14±15,

29±32, 102, 211

failure of banks 188, 275

future of 7±16

globalisation and 1, 8, 18, 30;

regulation 123±7

government support and

ownership 14, 132, 133, 287±9

industrial organisation theory and 20,

21±5

information technology and electronic commerce 9±10, 11, 17±28, 65±72, 81±2, 215, 272±4; Swedish experience 68±72 innovation 23±4, 31±2, 251

investment banking 8

mergers and acquisitions 13, 14, 15,

31, 209, 211±12, 216

public ownership 14, 132, 133

regulation 19±20, 135±6, 275±91;

administrative rules versus

market-based instruments

186±96; Africa 177±80; Asia

study 128±32; globalisation

and 123±7, 179±80; market

discipline and 277±81; rationale

for 187±8, 275±81; reform

proposals 147±9, 152±5, 156,

158±60; see also Basle Committee

Bailey, M. 172

Bank of Credit and Commerce

International (BCCI) 178

Bank for International Settlements

(BIS) 154, 155, 158, 163, 180, 205,

294

Financial Stability Institute (FSI) 133±9

Bank Watch 129, 266

bankruptcy 194±5, 209

banks and banking

African ®nancial markets reform

and 171±84

bankruptcy 194±5, 209

309

310 Index banks and banking (continued ) risk and 188, 258±67; internal

models 192; junior debt

requirement 193±4;

precommitment approach 192±3,

284; rating 191±2, 201±3, 259,

262, 266±7

scale and scope economies 24, 25,

212±15 size of banks 209±18 strategic options for 13±14, 253±7 technology 24±5 Basle Committee 163, 188, 263, 287

Capital Accord (1988) 8, 123±7, 131,

158, 188±90, 191

Core Principles of Banking

Supervision 134, 136, 137, 158,

179

new proposals (1999±2000) 283±4 Belgium banking in 31±2 stock exchanges 113±14 Berger, A. N. 213

BfG Bank 69

Black, F. 215

bond markets see corporate bond markets

bonuses 266

BSCH 211

Calomiris, C. 186, 193

Cantor, R. 202

capital

banks and 8, 123±7, 131, 158, 188±90,

191, 281±5

Basle Capital Accord (1988) 8, 123±7,

131, 158, 188±90, 191

capital asset pricing model (CAPM) 42

capital markets: electronic

commerce 78±83; globalisation 1±3, 8

corporate see corporate capital

free movement of 155

Caprio, G. 176

cherry picking 10±11

Chile 151

China 293

banks in 129, 132

Citibank 24

Codan 69

Cold War 141

Collier, P. 171

community banking 18±19, 25

competition 249±53

in banking 10±11, 12±13, 19, 102

in network markets 64

stock exchanges 88, 89, 101, 118,

269

computers 59, 60

conglomerates 209±18, 289±91

ConSors 11, 29

contingent claim approach to credit

risk 203±5

Contingent Credit Lines 298

Cooper, Richard 148

corporate bond markets 8, 75±7

electronic trading 75±7, 78±83 corporate capital 33±56

capital resources 36±7

economic capital 34

models of capital structure 37±55;

insurance model 43±51; insurative model 33, 51±5; standard model 38±42 off-balance-sheet capital 36±7

operational capital 34

paid-up capital 36; return on

(ROP) 40

risk capital 34

role of 33±5

signalling capital 34±5

corporate governance 257

corporate strategies 13±14, 253±7

cost of debt (COD) 41

cost of equity (COE) 41±2

cost of insurance (COI) 49

country risk 262±3

credit derivatives 252

Credit Monitor model 207

credit risk 198±208, 224, 226±7, 262±3

complexity of 199±201

portfolios and 205±8

ratings 191±2, 201±3, 259, 262, 266±7

theoretical literature on 203±5

credit scoring 259

Credit Suisse 150, 151, 206, 266

Creditmetrics 206

CreditPortfolio model 207

CreditRisk+ 206

crises see ®nancial crises

cross-subsidisation 10, 13

Index 311 customers, banks and banking 9, 11±12,

22±3, 30, 66

DAB 29

Danthine, J.-P. 186, 217

data mining 65

Datek Securities 11

debt

banks' junior debt requirement 193±4

external 133

insurance 148±9

decentralisation, banks and banking 26±7

democracy 142

Denmark 68

deregulation 58

banks and banking 8, 18, 22, 211

Deutsche Bank 211, 255

development aid programmes 172

disintermediation 8±9, 67, 253

diversi®cation strategy 255±6

DLJ direct 11

EASDAQ 89, 92, 108±9, 112±14, 269

economic aid programmes 172

economic capital 34

economic performance

African 171±3 information technology and 61±2

Egg 11

Eichengreen, Barry 133

electronic commerce see information

technology and electronic commerce employee development, banks and banking 30±1

Entrium 11

Ericsson 68

E*Trade 11, 271

Eurex 75, 76, 78, 89, 269

Euro MTS 268

Euro NM 269

Euronext 90±1, 269

European Union

bond markets 8

central bank 148, 162

®nancial crisis and 154

future of banking in 14±15, 29±32

single currency 14±15, 29±32, 101±14,

211, 301

stock exchanges 88±114; current

status 91±2; demise of old

model 88±9; electronic

trading 11, 66, 102±6; European

Monetary Union and 101±14;

impediments to uni®ed European

market 106±14; regulation

92±101, 102±6, 107±14;

reorganisation 89±91

exchange rates 148, 152±3, 175, 292

extreme value theory 233±4

factoring 263

failure of banks 188, 275

®nancial crises 128±32, 133, 145±57,

162, 186, 267

analysis of 145±7

reform proposals 147±9, 152±5, 156,

158±60

risk management and 220±35

role of banks and private

creditors 149±52

sources of instability 291±4

stabilisation 294±300, 301

®nancial liberalisation Africa 173±5 sequencing of 299±300 Financial Stability Forum (FSF) 136,

163±4, 294

Financial Stability Institute (FSI) 133±9

Finland 68

Fischer, Stanley 134

Fitch IBCA 191, 266

Forum of European Securities

Commissions (FESCO) 109±10, 111

France

banks and banking in 11

insurance in 112, 113

stock exchanges in 112±13

free market model 58

Friedman, M. 172

Fry, M. 172

functional approach to ®nancial

intermediation 180

Garten, Jeffrey 134, 148

Gates, Bill 10

General Electric Capital 11

Germany

banks and banking in 10, 11, 287±8

Berlin Wall 141

312 Index Germany (continued )

®nancial crisis and 146

on-line brokerage 11

Ghana 182

global stabilisation 294±9

globalisation 58±9

African ®nancial markets reform

and 171±84

banks and 1, 8, 18, 30;

regulation 123±7, 179±80

capital markets 1±3, 8

challenges for Switzerland 140±4

regulation and 1, 161±4

stock exchanges and 118

Globex 269

Goodhart, C. 186, 196

Gordon growth model 42

government and the state

ownership by 14, 132, 133

support by 287±9

Grove, Andy 9

Gunning, W. 171

Gyllenberg 69

Hite, G. 203

Hong Kong

®nancial crisis 133

stock exchange 118, 120

Honohan, P. 176

Hughes, J. P. 213, 215

Hugo, Victor 143

human capital 1±2

India, banks in 129, 132

Indonesia

banks 129, 130, 132

®nancial crisis 129, 292

industrial organisation theory 20, 21±5

in¯ation 61, 62, 68, 172

informal sector 181

information capital 1±2

information technology and electronic

commerce 59±60, 167±8, 270±4 banks and 9±10, 11, 17±28, 65±72, 81±2, 215; Swedish experience 68±72 banks and banking 9±10, 11, 17±28, 65±72, 81±2, 215, 272±4

brokerage and 11, 66

challenges to management 64±5

corporate bond markets 75±7, 78±83 economic growth and 61±2 electronic communications networks (ECNs) 78, 79±80, 91, 117±18, 270

future of 60±1

market changes and 63±4

security concerns 274±5

stock exchanges and 11, 66, 89±90,

102±6, 117±18, 268, 270±2

SWX Swiss Exchange 75±7, 89

innovation 249±53

banks and banking 23±4, 31±2, 251

Instinet 118, 271

insurance

credit risk 264

debt insurance 148±9

insurance model of corporate capital

structure 43±51 insurative model of corporate capital structure 33, 51±5

interest rate controls 173, 176

International Monetary Fund (IMF) 134,

136, 152, 153, 156, 158, 163, 172,

267, 293, 294±8

International Swaps and Derivatives

Association (ISDA) 252

Internet 60

see also information technology and

electronic commerce

Intuit Home Banking 23

investment funds, optimal

portfolio 236±44

Island 118

Italy

®nancial crisis and 146

stock exchanges in 112, 113

Japan

banks and banking in 13, 129, 133,

165±6

deregulation in 8

®nancial crisis 129, 133, 146±7, 153,

186, 293

information technology and electronic

commerce in 11, 167

Jiway 89, 92

judgement, risk and 266±7

junior debt requirement 193±4

Kaufman, Henry 134, 147

Index 313 KBC 31

Kishore, V. 202

KMV 207

Kohl, Helmut 150

È hler, Horst 297

Ko

Korea

banks 129, 130, 132

®nancial crisis 129, 152, 188, 292, 296

®nancial liberalisation 299

Krugman, Paul 133, 155

liberalisation Africa 173±5 sequencing of 299±300 Long Term Capital Management (LTCM) 265±6, 285±6

Lonski, J. 202

Lucas, D. J. 202

Malawi 182

Malaysia

banks 129, 132, 153

®nancial crisis 129, 292

McKinsey & Co. 207

Mehran, M. 173, 175

mergers and acquisitions 164±6, 254±5

banks 13, 14, 15, 31, 209, 211±12, 216

stock exchanges 89, 90±1, 119

Meridien Bank 178

Merton, Robert C. 180, 203, 207, 215

Mester, L. J. 213

Mexico 151, 186, 296

micro®nance institutions 183±4

Miller, Merton 39

Modigliani, Franco 39

monetary policy 176±7

Moody's Investors Service 191, 266

moral hazard problem 12±13, 130, 134,

149, 152, 277, 288, 296

Morgan, J. P. 206

Multilateral Investment Guarantee

Agency (MIGA) 264

NASDAQ 91, 268, 269

network markets 63±4, 67

neutrality 141

Neven, D. 217

Nickell, P. 202

Nigeria 182

Nokia 68

North Atlantic Treaty Organisation

(NATO) 141

Norway 68

off-balance-sheet capital 36±7

operational capital 34

optimal portfolio of investment

funds 236±44 paid-up capital 36

return on (ROP) 40

Philippines, ®nancial crisis 129

portfolios, credit risk and 205±8

Posit 118

poverty 3

precommitment approach to risk 192±3,

284

privatisation 174

productivity 59, 62

quality 58

rating of credit risk 191±2, 201±3, 259,

262, 266±7

Reagan, Ronald 141

reduced-form approach to credit

risk 203, 205

regulation

banks 19±20, 135±6, 275±91; administrative rules versus marketbased instruments 186±96; Africa 177±80; Asia study 128±32; globalisation and 123±7, 179±80; market discipline and 277±81; rationale for 187±8, 275±81; reform proposals 147±9, 152±5, 156, 158±60; see also Basle Committee expansion of 285±7

®nancial conglomerates 290±1

future of 161±8

globalisation and 1, 161±4

proposals for new ®nancial

architecture 147±9 Switzerland's contribution 156

stabilisation and 291±300

stock exchanges 92±101, 102±6,

107±14, 268

retained risk 37

return on assets (ROA) 39

314 Index return on equity (ROE) 39, 41, 45±8,

53 return on paid-up capital (ROP) 40

risk 2±3

banks and 188, 258±67; internal

models 192; junior debt

requirement 193±4;

precommitment approach 192±3,

284; rating 191±2, 201±3, 259,

262, 266±7

Basle Capital Accord (1988) and bank

capital adequacy 8, 123±7, 131

corporate capital and 34, 35;

insurance model 43±5; insurative

model 51±5; standard

model 38±9

credit risk see credit risk

dynamics of 259±63

extreme value theory 233±4

judgement and 266±7

management of 33, 55±6, 150,

258±67; crises and 220±35; see also credit risk mitigation of 263±4 moral hazard problem and 12±13, 130, 134, 149, 152, 277, 288, 296

new methods of assessing 128±32

retained 37

systemic risk 267, 277

transferred 37

value-at-risk model 264±6

vega risk 222, 226, 231±3

Royal Bank of Scotland 212

rural sector, African ®nancial sector

and 181

Russia

Cold War 141

crisis in 133, 146, 147, 149, 150, 152,

154, 186, 296

Sachs, Jeffrey 133, 149, 171

Saunders, A. 213

savings 174

scale economies

banks and banking 24, 25, 212±15

information technology 63, 67

Scholes, M. 215

Schumpeter, Joseph 61, 62

Schure, P. 216

Schwab, Charles 11, 23, 271

scope economies 24, 25, 212±15

second sourcing 23

securities markets 8, 75±7

security concerns, information

technology and electronic commerce 274±5 sequencing of liberalisation 299±300 signalling capital 34±5 Skandinaviska Enskilda Banken (SEB) 68±72

Sony 11

Soros, George 133, 148

South Africa 175

speculation 175

stabilisation 291±300, 301

global 294±9 sequencing of liberalisation and 299±300 sources of instability 291±4 standard model of corporate capital structure 38±42

Standard & Poor's 191, 266

state see government and the state

stock exchanges 88±114

competition 88, 89, 101, 118, 269

current status 91±2

demise of old model 88±9

European Monetary Union and 101±6;

impediments to uni®ed European market 106±14

future of 117±20, 268±70

globalisation 118

information technology and electronic

commerce 11, 66, 89±90, 102±6,

117±18, 268, 270±2

mergers and alliances 89, 90±1, 119

regulation 92±101, 102±6, 107±14,

268

reorganisation 89±91

strategic options 13±14, 253±7

structural adjustment programmes 172

Summers, Larry 297

Sweden, banks and information

technology in 68±72

Swissair 140

switching costs 22±3

Switzerland

bank bankruptcy in 195

central bank 148

challenges of globalisation 140±4

Index 315 contribution to proposed for new ®nancial architecture 156

investment funds 236

stock exchange 75±7, 89, 268

syndication of loans 263

systemic risk 267, 277

Taiwan, ®nancial crisis 129

takeovers see mergers and acquisitions

Tanzania 182, 183

taxation 58, 68, 112±13

technology, banks and banking 24±5

Thailand

banks 129, 130, 132

®nancial crisis 129, 267, 292, 297

Tietmeyer, Hans 163

Tobin, James 238, 239

total average cost of capital (TACC) 49,

50, 53±4

Tradepoint 80, 89, 91, 92, 272

transferred risk 37

Trygg-Hansa 69

UBS 216, 217, 265

unbundling 64

Ungern-Sternberg, T. von 217

United Kingdom

®nancial crisis and 146

on-line banking in 11

stock exchange regulation 103

United Nations 141

United States of America

banks and banking in 14, 18±28, 213,

289; deregulation 8, 22, 211;

mergers and acquisitions 209;

regulation 135±6

bond markets 8

Cold War 141

conglomerates in 289±90

electronic commerce in 11, 79

®nancial crisis and 133, 146, 147, 153

global currency and 148

government support in 288

investment funds 236

regulation in 135±6, 285

stock exchanges 91, 268

value-at-risk model 264±6

vega risk 222, 226, 231±3

Vietnam, banks in 129, 132

volatility 3

vega risk 222, 226, 231±3

Wagenvoort, R. 216

Walter, I. 216

Warga, A. 203

Warner, M. 171

weighted-average cost of capital

(WACC) 39, 41, 42, 48±9, 53

Westdeutsche Landesbank 288

World Bank 134, 158, 172, 182, 184,

264, 294

x-inef®ciencies 216, 217

Zambia 178

Zimbabwe 178