Chapter 3 - Market Structures III

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• Chapter 3 - Market Structures III

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This Lecture
This Lecture

• Financial Systems in Europe
• Bank-based systems
• Market-based systems
• Financial systems in Eastern Europe

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• Why do financial institutions exist?
• Traditional explanations
• transaction costs
• Institutions take deposits and channel funds to
  individuals and firms evaluating assets gives
  rise to fixed costs that intermediaries can
  share, thereby giving them an advantage over
  individuals.
• asymmetric information
• As a rule, borrowers have better information
  about the riskiness of their financial situation
  and repayment prospects than do their lenders,
  and managers know more about the profitability
  of their firm than shareholders and lenders.
  Financial institutions have a comparative
  advantage in screening and monitoring
  borrowers.

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• Why do financial institutions exist?
• In recent years financial intermediation has
  become less and less restricted to the
  traditional bank business
• Banks started securitising loans in searching
  for a way not to keep all the money they lend on
  their balance sheets,
• companies developed their asset management
  capabilities beyond their core competences and
  began widening their activities to the financial
  realm,
• most trading of financial instruments takes
  place among financial institutions without any
  customers involved at all.

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Why do financial institutions exist? Some of
the changes cannot be explained by traditional
arguments. For example, although recent
advances in information technology have
substantially reduced information costs and
asymmetries, the need for financial services
has not declined to a similar extent direct
lending is still the exception and not the
rule. Another unresolved puzzle is the large
share of trades among intermediaries.
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Why do financial institutions exist? More
recent concepts therefore stress the ability to
distribute risks as an additional rationale for
banks. Financial intermediaries transact at
near zero cost and can create a large number of
synthetic assets through dynamic trading
strategies, allowing them to create products with
very safe payoffs and/or with varying degrees
of complexity according to their own needs and
those of their customers.
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• Synthetic assets
• Synthetics are securities that allow combinations
  of assets to be obtained with low transaction
  costs.
• Examples
• Synthetic stocks can be constructed by buying a
  stock index future contract and a riskless
  security.
• Synthetic securities assets or liabilities
  denominated in one currency can be constructed
  by combining a security denominated in another
  currency with a forward foreign exchange
  contract of similar maturity and a spot contract.
  
• A forward foreign exchange contract that does
  not exist can be replicated by using a spot
  contract combined with borrowing and lending in
  the two currencies involved.
• A synthetic option is built from a set of
  transactions replicating a portfolio of the
  traditional financial claims it corresponds to.

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Synthetic assets Common to all synthetic
assets is that they are so-called redundant
securities Their cash payoffs may be
replicated by a set of transactions in other
financial instruments. Synthetic assets mimic
the payoffs, but not necessarily the risk profile
of the desired product. The latter refers to
the underlying distribution of returns for
various instruments and also to the assumption of
continuous price movements and liquid markets
that is usually made.
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Financial market volumes worldwide differ
markedly
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In Europe, much of this and other financial
activity takes place in London
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• The City of London has
• by far the highest number of foreign banks
• the highest share of equity turnover, foreign
  exchange dealing and OTC derivatives trading
• it is the most important centre of
  international bond trading in both primary and
  secondary markets
• there are more corporate headquarters in London
  than in any other European centre one-third of
  Fortune Global 500 companies have their
  European headquarters there, compared with 9
  in Paris, 6 in Brussels, 3 in Düsseldorf and
  3 in Frankfurt.
• Over 65 of the Fortune Global 500 companies
  are represented in London more than in any
  other European city.

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• However, other European places, too, attract a
  considerable share of business
• and in some market segments are even taking the
  lead
• exchange-traded derivatives are primarily
  traded in Frankfurt
• the world's second-largest market behind the US
  of mutual fund management is in France
• the insurance industry is largely concentrated
  in Munich where total premium income exceeds
  those in both New York and London, the Numbers
  Two and Three respectively
• money and government bond trading is not
  concentrated in one place
• sales teams for non-government bonds and equity
  sales and MA, too, are decentralised across the
  euro area.

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Traditionally, a distinction is made between
bank-based financial systems and market-based
systems. In Europe, both can be found
Anglo-Saxon countries have market-based
system, while France and Germany are examples
of bank-based systems.
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Financial systems
A look at the relative importance of banks and
securities markets in the US and Germany shows
the difference In the US, banks are relatively
unimportant compared to equities and, in
particular, bonds, which play by far the largest
role. In Germany, the contrary holds here,
apparently, banks are relatively important and
bond and equity markets less so.
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Financial systems The data also show that, in
the 1990s the importance of bank finance has
declined in both systems, while the share of
equities has risen markedly. This indicates a
worldwide structural change in financial markets
rather than an adjustment or convergence of
systems.
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Bank-based Systems In countries with bank-based
systems, firms' external financial funds are
primarily provided by banks with which they have
long-term relationships. As a rule, banks are
universal banks allowed to offer a wide range of
financial services. Banks take deposits and
lend directly to firms and individuals and, at
the same time, trade in equities and provide
underwriting services. The latter is in
contrast to market-based systems where more or
less strict "firewalls" separating different
kinds of financial services such as taking
deposits and granting loans on the one hand and
underwriting and trading equities on the other
exist.
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Bank-based Systems However, the lines are
not clear-cut and the limit of what is allowed
or forbidden varies from country to country
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• Differences in financial systems
• As the Table demonstrates, in the mid-1990s the
  differences in various areas of financial
  business in and outside of Europe have been
  considerable.
• Many of these differences still persist,
  although, over recent years, European countries
  have experienced some convergence in the course
  of the implementation of the single market
  program.
• Among all bank activities, the most sensitive
  cases seem to be involvement in real estate
  business, which is restricted in a large number
  of countries, ...
• and mutual investments, both of banks in
  nonbank financial firms and vice versa.
• For European banks, in contrast to those in the
  US and Japan, securities trading is widely
  unrestricted.
• Although overall restrictions on insurance are
  low, they exist among others in the country
  with some of the largest insurers worldwide,
  Germany.

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Bank-based systems A practice which is
widespread in bank-based systems but is not
exclusive to them has become known as
relationship pricing banks offering credit to
investment-grade companies tend to charge very
little in the hope of being rewarded later with
more lucrative work such as underwriting
securities. Often banks use this instrument
to survive in an ever increasing investment
banking competition worldwide. Many of these
commitments are based on the assumption that the
related costs are low because companies would
rather sell commercial paper than draw down
credit lines, which are more expensive.
However, this way of competing contains a
systemic risk under changing economic
conditions, companies may become unable to
raise funds in the markets and the demand for
credit may rise. In such a situation, repricing
- which would be a normal reaction - may be
prevented just because the banks find themselves
too close to the firms.
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• Bank-based systems
• Relationship finance many advantages
• It promotes cooperative behaviour
• A firm that defaults on a bank loan risks being
  excluded from further credit in the future.
• Systems risks can be contained by intertemporal
  smoothing
• In accumulating low-risk, liquid assets, banks
  reduce the need for cross sectional risk sharing
  through markets.
• In a market-based system, competition from
  financial markets where risks are actively
  managed and traded would rule out this
  possibility.
• Banks standing in long-term relationships with
  their customers are necessarily better informed
  than stock market investors.

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Bank-based systems However, these arguments have
to be put into perspective The overall
efficiency of a bank-based system depends on the
extent to which the advantages are realised. In
international debates on investor relations and
shareholder value, bank-based systems are usually
equated with financial backwardness. By most
measures financial markets in the US and UK are
more developed than in France, and far more
developed than in Germany, raising concerns
about corporate governance and control. One
example - the German hausbank system
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• Bank-based systems
• The German hausbank system
• there are three kinds of activities not reflected
  in banks' balance sheets
• control of equity voting rights by the banks
• which allows them to considerably influence the
  outcome of shareholder meetings. The banks derive
  their strategic advantage in these meetings not
  only from direct holdings of equity but also from
  proxy votes from client shareholders.
• banks' representation on firms' supervisory
  boards
• the underwriting of new share issues of large
  listed stock corporations.
• In Germany, this is often concentrated in the
  hands of few big banks that have an
  informational advantage over potential
  competitors with no relationships whatsoever to
  the companies.

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• Bank-based systems
• The abuse of these and other instruments of power
  in bank-based systems is widely held responsible
  for
• outdated structures,
• high costs
• a great deal of red tape
• that deter investment and make venture capital
  scarcely available,
• thereby adding considerably to the structural
  weaknesses of the economy.
• In bank-based systems, corporate governance and
  control is largely exerted behind closed doors
  for example, changes through a stock-market
  takeover, as in Anglo- Saxon countries, are
  rare.

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Market-based systems ... in general, their
superiority is reflected in performance
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Market-based systems
However, again, these arguments have to be put
into perspective Even in market-based
systems, shareholders' rights rarely go beyond
electing directors, and no mechanism ensures
that managers do not pursue their own
interests.
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Market-based systems
Both bank-based and market-based systems have
advantages and disadvantages
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Bank-based and market-based systems
Inefficiencies are found in both of them
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Financial systems
In principle, neither bank-based nor
market-based systems exist in pure form.
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Financial systems
These days, even market-based systems are
changing.
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Financial systems
The most obvious example of system change is
the increasing role of institutional investors,
...
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Financial systems
which is fundamentally altering the
traditional environment for corporate governance
and control in these systems.
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Financial systems

• Institutional investors are a relatively new
  phenomenon in market history.
• They differ from other market participants above
  all in two respects
• They are answerable not only to shareholders,
  but as they are not as anonymous as other
  private shareholders also in a sense
  potentially to public opinion.
• In contrast to other shareholders exit is
  rarely an option.
• As a consequence, they have begun to cultivate
  a
• constant dialogue with the companies (capitalism
  of voice).

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Financial systems
The debate on bank-based versus market-based
systems easily eclipses the fact that in many
countries internal finance is still the most
important source of funds for firms. In these
countries, the nature of the financial system is
less important than the overall economic and
institutional environment allowing generation
of profits that may be used for this
purpose. However, studies have shown that
this does not necessarily hold true for
emerging economies ...
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Financial systems

• Emerging economies are special in that to them
• external finance is often more important than
  internal finance,
• and their reliance on the nature and quality of
  the financial system is much greater than that of
  developed countries.

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Financial systems
In May 2004, ten countries became new EU
members Malta Cyprus Poland the Czech
Republic Estonia Hungary Latvia Lithuania Slovakia
Slovenia Bulgaria and Romania are expected to
follow in 2007.
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CEEC financial systems
The accession of these countries, in particular
those from Central and Eastern Europe (CEEC), is
posing huge challenges to Europe's financial
markets and currency relations Their
membership will alter rules and regulations in
these countries and intensify competition
and structural transformations with
repercussions on western markets and systems.
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CEEC financial systems
Despite the great progress made over recent years
financial systems and markets in the CEEC are
still largely underdeveloped
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CEEC financial systems

• Banking sectors
• transformed from a single-tiered system under
  the communist rule of the late 1980s, where the
  state bank had a quasi-monopoly on banking and
  credit, to a two-tiered one.
• Bank legislation along the lines of the EU
  rules has been implemented everywhere.
• In all countries, except Slovenia, major banks
  have been privatised.
• Foreign banks have entered the region's
  markets, buying domestic banks and stepping up
  retail networks where these already existed.
• In Hungary, Bulgaria and the Czech Republic,
  foreign banks hold a share of between 60 and 70
  percent of total bank assets in Slovakia the
  share is even higher.

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CEEC financial systems

• Monetisation and bank penetration
• The degree of monetisation in these countries
  is low compared to EU standards. In 2002, money
  in circulation plus deposits in the CEEC as a
  percentage of GDP was only about two-thirds the
  EU level.
• Bank intermediation, measured as bank claims on
  the domestic sector as a percentage of GDP, is
  about one third of the respective EU measure.
• The use of bank accounts is less widespread
  than in western Europe. This is the case for
  Bulgaria and Romania in particular, where less
  than 10 percent of the population have bank
  accounts even in Poland the share is only 34
  percent, while in Slovenia it is close to 80
  percent.
• The difference between old and new member
  states is even greater for the total of bank
  assets. While in the euro area, bank assets
  amount to 265 percent of GDP, in the CEEC they
  range from 30 to 100 percent.

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CEEC financial systems

• The role of foreigners
• In contrast to many other countries, in the
  CEEC, foreign investors control a large part of
  the banking sectors.
• Advantages import of capital and know-how,
• assistance in establishing best practices in
  bank business,
• strengthening of competition,
• enhancing of financial sector restructuring and
  adjustment to international standards.
• Disadvantages in many cases, foreign-owned
  institutions in these countries have lost
  important functions in recent years as trading
  and other key activities were shifted to the
  investors' headquarters,
• danger of disinvestment as a result of a
  worsening domestic environment or a change in
  the owner's commercial strategy, as has already
  occurred in a few cases.

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CEEC financial systems

• Stock markets
• In the first few years of their existence
  exchanges in eastern Europe showed high market
  dynamics,
• measured as growth in market capitalisation,
  traded value and number of listed companies
  they clearly outperformed not only those in
  developing countries outside Europe but also
  western European exchanges

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1 World rank in parantheses. 2 End of 2001. 3 In
dollar terms, percentage increase 1996-2001. 4
1998-2001. Source The Economist (2004) Pocket
World in Figures, London.
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CEEC financial systems
Stock markets However, market capitalisation
in the CEEC remained low. The combined annual
turnover on the stock exchanges of Prague,
Budapest and Warsaw is said to equal that on the
Frankfurt stock market in ten trading days.
In an international context, only the markets
of Poland and, to a lesser extent, the Czech
Republic and Hungary, play some role. The
dire state of the exchanges makes it easy to
forget that before World War II some countries
had vibrant financial markets and a long
tradition of stock trading in Warsaw, the
first exchange was established in 1817, in
Budapest in 1864.
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CEEC stock markets
The development of stock markets in the CEEC
was strongly influenced by the privatisation
strategies chosen
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CEEC stock markets
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CEEC stock markets

• In principle, three different privatisation
  strategies were pursued
• voucher privatisation,
• management and employee buy-outs and
• initial public offerings including direct sales
  to strategic investors.
• In countries with mass privatisation schemes,
  such as Bulgaria, the Czech Republic, Lithuania,
  Romania and Slovakia, at first a large number
  of companies were listed rapidly, but liquidity
  remained low and corporate governance structures
  were insufficient as the result of widespread
  ownership. The consequence was an equally rapid
  delisting.
• In countries where privatisation took place in
  the form of initial public offerings, such as
  Estonia, Hungary, Latvia, Poland and Slovenia,
  firms were only listed after a framework for
  securities trading had been established.

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CEEC bond markets

• are dominated by government bonds and
• still small, accounting for between five and
  20 percent of GDP, compared to an average of 50
  per cent in the euro zone.
• Even in the Czech Republic, where the
  non-government bond market is larger than the
  government market, liquidity is higher in the
  latter.
• In many countries, government bonds are mostly
  bought and held until maturity.
• Liquid secondary markets exist only in the Czech
  Republic, Hungary and Poland.
• In recent years, foreign currency-denominated
  bonds have gained significance.
• Spreads on these instruments have fallen
  considerably against the background of reforms
  and the prospects of EU accession.

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CEEC foreign exchange markets
Foreign Exchange Markets developed rapidly after
the transition to full convertibility of CEEC
currencies, often providing the most important
transition channels of monetary policy. This
particularly holds true for countries with a
currency board arrangement
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CEEC foreign exchange markets

• Currency Board Arrangements
• exist in countries as diverse as Argentina,
  Hong Kong and Estonia
• widely regarded as a strategy to prevent or
  withstand foreign exchange market speculation
  
• strongly limit the scope of monetary policy.
• A currency board is a constitutional guarantee
  of a currency's foreign value which goes beyond
  a mere fixing of the exchange rate and comprises
  explicit restrictions on the government's
  ability to print money.
• Currency can be issued only in exchange for the
  foreign currency against which its rate had been
  fixed which may be another currency such as the
  euro or the US dollar, or a basket of
  currencies.
• The advantage of such a system is credibility
  the central bank can no longer provide free
  liquidity to banks financial sector reforms
  which are otherwise difficult to implement will
  be forced and discretion will be removed from
  corrupt and incompetent economic managers.

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CEEC foreign exchange markets
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CEEC foreign exchange markets
In general, there is a risk related to the
existence of these and other currency regimes in
eastern Europe After EU entry, the countries
are obliged to wait for a transition period of
two years before joining the euro. So far,
Poland and Slovakia are planning to adopt the
common currency in 2008, while the Czech Republic
and Hungary are aiming for 2009/10 during this
period, their currencies will be exposed to a
heightened risk of speculative attacks.
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CEEC foreign exchange markets
On the other hand, experience with former
enlargements demonstrates that crises need not
occur despite major weaknesses in accession
countries' economic performance before entry.
One example is the Maastricht criteria. when
in December 1991 the leaders of the 12 EC
countries met at Maastricht in the Netherlands to
negotiate a treaty on the European Union, they
not only set out a detailed timetable for
economic and monetary union (EMU) but also
convergence criteria for economies wanting to
join in EMU
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CEEC foreign exchange markets

• The Maastricht Criteria
• The convergence criteria are five conditions
  countries must meet before taking part in full
  economic and monetary union. These are
• Inflation must stay below 1.5 percent above the
  average inflation rate of the lowest three
  inflation countries in the EU.
• Their long-term interest rate should be no more
  than two percent above the average of the three
  countries with the lowest inflation rates.
• Budget deficits must not exceed three percent
  of GDP.
• National debt must not exceed 60 percent of
  GDP.
• Exchange rates should have been within the
  15-percent fluctuation range from parity of the
  Exchange Rate Mechanism (ERM) without
  re- alignments for at least two years.

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CEEC foreign exchange markets
The Maastricht Criteria Experience with former
enlargements demonstrates that crises need not
occur despite major weaknesses in accession
countries' economic performance before entry. A
look at the performance of old and new member
countries shows that large deviations from the
criteria before the beginning of the transition
period were not unusual
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CEEC foreign exchange markets
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CEEC foreign exchange markets
The Maastricht Criteria The prospect of joining
the common currency may help to force
governments into fiscal discipline, as happened
in Spain, Portugal and Italy. On the other
hand, much depends on the nature of the budget
deficits in Portugal and Italy, for example,
these were mainly caused by high interest
payments on public debt whose reduction was easy
to justify and to achieve with the prospects of
declining interest rates in the course of
monetary unification. CEEC deficits are largely
due to high social spending, investment and tax
reductions, which are much harder to reduce.
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• Summary
• In recent years, the rationale for the
  existence of financial institutions has altered
  with a greater emphasis on the ability to
  distribute risks.
• Traditionally, a distinction is made between
  bank-based and market-based financial systems.
• Bank-based systems are characterised by
  relationship finance and cooperative behaviour
  between borrowers and lenders.
• Market-based systems provide arm's length
  finance with bond and equity markets playing an
  important role.
• Financial systems in the "new" EU member states
  from Central and Eastern Europe are
  characterised by a low degree of monetisation
  and underdeveloped banking sectors.
• Equity markets in CEEC countries showed high
  dynamism in the first years of their existence
  but market capitalisation remains low.