European banking: An overview

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Abstract

Against a background of far-reaching structural change in the banking sector, this article reviews the recent academic literature on developments in European banking. European banking markets have become increasingly integrated in recent years, but barriers to full integration, especially in retail banking, still remain. European integration has possible implications for systemic risk, and poses various challenges for the current supervisory framework. The banks’ responses to the changing competitive environment include the pursuit of strategies of diversification, vertical product differentiation and consolidation. European integration has implications for competition in banking markets, for the nature of long-term borrower-lender relationships, and for the relationships between ownership structure, technological change and bank efficiency. The article concludes by reviewing recent literature on the credit channel in the monetary transmission mechanism, and interest rate pass-through.

Introduction

This survey article highlights a number of key recent developments in the academic literature on European banking. During the last 20 years, forces such as globalization, technological change, deregulation and European integration have fundamentally transformed the European banking industry. Against a background of rapid and far-reaching structural change, this survey article is structured as follows. The rest of Section 1 quantifies the extent of structural change in European banking, by presenting some key data and stylized facts. Section 2 examines the impact of European integration and the creation of the single market on the banking industry, including an assessment of barriers to integration and the impact of integration on the stability of the financial system. Section 3 examines the strategic responses of banks to their changing competitive environment, including product and geographic diversification, vertical product differentiation, and consolidation. Section 4 describes the measurement of competition in European banking. Section 5 examines relationship banking. Section 6 describes the measurement of cost structure and efficiency, and deals with the influence of ownership features and technological change on costs and profitability. Section 7 examines the role of the credit channel in the monetary policy transmission mechanism, and recent evidence on interest rate pass-through. Finally, Section 8 offers some brief concluding remarks.

Table 1 reports a number of structural indicators for the banking sectors of the EU15 (the 15 pre-2004 EU member states, identified in the left-hand column of Table 1). Between 1985 and 2004, the total number of banks operating in the EU15 fell from 12,315 to 7300. The total assets of the banking sectors of all countries for which data are reported increased dramatically between 1985 and 2004. In the five largest EU15 countries by population or GDP combined (France, Germany, Italy, Spain and the UK), the rate of increase was 340% in nominal terms. The ratio of banking industry assets to GDP for the ‘big five’ stood at 283% in 2004: a large increase on the 1985 figure of 175%.4 According to Dermine (2006), this growth reflects the effectiveness of deregulation and the single market program in bringing about the end of ‘repressed’ banking systems.

In four of the ‘big five’, the number of bank branches increased between 1985 and 2004. The sole exception was the UK, in which there was a large reduction in the size of branch networks. Meanwhile, total EU15 banking sector employment rose by around 10–15% over the same period, reaching a total of around 2.8 million in 2004. Again there were large differences between countries, with the UK and (to a lesser extent) Germany experiencing significant employment growth, while there was relatively little change in France, Italy and Spain. Finally, the data on CR5 (the five-firm concentration ratio for total assets) show little evidence of any consistent trend in banking sector concentration, which increased in some countries but fell in others between 1985 and 2004. A tendency towards deconcentration in traditional loans business may have been offset by a tendency towards increased concentration in non-traditional banking business (Maudos and Fernandez de Guevara, 2004, Carbó and Fernandez, 2005).

Of course, these trends mirror and reflect a process of structural change in European banking that is considerably more complex than the raw data are capable of representing (Berger et al., 1999, Groeneveld, 1999, Amel et al., 2004, Gual, 2004). For example, the integration and liberalization of European financial markets and payments systems has placed considerable pressure on the banks’ traditional lines of business. In response to growing competition, banks have diversified into non-interest earning activities such as insurance and mutual fund sales, private banking and asset management. Meanwhile insurance companies and investment and pension funds have grown, as household savings have been siphoned away from banks and toward alternative savings and investment products. Non-bank institutions such as supermarkets and telecommunications firms now compete in financial services markets. Banks have also sought to re-engineer value chains through securitization of their loan portfolios. ECB (2005a) notes that securitization issues amounted to €243.5 billion in 2004, of which nearly one-half related to residential mortgages. As a result of financial innovation, banks offer more products and services than ever before, and conduct a growing proportion of their business off-balance sheet. Consequently, the distinction between banks and non-bank financial intermediaries has become increasingly blurred (Rajan and Zingales, 2003, Van der Zwet, 2003). The market shares of foreign banks have increased in many European countries, leading to a further intensification of competition (Lensink and Hermes, 2004).

Undoubtedly, the process of European integration in general, and the creation of a single banking market in particular, has contributed significantly to many of the developments outlined above. Nevertheless, the degree to which the ideal of an integrated European banking market has yet been realized remains open to debate. Section 2 examines in more detail the extent to which the integration of the European banking industry has been achieved.

Section snippets

Integration of the European banking industry

Table 2 summarizes the key legislative changes since the late-1970s at EU level that have contributed towards the integration of European banking and financial markets. Other major developments at a more general level, that have nevertheless impacted significantly on the banking and financial sectors, include the 1985 White Paper on the Completion of the Internal Market; the 1986 Single European Act; the 1992 Maastricht Treaty (which consolidated the single market program), the introduction of

Diversification, vertical product differentiation and consolidation

Many of the most successful European banks have responded to the changing competitive environment by expanding significantly, either through internally generated growth, or through merger and acquisition. Growth has enabled banks to realize scale and scope economies, reduce labour and other variable costs, and reduce or eliminate operational inefficiencies. Many banks have sought to diversify their revenue sources. As net interest margins have been subjected to increasing competitive pressure,

Competition in European banking

The competitive environment in which banks operate has long been of interest to researchers and policymakers. Most of the early literature on competition in banking markets was based on the structure-conduct-performance (SCP) paradigm. According to the ‘collusion hypothesis’, high concentration reduced the costs of collusion, resulting in higher rates being charged on loans, lower interest paid on deposits, higher fees, and so on. The alternative ‘efficiency hypothesis’ explained the relatively

Relationship banking

Insights into the nature of competition in banking can also be obtained from investigation of specific aspects of bank behaviour that are influenced by the competitive environment, and which also impact on competition. One such topic is relationship banking, which can be defined simply as the provision of financial services repeatedly to the same customer (Sharpe, 1990, Rajan, 1992, Rajan and Zingales, 2003, Elyasiani and Goldberg, 2004). According to Degryse and Ongena (2006), switching costs

Efficiency, ownership and technological change

There is a large empirical literature on the measurement of cost structure and efficiency in banking. The early literature, reviewed by Berger and Humphrey (1997), was concerned with identifying the potential for achieving cost savings in two ways: first, by selecting the optimal firm size and product mix, or in other words by exploiting economies of scale and scope; and second, by maximising operational or productive efficiency. There are two aspects to operational efficiency: technical or x

The monetary transmission mechanism and interest rate pass-through

In recent years and in most countries, monetary policy has replaced fiscal policy as the principal tool of macroeconomic policy for the stabilization of output and inflation. However, precise identification of the ways in which monetary policy influences the economy has proven to be a difficult task. Mishkin (1995) describes an interest rate channel, an asset price channel and an exchange rate channel for the transmission of monetary policy changes.

Concluding remarks

In this survey article, we have reviewed the recent academic literature on various aspects of European banking. The sustained legislative drive over the past two decades towards European integration and harmonization has presented researchers with many new challenges and opportunities for investigating economic hypotheses concerning the functioning of banking and financial markets. The sheer volume of literature that has been cited in this article can be interpreted as one key indicator of the

Acknowledgement

The authors would like to thank David Humphrey for many helpful and insightful comments on an earlier draft of this article. The usual disclaimer applies.

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