Future of Banking in Europe

REINHARD H. SCHMIDT

THE FUTUREOF BANKING IN EUROPETHE

Reinhard H. Schmidt, Goethe-University in Frankfurt/Main,

[email protected]

This article is a revised version of a paper presented

at the 7th German-French Economic Forum, Paris, July 4, 2000.

The format of a lecture is maintained in the present text.

The author is grateful to Andreas Hackethal,

Marcel Tyrell, Falko Fecht, Christian Pfeil, Jan Krahnen,

Jean-Charles Rochet, Markus Rudolf and Markus Solf

for their comments.

1. Introduction

1.1 The General Problemof Economic Predictions

Any attempt to write a paper about the futurein general has to face the fact that its author isnot a clairvoyant. I simply do not know whatthe future of banking in general, and banking inEurope in particular, will be – and indeed,nobody can rightly claim to know this. Thefuture is uncertain, it unfolds as time goes by.One important source of uncertainty is innova-tion, which is inherently unpredictable. Butapart from the nature and effects of innova-tions, one can identify certain general classesof factors which will shape the future of bank-ing (in Europe) and which at the same timegive cause for uncertainty with regard to thisfuture.

It is useful to distinguish between two generalsources of uncertainty: Firstly, external factorsrelevant to the development of banking arelikely to change, and they may change in waysthat are surprising. Secondly, banks and theirmanagers as well as their competitors, regula-tors, policy makers and the clients of banks acton the basis of their expectations about thechanging external factors as well as about theconsequences which they expect others todraw from the changes which they anticipate.The actions and reactions of the “players” inthe banking world can be just as surprising asthe external factors.These two classes of determinants of the fu-ture, and causes of uncertainty, with respect tothe future are not independent of each other.Economic agents hold beliefs about the futureand have strong economic incentives to takethese expectations into account when they de-termine how to act and to react, even thoughthese beliefs may be quite vague. By acting andreacting as rationally as possible, the economicagents jointly create the future which they in-dividually try to anticipate. In the social andeconomic sphere, there is no future whichwould be independent of the expectations andthe actions of people.Thus an economic prediction of the future ofbanking in Europe or any other comparable is-sue can only be a speculation about possible

© Swiss Society for Financial Market Research (pp. 429–449)

FINANCIAL MARKETS AND PORTFOLIO MANAGEMENT / Volume 15, 2001 / Number 4 429

paths of development These possible paths are,however, constrained by the fact that agentsact in anticipation of, and in response to, ex-ternal developments, the strategies chosen byother economic agents, and their relevant be-liefs. In essence, economic evolution should beunderstood as an uncertain equilibrium pathover time. Thus simply extrapolating currentlyobservable trends would not be enough andmight indeed lead to inappropriate conclusions.The necessity of taking into account the inter-relationships between the object of a predictionand the expectations and actions of those whojointly shape this object is the essence of theconcept of a rational expectations equilib-rium.[1] Any attempt by an economist to pre-dict the future (of banking in Europe) must in-corporate at least an informal attempt to makeuse of this concept.However, the author of a paper like the pres-ent one should not take his inability to predictthe future of banking in Europe too seriously.As the concept of rational expectations sug-gests, he shares this inability with those whoshape this very future through their decisionsand actions within and outside of banks. It maytherefore even be helpful to put oneself in theirshoes.

1.2 The Focus of the Paper

There are many questions which one mightwant to ask concerning the future of banking inEurope. It would, of course, be impossible toaddress all of them here.[2] The choice of spe-cific questions to focus on is dictated by theresearch interests of its author. At least to methe most interesting question is whether theconsiderable differences between the financialand banking systems of EU member countrieswill remain or whether banking in Europe willconverge – either to a position located some-where between the present systems, or to asystem that is in effect modelled on the Anglo-

Saxon system.[3] I therefore want to focus onthe future of the typical features of banking inmuch of continental Europe. These peculiari-ties are, or at least have been until quite re-cently, the following:(1) Not strictly profit-oriented types of banks,

such as savings banks and financial co-operatives, play an important role.

(2) Relationship banking is the dominant or atleast the most characteristic model ofbanking.

(3) Universal banks are the prevailing type ofbanking organisations.

(4) The main function of banks is to act as in-termediaries between depositors or saversand borrowers.

(5) Financial systems are bank-dominated andnot capital market-dominated.

(6) Finally, there are considerable “structural”differences between the financial systemsof different countries in Europe.

Many competent observers in the academicworld and in the banking and business commu-nity seem to be convinced these days that fi-nancial and banking systems are likely tochange and also to become more similar in thenear future – both worldwide and particularlybetween European countries. Typically, theyexpect all financial systems to adapt to the An-glo-Saxon type of financial system, which iscapital market-dominated and in which banksstill play a role, but one that is different andmuch more limited than their traditional role incontinental Europe.[4] More specifically, theseobservers do not see much of a future for tra-ditional banking in the sense of financial inter-mediation; for relationship banking as thedominant model of banking; for non-profitbanking or more specifically, banks which arenot strictly profit-oriented; for the dominanceof banks in the respective financial systems;and finally for important “structural” differ-ences between national financial and bankingsystems.

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1.3 The Structure and Methodologyof the Paper

The attempt to shed some light on the questionwhether these expectations can be sustainedor, in other words, whether the six peculiari-ties of banking in Europe listed above arelikely to remain or to disappear soon, deter-mines the structure of the paper. Before em-barking on an attempt to predict the future ofbanking in (continental) Europe under the as-pect explained and the provisos mentionedabove, I take a brief look at the past and thepresent – or rather the quite recent past – ofthe financial systems of three major Europeaneconomies in order to provide a basis for com-parison. I will then discuss three sets of exter-nal or exogenous factors which most observerswould consider to be highly relevant to thefuture development of banking in Europe.These factors are

(1) deregulation and liberalisation,(2) dramatic advances in the field of informa-

tion technology (IT), and(3) the progressive economic and financial in-

tegration of Europe and the advent of theEuro.[5]

One of the main problems with predicting thefuture of banking in Europe consists in know-ing how these exogenous factors can be linkedto the “observable” specific characteristics of(continental) European financial and bankingsystems, which may or may not be likely topersist. As the opening paragraph tried tomake clear, there seems to be only one way ofestablishing a relationship between them. Itconsists in taking into account the fact that theway in which the development of the externalfactors influences the observable features ofthe European banking system or systems, de-pends on the strategies chosen by the economic

Figure 1: Structure of the Argument

Level A:ExogenousFactors

Level B:Firms’Decisionsand IndustryDevelopment

Level C:Conse-quences

Deregulationand

Liberalisation

Developmentof InformationTechnologies

European Monetaryand Financial

Integration

Strategies (andOrganisational

Structure) of Banks

Industrial Structureand Competition

in Banking

Importanceof Sav.+

Coop Banks

Relation-ship

Banking

UniversalBanking

Banks as

FinancialIntermediaries

BankDominance

Heterogeneityof Financial

Systems



agents, mainly the banks themselves. But bankstrategies are not the only “intermediary vari-able”.[6] In addition to bank strategies, the in-termediary variables also include the nature ofcompetition in the various segments of themarket for financial and banking services, andthe structure of the banking industry in the in-dividual countries and in Europe as a whole.Thus bank strategies, competition and bankingstructures serve as conceptual bridges on theway from external developments to an assess-ment of whether the main characteristics ofcontinental European banking systems arelikely to disappear or to remain.The approach taken in this paper is thereforeto outline an informal microeconomic frame-work or model, which is inspired by the con-cept of rational expectations, for the future ofcontinental European banking. Its structure issummarised in Figure 1. Besides being informaland incomplete, this model has some additionalweaknesses. Firstly, to a certain extent the in-termediary variables are themselves features ofbanking systems which are partially observable.Secondly, they are not independent of one an-other. Furthermore, the lists of external fac-tors, of intermediary variables and of observ-able attributes are incomplete; and last butcertainly not least, our knowledge of the linksbetween the elements is incomplete and highlyspeculative. Nevertheless, I hope that thisframework will serve the purpose of providinga conceptual structure for this paper and foranswering the questions addressed in it.

2. The Past and “Present”of Financial Systems in Europe

National banking systems are a part of nationalfinancial systems. They can only be under-stood properly if one takes this “embedded-ness” into account.[7] When we study the fi-nancial systems of Germany, France and theUnited Kingdom (UK) as they were 15 to 20

years ago, i.e. before the wave of deregulationand liberalisation of the mid 1980s, before thestart of European financial integration and be-fore the revolutionary advances in IT of thepast few years, and then look again at thesethree financial systems as they presented them-selves in the recent past – say two years ago[8]– then the following picture emerges.(1) In the early 1980s, the German financial

system was bank-dominated. Banks werevery important financial intermediaries,and intermediation was the main functionof the banking system. Business financingwas mainly provided by banks. Banks alsoplayed a strong role in the “insider-controlled” governance systems of thelarge German non-financial firms. Closerelationships between banks and theircustomers – or in the case of firms,“housebank relationships” – were a fact.Financial markets were relatively underde-veloped. Non-bank financial intermediariesand capital markets were strongly influ-enced by the banks. The German bankingsector was fragmented into different sub-sectors, and the market share of notstrictly profit-oriented banks was high. Thedominant, and certainly the most promi-nent, type of banking organisation was theintegrated universal bank. It would seemthat, contrary to the view conveyed in thepopular and financial press, these funda-mental characteristics of the German finan-cial and banking systems did not changeuntil very recently.[9]

(2) The British financial system was the polaropposite. It was capital market-dominated.Banks played a limited role in providinglong-term financing to firms. The typicalbank in the UK was much more specialisedthan its German counterpart; bank-customer relations were “at arm's length”.Bank concentration was higher, and thedegree to which the banks could rightly becalled universal banks was lower than in



Germany. As far as corporate governancesystems are concerned, the UK had an“outsider-controlled” system, and thebanks had hardly any role in it. The devel-opment of capital markets was already atthat time more advanced; and non-bank fi-nancial intermediaries (NBFIs) and capitalmarkets were much less dependent onbanks than in Germany. The different rolesof banks, NBFIs and capital markets, incomparison to Germany, are reflected indifferent levels of intermediation and dif-ferent patterns of corporate finance. Again,when we look at the data referring to thelate 1990s, we can recognise the samestructural features. Thus the British finan-cial and banking system has also notchanged fundamentally. [10]

(3) The case of France is more difficult, as itdoes not offer such a clear picture. At thebeginning of the 1980s, the French financialsystem was strongly dominated by state in-fluence, and banks dominated the financialsector; at least the large firms were “gen-erously” financed by banks which in turnwere refinanced by central public institu-tions, notably “le trésor”. Banking regula-tion was pervasive and oppressive, and ir-respective of their legal status and owner-ship structure, banks were mainly instru-ments of government policy. Financialmarkets were cloissonnés and unimportantfor all but the government; access to themwas very restricted. All this changed dras-tically in the following years. The bankshave lost their traditional burdens andprivileges – and they have in the meantimesuffered greatly from the consequences oflibéralisation, banalisation, marchéisationetc. If one looks at purely quantitativemeasures like bank-related intermediationratios and financing patterns, it seems thatFrance and its financial system have madea huge step from being “more German thanthe Germans” – or from having a strongly

bank-dominated system – to being “moreBritish than the British”. However, incontrast to British banks, which seem toknow well what their specific strengths areand can exploit these strengths, it appearsthat French banks have at least for a longtime been searching in vain for an orienta-tion and a profitable strategy in their newenvironment.[11]

The upshot of all of this is firstly that thesethree financial systems differed greatly at thebeginning of the 1980s, and they were stillvery different at the end of the 1990s. In factthere does not seem to have been much con-vergence on a fundamental or structural levelduring this time span, except perhaps for thecase of France. This must come as a surprise,as the convergence of regulation in Europe,advances in IT and financial integration fol-lowing the single market initiative have ledmany to expect that there would even be a“fundamental” convergence of the three sys-tems.[12]

3. An Attempt to Predict the Futureof Banking in Europe

As indicated in the introduction, I want to pre-sent a framework or an informal model of thefuture of banking in continental Europe. Thusin much of what follows, I exclude the UKbanking system from the set of empirical refer-ences, because it clearly represents a differenttype than those of continental Europe and onetowards which others might develop. Moreo-ver, there seems to be a considerable differ-ence between the development of the bankingsystems in the larger economies in continentalEurope on the one side and that of smalleconomies like Switzerland, the Netherlandsand Belgium on the other. Thus the followingdiscussion mainly refers to the larger conti-nental European economies.[13]



3.1 External Factors and their Impacton Bank Strategies and Competition

The Development of the Exogenous Factors

The exogenous factors and developments(level A in figure 1) which will probably con-tinue to have an indirect influence on the ob-servable peculiarities of banking in Europe(level C) and a direct influence on the strate-gies pursued by banks, on the nature of thecompetition in the market for banking servicesand on the structure of the banking industry(the intermediary variables at level B) areregulation, mainly deregulation and liberalisa-tion, but also reregulation; advances in IT; andeconomic, financial and monetary integrationin Europe.(1) Regulation: The dominant trend in the area

of banking and financial regulation hasbeen, and will continue to be in the future,that of deregulation and liberalisation. Inmost European countries banks are nowallowed a much freer choice of the waysthey conduct their business (conduct de-regulation), and they may now engage inlines of business which had previously beenbarred to them. At the same time, othersmay now enter fields of economic activitywhich had formerly been reserved forbanks (structural deregulation). Thus interms of what they do, the distinction be-tween banks and other financial serviceproviders has become blurred, and thisprocess is likely to continue. The degree towhich deregulation has taken place in re-cent years differs greatly from country tocountry, which mainly reflects differentdegrees of restrictive regulation at the be-ginning of this process after 1980. [14]But there is also a trend towards substi-tuting the old-fashioned conduct andstructural regulation by other forms ofregulation, notably capital requirements.These requirements are currently under

discussion, and it can be safely predictedthat they will change in the near futurewhen the “new capital adequacy frame-work” of the Basle Committee becomeseffective; European banks will certainly beaffected by this development which is dis-cussed under the heading of “Basel II”.However it seems that, as the discussionprocess about the new capital requirementregime continues and as new drafts of theproposed new regulation which take intoaccount the concerns of continental Euro-pean governments are forthcoming, theforeseeable effect of “Basel II” on nationalbanking structures in continental Europe isbecoming less and less obvious.

(2) Information technology: The incredible ad-vances in information technology and itsapplication in banking range from thecomputerisation of many back-office func-tions to ATMs and most recently to elec-tronic banking. One of the most importantIT-related developments is that it is nowtechnically feasible to have computerisedsecurities trading systems with almost un-limited remote access, which is having aprofound effect on the efficiency of or-ganised capital markets. As a result, capi-tal markets will become deeper, more liq-uid and thus ultimately more attractive.[15]This development has a historic parallel inthe invention of the railroad, which re-duced transportation costs, increased thesize of markets and completely changedthe structure of many industries.[16] How-ever, similar to the cautioning observationrelating to “Basel II”, it seems appropriateto add here that the impact of IT-relateddevelopments on banking business in gen-eral and banking structure and competitionin particular may be less strong than itseemed to be only a short time ago.[17]

(3) Financial and monetary integration: Par-tially as an immediate consequence of thepolitical decision of 1986 to create a single



market in Europe by the end of 1992, andpartially as a consequence of its imple-mentation, the complete mobility of capi-tal, people and banking and many other fi-nancial services within the European Unionbecame a reality in the early 1990s. Thegeneral model of financial integration inEurope is that of the “single passport”.This concept combines minimum harmoni-sation, mutual recognition and homecountry control for banks and other im-portant groups of financial service provid-ers. The process of financial integrationhas gone a long way, but it is still notcomplete. By eliminating the exchange raterisk within the Euro zone, the recent intro-duction of the Euro as a common currencyin most member countries of the EU hasgiven this process an additional push.[18]

Implications for Bank Strategies

The term “strategy” refers to the way in whicha firm tries to establish and maintain competi-tive advantage. It includes many aspects, suchas the determination of markets or fields ofactivity in which a given firm operates, itsmarket entry and exit decisions, pricing, prod-uct design and organisational design. Strate-gies are a reflection of external factors and ofthe competitive situation in the industry underconsideration. Competition is itself the out-come of the strategies which the market par-ticipants choose and implement. Thus strate-gies and competition determine each othermutually and are jointly determined by externalfactors.In what follows, the likely implications of theaforementioned external factors for the strate-gies of banks and their main competitors willbe briefly sketched. A certain overlap and,moreover, an interaction between the effectswhich the three external factors have on bankcompetition are unavoidable. In the next sub-

section, the arguments pertaining to competi-tion are briefly summarised.

(1) Effects of (de-)regulationon bank strategies(a) Banks in many countries will widen the

scope of products which they supply, whilebank products are now, and will probablybe to a greater extent in the future, alsooffered by non-bank financial intermediar-ies. Therefore banks will face stiffer com-petition in the future. This will put– cost-containment– the entry into, and exit from, specific

market segments, and– alliances, acquisitions and mergerson the strategic agenda of all banks. Cost-containment appears possible in principleby exploiting economies of scale throughinternal growth and external growth viaacquisitions and mergers, and by reducingbranch networks, which is often a motivefor horizontal mergers within countries.Market entry and exit strategies manifestthemselves for instance in the attempt toleave the field of retail banking, which isconsidered to be unprofitable in somecountries, and to enter specific areas in thebroad field of investment banking.

(b) The traditional forms of bundling togetherdifferent banking products, of followingintegrated pricing strategies and cross-selling and cross-subsidising, which hasbeen one of the pillars of universal bankingand also of relationship banking in thepast, may become less attractive or evenno longer feasible as a consequence of thenew forms of competition from market en-trants and the increasing intensity of com-petition.

(c) Strategies in the credit business are likelyto change as a consequence of the newcapital adequacy regulation. At least in theearly stages of the process of developing



new capital adequacy rules it was assumedthat the new regulation would mainlybenefit large borrowers with external rat-ings and big or network-affiliated lendersthat possess sophisticated internal ratingand risk management systems, or can moreeasily bear the cost of setting them up. It islikely that some strictly profit-orientedbanks, and particularly small profit-oriented banks, will withdraw altogetherfrom lending to small and medium-sizedbusinesses and non-rated firms. This opensup new opportunities for savings banksand co-operative banks, which are typicallyaffiliated to networks and can thereforeshare the set-up costs of rating and riskmanagement systems. Thus in the futurebanks will differ much more than duringthe past two decades with respect to howmuch, in which forms and to whom theylend.

(d) Although deregulation and liberalisationmake mergers and acquisitions easierwithin countries and also across borders,strategies of external growth will differgreatly between banks which focus on re-tail banking and those which are mainly in-volved in investment banking.

All in all, de- and reregulation offer opportu-nities to gain competitive advantage by adopt-ing differentiating strategies.[19] A one-size-fits-all approach, which seems to have domi-nated bank strategies in past decades andwhose adoption may have been inspired bycertain notions of “best practice”, does notseem advisable for the future and will probablynot shape the emerging new banking scene inEurope.

(2) Effects of information technologyon bank strategiesThe overall effects of IT-related advances aretwofold: IT reduces the costs of providing

banking services in general; and it changes thecost structure in such a way that fixed costsincrease while variable costs decline sharply.These effects apply to banks, to non-bank fi-nancial intermediaries and to securities mar-kets, though probably not with equal force.Banks should take these effects into account intheir strategies; and the greater flexibility theynow have as a consequence of recent deregu-lation makes it more likely that these effectsare indeed incorporated into the strategies ofbanks in the future.(a) The most dramatic effects of IT are proba-

bly those on the internal processes andstructures of banks. An obvious example isthe opportunity to reduce costs by install-ing ATMs and concentrating and relocat-ing back-office functions. IT also changesthe balance between the centralisation andthe decentralisation of decision-makingauthority. Decentralised decision makingcombined with centralised monitoring andperformance measurement has becomemuch easier in recent years; and the fullimplications of this trend are yet to beseen. Banks which make full use of thepotential to reduce costs and to increaseflexibility are more competitive. As thisapplies to all or most banks, there will bemore competition, to which banks willhave to react by lowering their costs. Thiscan be done by reducing staff and increas-ing flexibility via decentralising the organi-sations and trimming administrative hierar-chies.

(b) Although econometric research suggeststhat economies of scale or the benefits ofsheer size are limited in banking in generaland commercial banking in particular[20],one can nevertheless expect that IT-relateddevelopments increase the minimum effi-cient firm size in the banking industry andtherefore encourage mergers in retailbanking. Most of all, domestic mergers andacquisitions appear to be a way of reduc-


436 FINANCIAL MARKETS AND PORTFOLIO MANAGEMENT / Volume 15, 2001 / Number 4

ing superfluous retail capacity. In spite ofthe failure of the recent attempted mergersbetween BNP and Societé Générale inFrance and between Deutsche Bank andDresdner Bank and Dresdner Bank andCommerzbank in Germany, there are nu-merous examples of large bank mergerswhich have been successfully completedrecently. Almost all of these have takenplace within national borders, while crossborder mergers of commercial banks areextremely rare.[21] This suggests that theirmain motive may indeed have been to cutcosts. The potential for closing costlybranches would be limited in the case of amerger between Deutsche Bank and So-cieté Générale.

(c) IT is changing the balance between banks,NBFIs and capital markets, i.e. banks havetended to lose ground to their competitors.Especially as far as lending to big corpo-rations is concerned, capital markets havefor quite some time been cutting into thetraditional business of banks. At least forcertain types of borrowers, disintermedia-tion seems to be a reality.[22] Many banksare in fact reacting to this presumed trendby shifting their focus to fee-earning andinvestment-related services. Germany'sbiggest bank, the Deutsche Bank, is a goodexample for this strategic move. The ad-vances which NBFIs have made during thelast decade in the area of savings mobilisa-tion, which represent a second type ofdisintermediation, are also largely due tothe fact that, in the era of the Internet,branch networks seem to become less im-portant for providing financial servicesthan they used to be.

(d) Given that IT seems to benefit capital mar-kets at the expense of financial interme-diation, banks can react strategically bygiving up territory they cannot defendanyway, such as lending to multinationals,or by withdrawing from retail banking, or

by becoming allies and handsomely re-warded servants of the winning competi-tor, i.e. the capital market, providingcapital market-related services. But thereare still fields of activity in which banksretain a competitive and genuinely strate-gic advantage. These are quite traditionalbanking functions such as providing li-quidity insurance, lending in difficult-to-monitor cases and providing all-round ad-vice and services. For offering these serv-ices and for serving the clients who needthem and are willing to pay for them, espe-cially small and medium-sized firms, thetraditional approach of relationship bank-ing – possibly also provided in the tradi-tional organisational form of a universalbank – seems very well suited.[23] Banksshould, and successful banks will, be ableto benefit from this strength. Furthermore,better communication technology makes iteasier for banks to provide this compre-hensive set of services to far-away clients.Thus it appears inappropriate to predictthat the advent of IT leads to a complete“breaking up (of) the bank”[24] or, moreprecisely, of the value chains whose com-bination under one roof has been the hall-mark of the traditional bank.

(3) Effects of economic, financialand monetary integration on bank strategiesAmong managers of large banks and some oftheir professional advisers, there seems to be awidespread conviction that – in addition to thegeneral trend towards globalisation – the “sin-gle market programme”, and much more so theintroduction of the Euro, have indeed alreadyled, or will soon lead, to the emergence of onesingle market, in which rivalry between exist-ing banks is so fierce that only the strongestcompetitors can survive. As strength is oftenassumed to come mainly from size, all one hasto do in order to survive is to consolidate ei-ther actively or passively, that is, to acquire or



to be acquired or to merge. At least in its gen-erality, this prediction is not warranted. Thereis a need to differentiate between commercialand retail banking on the one side, and invest-ment and wholesale banking on the other. Thestrategic implications of financial and monetaryintegration are different for these differentlines of business. The fact that in continentalEurope these different markets have typicallynot been served by different groups of banksmakes it a delicate task to draw practical con-clusions from this general insight.[25](a) We do not see much evidence of foreign

banks' entering the retail markets of othercountries through geographical expansionor cross-border mergers and acquisitions.Retail banking, which makes up the largerpart of commercial banking, is a local andat best regional industry, and it is likely toremain so in spite of the Euro. Economiesof scale are probably not easy to achievein this industry, and if they are achiev-able, then mainly through cost reductionby eliminating branches, which is onlyfeasible within countries. Thus cross-border consolidation is not a source of in-creased competition in retail commercialbanking.

(b) However, increased competition for com-mercial banks results from the benefitswhich financial and monetary integration inEurope offers for capital markets. This is astrategic threat to commercial banks, or tothe commercial banking divisions of uni-versal banks, as corporations are now in abetter position to fund themselves throughcapital markets. The corporate bond mar-ket in Europe has seen a virtual explosionsince the introduction of the Euro. Stockmarket activity has also increased consid-erably. The growing importance of securi-ties markets may reduce the demand forbank loans by – a less narrowly definedgroup of – large corporations, and cer-tainly makes a strategic shift of banks to-

wards investment and wholesale bankingattractive.[26]

(c) An additional push in this direction comesfrom the fact that European integrationstimulates mergers of non-financial firms.Banks will try to benefit from this businessopportunity. Investment banking is to be apan-European and in many segments evena global industry in which only “big play-ers” can compete successfully. Some ofthese are American investment banks. At-tempts to match their size and prowess willlead to additional mergers and acquisitionsamong European banks with a strong in-vestment banking orientation and even theemergence of a “league” of big Europeaninvestment-oriented banks. This trend islikely to find some support from nationalgovernments who want their “nationalchampions” to be part of this “champions’league”.

(d) The increasing importance of investmentand wholesale banking poses a strategicchallenge to most banks in Europe. In thepast, most European banks were essen-tially commercial banks. Now this situationis changing. At least in some banks, in-vestment banking can no longer be treatedas a useful addition to the main business,i.e. commercial banking. These banks facethe difficulty that commercial (and retail)banking on the one side, and investment(and wholesale) banking on the other siderequire vastly different organisational de-signs. For instance, optimal pay structuresand career paths are different for these twotypes of banks. Thus European integrationchallenges, indirectly at least, the conven-tional concept of a universal bank.[27]Banks will have to decide to what extentthey want to be “real” investment banksand how they adjust the rest of their busi-ness to this decision. As a consequence weare likely to see more specialisation ofEuropean banks in the future.



(e) The deepening of European stock markets,to a large extent caused by financial inte-gration in Europe, also leads to growingpressure on privately owned and publiclyheld banks to create value for their share-holders and to improve their financialperformance. One can speculate that thepressure to create shareholder value mightprevent some banks from undertakingmergers and acquisitions which wouldmainly increase the prestige and power ofthe top management of the respectivebanks.

(f) Financial integration should make cross-border mergers and acquisitions in thebanking industry easier in principle, andthere are at least certain advantages to astrategy which entails elements of a pan-European expansion. Nevertheless, cross-border M&A activity in Europe has beenvery limited in recent years. One reason forthis seems to be that the banking industryis shaped by national cultures and nationalidiosyncrasies. It seems highly unlikely thata “merger of equals” between two bigbanks from different European countrieswould “work”. The same can be expectedfor straight takeovers. Alliances and otherforms of co-operation might be more ac-ceptable to the people who create value inthe banks. However, their success isstrongly dependent on the partners' will-ingness and lasting ability to respect theother partners' interests. Given the pres-sures under which they find themselvesnow, big privately owned and publiclytraded banks and their top managers maynot find that easy, and are therefore notlikely to restrain their desire to dominatetheir foreign partners.[28] In this respect,not strictly profit-oriented banks might bein a better position; they may appear to be,and indeed may really be, more reliablepartners in pan-European alliances.

In summing up, one can say that the effects offinancial and monetary integration are differentfor mainly retail-oriented commercial banksthan for more wholesale-oriented banks or forprimarily investment banks. We are not likelyto see a fully integrated European bankingmarket except for wholesale (and) investmentbanking.[29]

Implications for Competition

In the last subsection, three external factorswere discussed at some length in an attempt todescribe their isolated impact on the strategiesof banks. Obviously, though, the three exoge-nous, or external, factors are interdependent intheir influence on bank strategies. Therefore, alogical next step would be to analyse howthese factors interact in shaping bank strate-gies. At the moment there does not seem to beenough theoretical and empirical research evi-dence to permit more than the “informedguess” that the three factors tend to reinforceeach other in terms of what they imply forbank strategies.One implication of the three external factorsand their interaction is that we can expectcompetition in banking to intensify in the nearfuture as a general tendency. Competition be-tween existing competitors is likely to becomestronger, mainly because of the effects of ITon the cost structures of banks. The efforts ofbanks to spread their higher fixed costs over alarger volume of business will induce them tocompete for market shares, and this typicallyleads to a general pressure on bank profitabil-ity. Non-banks and near-banks and organisedcapital markets are likely to enter marketswhich were formerly reserved for banks of agiven country. Market entry of various typesof new competitors from other countries hasnow become at least a realistic possibility.The strategic implications of this for an indi-vidual bank are very specific to the situation of



the bank. All one can say on a general level isthat each bank must react to the increasingcompetitive pressure by selecting very care-fully the fields of activity in which it wants tobe involved in the future, and then by adaptingall of its internal processes and structures tothe requirements of the market segment orsegments in which it wants to compete. Thesesegments can be defined by type of serviceprovided, by type of client, and by geographicscope. Given that, obviously, not all banks willselect similar strategies, we are likely to seemore specialisation of banks in the future.Some will become mainly investment banks,some will remain mainly commercial banks;some will have a local or regional focus, whileothers will have a broader geographic out-reach. Clearly, the strategic selection of prod-uct focus, client focus and geographical scopehas to take into account that some combina-tions are less attractive than others. It wouldbe nice to be able to make general statementsconcerning the nature of competition in thecommercial banking and the investment bank-ing segments. But this is not possible; for sucha statement, the broad categories of commer-cial and investment banking would have to bebroken down into much smaller segments.There is a counterforce to the trend of in-creasing competitive pressure. The strategicreaction of individual banks to the increasedcompetition can be twofold. Banks can try togain a competitive advantage by growth, in-cluding mergers and acquisitions, in order toexploit economies of scale; or alternativelythey can specialise in certain market segments.Given that economies of scale are difficult toachieve and that cross-border mergers and ac-quisitions may be very difficult to negotiate,and even more difficult to implement success-fully, the specialisation alternative would seemto have a lot in its favour. If many banks de-cide to specialise more in the future, this willreduce the number of competitors in mostmarket segments; and to the extent that com-

petitive pressure is a function of the number ofmarket participants, the widespread adoptionof strategies emphasising specialisation couldcounter the competition-increasing forceslisted above. However, in banking the relation-ship between the number of competitors andthe intensity of competition is ambiguous. It istherefore impossible to state categorically thatthe intensity of competition will generally in-crease in the future. Nevertheless, as a generaltendency this appears highly likely.Even though I have not been able to provide adetailed analysis of the competition in the vari-ous parts of the market for banking services, itseems to me that the considerations about bankstrategies presented above are not inconsistentwith the sketch in this subsection: the strategicimplications of the external factors do not needto be rewritten when one takes into accountthat the strategies of banks must also be afunction of the prevailing and expected com-petitive situation, which is itself an outgrowthof the strategies adopted by the banks.

3.2 The Developmentof Banking Structure(s) in Europe

There will be a process of consolidation inEuropean banking. The number of banks willgo down. Some banks will be unable to adaptand therefore be bought or merge or simplydisappear. Whether this also implies a higherlevel of concentration depends on the specificmarket segment and the extent of new marketentry into this segment.

The Future of Different Segmentsof the Banking Market

(1) Commercial and retail bankingIt seems safe to expect that, mainly as a conse-quence of IT and of the declining importanceof traditional lending to corporations, concen-



tration in national retail markets will go up.But it is unclear how far this process of con-solidation and concentration will go. Nationalpeculiarities are strong in this area. It is hardto measure and to compare concentration lev-els between countries because of the differentroles of the network-affiliated savings and co-operative banks in different countries. Notleast because of these networks, which are tra-ditionally important in Europe, the patterns ofconsolidation and concentration will differgreatly between countries. As explained above,large privately owned listed banks with a clearinternational focus might decide to leave theretail market. The example of Deutsche Bankand Dresdner Bank, at least as was said at thetime when these two institutions considered tomerge, supports this proposition. But big Brit-ish banks are moving in precisely the oppositedirection. Smaller privately owned banks canbe expected to reduce their lending activity oreven to give it up completely. Many of themhave already taken this step.As market entry by foreign banks is relativelyunlikely in the retail market, the commercialand retail banking markets of the individualcountries will in the future still be relativelyclosed to foreign market entrants and moreconcentrated than in the past. They will bedominated by a small group of banks or banknetworks. Even though banks which are notstrictly profit-oriented may be successful inbuilding up transnational pan-European net-works, the European market for retail bankingwill remain a patchwork of national markets.

(2) Investment bankingIn several subcategories of investment banking,international focus and size are important, be-cause size helps to attract high-calibre staffand to establish and use reputation. Both ofthese arguments also suggest that it is attrac-tive for an investment banking firm to coverseveral areas in which valuable human capitaland reputational capital can be used. As far as

the relationship with customers is concerned,national borders are relatively unimportant formost parts of the investment banking business.We will therefore see an increasing trend to-wards concentration and consolidation in theinvestment banking industry on a Europeanlevel. For reasons which are internal to thebanking organisations it appears plausible thatthose European banks which will be successfulin this market will still retain a distinct nationalidentity. As the number of truly big banks inEurope (with a national flavour) is probablynot great we might see the market dominatedby one or two big financial institutions fromeach country. However some highly specialisedsmall “boutiques” with a good reputation willbe able to defend their positions.

The Future of Different Types of Banks

(1) Big banksOne of the interesting questions about a newbanking structure is which role the really bignational banks will play in the future. Today,most of them are national universal banks pro-viding a large array of services to many groupsof clients. In the past, some of them seem tohave envisaged playing a similar role in severalcountries, that is, becoming truly Europeanuniversal banks. But this now seems to beneither achievable nor attractive.[30] The costsof internal growth would simply be too higheven for the largest banks; external growthseems very difficult because national bankingcultures differ too much, and the benefits ofbeing present in all market segments do notseem sufficiently great. So what we can expectto see is a number of big national banks whichwill remain universal banks in their homecountries and at the same time pursue selectivestrategies in other countries, such as concen-trating on specific businesses or specific typesof client. Their number will probably decreasefurther as a consequence of domestic mergers.



(2) Not strictly profit-oriented banksCo-operative and savings banks have in thepast played an important role in many Euro-pean banking systems. It is therefore natural toask whether they will be able to maintain theirpositions in a future European banking sys-tem.[31] The prospects appear good for variousreasons. One is that at least in some countriesthe big privately owned commercial banks areretreating from the domain in which the co-operative and savings banks have their strong-est position, namely the local and regional re-tail market.The typical business clients of co-operativeand savings banks are not likely to migrate tothe capital markets. The networks to whichthese banks belong provide a balanced mixtureof scale and flexibility and enable them to de-fend their traditional turf without having toforgo the opportunities which the recent de-velopments of deregulation, IT and financialintegration might offer them. They might evenbe particularly well placed to benefit from theoption of financial integration. As was ex-plained above, their tradition of being part ofnetworks or federations and the limited per-formance pressure to which they are ex-posed because of their specific ownership andgovernance structures may make them moretrustworthy partners in pan-European alliancesthan big, acquisition-hungry strictly profit-oriented banks. However, whether the co-operative and savings banks can exploit thispotential is open to question because of theirunclear and, at least in the view of some ob-servers, deficient ownership and governancesystems. Moreover there is at least a possibilitythat the European Commission will break upthe governmental support and ownership ofthese institutions. It is too early to say whatthis would imply for the savings banks; the an-swer will largely depend on the strategies cho-sen by the big banks. If the latter withdrawfrom the retail market, as some big Germanbanks seem to be contemplating, then the

prospects for semi-privatised savings bankscould remain good.

4. Is Banking in Europe Likely to Retainits Specific Features in the Future?

In the introduction, six features were listedwhich are at least to a certain extent specific tothe banking and financial systems of continen-tal Europe. As was said there, many competentobservers claim that in the process of moderni-sation and integration, these features might belost and that, moreover, the banking and finan-cial systems in continental Europe are likely toconverge to the Anglo-Saxon type of a finan-cial and banking system.The question which this paper addresses iswhether these expectations are correct. In thisfinal section, an answer is sketched. The re-sults of the preceding analysis will prove usefulfor this undertaking. However, they are cer-tainly not sufficient and must be combined withadditional considerations. It also should not beforgotten that history plays an important rolein shaping economic phenomena such as bank-ing systems.

(1) The important role playedby not strictly profit-oriented types of banksIn the past and at present savings banks andco-operative banks play an important role inthe banking systems of many European coun-tries, and they clearly differ from other banks.The analysis presented above shows that co-operative and savings banks are not likely tobe eliminated by mere market pressures forvarious reasons. Their specific feature of notbeing strictly profit-oriented even has someadvantages in the new environment. They canbenefit from the retreat of other banks fromthe segment of retail banking; and they couldgenerate successful pan-European alliances inthe future. This assessment can be supportedby empirical evidence which shows that these



banks have survived the recent turmoil in fi-nancial markets better than many privatebanks. There are theoretical considerationswhich would have led to predictions that thiswould be the case.[32]

(2) Relationship bankingas the dominant mode of bankingRelationship banking will remain an importantfeature of banking in Europe. But it is ques-tionable whether it will remain the dominantmodel for all companies. Big and even not-so-big corporations have begun to use capitalmarkets to a much larger extent than they usedto, and many banks have shifted to investmentbanking. In this context, the scope for relation-ship banking is limited. Relationship bankingwill remain important or even increase its im-portance for small and medium-sized firms andthus also for the savings and co-operativebanks which will specialise, to an even greaterextent than they have in the past, in servingthese clients if, or because, private banks turnaway from them.[33]

(3) Universal banks as the prevailing typeof banking organisationsIn the past, the term universal bank was usedin a broad sense to designate a bank whichprovides all kinds of banking services to allkinds of clients. Universal banks in this sensemay continue to exist, but they will certainlyno longer be the prevailing form of banks evenwithin national banking systems. The need tospecialise is so great that banks will not wantto remain universal banks in this broad sense.A fortiori, we will not have universal banks ofthis type covering several European countries.However, one can also speak of universalbanks in the sense of banks which providemany services to specific groups of clients.Universal banks in this narrower sense are hereto stay and may even gain in importance incatering for specific, but economically im-portant, groups of clients such as small and

medium-sized firms. They are the appropriateorganisational form for relationship bank-ing.[34]

(4) The important role playedby traditional banking andbank-based financial intermediationFinancial intermediation, i.e. the combinationof deposit mobilisation and lending, was oncethe essence of banking. The decline of financialintermediation in general and by banks in par-ticular has been predicted for quite some time.Recent empirical research indicates that thisprediction was wrong at least until the late1990s and as far as the entire financial systemof a country is concerned.[35] Bank interme-diation ratios have remained stable in manylarge industrial countries, notably Germany andthe UK. However, this might well havechanged recently. The growth of securitiesmarket activity in the years 1999 and 2000points in this direction; and some banks, inparticular some big private banks, are eager toreact to this situation by curtailing their in-volvement in traditional banking operations.But I do not expect this to be a general andlasting tendency.[36]

(5) The dominance of banks,as opposed to capital markets,in the respective national financial systemsThe importance of banks relative to capitalmarkets will decline in the future. However,this does not imply that the financial systemsof continental European countries will soonchange their general character and becomecapital market-dominated. Whether a financialsystem can be considered bank- or capital mar-ket-dominated depends on many more aspectsthan merely the level of capital market activity.I do not have the space to describe the otheraspects here, but if I did, my description wouldnot support the proposition that the financialsystems of continental Europe are on their wayto becoming capital market-dominated. In spite



of all the changes, banks seem able to maintaintheir strategic position in a financial system ifthis position has traditionally been strong.[37]Bank dominance might however disappear incountries like France, in which the formerlystrong, or even dominant, role of banks wasmainly a consequence of regulation and gov-ernment policy.

(6) Considerable differences betweenthe financial systems of different countriesEven though the banking system in Europe willremain fragmented along national lines to acertain extent, banking markets and evencapital markets are in the process of becomingmore and more integrated. However, this alonewill not eliminate the profound or “structural”differences which still exist between some fi-nancial systems in Europe. A financial systemis a configuration of several elements whichcomplement each other. This feature makescoherent financial systems resistant to “struc-tural” change and thus also to forces whichcould be assumed to lead to a gradual conver-gence. Increasing similarity with respect to oneor a few elements is not sufficient to changethe fundamental structure of a given financialsystem and therefore does not lead to a con-vergence of entire financial systems. However,it is an open question whether the recent andthe foreseeable developments mainly in theyears 1999 and 2000, the era of the stock mar-ket rally and the new issues wave in manyEuropean countries including Germany, areimportant enough to undermine the coherenceof the individual financial systems in Europeand thereby destabilise them, and whether theywill converge after having been “sufficientlydestabilised”.[38]



FOOTNOTES[1] See GROSSMAN (1981). It should be kept in

mind that this concept of rational expectationsneither has to assume the unlimited rationalityof all agents, nor does it abstract from uncer-tainty.

[2] For a different selection of aspects of the samegeneral theme see the book by DANTHINE etal. (1999).

[3] Relevant recent work concerning this issue issummarised in SCHMIDT et al. (2002).

[4] See RAJAN/ZINGALES (1999) and, with a moremoderate position, DANTHINE et al. (1999) andDANTHINE et al. (2000) as important sourcesfrom the academic world. One source from thebanking community, though certainly a very sig-nificant and influential one, is Rolf-E. BREUER,the CEO of Deutsche Bank. Over the years,Mr. BREUER has regularly made statements tothe effect that a convergence to the Anglo-Saxon type of a financial system is to be ex-pected. See also the collection of interviewswith chief operators within the banking industryin ENGLER/ESSINGER (2000). An article byDavid ROCHE (2000) entitled “The 'Global'World is Anglo-Saxon” in the Wallstreet JournalEurope perfectly summarises this view and in-dicates how wide-spread it is. The opposingview that there will be a convergence towardsa position which incorporates “the best fea-tures” of the Anglo-Saxon and the German fi-nancial systems can be found in OECD (1995,p. 119).

[5] References to the relevant literature will be pro-vided in section III.1 below

[6] The term “intermediary variable” may be unfa-miliar to some readers. It corresponds to theterm “intervening variable” used in the psycho-logical literature to designate unobservableelements (such as perception or cognition)which create a (causal) link between observableinputs (stimulus) and outputs (behaviour).

[7] The concept of “embeddedness” goes back toGRANOVETTER (1985), a theoretical sociolo-gist, and plays an important role in many aca-

demic discussions of all kinds of social sys-tems.

[8] Limiting the considerations in this paper to thequite recent past – instead of “the present” – ismotivated by the concern that the developmentsof the last two years are too complex to permitan assessment at present. This concern will betaken up again in the concluding section.

[9] Surprising as it may seem, there do not existmore than a few English-language sources onthe German financial system. The best-knownsource addressing the financial system as awhole is still EDWARDS/FISCHER (1994).Many individual elements of the German finan-cial system are covered extensively in OBST/HINTNER (2000). For the proposition that thegeneral character of the German financial sys-tem has not changed substantially in the pasttwo decades, see the reference in note 3 supraand the articles summarised there.

[10] Among the best references covering the Britishfinancial system are BUCKLE/THOMPSON(1998) and BAIN (1992).

[11] On the transformation of the French financialsystem in general see BERTERO (1994),FAUGÈRE/VOISIN (1994) and ZERAH (1993),and specifically on the change of the bankingsystem PLIHON (1999).

[12] See SCHMIDT et al. (2002) for details.[13] It would in fact be a worthwhile undertaking to

investigate why there seems to be this differ-ence between the financial systems of large andsmall countries; but this topic is beyond thescope of the present paper.

[14] One of the best sources on the impact of de-regulation on banking in various Europeancountries is GUAL/NEVEN (1993); see alsoGUAL (1999) and ENGLER/ESSINGER (2000).

[15] See BIAIS (1999) and SEIFERT et al. (2000).[16] See MERTON (1995), MISHKIN/STRAHAN

(1999) and again the interviews in ENG-LER/ESSINGER (2000) on the impact of IT onbanking and finance.

[17] See the references concerning recent develop-ments in note 24 below.



[18] As a selection from the literature on this issue,see ECB (1999), DANTHINE et al. (2000) andWALTER/SMITH (2000).

[19] This is one of the core strategies in the classifi-cation system of Michael PORTER (1980); spe-cifically for the field of banking, see SMITH/WALTER (1997), Chapter 14, and CANALS(1993). In a recent article, PORTER empha-sises that IT-related advances or, as he puts it,“the internet”, do not make his standard classif i-cation of successful strategies obsolete, seePORTER (2001).

[20] For a summary of this line of research, seeBERGER (2000), and specifically for Europe MO-LYNEUX et al. (1996) and BERGER et al. (2000).

[21] In a recent study, the ECB (2000) reports thatout of the 2,153 M&As in the banking industry inEurope between 1995 and the middle of 2000,only 16% had at least one aspect of a cross-border transaction; the rest were purely internalmergers and acquisitions.

[22] While this applies to certain groups of formerbank borrowers, notably large corporations, em-pirical arguments provided in SCHMIDT et al.(1999) cast doubt on the wide-spread assump-tion that disintermediation should constitute ageneral trend. On this, see also HACKETHAL(2000 and 2001) and HACKETHAL/SCHMIDT(2000b).

[23] Empirical evidence concerning the persistenceof relationship banking in Germany is providedin ELSAS/KRAHNEN (1998). See also EL-SAS/KRAHNEN (2000).

[24] This is the title of a book by Lowell BRYAN, aconsultant with McKinsey, from 1988. Similarassessments are also found in the more aca-demically oriented literature; see e.g. MILLER(1998). Empirical evidence for the propositionthat this dire prediction may not be right is pro-vided by the present difficulties of online bank-ing and online brokers. See the articles on thehard times for – formerly overestimated – on-line-banking outfits and on of online brokers inLE MONDE (2001) and FRANKFURTER ALL-GEMEINE ZEITUNG (2001), respectively.

[25] One of the most competent sources on the ef-fect of the single market and the advent of theEuro on the banking system, or banking sys-tems, in Europe is WALTER/SMITH (2000). Seealso DANTHINE et al. (1999).

[26] For new empirical data, which support this as-sessment, see ECB (2001).

[27] As of early 2001, the general organisationalstructure of the three traditional German Gross-banken has been adjusted in such a way that adivisional structure has replaced the older cli-ent-oriented structures. This tends to makeGerman banks more similar to British bankswhich have for a long time been organisedsimilarly.

[28] The implicit allusion to the Daimler-Chryslercase is not accidental, see DER SPIEGEL from26.2.2001.

[29] This is also the view expressed and supportedat great length in WALTER/SMITH (2000).

[30] See already BÜSCHGEN (1993) and variouscontributions in SAUNDERS/WALTER (1996).

[31] See WHITE (1998) for empirical data, and thetheoretical argument in ALLEN/GALE (2000),Chapter 3.

[32] See ALLEN/GALE (2000), Chapter 6.[33] See also CANALS (1993) and the empirical

support in the references provided in note 25supra.

[34] For similar assessments see WALTER (1997)and DOERIG (1996).

[35] See the references in note 22 supra.[36] Interesting evidence to the effect that in a

crisis situation corporations turn back to banklending is presented in SAIDENBERG/STRU-HAN (2001).

[37] Moreover, the unfavorable development of thestock markets in Europe since the time whenthe first version of this paper was written cor-rects the impression that the stock market hasstarted to replace banks to a large extent – animpression which was indeed hard not to haveat that time.

[38] See HACKETHAL/SCHMIDT (2000a) andSCHMIDT/SPINDLER (2001).


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Future of Banking in Europe