Financial Competition, Risk and Accountability

The term ‘globalisation’, which has been the subject of much public debate for some time now, triggers a mixed reaction in many people. They associate it on the one hand with worldwide trade in goods, new opportunities for travel and an unrestricted exchange of information. But globalisation also means the disappearance of old orders. National policies reach their limits earlier and more often when there is transnational freedom for people, capital and management. This is often a source of fear and resistance.

The banking systems of Britain and Germany are among the most stable in the world. In both countries bank failures are exceedingly rare, and even periods of difficulty among more than a few banks very uncommon. Yet the two systems are very different. They differ both in structure and in how banks in the two countries behave. In this chapter we compare the two systems, so as to bring out the key features which have contributed to their stability and to see if anything can be said about the prospects for their continuing stability in the future. We start, though, by looking at recent periods of major instability — not in Britain and Germany, where there have been no such episodes for many years but in other countries, so as to highlight the kind of events which can bring serious disturbances to a country’s financial system. Then we turn to describing the systems of Britain and Germany, showing how both have experienced substantial liberalisation in recent years. This leads to a comparison of banking profitability in the two economies, and to an appraisal of the factors which may have contributed to the radically different experience of the two countries in this regard. This enables us to offer some suggestions as to the impact of liberalisation and of inflation on banking sector stability.

European economic integration and the advent of a common European currency raise fundamental questions about the operations of the financial systems that are supposed to support these changes. Prominent among these questions is how banks and financial institutions operating in different ways and with different histories and traditions will deal with increasingly common European business as financial systems merge into one. The conventional wisdom is that competition between financial firms will ensure that those with competitive advantages (for example, British merchant banks with greater capital market expertise) will survive, while those firms which have fewer competitive advantages (for example, perhaps Germany’s small co-operative banks) will fail. In other words, that some common marketplace for financial services will sort out the less efficient from the more efficient, and ensure that the former are driven out of business or are forced to become more competitive (see Chick 2000 for a perceptive discussion of these issues). Implicit in this view is the notion that systemic factors, that is the way in which a financial system supports the intermediary firms in it and is vulnerable to changes in aggregate financial flows, do not influence the business of particular financial firms.

The banking industries of Britain and Germany have for many years maintained distinct traditions with regard to lending to industry. British banks have viewed firms as customers, lending to them on a short-term basis. German banks, by contrast, have viewed firms as partners, lending to them for long periods of years, building up associations, often having representatives on the firms’ boards. This has, in turn, encouraged banks to take a long-term view of ‘industry’s’ long-term plans, to the mutual benefit of both banking and manufacturing. So, at least, the story goes.

Classical economics has produced conflicting interpretations of the responsibilities of individual agents engaged in market competition. Although it is widely accepted that it is the competition of individuals that produces the economic efficiency associated with free markets, Lionel Robbins has warned that ‘the pursuit of self-interest unrestrained by suitable institutions, carries no guarantee of anything except chaos’ (Robbins, 1952, p. 56). More recent analysis, on the other hand, suggests that while ‘millions of greedy, self-seeking individuals in pursuit of their own ends and mainly uncontrolled in their pursuits by the State, seem to common sense a sure recipe for anarchy’, it is in fact the very basis of the economic efficiency of the market (Hahn, 1980, p. 123).

The traditional function of commercial banks has been to act as financial intermediaries between deficit and surplus sectors (Heffernan, 1996) but fundamental to this process has been the assumption that banks can intermediate at lower costs than those prevailing in direct financing arrangements (Gurley and Shaw, 1960). Developments in corporate wholesale financing over the past twenty years or so have, however, significantly undermined this ‘cost imperative’ for large national and international companies. This has resulted in significant disintermediation of commercial banks by large companies and raised the question as to whether this development signals merely another evolutionary phase in modern banking or something far more fundamental which could herald the ultimate demise of commercial banking (Gardener and Revell, 1988).

Option theory, swaps and securitisation are the massive changes of the last twenty years in the financial markets. Of these only the first is ‘new’, relying principally on the mathematics of the model developed by Black and Scholes. However, swaps and securitisation have had such a radical and creative effect on the way in which finance is considered that they have changed the whole landscape of large-scale, especially corporate, financing. Everything else is basically derivative, with the scale of dealing being the only reason to attract attention. By contrast, the long and widespread history of futures is demonstrated by my regular discussions in the local undertaker’s hearse with one of the bearers, whose main job is farming, on the futures prices in potatoes, which have varied from £0.70–£5 per bag in the last two years.

Individual banks as well as the banking industry as a whole are facing broad public unease because of a wide range of scandals such as insider trading, money laundering and misuse of funds for personal gain. In this climate, in the United Kingdom just as in Germany, ethical questions have become more relevant for banks especially because there is an awareness that only the tip of the iceberg of illegal and unethical dealings has been exposed. As a consequence, for a larger part of the public, banking business and moral principles are considered to be more and more antagonistic. Regarding these developments, banks seem to need some good advice on how to cope with their ethical problems, in order to regain public acceptance.

Deregulation, liberalisation and globalisation of financial markets in the 1980s and the 1990s has meant more reliance on prices (interest rates) as the clearing market mechanism. Moreover, central banks throughout the world are making much heavier use of interest rates to control monetary aggregates and the other ultimate targets of economic policy. These structural changes imply much larger volatility in interest rates than before which, in turn, causes a more stressful adjustment for the corporate, personal and financial sectors. This adjustment is not uniform. Small businesses are hit more than large ones, and the consumer is hit even harder when interest rates rise, thus raising general issues on the preferred method of the conduct of monetary policy and the effects of deregulation, liberalisation and globalisation.

This chapter originated as a few discussant remarks on the Frowen and Karakitsos contribution to this volume (Chapter 9) (hereinafter F&K1). I was subsequently invited by the editors to expand my remarks into a self-standing chapter. The working title of F&K1 was ‘A Comparison of the Conduct and Ethical Underpinnings of Monetary Policy in the United Kingom and Germany’.

The topic of this chapter is of immediate interest. The recent crisis of financial markets in Southeast and East Asia and the spectacular devaluations of currencies involved once again raises the question of the role of the leading central banks in today’s world.¹ Of course, the US$ and the euro are not challenged immediately. The third major currency, the yen, is weakened by domestic factors. The world financial centres are touched but not destabilised. Waves of financial transactions signal irritation and anxiety, but have left no deep distrust in the international financial system. At stake are the financial markets of the industrialised countries, the relationship between their international credits and debits, the efficacy of their monetary policies and the reputation of their governments. The crisis has exposed the vulnerability of emerging financial markets, the carelessness of borrowing and lending, and the propelling force of financial flows in creating speculative bubbles and exacerbating the crisis. The interrelations between waves of capital movements and structural distortions in the real economy have become obvious.

My role in the Bank of England currently has three dimensions. First, I am a supervisor of banks. Secondly, I am heavily involved in the design of the new single financial services supervisory agency, which the government announced in May 1997 it wished to create. This will be known as the Financial Services Authority (FSA). (At the time of the Conference, the agency was known by its provisional title of NewRO.) It will encompass the banking supervision currently done at the Bank of England, the work of the City regulators set up under the Financial Services Act, the supervision of Building Societies and Friendly Societies and the regulation of the Insurance industry. Thirdly, I am the Bank’s Business Ethics Adviser. I therefore propose to focus my remarks on issues that both affect the FSA and have an ethical dimension. However, all these views presented are my personal ones and should in no sense be taken as an official statement either by the Bank of England or by the future management of the FSA.

In 1848, John Stuart Mill deplored ‘the barbarism of most civilised nations’ who ‘assert their nationality by having, to their own inconvenience and that of their neighbours, a peculiar currency of their own’. One hundred and fifty years later the arrival of Economic and Monetary Union in Europe generates great passion among supporters and opponents. What is it about EMU which makes it of more than technical importance? What is the ethical dimension to decisions on EMU — indeed is there one at all? This chapter seeks to approach the key issues raised by EMU and their wider implications for the group of European countries embarking on a new form of economic relation between sovereign states.

The hypothesis of this chapter is that a strategy in favour of financial liberalisation in the emerging market economies of Central East Europe will lead to Anglo-Saxon types of financial sectors, including the implantation of chronic short termism and vulnerability to speculative attacks. For economic policy we argue therefore in favour of a careful rehabilitation approach following the postwar West German example (see Grünbacher and Hölscher 1997).

‘Public goods cannot be provided by private enterprise’. This statement by a representative of one of the leading German banks emphasises the traditional borderline between state responsibility and market mechanisms, between the redistribution of wealth and its concentration in a profit-orientated market. It expresses rather well the present philosophy of private bank managers in Germany who may be active in sponsoring cultural events, but nevertheless remain quite remote from what in the Anglo-American context is understood as community reinvestment and social banking.