European Financial Markets and Institutions

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European Financial Markets and Institutions

Written for undergraduate and graduate students of finance, economics, and busi￾ness, this textbook provides a fresh analysis of the European financial system.

Combining theory, empirical data, and policy, it examines and explains financial

markets, financial infrastructures, financial institutions, and challenges in the domain

of financial supervision and competition policy.

Key features:

Designed specifically for courses on European banking and finance

Clear signposting and presentation of text with learning objectives, boxes for key

concepts and theories, chapter overviews, and suggestions for further reading

Broad coverage of the European financial system – markets, infrastructure, and

institutions

Explains the ongoing process of financial integration, in particular the impact of

the euro

Examines financial systems of new Member States

Uses up-to-date European data throughout

A companion website can be found at www.cambridge.org/de_Haan with exercises

and freely downloadable solutions.

Jakob De Haan is Professor of Political Economy at the University of Groningen.

He is also a fellow of CESiFo (Munich, Germany) and Editor of the European Journal

of Political Economy.

Sander Oosterloo is Senior Policy Advisor at the Netherlands Ministry of Finance.

He received his PhD from the University of Groningen and is affiliated with its

Faculty of Economics and Business.

Dirk Schoenmaker is Professor of Finance, Banking, and Insurance at the VU

University Amsterdam, and Director of European Affairs, Competition, and Consumer

Policy at the Netherlands Ministry of Economic Affairs. Before that, he was Deputy

Director Financial Markets Policy at the Netherlands Ministry of Finance.

European Financial

Markets and

Institutions

Jakob de Haan

Sander Oosterloo

Dirk Schoenmaker

CAMBRIDGE UNIVERSITY PRESS

Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo

Cambridge University Press

The Edinburgh Building, Cambridge CB2 8RU, UK

First published in print format

ISBN-13 978-0-521-88299-6

ISBN-13 978-0-521-70952-1

ISBN-13 978-0-511-50686-4

© Jakob de Haan, Sander Oosterloo, and Dirk Schoenmaker 2009

2009

Information on this title: www.cambridge.org/9780521882996

This publication is in copyright. Subject to statutory exception and to the

provision of relevant collective licensing agreements, no reproduction of any part

may take place without the written permission of Cambridge University Press.

Cambridge University Press has no responsibility for the persistence or accuracy

of urls for external or third-party internet websites referred to in this publication,

and does not guarantee that any content on such websites is, or will remain,

accurate or appropriate.

Published in the United States of America by Cambridge University Press, New York

www.cambridge.org

paperback

eBook (EBL)

hardback

Contents

List of Boxes page viii

List of Figures x

List of Tables xiv

List of Countries xvi

List of Abbreviations xviii

Preface xxiii

Part I Setting the Stage 1

1 Functions of the Financial System 3

1.1 Functions of a financial system 4

1.2 Bank-based versus market-based financial systems 14

1.3 Conclusions 28

2 European Financial Integration: Origins and History 33

2.1 European integration: introduction 34

2.2 European institutions and instruments 36

2.3 Monetary integration 42

2.4 Financial integration 48

2.5 Conclusions 55

Appendix: Examples of FSAP in action 56

Part II Financial Markets 61

3 European Financial Markets 63

3.1 Financial markets: functions and structure 65

3.2 Money market 71

v

3.3 Bond markets 77

3.4 Equity markets 91

3.5 Derivatives 97

3.6 Conclusions 103

4 The Economics of Financial Integration 107

4.1 Financial integration: definition and drivers 108

4.2 Measuring financial integration 112

4.3 Integration of European financial markets 117

4.4 The consequences of financial integration 125

4.5 Conclusions 131

5 Financial Infrastructures 135

5.1 Payment systems and post-trading services 136

5.2 Economic features of payment and securities market infrastructures 147

5.3 Integration of financial market infrastructures 151

5.4 Conclusions 160

Part III Financial Institutions 165

6 The Role of Institutional Investors 167

6.1 Different types of institutional investors 168

6.2 The growth of institutional investors 180

6.3 Portfolio theory and international diversification 187

6.4 The home bias in European investment 191

6.5 Conclusions 200

7 European Banks 204

7.1 Theory of banking 205

7.2 The use of risk-management models 212

7.3 The European banking system 220

7.4 Conclusions 232

8 The Financial System of the New Member States 236

8.1 The financial system 237

8.2 The banking sector 240

8.3 What attracts foreign banks? 244

8.4 Financial integration and convergence 250

8.5 Conclusions 255

vi Contents

9 European Insurers and Financial Conglomerates 259

9.1 Theory of insurance 260

9.2 The use of risk-management models 273

9.3 The European insurance system 279

9.4 Financial conglomerates 288

9.5 Conclusions 293

Part IV Policies for the Financial Sector 297

10 Financial Regulation and Supervision 299

10.1 Rationale for government intervention 300

10.2 Prudential supervision 304

10.3 Conduct-of-business supervision 312

10.4 Supervisory structures 317

10.5 Challenges for financial supervision 321

10.6 Conclusions 329

11 Financial Stability 334

11.1 Financial stability and systemic risk 335

11.2 How can financial stability be maintained? 346

11.3 The current organisational structure 353

11.4 Challenges for maintaining financial stability 356

11.5 Conclusions 365

12 European Competition Policy 371

12.1 What is competition policy? 372

12.2 The economic rationale for competition policy 373

12.3 Pillars of EU competition policy 378

12.4 Assessment of dominant positions 383

12.5 Institutional structure 391

12.6 Conclusions 395

Index 399

vii Contents

Boxes

Box 1.1 Financial development and economic growth page 7

Box 1.2 The political economy of financial reform 13

Box 1.3 Corporate governance in EU Member States 17

Box 1.4 Does the financial system matter after all? 20

Box 1.5 Legal origin or political institutions? 27

Box 2.1 The role of treaties 35

Box 2.2 The Lisbon Treaty 38

Box 2.3 Dynamics of integration 41

Box 2.4 Decision making within the ECB Governing Council 46

Box 2.5 Basel Committee on Banking Supervision 49

Box 3.1 Credit-rating agencies 67

Box 3.2 Recent developments in government-debt management 80

Box 3.3 How much transparency is optimal? 90

Box 4.1 Euro area vs. non-euro area member countries 117

Box 4.2 Financial integration of the new EU Member States 126

Box 4.3 Financial integration and economic growth 129

Box 5.1 Core payment instruments 137

Box 5.2 The Herstatt crisis 153

Box 5.3 Concentration in credit and debit card markets 155

Box 6.1 ABP 171

Box 6.2 The LTCM crisis 175

Box 6.3 Regulating hedge funds and private equity 178

Box 6.4 Institutional investment in the new EU Member States 182

Box 6.5 The international CAPM model 188

Box 7.1 Securitisation techniques 207

Box 7.2 Liquidity management during crises 210

Box 7.3 When is it optimal to delegate monitoring to banks? 211

Box 7.4 Value-at-Risk 216

Box 7.5 Retail banking market integration 222

Box 7.6 The economics and performance of M&As 228

viii

Box 8.1 The impact of foreign ownership on bank performance 241

Box 8.2 Foreign banks and credit stability 252

Box 9.1 The mathematics of small claims insurance 264

Box 9.2 Flood insurance 268

Box 9.3 Some numerical examples with high- and low-risk individuals 272

Box 9.4 The underwriting cycle 275

Box 9.5 Functional or geographical diversification? 291

Box 10.1 Principles of good regulation 303

Box 10.2 Forbearance versus prompt corrective action 306

Box 10.3 Liquidity-risk management 309

Box 10.4 Pro-cyclicality in bank lending? 311

Box 10.5 Country experiences 319

Box 10.6 Evolutionary approach to refine EU banking supervision 328

Box 10.7 A European SEC? 329

Box 11.1 The Nordic banking crisis 339

Box 11.2 Sub-prime mortgage crisis of 2007/2008 342

Box 11.3 Resolving banking crises: experiences of the Nordic countries

and Japan 352

Box 11.4 Financial stability: a euro-area or a European Union concern? 358

Box 11.5 Multilateral Memoranda of Understanding at the EU level 362

Box 11.6 Regional Memoranda of Understanding 363

Box 12.1 Article 81 cases: MasterCard and Groupement des Cartes

Bancaires 380

Box 12.2 State aid to banks 384

Box 12.3 Algebra of the SSNIP methodology 387

Box 12.4 Which level of (de)centralisation? 393

Box 12.5 Antitrust policy in the EU and the US 394

ix List of Boxes

Figures

Figure 1.1 Working of the financial system page 5

Figure 1.2 Stock-market capitalisation and domestic bank credit,

1995–2004 15

Figure 1.3 Corporate governance rating in EU Member States, 2006 17

Figure 1.4 The IMF Financial Index for industrial countries, 1995 and 2004 22

Figure 1.5 Consumption-income correlations and the Financial Index,

1985–2005 23

Figure 1.6 Business investment response to business cycles, 1985–2005 24

Figure 2.1 The three stages leading to EMU 44

Figure 2.2 Objectives of FSAP 51

Figure 2.3 The Lamfalussy structure of supervisory committees in the EU 54

Figure 3.1 Size of the equity markets, annual turnover, and year-end market

value, 1999–2006 70

Figure 3.2 Bond markets, amounts outstanding year-end, 1999–2007 71

Figure 3.3 Monetary policy and the money market: a schematic view 74

Figure 3.4 Key ECB interest rates and the shortest segment of money￾market rates, 2004–2007 75

Figure 3.5 Average daily turnover in the money market, 2000–2007 76

Figure 3.6 Rating of euro-denominated debt securities, September 2006 79

Figure 3.7 Euro-area government-bond yield (benchmark), 1999–2006 82

Figure 3.8 Ten-year spreads over German bonds, 1999–2006 85

Figure 3.9 Spreads of corporate bonds over AAA-rated government bonds,

1999–2006 86

Figure 3.10 Average bid and ask spread, 2003–2006 87

Figure 3.11 Market capitalisation and number of listed firms, 2000–2006 92

Figure 3.12 Market capitalisation of some exchanges in the EU, 2004–2006 92

Figure 3.13 Net sources of funding of non-financial firms in the euro area,

1995–2004 93

Figure 3.14 IPOs and SPOs in the euro area, 1994–2005 94

Figure 3.15 Market share of EU stock exchanges, 2006 95

x

Figure 3.16 Global derivatives markets, notional amounts, 1996–2006 98

Figure 3.17 Location of OTC derivatives markets, 1998–2007 99

Figure 3.18 Notional amounts of outstanding interest-rate derivatives

traded on European exchanges, 1992–2006 100

Figure 3.19 Market shares of various OTC derivatives markets in the euro

area, 2001–2006 101

Figure 4.1 Impact of enhanced competition 110

Figure 4.2 Integration of the money market: standard deviation of interest

rates, 1994–2007 119

Figure 4.3 Cross-border holding of short-term debt securities issued by

euro-area residents, 2001–2005 120

Figure 4.4 Cross-country standard deviation in government-bond yield

spreads, 1993–2006 120

Figure 4.5 Average distance of intercepts/beta from the values implied

by complete integration, 1992–2007 122

Figure 4.6 Estimated coefficients of country dummies 123

Figure 4.7 The degree of cross-border holdings of long-term debt securities

issued by euro-area residents, 1997–2005 124

Figure 4.8 Proportion of variance in local equity returns explained

by euro-area and US shocks, 1973–2006 124

Figure 4.9 The degree of cross-border holdings of equity issued

by euro-area residents, 1997–2005 125

Figure 4.10 Yield spreads for 10-year government bonds, 2001–2006 127

Figure 5.1 The process of initiating and receiving payments (push

transaction) 139

Figure 5.2 Average value of transactions per non-cash payment instrument

in 2005 140

Figure 5.3 Four-party payment scheme 141

Figure 5.4 Three-party payment scheme 142

Figure 5.5 Clearing and settlement of a securities trade 144

Figure 5.6 Economies of scale in the payment market 147

Figure 5.7 Simple network consisting of four side branches 149

Figure 5.8 Two-sided market 150

Figure 5.9 The number of large-value payment systems for euro

transactions in the euro area, 1998–2006 152

Figure 5.10 A comparison of prices for payment services in 2005 154

Figure 5.11 Concentration in payment systems 156

Figure 6.1 Portfolio of ABP, 1970–2005 171

Figure 6.2 Global hedge funds market, 1985–2006 177

xi List of Figures

Figure 6.3 Hedge funds’ sources of capital, 1996–2006 177

Figure 6.4 Investment horizon and decision power about asset allocation 180

Figure 6.5 Institutional investment and economic development, 2005 182

Figure 6.6 The simplified efficient frontier for US and European equities 187

Figure 6.7 Equity home bias per region, 1997 vs. 2004 196

Figure 6.8 Bond home bias per region, 1997 vs. 2004 197

Figure 6.9 Regional equity bias per region, 1997 vs. 2004 197

Figure 6.10 Regional bond bias per region, 1997 vs. 2004 198

Figure 7.1 Simplified balance sheet of a bank 206

Figure 7.2 Liquidity pyramid of the economy 209

Figure 7.3 Economic capital of an AA-rated bank 214

Figure 7.4 Loss distribution for credit risk 215

Figure 7.5 Loss distribution for market risk 217

Figure 7.6 Calculation of VaR with a confidence level of X% 217

Figure 7.7 Loss distribution for operational risk 218

Figure 7.8 Cross-border penetration in European banking, 1995–2006 220

Figure 7.9 Convergence of retail banking interest rates, 1997–2006 223

Figure 7.10 Biggest 30 banks in Europe, 2000–2005 227

Figure 7.11 Banking M&As in Europe, 1985–2006 227

Figure 7.12 Performance of banks in the EU-15, 1994–2006 231

Figure 8.1 The financial system in the NMS-10 and the EU-15, 2002 239

Figure 8.2 Performance of banks in the NMS, 1994–2006 243

Figure 8.3 What drives greenfield investments? 248

Figure 8.4 Credit to the private sector, 1995–2003 251

Figure 9.1 Simplified balance sheet of an insurance company 261

Figure 9.2 Combined ratios across Europe, 2003–2005 262

Figure 9.3 The law of large numbers and fire insurance claims 266

Figure 9.4 Heavy-tailed distribution 266

Figure 9.5 The Rothschild–Stiglitz model of the insurance market 270

Figure 9.6 The relative role of risk types in banking and insurance 276

Figure 9.7 Organisation of risk and capital management in insurance groups 280

Figure 9.8 Biggest 25 insurers in Europe, 2000–2006 284

Figure 9.9 Cross-border penetration of top 25 EU insurers, 2000–2006 285

Figure 9.10 Distribution channels in Europe 289

Figure 10.1 Assets of European investment funds, 1996–2006 315

Figure 10.2 Supervisory synergies and conflicts 320

Figure 10.3 The trilemma in financial supervision 323

Figure 10.4 A decentralised European System of Financial Supervisors (ESFS) 326

xii List of Figures

Figure 11.1 Real asset prices and total loans in proportion to GDP, Sweden,

1970–1999 338

Figure 11.2 Number of systemic banking crises, 1980–2002 340

Figure 11.3 Framework for maintaining financial stability 346

Figure 11.4 Number of central banks that publish a FSR, 1995–2005 348

Figure 11.5 The level of coverage of deposit insurance in the EU 351

Figure 12.1 Welfare loss from monopoly 374

Figure 12.2 Flowchart for undertaking abuse-of-dominance investigations 385

Figure 12.3 Enforcement of EU competition policy 392

Figure 12.4 Degree of centralisation 393

xiii List of Figures