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Banking Effect Due to Technological Factors by cyw14948


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									Erosion of Barriers to Entry in the Banking Industry

Evidence from the Impact of the Emerging Financial Markets
on the Swiss Banking Structure 1850-1920

     Oxford Economics History Workshop
     5th June 2008

     Andreas Mattig
     University St. Gallen

1   Idea, Motivation and Central

Idea and Motivation

   „History Motivation“:
       Few is known about the banking and capital market in Switzerland. No doubt, the
        financial system„s most dynamic period was the post-WW II years, however the bank„s
        reputation in the war years had to be have its roots earlier…

   „Policy Motivation“:
       What happens to the banking industry structure under increased capital openness? We
        have a set of emerging economies, but the corresponding results are often strongly
        biased by local political, cultural or legal mechanisms. The analysis of non-regulated
        market data under similar conditions might be valuable

   „General industry structure and Theory Motivation“:
       Industry data is often not to easy to be handled and analyzed: Multicollinearity is a
        permanent issue and in today„s market efficiency is often too high to really measure
        structural shifts over time

Methodology and Data

   This is no empirical paper! The approach relies on inductive theory
    building and starts with a central argument as „quasi-hypothesis“. The
    methodology can be grouped into four stages:

    (1) We observed descriptive patterns and analyzed the existing data set

    (2) A model (Veloce-Zellner) was applied to describe the economics behind the patterns

    (3) The model was adjusted for the specific conditions and re-solved, resulting in a dominant
          role of the individual firm„s cost of liquidity for survival and growth dynamics in the
          emerging industry

    (4) The evidence was summarized in four propositions

   Data is derived from the Swiss National Bank, various state archives
    and a first descriptive approach by Ritzmann (1963)

Central Argument

   The Central Argument in this presentation is that

       the emergence of an international capital market in Switzerland came as some kind of an
        economic shock after the country was turned into a capital lender after producing and
        exporting surpluses for years

       the emergence of an international capital market in Switzerland lead to a re-valuation of
        asset prices

       the role of financial intermediaries changed from foreign agents and asset managers
        towards transformation of risks and maturities

       the value of bank liquidity was sharply increased during this process

       new entering banks won a sustainable comparative advantage over the incumbents
        within a short period of time

Evidence I

   In the absence of regulatory boundaries, the relative value of input
    factors are the crucial element in banking, allowing to build absolute
    cost advantages

   The critical element for banks is the price for liquidity, either to be
    funded by internal (equity or saving) or external (capital market)

   In the observed time period, saving stocks were initally low and capital
    demand high

   Pre-19th century banking was mostly an equity-story

   Access to capital markets and flexibility in balance sheet management
    prooved to be crititical for success and industry (re-) formation

Evidence II

   Incumbent banks generally have an advantage over new entrants
    (existing reputation, customer base, regulatory and technological
    barriers to entry)

   There is evidence that for all bank classes, this incumbent-advantage
    was replaced by a new-entrant advantage for the period of 1850-1870

   This evidence correlates with the initiation of external capital markets
    in Switzerland (first capital market financed banks and first stock

   When modelling the entry formally and controlling for regulatory
    barriers to entry (that is focussing on absolute cost of capital
    advantages, the relative cost of liquidity (not capital) for the bank
    remains as sole explanatory factor

Evidence III

   The critical role of the cost of liquidity is in line with general

       Capital Markets tend to be more liquid than internal conglomerate markets
       Excess Capital Supply due to „openness“ to small and foreign investors

   Increased demand for funds (growing middle-class and infrastructure)
    was more than met by available capital, thus affecting the „price“ of

   But: No evidence for inflation/ capital oversupply

       Hint towards increased productivity of capital as financial intermediation innovated from
        payment transaction and lend lending, towards maturity and risk transformation
       General (historic assumption: Harrod-Domar Model – like effect for development; i.e.
        Capital Increase, but argument for an instutional efficiency effect seems fair

„Summary of the Argument“

   “A bank holds only that much equity that is required to cover losses or
   draw backs likely with respect to counterparty and market risks. In an
   almost closed national banking system (such as the Swiss banking
   system in the observed period), the endogenous probability of cash
   withdrawal will be neglectable as the system is, adjusted for some cash
   hold in the individual households is closed (Jöhr 1940). Total liquidity is
   thus the individual bank‟s levels of liquidity at hand. In a cleared
   market (CLE equilibrium), it can be assumed that this level equals the
   amount of ri. ri prooved to be the critical variable for increased
   competitiveness of new entrants versus incumbents.”

Four Propositions:

   The relative price of liquidity deteriorated between 1980 and 1910
    compared to the decennials prior and after, unveiling a structural beak
    in the entry dynamic patterns in the banking industry

   Bank type specific cost of capital is affected directly depending on the
    relative elasticity between external markets and their own balance
    sheet structure

   The absolute cost of capital or cost of market entry deteriorated in
    such an environment for incumbents

   Banks with balance sheet structures open to external market
    instruments enjoyed higher growth rates

    Theory and Background

Switzerland in the 18th century

   French troops invaded Switzerland in 1798, broke the power of the
   ruling élites there and temporarily destroyed the cantonal system by
   creating the centralised Helvetic Republic.

   During the 18th/19th century, great advances were made in scientific
   agriculture. New industries got off the ground, including clockmaking
   and textiles.

   Napoleonic policies („embargo against UK“) allowed to build one of the
   leading textile industry and manufacturing centres on the continent by
   taking advantage of a protected (French market) and established

   The 19th century was a period of relative peace and prosperity, after
   the turmoils following the Napoleonic wars had ended

   Patriotic societies sprang up all over the country. They promoted Swiss
   national awareness, going beyond narrow cantonal/state boundaries
   what ultimately lead to a short civil war and the establishment of
   Switzerland (1848).
What determines Market Structures in Banking?

   Beyond Capital demand and suppy, banking generally refers to two
    strings of argumentation when observing changes in market structure
    in more detail:

   Endogenous Factors

   Exogenous Factors

What drives banking structures today? Endogenous

                              Demand-Side Aspects


 Technology Aspects                                             Risk Mgmt. Aspects
                                       Endogenous                              Meta
        Int. Systems                  Innovation in                            Risk
                                    Financial Services

    Value         Value                                           Volatility
   Creation     Recognition    Normative Issues


                                 Ethics          Compliance
What drives banking structures? Exogenous Arguments

                                                            Law and Regulation
            Macro Economic
                                       Innovation in
                                     Financial Services
                                                             Technological Advances

  Internationalization of Markets/
   Co-Movement in Asset Prices                    Market Structure/
    The Swiss Banking Market
        Landscape 1850

A shift in bank types and evidence for attribution of this shift
to the entry dynamics of „U“ and „L“

New entry dynamics (Equ.3):
Or: How much did the number/size of new entrants advance compared to the total market?

U, L and B grew due to improved re-financing cost structures (savings and capital markets

S and P as traditional banking forms before 1850 lost ground or grew below market average, whilst
at the same time displaying high volatility in their overal balance sheet size

Industry growth: Annual Growth rates of Banking Industry
Market Volatility: Annual Growth volatility of Banking Industry
Structural Breaks

   The key idea was to measure at what point in time a specific category/
    type of banks enjoyed what level of dynamics compared to its peers.

   Structural breaks are those decils wherein one bank type significiantly
    outperformed its peers in terms of growth rate of new entrants
    (market entry)

   And of growth rates of new entering firms compared to incumbent
    firms of the same bank type (new entry dynamics)

Focus on „Bodenbanken“

Focus on „Sparkassen“

Focus on „Universalbanken“

Focus on Lokalbanken

Balance Sheet Structure Shifts

                                Cross Section                               Cross Section
                                    1850                                        1900
                    B          G              L         S        B          G             L        S
Cash                 14.44%     0.00%         27.14%     0.00%    16.25%    11.30%       13.03%     7.66%
Wechsel              14.40%     0.00%         15.61%     0.00%    16.25%    11.14%       18.53%     6.86%
Credit               14.44%     0.00%          0.00%     0.00%    16.25%    12.45%       31.96%    12.68%
Mortgages            28.06%     0.00%         12.64%    92.51%    18.06%    42.06%       13.90%    53.40%
Assets               14.44%    83.33%          7.43%     0.00%    16.25%    11.43%        9.27%    11.34%
Other Assets         14.21%    16.67%         37.17%     7.49%    16.95%    11.63%       13.30%     8.06%
Total Asset         100.00%   100.00%        100.00%   100.00%   100.00%   100.00%      100.00%   100.00%

Money bills          18.16%     0.00%         25.44%     0.00%     4.72%     0.00%       16.24%     0.00%
Checks               16.14%     0.00%         11.61%     0.00%     5.00%     0.00%        8.18%     0.00%
Credit-Notes         10.76%     0.00%          0.00%     0.00%    33.76%     0.00%        0.00%     0.00%
Savings              24.98%     0.00%         18.34%    92.51%    23.56%     0.00%       18.34%    90.91%
Bonds                14.71%    83.33%          7.43%     0.00%    26.02%    97.29%       28.41%     0.00%
Equity               15.25%    16.67%         37.17%     7.49%     6.94%     2.71%       28.84%     9.09%
Total Liabilities   100.00%   100.00%        100.00%   100.00%   100.00%   100.00%      100.00%   100.00%

Problems, Implication, Future Research

   Data Quality and Availability
   Implications with respect to emerging capital markets and capital
    efficiency through institutionalization
   Institutionalization moves along fungibility
   Stronger Focus on Cummulative defaults statistics
   Comparative approaches with other country evidence

Alternative explanations

   An alternative explanation for the structural peculiarity could be seen
   in the banking crisis that hit especially English Commercial Bank
   between 1860-1913 (Baker, Collins 2002; Collins 1989). However, this
   explanation is less likely due to the limited direct exposure of Swiss
   banks (especially the regional banks) to the UK economy in these
   days. Other boundaries can be identified when referring to the so far
   only anectodical evidences. Here, limits can be seen as the observed
   above normal growth of universal banks might as well be attributed to
   their reluctance to participate in the money-issuance functions allowed
   under freebanking conditions. In this respect, Hickson and Turner
   (2004) showed that early joint-stock banking systems did not equally
   likely adopt free banking as local branch banking did. Especially these
   open alternative explanations lead the way to future research in the
   field. This could be addressed by more detailed modeling and further
   considerations on the interplay between the relative value of liquidity
   and the effects on banks – and here beside industry structure also on
   the effects on the valuation of the asset side of the balance sheet.

    Globalization of Financial
          Market‟s Impact

What can be learned from 19th century data for today„s
problem sets with respect to banking market structure?

   Problems and Logic of financial intermediation is constant over time
       Risk Transformation
       Maturity Transformation
       Liquidity/ Payment System

   But, data availability and industry business modells are not

   Data Sets on industrial level are extremely noisy

   Industry structure is shaped by conglomerates and intransparent
    pricing and accounting standards

   Nevertheless: 19th century as focus for analysis has advantages
       No regulatory impact
       Observable start of regulatory work
       Slower price/information transmission makes effects more visible over time

What can be learned with respect to the current era of

   Globalized markets are in many aspects comparable

       Increased Efficiency of Capital Utilization rather than capital oversupply
       Therefore institutionalized mechanisms needed
       Lack of fungibility/market liquidity ; control problems

        „Public Debt-to-Equity-Swap in UK as an often used explanation for the start of
        institutional markets applicable“

        „Evidence for foreign investments in 18/19th century only in markets under
        parliamentary control“

   No global regulation – Free banking Parallels?

   Industry Structures in Emerging Economies comparable in terms of
    capital intensity of textiles and the like?

Q&A / Discussion

The Free Banking Idea

The idea behind „free banking“ today is that the systemic costs is lower for self-organizing
institutions compared to external regulation, hence state regulation is not necessarily
Market control is excerted through default risk. The proponents of the theory argue that in
absence of a de-facto state guarantee for banks (as it exists today in virtually all mature
(i) risk aversion will be higher within banks
(ii) monitoring of counterparty risk by other banks will be more sincere
(iii) actual costs- and benefits of risk-taking will be more transparent (in asset prices of the
Money Markets Mechanisms

                     Interbankgeschäft (Geldmarkt im engern Sinn)
                      Geldanlagen              Geldmarktaufnahmen
   Notenbank          bei Banken                       von Banken          Notenbank

Unternehmungen        Geldmarktanlagen/           Geldmarkteinlagen     Unternehmungen
                      Geldmarktkredite             von Nichtbanken
Private Haushalte     Bankkredite                     Kundengelder      Private Haushalte
                      (Bankenkreditmarkt)     (Bankeneinlagenmarkt)
     Staat                                             Geldaufnahmen
                      am Kapitalmarkt                 am Kapitalmarkt
    Ausland                                                                 Ausland
                    Geldmarktpapiere / Geldmarktbuchforderungen
                      Kapitalmarktanlagen von Nichtbanken
                              (Aktien, Obligationen)

                          Andere Finanzintermediäre

                            Versicherungen, Pensionskassen

                                                                                            Source: M.Lüscher
Der Repomarkt:
Hauptnutzungsarten und wichtigste Marktakteure

Liquiditätsinduzie rtes Segment:
Repoverkäufer                                                          Repokäufer
(hält Wertpapiere, möchte Kasse                                        (hält Kasse, nimmt Sicherheiten in Form
                                                                       von Wertpapieren

  Hauptnutzung                                                      Hauptnutzung
                                             Liquide Mittel
  Kassenkredit zu günstigen Bedingungen                             Minderung des Adressenausfallrisikos
  Finanzierung von Wertpapier-Kaufpositionen                        Eigenkapitalentlastung
  Zugang zu kurzfristiger Liquidität.                               Diversifizierung

  Hauptakteure                                                      Hauptakteure
  Investmentbanken, Wertpapierhäuser                                Zentralbanken
  Geschäftsbanken                                                   Geschäftsbanken
  Unternehmen                                                       Unternehmen
Wertpapierinduziertes Segment:                  (in der Regel GC)
Repoverkäufer                                                         Repokäufer
(hält Wertpapiere, nimmt Kasse als Sicherheit                         (hält Kasse, möchte Wertpapiere
                                                                    Deckung für Wertpapier-Verkaufspositionen
  Finanzierung von Wertpapier-Kaufpositionen
                                                                    Einlieferung in Terminkontrakte
  Zusatzertrag aus Portfolio
                                                  Spezifische       Deckung für nicht zustande gekommene Abwicklung
                                                 Wertpapiere /
  Hauptakteure                                    „Specials“        Hauptakteure
  Investmentbanken, Wertpapierhäuser,                               Investmentbanken, Wertpapierhäuser
  Inhaber grosser Portfolios (Investmentfonds,

                                                  Liquide Mittel                               EZB - Monatsbericht - Oktober 2002
   The rise and fall of the Anglo-American wheat trade
   The story of the development of the early transatlantic trade, never previously
    told, makes for fascinating reading in its own right. Britain was a net exporter of
    wheat until the late eighteenth century, but even for these years a bad harvest
    meant that the American colonies were looked to in order to make up the
   The onset of the Industrial Revolution, however, combined with the associated
    population explosion, meant that domestic production was no longer sufficient.
    From this point on, the United States was considered an important source for
    wheat imports.
   The ultimate proof for eighteenth-century proto-globalisation is that prices of
    grain in the United States and Britain influenced each other. As far back as the
    1770s, when Britain became a net importer of wheat and large volumes started
    to be imported from the United States, there is evidence that prices on both sides
    of the Atlantic were moving together.
   A relaxation of the Corn Laws in 1773 ushered in a period of almost free trade in
    grain, and American wheat began to flood into British ports. But if globalisation
    might have started at this time, it was soon knocked off course – perhaps not so
    much by the American War of Independence, but rather by a plague of insects:
    the Hessian fly (so called because it was commonly supposed to have been
    introduced to the country in the straw bedding of the hated British Hessian
    mercenary troops).
   These insects devastated the American wheat crop, and it was many years until
    the wheat export trade began to recover. Even when it did, the Corn Laws turned
    protectionist again, and it was not until Prime Minister Robert Peel‟s famous
    ”repeal” in the 1840s, that the trade again resumed major importance.
18th century Economic Environment
   Eighteenth-century globalisation
   The evidence for the early importance of the transatlantic wheat trade comes
    from two sources.1 First, statistics survive for the wheat trade between the
    American colonies and the early years of the United States and Britain. These
    show the beginnings of intercontinental trade in a bulky product, which at the
    time was a leading component of consumption in Britain.
   Second, lending support to the trade statistics is primary evidence, ranging from
    presentations, to Parliamentary select committees to the correspondence of
    individual farmers, which all suggests that contemporaries were aware of the
    significance of this trade. Indeed, by 1800, the British Board of Trade wrote that
    „America be, or is hereafter to be the granary of Europe‟, a role which it only
    fulfilled at the end of the century.
   In fact, when the United States did finally emerge as the major supplier of wheat
    in the 1860s and 1870s, it appears that contemporaries considered this to be a
    new development, seemingly unaware of the events of the previous century.
    Their reason for this mirrors the belief that many hold today that globalisation is
    a modern phenomenon: the early growth in trade was continuously being
    knocked off course by „extraordinary‟ events, such as war, politics and even
    plagues of insects.
   Moreover, the trade was finally closed down altogether by the imposition of
    prohibitive new Corn Laws after the Napoleonic Wars in 1815. That observers had
    forgotten the importance of this trade after half a century is similar to
    commentators now often being unaware of the level of globalisation prior to the
    First World War.

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