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Instructor: Jacques REGNIEZ – Associate Professor Université Paris 2
Panthéon-Assas & Institut d’Etudes Politiques de Paris – Managing
Director EuroAmericaLink LLC Private Equity Broker
Copyright Jacques REGNIEZ/Wigbond Services ltd

                             BANKING AND FINANCE


1 – The broad view: a tradition centred on banking and three main financial centres

1 – 1 - A tradition centred on commercial and credit banking

1 – 2 – Three main financial centres

2 – Financial Assets, financial markets,

2 - 1 – Primary market, secondary market

  2 – 1 – 1 - Primary market
  2 – 1 – 2 - Secondary markets and their possible organization
      Organized vs OTC markets
      Fixing Markets vs market-Makers

2 – 2 - Fixed income and equity securities

  2 – 2 – 1 – Fixed income assets
     Bond trading
     Trading of monetary instruments

  2 – 2 - 2 – Equity (or “Stocks” or “Shares”)

2 –3 – Derivatives and “underlying” assets
  2 – 3 – 1 - Futures
  2 – 3 – 2 - Options

2 – 4 – Back-office functions, regulation and surveillance

2 – 4 – 1 – The organization of back-office functions
        2 – 4 - 2 - The different regulatory frameworks for securities markets, banks and other
        financial institutions

3 - Contemporary professional assets-management
3 – 1 – Segments of the asset management industry
3 – 2 - The basic concepts of Portfolio Theory
3 – 3 - Mutual funds and the philosophy of relative returns
3 – 4 - Hedge Funds and the philosophy of absolute returns
3 – 5 - Insurance

4 – Banking

4 – 1 - Commercial and credit banking

     4 – 1 - 1 - A technology driven industry scoring efficiency

       4 – 1 - 2 - The results of rationalization and concentration

4 - 2 – Investment banking

4 - 3 – Banks as managers of risk
       4 – 3 – 1 – Basic notions
      The key-notion of Value At Risk
      Returns per unit of risk – the “Sharpe Ratio”
       4 – 3 - 2 – Sources of Risk in banking and finance
       4 – 3 - 3 – Why be a “bank”?

4 - 4 - Insurance companies: key-players in the European banking
and financial sector
5 – Asset-Backed Securities and Credit Derivatives

5 – 1 – Securitization and the expansion of credit granted by banks
5 – 2 – The diversity and flexibility of ABS-making make them a source of desirable financial
assets for institutional investors


1 - The case for the consolidation of Europe’s banking and financial sector: The dream
vision of monetary nad financial integration

1 - 1 - A more efficient allocation of capital

1 – 2 – The dimensions of Europe’s deeper financial integration

        1 – 2 – 1 – The situation and role of Banking and finance: a source of externalities and
an instrument of re-allocation of capital

       1 – 2 – 2 – Europe’s financial and economic system and the issue of pensions

       1 – 2 – 3 – The rationale backing the “Lisbon Financial Agenda”

       1 – 2 – 4 – The institutional dimension

2 - Assessing the concentration of Europe’s financial and banking industry at the
beginning of the 21st Century

2 – 1 - The concentration of the banking industry is very heterogenous in the various
European countries

2 – 2 – A historical legacy of diverse national payment patterns

3 - The consolidation of Europe’s banking in practice

3 – 1 – The “pioneers” of pan-European banking

       3 – 1 – 1 - The main pioneers of Europe’s banking integration
       3 – 1 – 2 - The earlier attempts to promote a pan-European brand name

3 - 2 - The consolidation in the European banking sector within the national borders in the
years 1990s

3 - 3 - Cross-border consolidation
3 - 4 - An alternative form of consolidation: the European bank-networks

3 – 5 - Towards a European financial landscape dominated by a small set of pan-European
institutions and local players

       3 - 5 - 1 - Three types of situations

       3 - 5 – 2 - The self stimulating process of consolidation and Europeanization

3 – 6 – Investment banking and asset-management

                                        CHAPTER I
                      EUROPE’S FINANCE AND BANKING

In its broader meaning, the word “finance” designates the set of techniques and practices
which are used (or may be used) in order to achieve or perpetuate economic projects.
This include notably raising funds to make a business work, the optimal structure and use of
this funding, the production and disclosure of the relevant quantitative information to pursue
the project, the monitoring and reporting that allow to fine tune the business-decisions etc.
Contemporary finance and banking are sophisticated activities involving a lot of intellectual
abstraction, advanced mathementatics etc. which make them hard to understand by most lay-
Many confuse their own misunderstanding of the sophisticated techniques and concepts used
in contemporary finance and banking with an alleged “irrationality” of the financial industry.
In some cases, finance is accused of playing a perverse “anti-economic” role. Nothing is more
false. Finance has intrinsic relationships with economics. Furthermore, an efficient financial
and banking industry is a pre-requisite for a prosperous economy – To illustrate this by a
counter-example, let us think of the years 1990s and early years 2000s when the Japanese
financial system has been weakened by various shocks - the bond market crash of 1994, the
burst of the East Asian bubble of 1997 … - as a result the Japanese economy has gone
through several years of sluggish growth and rampant deflation. Also, the burst of the
international monetary system resulting from the 1944 Bretton-Woods agreement (see
Chapter II) in the 1970s was the cause of a durable slowing down of the growth of the global
To understand the current situation and the perspectives for Europe in the 21st Century, it is
therefore necessary to describe and analyze Europe’s banking and finance at the time of its
monetary unification.
This third part is devoted to describing, analyzing and assessing the situation (Chapter VII)
and the perspectives (Chapter VIII) of Europe’s financial and banking industry. We will seize
the opportunity to remind the basic notions and vocabulary of contemporary banking and
finance, of course the related paragraphs and sections can be skipped by the reader with an
adequate background and training in finance.
In this Chapter VII we will deal first with finance, stressing on financial assets and the
“financial markets” on which they are traded. As most investments in the contemporary world
are made by “institutional investors” – insurance companies, pension funds, asset
management companies, hedge funds - we will also describe the main features of
professional assets management and then we will deal with banking. As was already said, as
far as possible we will seize the opportunity to remind the necessary definitions.
1 – The broad view: a European financial tradition centred on banking and three main
financial centres

To start with the “broad view”, let us mention that together with the economic importance of
the states and Social Security institutions in the European economies, the prominent place of
the commercial and credit banks in the European economies is the reflection of the distrust in
the virtue of “markets” inherited from the troubled years of a large part of the 20th century
which add up with many longer term national historical traditions of reluctance to market-

1 – 1 - A European tradition centred on commercial and credit banking with a trend towards a
bigger role of financial markets

The European financial tradition is centred around bank credit more than around financial
The main reasons why until now the financial markets have played a lesser role in financing
the economy than they have in the US are historical. These reasons have to be related to the
long “European Civilian War” which was accompanied by inflation and have ruined many
private investors.
However, after fifty years of economic reconstruction and progressively recovered prosperity,
it is to be expected that the financial markets will be regaining ground in mainland Europe.
Besides, fostering the role of the financial markets, especially that of the equity markets, in
21st century’s Europe has been set as a top priority by the European Union’s authorities, an
aspect which will be developed in the next chapter.
Comparative Data on Financial Systems, Euro-Zone and US
                                   Euro-Zone                      US
Bank Loans to Corporate            45.2%                          12.4%
Fixed Income Securities            98.8%                          166.8%
(Corporate)                        (7.4%)                         (29.0%)
(Financial Institutions)           (36.4%)                        (46.8%)
(Public Sector)                    (54.9%)                        (48.4%)
Stock Market
Capitalization                     90.2%                          179.8%
(%GDP 1999)   - Source: ECB Monthly Bulletin July 2000

The European corporate sector has traditionally been more dependent on bank loans as a
source of external finance than its US counterpart: at the start of the years 1980s, over 80% of
external financing of continental European firms was provided by banks, and the European
commercial paper market was non-existent.
However, things are changing rapidly and the raising of finance through the issuance of equity
and corporate bonds has now overtaken bank loans as a source of corporate finance.
Nevertheless, these sources of finance are still less developed in Europe than in the US. The
bulk of private bonds are in fact issued by financial institutions. These represent no less than
87% of the total outstanding amount of private bonds, which is a decrease from 89% since the
introduction of the euro. In fact, many innovations with respect to private bonds have
occurred in the sector of bonds issued by financial institutions, such as the apparition of
“Pfandbrief-style” mortgage bonds in, inter alia, France and Luxembourg and its revival in
other countries, like Spain. The domination of bank-bonds is fairly homogeneous across all
countries of the Euro Zone, confirming the importance of bank finance in continental Europe.
More details about this features of Europe’s finance will come in the following pages while
the perspectives for a wider role of financial markets will be developed in Chapter VIII.

1 – 2 – Three main financial centres

To stay a little longer with very general indications about Europe’s finance let us underscore
that finance and banking do not take the same place in every European country. This is one
aspect of the specialization of the European countries according to their comparative
advantages within the framework of the “Common Market” and the “Single market”.
The table below comes from a survey of the participants of the well-known World Economic
Forum taking place each year in Davos. Though based on a simple methodology, it
nonetheless provides an illustration of the image of the various financial and banking national
industries in the eyes of the surveyed participants.
Finance Competitiveness Rankings
Overall Business        Country                 Finance
Competitiveness                                 Competitiveness
1                       Singapore               2
2                       US                      3
3                       Hong Kong               7
4                       Taïwan                  8
5                       Canada                  9
6                       Switzerland             6
7                       Luxembourg              4
8                       UK                      1
9                       Netherlands             14
10                      Ireland                 11
23                      France                  17
25                      Germany                 26
26                      Spain                   16
35                      Italy                   32
Source: World Economic Forum

According to the table, obvioulsy, banking and finance are not a specialty of neither Italy nor
Germany (see below in this chapter). On the contrary, the UK and Luxembourg, as well as
Switzerland, are successfully specialized in this industry. London in particular hosts the
biggest financial center on the planet and Luxembourg is a continental center with a strong
position in international asset management (see definition of this segment of the financial
industry below). Thanks to the country’s tradition of neutrality, Switzerland has a very strong
specialization in private banking, insurance and re-insurance in addition to being the country
of origin of two of the World’s banking giants Credit Suisse and Union des Banques Suisses
2 – Financial Assets, financial markets

The word “market” is more often than not used by economists. In the day-to-day language
“market” tends to designate a “market place” i.e. a location. In the economic jargon,
“markets” don’t have to be materialized and located. The economists use the word “market”
to refer to any procedure that allows a supply to meet a demand, prices to be set, quantities be
traded. It is the case for financial markets. The terms “financial markets” designate a varied
set of organizations and formal or informal procedures through which in effect at every
second financial assets of all sorts change hands.
Therefore, the expression “financial market” refers to all the procedures by which financial
assets or “securities” are traded. A “financial market” does not need to be located in a
physical place.
In fact most trading in financial assets takes place within the IT systems of the contemporary
world. The universe of financial markets is a complex one and it is necessary to categorize its
very varied aspects.
The first distinction to be made in order to categorize the various existing financial markets
lies between
       “primary markets” on the one hand,
       “secondary markets” on the other hand (§ 2 – 1) .

Another disctinction that we will expose lies between
    “fixed income” assets and
    “Equity” assets (§ 2 – 2).

The third distinction that will be made in this first section will be between
     “underlying asets – which designate the pure basic assets like equities and bonds – on
        the one hand,
     more sophisticated assets called “contingent assets” or also “derivative assets” which
        are more sophisticated contracts with a value depending on a pure “underlying” asset
        (§ 2 – 3).
In order to provide the reader with clues about the importance of the practical completion of
security trading, § 2 – 4 will briefly describe the less glamorous but essential so-called “back-
office” functions.

2 - 1 – Primary market, secondary market

        2 – 1 – 1 - Primary market
The deals consisting in the creation of new securities are called “primary market deals”.
They typically aim at providing funds to an issuer - most often a corporation, a municipality
or any other organization with an economic project needing “finance”.
The “issuer” will mandate a bank or a group (“syndicate”) of banks to create on its behalf
“securities” which will be sold to investors in exchange of amounts of money.
The bank in charge of coordinating the participants to the deal – i.e. the “issuance” of the new
securities - will be called the “lead-arrangeur”.
In order to prepare the marketing of the new securities so as to sell them to the investors, the
potential demands by the prospective buyers or investors are compiled in a book and the bank
in charge of running such a book will naturally be called the “book runner”.
Brokering such deals on the primary market is a key element of this part of the banking
activity designated as “investment banking”.
Though it may seem that investment banking is purely a broker business consisting in
matching the needs of the issuers with that of the investors, investment banking requires
capital. The reason why this is so lies in the fact that the mandated investment bank - or
syndicate of banks – will provide the issuer with a service involving a sizable market risk, the
service of “underwriting”. The word “underwriting” means that in practice, the mandated
bank – or syndicate- will acquire the totality of the newly issued securities from the issuer.
Therefore, between the moment when the new securities are issued and the time when they
will have been sold to the investors, the new securities are present in the bank s balance sheet.
Should significant changes in the mood of the financial markets leading to a drop in the value
of the new securities occur during this period, the underwriting bank will bear the cost.
Underwriting involves risks and consequently, investment banks need a strong capital base to
be able to bear these risks (see below the description of the banks as “managers of risk” as
well as the paragraph about the “sources of risk”).

        2 – 1 – 2 - Secondary markets and their possible organization

The trading of already existing securities is called “secondary market”. Most financial assets
that are traded are traded on secondary markets.
The practical implementation of the euro on January 1st 1999 for all financial transactions
within the euro-zone has been a major driving force toward the integration of EU financial
markets, though quite differently in each compartment.
There are secondary markets for bonds, monetary assets like commercial paper as well as for
equity and many derivatives.
   Organized vs OTC markets

In practical terms, “Markets” can be either
     “organized”
     “Over the Counter” (OTC). OTC markets regroup players who are binded by the only
      fact that they trade certain assets. The archetypal OTC market is the currency – or
      “forex”- market. Almost every bank will trade currencies and there is no formal
      organization, charter or whatever which is associated with this activity.
Markets may have a physical location like the New York Stock Exchange in Wall Street in
downtown New York City.
In general, the market has a physical location when the quotation of asset-prices is made by
“outcry” involving human beings. In Europe, markets have become automated since the mid
1990s. This type of market based on sophisitcated IT system instead of employees has no
physical location. The quotation and trading takes places via a computer system – also called
an “Electronic Communication Network” (ECN) – The ECN is called XETRA in Frankfurt. It
is named “CAC” on the pan-European Exchange Euronext. In New York, in addition to the
physically-located NYSE, there exist ECNs, the biggest being Archipelago – now acquired by
the NYSE - and the NASDAQ, an acronym that stands for National Association of Security
Dealers Automated Quotation.
 Fixing Markets vs market-Makers
From the point of view of the technique used to generate quotations and trades, the two main
forms of organizations are
     Fixing markets
     Market Makers
“Fixing markets” are also called “order-driven” or “centralized markets”. In such markets, the
members of the “exchange” (an other word for “market”) pay for their connection to the
market’s ECN which they will feed by the orders of their customers. The ECN will compute
the offers and the demands and build the Supply/Demand curve of the elementary
microeconomics text books for every traded security. The ECN will generate the asset-price
and therefore the amount traded. There is a single counterpart for every investor which is the
market organization itself:
             Deutsche Borse-Eurex in Germany,
       Euronext in Belgium, The Netherlands, France and Portugal… Therefore, there is near-
        zero counterpart risk in centrally organized markets.
This is a difference with “Market Makers” or “price-driven” markets. In this case,
intermediaries allocate some of their capital to a certain amount of a set of securities and they
will trade them, selling them at a certain price, buying them at a certain lower price in order to
make profits. This is a more risky technique of trading and the financial soundness of the
intermediary will be an issue. The investors will have to survey the “Bid and Ask” displayed
by the various market-makers before they decide to deal with one. This explains the
terminology of “price-driven” markets.
There is a common dominant organizational strucutre in Europe whose features are summed
up in the following table.
Unfortunately the reality is somewhat more complex and the dominant organizational
structure described below co-exists with many exceptions. In particular, for big trades,
market-making is the dominant trading technique with most of such trades (representing some
30% of all the trades) taking place within banks and not directly within the market

     Order-driven markets
     operated by for-profit public companies
     central order-book and general counterparty
     Automated
     Integration of cash & derivatives

2 – 2 - Fixed income and equity securities
A financial asset - or “security” - can be defined in very general terms as a contract by which
an issuer commits itself to an investor to provide her or him with cash-flows in the future. To
illustrate this definition with a mathematical formula, let us say that a financial asset will be a
commitment “A” to provide the investor acquiring “A” with a sequence of cash-flows (“CF”)
for the future dates t = 1, 2, ….., T, …etc.

A = { CF1, CF2, … , CFT, ….}

From this formula it is obvious that the fair value of a financial asset must reflect the
actualized (i.e. the value at the current time) value of the expected cash-flows. The bsic
increments of asset-valuation will therefore be:
-   the expected cash-flows
-   the conversion factor of future values in current values i.e. the “actualization rate”, itself
    the sum of the mere price of time of “interest rate” plus a risk premium which will reflect
    the possible fluctuations around the expected values (see below the definition of “risk” in

In practice, such contracts are registered under the form of securities that can be material -
i.e. exist under the form of paper-documents - or not - i.e. that the securities will be
designated by a code-number and will exist under an immaterial manner as a book-entry in
the IT system of certain financial institutions.
The two main categories of financial assets – which correspond to two rather different
professional cultures – are named “fixed income” securities on the one hand, “equity” on the
other hand.

2 – 2 – 1 – Fixed income assets
Fixed income securities include
       bonds,
       notes,
       commercial paper,
       certificates of deposit
       most Asset Backed Securities or ABS (see below for a definition of some of the
        preceding terms).
The expression “fixed income” must not be misinterpreted. It does not mean that the income –
or cash-flows – mentioned in the contract are constant from period to period, it simply refers
to the fact that the promised cash-flows may be calculated precisely from the terms of the
       Bonds are long and medium term debt contracts. Investors in bonds are promised the
        payment of pre-defined interess or “coupons” (which does not mean that the coupons
        are fixed along time as for instance there exist floating rate bonds) plus the re-
        imboursement in a pre-defined way of the principal (or “capital”).

                          Average (as of 2003Q1)       % of total issuance

                                        (in euro million)

Agencies                           15,072                      3.9

Central Government                176,628                    45.5

Local Government                   12,935                      3.3

Supranationals                      4,475                      1.2

Asset-Backed Securities            13,501                      4.4

Financials                         78,867                     20.3

Pfandbriefe Covered Bonds          53,158                     13.7

Corporates                         30,035                      7.0

Total                             388,278                    100.0

       Commercial paper are short term (less than one year) debt instruments issued mostly
        by non-banks. In addition to the Certificate of Deposits issued by banks and financial
        institutions, industrial and service companies issue commercial paper to fulfill their
        short-term funding needs. The segment of the commercial paper market with the
        fastest growth is the segment of the Asset Backed Commercial Paper (ABCP). ABCP
       are specially attractive for banks as a source of liquidity and a means to save their own
       capital (see Asset Backed Securities in § 5 below in this Chapter) .

In 2003, there were two main types of commercial paper in Europe but actions are taken by
various trade associations to create an integrated market for European commercial paper by
The European commercial paper market is a 750 billion euros market. This amount compare
with some 1.230 billion in the US. The two compartments which currently co-exist are
1/ the nationally regulated commercial paper markets of France - 280 million euros in 2003 -
Belgium, as Brussels is the place where several European companies have located their
treasury operation - 25 million euros - Spain - 22 million euros - Germany - 20 million euros
- and the UK for the fraction of the commercial paper programs issued in the UK which
benefit from a validation by the Bank of England. As was said, the main distinctive
characterisitc of these markets lies in the fact that they are under the supervision of the local
financial surveillance authorities like the Bank of England in the UK, the Commission ds
Opérations de Bourse in France. With some 250 odd billion euros of their CDs in circulation,
the banks benefit the more of this market. Industrial and service companies account for some
65 billion of the total. ABCP on this fragmented first compartment of the European
commercial paper market accounted for roughly 35 billion euros but was growing fast.
2/ The euroCP (ECP) market based in London is an off-shore unregulated 400 billion euros
OTC market. Here again, with more than 210 billion of CD, banks benefit more from this
market than corporations - 60 billion euros - and sovereigns - 40. ABCP amounted to some 60
billion and represented the fastest growing segment.
The ECP on one hand, and the regulated CP on the other hand are traded by distinct
intermediaries: the big London names like Citigroup, Deutsche bank, JP Morgan, lehman
Brothers, Goldman Sachs or Morgan Stanley, for the first, the local bank like BNP-Paribas or
Sciété Générale for the second. The two categories of European commercial paper have two
main technical differences:
1/ Being non-regulated, the ECP is not authorized as an investment vehicles to certain
inveestros like insurance companies or mutual funds by some local financial regulation.
However, the February 2002 European directive on Mutual Funds should open the ECP the
door of mutual funds in all EU countries.
2/ The regulated CP is under the form of book entries and the clearing and settlement is both,
secure, cheap and fast (within the day) although the clearing and settlement of an ECP trade
takes normally to days.
Under the sponsorship of the European Central Bank, the trade organizations of short term
papers dealers of Continental European countries have launched a “Short Term European
Paper” program aiming at integrating and harmonizing the local regulated commercial paper
market at the horizon of 2005, especially in what regards the information disclosed by the
issuers and the provision set by the surveillance authorities. The local central banks (Bank of
Belgium, Banque de France etc.) would be responsible for authorizing the commercial paper
programs. The issue of the UK joining or not the Euro zone might impact the ability of
London to remain a significant player in this market.
 Bond trading
The trading of bonds is for its most part very differently organized from that of shares as it is
mostly made in “OTC” – or “Over The Counter” – markets i.e. markets managed under the
form of voluntary dealers, with little or no formal regulation but a confidence and trust based
on effectiveness and experience.
They are market-makers - i.e. price driven markets - though it is worthy noting that since the
spread of IT technology in the financial industry a growing part of the secondary trade is
made via ECNs. Following the trend seen in global financial markets, electronic trading has
developed rapidly in the euro-denominated bond market. A variety of competing platforms
has emerged, both for inter-dealer trading and for dealer-to-customer transactions. The two
most prominent automated trading players in European bonds with a roughly more than 50%
market share of the Euro-bonds trading are MTS – an Italian company headquartered in Milan
– and Broker Tec. MTS is the leader in this business. It is in fact the parent company of
EuroMTS – headquartered in London and aimed at the inter-dealer market, as well as 13 local
MTS’s where European government bonds are traded. For its part, Bond Vision is a bank-to-
client bond trading platform.
Some bonds are quoted in parallel on the markets of several countries. This is the case, for
instance, of some debt securities of Italian issuers (the “EuroMOT”), initially quoted only
outside Italy and now also quoted on the Borsa Italiana.
At the end of 1998, most wholesale markets –i.e. only big trades involving either institutional
investors or intermediaries - in the European Union were “telephone based”, with the
exception of MTS in Italy and HDAT in Greece. This situation has been reversed as the
consequence of a combination of factors. The much broader euro-denominated market, has
led to an increase in the number of actors (issuers, intermediaries, investors and
infrastructure providers), in almost every segment, and intensified competition within each
category. This has reduced the advantages of telephone trading, such as exact knowledge of
one’s counterparty or the ability to conduct a transaction without it being disclosed to the rest
of the market. At the same time, increased competition has led to increased demand for the
efficiency that can be provided by technological innovation.
This demand originated both from the investor side and from the issuer side, insofar as a
liquid secondary market supports investor.s interest in the primary market as well.
While the trend towards more widespread use of technology in the bond market has been
reinforced by the introduction of the euro, this is not a consequence of the single currency per
se. Developments in the euro area are mirrored by developments in other currency areas (e.g.
the United States).
Several different patterns of development of wholesale markets have been witnessed in the
euro area:
   A first strategy displayed by the MTS group consisted in exporting the Italian electronic
    model MTS to other European countries. At the end of 2000, the MTS group consisted of
    5 .national. MTS markets (Italy, the Netherlands, France, Belgium and Portugal) as well
    as the London-based EuroMTS .
   Other developments included the launch in 1999 in Spain of an electronic platform
    (Senaf) created by the four previously active interbroker-dealers, aimed at concentrating
    wholesale trading in Spanish fixed income.
   Another national initiative was Eurex Bonds, launched in October 2000. Eurex Bonds
    provides a platform for wholesale transactions (initially only for German government
    bonds) as well as the ability to carry out so-called basis trades, in which offsetting cash
    and derivatives transactions are conducted simultaneously. The shareholders of this
    private joint venture are Eurex Frankfurt AG and several leading market participants in
    the bond market. The strategy of the initiative is to provide a vertically integrated market
    for some of the most important euro-denominated securities. Since the end of October
    2000, Eurex Clearing AG has also been acting as a central counterparty for cash
   In addition to these national initiatives, a number of global private inter-dealer platforms
    have been launched.

Several of these Electronic Communication Networks (ECN) provide capabilities for trading
both US and European government bonds (e.g. BrokerTec).
Finally, mirroring developments on the inter-dealer front, initiatives have been taken to
develop dealer-to-customer platforms, where institutional investors can compare the prices
provided by several intermediaries simultaneously. Here again, initiatives tend to be multi-
product ones, providing services for both US dollar and euro-denominated products
(examples are TradeWeb, Bondclick). While there are numerous initiatives, many market
participants believe that a certain degree of consolidation in the field of electronic trading
platforms is inevitable.

 Trading of monetary instruments
Monetary assets like commercial paper and CDs (certificates of deposit) are typically traded
via market-makers, specialized money-market brokers or investment banks having
contributed to the commercial paper program. In addition, more and more, the needs of the
corporations regarding their cash-management are met by customized products specially
engineered by banks for each client – “structured products” – and that will include
sophisticated elemtns like swaps (trading of e.g. a floating rate vs a fixed rate) caps (upward
limit for the variation of interest rate for example) and the like. This type of business is
typically made under a market making organization.

2 – 2 - 2 – Equity (or “Stocks” or “Shares”)
“Equity” contracts that designate stocks and shares. In an equity contract, it is mentioned that
the investor is to become a share-holder of a company and therefore will bear a type of risk
similar to that of an entrepreneur. The cash-flows that the investor will get according to an
equity contract cannot be calculated in advance as they will depend on the profits that the
issuer - most of the times a corporation – will generate as well as the share of this profits that
will be distributed to the shareholders as opposed to the share of the profits that will be re-
invested into the company. Should the issuer of an equity contract get bankrupted, the holder
of its shares will be the last to be entitled to get any right upon the remaining assets if any.
The European equity markets offer investors a choice of company-stocks that compares with
what they are offered on the US stock markets. To illustrate, the table below displays the
market capitalizations (Trillion of USD fro the year 2000) of major European stock market
indices. Obviously, part of the figures reflect methodological differences in the making of
these statistical toolds which indices are, nevertheless, the reader will notice that the sum of
the capitalizations of the major European stock-market indices is comprised between the
narrowest “Dow Jones Industrial Average” index (DJIA) for the US Stock market and the
widest Standard and Poor’s 500 (S&P500). (in Trillion – Tn – i.e. thousands of billion euros):
     UK (FTSE)...Eur 2.04 Tn
     F (CAC)........Eur 0.99 Tn
     I (MIB)..........Eur 0.43 Tn
      E (IBEX).......Eur 0.33   Tn
      D (DAX).......Eur 0.68    Tn
      Fn (HEX)......Eur 0.21    Tn
      CH (SMI)......Eur 0.57    Tn
      G (ASE)........Eur 0.06   Tn
      NL (AEX).....Eur 0.47     Tn
      S (OMX).......Eur 0.16    Tn
      Total Europe.Eur 5.94     Tn
      USA DJIA...........Eur 3.87 Tn
      USA S&P500......Eur11.71 Tn
      DJ EuroSTOXX..Eur 2.16 Tn
      DJ EuropSTOXX.Eur3.27 Tn

             Stock Exchanges and equity trading
In the case of equity, only the trading of shares of public - i.e. listed companies - can take
The institutions that trade listed companies’ stocks are called “stock-exchanges”.
Since the 1990s stock exchanges in Europe are for-profit companies. Their revenues come
from the fees the companies pay to be liste on the exchange and the exchange also gets
trading fees on the trades. An other important source of revenues comes from the sale of the
market data – real time security-prices, traded volumes … - to investors. Many sophisticated
contemporary financial techniques like the writing of options (see § 1 – 3 below) require
permanent optimization of the investor’s portfolio that is practiced via “computer trading”
(orders generated by computer calculations fed by real time data coming directly from the
exchange) and any lag in the utilized information from the actual market data is a source of
The first stock exchange has been implemented in Amsterdam in 1604. Its founder was of
Spanish origin expelled from Spain by Isabel the Catholic, a man called Jossep de la Vega.
The first stock-brokers were Dutch brothers, the brothers Beurs, their name gave birth of an
alternative name for stock exchanges, “Bourse”. Until the last decade of the 20th Century, all
stock exchanges wre non for-profit mutual organizations that were commonly owned by the
security brokers members of the exchange. This has started to change in the 1990s with many
stock exchanges becoming normal for-profit corporations, particularly in continental Europe.
Most European stock exchanges are now public corporations and one can buy stocks of the
London Stocck Exchange, of Deutsche Borse, of Euronext or of Borsa Italiana. In the US, the
move has taken place later on, in the 21st Century and is not completely achieved.
The tradition in Continental Europe focuses on centralized order-driven markets while in
Britain and the US the tradion is more of market making. Generally speaking, order-driven
market are more adapted to individual investors while market making fits better the needs of
institutional investors who will trade big amounts at a time. The complicated thing to
understand is that every existing stock exchange combines the two types of market
organization. On the Deutsche Borse, trade takes place both via the ECN “XETRA” and via
market makers for the “blocks” i.e. trades of big individual amount. The same is true for
Euronext. The reader has to keep in mind that only 70% of the trade goes through the market,
on average roughly 30% of the trades on equity remains within the investment banks who will
match their clients buy-orders with other clients sell-orders. In how much transaction made
outside the market must be disclosed and their terms connected to that prevailing on the
market is the subject of fierce discussions, especially within the context of the writing of the
EU directives on the topic.

European Stock Exchange Market Capitalisation (and Number of listed-companies):
Main and Parallel Markets (excluding Investment Trusts, Listed Unit Trusts and UCITS)
1/ The « Big-3 » European Equity Market Companies + Zurich
    London Stock Exchange 1.956.258                          (2920)
    Deutsche Borse          930.841                          (3525)
    Swiss Exchange(VirtX)  591.265                   (425)
    EURONEXT              1.613.305                           (1730)
      Of which :
      Brussels                    210.322      274
      Amsterdam                   512.445      359
      Paris                        837.061     962
      Lisbon                        53.477     135

2/ The national independent Stock-Exchanges
    Stockholm                    239.063       276
    Italian Exchange             484.030       243
    Madrid                       342.486       484
    Luxembourg                     32.516      276
    Vienna                          30.444     128
    Helsinki                      131.474      131
    Oslo                             40.109    236
    Copenhagen                      84.367     254
    Iceland                          2.693      57
    Dublin                          59.305     100
    Athens                           69.281    229
  year-end 1998

 Growth companies stock markets

The example of the Nasdaq has induced the creation in Europe of specific stock markets for
growth companies stocks.
In the first years 1990, such new economy success stories as Business Object in France
seemed to have no other choices than to get listed on the Nasdaq and this contributed to entice
the Stock Market managements and Authorities in the main European countries - firtsly in
Paris and Frankfurt - to settle specific markets for growth companies.
As has been already underlined, the new economy does not spread exactly in the same way in
Europe as it does in the USA, rendering strict comparisons difficult.
In particular, as it has been already udrlined, the role of the financial markets and of the
institutional investors is much smaller in Europe - mainly in Continental Europe - than it is in
the US. Conversely, much of the new economy develops within the bigger corporations, most
of which encourages innovation among their staff or favour young companies through their
own in-house venture capital dedicated branches. This being born in mind, there remain a
significant part of Europe’s new economy which develops under the form of entrepreneurship
and the various European growth companies stock markets aim precisely at these new
economy entreprises. Nonetheless, it has to be stressed again that there has been no market
nor set of markets for growth companies stocks of the same size, scope and overall
importance to the US Nasdaq in Europe.

2 –3 – Derivatives and “underlying” assets
Mainly since the mid 1970s and the intrusion of “volatility” in the economic and financial
world, a new type of sophisticated financial instruments called “derivative assets” have
overtaken in terms of quantitative importance and impact the traditional pure equity or fixed
income securities.

         2 – 3 – 1 - Futures
“Future contracts” have existed for long in agriculture, the main market-place being Chicago
in liaison with the specialization of the US mid-West in Agriculture. Future contracts based
on financial assets have been introduced in the 1970s mainly to fulfill the need for porfolio
insurance intruments of institutional investors.
The ancestors of “future” contracts are “forward” contracts. Forward contracts date back from
the bottom of history and were known by the most ancient civilizations like the Egyptian. A
forward contract is si;ply a contract in which the terms – product, price, quantity … - are
determined at the current time but for a trade that will physically take place at a later date. For
an illustration, the reader may thinmk of the forex market where it is common to trade
currencies on the basis of forward contracts.
Forward contracts have developed for agricultural products because of the obvious
unconvenience of many aspects of this business – concentration of revenues on the period of
harvest while costs are continuous, risks about the size and price of the crop are substantial
and so on.
Once someone is in possession of a forward contract, one may need to sell it. At the same
time, one may need a forward contract that one has not got. There is a potential trading of
forward contract. However, for a secondary market for forward contracts to emerge thre need
to be a standardization of the terms = precise definition of the product, standard quantity, time
frame and so on. A Future Contract is nothing else than a standardized forward contract able
to be traded on a secondary market.
With the burst of the international monetary system between the late 1960s and 1973 (see
Chapter II above) the volatility of the prices of financial assets has spurred the imitation of the
techniques used in agriculture by the financial industry. The market-organization in Chicago
which were experts in derivatives products were obviously well positioned to be the first
offerers of future contracts with “underlying assets” coming not from the agricultural industry
but being bonds or Treasury notes.
Future contracts on financial products have started with fixed income financial assets. They
fulfilled the needs of institutional investors with bonds portfolio to hedge the value of their
portfolio using the correlation that exists – thanks to the abitrageurs – between the value of
the future contract and its underlying asset (the capital loss on the bonds being potentially
counterbalanced by a capital gain on the futures or vice versa). Futures markets have
developed so much as to acquire a “notional” value of their trade bigger than that of the
underlying assets markets. This is due to the many conveniences offered by future contracts,
conveniences often larger than that of the underlying – “physical”- asset.
Future contracts were also rather early made available for such equity related underlying
assets like stock-market indices. But it took more than two decades for futures to be used with
single stocks as underlying assets. First implemented in Europe by the derivatives’ branch of
Euronext, the LIFFE (London Financial Futures Exchange), futures on single stocks (called
“Universal Stock Futures”) have now spread in the US as well and are in particular issued and
traded by an organization called OneChicago which manages the dedicated ECN.
Their success comes from the many benefits they bring to the investors comparatively to the
“pure” assets which individual stocks are. Among these benefits:
      Tax efficient investment tool
      Management of ownership disclosure rules and stock holding limits
      Effective tool for dividend and dividend tax credit arbitrage
      Capitally efficient
      Effective hedging tool
      Asset allocation tool
      Market timing
      Stock or sector replication
      Delta hedge for volatility trade
      Adjust weightings when changes occur in an index
      Ability to short stocks

   2 – 3 – 2 - Options
Option contracts, like forward contracts, have alos been used for very long in various
businesses and in agriculture in particular. They have started to be widely used in finance in
the mid-1970s under the double influence of the greater volatility of financial asset prices –
which created the need for instruments allowing to trade volatility – and the establishment of
the mathematical theorems leading to a reliable pricing of options (Cox-Rubinstein, Black and
Scholles, Merton).
Options are contracts by which the owner of the option has a right toward the issuer or
“writer” of the option. The right may be to buy a certain asset at a determined price called
“strike” at a given period, in this case the option will be called a “call-option” but the right
may be in other cases the right to sell a given asset at a given price at a given time in which
case the option will be called a “put-option”
Options offer a wide array of new financial strategies to hedge portfolios, to speculate or to
make arbitrages. Given the charaterisitcs of strike price, expiration date, type – put or call -
their value depends not only on the price of the underlying asset (the so called “Delta”
parameter), it depends also of the implicit volatility of the expected probability distribution of
the returns of the underlying asset (measured by the parameter called “Vega”) as well as on
the speed of change of the market-price of the underlying asset (the “gamma” parameter). In
total, the fair-value of an option contract as determined by the pricing theorems is
mathematical function of five variable and there is no need to insist on the level of abstraction
involved nor on the absolute impossibility to deal with options without the assistance of a
computer. Options are amongst those financial products that are too sophisiticated for most
persons and make them critize the alleged malvolance of finance and financiers.
Options are available on all financial assets for which a volatility can be estimated.

There are available under three main forms
- when issued by banks for the mass market, they are called “warrants”
- when issued by a market organization they are called “tradeable options” (the main
- when issue on a bi-lateral basis they are called “OTC options” – when particularly
   sophisticated they are called “exotic options” as opposed to the basic calls and puts
   dubbed somewhat derogatorily “vanilla” options.

Trading of derivatives
 Futures
Futures are issued by market organizations like the historical markets in Chicago – Chicago
Board of trade (CBOT) Chicago mercantile Exchange (CME) Chicago Board Option
Exchange (CBOE) and the Europan markets like the London Financial Futures Exchange (the
derivatives subsidiary of Euronext-LIFFE), Deutsche-Borse Eurex which has a dominant
position in fixed-income based derivatives products.
There are very few futures issued on an OTC basis. The market organizations that issue
futures also trade them on the secondary market and this will generally be made on a central-
counterpart fixing market but there are significant exceptions like that of Single Stock Futures
for which there are market makers.
- Options
There are traded options issued by market organizations – the Chicago “historical” markets,
Euronext-Liffe, Deutsche Borse-Eurex … - and such options will be traded on the secondary
market by the same market organization on the basis of a centralized generally fixing market.
There are plenty of OTC options. The trading of this options on the secondary market is by
nature more difficult and can only take place within the framework of market making.
Eurex (D/CH): 371,843,179
CBOE (USA): 186,687,727
CBOT (USA): 148,247,028
CME (USA): 220,731,456
Amex (USA): 135,050,999
KSE (S-Korea): 304,423,701
PSE (USA): 65,118,611
Nymex (USa): 60,671,181

EuroNext (exLisbon, ex LIFFE) (EU): 231,300,000
LIFFE (EU): 113,923,523

Source:Futures Industry Ass Nb of traded contracts 2001/01 to 2001/07

In 1982, the London International Financial Futures and Options Exchange (LIFFE) was
established following the elimination of foreign exchange controls in the United Kingdom.
LIFFE was originally set up as a financial futures and options exchange. In its first 10 years it
offered contracts on interest rates denominated in most of the World’s major currencies. In
1992, LIIFE merged with the LTOM (for London Traded Options Market) adding equity
options to its trading range. In 1996, it merged with the London Commodity Exchange (LCE)
and as a result, a range of soft and agricultural commodity contracts were added to its
Trading on LIFFE was originally conducted by open outcry. Traders would physically meet in
the Exchange building where each product was traded in a designated area or “pit”. In 1998
LIFFE embarked on a program to transfer all its contracts from the traditional method of
trading to an electronic platform “LIFFE Connect”, the most sophisticated electronic
derivative trading platform to this day in the World.
LIFFE initiated a wide-ranging restructuring program to address the needs of the wholesale
market customer and at the same time the requirements of an increasingly technologically
driven and competitive market place. The first steps in this process were the launch of LIFFE
Connect and the re-invention of LIFFE as a commercial entity. To achieve this membership
and the right to trade were split from shareholding, which simplified a complex share
structure as in the new structure a shareholder was not required to become a member of the
In June 2000, following the successful transition of all its financial and equity futures and
options on to LIFFE Connect, the exchange announced its intention to become a market
leader by building to complementary businesses. These businesses were founded on LIFFE’s
established skill and expertise in running a successful exchange, and in developing the state of
the art technology of LIFFE Connect. The exchange continued to focus on its core business of
providing the products required for managing exposure to financial markets in a cost-
effective, efficient environment. In parallel, a new technology business was set up to provide
technology and associated services to exchanges around the World.
In January 202 the acquisition of LIFFE by Euronext was completed.LIFFE’s focus on short
term interest rate derivatives closely complemented Euronext’s expertise in a range of bonds
and equity products. The derivatives business of Euronext and LIFFE have now been
combined as Euronext-LIFFE.
Euronext-LIFFE is creating a single market for derivatives by bringing together all its
derivatives products on a single electronic platform, LIIFE Connect. Starting with the
Brussels and Paris markets in 2003, and continuing with the transfers of the Lisbon and
Amsterdam markets, the replacement of multiple trading venues with a single market
supported by a state of the art electronic trading system will reduce costs for both Euronext-
LIFFE itself and its customers, and make cross-border trading easier and cheaper.

CONTRACTS TRADED ON THE LIFFE (2002 – number of contracts per support)
Total trades                                                            253,981,628

All individual equity products                                            16,824,543

      Futures                                                            3,935,121
      Options                                                           12,858,422

Equity Index products                                                    32,024,600

Of which
    Futures on FTSE 100 Index                                           17,230,726
    Options on FTSE 100 Index                                           13,253,116

All short term interest rate products                                   157,734,840

Of which
    Futures on 3 Month Euribor                                         105,758,584
    Futures on 3 Month Sterling                                         34,307,727
    Options 3 Month Euribor                                             33,481,758
    Options 3 Month Sterling                                             7,364,057

All medium and long term interest rate products                            12,172,843

Of which
    Futures on Long Gilt                                                  7,788,011

All commodity products                                                      5,224,802
2 – 4 – Back-office functions, regulation and surveillance

The practical completion of a trade on financial markets includes several phases.
- Trading is the phase when price and quantity of the traded asset are determined,
- Clearing is the phase when buyer and seller confront their information about the trade
- Settlement is the phase when assets and money change hands
Once the asset is in the books of its owner, there remain tasks to be done like keeping the
asset in a specialized institution called “custodian” ( assets can be materialized in which case
they support a physical risk and must be kept safely, or under the immaterial form of “book
entries” in which case they must be managed in an appropriate IT system). As a financial
asset is a contract entitling its owner to cash-flows, these have to be managed (in addition to
other pratical issues like taxes) by specialized services providers called “admistrators”.
All these tasks to be acomplished after the trading has been done are called “back-office”

       2 – 4 – 1 – The organization of back-office functions
In the US there exist one unified infrastructure managed by the National Securities Clearing
Corporation (NSCC) and the Depository Trust Company (DTC). That unified infrastructure is
available to all markets for clearing and setttlement.
On the other side is Europe with a mosaic of national Central Securities Depositories (CSD) -
CrestCo, Sicovam (which has recently become Euroclear France), Monte Titoli,
Segalntersettle... - and the two international ICSDs, Clearstream (which results from the
merger between Cedel and Deutsche Borse Clearing) and Euroclear. The users of the
European financial markets have to deplore the duplication of costs and the need to interface
with many clearing systems hence many users would like to see a single settlement system -
covering equities and debt, on market as well as OTC, derivative and cash.
The driving forces in technology - real time, multichannel access... - are viewed as facilitating
convergence, however, beyond technology, there still are legal, political and commercial
aspects to be conciliated: the ICDs cannot handle the colossal retail and national dimensions
while the local CSDs would have to build the complex relationships and understanding to
handle all the cros-border aspects, whether within Europe or, for example, with the US.
In the US, key market infrastructures like DTC and NSCC are developped and funded on a
not-for-profit basis as a general utility owned by the key market organizations. Europe by
contrast has a very diverse combination of national monopolies, for-profit organizations like
Cedel, as well as cooperatives like Euroclear and S.W.I.F.T.
The big users want to see the way to a single feed and, in the short term, want to minimise the
number of feeds under an American DTC type of arrangement which would include the UK
and Switzerland even though these countries are not part of the EMU.
The yearly benefits of the consolidation of the European clearing and settlement services have
been estimated to Euro 1 billion.

       2 – 4 - 2 - The different regulatory frameworks for securities markets, banks and other
financial institutions
Banking and securities markets are at very different stages of harmonization. Central bankers
have the benefits of the Basle and EU standards, they can be guided, at least at a first step, by
clear-cut prudential ratios. For securities markets, in contrast, the problems regulators must be
alert to are more diffuse, more complex.
There are different families of regulatory frameworks for securities markets in Europe. Some
countries such as Scandinavia and the UK, have a fully integrated “one-stop” approach where
the systemic/prudential regulation and the “micro-regulation” of markets, dealing with the
proper functioning of markets and investor protection, are merged.
Other countries including Italy, Spain and France, have opted for a “twin-peak” regulation,
where the prudential regulation is distinct from the “micro” regulation. In addition, and this
second distinction does not operate along the same geographic borders, some countries have
entrusted exchanges with self regulating organization (SRO) functions, while in other
countries statutory regulation, together with some responsibilities entrusted to professional
bodies, is critical to the regulatory framework.
The European directives have been based on the concept of interdependence of national
authorities within the European Union, that is to say on a legislated interdependence among
independent authorities.
This may entail difficulties for some cross-border operations in what regards assessing which
regulator is competent.
In what regards the “level playing field”, this implies a certain degree of harmonization of the
local regulations. Through different forums - such as FESCO, the Forum of European
Securities Commissions (see above) - a “standard-setting” mechanism is taking place despite
the existence of substantially different legal systems among the Member States of the
European Union. Twenty years ago for instance there were radically different attitudes
regarding what is accpetable in terms of insider trading in different countries of Europe. What
was a major crime in one country was not even a misdemeanour in another and today this is
no longer the case, and the same is true for capital adequacy or for sales practices: in most
respects, national standards are getting more and more mutually accepted and enforced
because common standards and common best practices develop and conduct to rather similar
standards among European countries.
The United States has one single jurisdiction for the application of most securities legislation.
But despite some important European Union directives, Europe’s financial markets remain
separated legally even if they are substansively integrated by market forces.
This has important implications for the structure of legislation, regulation, compliance and
In the United States, the SEC, and to a certain degree the CFTC, are sole regulators whereas
Europe has as many securities supervisors as jurisdictions. However, under the efforts of
FESCO, the Forum of European Securities Commissions (see below), as well as through a
framework directive prepared by the “Group of Wise Men” chaired by Alexandre Lamfalussy,
Europe’s securities supervisors are on the road to harmonize their basic rules and to adopt the
same principle of mutual recognition as is already the case in banking and other financial
The dramatic increase in cross-border transactions generates a strong need for a common
interpretation of rules and regulations among European regulators. An organization like
FESCO would view itself as the basis for an ad hoc mechanism which would aim at agreeing
on a common interpretation of the European legal framework, thus ensuring consistency in
domestic interpretation of the European directives as well as facilitating a harmonized
implementation of the directives (see below, chapter VIII).
                        The Forum of European Securities Commissions
FESCO, the Forum of European Securities Commissions, was set up in late 1997 by the
Statutory Securities Commission of the European Economic Area and became operational in
1998. FESCO members are the Securities Commissions of the Member States of the European
Economic Area (EEA). It is seeking to develop standards complementing the legal framework
created by the EU directives. FESCO members have also agreed on a multilateral Memoranda
of Understanding to establish a general framework of cooperation and communication between
each other. It provides for mutual assistance between the parties.

Achievements of FESCO include the creation of FESCOPOL to coordinate better the
supervisors’ work toward market integrity and to allow them to conduct well coordinated
inspections and inquiry missions.

3 – Contemporary Professional Asset Management
Asset management consists in investing in financial assets on behalf of customers.
Alongside subsidiaries of banks which in Europe dominate these industry, there exist
hundreds independent asset management companies - due to historical tradition, there are
more independent asset managers in the US than in Europe where asset management is more
in the hands of banking groups.
From a corporate perspective, asset management is amongst the financial and banking
services that a financial institution can offer to customers the one which presents the lowest
risks as there is no “credit risk” (see below the definition) and the “market-risk” (see below) is
born by the investors, not by the manager. As the profit marginds are substantial, this makes
asset management the segment of the financial industry with the most desirable return on

3 – 1 – Segments of the asset management industry

Asset management has different segments
     the “mutual fund” segment mostly addresses the individual customers
     institutional investors are more sophisticated and are addressed by specific teams who
       will often design a customized investment vehicle based on a specific investment
       strategy especially for them. An important segment of such specific instruments with
       specific investment strategies are the so-called “hedge funds” (see below)
     when the customers are “high-net worth individuals” – the threshold for being granted
       this appellation depending on each bank but being situated somewhere between
       200.000 euros and 1 million euros – the corresponding segment of the asset
       management business is called “private banking” and will include other services like
       fiscal and strategical family wealth transmission advice.
       A fourth segment can be added to the three preceeding as many banks (Deutesche
        Bank, Societe Generale…) include it in their asset management subsidiary. This
        fourth segment is “private equity” otherwise often called “LBO” or “Leveraged Buy-
        Out”. As the terms indicate, private equity consists in investing in non-listed (i.e.
        “privately-owned”) companies. This segment has developed fastly in the 1990s with
        the interest of investors for technology companies, often at an “early stage” or “start
        up” companies (this part of private equity investment focused on young hopefully
        fastly growing companies is called “venture capital”, it has also different specialities
        according to whether the investment is made to launch the company – “seed money”
        – or to develop it – “development capital”. In the years 2000s, the private equity
        business has been spurred by the drough on the IPO (“Initial Public Offering”) market
        resulting from the “corporate scandals” Enron-style, that made the investors wary
        about the information provided by the public companies and by their manipulation by
        financial analysts or even auditors. It has in addition become more costly for a
        company to go public as the regulation has be made tougher in most develop
        countries (see the Sarbannnes-Oxley Law in the US e.g.). There are currently
        approxsimately 1.000 private equity companies of all sizes and sorts, i.e. focusing
        each on a given set of industries, a certain geographical zone, agiven maturity of the
        targets etc. The expression “Leveraged Buy Out” refers to the fact that most
        acquisitions by private equity funds are financed by a substantive amount (sometimes
        up to 60%) of debt, as the interest rates have been historically low and therefore
        smaller than the profit-ratre generated by the acquisition, enhancing – “leveraging” -
        the return of the investment for the fund and its investors (called “limited partners”).

3 – 2 - The basic concepts of Portfolio Theory

The mutual fund industry addresses the mass market for investment products. There are
thousands of mutual funds competing to be bought by individual investors and permanently
ranked and classified by specialist magazines and newspapers. The development of the
industry dates back to the post-WWII years. It has been intellectually structured by the
“portfolio theory” developed in the 1950s and 1960s by theorists like Markovitz and Sharpe.
Portfolio theory rests on a few basic concepts, actually mostly the concepts of return and risk.
To understand the concept of return one has to keep in mind that a given object or amount of
money does not have the same value when possessed and hold currently than when due to be
possessed and hold at a future date. As we already mentioned above, financial assets – or
securities – are promises of future cash-flows. Even when these future cash-flows can be
calculated in advance, it remains that their calculated value is valid for the future not for the
present. The operation consisting in translating the values at future dates into values at the
current date is called “actualization”.
The actualized value of a sequence of promised cash-flows will be the result of the summation
of the actualized value of each of the promised cash-flows. These actual values are obtain by
dividing each promised cash-flow by the factor (1+A) where A will designate the
“actualization rate” i.e. the rate of conversion of the values prevailing at a certain horizon of
time into values prevailing at the present time. A, the actualization rate, is the sum of two
elements, the pure price of time or “interest rate” on the one hand, the risk premium
representing the randomness included in the valuation of the future cash-flows on the other
The interest rate – or pure price of time – depends on the horizon of time that is considered. In
fact, there does not exist “an” interest rate but an all “interest rate curve” which relates each
horizon of time with the prices of the future in terms of the present otherwise called interest
rates. In normal circumstances, the interest rates curve is ascendant i.e. that the longest the
horizon of time, the highest the interest rate but there are situations when the interest rate
curve ins declining or “inverted” i.e. when the interest rate for short term commitments will
be higher than the interest rate for long term commitments.
Actualization is necessary for measuring all economic undertakings in the same monetary
units prevailing at the current time. In practice, many an economic project – e.g. a start-up
company – will be described by a “business plan” providing prognosis of future cash-flows on
the basis of market research for the service or product offered by the projected company as
well as competition, pricing policy etc. By definition, the actualization rate that will render the
actual value of an economic project equal to zero is called the “internal rate of return” of the
project (IRR). The IRR is very convenient as it suffices to compare it to the interest rate to
determine whether the project will be viable or not. Obviously, all projects with internal
returns not even covering the interests that have to be paid for the funding provided for
instance by the bank will not be undertaken. Obviously also, the highest the interest rate, the
smallest the number of economic projects that will pass the viability test. One understands
here that – everything being equal - high interest rates are a burden on economic growth, and
conversely that a policy (like the anti-inflation policy favoured by the ECB as described in
Chapter IV) aiming at low interest rates will be supportive to growth provided of course that it
does not impair growth in a larger proportion by creating an overvaluation of the exchange
The total return for an investor of holding a given financial asset is the sum of the relative
change in the price of the asset during the period of holding (capital gain) and the dividends or
coupons that might have been paid to the investor during that same period.
According to Portfolio Theory, asset-returns are random variables (most of the time seen as
Gaussian) with a mathematic expectancy and a standard deviation or “risk”. An investor will
have a portfolio of assets that is efficiently allocated if for any given level of risk it choses the
very security (financial asset) with the highest return, or conversely if for any return, the
investor picks the security with the smallest risk (or standard deviation).
Alongside this basic notion of efficient portfolio, the Portfolio Theory demonstrates that it is
possible to diminish the risk of a portfolio through diversification i.e. that provided that they
bear the same range of individual risks, several assets will bear a smaller risk than one single
asset. Obviously this result from the simple fact that the random elements of the returns of
various asset will generally not be all in the same direction and therefore will more or less
compensate themselves. Obviously also reducing risk by diversification meets a limit which is
nothing else than the risk common to all the assets otherwise called “market risk”.

3 – 3 - Mutual funds and the philosophy of relative returns

These principles of Porfolio Theory exposed in the 1960s still very much structure the
methods used by the mutual fund industry.
First, it has to be reminded that as the mutual funds industry addresses the mass market, it is
regulated in a way that aims at protecting individual investors who are not supposed to be
experts in finance. The regulatory and surveillance authorities thus try to provide this
protection of the individual customer by imposing strict disclosing and information provisions
to the promoters of mutual funds. The mutual funds will have to clearly specify which asset-
class they will invest in – e.g. stocks of big US corporations listed on the New York stock
Exchaqnge or e.g. Growth Companies of the Bio-technology industry in European Nordic
countries, or e.g. bonds issued by eastern European Governments etc. Once the “investment
philosophy” of the funds has been declared to the regulatory authority, the fund has to stick to
This practice leads to the management philosophy based on relative returns. This means that
each fund will compare the total return it brings to its investors (otherwise called
“performance”) to a “benchmark” which in practice will be the market index for the class of
assets in which the fund investment policy forces it to invest. In such a context, the
competition amongst asset manager will naturally focus on the comparison of the perfomance
of each fund to the performance of the benchmark, hence the terminology of “relative
returns”. Investors May lose money but the manager might consol them in saying that they
have lost less than the market or less than the investors having turned to the competitors.

Mutual funds are invested either on
     Stock markets
     Fixed income markets
     Money markets (“money market-funds”)
     There are also many investment vehicles – often with garanteed capital – which are
         made out of “asset backed securities” (ABS) which will be described below when it
         will be dealt with the prudential rules imposed to banks by the regulatory authorities
         and the international accords.
- Stock Market Mutual Funds
The most elementary technique to in vest in stock markets is called “Top Down” investment.
“Strategists’ provide the “portfolio manager” with a macro-economic scenario for the future.
This macro-economic scenario is then translated in terms of industries and more precisely the
relative advantages that each industry will take from the forecast-outlook – e.g. a recovery
will favour retail and consumer goods, while a downturn will relatively favour
pharmaceuticals as people get ill rather independently of the economic situation. The
“financial analysts” for their part will help the portfolio managemer “pick” the companies that
will at that time be the most adequate representatives of the industry – e.g. in the automotive
industry Daimler Chrysler or Volkswagen, or PSA etc… For this investment technique to
prove successful even in relative return terms, the strategists have to forecast the economic
outlook ahead of the competition, otherwise the desirability of the industry and its
representative-compay stocks’ prices will already include the “market expectations” and the
return provided by the investment will be no greater than the average. This is the main reason
why 90% of professional equity managers do not do even as good as their benchmark. In turn,
this justifies two other observations (1) 50% of institutional money is invested in “index” or
“passive” funds i.e. vehicles than just replicate the benchmark and do not spend money trying
to get better returns than the benchmarks, (2) this also explains the observed success of the
“contrarian strategies” – strategies which in principle do the opposite of the main-streeam
market opinion - as on average doing differently than the market gives a larger probability to
have forecasted the adequate macroeconomic context ahead of the market.
The other main technique used in stock market investment is called “bottom up”. It relies on a
specific expertise to pick individual companies that are either “undervalued” by the market
(‘value-investing”) or promised to grow fastly (“growth-investing”). More generally chosing
the best stocks is called “stock picking”.
The role of non-European institutional investors in Europe’s capital markets
The European corporations have been a success on the various Stock Exchanges. On the
average, European stock prices have been roughly multiplied by two during the years 1990s,
not mentioning such dramatic success stories as Nokia for which a euro 10.000 stake in 1991
was worth some euro 3 million some ten years later.
This explains why European stocks are heftily present in most big US investment vehicles
(mutual funds, pension funds portfolios...).
Precisely, not accounting for specialized vehicles such as the closed-end country funds, the
European blue chips stocks present in the first 30 biggest US and UK investment funds’
porfolios amount to near USD 100 billions. On the average, the share of the European stocks
in the portfolios amounts to 3.81% with a peak at 12.55%. The need for good value stocks
makes it quite likely that the interest of US and UK institutional investors for European stocks
will be growing in the years to come.
In addition, one can expect that the expansion of on-line trading in the US (according to
Forrester Research the number of on-line trading accounts is expected to grow from 3.5
millions in the US in 1999 to 20 million by the year 2003 with trading amounting to USD 2
trillion on a yearly basis) will contribute to spread the investment in European stocks among
the individual investors as well as among the smaller institutional investors (such as the so
called “baby pension funds”, i.e. the smallest of the 900.000 recorded US pension funds).
The European stocks in the first 30 US and UK Investment Vehicles’ portfolios
                        Assets (USD billion)    European Equities        % of portfolio
                                                (USD million)
 CALpers Group            266.                   9 127                    3.43%
Franklin Templeton        126                    8 414                    6.67%
Capital Group             158                    8 318                    5.26%
Fidelity                  587                    6 886                    1.17%
Morgan Stanley            131                    5 207                    3.96%
Prudential                138                    5 192                    3.75%
Janus Capital             128                    4 893                    3.82%
Schroder                   83                    4 879                    5.91%
College Retirement        140                    4 458                    3.19%
T Row Price &              42                    4 144                    9.71%
CGU                        36                    3 825                   10.59%
Putman Investment         219                    2 488                    1.13%
Merrill Lynch +           175                    2 323                    1.33%
AXA + Equitable +         265                    2 152                    0.81%
Sun Life + Alliance
Deutsche                  266                    2 099                    0.79%
Scudder                     95                    1 958                    2.07%
Gartmore                    25                    1 607                    6.52%
Standard Life Inv           56                    1 437                    2.58%
American Express            97                    1 258                    1.29%
Vanguard Group             172                    1 192                    0.69%
Foreign & Colonial          20                    1 149                    5.61%
Newton Invest                9                    1 127                   12.55%
Wellington                 123                    1 116                     0.91%
Lazard                      35                    1 052                     2.98%
AIM                         81                    1 018                     1.26%
Crédit Suisse               37                    1 012                     2.76%
Texas Teachers              50                      958                     1.90%
Sanford Bernstein            62                    817                     1.32%
   Phillips & Drew           14                    789                     5.52%
 Perpetual                   15                    726                     4.74%
TOTAL                     3 653                  91 591                    3.81%
Source: Crédit Lyonnais

-   Mutual funds invested in bonds
Bonds are financial assets naturally impacted by the changes in interest rates. A successful
bond-portfolio manager will be the one capable of anticipating the deformations of the interest
rate curve (see below for the definition of this concept).
For a given situation of the interest rates at various horizon of time, bond investment can also
play with the “spreads” i.e. the differences in yields associated with the various issuers’

-   Money market funds
Most investors in money market funds do it on a short term basis and most money invested
consists in temporary excess treasury on which no capital-loss is supposed to be made. Most
money-market funds will therefore present a low if not nil risk on capital but also low returns,
close to that of the “risk-free asset” return of the theory.
The most common technique used by money market fund managers is the “repo” or
“repurchase agreement”. This technique consist for the fund to acquire for one dy or two
bonds (Treasury bonds preferably) from bond-portfolio holders like insurance companies in
temporary need for cash. The purchase by the fund is associated by contract with a put option
that allows the fund to sale the bonds back to the initial seller eat the end of the period.
When a money market fund invests in short term assets like commercial paper, it will bring its
investors higher returns but as there is an element of credit risk in commercial paper, the
capital-guarantee is no longer 100%.
Some money-market funds guarantee a total protection of the investors’ capital associated
with the hope of a higher return. The technique they use consists in investing the capital of the
fund in Treasury Bonds and to invest the interests generated by the Treasury bonds in
speculative instruments. Obviously (1) this technique is not adequate for short term
investments as most money-market fund investrment actually are, (2) only when the
speculation undertaken with the interests generated by the Treasury Bonds is successful do the
investors gain higher returns.

3 – 4 - Hedge Funds and the philosophy of absolute returns

It is quite obvious that the philosophy of relative returns might not seem satisfactory for many
investors. After all, what counts is to obtain a positive return as high as possible on one’s
investment more than to know whether one’s neighbor has done worse or better. The term
“hedge funds” refers to a vast array of investment vehicle which aim at investing in a manner
not directly derived from Portfolio Theory while focusing on absolute performance thanks in
principle to their liberation from the tyranny of the benchmark. Many “alternative” styles of
management are thus offered to investors by the hedge fund industry, for example
-   currency or commodity speculation
-   profitable arbitrages based on market inefficiencies
-   option trading
-   long/short stock picking i.e. the possibility to short-sell certain stocks in difference with
    the buy-and-hold, or “long only”, strategy of equity mutual funds.
Hedge fund management is also called “alternative management”, alternative obviously
referring to mutual funds. It is also said that alternative management looks for “de-
correlation” with the financial markets. In truth, in 1987 (stock market-crash), 1989 (other
stock market-crash), 1991 (first Gulf War), 1992 (Mexican Crisis), 1994 (Bond market-
Crash), 1997 (Asian Crisis), 1998 (Russian Crisis), 2000 (Burst of the Technology Bubble),
2001 (Terror Attacks, Corporate Scandals and Economic Downturn) the financial markets
have provided the investors with a lot of disappointment in terms of protection if not return on
their assets. The idea to try and offer investors investments that will make their money
immune to ups and downs of the financial markets is natural.
There exist several thousands of Hedge Funds. The problem now faced by the industry comes
from this over-crowding. In practice, the correlation of hedge funds with the markets tends to
increase. The reason is quite simple. As the number of players grows, the market-
inefficiencies on which many “alternative” strategies are based tend to disappear, leaving no
option than to try and beat the market again…
The same type of conclusion apply to the assets management industry. Various hints and even
some official speeches or declarations of the year 2000 authorize to believe that this necessity
for Europe’s economic future development to implement a US-like “pension capitalism” has
been recognized by the Commission and the Council of Ministers of the European Union.
Besides, backed upon their powerful private banking activity, it is no surprise that the largest
Swiss banks (UBS, Crédit Suisse) have for long been ahead of their European Union’s
counterparts in this profitable - and strategic - segment of the financial industry.
Leading Private Banks - Assets under Management (USD bn)
UBS                                               428
JP Morgan Chase                                   320
Crédit Suisse                                     293
Goldman Sachs                                     293
Deutsche bank                                     200
Citibank                                          153
Merrill Lynch                                    140
Bank of America                                  129
HSBC                                             115
ABN Amro                                         115
BNP Paribas                                       99

3 – 5 - Insurance
Especially in Europe, banks are also involved in insurance – in the US the tradition is more in
a separation of the different businesses. Insurance companies like banks have their core-
competence in risk management. However, there are at least three differences between
banking and insurance
            1. the risks that are dealt with are different, in particular banks do not deal with
               the risk of accident,
            2. subsequently the techniques are different even though they both rely a lot on
               probabilities and actuarial calculation,
            3. in most countries – though by far not in all – banks and insurance companies
               are not under the surveillance and the regulation of the same authorities.

As was reminded in the first Chapter, Europe has a strong position in the insurance industry as
illustrated by the fact that the non-mutuam insurance companies from Europe have some 70%
of the World’s market-share in this industry. The table below displays the non-life insurance
premiums by regions and shows that more than one third of non-life insurance premiums are
originated in Western Europe.
Non-Life Premiums by Region
                                      In USD billion   As a % of the Total
North America                         39.9             38.9%
Western Europe                        36.1             35.1%
Japan                                 4.3              4.2%
Asia/Pacific                          12.4             12.2%
Latin America                         3.3              3.2%
Eastern Europe                        1.7              1.6%
Rest of the World                     5.0              4.9%
TOTAL WORLD                           102.6            100%

Source: Swiss-Ré’s Sigma, No 9/1998
4 – Banking
To get the funding for an economic project, every one will have the reflex to go to a bank.

4 – 1 - Commercial and credit banking
Banks are institutions which provide a range of services.
The most commonly known by the public at large are:
      management of means of payment – cheque-accounts, debit or credit cards, money
       transfers and so on,
      credit – either for individuals under the form of consumer credit, morgages or credit
       cards, or for corporations under various specialized procedures like leasing, factoring
      cash management – overdrafts, commercial paper programs (see below), currency
       conversion, structured products …
The business consisting in providing this services is called commercial banking, sometimes
also it is called commercial and credit banking, in some occasions it is also designated as
“retail banking” though this designation assumes that most customers are individuals and not
The tradition in Europe is very much oriented around commercial and credit banking and
European countries are covered by a vast number of branches of big banking groups like
Deutsche Bank, Dresdner Bank or Commerz Bank in Germany, BNP-Paribas, Credit Agricole
or Societe Generale in France, HSBC, Royal Bank of Scotland in the UK, ABN Amro, Dexia,
Fortis, ING in the Benelux, BBVA, BSCH in Spain, Union des Banques Suisses – UBS – and
Credit Suisse in Switzerland etc.
We have reminded the reader in Chapter I that the European commercial and credit banks had
some 60% of the global market. Chapter VIII in turn will develop the trends towards more
pan-europeanisation of the banking industry.

4 – 1 - 1 - A technology driven industry scoring efficiency gains

In the last decade, Europe’s banking sector has heavily invested in technology. As a result, it
is more automated than its US counterpart.
Such regions as Scandinavia and Finland already score the highest rates of Internet banking
and other state-of-the-art banking services and techniques.
The banks’ technology budgets are still penting up and the European institutions are decidedly
investing in remote banking.

 Automats
The equipment of the retail banking sector in automats - Automated Teller Machines (ATM),
Electronic funds transfers at the point of sale (EFPTOS)... - has grown fastly (respectively
+324% and + 84% in the European Union during the years 1993-1997) and has paralleled the
increasing use of cashless instruments such as cards (+86%).
Less apparent but still at least as important are also the improvements of information systems
in front offices and back offices. As a study by the European Central Bank (ECB) states it:
“the developments in information collection, storage, processing, transmission and
distribution technologies have influenced and continue to influence all aspects of banking
Indicators of the shift of EU retail banking towards more technology intensive
automated processes
                           % increase in ATM*   % increase in cards** % increase in
                           per head 1993-1997   per head 1993-1997    EFTPOS***1993-
Belgium                    +76%                 +67%                  +48%
Denmark                    +134%                +72%                  +184%
Finland                    +591%                +37%                  +27%
France                     +325%                +44%                  +44%
Germany                    +308%                +66%                  +252%
Greece                     +82%                 +15%                  +1075%
Ireland                    +220%                +52%                  n.a.
Italy                      +262%                +184%                 +268%
Luxembourg                 +294%                n.a.                  +32%
Netherlands                +292%                +417%                 +381%
Portugal                   +283%                +137%                 +116%
Spain                      +557%                +55%                  +101%
Sweden                     +255%                +156%                 +155%
UK                         +328%                +86%                  +94%
Overall EU                 +324%                +84%                  +86%
* Automated Transfer Machines
** Debit/Credit/Retailer Cards
*** Electronic Transfers at the Point of Sale
Source:European Monetary Institute

According to the data displayed in the above table, automated card payments via EFPTOS
terminals are particularly wide spread in Denmark, France, Luxembourg and Finland.
Regarding debit and credit cards outstanding and the overall share of card payments, the
importance of card payments is particularly high in Belgium, Denmark, Luxembourg,
Portugal, Finland and the UK.

 Productivity gains

Technology developments impact banking mainly in two ways:
1. since they replace paper-based and labour-intensive methods with automated processes,
   they contribute to the reduction of costs of management of information (collection, storage,
   processing, transmission...)
2. they change the channels through which customers access to banks services and products
   (“remote banking”).

The cost per transaction can be significantly reduced.
Estimates of the costs of various remote banking transactions range from 1-25% (Internet
banking) to 40-71% (telephone banking) of the cost of the transaction handled manually. The
largest cost-savings are expected in retail securities and payment business.
However, investment costs in on the edge hardware and software are high and recurrent. The
shift toward higher technology also implies more qualified staff with higher wages as well as
training budgets.
According to data from the OECD, banks’ total operating expenses related to non-bank
deposits on a EU weighted average basis have been showing a tendency to decrease since
1992. In addition, the ratio of staff per ECU/Euro 1 billion assets decreased steeply in the
period 1985 to 1997.
These factors, as underlined by an ECB research, “suggest a general productivity increase in
banking due to technology developments”.
Though rather different from a country to an other, the ratio of staff expenses has generally
decreased. As for the change in bank staff per branch office (see table below) there actually
exist in the European Union three types of situation and three related categories of countries:
1. The UK and Luxembourg which in Europe (alongside Switzerland which is not a EU
   member) are the most finance industry-focused countries. These countries score a
   significant increase in branch staff, even in the recent years;
2. the second category of countries include the majority of EU countries, in which, at least
   since 1995, the number of staff per branch office is declining despite the increase in
   financial and banking services;
3. Belgium and Germany, in which countries the number of staff per branch office has been -
   though moderately - keeping on growing.

Changes in bank staff per branch office
                        change 1985-95           change 1995-1997        change 1996-1997
Belgium                 19%                      5%                      3%
Denmark                 50%                      -7%                     -2%
Germany                 8%                       2%                      2%
Greece                  -13%                     -3%                     -2%
Spain                   -15%                     -5%                     -2%
France                  -3%                      -1%                     -1%
Ireland                 25%                      -10%                    -9%
Italy                   -38%                     -10%                    -5%
Luxembourg              40%                      17%                     12%
Netherland              28%                      1%                      0%
Austria                 1%                       -3%                     -2%
Portugal                -56%                     -16%                    -9%
Finland                 53%                      -1%                     -1%
Sweden                  40%                      3%                      -1%
UK                      14%                      17%                     15%
Overall EU*             4%                       1%                      2%
Source: ECB publication: “possible effects of EMU on the EU banking systems in the
medium to long term” (February 1999)
   unweighted average

One consequence of the above table is that though widely driven by technology in such areas
as retail banking, success in the banking business relies also on other sources of comparative
advantages such as reputation, tradition, image, quality of service, respect of privacy, tax
issues etc. This explain why though benefiting from excellent rankings regarding the
competitiveness of their finance industry - UK’s finance is ranked first on the global level,
Luxembourg is ranked fourth - the most finance-focused EU countries’ technologies are far
from being ranked among the first (see table 1 above).

4 – 1 - 2 - The results of rationalization and concentration

As has been suggested above, as a compulsory passage , in the short run, the rationalization of
the banking industry in Europe will have to address prioritarily the two following issues:
1. The de-fragmentation of the European payment system through the emergence of pan-
   European retail players, through more homogeneous payment behaviors and more
   harmonized local regulations regarding consumer protection etc;
2. the rationalization of the German banking industry, and to a lesser extent, that of Italy.

 In the concentration process of banking institutions, the initial features of the respective IT
  systems are of growing importance

As for them in particular, the driving forces of concentration mainly are:
1 - reach critical size to cope with the price of IT equipments as well as to improve ROE
2 - increase market shares
3 - seal technical partnerships on the domestic or on foreign markets
4 - seal strategic partnerships or M&A

The IT budgets have become a major issue in modern banking. Therefore the IT systems
have to be designed in order to be able to adapt to evolutions - such as mergings - that are not
predictable at the time when they are implemented.
The cost and time of adapting the Information Systems of two merging institutions may
cancel the overall economic benefits of a given concentration operation, for example when it
conducts to the need to build a completely new common system when the two existing have
not been properly amortized.

 The driving forces to an improved efficiency

The well known driving forces to an improved efficiency in the banking sector are:
 technology
 Size, concentration and economies of scale
 organization
As a recent example, in November 2000 Commerzbank announced an 18 months plan aiming
at reducing the number (935) of its branches by nearly 200. The bank will be organized in
two divisions (Corporate and investment banking and Asset Management and retail banking).
CommerzLeasing und Immobilien Gmbh (with contracts totaling euro 16 billion) will be sold
out preferably through an IPO.
Operating ratios of European Banks
                 Share of           Intermediatio     Structural        Structural        Return on
                 commissions        n margin (net     Overheads/        Overheads/        Equity (ROE)
                 in net banking     interests+inco    Weighted risk     Net banking
                 revenues           me adjusted       & clients         revenue
                                    for capital)      deposits
France           31.8%              2.0%              2.3%              68.7%             12.9%
Germany          31.4%              1.9%              1.8%              69.2%              9.2%
Belgium          22.3%              2.6%              1.2%              63.6%             12.4%
Spain            28.6%              3.6%              2.2%              62.5%             10.2%
Italy            35.5%              2.4%              1.9%              64.6%              6.3%
Netherlands      26.0%              3.1%              2.1%              69.8%             12.6%
UK               29.3%              3.8%              2.0%              56.1%             19.5%
Portugal         15.6%              3.4%              2.5%              69.3%              9.6%
Source: AFB (France’s Banks Trade Association)

Efficiency gains in the EU banking sectors 1994-1997
                     Technology            Size                  Organization          Global
Austria                 0.0 %                0.0 %                 -0.7 %               - 0.7 %
Belgium                -1.7 %               -0.08%                 +1.6 %               -1.0 %
Denmark               +0.9 %                -0.06%                 +5.8 %               +6.0 %
Finland               +2.1 %                -1.31%                 +4.2 %               +3.3 %
France                +1.1 %                +0.08%                 +1.7 %               +3.7 %
Germany               -0.06%                +0.05%                  0.0 %              -0.01 %
Italy                    0.0 %              -0.03%                 +4.9 %               +4.6 %
Netherlands            +0.6 %               +0.06%                 +2.2 %               +3.4 %
Portugal               -4.4 %               -0.03%                 -0.03%               -5.1 %
Spain                  -1.9 %               -1.2 %                 +0.01%               -3.0 %
Sweden                - 0.03%               +0.03%                 +0.05%              +0.05%
UK                     +0.1 %               +0.01%                 +0.03%              +0.05%
     Source: Banque Stratégie n°167 - Paris January 2000 - Philippe Bourgeois, Marie-Hélène Fortesa, Ingrid
   Leroyer: Productivité: les banques françaises sur la bonne voie

4 - 2 – Investment banking
Institutions called “banks” also provide services regrouped under the name of “investment
Investment banking consists mainly in providing economic agents like corporations, states,
regions and municipalities with funds that are brought by investors.
In contemporary economies, insurance companies and pension funds are the main channels
through which the individuals and the households manage their retirement plans and hedge
their risks – accidents, health etc. “Institutional investors”, as institutions like pension funds
and insurance companies are called, need assets in which to invest so as to be able to fulfill
the commercial commitments they have taken toward their customers. Therefore, the core-
competence of investment banks can be summed up in the following formula: Matching the
needs of issuers of securities with the needs of institutional investors for financial assets.
Therefore the core competence to engage succsssfully into investment banking is twofold.
       It must involve the ability to communicate regularly and in confidence with the
        shareholders and the top-management of potential issuers – Chair-persons of the
        Board, CEOs …
       It must also include the ability to perceive the needs of the investors at any given
        moment of time – otherwise called the “mood of the financial markets”. These are
        sophisticated activities undertaken by highly educated individuals.
The compensation of the employees of investment banks can be much over the average
compensation of a top-executive in a commercial or industrial company but the profits at
stake in every single investment deal are most often bigger than in ordinary business and the
probability of success in every single prospective undertaking is low. It would be wrong to
believe that it is easy to make big money in investment banking and it is not rare that the
investment banking division of big banking groups provide disappointing financial results.
As they know well the demand for equity by such insititutions as the US pension funds, it is
not surprising that the US banks have their dominance in equity investment banking i.e. the
deals involving equity contracts. On the other hand, European institutions like Deutesche
Bank or BNP-Paribas with the good understanding they have of the needs of the European
insurance companies are dominant in the fixed-income side of investment banking (see next
chapter for examples).

The persons within the bank staff in charge of detecting the potential needs of corporations or
other potential issuers of securities are called “senior bankers” – or “partners” if the
investment bank is under the legal status of a partnership. When a senior banker has detected
a potential deal with one of the bank’s client he or she will turn to the “execution teams” of
the bank so as to get back to the customer as soon as possible with a proposal that would
define the terms and conditions of a proposed deal. To do this, the execution teams will gather
information from their colleagues – called the “sales” – who are in charge of the permanent
touch with the investors in rder to sell them securities – and this information will be shaped
out so as to describe the condition of a successful marketing of the securities that would be
issued. When the customer agrees the proposal made by the bank, it is said that it grants the
bank a “mandate”. When time comes of execution of the mandate, the financial parameters
described in the proposal will have to be translated in legal form so as to form a contract. In
most cases, the task of legal wording is outsourced to specialized legal firms under the
supervision of the bank’s legal experts. The mandate will describe among other elements, the
fees that the bank will receive as a compensation of its successful efforts. Due to their size,
some deals will involve several banks and it will be said that the deal wil be undertaken by a
“syndicate” of banks.
The core business of investment banking consists in
        engineering the issuance of securities by those economic agents in need of funding
        selling the securities to investors.
Investment banking is more a US tradition than an European one, though as time goes by
there is a convergence taking place. In particular, all the big banking groups from Europe that
we have mentioned above are involved in investment banking alongside their commercial
banking activity. Nevertheless, the big names in investment banking remain those of such US
institutions like Goldman Sachs, Morgan Stanley Dean Witter, Salomon Smith Barney,
Lehman Brothers, Merrill Lynch. Some of them are now part of a wider banking group like
Citi Group. As will be exposed in more details in the next chapters, each banking goup has its
own strategy as for the manner in which it will expand its investment banking activity. Some
like Deutsche bank, through acquisitions like e.g. Bankers Trust in the US, prefer an external
growth strategy, others chose organic growth. An investment banking tradition reflects a
bigger role of financial markets in the financing of the economy as well as a lower aversion to
risk. The European tradition of commercial and credit banking can be explained by the wars
that plagued the continent during the 19th and 20th Centuries. War is not the propicious
context to lower aversion to risk and favour the development of financial markets. As the last
war in Europe is now more than sixty years back, its is no surprise that financial markets are
getting a greater role in Europe as will be described below in Chapter IX.
Despite the high number of European players, some of them powerful, some highly profitable
segments of the financial business in Europe - mainly such segments of investment banking as
Mergers and Acquisitions - have until recently been widely dominated by US institutions.
Investment Advisors for European Targets or European Acquiror
Rank Advisor                        Value of Transaction (USD   Number of Deals
1. Goldman Sachs                    708.7                       148
2. Morgan Stanley Dean              667.4                       188
3. Merrill Lynch                    525.9                       159
4. JP Morgan                        401.4                       112
5. Warburg Dillon Read              308.1                       163
6. Crédit Suisse First Boston       275.1                       152
7. Lazard Houses                    233.4                       122
8. Deutsche Bank                    220.5                       110
9. Rothschild                       143.4                       175
10. Dredsner Kleinwort              139.2                       82
11. Lehman Brothers                 119.1                       84
12. Salomon Brothers                118.9                       64
13. BNP Paribas                     112.7                       92
14. Donaldson Lufkin Jenrette       80.2                        82
15. Crédit Agricole Indosuez        62.3                        11
Source: Thomson Financial Securities Data as of 05/01/2000

The weakness of European banks in the global investment banking business may be seen as a
greater paradox as Europeans have always had net financing capacities, and as Europe (at leat,
the European Union) appears as the most important saving pool in the World in terms of
flows. The overall financial wealth of European households amounted to nearly Euro 18,000
billion (by year-end 1999), three quarters of the total coming from four countries: Germany,
France, the UK and Italy. With less than 16% of the European population, the UK represents
27% of Europe’s private financial holdings.
On the other hand, because for a long time the US institutional investors have been their
clients which in turn they have been successfully providing with the financial assets they have
needed in order to fulfill their comitments towards their subscribers, the US investment banks
- the likes of Goldman Sachs, Salomon Smih Barney, Merril Lynch, Morgan Stanley Dean
Witter ... - have since now been dominating the investment banking and equity business.
In a rather similar way, because they back themselves on the huge capitals invested in
Switzterland, such banking institutions as Crédit Suisse and UBS (Union des Banques
Suisses) have also strong positions in those businesses through such specialized arms as
CSFB (Crédit Suisse First Boston which, through its recent acquisition of US Donaldson
Lufkin and Jenrette has become global number one in M&A deals, in IPO volume and in high
yield debt underwriting) and UBS Warburg (which recently has acquired Paine Webber).
Until recently, most European banks seemed to approach investment banking not globally but
concentrating on profitable niche activities. Such a prudent approach had been illustrated for
example by the acquisition by Société Générale of France of the US firms Barr Devlin -
specialized in M&A in the sector of utilities - and Cowen - specialized in IPOs - in 1998.
As for the other biggest European banks - which have the clientèle of the biggest European
corporations - they have their eyes on the very profitable and prestigious businesses equity
and investment banking: in itself the European cross border M&A business represented USD
500 billion in 1999.
For the coming years, the monetary union, the circulation of the euro, enhanced competition
should entail further consolidation in many sectors of the European economy and therefore
offer bright prospects for the M&A business in the Old Continent. It is natural to expect that
the European banks will try to capture as much as they can of the corresponding bounty and
thus compete fiercely with their US peers in the business of investment.
Regarding the investment banking business, however, the major european banks have one
major handicap from their US counterparts. Their handicap lies in the comparatively weak
potential of investment of the European institutional investors as this is illustrated by the
observation that the assets of the US pension funds are roughly ten times higher as that of the
European pension funds. This problem of accessing the US institutional investors justify
Deutsche Bank Alex Brown’s acquisition of Banker’s Trust.
An other problem which the European banks have to solve regarding their desire to enhance
their position in investment banking lies in the historical separated development of the
commercial and credit banking on the one hand, and that of merchant and invesment banking
on the other hand, the result being that the bank with the financial ressources are not those
with the expertise and credentials in the area of investment. Such an observation explains the
partnership which have been concluded by ABN Amro with Rothschild and by Crédit
Agricole with Lazard.
Finally, the chances that the major European banks become important players in the
investment banking business significantly rest on the chances of having institutional assets
developing rapidly in Europe however, the return of capital markets, the consolidation of the
European economy in the wake of the monetary Union and the European institutions
ambitions in investment banking are factors of hope to vercome the historical well-known
 equity markets have been fragmented for a long time,
 due to the dominant “pay as you go pension systems” in the largest European countries,
  unlike in the US, there do not exist in Europe powerful institutional investors to invest
  heftily in equities (to the exception of the UK, Switzerland and The Netherlands, the
  largest European economies - Germany, France, Italy - are still characterised by pay-as-
  you-go pension systems with, therefore, less powerfull institutional investors than in the
  US. Thus, European pension funds assets are smaller by approximately a 1 to 10
  proportion to their US peers’ holdings),
 the equity and investment banking business have been dominated by huge US institutions
  (the “bulge bracket”, as the four US giant firms are refered to) backed upon their strong
  institutional investors client base.

Top 10 managing underwriters for international and domestic equity issued in Europe
Rank                        Company               Number of tranches     Amount adjusted
                                                                         (USD bn)
1                           Goldman Sachs         98                     31.11
2                           Morgan Stanley dean   86                     22.10
3                           Deutsche Bank         98                     21.77
4                           Merrill Lynch         85                     17.84
5                           ABN Amro Holding      125                    13.20
6                           UBS                   103                    12.37
7                           Crédit Suisse         116                    12.01
8                           Dresdner Bank         72                     9.58
9                           Citigroup             72                     7.69
10                          Scandinaviska         44                     5.60
                            Enskilda Banken
Source: Thomson Financial

Ahead of, but among other European institutions, Deutsche Bank - notably through its
acquisition of the US Banker’s Trust - has already clearly posted its ambitions in this area.
However, this goes alongside the ancient ambitions of the largest Swiss banks (UBS-Warburg
Paine Webber and CSFB-Donaldson Lufkin and Jenrette). In the Netherland’s ABN-Amro is
associated with Rothschild and in France Crédit Agricole h for its part is associated with the
Lazard Houses in the equity business. France’s BNP-Paribas has also posted ambitions. UK’s
HSBC has acquired Merrill Lynch. Germany’s Dresdner Bank recently spent USD 1.4 billion
to acquire US M&A organisation Wasserstein Perella. France’s Société Générale trough a
niche strategy, together with Spain’s BSCH, for instance, are also willing to play a part in the
highly profitable investment banking business.
The interest of the major European banks in investment banking has started to show in the
years 1980s and 1990s when banks from mainland Europe started to acquire most traditional
investment and merchant banking institutions in the City of London with such examples as
Deutsche Bank’s acquisition of Alex Brown, UBS’ acquisition of Warburg, CCF’s acquisition
of Charterhouse, ING acquisition of Barings etc. Nevertheless, the integration of such London
investment banking arms by the major continental banks may be seen as a first step, mainly
purposed to unable them to gain credibility in the investment business.
The second step in which the more agressive of the European banks are now engaged, lies in
the acquisition of US investment banking institutions which will give them access to the US
institutional investors clients. However, as has been said above, the chances of the most
powerful European banking institutions to become significant players in the global investment
banking business depend broadly on whether or not, like their US peers, they will be backed
upon a loyal and financially powerful client base of local institutional investors. The question
of the future of Europe’s pension system is thus of first importance for the future of its
banking sector both on the European and on the global level.

In the current situation, for their investment banking activity, the European banks can rely
upon the mighty corporate client-base which the European global corporations constitute.
However, until now, this has not been sufficient and the investment business - at least
regarding equity financing since the situation of investment banking appears quite different on
the bond markets (see above) - has still been dominated by the US investment banks like
Goldman Sachs, Morgan Stanley Dean Witter or Salomon-Smith Barney. Rebalancing the
competition in the securities and investment business at the global level would require a fast-
pace setting of an European pension capitalism in the largest European countries, as Germany
as partially started to do.
These observations again justify the acquisitions by the European most powerful banks of US
investment banks in order to give them access to the US institutional investors clientèle. The
same observations also underline how important it will be for the flourishment of the
European financial system that its banks would be backed upon as dependable and sizeable
European institutional investors as there exist in the US.
The weakness of European banks on equity business and M&A, which has been underlined
above, is due to the narrowness of their local institutional investors client base. However, the
category that dominates as institutional investors - mainly insurance companies - in Europe
have long been more bond oriented that equity oriented. This last observation explains why
such European banks as Deutsche Bank, ABN Amro, BNP Paribas, Dresdner Bank and UBS
rank in the Top five book runners as for euro denominated bond issues.

The strong position of European banks in fixed-income investment banking
All issues in Euro Since Inception: Bookrunners 1/1/1999-6/30/2000
Lead Manager               No of Issues               Total (EUR m)       Share (%)
Deutsche Bank              464                        96,323.22           10.84%
Dresdner KB                306                        58,163.11            6.55%
BNP Paribas                216                        56,929.60            6.41%
ABN Amro                   256                        56,678.63            6.38%
Morgan Stanley DW          246                        52,669.67            5.93%
Source:International Financing Review (IFR) Issue 1340 pp15-16
Data for 1999 include both BNP and Paribas
Non European sovereign issues in Euros: Bookrunners 1/1/2000-6/30/2000
Lead Manager               No of Issues               Total (EUR m)       Share (%)
Deutsche Bank              145                        38,636.86           12.18%
UBS Warburg                 71                        20,759.93            6.54%
Salomon SB                  61                        20,624.89            6.50%
Morgan Stanley DW           71                        18,818.57            5.93%
ABN Amro                    76                        18,316.76            5.77%
Source:International Financing Review (IFR) Issue 1340 p15
Corporate Issues in Euros: Bookrunners 1/1/2000-6/30/2000
Lead Manager               No of Issues               Total (EUR m)    Share (%)
Deutsche Bank              26                         9,291.67         13.57%
Schroder Salomon SB        26                         9,025.00         13.18%
BNP Paribas                22                         5,765.00          8.42%
ABN Amro                   20                         5,173.33          7.55%
Morgan Stanley DW          20                         4,696.67          6.86%
Source: Euroweek June 29 2000

US Corporate Issues in Euros: Bookrunners 1/1/2000-6/30/2000
Lead Manager               No of Issues               Total (EUR m)    Share (%)
Deutsche Bank              9                          2,475.00         17.28%
BNP Paribas                6                          2,083.33         14.54%
Schroder Salomon SB        7                          1,758.33         12.27%
JP Morgan                  6                          1,700.00         11.87%
ABN Amro                   6                          1,625.00         11.34%
Source:Bloomberg (as of June 30 2000)

Corporate Crédit Issues* in Euros: Bookrunners 1/1/2000-6/30/2000
Lead Manager               No of Issues               Total (EUR m)    Share (%)
Deutsche Bank              20                         6,195.83         18.42%
Schroder Salomon SB        15                         3,920.83         11.66%
ABN Amro                   13                         3,803.33         11.32%
JP Morgan                   9                         2,308.33          6.86%
BNP Paribas                10                         2,208.33          6.57%
Source:Bloomberg (as of June 30 2000)
*All single A-rated and B-rated corporate issues
Sovereign Issues in Euros: Bookrunners 1/1/2000-6/30/2000
Lead Manager               No of Issues               Total (EUR m)    Share (%)
Deutsche Bank              16                         8,458.55         23.27%
Morgan Stanley DW           6                         3,178.51          8.75%
ABN Amro                    4                         3,077.44          8.47%
JP Morgan                   6                         3,012.71          8.29%
UBS Warburg                 4                         2,701.08          7.43%
Source:International Financing Review (IFR) Issue 1340 p22
Banks and secondary markets
Investment banks or the Corporate and Investment Departments of commercial banking
groups are involved in secondary market activity in several ways.
- First, they benefit from an asymmetrical analytical expertise which makes them liable to
make money in trading in security markets. In pratice, there are teams in the banks whose job
it is to trade on specifically designed segments of the financial markets so as to generate
profits. This part of the bank’s business is called “proprietary trading”.
- Second, banks act as “agents” of their customers and provide them with investment
recommendations as well as with the full investment service of trading the given security
accompanied with the back office operations such as clearing, settlement, administration and
custody of the securities. Most existing banking gropus have subsidiaries that do this kind of
business also made by brokers.
In contemporary banking and finance, these investment services involve huge IT systems –
the financial and banking industry represents some 30% of the sales of the IT companies –
subsequently, economies of scale are an important factor in this business with the
consequence that some banks will chose to specialize in some segments of the business while
other will give these segments away and outsource their business to the specialized

4 - 3 – Banks as managers of risk
In the contemporary World, especially in Western Europe, the financial business is dominated
by universal bank-insurer groups.
There exist synergies between the various activities described in sections above. In particular,
insurance companies can provide the credit banking side of the business with capital and
financial reserves while the commercial banking side can provide insurance companies with
the branch network that facilitates the marketing of their policies. As will be described below
in the case of Europe, one can find various degrees of integration between banks and
insurance companies, some group having a strong integration with the insurance business
being a subsidiary or a division of the group while in other situations, there will exist
capitalistic links between insurance companies – the likes of Allianz, Generali, Axa, Aegon,
Prudential etc. – and banking groups.

       4 – 3 – 1 – Basic notions
We have used the word “risk” several times without providing the reader with a definition of
what is meant by risk in banking and finance.
Actually, in banking and finance the word risk does not bear the same meaning as in the day
to day language.
The first distinction that finance makes much more strongly than the common language is
between risk and uncertainty.
For the financier, risk concerns the situations when outcomes can be associated with
probabilities while uncertainty refers to situations where no probabilities are available.
Probabilities derive from the statistical observation of history. Probability theory has started to
be developed in Europe in the Renaissance with the names of Blaise Pascal and Daniel
Bernoulli amongst others. An uncertain situation will be a situation that cannot be dealt on
the basis of the accumulated experience simply because there exits no precedent for it. In
principle, banks – and insurance companies - deal only with risk, they don t deal with –
      The key-notion of Value At Risk
The key technical notion involved by risk management in banking is the notion of “value at
risk” – VAR.
VAR is the result of a probability calculation. It will provide the bank with the crucial
indication of the amount of capital it will need to have only a certain probability of getting
bankrupt. To make this notion less abstract, let us think of a bank specialized in consumer
credit. The bank will be able to score each of its customers according to their age, occupation,
wealth etc. and the past experience will provide it with the statistics of defaults associated
with these characteristics. Consequently, given its credit-portfolio, for each level of
probability – e.g. 95%, 99%, 99.5% … - the bank will be able to compute the maximum
amount of defaults that have appeared in history. This amount, maximum in historical terms,
will be the bank’s value at risk for a certain chosen probability. Once the bank has opted for a
residual probability of bankruptcy – say 0.5% as 0% is not an option because it will require an
infinite capital or no business… - it will be able to determine the financial reserves, or
“capital”, that will allow it to mope out its losses in the worst historically observed situation.
In the contemporary World, banks are not free to choose their probability of bankruptcy. In
fact, Banking and finance are amongst the most regulated activities and the Surveillance
Authorities will make sure that the banks in their jurisdiction comply with compulsory
prudential ratios (see below).
However, risk has an even more specific meaning in finance than that suggested by the notion
of value at risk. This comes from the fact that many natural and social phenomena are ruled
by the Normal Law or Gauss Distribution of probability – a key theorem in statistical
mathematics, the “central limit theorem” shows that every phenomenon that can be
decomposed into binomial elementary segments will follow a normal Gaussian distribution of
Any Gauss distribution - akka “bell curve” because of its shape resembling that of a bell – is
completely determined by two parameters, the mean and the standard deviation and it is
symmetrical around the average or mathematical expectancy. For a financial phenomenon
like credit-default ruled by a Gauss distribution, it is possible to demonstrate that the value at
risk is proportionate to the standard deviation of the probability distribution.
This is true for many other financial phenomena like the evolution of financial asset returns
etc. This is why, in the financial jargon, risk will designate the standard deviation of the
statistical distribution of a given variable. As a consequence, in the financial jargon contrary
to the day to day language, risk is symmetrical, by what we mean that positive outcomes that
diverge from the average outcome are also qualified as “risk”.
       Returns per unit of risk – the “Sharpe Ratio”
The assessment of the performance of a financial strategy when solely based on the
measurement of the return it brings is not adequate. The proper assessment must take into
account the amount of risk associated with the obtained return. It is obvious that high returns
obtain by investments in very risky assets can be the sole result of chance. Conversely, many
assets – like Treasury notes – wil never allow spectacular returns, but they carry small risk.
To account of this logics, Sharpe has proposed to assess performances by the ratio of
return/risk. In practice, some will calculate this ratio, not on the basis of observed return but
on the basis of the return in excess of the risk free asset return.

4 – 3 - 2 – Sources of Risk in banking and finance
From a practical standpoint, there are three main sources of risk
-   Credit Risk – also called “signature”, counterpart” or “default” risk,
-   Market Risk
-   Operational risk
We have explained what the credit of default risk is. It is simply the risk that a borrower does
not fulfill her or his commitment to re-imburse her or his debt or pay the interests.
The market risk represents the change in the value of financial assets. Let us take the simple
example of a bank having bonds amongst its assets. The value of bonds is a declining function
of interest rates as has been explained when the operation of “actualization” has been
described. Mar5ket risk can come from the variation of other variables than interest rates e.g.
exchange rates, commodity prices etc.
Every situation where there exists a market risk is by definition called by finance theory a
“speculative” situation – it is also called an “open” position. Conversely, a position immune
to the market-risk will be said “hedged” or “closed” or typical of an arbitrage.
              Operational risk
Operational risk is an heterogeneous set of sources of risk coming from the practical
completion of banking and financial operations. Operational risk includes
-   legal risk, when the wording of a contract will leave the door open to litigation for
-   execution risk, when there are failings in the definition of the terms (e.g. amount) of a
-   organizational risk, like in the case of the bankruptcy of the Barings Bank when one trader
    on Asian derivative products was also responsible for their accounting,
-   fraud risk, this justifies that some banks forbid their employees to enter the premises when
    on leave,
-   accounting risk
-   etc.

As was metionned earlier, the surveillance authorities impose to banks compulsory ratios and
procedures aimimg both at minimizing the realization of risks and at putting aside the
financial provision to cope with them if necessary.
The so-called “Basles Accord” the prudential policy for banks and the corresponding financial
ratios. “Basles II” is a new international agreement which will be more refined than “Basles I”
and which, in addition, will make it compulsory for banks to provision operational risk. No
need to insist on the technical difficulty of this requirement.

4 – 3 - 3 – Why be a “bank”?
In most countries, granting credit is not authorized unless the organization that grants it is
registered as a “bank” therefore under the surveillance of the appropriate authorities who will
monitor and enforce the legal prudential rules.
However, especially in investment banking many segments of the business may be exerted
without the compulsory requirement of being registered as a “bank”. Also, many industrial or
commercial corporations will chose to have their financial division registered as a “bank” –
the most obvious example is General Electric for which financial services have even become
an axis of development but many other examples could be quoted e.g. the big European car
makers like Renault or PSA have “in-house” banks i.e. financial divisions with the legal status
of a bank.
As the fact of being a bank entails a lot of constraints visavis the surveillance authorities one
may wonder why so many chose to be registered as banks. The main explanation lies in the
fact that only registered banks have access to the cheapest resources available on the
interbank market and in case of need from the central bank. For these organizations whose
turn over is large enough as to make a few basis points in the cost of resources a siginificant
difference in terms of profits, it wil be worthy bearing the costs of the red tape associated with
the official status of “bank”
As was said in Chapter II, insurance companies play a key part in Europe’s financial industry.
Most of them - Axa, Allianz, Generali ... - have strong cross-shareholdings with the major
banks. Such a cross-shareholding is not only of financial nature but of strategic nature as
banks have branch networks capable to distribute insurance policies.

4 - 4 - Insurance companies: key-players in the European banking
and financial sector

For example, even befoe it was acquired by Allianz, Germany’s Dresdner Bank had a very
far-reaching distribution agreement with Allianz under which it distributes Allianz products
through its network. Dresdner thus generates a significant part of the flow of Allianz
insurance policies. Allianz in return distributes through their agents Dredner Bank’s mortgage
credits, savings products targeted at real estate purchases and its investment funds. Beyond
distribution agreements and relationships, the two institutions also have a common
infrastructure in asset management. Before its merger with Dredner Bank, Allianz had the
same type of relationship with Bayerische HypoVereinsbank.
Other example, Italy’s insurer Generali has a cross-shareholding with Commerzbank which
aims at expanding the distribution of its insurance products in Germany through the branch-
network of the bank.
Logically, insurers would like banks to stay out of the insurance market except for their role
as distributors of insurance companies products yet major banks have not limited themselves
to this role but, on the contrary have developed insurance capacities of their own. Hence, for
instance in France, Crédit Agricole has developed Predica which is doing well. BNP has
developed its “Natio Assurance” affiliate which has now entered into agreements with Axa.
Similarly, Crédit Lyonnais has a life-insurance arm, Union des Assurances Fédérales, as well
as an agreement with Allianz. Société Générale also has its insurance arm, Sogessur, a joint
subsidiary with Commercial Union and AGF, while CCF has agreements of that type with
Swiss Life. In such countries as Portugal, where banking and insurance are tightly intertwined
through cross-holdings, such integrated groups can take advantage from synergies in logistics
and back office operations.

5 – Asset Backed Securities and Credit Derivatives
 Asset backed securities (ABS). are the fastest growing segment of the financial industry. This
is not really a surprise as the ABS solve some problems for two types of institutions
-   the banks
-   the institutional investors and in particular the insurance companies.

5 – 1 – Securitization and the expansion of credit granted by banks

Banks are limited by their capital for granting as much credit as they wish. This is an outcome
of the prudential rules that has just been exposed.
In theory, banks could increase their capital-base so as to increase their credit-offering. In
practice, this is not how things work as a capital increase is a heavy operation when it comes
to its legal aspects in particular and especially when the bank is a public company. In
addition, capital increases parallel to the expansion of the credit offering would limit the
profitability of loan granting.
Appeared in the 1980s, “securitization” brings a solution to this problem of the banks. As the
banks cannot increase their capital-base easily to expand their credit-portfolio, the alternative
is to push out of the bank’s balance-sheet some of the already granted credits.
To do this, a special purpose company will be created that will acquire some of the credits
present in the banks portfolio. As a counterpart, this specially created company will issue
securities, our “asset-backed securities”. The proceeds of the sale of these credits will come to
reinforce the bank’S capital available for new lending and new fees …

5 – 2 – The diversity and flexibility of ABS-making make them a source of desirable financial
assets for institutional investors
As we have mentioned, banks are availed with all the information tools needed to “package”
the credits as they wish, by maturity, type of customer, type of credit - mortgage, credit card
In this context, banks will be able to create a vast array of customized financial assets that will
be able to fit any specific need of many institutional investors.
There are also mass market investment products – many with a capital guarantee – made out
of asset backed securities.
                                       CHAPTER II

As the previous chapters have argued, integration has been a major driving force for Europe’s
economic progress during the last decades of the 20th century. Economic integration has led to
the current strong economic position of Europe in the global economic and financial arena
based on its corporate sector, its financial power, its innovation capabilities which we
described in the first chapter.
One of the industries where integration has not gone far is banking and finance. This is
somewhat paradoxical within the context of the moneatry integration.
To foster financial integration, at their Lisbon European Council in March 2000, the European
Union’s heads of state and government endorsed a “Financial Services Action Plan” (FSAP)
which at the time was widely seen as containing the key elements for constructing an
“integrated European financial services market” - “by 2005 to the latest” as firstly overly
ambitioned. The dead-line date of 2005 in itself was a clear indication that financial
integration was a priority which in principle - had to be achieved very soon after Europe’s
monetary unification. Together with the consolidation of the over-crowded banking industry,
this new step in the making of an efficient integrated European economy should be a natural
sequel of the monetary integration and a stimulus to growth in the first decade of the 21st
Century as we mentioned above in Chapter III (see Chapter III § 3 - 2).
The initial Lisbon ambitious program has not been achieved within the planned time-
framework. In this chapter we will describe and analyze the perspectives for Europe’s
banking and finance as things stand in the middle of the first decade of the 21st Century.
However, before coming to this issue from a rather technical and industrial point of view we
find it necessary to remind the reader of the broad context within which Europe’s financial
integration would take place in the first decade(s) of the 21st Century as this will help
understand the timing and the difficulty of Europe’s financial integration agenda.
We would like to start to argue that the launching of the euro can be seen as the crowning of a
first stage of Europe’s integration. In this first stage politics played an obvious key-part
because the decision-making process involved quite clearly the governments and heads of
state within the framework of a centralised and rather simple decision-making process for an
European Union of 15 members or less. In short, this stage may be coined the “easy times” of
Europe’s integration. At the same time, the implementation of the euro and monetary
integration may be seen as the starting point of an other stage of Europe’s integration where a
very significantly enlarged European Union will function with an increasingly elaborated
decision-making process. In this new stage, together with the statutory changes in regulation
decided at the political level and alongside more and more business self-regulation, the euro
and the monetary union should have to act as the catalysts of the propper market forces.

From a rough historical perspective, there is no doubt that such achievements as the Customs
Union in the years 1960s, and later the settling of the Internal Market, the single Competition
policy, the deregulation of sectors such as telecoms or energy, together with the
implementation of the Stability Pact, the launching of the euro, the implementation of the
European Central Bank are among the many milestones of Europe’s economic integration
which could not have taken place without a strong political impetus. More generally, in its
early stages, Europe’s economic integration has mainly taken the form of statutory and
prescriptive regulation.
As has been developped in the earlier chapters, Europe’s financial integration is a natural
prolongation of the implementation of the euro and the monetary union. From the overall
European-economy standpoint, the players of the European financial industry will have to
support more and more efficiently the global operations of Europe’s global corporations
through more and more complex and risky techniques. They will also have to finance the
consequences of the continuing deregulation process in such sectors as telecommunication,
energy, utilities etc.
Even more than contributing to the global and continental expansion of Europe’s big
corporations, Europe’s finance industry will have to enable the pan-Europeanisation of many
medium sized companies while being capable of supporting the emergence of successful new
companies. As well as big corporations, efficient small and medium sized companies will
have as many more chances to expand on the pan-European level as they will be supported by
providers of adequate, cheap cross-border financial and banking services. Within this
strategical framework, the integration and transformation of the European financial sector
should widely be driven by market forces, albeit provided the necessary adaptation of the
regulatory framework be timely and properly delivered. Here is obviously one of the most
ambitious objective that the European elites have ever set for the Continent.

However, for historical reasons exposed in Chapter II, because the monetary unification has
been contemporary with the collapse of the Soviet Block and subsequently EU’s enlargement,
the monetary unification of Europe appears also as a “floor” to further integration in an
enlarged and more sophisticated European Union where political will is bound to be more
diluted and will have to co-exist – and sometimes collide - with market-forces, profound
economic reforms and other forms of regulation. Although, political will should have given
more way to market forces in an EU remaining a rather homogeneous 15-member club,
because of enlargement, politics still matters a lot and it is likely that the political agenda
linked to the new nature of the enlarged European Union will not be the more propicious for
the ambitious objective of Europe’s banking and financial industry consolidation. Together
with the transformation of the very nature of the EU’s economy, enlargement is a priority of
higher rank on the European Union’s agenda. The changes in the functionning of the
European Union within the next ten to fifteen years will be immense. These changes will have
to be accepted by the electorates of the European countries and for the European elites this is
obviously not the easiest part of the game – as the rejection by the Dutch and French electors
of the Constitutional Treaty in may 2005 illustrates.

1 – The case for the consolidation of Europe’s banking and financial sector: The dream
vision of monetary and financial integration

Together with cheaper financial resources for the European corporations, such possibilities as
purchasing goods and services throughout Europe using one’s bank account in a given
European bank, at low or with no cost at all, would be an important step towards the full
completion of the single market for many products and services. The further step of the actual
integration of the European financial and banking industry in the wake of the practical
circulation of the euro in 2002 may thus be viewed as the next “big bang” in Europe.
1 - 1 - A more efficient allocation of capital

To gain access to the global markets, like all other players, European companies and financial
institutions have to meet increasingly rigorous standards based on global best-practices
regarding such important aspects as governance, profitability or accounting. They have also to
gain access to appropriate financial resources. Such obvious requirements draw the two main
driving forces of Europe’s financial integration:
      harmonization
      defragmentation and the creation of wider pools of financial resources.

In so far as it contributes to the development of European companies, it is admitted that
Europe’s financial integration, albeit with lags, must go alongside the growing strength of
“Corporate Europe”.

The dream vision for Europe in the coming years of the first decade of the 21st century will
thus pave the way for a 450 million inhabitants European Union, with a single currency, a
single market for goods and services sustaining a strengthened continental corporate sector
and an integrated financial system.
According to unofficial estimates by investment bankers, through enhanced competition in a
wider and more liquid financial market - all things being equal - the unified liquid pan-
European market of the euro would already have (by the year 2000) have pulled down the
cost of financial resources for European corporations by some half a percentage point (50bp).
While the euro has been successfully implemented, from the standpoint of competition and
efficiency, of all European sectors, the banking and financial industry is one of the most
fragmented (see §2 below). A corollary of this observation is that the de-fragmentation and
consolidation of Europe’s financial sector would be the largest source of economies of scale
and potential efficiency gains in the first decade of the 21st century. Europe is a fragmented
banking region where concentration and rationalization are both possible and likely to take
place. To a wide extent these remarks apply to financial markets too.

1 – 2 – The dimensions of Europe’s deeper financial integration

From the institutional standpoint, Europe’s monetary unification and the official launching of
the euro in 1999 were important milestones within Europe’s integration long term strategy.
However, several other important structural reforms have still to be implemented in the first
decade of the 21st century in order to garantee the consistency of the EU’s economic strategy.
In this regard, the integration of Europe’s banking industry and financial markets is the most
prominent of the reforms to come in the wake of the monetary union, and as we said in the
beginning of this chapter in the year 2000 the integration of the European financial system has
officially been recognized as an urgent priority by the European Union’s heads of state.
Actually it was one of the main pillars of the so-called “Lisbon Strategy”, the bureaucratic
dream-vision that extrapolated the consequences of monetary unification to most segments of
Europe’s society making it the “most competitive” economy by 2010.

1 – 2 – 1 – The situation and role of Banking and finance: a source of externalities and an
instrument of re-allocation of capital
It is widely recognized that the financial sector is not just an industry among others: as was
explained in the previous chapter (see Chapter VII §1) banking and finance are also upstream
activities in the sense that their efficiency, their dynamism, their innovation-capability etc.
spread in the rest of the economy by the diminishing costs of financial resources that follow.
Independently of its upstream situation within the macro-economic system, Banking and
Finance is a nindustry with its own substantive weight representing several percentage points
of Europe’s GDP (say at least some 8%). Therfore, in itself, the consolidation of Europe’s
banking industry and financial markets represents a significant part of the general
consolidation process of the European economy which – as argued in Chapter III - forms the
core of Europe’s macroeconomic strategy.
Furthermore, the financial sector - and above all, as in every market economy, the equity
market - is also viewed as a key-player in the consolidation of the other sectors.

The greater integration of Europe’s banking and financial markets so that they play their
regular and full role in the allocation of resources within a competitive market economy
would mean:
      From an international macroeconomic competition standpoint, as each financial system
       competes with the others to offer global investors the higher liquidity, the wider range
       of investment opportunities, the greatest information-efficiency and transparency etc.,
       that the European Union avail itself of a financial system offering international
       investors at least the same qualities as the US financial markets. Such an objective can
       be reached only through the defragmentation of the European banking and financial
       markets, but it requires also the creation of a truly European financial system which
       would be a breakthrough from the prior juxtaposition of the various national financial

      The consolidation of the European financial system indeed has the main apparent
       objective to lower financial resources for the European corporations. However, to be
       fully consistent with the overall strategy of the European union this fundamental
       reform should also allow European corporations to be less dependent on non-European
       institutional investors because the longest the physical distance between the investor
       and the investment, the higher the risk-premium. At a time when Europe’s
       demographic imbalance make it an urgent need to complement the pay as you go
       pension systems by pension schemes based upon capitalisation, the financial
       integration of the European Union should thus also include the flourishment of
       powerful European institutional investors like the US pension funds.

The financial assets held by the US institutional investors accounted for 62% of the total
assets held by the other five countries. Altogether the US pension funds with their USD 20
trillion assets compare with the approximately USD 2 trillion assets of their aggregated
European counterparts. In addition, the portfolio turnover of US investors is up to three times
as high as that of the Continental European investors in equity and up to ten times as high in

1 – 2 – 2 – Europe’s financial and economic system and the issue of pensions
For the last two decades, capitalism has developed under the dominance of such powerful
institutional investors as the pension funds from the US and the UK - the outcome of this
development being refered to as "pension capitalism" and an increasing number of European
corporations having adopted shareholder value as their core corporate governance principle -
the biggest political issue in terms of the future effective participation of Europe in global
capitalism is that of creating an European "pension capitalism".
Especially in the EU’s largest countries (Germany, France, Italy) to gain the qualities of
liquidity, depth, efficiency, transparency etc. that are needed by the global corporations, the
equity markets, of whichever form or degree of consolidation, have still to be backed upon
powerful local institutional investors, namely pension funds. Besides, the development of
pension funds in the largest EU countries appear inevitable to cope with the expected
difficulties of the “pay as you go” pension systems due to the demographic imbalance and the
ageing baby-boomers.

                  Ratios over-60-years-old population to 20-59-years-old
                                US    UK France Germany           Spain Italy
                    2010 34%         52%    43%        45%        42%     50%
                    2020 45%         57%    53%        54%        51%     60%
                 Source: OECD

In "only a handful of member states" will spending pressures rise slightly before peaking.
Public pension expenditure in Spain could leap from 9.4% of GDP in 2000 to 17.7% in 2050.
Spending in the Netherlands is projected to rise by 6.2 percentage points to a peak of 14.1%
of GDP in 2040. In Portugal outlays will peak in 2030 at 16 percent of GDP, up 6.2
percentage points from today...
Developing significant pension funds in Europe in the coming years raises two types of

    in those countries where pension funds do not exist yet, or are little developed, the
     priority is clearly to change the mindsets which are currently impeding the creating of
     those powerful savings instititutions;
    for the various existing pension funds in Europe, harmonize regulations and tax
     regimes in order to permit cross-border workers moves in accordance with the
     principles of the single market, as well as to help create powerful pan-European
     insitutional investors competing with their US peers

1 – 2 – 3 – The rationale backing the “Lisbon Financial Agenda”
According to the Lisbon Strategy within the next fifteen years,
 of at least a comparable weight though still significantly differently organized than the US,
 the European Union will be the other economic superpower in the global economy,
 which very likely, like the US, will be ruled by what may be called “pension capitalism”
  within an integrated and consolidated banking and financial sector
 and based upon competition and shareholder-value guided corporate-governance,
 while more and more European corporations will acquire strong positions in the global
 the equity market is also viewed as a key-player in the consolidation of the other sectors.

In the years to come, Europe’s finance is thus expected to play a special role in leveraging the
flourishment of a new breed of European efficient medium sized companies.

The economies of scale brought out by the consolidation of Europe’s banking and financial
industry could suffice to justify the efforts of the EU’s authorities in that direction. However
there is another, more structural, argument: transforming Europe’s financial system is also a
requirement of the EU’s vow to make the EU of fully capitalist market-economy in which the
financial sector plays a central role in the efficient allocation of resources.
Within an integrated European capital market, European investment funds, pension funds, and
private investors would be able to invest more freely across the EU. Funds will be better able
to use modern investment management techniques.
They will also have a more diversified investment choice of the whole European market.
European funds could grow in size - reducing administrative costs and improving net returns
for investors. On average, a US investment fund is 6 times larger than its European equivalent
and overall the capitalization of all US investment funds is twice as large as those in the EU.
Over the period 1984-1998, the average real return on pension funds was 10.5% in the US and
6.3% in those EU countries where funds faced severe investment restrictions. Integrated
European markets with more flexible investment rules, therefore, should improve the risk-
return frontier. Higher returns could also lower the cost of pension schemes, resulting in a
reduction of labour costs and an improvement in competitiveness.
Financial integration will benefit the financing of small and medium sized companies - the
essential employment creator and backbone of the European economy. At the end of the
Twentieth century there is still an inadaquate supply of venture capital in the EU with only
1/5 of US per capita level. Even if during the last years, venture capital investments have
grown by 40% in continental Europe, a growth rate which matches that of the venture capital
investments in the US, it remains that the amounts of the capital flows are much higher in the
US than in Europe: for the year 1999, for example, US venture capital investments have
amounted to USD 99.4 billion, that is to say between three and four times more than the
investments completed in Western Europe.

All in all the US venture capital investments account for 73% of the global investments -
which have jumped by 65% in 1999 as compared to 1998, amounting to USD 136 billion i.e.
0.5% of the World’s GDP.
Venture Capital Investment (USD billion)
United Kingdom                                   12.3
Germany                                          3.4
France                                           3.0
Italy                                            1.9
The Netherlands                                  1.8
Sweden                                           1.4
Spain                                            0.8
Belgium                                         0.7
Switzerland                                     0.5
Norway                                          0.3
TOTAL Western Europe                            26.1
North America                                   99.4
Source: 3i, PWC

1 – 2 – 4 – The institutional dimension

The consolidation and integration of the European financial system will result from market
forces – as for example through the transformation of the formerly mutual stock exchanges
into for-profit listed companies and the ensuing corporate game of consolidation via take-
overs etc. that might take place - but it also requires a great deal of harmonization of the
various regulations in this particularly heavily regulated field of business. Financial
integration means develop deeper pools of interconnected liquidity, a common prospectus for
cross-border capital raising, common listing requirements together with one set on
international accounting standards. It means that the whole financing chain - from seed
money, start up capital, to initial public offering - will work more efficiently.
In this regard, as a central part of its “Lisbon Strategy” set in March 2000, the European
Union has adopted an amibitious “ Financial Services Action Plan “ (FSAP) consisting in 42
measures aiming at leveling the playing field within the financial industry and to be adopted
“by 2005 to the latest”. Its purpose is to serve as an inspirational programme for rapid
progress towards a single financial market. Some of the points mentioned in FSAP are also
part of the Risk Capital Action Plan which the Lisbon European Council stated should be
delivered by 2003 (e.g. prospectuses, accounting rules etc.).

Within this framework that leaves space for wide rationalization, the Financial Services
Action Plan (FSAP) is the EU Commission’s response towards improving the single market
in financial services.
Adopted in 1999 following a Commission Communication and a consultation with all
interested parties, the FSAP contains a list of 43 measures to be implemented, grouped around
4 strategic objectives:
      retail markets,
      wholesale,
      prudential rules and supervision,
      wider conditions for an optimal single financial market.

Indeed the national discrepancies in key-areas such as taxes, accounting and investor
protection will for a while result in a still fragmented European banking sector.
However one can expect that such hurdles and costs will in time be overcome by appropriate
improvements in softwares and information systems which will allow the adaptation of the
offering of banking products and services to the local characteristics at a reasonable cost -
besides, as has already been mentioned, Egg, the online arm of UK’s insurance company
Prudential, through a common technical core operated in Ireland then fitted to each national
tax pattern, already offers financial products on a pan-European basis.
Through the “pan-Europeanization” of Europe’s banking sector, the monetary unification of
Europe, together with more and more deregulated markets and enhanced competition policies,
will in turn encourage more and more European companies - notably efficient small and
medium sized companies - to increase their cross-border activities. The success of the pan-
Europeanization of medium sized companies will require the ability for the European players
of the finance industry to provide those companies with adequate financial and banking
services on a continental basis. In this respect, technology appears as a powerful factor of
convergence for the near future since the shift to automated processes in such areas as
payment-patterns contributes to shape up a set of more uniform behaviours of the customers -
retail as well as corporate - throughout Europe.
The future - and already appearing - pan-European players will have a chance to reach the
critical mass unabling them to amortise on an adequate scale the investment in new mass
payments systems, new products and services, which will act as as many new entry barriers.
Rebalancing the competition in the securities and investment business at the global level
would require a fast-pace setting of an European pension capitalism in the largest European
countries, as Germany as partially started to do

2 - Assessing the concentration of Europe’s financial and banking industry at the
beginning of the 21st Century

European banking is frequently referred to as a very fragmented industry. However, in this
particular case, the word “fragmentation” must be made clear. Indeed, the Euro Area accounts
for more than 7000 banks but the outlook is significantly different in the various European
Without further look, this could be taken as a sign of undisputable fragmentation. However, at
each countries’ level, with the important exception of Germany, the banking industry appears
less populated (in relative terms) in the European countries than in the US.

2 – 1 - The concentration of the banking industry is very heterogenous in the various
European countries

Number of Institutions and Size Concentration
                         Top 10 share (%)         Top 5 share (%)       Number of
                          of total assets          of total assets      institutions
Euro Area               n.a.                    n.a.                    7 040*
Austria                 57%                     44%                     995
Belgium                 74%                     57%                     136
Finland                 80%                     77%                     341
France                  73%                     57%                     567
Germany                 28%                     17%                     3 577
Italy                   38%                     25%                     909
Netherlands             88%                     79%                     169
Portugal                n.a.                    n.a.                    39
Spain                   62%                     47%                     307
Sweden                      93%                         90%                         124
UK                          68%                         47%                         537
Switzerland                 62%                         49%                         394
US                          26%                         17%                         22 140
Japan                       51%                         31%                         610
*Excluding Ireland and Luxembourg
Source: Retail banker International September 20 1999

The banking sector is highly concentrated in Sweden where the top ten institutions hold 93%
of the assets and in the Netherlands (88% of the assets hold by the top ten banks).
Conversely, the banking sector is by far the less concentrated in Germany (28% of assets held
by the top 10 banks) - and to a lesser extent in Austria. Germany clearly appears as an
exception in the European banking landscape. It is the German situation which makes the
overall European banking sector as little concentrated as the US’ where the situation results
from the Glass-Steagall Act and is thus bound to change with its abolition.
In the rest of Europe, with the exception of Italy, the top-10 institutions hold between over
60% to nearly 90% (88% in the Netherlands) of the assets. Were Germany in the other
European countries’ average in terms of number of banking institutions, Europe’s banking
industry would appear more concentrated in terms of assets-holdings than the US and Japan.
However, an other important feature of the European banking sector, which makes the
diagnosis still more complicated, lies in the absence of huge dominant banks.
Despite the presence of powerful players, no European banking institution dominates the
market for deposits
As compared to the US mastodons like Bank America (which holds over 11% deposit market-
share in the US) or Japanese (Bank of Tokyo Mitsubishi holds over 8% of the deposit market)
the biggest European banks - Deutsche Bank, Crédit Agricole, ABN Amro... - score small
(nearing 3%) deposit market shares. This results from the fragmentation of Europe in as many
currency areas as, prior to the euro, there were national currencies.
Deposit Market Shares
EuroZone*                            USA                                     Japan
Deutsche Bank............... 3.5%    Bank America...............11.1%        Bk ofTokyo Mitsubishi. 8.3%
Crédit Agricole.............. 3.3%   Citigroup........................7.1%   Dai-Ichi Kangyo Bank....6.3%
ABN Amro.....................3.1%    Chase Manhattan............6.6%         Sakura
UBS................................2.6% Bank One........................5.0% Sumitomo Bank..............6.0%
BNP-Paribas...................2.1% First Union......................4.4% Fuji Bank........................5.8%
Source: OECD, Goldman Sachs,
Estimates recalculated for the Eurozone from data publlished in Retail Banker International June 18 1999

The top five banks in the Euro Zone control only some 16% of their markets’ deposits
whereas their US or Japanese counterparts control about 30%. Such an observation contribute
to explain why, though the diagnosis is complex, one is still entitled to view Europe as a
fragmented banking region where concentration and rationalization are both possible and
likely to take place.
Clearly the potential for rationalization and concentration lies mainly in Italy and Germany,
although in Germany the situation is also characterized by the role and special status of some
12 landesbank, 600 savings banks and some 2 500 mutual banks. A challenge in going fully
capitalist and competitive is therefore also - and prioritarily - facing Europe’s banking sector
in its biggest national economy.

The particular case of the German banking system

The European Banking Federation (EBF) lodged a formal complaint, on 21 December 1999,
with the European Commission against the German system of public guarantees of the
German Landesbanken (there are 12 Landesbanken) and savings banks (there exist some 500
SparKassen). A supporting brief was filed on 26 July 2000.
The formal complaint set out the following points:
   The EBF considers the system of public guarantees for Landesbanken and savings banks
    to be illegal state aid, which creates significant market and competition distorsions
    breaking Community law and allowing those public banks to compete with unfair
   The system of public guarantees constitutes substantial financial aid, because among
    other benefits it enables public sector banks to obtain very favourable external credit
    ratings. They are thus in a position to reduce their refinancing costs and to facilitate
    refinancing in general.
   The current system adversely affects trade between Member States. This is true both for
    other banks wishing to compete in Germany with German savings banks as in other major
    financial centres outside of Germany (Paris, London etc.) where especially Landesbanken
    compete on an unfair basis.

The EU’s Commission had given Germany until July 11 2001 to bring the landesbanken into
line with EU rule but that deadline has been passed. German Landers’ authorities call for a
transition period of up to 10 years. Failure to reach agreement could result in the
Commission starting formal proceedings.

2 – 2 – A historical legacy of diverse national payment patterns

                                        Cheques Cards Credit Transfers           Direct Debit

           Belgium                         8%        23%           58%                 10%

           Denmark                        15%         63%          n.a.                 21%

           Germany                          3%         4%          48%                  42%

           Greece                          12%         74%         n.a.                  3%

           Spain                           13%        21%          14%                  45%

           France                          46%         22%         17%                  13%

           Ireland                         50%         9%          26%                  15%

           Italy                           28%         11%          42%                  9%

           Luxembourg                       n.a.       n.a.         n.a.                 n.a.

           Netherland                       3%         18%          52%                  27%

           Austria                          3%          6%          62%                  29%

           Portugal                         41%        39%           7%                  11%

           Finland                           0%        38%          58%                   3%

           Sweden                            n.a.      19%          74%                   7%

            UK                               31%       31%           20%                 19%

       EU Average                            23%       18%            34%                26%
   source: ECB

One can expect that the actual circulation of the euro by January 1st 2002 will help make the
patterns get rapidly more similar from one country to the other as the development of card-
payments described above in Chapter VII seems to confirm.
Nevertheless, for the banks willing to lead a pan-European development in the retail banking
business, a lot of help in this regard will come from the rapidly spreading technology and
remote-banking, as automats and non-cash payment instruments - like cards and direct debit
or credit-transfers - tend to rapidly overcome old instruments of payments like cheques.
On the legal side, one can also be reasonably optimistic. For example, as an illustration
proving the efficiency of Mutual Recognition and EU directives allowing banks to do
business across borders without authorisation barriers and despite such remnant hurdles as
payments patterns and heterogenous national legal frameworks in particular peripheral areas
(consumer/saver protection etc...), it can be underlined that there are in London already more
than one hundred banks licensed to take deposits and which are supervised by other European
regulators rather than by the FSA (UK’s Financial Services Authority).
Together with such technological solutions to the remnant factors of fragmentation of the
European financial services market, it is to be expected that the European authorities will, on
their side, be actively working at leveling the legal, fiscal and regulatory framework so that,
such failures as the year 2000 planned merger between Italy’s UniCredito and Spain’s BBVA
(due to unsortable legal problems) will no longer happen.

3 - The consolidation of Europe’s banking in practice

Most of the rationalization and consolidation of the European banking sector may be seen as a
two-step process, including
1. consolidation operations of diverse forms on each local market as illustrated in table 24
   below, then,
2. followed by mergers, acquisitions or partnerships between institutions from different
   national origins.

However, there were earlier initiatives to apprehend banking on a European basis together
with precocious rationalization strategies.

3 – 1 – The “pioneers” of pan-European banking
There has been early attempts from such banking groups like ABN-Amro or Dexia to operate
at pan-European level. These attempts by the “pioneers” of pan-European banking will be
decribed below.

3 – 1 – 1 - The main pioneers of Europe’s banking integration are the following institutions:
 ABN Amro: the pioneer of Europe’s banking rationalization

Given the dominance of retail commercial banking in Europe’s financial landscape, the
reshaping of the European banking sector has been due to a few number of national
commercial banks with solid local customers base. In this respect, The Netherlands’ ABN-
Amro is commonly seen as the pioneer.
ABN-Amro was born in 1990 when the two biggest Dutch banks merged. It now ranks among
the top ten World banks (6th in terms of assets by year end 1998). Regarding its
rationalization, the Dutch banking sector has been ahead of other European local banking
sectors. In fact, as soon as in the early years 1990s, the top three Dutch banks - ABN Amro,
Rabobank and ING - had a total share of their national banking market nearing 90%. The
strong position they had on their local market facilitated the international expansion of the
Dutch banking groups.
In the process of rationalization, ABN-Amro has been a pioneer since it has cut the number of
its branches by 36%, reducing it from 1474 to 950 at the beginning of the decade.
Contrarily to ING which has based its strategy on bancinsurer business, contrarily as well to
the mutual group Rabobank which focused on the national market, the strategy adopted by
ABN Amro lies in the model of the “Global Universal Bank”. Thus, outside The Netherlands,
ABN Amro operates in 74 countries with its overall international activity representing 66% of
its staff, 50% of its profits and 58% of its assets.
Though “universal” in principle, ABN Amro’s development has been focused on retail
banking. The time and size advantages have allowed ABN Amro to set up an international
network in the retail banking business although its positions on the global stage in other
segments of the banking business are by far less favourable. This last observation holds in
particular for the Asset management industry where ABN Amro ranked only as 30th on the
global level. It holds also for such business as custody (where ABN Amro has a deal with
Mellon Bank) and even investment banking despite ABN Amro’s deal in this business with
Rothschild (see below).
ABN Amro’s strategic model is implemented through a combination of organic growth,
acquisitions and partnerships. The management of different banks in different countries with
different brand names has been succcessfully achieved. Most often, the non-Dutch
acquisitions of ABN-Amro hold siginificant market shares on their local market. They also
are managed on an autonomous and local basis.
A combination of global vision and local action, ABN Amro tends toward a “nationally
neutral” institution adapted to the Euro Area as well as the globalized economy. It is ahead of
most of its competitors which, as for themselves, still have to cope with the post-merging
process and the generation of value-creating synergies.

 Dexia: the first European merger with unified management and pan-European approach of
  markets, the European leader in public finance

Dexia was born in 1996 as the result of the merging of Crédit Communal de Belgique and
Crédit Local de France. The Franco-Belgian Dexia is the European leader in public finance
and ambitions to become the global leader of this segment of the finance industry. Dexia is a
single company with a single status and its organization is structured by business lines at the
global level.
The European nature of the Dexia Group is materialized at the level of the board of directors
(16 to 20 members): 2/3 of the directors are either French or Belgian, 1/3 are from other
European countries (Spain, The netherlands, the UK, Luxembourg...). The executive
committee has six members and is organized around three lines of business - public finance,
commercial bank and bancinsurer, private banking and asset management - and two central
functions (capital markets and strategy).
Dexia’s offerings extend from regular public financing to the management of civil servants
bank accounts and providing them with personal insurance policies in a global - or at least
pan-European - approach. Dexia has also a private banking arm and expands in the asset
management industry.
3 – 1 – 2 - The earlier attempts to promote a pan-European brand name

In the wake of the capability to do financial business across borders, several European
financial institutions have started to establish their brand name on a pan-European basis.
For example,

 Deutsche Bank established a beachhead under an Italian name 10 years ago, then has put
  its own name on its offices and outlets, and in November 1998 has begun selling financial
  products over the Internet to French investors as well as through its ten “bricks and mortar”
  branches. In October 2000 Deutsche bank has extended its presence in France through its
  acquisisition from AXA of “Banque Worms”, a 850 staffed bank specializing in private
  banking and institutional assets management (with euro 7.5 billion of assets under
  management) as well as in medium sized companies (2000 clients companies for FRF 23
  billion (euro 6 billion) credits).
 ABN-Amro has a strong minority shareholding (9.65% with an option up to 30%) in the
  number 4 Italian bank, 1300 branch offices, Banca di Roma, and in order to post its
  ambitions in France has moved into the impressive former Indosuez’ heardquarters in
  Paris. Already, in terms of size and profitability, ABN-Amro ranks first of non-French
  banks in France ahead of San Paolo IMI and ING/BBL. Its French arms (Banque
  NSMDemachy, OBC, Banque du Phenix) hold FRF 3,3 billion of deposits (USD 0.5
  billion) FRF 2,7 billion of assets (USD 0.4 billion) and FRF 440 million of net revenues
  (USD 60 million).
 Barclays Bank has extended to Germany and France its credit cards business.
 EGG, the online arm of UK’s insurance company Prudential, through a common technical
  core operated in Ireland then fitted to each national tax pattern offers financial products on
  a pan-European basis. Prudential also signed an agreement with France’s Caisse Nationale
  de Prévoyance (CNP) which specialized in group life-insurance and which, through its
  relationship with the Savings and Loans Network (Caisses d’Epargne) as well as with La
  Poste, benefits from an unchallenged powerfull distribution network. The agreement
  includes CNP’s provision by Prudential with innovative investment products, with, as a
  reciprocal, the selling of certain CNP’s products through Prudential’s distribution
 Credit Lyonnais began selling mutual funds through Italian banking partners.
 Since 1998, Italy’s insurer Generali has been a shareholder of Germany’s Commerzbank.
  September 2000, Generali has doubled its stake in Commerzbank up to 10%. The two
  institutions have also set partnerships in bancinsuring business: Commerzbank will set up
  250 banking centers in Generali’s German subsidiary and third biggest insurance company
  in the German market, Aachener und Münchner (AM) while 650 insurance experts of AM
  will be present in Commerzbank branches.The two companies will also merge their
  respective Swiss subsidiaries Commerzbank Schweiz and Banca Svizzera Italiana. They
  also intend to create joint venture capital funds in European High Tech companies.
 ING, the Dutch financial group, has initiated an online pan-European offering which
  includes cheque accounts as well as financial products.

In addition to those examples, it has to underlined that most significant European life
insurance companies are gravitating towards private banking and wealth management on a
pan-European basis: AXA, Generali, Allianz.... This observation is true even for non-EU
institutions such as the Swiss giants of insurance: Swiss Life, Zurich Financial Services in
3 - 2 - The consolidation in the European banking sector within the national borders in the
years 1990s

The European banking arena has started to reshape in the early years 1990’s in the
Netherlands, Belgium and to some extent in France, later, but relatively dramatically, in Italy
and Spain. It even has started a slow but sensible move towards pan-European banking.

Banks mergers within national borders
COUNTRY                         ACQUIROR        TARGET           RESULTING INSTITUTION

The Netherlands/Benelux         ABN             Amro             ABN Amro

                                Fortis          CGER             Fortis

France                          Société         Crédit du        Société générale
                                générale        Nord*

                                BNP                              BNP Paribas
                                Crédit Mutuel                    Crédit Mutuel-CIC
                                                CIC (Crédit
                                                Industriel et
                                Banques                          Natexis-Banques Populaires
                                Populaires      Natexis

                                CCF                              CCF
                                                de Crédit
                                Crédit                           Crédit agricole
                                agricole        Sofinco

                                CDE                              CDE La Hénin
                                (Comptoir des La Hénin
Spain                           Banco Bilbao Banesto

                                BCH (Banco      Santander        BSCH

                                BBV (Banco      Argentaria       BBVA
UK                              HSBC            Midland          HSBC
                                     Lloyds            TSB            Lloyds-TSB

                                     Lloyd s-TSB       Scottish       Lloys TSB

                                     Royal bank of Natwest

                                     Barclays          Woolwich       Barclays

                                     Abbey             Bank of        not yet concluded
                                     National          Scotland

Germany                              Bayerische        Hypo bank      HypoVereinsbank

Italy                                Banca             Banca Intesa   Banca Intesa-COMIT

                                     San Paolo         IMI            SanPaolo IMI

                                     SanPaolo IMI Banco di            SanPaolo IMI
Nordic countries                     Nordbanken Merita                Merita Nordbanken
Austria                              Creditanstalt Bank Austria       Creditanstalt-Bank Austria
* Dexia has later acquired a 20% stake in Crédit du Nord

BSCH (Banco Santander Central Hispano) is a good example of how the consolidation within
the nation borders may be a necessary first step towards a global and pan-European strategy.
The post-merger problems it has been encountering notwithstanding, BSCH stands as the
largest Euro-Area bank by capitalisation. It is also one of the very leading banks in Latin
BSCH is the result of the merger of Spain’s leading financial group Banco Santander with
Banco Central Hispano Americano in January 1999. It manages three brand names in Spain:
Banesto, BCH and Santader, with a total market share of 19% in loans, 18% in deposits and
22% in mutual funds. It is the eigth-largest bank in Europe in terms of assets (USD 227
billion) and, as has been said, the largest in the Euro Area in terms of market capitalisation
(USD 32 billion).
With 22 million customers in Spain, the merger is a boost at Europe’s financial services
industry consolidation since significant cost-savings (between 10% to 15% according to
different analysts’estimates) should procede from the rationalisation of the total branch
network of 8000 outlets. The two banks - BCH and Santander - have a string of alliances
throughout Europe (San Paolo IMI, Banco Comercial Portuge...). They also have strong
complementary positions in Latin America representing altogether nearly USD 4 billion of net
3 - 3 - Cross-border consolidation

Despite such failures in the pan-European concentration process as the BSCH/Champalimaud
case, or the misfortunes of ABN Amro’s acquisition policy in France (CIC) or in Belgium
(CGB), the cross-border consolidation has already started.

a - The recent cross-border consolidation operations
In terms of size, the most siginificant operation so far has bee the acquisition by UK’s giant
HSBC of France’s CCF (Crédit Commercial de France). The following table records some
other cross-border operations having taken place recently.

Cross border consolidation operations
Bank 1                  Country of origin        Bank 2                  Country of origin
ING                     Netherlands              Barings                 UK
ING                     Netherlands              BBL                     Belgium
ABN Amro                Netherlands              Banca di Roma           Italy
                                                 (9.65% to 30%)
ABN Amro                Netherlands              Banque NSM              France
ABN Amro                Netherlands              Banque du Phenix        France
ABN Amro                Netherlands              OBC                     France
Deutsche Bank           Germany                  Banque Worms            France
HSBC                    UK                       CCF                     France
Hypovereinsbank         Germany                  Bank Austria            Austria
Fortis                  Netherlands              CGER                    Benelux
Dexia                   Belgium/France           Crédit du Nord (20%)    France

3 - 4 - An alternative form of consolidation: the European bank-networks
Alongside mergers and acquisitions, the consolidation process takes the form of commercial,
and more often, capitalistic partnerships.
The most significant of such networking involves such a string of European institutions as
BSCH (Spain), Generali (Italy), BCI (Italy), Société Générale (France), Crédit Lyonnais
(France), Commerzbank (Germany). For example, Commerzbank and BSCH have
partnerships in the areas of investment banking and e-brokerage (Comdirect).
The partnership between Dexia and Crédit du Nord (SG group) may also be quoted as an
other example of such pan-European networking.
An other prominent network evolves around France’s mutual giant Crédit Agricole and
involves such banks as Intesa, Comit, Crédit Lyonnais and Lazard.
An other type of neworking can be viewed in the gathering of players in a mega-region such
as the Nordic area. Nordea, the result of the merger of financial institutions from Denmark,
Finland, Norway and Sweden has 2 million e-customers and total assets of EUR 230 billion,
six business areas which serve 9 million personal and 700 000 corporate and institutional
customers. Nordea comprises Merita Bank, Nordbanken, Unibank, Christiana Bank og
Kreditkasse, ArosMaizels, Tryg-Baltica, Vesta, Merita Life and Livia. It has 1260 bank
branches, 125 insurance service centres, operations in 18 countries outside its region of origin,
with EUR 107 billion under management it holds a leading position in the Nordic asset
management market.

Shareholding Network in Europe
BELGIUM                                          THE
BBL                     ING 100%                 ING                      Aegon 5% Fortis 5%
                                                                          ABN Amro 5%
Générale Banque         Fortis 100%              ABN Amro                 Aegon 9.9% ING
                                                                          16.6% Rabobank
                                                                          5.7% Fortis 5.7%
                                                                          CGU 5.9%
SWITZELAND                                       SPAIN

Crédit Suisse           Swiss-Ré 5%              BBVA                     AXA 2%
GERMANY                                          Popular                  Allianz 5.2%
                                                                          Hypovereinsbank 3%
Allianz                 Hypovereinsbank 7%,      BCH                      Generali 5.8%
                        Deutsche Bank 5%                                  Commerzbank 4.9%
                        Dresner Bank 10%,                                 BCP 4.65%
                        Munich Re 25%
Munich Re               Deutsche Bank 10%        PORTUGAL
                        Dresner 10%
                        Hypovereinsbk 10%
                        Allianz 25%
Bayerische              Allianz 18.7%            Banco Comercial          BSCH 14%
Hypovereinsbank         Munich Re 6.7%           Portuges
Commerzbank             Generalli 10% BSCH       Banco Espirito Santo     Crédit Agricole 22%
                        3.6% Mediobanca
                        0.7% BCI 1.3%
Deutsche Bank           Allianz 5% Munich        Banco Portuges de        Allianz 9.5%
                        Re 2%                    Investimento
Dresdner Bank           Allianz 22.3%            Banco Portuges do        BCP 67%
                        Munich Re and other      Atlantico (BPA)
                        holdings from Allianz

Bank Austria            Banca Intesa 9%
                        Hypovereinsbank %

AXA                     AXA Mutuals 30%
AGF                     Allianz 51.4%
BNP Paribas             AXA 7.5% AGF 3%
Crédit Lyonnais         Crédit Agricole
                        10.0% Intesa 2.75%
                        BBV 3.75% AGF 6%
                        Commerzbank 4%
                        AGF 6% SG 2%
Société Générale        AGF 2% CGU 3%

The Royal bank of       Santander 10%

Generalli              Mediobanca 12%
                       Lazard 5%
Mediobanca             BHF 4.8% Allianz
                       2% Lazard 0.8%
                       Generalli 2%
Alleanza               Generalli 23%
RAS                    Allianz 51%
BNL                    BBV 10% INA 10%
                       Viventina 7.75%
Banca Intesa           Crédit Agricole
                       22.8% Alleanza 6.4%
                       Cariplo (found) 19%
BCI                    Generali 5%
                       Commerz. 5%
                       Deutsche Bank 4.5%
                       Paribas 3.5%
UniCredito             Allianz 2.94%
San Paolo IMI          BSCH 6% Cariplo
Banca di Roma          ABN 6.75%
Source: completed and modified from Merrill Lynch as published in Retail Banker
International Yearbook 2000 p128

3 – 5 - Towards a European financial landscape dominated by a small set of pan-European
institutions and local players

Within the next decade the acknowledged driving forces will lead to an absolutely new
financial and economic landscape. Such a reshaping will impact not only the Old Continent’s
finance and economy but also, according to the economic power which Europe represents, the
global financial and economic landscape as a whole.
In particular, together with the technological change, instead of the currently fragmented
addition of national banking sectors, financial industries and medium sized local players, the
monetary unification of Europe will likely lead to a European financial landscape dominated
by a small set of pan-European institutions. Most of these institutions will be such
powerhouses that they are likely to be significant players alongside the big US investment
banks in the global competition arena.
Beside these powerhouses of continental dimension, a set of local niche players will keep
their raison d’être from such competitive advantages as their knowledge of the ground, in
particular as far as banking services and credit for small companies are concerned. To address
this question again, this might be the case of German Landesbanken and savings banks
provided they can compete on a level playing field, whether that be on their own, through
mergers with peers, or through joint ventures, outsourcing of certain functions or other
initiatives. As shall be argumented below, aven though the brand names and customers
confidence are rather effective entry barriers, the technological background is also likely to
favour the entrance of newcomers in the financial business, whether these potential
newcomers be Internet financial portals, insurance companies or retailers.

       3 - 5 - 1 - Three types of situations

Roughly speaking, at the outset of the years 2000, three types of situations may be found
among European Banking institutions:
1. the European “heavy weights” - Crédit agricole, HSBC, Deutsche Bank, BNP-Paribas,
   ABN-AMRO... - which already have significant market shares, which are also profitable
   and thus guaranteed to be able to conduct a successful strategy of market-shares
   acquisitions outside their country of origin.

     These institutions benefit from powerful brand names which guarantee them with a pan-
   European influence. In addition, such a business as investment banking is not a local
   business but an Euro-based one, or even a global business, and only those players with a
   competitive edge will succeed on such markets. For these likely pan-European banks, two
   questions are pending:
      first, which strategy and which hierarchy are going to characterize each bank in relation
       to the others;
    second, the part these European heavy-weights will be able to play in the
     global competition relatively to their US peers, in particular in such areas as investment
2. An other type of situation relates to smaller institutions playing on niches or benefiting
   from competitive advantage from their proximity with their client base.

     This is the situation which characterizes such institutions as the banks specializing in
   credit to small and middle sized companies, the likes of France’s Banques Populaires.
   Challenging the competitive advantage of such players would be extremely costly.
3. In between the two previous situations, the game is open.

   The institutions which belong to this third category will benefit from Europe’s monetary
   unification only if they demonstrate their ability to forge efficient cooperative networks
   between institutions of different national origins.
The top-5 likely pan-European Banks
                        Assets (USD Mds)         Profitability (%)       Capital
                                                 (profit on average      (tier one)
Deutsche Bank           844                      24.5                    17
BNP-Paribas             702                      33                      20
HSBC                    570                      28                      29
ABN-Amro                460                      26                      18
Crédit Agricole         442                      18                      23
Data: The Banker

       3 - 5 – 2 - The self stimulating process of consolidation and Europeanization

As seen above, the biggest European institutions hold a relatively small market-share of the
deposits (roughly over 3% for each of the first five) as compared to their US and Japanese
peers. It is thus quite likely that the biggest European institutions will progressively be in
situation to acquire market-shares through the acquisition of smaller banks outside their
country of origin.
The cross-capitalistic and commercial partnerships which have been described earlier give
probably a reasonable idea of the driving forces of the coming practical process of

The improvement of the biggest European banks ROEs will benefit from the conjonction of
ICT and from the pan-European concentration process.
ROEs will also tend to be more different from one institution to the other. The differentiation
of profitability rates will in turn favour the acquisitions of the weakest institutions by the
strongest ones.
As markets integrate and competition strengthens, there will be an inevitable Schumpeterian
“creative destruction process”. Rationalization and restructuring can be expected particularly
among intermediaries and in the banking sector, as the combination of the effects of
disintermediation, concentration and conglomeration multiply.

3 – 6 - Investment banking and asset management

It will be more and more possible to extend on a pan-European basis such activities as Asset
Management (cf in particular the acquisition of Banque Worms and the implementation of a
private banking branches network in France by Deutsche bank), credit, mortgages, cash
management, investment banking and non-European commercial banking. Although cultural
features and local legal frameworks make it apparently difficult to reduce the cost of branch
networks through pan-Europeanization, the likely generalization of remote banking will solve
a significant part of the problem, precisely at a time when many bank staff reach the
retirement age.
Regarding the investment banking business, the already mentioned weakness of the European
pension funds has led some of the most agressive European banks to acquire UK and/or US
investment banks. For example, the need of accessing the US institutional investors justify
such moves as Deutsche Bank Alex Brown’s acquisition of Banker’s Trust.
Regarding their desire to enhance their position in investment banking, an other problem
which the European banks have to address lies in the historical separated development of the
commercial and credit banking on the one hand, and that of merchant and investment banking
on the other hand, the result being that the banks with the financial resources are not those
with the expertise and credentials in the area of investment. Such an observation explains the
partnerships which have been concluded by ABN Amro with Rothschild and by Crédit
Agricole with CDC-Ixis. Nonetheless, as has already been underlined above, the chances that
the major European banks become important players in the investment banking business
prioritarily rest on the chances of seeing institutional assets developing rapidly in Europe.

4 - The return of financial markets in mainland Europe coupled with the process of
integration of Europe’s financial markets

4 – 1 - A rather high integration of fixed income and debt markets
The euro has helped create deep, broad and liquid financial markets and is having profound
effects on financial systems. As stated by the President of the European Commision Romano
Prodi, integrating financial markets has long been a priority for the Commission. This
corresponds to the macro-economic perspective that has been exposed in the preceding
chapters. Described in terms of the Mundell-Fleming representation of economic policy
matters, well functioning financial markets will incite international capital flows to acquire
the financial assets offered by the euro-zone issuers – resulting in a translation to the left of
the LM curve, therefore, the rest being equal, to lower interest rates and a higher level of
As has just been said, the launching of the euro has made its most immediate impact on
money markets which have rapidly become substantially integrated in particular thanks to the
efficient functioning of TARGET the IT system which interlinks the national central banks’
own Straight Through Processing systems (see Chapter VI above).
Similar progress has been observed in fixed income securities in general. In particular the
issuance of asset-backed bonds and the securitization of loans by financial institutions have
grown substantially. The European corporate bond segment is also starting to increase (with
18% growth in 1998 and 58% in 1999). The size of the average corporate bond issuance also
doubled in 1999, reflecting the better absorption capacity of the markets. From a more
qualititative point of view, the European bond market has been transforming itself from a
market focused on State-guaranteed issuances with AAA or AA ratings to a more diversified
market with even a growing high yield segment.

      A traditionally rather integrated bond market
The European bond market has been an OTC market for long (see definition § below). As
already mentioned above in Chapter II, the bond market in Europe has adopted many of the
features of the so-called “euro-market” i.e. the London-based market for financial assets using
the pool of resources made of book-entries in banks outside the jurisdiction of the country of
issuance of their currency of denomination. In Europe, bonds are issued either within a given
national regulatory framework or on the “euro-market”. In both cases, bonds can be traded
internationally. In Europe, most bonds are denominated in Euros but for reasons of
convenience, some issues are denominated in other currencies, mainly the US dollar.
Conversely, many issuers who are not residents in the Eurozone issue bonds denominated in
Euros. The overall size of the euro-denominated bond market at the end of 2000 was EUR
6,623 billion. While still significantly smaller in terms of outstanding amount than the largest
bond market in the world, the one denominated in US dollar, the euro-denominated market is
now roughly on a par with the US dollar-denominated market in terms of new issuance.

This nevertheless does not mean that the European bond market has reached the depth and
liquidity of its US counterpart: if progress has actually been made for the corporate bonds -
e.g. in the case of “Telecom bonds” as bonds issued by Telecom companies are called - there
still remain fragmented compartments for sovereign bonds (because, though commonly
denominated in euro, each country-member continues to issue its own bonds under its own
name and signature) as well as specific local markets such as Germany’s Panbrieffe aiming at
financing mortgage credit institutions.
International bond issuance in 1999, the year of the launching of the euro, split evenly
between the euro and the dollar with corporate bond issuance increasing fourfold as compared
to 1998. Since the year 2000, international bond issuance in euro have overtaken international
bond issuance denominated in dollars.
Corporate issuers are trying to reach as wide a base of investors as possible through the
issuance of global or international eurobonds. In addition, Luxembourg is already one of the
preferred locations for the custody of corporate bonds. For instance, around one-third of the
corporate bonds eligible as collateral in the context of the Eurosystem credit operations and
issued by German institutions are in fact deposited in Luxembourg. Indeed, the Luxembourg
Stock Exchange currently hosts 65% of the internationally listed bonds. This underlines the
notion that the nascent euro corporate bond market is not merely a juxtaposition of national
markets, but is, from this specific point of view, an integrated market. The same is less true,
so far, for the market for bonds issued by financial institutions.
On the primary market, - i.e. the market for bond newly issued and never traded before - the
main structural development has been the continued reduction in the relative share of
government bonds issuance: the share of public bonds in the market as a whole fell from 54%
at the end of 1998 to just 50% at the end of 2000. This comes from (i) the restraints on public
deficits set by the Growth and Stability Pact (see Chapter III § ….. above) albeit not as strictly
in practice than according to the letter of the Pact, and (ii) from the development of the
issuance of bonds by the corporate sector, this being a reflection of the trend towards the
“financiarization” of Europe’s economy, by which term we mean a growing place of financial
markets techniques in partial replacement of banks loans for the funding of the European
economic agents.
Simultaneously, the increased attention of national Treasuries to the demands of final
investors - itself a consequence of intensified competition - resulted in a number of measures
aiming, inter alia, at improving the liquidity of the secondary markets for government bonds.
The average size of individual public issues increased in the first two years after the
introduction of the euro. Buybacks and bond exchanges were used by several European
governments, both to reduce the level of their debt and to improve the liquidity of selected
issues. Though still varied, newly issued government bonds have become more standardised.
With limited exceptions (e.g. the French index-linked known as OATi), the issuance of
indexed bonds and non-conventional instruments is shrinking. Floating-rate notes are no
longer in favour, with the exception of the Italian indexed-rate CCTs.
While there are many similarities between the overall characteristics of sovereign bond
markets (the average maturity of government debts is, for example, relatively homogeneous),
some governments have developed particular niches. The French government, for instance, is
the only euro area sovereign government so far to have issued inflation-linked bonds.
Elsewhere in the EU, the governments of the United Kingdom (with GBP 65.5 billion
outstanding) and Sweden (with SEK 96.5 billion outstanding) have a longer experience in
issuing inflation-linked debt. The development of this segment was illustrated in 1999 by the
issuance by the French Treasury of a new 30-year index-linked security.
Another market niche of the French Treasury is the issuance of constant maturity bonds
(known as .TEC.) referenced to the ten-year segment of the French government yield curve.
This segment accounts for 1.4% of the outstanding amount of French government bonds.
By contrast, the Italian treasury dominates the segment of floating rate issues, with an
outstanding amount of €228 billion. However, since 1993 the Italian treasury has engaged in a
debt-restructuring programme aiming, inter alia, at increasing the relative share of fixed rate
debt. As a result, the composition of the Italian public debt has undergone a profound shift
away from variable rate instruments, and their weight has decreased from 35% of the total
debt in 1993 to just above 20% in 2000. A two-year floating rate note (for an outstanding
amount of €3 billion) was the instrument chosen by the Italian treasury to test for the first
time the capabilities of the internet for bond issuance, with direct connection with the
underwriters. systems.
For other euro area sovereign issuers, the floating rate segment is either insignificant (e.g. in
Belgium, where it amounts for under 1% of the total debt) or non-existent. The same applies
to Greece, where issuance of floating rate notes has been discontinued.
A review of the structure of the euro area government bond market by maturity reveals the
relative importance of bonds maturing in just under ten years (especially in 2009) and the very
small amount of bonds maturing shortly afterwards . This pattern reflects the concentration of
sovereign issuance in the ten-year segment of the yield curve over the past few years, both as
a means to exploit the environment of low yields and to boost the liquidity of these
“benchmark” bonds.
Continuing the trend initiated in 1999, bond issuance by private non-financial issuers
(corporate bonds) remained buoyant in 2000. This represented almost 9% of the total issuance
of euro-denominated bonds over the period 1999-2000. The share of corporate bonds in the
market as a whole thus rose from 5% at end-1998 to almost 7% at end-2000 (when including
non-monetary financial corporations, the corresponding figures rise respectively from 9% at
end-1998 to 12% at end-2000). . Furthermore, the growth of the euro-denominated private
bond market is also the result of its increasing internationalisation. In 1999, the outstanding
amount of euro-denominated bonds issued by non-euro area residents increased by 38%,
compared with 9% for euro area residents. For 2000, the same pattern prevailed with
respective increases of 24% and 6%.
the domination of bonds issued by the financial sector does not apply to such a large extent to
non-resident issuers, in whose case as much as 36% of bonds are issued by non-financial
corporations. In fact, this ratio is up from 19% at the end of 1998, implying that for non-
resident issuers it is the non-financial sector that has been the most dynamic in taking
advantage of the new opportunities created by the introduction of the euro. This difference
between resident and non-resident issuers naturally reflects to a certain extent the relative
weights of bank finance and non-bank finance in the euro area with respect to other
economies. In addition, standard asset-liability management by banks makes it understandable
that issuance in euro by foreign banks should be relatively less pronounced than issuance by
domestic banks.
Another difference between resident and non-resident issuers is the pace of their activity. At
the end of 1998,non-euro area issuers represented merely 13% of the outstanding amount of
the market. At the end 2000, their share had risen to 18%. The outstanding amount of bonds
issued by non-residents (excluding international institutions) has increased by 123% since the
introduction of the euro, from an initial amount of €215 billion.
For residents, it had increased by “only” 23% from a starting point of €2,198 billion. The very
dynamic activity of non-residents, especially in 1999, followed by a considerable slowdown
in 2000, is a key element that has led some analysts to suggest that the development of the
private bond market was a one-off development.
According to this analysis, international liability managers were quick to assess the
opportunities to be seized from the introduction of the single currency and entered into a
programme of issuance, whose aim was to balance assets and liabilities. However, after the
completion of this re-balancing, issuance would then rapidly dry up.
This thesis found some support, in particular as regards the non-financial corporations sector,
since non residents accounted for 71% of net issuance in 1999. However, this situation seems
to have been reversed since the second quarter of 2000; for the first time, residents issued
more bonds, on a net basis, than non residents.
Since the overall level of issuance, while irregular, has been broadly stable, this would
suggest that residents are slowly catching up with non-residents.
Indeed, one can argue that a certain lag in the reaction of euro area corporations is justified.
According to a study conducted by Merrill Lynch in April 2000, 53% of rated industrial
companies in the US had issued bonds.
In the euro area, the proportion was only 28%. It is understandable that companies that have
never issued bonds take more time to access the market for the first time than companies that
have already established a “name”, have working relationships with investment banks and the
necessary infrastructure in place for issuing debt securities. It is possible, albeit by no means
certain, that as more European companies establish such an infrastructure, their recourse to
the market will become more regular. In this case, the growth of the private bond market
would probably remain significant.

The heterogeneity of platforms included under the generic term “electronic trading
platform” is illustrated, as mentioned above, by the distinction between inter-dealer and
dealer-to-customer platforms. But another substantial distinction should be made between the
markets which are “regulated”, as defined by the Investment Services Directive (ISD) of the
European Union (such as some MTS markets) and the platforms that, from a regulatory point
of view, are not considered as regulated markets but as investment services firms.
The difference between the two is significant, insofar as all authorised intermediaries in the
EU are allowed access to regulated markets, while this may not be the case for non-regulated
markets. The distinction between the two is however not fully settled, as Senaf, for instance, is
very close to the concept of regulated market.
The more competitive environment among issuers brought about by the introduction of the
euro has been a strong driving force behind the structural evolution of the European bond
market. This has been particularly significant in the sovereign bond sector, where competition
was fostered by the relatively high level of homogeneity (and therefore substitutability)
between government bonds, notably in terms of their financial characteristics and their
Several common trends have been witnessed in both the public and private segments of the
bond market. One common trend is the intensification of competition, which was a widely
expected consequence of the introduction of the euro. Increased competition has been
particularly marked in the public sector, where national treasuries used to benefit from a
quasi-monopoly situation and now compete for the same pool of funds.
Competition has improved transparency and encouraged standardisation of sovereign bonds.
Competition has also developed in the non-sovereign bond segment, if only as a consequence
of the rising number of issuers. In both cases, competition has also triggered a search for new
types of instruments. Another form of competition has developed between national legislative
and regulatory frameworks. This is leading to a gradual convergence towards “best practice”,
which is likely to provide significant long-term benefits to market participants. As an
illustration, following the example of France, Spain and Luxembourg, also the Irish
government is currently preparing legislation to allow the issuance of instruments similar to
the German Pfandbriefe.

Cross-border diversification of end-investors. bond portfolios appears to have been
developing since the inception of the euro, even if not as extensively as might have been
expected. The advantages of diversification are not clear-cut in the euro-denominated bond
market, especially in its sovereign segment, where bonds tend to be very homogeneous in
terms of price evolution, creditworthiness and other characteristics. Diversification, on the
other hand, still entails some costs, such as that of acquiring knowledge of the various legal
and technical environments prevailing in the twelve Euroarea countries. An element worth
highlighting is the apparent preference of issuers for “international” rather than “domestic”
issuance. This is more relevant for corporate bonds than for financial bonds, for which
domestic regulations (e.g. the existence of a legal framework for issuance of mortgage bonds)
are crucial. As regards corporate bonds, however, it would appear that Luxembourg is
attracting a growing share of issuance. Since the concept of a “domestic pan-European” bond
market does not yet exist, it seems that issuers resort to international issues as a substitute.
This is consistent with the assumption that A second trend common to both the public and the
private sector is the increase in the average size of outstanding bonds. One reason for this
trend, which was particularly marked in the public sector in 1999, was the desire to enhance
liquidity. In the private sector, the average size of individual issues also increased as a result
of the market’s ability to absorb larger issuances (as illustrated by the two record issuance
programmes of Deutsche Telecom in 2000 and France Telecom in 2001). The heterogeneity
of issue size remains, however, significant and reflects the diversity of issuers and investors.
In contrast with the common trends highlighted above, different developments have also
occurred in the public and private bond sectors since the introduction of the euro. For
instance, the issuance of floating rate notes remains marginal in the case of public issuers,
with the notable exception of Italy. The opposite holds for private issuers, especially financial
institutions. The relative shortage of floating rate notes issued by the public sector may have
attracted private issuers to fill the gap left open.
Heterogeneity between the different types of issuers also exists in respect of the maturity of
issuance. In the public sector, the trend is towards a lengthening of the maturity of newly
issued bonds, while the issuance of treasury bills is being reduced. Heterogeneity exists within
the private sector, in particular between the non-financial sector, where issuance tends to be
concentrated in the medium-term segment of the curve, and the financial sector, where the
short-term and long-term segments are relatively more important.
In the derivatives market, the benchmark status achieved in 1999 by the Bund futures contract
traded on Eurex was confirmed in 2000.
The interest rate swaps tend to be used as a pricing reference and a hedging instrument for
private bonds.
Another development arising from the introduction of the euro in 1999, and one which
continued in 2000, was the increase in the outstanding amount of individual bonds. This was
also a consequence of the efforts of issuers to enhance the liquidity of their debt. Already at
the end of 1999, ten-year bonds issued by the French and German governments exceeded €20
billion, while a similar issue in Spain totalled €16 billion. These figures are comparable to the
outstanding amount of US Treasury benchmarks (around USD 23 billion).
Since intermediaries and investors demand predictability of issuance, the competitive
environment faced by sovereign issuers in the euro area has led them to improve their funding
policy communications. This has been achieved notably through the use of internet and the
publication of periodical bulletins and annual reports, generalising a policy that existed in
several countries, such as France, already before the introduction of the euro. The Dutch and
Portuguese treasuries, for example, now publish on a quarterly basis the information
previously distributed respectively annually and semi-annually. In Germany, as a complement
to the quarterly issuance calendar, a preview of the Federal Government.s issuance,
redemption and interest payments for the whole calendar year has been published.
The reduction of costs and risks for the bidders in government bond auctions is another
consequence of competition between treasuries. For instance, to reduce the period of
uncertainty between the time of bidding and the announcement of the auction results,
treasuries in Finland, Portugal, Belgium and France have resorted to fully electronic tender
In the same vein, several public issuers have undertaken “e-placements” for government
bonds. The treasuries of Finland, Italy, Portugal and Spain have all made use of the internet
for this purpose. This underlines the potential for in-depth restructuring of government bond
markets resulting not only from the competitive environment brought about by the
introduction of the euro, but also from the new opportunities created by technological
While competition has led to a certain homogeneity of issuers. actions as described above, it
has not ruled out (in certain cases it may even have encouraged) some divergence in the
strategies of different public debt managers.
Ones such divergence is related to the size of the funding needs and outstanding debt of each
issuer. Achieving a significant level of liquidity is facilitated if the outstanding amount of
each bond is at least €5 billion. This is clearly less easy for a small issuer like the government
of Portugal to achieve than it is for the government of France, for instance. The former would
have to concentrate most of its annual funding programme on just one line to achieve this
objective, while the latter could reach it with just a few re-openings after an initial auction.
Consequently, the issuing strategies of large and small countries have differed.
Large issuers typically continue to issue bonds across the maturity spectrum, in order to
maintain a comprehensive and liquid yield curve. Some public issuers, however, have chosen
to limit the number of auctions, while increasing the amount of each of them. In Belgium, the
number of OLO auctions was reduced in 2000 from 12 to 5. Since 1999, 15-year bonds have
been issued in Spain every other month, whereas the issuance beforehand was monthly. This
policy was also pursued by smaller issuers, such as Finland, where the number of auctions has
been reduced from two to one per month.
By contrast to the policy followed by large issuers, smaller issuers have tended to reduce the
number of benchmark securities issued and/or to focus their efforts on “niches”. The choice of
issuance procedures also reflects the particular challenges faced by relatively small public
issuers. The Finnish and Portuguese treasuries, for instance, have increasingly resorted to
syndication rather than fully-fledged auctions. Even some larger issuers, like Belgium, have
adopted syndication as a convenient means to front-load new lines, even though they may use
regular auctions to increase their outstanding amount subsequently. One of the merits of
syndication, especially for small issuers, seems to be that, by making use of the distribution
capacities of the intermediaries, it may facilitate a broadening of the investor base. Not all
public debt managers, as testified by the examples of Ireland and Austria, envisage, however,
resorting to this issuance procedure.
In some cases, euro area governments have resorted to euro-medium-term notes (EMTN)
programmes for issuance of debt securities, so as to take advantage of the flexibility and
lower documentation costs of these programmes. This has been notably the case in Portugal,
with €2.6 billion medium-term notes outstanding at end-1999 and €2.1 billion at end-2000,
from €1.4 billion in 1998. The Italian treasury has also made use of this option, although the
relatively limited outstanding amount of EMTN issues by the Republic of Italy (around €15
bn at end-2000) illustrates the marginal character of this programme.
Finally, several governments have overhauled the institutional structure of their public debt
management, in order to respond more effectively to the new competitive environment.
France Trésor was hence awarded the status of debt agency with direct accountability to the
Director of the Treasury and more active management capabilities. In the same vein, the
German government has also announced a plan to gradually outsource its debt management
operations to a federal agency. This process is expected to be completed by the end of 2002.
Under the impact of the EU policies aiming at the completion of the Internal Market in the
field of financial
services, the drive towards the integration of EU financial markets started before the
introduction of the euro and goes beyond its borders. For instance, the Investment Services
Directive (93/22/ECC), published in 1993, allows authorised intermediaries established in
any Member State of the European Union to operate in any other Member State. In particular,
these intermediaries may operate directly in any regulated market of the EU.
For electronic regulated markets, intermediaries may operate without opening a branch in the
country where the market is located.
However, while regulation (or deregulation) can facilitate the integration of the market, this
process is ultimately achieved by market participants themselves. From that point of view, the
introduction of the single currency, by removing a major barrier to the cross-border
diversification of portfolios, was expected to foster the integration of the euro area bond
market, as seen from the point of view of investors.
The process of consolidation of infrastructure, in particular securities settlement systems,
continued in 2000. In Italy and Spain, notably, the number of central depositories decreased
because of rationalisation at a national level. Cross-borders mergers also took place or are
ongoing, as testified for instance by the merger of the activities of Euroclear, Sicovam
(Société Interprofessionnelle de Compensation des Valeurs Mobilières, the former central
clearing and settlement agency in France) and CBISSO (Central Securities Depository
formerly operated by the Central Bank of Ireland) into Euroclear group, or by the merger
between Cedel and DBC (Deutsche Borse Clearing, the captive clearing arm of Deutsche
Borse), giving birth to Clearstream International.
One indicator of the level of integration of the euro-denominated bond market is the extent of
the “home bias” shown by investors within this market. .Home. means the national segment of
the euro area market, in which the investor is located. Geographical diversification therefore
relates in this section to the reshuffling of bond portfolios previously denominated in legacy
currencies within the euro area, rather than to diversification in securities denominated in
third currencies.
While little data is available there are some indications of increased . albeit slow and limited .
diversification within the euro area. The limited benefits derived by investors from
geographical diversification, especially in the government bond sector, seem however to slow
down the process.
According to available data, the share of public bonds held by “domestic” investors (investors
resident in the same euro area Member State as the issuer) have declined since the
introduction of the euro. The share held by non-residents as a whole (including non-euro area
residents) has accordingly increased. Where data is available (in particular in Spain and
Belgium) it appears that these shifts are largely attributable to purchases by investors from
other euro area countries. Anecdotal evidence provided by institutional investors confirm this
trend towards diversification.
The current process is an ongoing one that started before the introduction of the euro (and
even before the formal announcement of the start of EMU and the official bilateral conversion
rates in May 1998).
The fact that diversification is first and foremost underpinned by risk/return considerations
serves to explain in part why the process is slow.
Indeed, in view of the administrative costs entailed by diversification (for instance,
in terms of the need to acquire legal and technical knowledge of the specific environment of
other euro area market segments), expectations of substantial additional returns are required to
lure investors away from their home market. In the years prior to the introduction of the euro,
for instance, such additional returns were provided by the perspective of significant yield
spread tightening between various categories of government bonds. The potential additional
returns to be earned from geographical diversification now seem to be less attractive.
The relative homogeneity of the euro area bond market is one relevant element in this respect.
Around half of the euro-denominated bonds are sovereign bonds. In the context of the fiscal
discipline guaranteed by the Stability and Growth Pact, all euro area governments enjoy high
and relatively homogeneous credit ratings. Furthermore, a large share (over 80%) of the bonds
issued by the private sector also enjoys a high level of creditworthiness. The relative
homogeneity of the different securities translates into relatively limited (and stable) yield
spreads, thereby reducing the incentive for diversification.
However, some diversification seems to have occurred in favour of those sovereign issuers
with relatively lower ratings and higher yields. This is reflected in the increase in the share of
public bonds held by foreign investors in Spain, Belgium and Italy, for instance. Meanwhile,
the trend towards a slight widening of yield spreads between French and German government
bonds has been attributed by market participants to the removal of obstacles to diversification
brought about by the introduction of the euro, allowing demand by French institutional
investors to be diverted away from their “home” market, thus alleviating a structural
“squeeze” on French government bonds. Another incentive that fosters diversification is the
preference for liquidity. In this regard, German government bonds continue to hold a
particular attraction for many investors because of the perception of their “safe haven” status
and because of their deliverability against the highly liquid Eurex futures contracts.
Preference for liquidity and the importance of deliverability against highly liquid futures
contracts is also reflected in the reported premium enjoyed by “on-the-run” issues in
Germany, while such premia seem to be relatively limited in France or Spain. Another
element in favour of German government bonds is the fact that, due to their “benchmark”
status prior to the introduction of the euro, their (legal and technical) characteristics are better
known to a broader base of investors than those of bonds issued by other governments. This
illustrates the importance of “administrative” costs to diversification, which are nonetheless
expected to diminish gradually as investors become more accustomed to various categories of
securities, and as standardisation of the features of the bonds extends.
In spite of all the efforts and progress achieved towards integration of the Euroarea bond
market, some barriers to integration persist. The infrastructure just mentioned remains
fragmented in the view of market participants, while tax issues and difficulties in assessing
credit risk adequately (particularly in view of the heterogeneity of bankruptcy laws) also
obstruct the full integration of the market.

In retail bond markets, developments fostered by technological innovation or by the
introduction of the euro have not been as significant as in other segments .
Already at the beginning of Stage Three of EMU, almost all retail markets used an electronic
As regards the level of integration of euro area retail markets, one indicator is the number of
intermediaries operating in markets located in other countries of the EU. Where data is
available, this number appears to have increased after the introduction of the euro. However,
as most regulated retail markets are multi-product ones, in the sense that bonds, equities and
other securities are listed on the same market, it is not possible to assume that this increase,
strictly speaking, is linked to the integration of the bond market. On the contrary, it seems that
it is the greater cross-border demand for equities that is the main reason for the increase in the
number of intermediaries that operate in one given market by remote access.
The introduction of the euro has played a crucial role in fostering a deeper and more liquid,

euro area-wide

bond market. The single currency per se does not, however, remove all the barriers to market
This point is illustrated by the work carried out by public authorities in the European Union,
with the aim of
achieving the completion of the Internal Market in the field of financial services. The
publication of the report of the Committee of Wise Men on the Regulation of European
Securities Markets, chaired by Alexandre Lamfalussy, is a testimony to that effect.
At the same time, market integration does not mean that the market has to become entirely
This second point is illustrated by the remaining spreads between government bond yields
across the euro
area, reflecting both liquidity and credit risk differences. It is also noteworthy that self-
imposed constraints by investors themselves seem, in some cases, to hamper cross-border
Early expectations and bond yield developments since the introduction of the euro
At the start of Stage Three of EMU, it was expected that the small yield spreads between
sovereign bonds issued by euro area governments would narrow further. The underlying
rationale was that these spreads reflected both liquidity premia and credit risk differentials. As
smaller issuers were expected to adopt a strategy of concentrating issuance on a small number
of larger issues, the liquidity premiums were expected to narrow as a result. Meanwhile, strict
adherence to the terms of the Stability and Growth Pact was expected to result in a general
strengthening of the fiscal positions of Member States, thereby reducing perceived differences
of creditworthiness.
A consequence of this reasoning is that many market participants expected a benchmark yield
curve to emerge consisting of the most liquid German, French and Italian sovereign bonds.
Yield spreads between euro area sovereign bonds widened slightly, if anything. A single
benchmark yield curve did not emerge.
Caution must be exercised when interpreting these developments, as they are not necessarily a
sign of insufficient integration.
For instance, the benchmark status of the German government yield curve, especially in the
ten-year sector, can be in part traced to the success of the Bund futures contract, which is to a
certain extent the true underlying benchmark for this part of the curve for the whole euro
market. However, it also appears that investors are not yet totally impartial as regards the
purchase of two bonds from two different euro area countries, for reasons which reflect a still
incomplete integration.
4 – 2 - The Equity Market: still on the road to less fragmentation

For various - and obvious - historical, cultural, practical and legal reasons, Europe’s equity
market is still very fragmented: not accounting for the various markets (Neuer Markt, Nasdaq
Europe, TechMarkt ...) for growth and new companies - no less than 16 different Stock
Exchanges (see chapter V below) are members of the European Federation of Securities
Exchanges. Other sources of fragmentation lie in the existence of specific features like for
example the absence of a proprio sensu clearing house in Frankfurt due to the historical
dominance of banks in the German equity business. Sources of fragmentation may also be
found as to whether the securities in a certain European country are still materialized or come
under the form of book entries etc.
4 – 2 - The rapid growth of equities issues
The most notable growth in financial market operations has to date been achieved in equity,
where recent annual growth rates of volumes traded have exceeded 30% per annum over the
period 1995-1999.
New securities and new listings have been a significant component in the growth of European
stock market capitalization. In 1999, the stock market capitalization of EU-15 markets
reached 109% of GDP (85% for EU-11 countries). This compares with a cumulative total of
181% of the US GDP. The number of companies listed on EU-15 stock-exchanges has grown
steadily from 6401 in 1995 to 8111 in 1999, with the bulk of the growth occurring in the EU-
11 markets, from 3475 to 4416.

Stock Market Capitalization (%GDP )
Belgium                                         74%
Denmark                                         64%
Germany                                         68%
Greece                                          174%
Spain                                           72%
France                                          105%
Ireland                                         75%
Italy                                           62%
Luxembourg                                      192%
Netherland                                      176%
Austria                                         16%
Portugal                                        62%
Finland                                         272%
Sweden                                          155%
UK                                              206%
EU-11 (Euro-Zone)                               85%
Japan                                           102%
US                                              181%
Source: BIS, FESE (2000)
Nevertheless, since the launching of the euro, the investment horizon of funds and private
investors are becoming “more pan-European”.
Some sectors have become more integrated on the pan-European level and the companies
belonging to this sectors are less and less dependent on the local markets while showing
higher correlation to the pan-European sectoral indices. This is the case for such industries as
Automotive, Raw Materials, Food Industry, Energy and Chemistry. Conversely, Consumer
Goods, Banks and Financial Services as well as Utilities companies stocks still score higher
correlations with their local markets than with the sector’s pan-European index.

Pan-European indices, such as the STOXX - the STOXX group of indices jointly calculated
and marketed by the French and German Stock Exchanges, the Swiss Exchange SWX and the
Dow Jones company - or the FTSE indices, provide the possibility for portfolio insurance on a
pan-European basis thanks to the available pan-European derivatives products.

Thus, though having to cope with the fragmentation among several exchanges (and the related
costs), a pan-European equity portfolio management has started to make sense. Besides, such
a progressive “pan-Europeanisation” of Europe’s equity market is reflected in the numerous
pan-European funds which are offered by Asset Management companies which illustrates that
despite the sceptics press articles, the community of investors act with confidence in the
        The relative share of domestic equity in portfolios of unit trusts (mutual funds) is in
        The volume and number of cross-border transactions is increasing.
        The same investment firms constitute the membership of different exchanges and
         serve multiple national client bases.
        Finally, exchanges and new types of trading platforms are competing across borders
         for order flow and are increasingly, though still at a low pace, dependent on
         consolidated clearing houses/central counterparty facilities.

Despite these growing cross-border linkages, a strong home bias persists in primary and
secondary market activity in the EU equity markets. In part, this situation reflects the inertia
in investment patterns which is observed in all markets (for example, in the US, it was
observed that investors on the NASDAQ growth companies stocks tend to buy shares of
companies within a limited distance from their residence location). However, it is also the
case that cross-border issuance, trading and settlement are beset by numerous outstanding
legal and technical obstacles.
A main difference between Europe and the US is in Equity market structure: though slowly
moving in the direction of an order-driven market, Nasdaq remains a quote-driven market
where investors deal with market-makers while the New York Stock Exchange still has its
trading floor with crucial roles for floor-brokers and stock-specialists and is typical of an
order-driving market. One major source of difference between national stock markets within
Europe, the market structures and organizations, have deep historical roots. Thus, most
Continental Europe’s equity markets are “order-driven central markets” whereas “price-driven
markets” and market-makers organizations have been traditionally prevailing in the UK.
However, the UK has moved in the direction of an order-driven market since the introduction
of SETS.
European cash equity markets, even while remaining separated, have been moving towards
the common market-model of an automated order driven-market with a central order book and
a general counterparty, a type of market which enables quick execution and narrow bid/ask
spreads through the concentration of liquidity in the market order book for each instrument.
As to the combination of cash and derivatives markets, continental Europe is promoting one
and the same model, the integration of cash and derivative markets which allows exchanges to
propose to users the same systems, the same rules to enable them to make easy arbitrages, to
cross-margin their positions, notably between equity, index futures and stock options under
one single screen, one single access point. The growing combination of the cash and the
derivatives markets brings to the European exchanges a critical mass of liquidity, of members,
of resources, of capacity to invest.
In terms of capital raising the US market is ahead. In terms of how equity markets are
structured however, US markets are currently behind. They leapfrogged the European equity
markets in the 1970s but they languished and stayed with 1970s’ market models and
technology. In the years 1990s, European markets had to adapt due to competitive threats
much of which came from SEAQ International. As a result, they evolved radically, creating
very efficient exchanges that are totally electronic with easy accessibility at low cost.
The listing of the major European Stock Exchanges (London Stock Exchange, Euronext,
Deutsche Borse...) opens the way to future consolidations through the market forces - as
illustrated, even if it eventually failed, by the hostile tender offer by Stockholm’s OM on the
London Stock Exchange. Exchanges have long been strong national symbols and organized
under mutual forms. They have been operating as separate units like geographic “silos”, on
their own, not really connected. There have been also strong nationalist feelings at stake. The
merger of Amsterdam, Brussels and Paris exchanges into Euronext is an intersting move also
in this light which hints at the decline of the symbolic value of exchanges. In this respect, the
fact that with the creation of EuroNext, a joint company under the Dutch jurisdiction, the
former Bourse de Paris has been - at least legally - delocalised has not been enough
Further integration of Europe’s financial market through a more uniform regulation has been
one of the political directions given by the EU’s Lisbon Summit. As underlined by the
Lamfalussy Report - which will be extensively analysed in the Chapter VI below - the idea of
the settlement of an EU’s financial markets regulator equivalent to the US SEC would be
hardly practicable in the short haul. In particular, it would involve a modification of the
European Union’s founding treaties with all the many political complications this would
Challenging the political will to integrate the European financial markets expressed at the
Lisbon Summit would hence probably be more easily completed through the settling - under
the model of the European System of Central Banks - of a federated body of the form of the
already existing (see box below) Forum of the European Securities Commissions (FESCO).
According to the Report by the Group of Wise Men chaired by Alexandre Lamfalussy, such a
step forward could be reached through a EU’s directive which would set the general
framework for an harmonized market regulation, leaving the practical aspects and the
technicalities to the decentralized level. As will be developed later, this approach might be
seen by some participants in the EU’s institutions as challenging the EU’s decision process.

There is no doubt that the rationalization of the European Equity market will be one of the
largest source of efficiency gains for the European continent’s economy. On a broader level,
by the end of the year 2000, several clearing institutions - Clearnet (France), Eurex Clearing
(Zurich-Francfurt), the London Clearing House, the Tokyo Stock Exchange, the New York
Depository Trust and Clearing Corp - have announced their intention to settle a central
clearing house to improve the trading between the various Stock Exchanges.

4 - 2 - 1 - The “national champions”, the local stock exchanges and the fragmentation of
Europe’s equity market

The fragmentation of the European equity market contrasts with the pan-European coverage
of most European listed companies

a - The players

Table 34 The various stock markets in Europe: Market Capitalisations, Number of
Listed Companies
Exchange                        Market Capitalisation: Main     Number of company listed
                                and Parallel Markets
                                (excluding Investment Trusts,
                                Listed Unit Trusts and          year-end 1998
                                Euro Million year end 1998
Brussels                        210.322                         274
Amsterdam                       512.445                         359
Paris                           837.061                         962
EURONEXT                        1.559.828                       1595
Lisbon                          53.477                          135
EURONEXT+Lisbon                 1.613.305                       1730
Deutsche Borse                  930.841                         3525
London                          1.956.258                       2920
Stockholm                       239.063                         276
Swiss Exchange                  591.265                         425
Italian Exchange                484.030                         243
Madrid                          342.486                         484
Luxembourg                      32.516                          276
Vienna                          30.444                          128
Helsinki                        131.474                         131
Oslo                            40.109                          236
Copenhagen                      84.367                          254
Iceland                         2.693                           57
Dublin                          59.305                          100
Athens                          69.281                          229
Source: Federation of European Stock Exchanges. Annual Report 1998. June 1999

The two biggest players on Europe’s equity market are the London Stock Exchange (LSE)
and Euronext. Deutsche Borse is a serious follower whose importance is obvioulsy rooted in
the weight of the German economy. The Swiss Bourses centered in Zurich are a serious
contender backed upon the power of the Swiss Private Banking and insurance industry and on
the global reach of such corporations as Roche or Nestlé. The Swiss Bourses have also
heavily invested in technology and are ahead of most of their competitors in this regard.
Though Switzerland is no member of the European Union, the Swiss Bourses obviously
intend to participate in the consolidation of the European financial markets. Finally, at the eve
of the practical circulation of the euro, one can say that the consolidation process of Europe’s
equity market seems to orient itself among two polar sets of stock markets:
 one constituted of Euronext
 the other less explicit including the Swiss Bourses, Deutsche Borse AG and the LSE.
Of course, one of the main challenges for the years to come consist for each of this “poles” to
attract the other smaller equity markets such as Milan, Madrid etc.

In addition to the competition between the traditional players, equity trading is a business in
which technology encourages the appearance of newcomers such as the ECNs (Electronic
Communication Networks), the Alternative Trading Systems (ATS), or pan-European
brokerage platforms like Instinet, through which, with three keys, orders can be sent to 40
different markets and of which 30% of the business is made of cross-border transactions. For
the traditional European equity markets, new competition came also from a new electronic
stock exchange focused on the Top 300 European companies, the London based TradePoint,
and more recently from the joint venture between the London Stock Exchange and the Swiss
Exchanges called VirtX.
For exemple, the service provided by Instinet results from Instinet’s membership of every
market that has an electronic exchange platform and from the electronic connection between
its brokerage service and the market as with the client so clients can send orders directly down
to those electronic markets. Instinet is not the only firm providing connectivity, other
companies like GLTrade in France provide electronic order-routing systems and electronic
exchange-interface for financial markets, but Instinet is present in many more markets and
provides, in addition to order-routing, services like block-trading tools, crossing, portfolio
trading and management software, research and analysis, transaction-cost analysis...
The competitive pressure exerted by ECNs on the European stock exchanges is weaker than it
is in the US because all the European Stock Exchanges are efficient electronic exchanges and
have reached a competitive edge in terms of liquidity and costs savings: in Europe’s securities
business, the total cost is accounted for 90% by the intermediaries and only for 10% by the
infrastructures. Thus, all European Stock Exchanges being now fully electronic, the
independent electronic communication networks (ECNs) have relatively modest positions
whereas in the US, Alternative Trading Systems (ATSs) compete head-on with the large
exchanges and have now captured some 30% of NASDAQ’s trading volumes and 5% of
NYSE’s. In Europe, ATSs provide specialized intermediary services for professional
participants with complement rather than substitute for exchange-based trading arrangements.
There are now more than 20 ATSs operating in Europe - largely based in Germany and in the
4 - 2 – 2 - The “national champions”

On each European Stock Exchange, a small number of Corporate Stocks account for a
significant amount of trades:

The “local champions” and Stock Tradings
Exchange                      Company                       % of Exchange Trading
London                        Vodafone                      10%
                              British Telecom               5%
                              BP Amoco                      5%
                              Cable & Wireless              4%
                              Glaxo Wellcome                4%
Frankfurt                     Mannesmann                    12%
                              SAP                           11%
                              Siemens                       10%
                              Deutsche Telekom              6%
                               Deutsche Bank                5%
Paris                         France Telecom                9.5%
                              TotalfinaElf                  6.5%
                              Vivendi                       4.5%
                              Carrefour                     4%
                              STMicroelectronics            3.5%
Milan                         Telecom Italia                14%
                              Olivetti                      9%
Madrid                        Telefonica                    21%
                               BBVA                         11%
Zurich                        Novartis                      12%
                              UBS                           11%
                              Roche                         11%
                              Nestle                        10%
                              Crédit Suisse                 7%
Amsterdam                     Philips                       7%
                              Royal Dutch                   6%
Bruxelles                     Fortis                        19%
                                   Electrabel                    10%
                                   Dexia                         7%
                                   KBC                           6%
Stockholm                          Ericsson                      35%
                                   Volvo                         3%

Source:Federation of European Securities Exchanges

The table above illustrates the way the national comparative advantages are revealed by the
position of the “local champions “ on each local Stock Market. This remark applies
particularly well in the example of Zurich were the two pharmacy giants (Novartis and
Roche) alongside the two mastodon banks (UBS and Crédit Suisse) in addition to Nestlé
account for some 50% of the Zurich Exchange trading and reflects the international
specialisation of Switzerland’s economy. Though to a lesser extent, the fact that the trading of
the shares of the “local champions” reflects the national comparative advantages,
notwhitstanding the global or pan-European coverage of the companies, is also true for the
other main European exchanges (with the home market taking care of anything between 80
and 100% of total liquidity).

4 – 2 - 3 - Alliances and mergers: toward a greater integration of the European Equity Market

On equity markets, the implementation of the euro has been contributing to shifting country-
based investment universes to pan-euro area investment. It has also contributed to stimulate
alliances and links among market institutions such as Exchanges and clearing and settlement
                                MARKET INSTITUTIONS
                              ALLIANCES AND MERGERS

Amsterdam Exchanges, the Brussels Stock Exchange and the Luxembourg Stock Exchange
gave their members direct access to each other’s market from the beginning of 1999. The
cooperation which means that dealers can trade stock listed on one market via the platform
of the home exchange currently covers at the start covers the cash markets but with plans to
extend it to include common clearing services and links between derivative markets as well.
Eurex is the result of a full merger of Soffex, the former Zurich derivatives market, and the
Deutsche Terminborse (DTB) the former Frankfurt derivatives exchange.
UK, Her Majesty’s Treasury has granted Swiss Exchange SWX the status of “overseas
recognised exchange” which allows securities dealers in the UK to use the Swiss
Exchange’s trading platform.
Helsinki Exchanges has decided to adopt the trading system of Deutsche Borse. HEX wil
also switch its derivative market operations to Eurex, the joint (and World number One
outpassing the CBOT in Chicago) derivatives market of the Deutsche Borse and Swiss
In 1998, SWX Swiss Exchange, SBF Bourse de Paris and Borsa Italiana had signed a letter
of intent with the following objectives: reciprocal admission (cross membership)
technological inter-connection of markets as well as that of clearing and guarantee systems,
harmonization of rules.
The Paris Bourse, through Matif (its former derivative market arm), together with the
Italian Exchange and the Spanish derivatives market Meff have set up an alliance to trade
fixed income products on a cross-border basis. A new joint platform (EuroGlobex) will
form the European arm of Globex in which the Chicago Mercantile Exchage is also
The Stockholm Stock Exchange and the Copenhagen Stock Exchange have agreed to share
the Swedish SAX trading platform and are intending to create a joint Nordic Stock
Exchange alliance (NOREX). Since 1999, Danish shares have been traded on SAX 2000.
There is also close cooperation between the danish Central Securities Depository and the
Swedish Central Securities Depository.
The Wiener Borse has agreed to use the Xetra trading platform of the Deutsche Borse from
the second half of 1999. The plan was also to form a new platform for Eastern European
stocks and to take over the 82 stocks from that region traded in Frankfurt.
VirtX is the amalgamation of Swiss Exchange’s international shares and Tradepoint.
Amsterdam, Brussels and Paris Stock Exchanges have merged into a single company
Euroclear, one of the two large international clearing houses alongside Cedel (Clearnet), has
merged with Germany’s Deutsche Borse Clearing (DBC)

The trend for European market institutions to form alliances or networks gathered pace in
1998 prior to the implementation of the euro. In constrast to the attempts at networking
among institutions in the past, today’s proposed arrangements are more focused and have
fewer participants. Recent alliances display a much sharper idea of what services are being
provided and tend to stick to their own time schedules for implementation. European
institutions appear wary of going for pan-European solutions from the start and prefer instead
to put new networks together one step at a time.

The first historical attempts to integrate Europe’s equity markets czn be placed at the
beginning of the 1990s with the “PIPE” and “Eurolist” projects.
           PIPE was developed between 1989 and 1991. Its objectives were to capture and offer
            information from the main European markets. PIPE aim was to create a network of
            connections between the markets which would allow it to unify the trades and the
            back office functions in one single platform. The project did not complete the phase of
           Eurolist, which began in 1989, intended to create a list of the major multinational
            shares that could be traded in all of the European markets with one listing document
            presented in the stock exchange of origin. Again the project was abandoned without
            achieving any of its objectives.

A period of several years passed before the integration process was restarted. In 1998 the
stock exchanges of London and Frankfurt publicly announced the creation of a single market
for Europe’s more liquid shares. The agreement was formalized in Madrid in May 1999 and
also included six other stock exchanges (Amsterdam, Brussels, Madrid, Milan, Paris and the
Swiss Exchanges). The aim of the alliance was to create one market where the largest and
most liquid European shares could be traded on one single platform or through one
connection system. In the end the platform was not established but it served the purpose of
helping all the parties to agree upon the model of a single market based upon:
            The principle of grouping the trades for each share in a single order book;
            Easy and cost effective access to the market from any point of connection;
            Electronic and continuous trading with periods of auctions for the shares at the
             opening and close of the market.

In January 1998, before the London-Frankfurt alliance, the Stockholm and Copenhagen Stock
Exchanges signed a document of co-operation in order to create NOREX, a unified Nordic
market with identical rules and regulations. Both stock exchanges remained independent but
they established a single order book for the shares, therefore allowing the crossing of trades
between both markets. In the following two years Oslo, Iceland, Riga and Vilnius Stock
Exchanges signed letters of intent in order to join NOREX. Though it included only Nordic
and Baltic markets NOREX was the first example that proved that integration of equity
markets was possible.
On March 18, 2000, the boards of directors of the Paris, Amsterdam and Brussels stock
exchanges signed an agreement to merge their markets, giving rise to EURONEXT.
Euronext is the first market of its kind in the Eurozone and the 2nd in the European continent
in terms of capitalization behind the London Stock Exchange (LSE). Euronext registered
office is in Amsterdam and it is ruled by Dutch law. It operates through 3 subsidiaries in
France, Belgium and the Netherlands. It has a board of surveillance made up of 12 members,
in representation of the parties who take place in the joint market. The selection of the
president is carried out every 4 years, its actual figure being Jean-François Théodore, who
was elected on September 12, 2000.
The Euronext 100, the main index in the market, is made up of the 61 largest companies in
Paris, 30 from Amsterdam and 9 from Brussels.
The key to Euronext’s success is its novelty and most probably the fact that its integration is
based on specialization:
      Paris is reserved for the largest companies;
      Amsterdam – at least at first – for derivatives
      Brussels for small and medium companies

The 3 markets work together with a unified operating system called NSC (for “Nouveau
System de cotation”). It has also integrated its back office functions.
At the of 2001 the Lisbon and Oporto Stock Exchanges also joined Euronext.

5 - The broad lines of the necessary harmonization of the regulation

On July 17, 2000, the European Union’s Economic and Finance Ministers gave terms of
reference to a “Committee of Wise Men”, chaired by Alexandre Lamfalussy, to propose the
appropriate measures to eliminate “the administrative, regulatory or other types of obstacles
which in practice impede cross-border securities transactions”.
According to the hearings conducted by the Committee of Wise Men on the Regulation of
European Securities Markets:
1. Issuers are still confronted with numerous practical difficulties. For instance:
 the EU passport for issuers is still not a reality. Firms wishing to raise capital in other
   jurisdictions are obliged to comply with different or additional requirements in order to
   gain the approval of local regulatory authorities. There is not even an agreeed definition of
   “public offering of securities” with the result that the same operation is analyzed as a
   private placement is some Member States and not in others. The current system
   discourages firms from raising capital on a European basis and therefore from real access
   to a large liquid and integrated financial market.
 Rules of disclosure of price-sensitive and relevant market and company information differ
   greatly between Member States. Accounting rules are not yet harmonized.
2. Investors.
 Professional investors are often subjected to multiple sets of conduct of business rules.
   There is still no legally agreed definition of what constitutes a “professional investor”,
   despite some recent progress.
 Retail investors are faced with different sets of consumer rules with varying levels of
   consumer protection.
 There is no agreed definition of “market manipulation”.
 Effective functioning of cross-border clearing and settlement is still impeded by legal
   differences in the treatment of collateral.

3. Markets and trading systems.
 There is no single passport for organized markets and trading systems i.e. they have not the
   right to provide services directly on a cross-border basis;
 The over the counter (OTC) market is mostly outside the scope of EU directives, with, for
   example, OTC transactions having to be declared in some jurisdictions but not in others.

4. Investment firms.
 Investment firms now have a European passport but are often faced with different
   obligations in each Member State because the firms providing core services - i.e. e-
   brokers, broker/dealers, portfolio managers and underwriters - are subject to substantially
   different supervisory regimes in different Member States.

5. In the EU there are approximately 40 regulatory organizations. The large number of
   Regulatory Authorities for securities in the Member States creates unnecessary cost and
   confusion among market players.

The conclusions of the Committee of Wise men will be exposed more extensively below
 Clearing and Settlement systems
                                         CHAPTER IX

                               Pensions and European capitalism

 Implementing a truly European financial system in substitution to the addition of national
   financial systems,
 fostering the consolidation of Europe’s banking and financial industry,
 facilitating the flourishment of US-like pension funds in the largest EU’s countries so that
   the overall EU’s economy be transformed into a “pension capitalism” where the financial
   markets play the central role in the allocation of resources,
 within which corporate governance principles based on shareholder-value
 together with the competition policy enforced by the competent EU’s authorities
 garantee a maximum degree of efficiency
are as many natural prolongations of the EU’s long term strategy and natural corollaries of the
creation of the euro.
Together with the EU’s enlargement to Central, Eastern and Southern countries, these
objectives clearly are the major issues of the European Union’s agenda for the coming first
years of the 21st century.

Practically, in addition to the consolidation and integration of the banking industry, the
transformation of Europe’s financial system requires the creation of a truly European efficient
capital market, backed upon local pension funds and other large institutional investors which
will be its natural users.
In the next decade, the banking and financial sector will be at the very heart of the historical
transformation of the EU’s macroeconomic system into a “pension-capitalist” highly
competitive market economy: banks, insurance companies, investments services companies
and securities markets will therefore be facing many changes in their competitive and
regulatory environment.
One of the main purposes of the research is to figure out the coming changes in Europe’s
finance from the standpoint of the industry itself. As a first step, the second part describes the
current features of the complex system and the set of players which form today’s Europe’s
banking and finance. It starts with dealing with the securities markets (Chapter V) and
continues with the banking industry (Chapter VI).
Generally speaking, up to now the financial markets have played a lesser role in financing
Europe’s economy than they have in the US. This observation holds especially for the Equity
market and for the role of venture capital in financing innovation.
This chapter starts with suggesting that the European financial markets will (as they have
actually started to do) fastly grow in importance as to their contribution to the financing of
Europe’s economy, even in what regards the financing of innovation and venture capital. The
chapter then deals with the current fragmentation of the equity markets, stressing that the
European blue chip companies are mostly traded on the stock exchange of their country of
origin with a corollary concentration of the liquidity for each of such blue chip traded share
on this same local market. Then the trend toward a certain consolidation of the equity market
is underlined prior to the drawing of the broad lines of the harmonization of the regulation
which should accompany the consolidation of the European financial markets. Finally, the
chapter describes the ambitions of the European banks in the investment banking business in
relation with the coming consolidation of the European econoomy as well as with the growing
importance of capital markets corporate financing.

1 - Making the EU a financial super-power and the issue of pensions

The relatively high level of financial savings in relation to GDP in such countries as the US,
the UK and Japan indicates that continental Europe still has a long way to go in terms of
financial capital accumulation by the households. For the continental European countries
catching up the required level of accumulated pension-savings should be an important feature
of the transformation of the European financial system in the coming decade.
As an illustration of such a likely transformation and its implications, based on this position of
departure of the European households financial savings and assuming a growth rate of
European households’ financial savings slightly higher than nominal GDP growth, a survey
by the Federation of European Securities Exchanges predicts on this rather conservative
assumption a total demand for marketable securities in nine European countries (France,
Germany, Italy, Netherlands, Norway, Spain, United Kingdom, Belgium and Portugal) to
amount to nearly Euro 5 trillion in the 1996-2005 period. The survey concludes that “the
future of securities markets in Europe today looks very promising, but a major effort is
needed to increase the volume of listed securities because demand will put an unprecedented
pressure on the markets. Possibly, the need for securities will produce in coming years a
strong outflow of European capital in search of international securities...”.
This paragraphs starts by describing Europe’s paradox consisting in generating rather high
flows of savings while being highly dependent on the financial ressources brought by the non-
European institutional investors. It thus points out the responsibility of the pension systems
and its implications on the structure of the househols assets. It then takes the opportunity to
explain why, though apparently thriftier, in reality the European households are more
indebted relatively to their assets than their US counterparts. Introducing partially the industry
perspective of the European financial sector which will be addressed in the Second Part of the
research, the chapter IV then describes the important role which, as a corollary of the
weakness of the pension funds in the largest European countries, the European life insurance
companies paly in the financial and banking industry. It finally relates the fundamental
finacial structures with the role potentially played - and the considerable corresponding value-
added - by the European institutions in the investment banking business and the coming
consolidation of Europe’s industry and services in the wake of the monetary union.

Europe’s paradox: a source of savings but a lack of capital
Europe’s paradox consist in being an important source of flows of savings while European
corporations are dependent on the US institutional investors’ capital lies in Europe’s
inferiority towards the US in terms of avalaible accumulated capital. In fact the US has taken
a twenty years time advantage on Europe in constituting a strong financial capitalism based
upon pension funds (“pension capitalism”).
The US advance in terms of capital accumulation not only plays a part in the innovation
process through the tens of billion of dollars which flow into venture capital and in IPOs etc.,
more broadly, through all the management structures - various types of consultancies,
professional services and practices, benchmarking, rating, auditing companies, boards of
directors, financial analysts etc - it sets standards and thus exerts a form of power.
Can one consider Europe’s economic integration as fully completed with the monetary uion
and even beyond the EMU once the Financial Services Action Plan is completed ?
The answer is clearly “no”, would it be only from the geographical standpoint as
economically important countries like Switzerland are no members of the EU. However, even
in terms of harmonization among existing or expected future members, there is far from
unanimity among Europeans as to how far the integration has to go on: after all, even in the
US, the different states have different corporate laws, legal and tax systems (for example, a
Californian wine-maker cannot legally sell wine to a Florida consumer directly through the
Internet) etc. and thus “harmonization” is no synonymous of “uniformization”.
From a political standpoint, this matter opposes the “federalists”, to the supporters of the
sovereignty (the “Sovereignists”). The firsts recruit mainly among the Social-Democrats or
the Greens, as for example Germany’s Ministry of Foreign Affairs, Joshka Fisher who has
even vowed for an European constitution. The seconds recruit among the Conservatives in
countries having a strong nationalist tradition like for instance in the UK or France.

However, going back to practicallities, there exists a certain degree of consensus on the idea
that differences in the Member States’ legal systems like bankruptcy regimes, sanctions
regimes or jurisdictional regimes still need to be (at least substantially) tackled to achieve an
integrated European financial services market.
More broadly, the future of a more integrated Europe raises the question of corporate
governance. Practically, as far as the corporations of European origin are global players they
have to adapt - and most of them have obsensibly adapted themselves - to the dominant
“Anglo-Saxon” model of corporate governance. Practically speaking this means further
privatisation, demutualisation, generalization of shareholder value principle and enhanced
competition which in turn means the settling of the appropriate leveled regulatory framework.
As has been mentioned earlier, this requirement is of particularly great importance for the
European banking sector, especially in Germany where not only mutual and savings
institutions still hold a dominant market-share, but where, in addition, the banks have strong
participations in the non financial - i.e. industry and services - sector, creating many
hindrances to the normal action of capital markets in economic restructuring as well as many
distorsions to the principle of shareholder value etc. In this context it is meaningful to quote
Dresdner Bank’ moto as it is stated on its Website “create additional value for shareholders -
with not ifs and buts!”.
All these thoroughly practical issues drive to the question: “how far European integration will
go”? Will it go until a uniform tax system, a common corporate law etc. ? Again clearly,
such questions arise that of the role which political will will play in the coming years in
fostering further integration in Europe.

It is hard to assess what exact part politics have played to forge Europe into the consistent
economic power it is at the beginning of the 21st century. The common view is that it has
played a large part. In particular, without the strong and long lasting commitments to the
monetary unification of Europe of France’s and Germany’s governments of whatever political
party, the euro would never have been born.
Nevertheless, even if the idea that politics will not matter as much as it did in the early years
of the Common market is probably true, yet, the alternative idea that political stimulation
would no longer be necessary is probably thoroughly wrong. The more complex, and often
longer, decision-making process in the EU, with a greater role of the European Parliament
will in many cases be under challenge as it might negatively interfere with the timeframe of
the overwhelmingly potent market forces.
However, this maintained importance of political will might be true for the recent past but not
for the current and future times as one often has the feeling that the momentum for economic
integration is now strong enough for its consequences to develop whatever takes place in the
political area. This, in the first place, boils down to the question of whether the advent of the
euro is the crowning or the floor of European integration (section 1).
Enlargement is another top priority on the European Union’s agenda. It is due to bring some
one hundred more people into the European Union. The changes of the European Union
within the next ten to fifteen years will be extremely important. In the new institutional
context of the European Union associated with its largest size, it is quite obvious that the
impact of political action will be more diluted than it was in the first times of Europe’s
Already though, even when political problems do not arise, the process to adopt legislation in
the EU is often slow: on average, it takes three years to agree a regulation or a directive. In
worst cases, delays are much longer: for example, more than eleven years for the Take-over
Directive which was eventually rejected by the Parliament. Yet examples outside the financial
services domain show that some proposals can be adopted and implemented quickly (adoption
in less than eight months) when the political will is there.
Nevertheless, in an enlarged and more complex European Union, not only will the proper
regulation have to be delivered but in addition the timing will have to be in adequacy with the
schedule of the market forces. The Financial Services Action Plan which aims at creating a
single market for financial services in the EU will be one of the major challenges to the more
complex decision-making process. As the outcome of the draft directive on Take Overs
already illustrated, it will give significant hints about the propects for more harmonization in
politically sensitive areas like taxation and corporate law (section 2). The third section of this
chapter addresses the central question of transformation of Europe’s economic and financial
system into a “pension capitalism”.

2 - Taxation and Corporate Law

   To some European players, tax differences have now become the most important barriers
   to a truly unified market in the European Union. Tax rates is such sectors as the energy
   sector can be very different. Many Europe’s increasingly integrated companies press for
   tax harmonisation. To others, who refer to the US where exist different levels of taxation -
   federal, state, municipal - a “levelled playing field” does not imply or require a full
   harmonization of all tax bases and tax rates for direct and indirect taxes.
   It should be borne in mind that the principles of “subsidiarity”, “attributed powers” and
   “proportionallity” are provided by the Treaty and stress the need for some autonomy and
   flexibility of Member States in the field of direct taxation.
   In addition, tax competition between Member States must not always be considered as
   harmful: it may result in “spontaneous harmonization” at a lower level of taxation. For
   example, in May 1998, the European Commission, based on a mandate of the Council of
   Ministers, submitted a proposal for a directive to “ensure a minimum effective taxation of
   savings income in the form of interest payments within the Community”. The professional
   markets associations - the International Securities market Association (ISMA) and the
   International Primary Market Association (IPMA) as well as national and European
   banking associations - reacted strongly to the proposal, not least because of the inclusion of
   eurobonds and the potential threat and risk of losing this important segment of the
   European capital markets to other centers.
Table 61
Rates of witholding tax
London                                             0%
Paris                                             25%
Frankfurt                                         30%
New York                                          30%
Switzerland                                       35%

From a practical and business standpoint, the main pending issues deal with tax
harmonization as well as with corporate law and governance. Tax harmonization should
facilitate the restructuring of cross-border activities in Europe by mergers, acquisitions etc.
    Tax harmonization is asked for more vehemently by countries such as France with a
     strong long-standing centralization and state culture. Conversely, such countries as the
     UK strongly oppose tax harmonization and instead have been supporting an
     interlinking of national tax data between member-governments by the year 2003.
     Indeed harmonizing withholding taxes throughout Europe would involve the
     introduction of a withholding tax in London.
 Taxation and the competition between financial centers

Taxation is a matter which is closely related to competition between financial centers with
London having had a long-time competitive advantage based on its zero saving taxes. It has to
be reminded that in the late years 1960s, the US withholding tax kick-started the Eurodollar
market in London. London’s anormalous position in the respect of not having withholding
taxes levied on all bond transactions has underpinned its dominance as a financial centre since
the very first days of the euro markets.
One remembers that the flourishment of the eurodollar market in London came about as a
result of US “regulation Q”, the Federal Reserve-imposed ceiling on the interest rates that
would be paid on domestic deposits and that drove the US money market off-shore to London
where banks could offer a market interest rate on deposits.
As for the US dollar bond market, it remained mainly a domestic affair until a subsequent
change in the Internal Revenue Service’s (IRS) policy on claiming tax on interest payments
made the offshore market located in London more attractive to bond investors. US tax
changes in the 1970s required bonds to pay interest net of a 30% withholding tax (which
could be claimed back by non US taxpayers).
An other powerful factor in the development in the euromarkets in London was the US
“regulation 6)F7” that required all bonds to be held in registered form so that the tax
authorities knew who to chase for the withholding tax. As part of the system, bearer bonds
were outlawed because of the ease with which they could be used to avoid paying the tax. As
bond issued off-shore were naturally outside the jurisdiction of the US tax authorities they
were able to have yields some 25 basis points less than comparable US domestic bonds
making them an attractive source of finance for US companies. In Britain, bonds never had to
be registered and the market became mostly “bearer” helping London’s emergence as the
eurobond center. It is thus not surprising that the British Bankers’ Association have stated
that the EC’s proposals on harmonizing savings tax would “increase funding costs for
corporate borrowers in the eurobond and other markets and so would erode the competitive
advantage of London”.

 The internal market perspective

Though the EU’s Commission will not make any formal proposals public until later in 2001,
in February 2001, the EU’s commissioner for the internal market presented a paper on tax
policy in which he stated that the priority is to reduce the tax burden EU-wide.
In this view, granted the EU is pledged to eliminate “harmful tax competition”, a “reasonable
degree” of tax competition would not be harmful and would even lead to a market-driven
convergence towards lower tax rates across the Union.
Such a view is that of the defenders of national control over taxes. However, some of the most
“integrationists”, such as the Belgian Premier, have in the same time called for a directly
levied EU tax to be imposed on all citizens in the Union. “Harmful tax competition” does not
extend to basic rates of corporation tax but would still target national tax breaks aimed at
bringing in foreign investors.
The rules of the internal market oblige the governments not to place obstacles in the way of
free movement of goods and people, they thus partly empower the Commission over taxation.
Differences in national tax systems, for example over the portability and taxability of
pensions could be construed as an impediment to labor mobility (see section 3 below).
As in the case of the integration of EU’s securities market which is recommanded by the
Committee of Wise Men, a possibility would be to draft a common set of rules for company
tax, right across the Union, rather than trying to correct perceived distorsions to the single
market by getting each of the EU’s 15 countries to adjust its own tax system.

b - The variety of local corporate laws is a hurdle in many cases of cross border and pan-
European merger operations
Different business culture make it difficult to setting a pan-European legal corporate status.
However, progress have been being made in the recent years mainly thanks to Germany’ shift
towards the worldwide corporate governance principles based upon shareholder value, with
the counterpart of Germany’s drifting away from its particular principle of «co-gestion» i.e.
management of corporation in association with the unions which have members present in the
board of directors.
It seems reasonable to expect that the harmonization of corporate law will record progress
topic by topic, with the financial regulation in such areas as mergers and acquisitions and
tender offers as a front runner topic as the already existing pan-European task force on this
subject illustrates. However, here again one might be wrong in expecting that harmonization
will wind up into a uniform corporate law all over the EU. As in other matters, the most likely
outcome of the search for convergence would be a mix of mutual recognition/competition
among rules and a minimum harmonization.

3 - Towards a European Pension Capitalism ?

  Despite the considerable amount of creativeness and energy which has already been
  devoted to improve the European financial sector and in addition to the afore mentioned
  supply-side driving forces towards a continuing momentum of progress, there still exist a
  powerful impetus also on the demand size of the economy to enhance the efficiency of
  Europe’s finance and banking industry.
  One important aspect of the pressure exerted on banks consists in providing their corporate
  customers with access to the pan-European market and to the global market. These
  pressures coming from the demand side, not only mean adequate financial products, but
  also concern advices and guidance to corporate best practices. To be able to fulfill their
  clients needs, the European financial institutions have to be placed into a framework
  which is compatible with the dominant corporate governance model.

a - Shareholder-value and “pension capitalism”
 As, for the last two decades, capitalism has developed under the dominance of such
  powerful institutional investors as the pension funds from the US and the UK - the
  outcome of this development being refered to as “pension capitalism” and an increasing
  number of European corporations having adopted shareholder-value as their core corporate
  governance principle - the biggest political issue in terms of the future effective
  participation of Europe in global capitalism is that of creating an European “pension

As underlined in the November 2000 Report of The Committee of Wise Men on The
Regulation of European Securities Markets, as the EU’s demographic trends will lead to far
more reliance on privately funded pension schemes in the future, the benefits from an
integrated European capital market, enabling higher returns on capital, are particularly
In addition, efficient European capital markets will improve the overall macroeconomic
performance of the economy, producing higher economic growth with positive impacts on job
creation and productivity: in a Schumpeterian view of modern economics, the existence of
well-developped financial market represents a source of competitive advantage for that
country, or group of countries, in industries - such as innovative industries - that are more
dependent on external finance.

 Pension reform, a priority for EU’s competitiveness

The EU heads of government have set agreement on pension reform as a priority for
improving EU’s competitiveness. Occupational and private pension funds are mainly
established in the UK, the Netherlands and Ireland (see above). In the EU altogether local
pension funds hold some Euro 2.300 billion in assets.
In most countries of Continental Europe, the issue of pension has been delt under the angle of
unfunded pension liabilities. Yet, unfunded pension liabilities might not be the main
drawback of the absence of pension funds in the largest Continental European countries. The
aspects of corporate governance and efficiency of the overall financial system might well be
much more consequential:
 A more liquid pension funds market would help integrate and enlarge the EU’s capital
 It would permit the development of a truly European investment banking business force.
 It would increase the compatibility of Europe’s corporate governance principles with the
  most generally spread model of governance, and therefore enhance European corporations’
  competitiveness in the global arena.

Practically speaking, the problem of developing significant pension funds in Europe in the
coming years raises two types of questions:
 in those countries where pension funds do not exist yet, or are little developed, the priority
  is clearly to change the mindsets which are currently impeding the creating of those
  powerful savings instititutions;
 for the various existing pension funds in Europe, harmonize regulations and tax regimes in
  order to permit cross-border workers moves in accordance with the principles of the single
  market, as well as to help create powerful pan-European insitutional investors competing
  with their US peers.

b - The financial impact of demographic imbalance
In November 2000 the EU finance ministers have reviewed an interim progress report
commissioned by March 2000’s European Union summit in Lisbon.
In the interim progress report the EU’s economic policy committee (EPC) warns that ageing
population could lead in most countries to an increase in pension expenditure of between 3
and 5 per cent of gross domestic product. In addition, a joint report of the EU Commission
and Council estimates ageing could boost spending on healthcare by about 3 percentage
According to a scenario based on current policies, the EPC’s progress report suggests that
 public pension expenditure in Spain could leap from 9.4% of GDP in 2000 to 17.7% in
 Spending in the Netherlands is projected to rise by 6.2 percentage points to a peak of
  14.1% of GDP in 2040.
 In Portugal outlays will peak in 2030 at 16 percent of GDP, up 6.2 percentage points from
 In “only a handful of member states” will spending pressures rise slightly before peaking.
 Italy’s already high outlays will increase by just 1.7 points to 15.9 per ceent of GDP by
 while in Sweden costs will peak at 10.7 per cent in 2030 compared with 9 per cent today.

Only in the UK will the share of GDP spent on public pensions fall - from 5.1 per cent in
2000 to 3.9 per cent in 2050.
The report also plots the future course of pension costs should the EU meet the Lisbon
summit targets of higher employment and productivity. The UK remains the only EU country
with a clear decline in costs as a share of GDP. Most EU countries would still face a heavy
pension burden even though outlays are projected to rise more slowly.
The EPC report urges member states to avoid adding to debt before the costs of ageing
populations starts to bite. But the joint Commission-Council document suggests countries are
paying no heed to such advice - though in 1993 Italy set a reform in favour of pension funds,
but in 1995 Italy also raised the retirement age for some workers in order to help the pay as
you go public and occupational systems. The same type of shift may be observed in Germany
where private individual insurance schemes contribute already by 10% to the overall
More generally, the pay as you go “complementary schemes” with tax advantages are a
problem in terms of competition fairness vis à vis insurance companies. The market oriented
European Commission would therefore prefer a system which would mix wellfare benefits
and pension funds. Warning that tougher budget policies may be needed, it reports “emerging
evidence of a pro-cyclical loosening of the budgetary stance” as the economies in most
member countries approach capacity working.
 A politically sensitive issue

There are significant political resistance to the extension of pension funds and pension
capitalism in countries such as France and Italy, were the workers’ unions have the most
Marxist oriented tradition and culture.
Such features coalesce with hefty proportions of state owned companies or public sector
workers - such again as Italy and France - which are the most reluctant to implement pension
The main arguments advanced by the opponents to the pension funds are:
 firstly, that the tax exemptions that pension funds contributions would be granted would
  necessarily be at the expense of the social security contributions for pay as you go systems
  and henceforth worsen their financial situation which, for demographic reasons, is already
 secondly that their is no positive impact of financial capital accumulation in pension funds
  on the macroeconomic capital accumulation. This argument lies simply on the denial of
  any mechanism refering to the supply-side economics with the paradoxical reference to
  such an “hyper-neoclassical” theorem as the Modigliani Miller “theorem”, which assesses
 that the debt/equity ratio of the corporations is of no importance to their competitiveness.
 Thirdly and furthermore, the opponents to the pension funds pretend to wonder why more
  savings would be necessary in European countries which are already scoring external
  current balances surpluses - that is to say, in Keynesian flows-analysis terms, an
  excedentary macroeconomic savings - as well as why - say the same opponents to pension
  capitalism - would it be necessary to stimulate the supply of labor through diminished
  social security contributions in countries which have mass unemployment ?

Actually, the main reluctance to pension funds lays in France where the government is
currently (in 2001) building a USD 130 billion reserve fund to make up shortfalls in social
security pay as you go pension schemes and has cancelled the previoulsy voted law (the 1993
“Loi Thomas”) creating pension funds.
 Cross-border pension schemes and taxation
Despite political resistance, one may expect that fiscal competition among European Union
member-states, free movements of capital in a pan-Europeanised financial system, added to
lobbying by the corporations and business community will in the end win against the
resistance of the unions.
The unions’ tactics seems to make pension a political issue for the European governments.
The future of pension systems has thus become an issue which should be discussed within a
political framework aiming to the harmonization of social regulations in Europe. At the same
time, the fragmentation of the EU’s pension system is in contradiction with the principle of
freedom of movement of workers within the EU: if a worker moves from a country where
contributions are taxed to a country where payouts are taxed it will face being taxed twice on
the same income. Some companies are reported to be considering test cases at the European
Court of Justice on this issue. However, from the governmental standpoint, not only the tax
reform is an embroiling debate in many EU countries such as France, but also making
contributions to private pension plans deductible would entail immediate losses of
government revenue while compensating revenue from taxing pension payouts would only
become substantial after many years.
Companies like BP and Ford have put pressure on governments to agree reforms that would
enable them to run cross-border pension schemes for all their workers in different EU
countries. They say this could save them up to Euro 40m a year in administration costs.
As an illustration of the links between the internal market and the tax aspcts of pensions, in
October 2000 the European Union’s internal market Commissioner has urged the German
government to change the way it intended to taxe private pensions in order to facilitate the
creation of a pan-European market for pension funds.The German government has thus been
asked to make private pension contributions deductible from taxable income and to collect tax
instead from pension payouts. In Germany until recently, as in some other EU countries,
private pension contributions had to be made from taxed income. This discourages people
from establishing their own retirement saving plans and makes harmonisation with other
countries, where contributions are deductible, difficult.
The EU Commission tabled a proposal to liberalise pension funds investments and enable
more funds to be sold across borders in the EU. However, it is difficult to achieve a single EU
market for private pension funds untill countries have not come up with more similar tax

 The dusk of “Rhineland capitalism” ?

The US households direct holdings in US stocks amounts to 43% of the overall US market
capitalization. Life-Insurance companies together with pension funds hold 29% of it and
mutual funds some 19%. Non-US investors holdings in the US stock market amount for a
little more than 8%. According to a survey by Morgan Stanley Dean Witter, Japanese
holdings of foreign financial assets amount to USD 1500 billion with 57% of them held by
financial institutions (insurance companies, pension funds, banks...). US financial assets
amount for approximately one third (34%) of Japan’s foreign portfolio when Continental
Europe counts for 32% and UK for 9%. The equivalent of USD 400 billion are held under the
form of euro-denominated assets and USD 450 billion under the form of USD-denominated
assets. This leaves much room for the expansion of the European households financial
holdings in European securities.
In Autumn 2000, the EU Commission made proposals to let Europe’s occupational pension
funds - those offered by unions, companies and professional organizations - which have about
USD 2 trillion in assets invest mostly in equities instead of low-yielding government bonds. If
the European Union adopts such a directive member-countries would have to let occupational
funds invest up to 70% of contributions in equities versus 35%, the limit that generally
prevails now.
Some analysts optimistically extrapolate the impact of such shifts to the equities markets with
figures toping to USD 1 trillion pouring in the continental equity market making it deeper and
more dynamic. Such a forecast may appear much over optimistic because of the reluctance of
many core countries (like France) to the risk and equity-based retirement plans à l’américaine.
A more careful analysis of the November 2000 German bill encouraging workers to put some
of their pay into private retirement funds leads to the conclusion that the shift will only
concern a slim share (0.5% in 2001 rising to 4% in 2008) compared with as much as 20% in
the US. Very little of that is likely to land in stock funds since the proposed law requires
pension managers to garantee retirees a stable or rising income for life, a rule which keeps
equity funds out because they cannot make such garantees contrarily to insurance companies
which invest mostly in bonds.

Even a certain slowness of the implementation of a US-like pension capitalism in Europe is to
be expected, the generalization in Europe of shareholder-value and other principles of
institutional capitalism is underway. This will involve a rethinking of cross-shareholding
between industry and financial institutions, especially - because of the so-called “Rhineland
Capitalism” - in Germany.
For example, German banks have to rethink their shareholdings in industrial companies in
order to avoid conflicts of interest and to unlock hidden reserves as this is the cheapest way to
expand their business. Such moves as spin offs of banks’ non-banks shareholdings in separate
corporate entities increase the transparency in the eyes of the shareholders and the capital
markets. It also makes it easier for the banks to re-allocate capital away from industrial
holdings - more generally from non-strategic holdings - and into strengthening their core
banking activities.

The old framework aimed at solving problems through international cooperative process in ad
hoc institutions like the United Nations Organization. Potentially, the need for a renovated
international framework opens the door for a resolution of conflicts outside the cooperative
logics set in place after World War İİ. This new context brings volatility and even uncertainty
into the global system of international relations. International business in the 21st Century
will take place within such a more volatile and uncertain background than the end of the 20th
Century. The management of risk will require more resources. Many initiatives will be
impeded as the costs of hedging and insurance will rise.

What makes the beginning of the 21st Century a particular moment in history ? After all don't
changes occur permanently ? The answer to this question lies in the fact that the World does
not change always in a smooth and regular way. There are times when the accumulation of
changes translate into a sudden dramatic change of situation although one by one these
changes seemed innocuous and were unnoticed. The beginning of the 21st Century is one
such time.

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