European Financial Services:

The twin challenge of eurofinance and cyberfinance

Charles Goldfinger*

Introduction

In the past twenty-five years, European financial services have undergone deep and extensive changes, under the combined impact of globalisation, information technology and competitive deregulation. We have called this process the “geofinance”. Yet, as important and far-reaching geofinance might have been, the pace and reach of mutation are likely to accelerate in the near future as a result of interactions between the euro and the Internet. Geofinance is now extended and amplified by eurofinance and cyberfinance. The article describes the process of recent and prospective evolution of the European financial services and the challenges to financial institutions and regulatory authorities resulting from this evolution. The main points of our analysis are:

- The absence of consolidation of payment systems in the Euroland is worrisome and should be given greater attention by political authorities

- The vision of a single unified market for financial services appears unrealistic. Instead, a multipolar model of financial markets is emerging.

- In a multi-polar model, the key challenge is no longer integration but interconnection between various poles and markets

- While institutional reforms, such as creation of an European SEC, are important in the long run, in a short run it is essential to set up an infrastructure and systems which facilitate interconnection. In particular, systems facilitating widespread dissemination of financial information are critical.

European Financial services: fragmentation and consolidation

Overlooked giant

While financial services are often considered as essential to the development of overall economy, their importance as a specific economic sector is often overlooked. And yet, this importance is considerable. According to Eurostat, financial services generate over 5% of GDP of the European Union. In 1992, this amounted to 255 260 million ECU or 265% increase over 1980. Financial services employ over 2,6 million people or 3,1% of the total EU employment. In comparison, financial services in the USA employ 1,4 million people and in Japan, 400 000 people. EU banking system is the largest in the world with more than 40% of global banking assets.

The overall structure of financial services in Europe is geared primarily toward banking intermediation rather than toward financial markets, as shown in the Diagram 5. This is a pattern similar to that of Japan but quite different from that of the United States. The relative underweighting of the equity markets relative to GDP (44% in Europe, 95% in the United States), suggests a high growth potential for European financial markets.

Diagram 5

Banking intermediation and Equity markets
(in billion EUR)

source: IMF

This pattern clearly highlights the potential for the development of equity markets in Europe.

Main characteristics

The main characteristics of the current landscape of European financial services are:

· Fragmentation

· Strong national variations

· Gradual pace of consolidation

According to Eurostat, in 1996 within the European Union, there were some 8 400 credit institutions, controlling around 234 000 local units (branches or subsidiaries). Such fragmentation is not specific to Europe. In the United States for instance, there were close to 10 000 banks (with 57 600 local units) in 1995. Nevertheless, there is a general sense that Europe is “overbanked,” with too many financial institutions and too many local units.

The European financial services sector is consolidating but throughout the 1990s the consolidation has been very gradual (see Diagram 7). In some countries such as Greece, Ireland or Sweden, the number of credit institutions has actually increased in the recent number. Interestingly, the overall reduction in the overall number of credit institutions has not led to a decrease of the number of local units. This trend suggests that the local units continue to play a key role as distribution outlets.

Diagram 7

Evolution of credit institutions in the EEA and Switzerland

source: Eurostat

European regulatory framework

The bulk of banking activities is regulated at the national level, with resulting considerable differences between countries. The European Commission has been a driving force in an effort toward harmonisation of regulatory approaches and, more importantly, toward liberalisation of financial services. The two key levers in this effort are:

· The Second Banking Directive, adopted in 1989

· The Investment Services Directive, adopted in 1993.

These directives established the principle of a single EU passport for banks and investment services companies, based on mutual recognition among EU supervisory authorities. IT development was expected to facilitate this trend by enabling remote selling and delivery of financial services. Hopes were high It was particularly hoped that the Investment Services Directives would stimulate cross-border equity trading.

Yet, the impact of both directives appears so far to have been limited, particularly at the retail level. Numerous obstacles remain to the creation of level playing field that would allow a free flow of financial transactions across Europe. For instance, institutional investors, pension funds and insurance companies in most European countries (with the exception of Netherlands and United Kingdom), are constrained in a way they can invest their funds. Obstacles are even higher in retail banking due to a combination of legal hindrances, discriminatory taxation regimes and above all high entry costs. Extensive local branch networks constitute serious obstacle to direct entry. State-controlled financial institutions benefit from many forms of official regulatory and fiscal protection and thus distort the competitive situation. Furthermore, there are numerous restrictions on product offerings such as interest-bearing checking accounts or innovative life insurance. Social legislation and protectionist attitudes of national regulators also discourage entry by acquisition.

Restrictions on competition and on new product/services deployment meant that the rationalisation of financial sector has not been progressed as far and as speedily as expected by promoters of the single market. While the net lending margin has declined, it was not sufficiently compensated by cost reduction or increase in commissions and other non-lending revenue sources. As a result, in many countries, banking profitability has substantially declined (Diagram 9). Interestingly, it was in the countries, United Kingdom, Ireland and Luxembourg, which adopted the most open attitude to the new entrants that the profitability has actually increased. Furthermore, those countries also demonstrate show higher level of banking profitability than the European average.

Diagram 9

Profitability of financial institutions
1990-1994 average

source: IMF

Restriction on competition affected not only financial institutions but also potential entrants from non-financial sector. Not surprisingly, the new entrants were most numerous and aggressive in countries with an open competitive environment. This was particularly the case in the United Kingdom, where retailers such as Marks and Spencer or Tesco were able to develop sizeable financial services business. However, retailers were also able make strong, if selective, inroads in countries such as France, where the market climate is more restrictive. Industrial companies, with very few exceptions such as General Electric Capital Corporation, a subsidiary of the US conglomerate, General Electric, which pursues pursued an aggressive Europe-wide acquisition strategy, have not sought to enter the financial services on a large scale. Thus, the European financial services remain dominated by banks. On the European continent in particular, universal banking, where a single institution offers a wide range of financial services, banking, brokerage, life insurance and fund management, remains a dominant model.

Many European banks have proved remarkably adept in cross-selling financial services. This is demonstrated by a rapid growth of bankinsurance. Bankinsurance has been the key for the strong performance of Lloyds TSB, which has become one of the most profitable large banks not only in Europe but also globally. In France, the largest French bank, Crédit Agricole, has developed a highly successful life insurance subsidiary, Predica, which, within two years after its launch, was able to claim 30% of all new life insurance subscribers. Diagram 10 shows the development of bankinsurance in selected European countries.

Diagram 10

Estimated share of new annualised life and pensions business, 1996

Source: Datamonitor

Retail banking continuity and investment banking upheaval

The evolution of the European retail banking has been marked by continuity. National fortress model still remains dominant. Each national market is dominated controlled by large domestic banks, none of which has really succeeded in significantly penetrating other national markets. Banks that sought to achieve penetration by building their delivery network from the ground have been notably unsuccessful. The only way to enter another market is through a merger, such as Merita and Nordbanken in Scandinavia or acquisition, such as ING acquiring BBL in Belgium or HSBC acquiring CCF in France.

On the other hand, the investment banking within Europe has gone through a major upheaval. On the Continent, the securities brokers have practically disappeared as independent entities, their clients and/or their business being taken over by commercial banks. In the City of London, practically all merchant bankers, which have ruled the City for over one hundred years, have been acquired by European or US banks. The most significant development however has been the triumphant progress of the large US investment banks, (in particular MGM (Morgan Stanley, Goldman Sachs and Merrill Lynch)), that have moved from cross-border to domestic transactions, from financial advice to financing, and from private sector to privatisations operations, to achieve dominant positions in both primary (IPOs) and secondary (trading) financial markets and related operations such as mergers and acquisitions.

Their success came largely at expense of large universal banks, particularly from Germany and Switzerland. Remarkably successful in the retail segment, the European universal banking model proved less resilient in the corporate segment. Protracted Difficulties difficulties and relative lack of international success experienced by European universal banks in investment banking area may appear somewhat paradoxical to the extent that they combine strong corporate relationships with massive distribution capability, which are generally believed to be the key factors of success in international investment banking. Moreover, universal banks appear well placed to offer the full range of various financial services and to integrate advice and financing. However, the emerging universal banking model is very different from the traditional one, which has been often characterised by opacity of bank-client relationships, low concern for the effective use of capital and conservative approach to financial innovation. The new universal banking, which can be called global universal banking, is based on transparency of relationships, gives absolute priority to the return on capital and aggressively promotes financial innovation. US investment banks, Goldman Sachs, Morgan Stanley Dean Witter and Merrill Lynch, appear as its most accomplished practitioners. It is this vision of global universal banking that underlies the spectacular merger of Salomon Smith Barney and Citicorp, and of Chase Manhattan and JP Morgan. It is also worth noting that the recent successes of Deutsche Bank in investment banking are largely attributed to its decision to hand over the top management responsibilities to a cadre of transfuges from US investment banks, thus showing its willingness to profoundly change its universal banking approach.

Financial Hurricane

Triumph of geofinance

In the past twenty-five years, financial services have undergone deep and extensive changes in all aspects of their business: products, delivery channels, market structure and regulation:

· Products: Financial products have become more varied and more complex. The product cycle has been accelerated: products are conceived, deployed and made obsolete much more quickly than before. They have become more liquid and tradable, as financial institutions seek to externalise and share their risks.

· Delivery channels: Delivery channels have proliferated in order to give customers an extensive array of remote and permanent access means: ATMs, telephone banking, on-line banking, Internet banking, etc. Contrary to early expectations, new channels have reinforced rather than cannibalised the existing ones and have not fundamentally changed the market shares allocation as all major financial institutions were quick to adopt a multi-channel strategy.

· Market structure: Boundaries between different categories of financial services become blurred. Banking, insurance and capital markets firms are invading each other’s turf and competing aggressively. Market structure is becoming more fluid and unstable. Established hierarchies can no longer be taken for granted. Deregulation has attracted many newcomers: retailers, industrial companies, telecom operators. In the US, new entrants achieved significant inroads in a number of segments, particularly in credit card issuing and specialised lending.

· Regulatory oversight: Boundaries between various financial services activities are no longer rigid. Geographical restrictions to entry have been considerably reduced. The increased risk level has led regulators to monitor international banking activities on a consolidated basis. Specific steps have been taken to better track positions in derivatives instruments.

This has been a worldwide trend. Nevertheless, there were significant differences in the rate and scope of change between various segments of financial services:

· Wholesale banking has changed more than retail banking

· Markets have changed more than banking.

Globalisation has been particularly pronounced in wholesale banking and over-the counter financial markets such as foreign exchange. Corporate lending and investment banking are dominated by few global players, active in all markets, established or emergent. On the other hand, globalisation appears to have affected relatively less the retail banking, which remains largely fragmented and localised. We call this pattern of transformation of financial services, created by interactions between globalisation, information technology and deregulation, “geofinance”.

Emerging trends: eurofinance and cyberfinance

The pace and reach of change are actually likely to accelerate in the near future. In particular, European banking and financial markets are on the verge of a large-scale upheaval under a combined impact of the euro and the Internet, the emergence of eurofinance and cyberfinance.

· Eurofinance: the creation of a common currency has set up a foundation for a very large integrated financial services market for 300 million people. Such market is already being built as evidenced by the explosion of activities in euro-denominated capital market instruments. Cross-border equity trading has also grown significantly in Europe.

· Cyberfinance: Both Internet banking and brokerage are developing rapidly and Internet technologies are penetrating all aspects of business operations. Cyberfinance associates closely traditional financial institutions and technology providers and other new entrants. The latter are in position to either marginalize or disintermediate financial institutions.
Furthermore, numerous efforts are being carried out to design and implement Internet-based payment systems. Some of those systems, according to their proponents, have a revolutionary potential and can trigger the emergence of alternative monetary systems, which would be outside the reach of the existing banking structure and its regulators.

Thus, while eurofinance appears a vector of continuity with the existing financial trends, cyberfinance contains a significant discontinuity potential.

Eurofinance challenge: overcoming fragmentation

The need for consolidation in the retail banking sector has been widely acknowledged. However, until late 1990s, the pace of mergers and acquisitions in European banking has been rather lethargic. Since 1998 and even more since the official euro launch, the speed of consolidation has accelerated and is likely to further step up. The value of merger and acquisitions in financial sector has increased from 41 billion euros in 1997 to 174,5 billion in 1999.

In retail financial services, the consolidation remains primarily national, most banks and national authorities following the model of a “national champion” and giving priorities to the strengthening of their home base. Cross-borders mergers are only beginning and they primarily affect neighbouring countries (Netherlands-Belgium, Sweden-Finland). The “national champion model” is evolving toward the regional one. It remains to be seen whether the takeover of Credit Commercial de France by HBSC in early 2000 constitutes a first sign of major wave of global alliances or an isolated case.

Payment systems and service infrastructure: the missing link

While the consolidation spotlight is on financial institutions, the success of euro-based financial services depends crucially on closer integration of the underlying infrastructure of payment systems and services. This infrastructure, while highly sophisticated, has been designed for national markets and treats crossborder transactions as marginal. Its structure is complex and hierarchical, with various systems for various payment categories (check/card, retail/wholesale). Those systems are interconnected linked by common membership and interoperability agreements but the degree of interconnection linkage and fluidity varies considerably.

Thuis the structure of European payment systems is doubly fragmented: by national markets and by type of instrument. This results in higher transaction costs and lower efficiency of crossborder retail payments and related services. It also entails a proliferation of incompatible standards. To take just one example: while there are at present close to 100 million smart cards issued by financial institutions, they are splintered into over 20 incompatible schemes, both from the technical and the business viewpoints. Attempts to achieve interoperability have been laborious and, so far, met with limited success.

It is quite puzzling that while the Euroland is approaching the final deadline of a switch to a single currency in early 2002, the current configuration of the European payment systems structure persists without much debate. The need for crossborder consolidation among financial institutions is widely acknowledged both by industry participants and among policy makers and the process, even if it appears rather laborious at times, is under way. Yet, the logical implication that the consolidation of financial institutions needs to be accompanied by a consolidation of underlying financial transactions processing systems has apparently not been drawn. The issue of payment systems configuration under single currency conditions is rarely discussed. Efforts to define policy orientations in this area appear to have been rather timid: the subject has never been put on the policy agenda of the European Council and of the European Commission. The essential questions - How much competition should there be between various payment systems? Is the current functional specialisation still relevant ? Should the current access approach, which restricts direct access to financial institutions only, should be liberalised and if yes, under what conditions? How the payment systems should be regulated ? - remain largely unanswered.

Convoluted saga of equity markets consolidation

The persistence of status quo in European payment systems is in stark contrast to the European equity markets, where the need for crossborder consolidation has been widely acknowledged by financial institutions, public authorities and markets themselves. Stock exchanges in the euro zone have been quick to endorse the common currency: since January 2, 1999, all the prices of listed equities are quoted in euros. And the process of market consolidation has been underway since the early nineties. As in financial services, it took place primarily initially at the country level, with regional exchanges either disappearing or merging with the leading national exchanges. Thus in France, Lille and Lyon exchanges have been closed down and in Belgium, Brussels Stock exchange has acquired Antwerp Stock Exchanges. In Germany the process has been somewhat less smooth, with Berlin Stock Exchange stubbornly maintaining its independence from the Deutsche Börse. The regional consolidation has been accompanied by cross-instrument integration, with derivatives markets (options and futures) being brought under the tutelage of cash equity markets (with a notable exception of LIFFE in London).

Euronext: work in progress

The process of crossborder equity market consolidation has been highly visible with complex twists and turns. Its two most spectacular manifestations so far have been:

- The failure in Fall 2000 of a planned merger between London Stock Exchange and Deutsche Börse. This merger was backed by major US investment banks and German banks but was opposed by many smaller UK institutions, fearful of a “German takeover”. Large continental players were rather lukewarm about the project and their ambivalence proved crucial, when OM Group launched its hostile takeover offer. Lacking broad support from its shareholders, LSE has decided to abort the merger.

- The creation in September 2000 of Euronext, a new entity combining the stock exchanges of Paris, Brussels and Amsterdam. The closing of the merger was not a foregone conclusion and thus constitutes a major milestone.

However, while LSE-Deutsche Börse merger is a definite failure, it is still too early to call Euronext an unambiguous success. Euronext is treading a new ground: it is a first full transborder merger of equity markets. Euronext management has promised significant benefits to the users such as a 10% reduction in trading costs per year and IT cost savings of 50 million euros over the next two years. To achieve these benefits, three different organisations, of uneven size and disparate corporate cultures need to be melded into a single coherent entity. At the same time, Euronext is committed to change its status from a co-operative to a publicly quoted company. Euronext IPO has been announced for late spring 2001, following a highly successful IPO of Deutsche Börse in February 2001. Going public implies a major change not only in internal culture but also in the relationships between the exchange and its current owners, who will have to accept that the exchange becomes more open, less “clubbish” and more independent.

Operational and management challenges to create a single efficient entity is daunting. Yet, it is not all, as Euronext faces a regulatory framework that remains highly fragmented, complex and costly to all parties concerned, issuers, financial intermediaries and investors. Expected benefits of Investment Services Directive have not been fully realised. There is no single European passport for issuers, no mutual recognition between exchanges, no common listing rules or disclosure requirements.

Overcoming regulatory fragmentation is a task of major magnitude, which cannot be achieved by Euronext alone. It requires a sustained commitment and co-operation of European regulatory authorities and legislative bodies. In the past, such commitment has not been evident. There are however some hopeful indications of change in official attitudes. In Fall 2000, the European Commission has appointed the Committee of Wise Men on the Regulation of European securities Markets, chaired by Alexander Lamfalussy. The Committee published its initial recommendations in November 2000 and its final report in February 2000. We will discuss these below.

Clearing and settlement systems: crucial link

While consolidation of equity markets has attracted a great deal of public attention, the consolidation of clearing and settlement systems is probably even of greater importance. It is in this area that European equity markets have lagged considerably behind the US markets, which benefit from a highly integrated infrastructure built around the National Securities Clearing Corporation (NSCC) and Deposit Trust Company (DTC). Thus, post-trade costs in Europe for cross-border equity transactions are up to ten times higher than those in the US.

This situation is likely to change significantly in the near future. A disparate patchwork of national bodies is being consolidated into two major systems, at the heart of which one finds two leading international clearing organisations, Cedel and Euroclear:

- Clearstream, created through a merger of Cedel and Deutsche Börse Clearing

- Clearnet, combing the resources of Euroclear, clearing entities of Euronext (SICOVAM in France, CIK in Belgium and Negicef in Netherlands) and of the London Clearing House (LCH).

The setting up of institutional framework for these systems has gone relatively smoothly. However, operational benefits will not be fully realised before operational integration of IT applications of various components is completed by mid-2001.

Limits to integration: toward a multipolar model ?

Current trends suggest that the vision of fully unified European equity market, even within the Euroland, may be unrealistic for at least two to five yearsin the foreseeable future. Instead, we see emerging a model based on at least two poles:

- Euronext pole

- Deutsche Börse pole

It remains to be seen whether other markets, in particular London or Scandinavia, will create their own poles or are likely to join in one way or another an existing poleone of the Continental poles.

It is interesting to note that the development dynamics of US equity markets resulted in a multipolar structure, rather than in a fully integrated national market, which had been an explicit objective of SEC in 1970s and 1980s. They are structured around three major poles: New York, NASDAQ and Chicago derivatives markets, which simultaneously co-operate and co-exist.

The persistence of the multipolar model suggests that, contrary to conventional wisdom, the globalisation and automation do not eliminate diversity and heterogeneity; to the contrary they allow financial markets to accommodate them.

A striking example of this phenomenon is the evolution of European markets for high technology stocks (Neue Market, Nouveau Marché, Techmark, etc). While many experts assume that the high technology investment is par excellence a cross-border phenomenon, in practice the European tech markets appear as primarily regional: German investors invest in German stocks, French investors in French stocks, etc. As a result, there have been strong differences in relative performance of high-tech markets, with Neue Market being, for a time by far the most successful: its market cap has grown over 600% between 1997 and early 2000 and several of its leading performers have at one point achieved valuations comparable or even superior to American high-tech fliers on NASDAQ. This disparity in performance has prevented a closer integration between markets and the planned and officially announced Euro-NM has never became an operational reality. The market created specifically for cross-border issuance and trading of high-technology stocks confirms rather than infirms this pattern. Whatever limited success EASDAQ was able to achieve was due to its capacity to attract Belgium companies such as Lernout & Hauspie or Option International that in turn attracted Belgium institutional and retail investors.

The emergence of multi-polar model means that the major challenge to the European financial intermediaries and regulators is not the integration of financial but their interconnection: creation of common rules and infrastructure links across various markets. The notion of interconnection lies at the heart of Internet.

Cyberfinance

Digital tornado

Internet is considerably more than a networking protocol and set of communications standards. It is a broad environment, which encompasses both technical and business architectures. It leads to an ultimate blurring of boundaries between processing and communications. Not only, as Sun affirms, “Network is the computer” but the converse is true is well: “Computer becomes the network.” Today, use of Internet is synonymous with logging on the personal computer, but as all-encompassing communication set of communication protocols, Internet will is also being embedded in voice communications and in video transmission. Internet-based broadband networks makes multimedia a reality.

From the economic perspective, Internet creates a series of new business models. Allowing a wide variety of pricing and valuation approaches, it provides highly sophisticated tools for transaction and behaviour monitoring. However, the tool availability does not imply that each click or eyeball can be priced by the service supplier and paid by the end-user. In the virtual world, value transfers are no longer tied to the actual exchange of goods and services. Internet generates tremendous value-added to its users and suppliers, but this value can no longer be captured by traditional methods such as marginal cost pricing or transaction fees. In the Internet universe, third party and indirect pricing are likely to be the rule rather than the exception. The Internet business model is deeply unsettling because very few businesses understand the new economic logic and most of the current models are preliminary and transitional. This difficulty to deploy and to apprehend new business models and is one element of explanation of the brutal slide of Internet dot.com companies. However, in a longer-run innovative Internet business models will achieve strong and stable market presence.

Clearly, there is an Internet financial bubble, whose speed and magnitude of inflation and deflation are unprecedented. On the other hand, there is no Internet hype: forecasts on the speed and the extent of adoption of Internet-related technologies (browser, Java) and applications (e-mail, electronic commerce), as wildly optimistic they might have seemed at the time of their publication, have consistently lagged behind the actual market development. Internet will have a broader, deeper and more destabilising impact on both Information Technology and business sector than the personal computer (of which Internet is a logical extension). In a nutshell, Internet means:

· Warp speed of development and, above all, diffusion of applications, products and services

· Low costs: even if Internet development and operational costs are not as low as asserted by its enthusiastic proponents, they are considerably lower than that of traditional networks and application distribution. Similarly, Internet lowers significantly business transaction costs

· New approaches to collaborative work and transaction management.

The three trends are mutually reinforcing. Their impact can be summarised around two major themes: ubiquity and mobility.

Ubiquity has three dimensions:

· Ubiquitous computing. The range of intelligent access and processing devices will continue to expand well beyond personal computers towards various forms of information appliances.

· Ubiquitous networking. Internet is likely to accelerate the trend to lower communication costs and, more importantly, force network operators to pass cost savings to consumers.

· Ubiquitous programming. Object technology and Internet carry the promise of democratisation of software application development process.

Computing and networking are increasingly mobile and this trend is likely to continue. It will be further stimulated by two technologies: wireless communications and smart cards. Both those technologies experience explosive growth, which is comparable to that of Internet. It should be noted that Europe is fairly advanced in the deployment of those two technologies.

Cyberfinance: uneven pace of penetration

Impact of Internet on financial services, what we call “cyberfinance” has been rapid and extensive. Far from a passing fad, Internet is in the process becoming the architectural platform of financial services and financial markets.

Development of cyberfinance is already noticeable but its rate has been uneven. Thus, while Internet banking is progressing at a measured pace, Internet securities trading showed a truly explosive growth. The former is still a relatively marginal phenomenon relative to traditional banking; the latter already has a major impact on the overall equity business. In the US, Internet-based trades represent 20% of the total and their share is increasing. Industry structure has undergone a dramatic change: a whole new group of players have emerged. Moreover, Internet is transforming the market structure and infrastructure: new trading structures, Electronic Communications Networks (ECN), and new intermediaries, such as Knight Trimark, have emerged to handle Internet based order flow. They challenge traditional stock exchanges, NASDAQ and New York Stock Exchange, which consider Internet both a tremendous opportunity – new listing, increase in trading volume – and a serious threat to their very existence. Many experts believe that alternative trading structures will eventually disintermediate and render obsolete the existing exchanges. In response to this threat, the exchanges are developing their own alternative trading systems (Super Montage by NASDAQ). Internet is also changing primary markets, with several newcomers seeking to create more open IPO process. The severe correction of the US markets may slow down the pace of change as Internet brokerages suffer more than traditional brokerages from reduced volume and the number of IPOs shrinks dramatically (374 in 1999, 241 in 2000, 2 in first two months of 2001). But it is unlikely to derail it.

US and Europe: imaginary and real cyberfinance gap

There is a widespread perception that the European Union is lagging behind the US in the deployment of cyberfinance. This perception should be qualified: situation differs significantly between Internet banking and Internet broking. European banks do not lag behind the US banks in the deployment of Internet banking, quite to the contrary. Banks such as Merita Nordbanken, Deutsche Bank or Barclays have more clients and offer a greater range of services than their US counterparts. Europe also leads in the development of pure Internet banks such as Egg in the UK, which boasted 1,350 000 clients, holding 5,5 billion euros in assets at the end of 2000.

The situation is quite different in Internet securities trading. In the US, Internet-based trades represent over 20% of the total and Internet brokers such as Charles Schwab and E-trade became a major market force. In Europe, Internet securities trading remains a largely an epiphenomenon. Only in Germany, Internet brokers have attracted more than 500 000 clients and in countries such as UK or France, market leaders have less than 100 000 clients. The total number of European on-line clients is less than the number of theUS clients of E-Trade, which has been created in 1995 and is not even a market leader. The gap is even greater concerning alternative market structures. There is no ECNs in Europe. Jiway, an alternative trading system, designed specifically for online brokers by OM Group from Sweden and Morgan Stanley Dean Witter, was launched in November 2000 but appears unable to generate any liquidity: in February 2001, it registered under 500 trades for the month. Many senior technologists within the exchanges and large financial institutions continue to look at Internet with a mix of doubt and loathing and are not ready to endorse it as a foundation of new architecture. The severe market correction has certainly not contributed to improving the image of Internet

This is not to say that Internet securities trading in Europe is doomed. Until early 2000, the account growth has been very rapid, although starting from a very low base. In some countries, the impact of Internet trading is already noticeable. Somewhat unexpectedly, Germany has become the most dynamic country in this domain: it has a largest absolute number of Internet broking customers in Europe; it spawned the emergence of new breed of financial entrepreneurs, of which the best example is Consors, created by a technologically-minded heir of a small private bank in Nuremberg and which today claims over 500 000 accounts. The largest German bank, Deutsche bank, without going all out Internet, has launched an innovative Internet-based IPO service, the first of its kind in Europe. The service intends to facilitate access to IPOs, managed or co-managed by the bank. It will cover not only the German issues but also Euro-land deals. Eventually, half of the orders from private investors are expected to come through Internet.

One reason for a greater impact, relative to other European countries, of Internet trading in Germany has been the success of Neue Market. As in the US, a virtuous cycle was created, where superior market performance of Internet stocks attracted individual investors, who naturally used Internet brokers for their trades. In turn, Internet brokers focused their marketing on Internet stocks. Furthermore, some Internet brokers, such as E-Trade, have gone public at very high valuations. In Germany, companies such Intershop or Brokat, become global leaders in e-commerce and Internet banking and had spectacularly successful IPOS. Consors itself has gone public and at one point, reached a market valuation of 4 billion EUR. The technology stock correction has triggered a partial reversal of the cycle. Between March 2000 and march 2001, Neuer Markt index has plunged more than 80 and the pace of new introductions slowed dramatically. Two listed companies went bankrupt. Not surprisingly, on-line brokers are also experiencing slowdown in their activity. As a result, their valuation has dropped severely, more than 80% in case of Consors. Nevertheless, German Internet brokers are not retrenching, quite to the contrary. They continue to beef up their offerings and expand internationally.

To the extent that the growth of Internet securities business is closely related to equity market performance, it appears unlikely that the market forces alone will lessen the transatlantic lag. In order to explore other measures that could contribute to its reduction, it is important to understand what are its underlying reasons.

The standard explanation, which emphasizes the lower rate of PC penetration and use, is unconvincing: after all, the use of Internet banking is actually higher in Europe than in the US.

In our view, the principal cause of the European lag is the lack of a mass equity culture. The problem is long lasting and pervasive. Europe has a larger total population and considerably higher savings rate than the US. Yet, the percentage of population holding equity investments is, on the average, four times lower than that in the US. Moreover, equity investment, particularly for the households, is heavily intermediated through banks, which tend to privilege their own products and fixed income instruments, which they can use to manage their assets and liabilities. Large retail banks do not appear to consider retail brokerage as a core activity. They seem to view it as a sideline of traditional banking (deposit taking, cards, payments, etc.). Independent securities brokers are small and confined to market niches: there are no European Merrill Lynch, Charles Schwab or Fidelity, large financial institutions with extensive branch networks, and dedicated to retail securities broking. This may appear surprising, as from the business perspective, brokerage is significantly more profitable than banking on a per client basis (and on-line broking is more profitable than traditional broking). Furthermore, in financial services incumbents have significant advantage over newcomers, due to the economies of scale in transaction processing and high switching costs for clients.

Another crucial European shortcoming, stemming from the lack of mass equity culture is the market and company information deficit. Such information is essential to the market development and integration. European deficiencies in this area are deep-seated and pervasive. For an average investor, obtaining the basic information – market capitalisation, basic financials, historical market performance - about even the largest quoted European companies is practically impossible. Some of those companies (Alcatel, Siemens, Daimler-Chrysler, Nokia, for example) are quoted on the US exchanges and the information about them that can be obtained from these exchanges is considerably easier to access and richer than the information from their “home” equity markets. Moreover, the standards and presentation formats for European market information vary widely, making cross-market comparison extremely arduous, if not impossible.

While European equity research is often of good quality (although it tends to focus on traditional industry sectors and on national markets), its dissemination is very limited.

The underlying problem is the widespread reticence both among listed companies and market intermediaries to display or to share sensitive information. Many industry participants refuse to divulge information about their activities, even when it is required by regulatory authorities. The resulting lack of transparency can lead to serious market accidents. Thus, the brutal fall from grace of two one-time leaders of European Information Technology, Baan in Netherlands (which was acquired at a rock-bottom price) and Lernout and Hauspie in Belgium (which had to declare bankruptcy) is in both cases due to highly questionable accounting practices, which had been tolerated for long-time by regulatory authorities in both countries. When outsiders, in particular American investors and analysts, questioned those irregularities, the management strenuously denied them, before having to admit, under continuous outside pressure, that they were indeed true. The loss of confidence provoked by those and many other “accidents” has durably damaged European Information Technology companies.

To complete this overview of the causes and implications of the lack of equity culture, one cannot ignore the attitude of politicians and policy makers, who have long remained ignorant and/or or ambivalent about equity markets. Even conservative politicians, such as Jacques Chirac, look at markets with distrust and consider them as a casino. In the Euroland, the deployment of large cross-border pension funds and similar investment vehicles continues to be hold back by a lethal combination of ideological and protectionist mind-sets of many national governments.

Considerable political capital has been invested to create a common currency, managed by the European Central Bank, which was granted large powers and built an infrastructure to handle large Euro payments. Nothing comparable has been done for equity markets. All projects to create common elements of infrastructure for various aspects of equity trading and processing, price dissemination or settlement, have failed. Nine years after the launch of the single market for financial services and two years after the launch of the euro, there is still no single European prospectus for issuers and listing procedures have not been harmonized. The regulatory framework remains a disjointed patchwork and constitutes a serious impediment to European equity markets development.

Politi