Ingo Walter
2.4 CONSEQUENCES FOR GLOBAL INSTITUTIONAL COMPETITIVE ADVANTAGE
The basic microeconomics of financial intermediation covering the financial services enumerated in the previous section have, to a significant extent, been reflected in the process of financial-sector reconfiguration summarized in Exhibit 2.6.
Moreover, in retail financial services, extensive banking overcapacity in some countries has led to substantial consolidation—often involving M&A activity. Excess retail production and distribution capacity has been slimmed down in ways that usu- ally release redundant labor and capital. In some cases this process is retarded by large-scale involvement of public-sector institutions and cooperatives that operate under less rigorous financial discipline. Also at the retail level, commercial banking activity has been linked strategically to retail brokerage, retail insurance (especially life insurance), and retail asset management through mutual funds, retirement prod- ucts, and private-client relationships. Sometimes, this linkage process has occurred selectively and sometimes using simultaneous multilinks coupled to aggressive
cross-selling efforts. At the same time, relatively small and focused firms have some- times continued to prosper in each of the retail businesses, especially where they have been able to provide superior service or client proximity while taking advantage of outsourcing and strategic alliances where appropriate.
In wholesale financial services, similar links have emerged. Wholesale commer- cial banking activities, such as syndicated lending and project financing, have often been shifted toward a greater investment banking focus, while investment banking firms have placed growing emphasis on developing institutional asset management businesses in part to benefit from vertical integration and in part to gain some degree of stability in a notoriously volatile industry.
Exhibit 2.7 shows the global volume of financial services restructuring through merger and acquisition (M&A) activity from 1986 through 2001—roughly two thirds of which occurred in the banking sector, one quarter in insurance, and the remainder in asset management and investment banking.
Exhibit 2.8 indicates that the vast bulk of this activity occurred on an in-sector basis. Worldwide, 78% of the dealflow (by value) was in-sector—85% in the United States (where line-of-business restrictions existed for most of the period) and 76% in Europe (where there were no such barriers). So cross-sector M&A deals, including banking–insurance, were a small part of the picture—only 11.4% even in Europe, home of bank assurance.
In addition to being largely in-sector, restructuring via M&A transactions was also largely domestic, as Exhibit 2.9 shows. Worldwide in commercial banking, less than 23% (by value) was cross-border. Only 12.7% and 20.2% of the U.S. and European banking dealflow, respectively, was cross-border (mostly European banks buying Exhibit 2.6. Multifunctional Financial Linkages.
SECURITIES ASSET MANAGEMENT
COMMERCIAL BANKING INSURANCE
Retail Whole- sale
Life Non-
Life Brokerage Invest-
ment Banking
Retail &
P.B.
Institu- tional
U.S. banks). Cross-border intra-European banking deals amounted to 25.8% of the European total. The share of cross-border activity in the insurance sector has been roughly twice that of banking, which possibly suggests somewhat different economic pressures at work. With a few exceptions like HSBC and Citigroup globally, and For- tis, Nordea, ABN AMRO, ING, BSCH, and BBVA as parts of regional or interre- gional strategies, the aggressive development of cross-border platforms seems to be the exception in the banking sector. In insurance, however, global initiatives by firms like AXA, AIG, Zurich, AEGON, ING, Allianz, Generali, and GE Capital seem to be a more important part of the M&A picture.
Industrial economics suggests that structural forms in any sector, or between sec- tors, should follow the dictates of institutional comparative advantage. If there are significant economies of scale that can be exploited, it will be reflected in firm size.
If there are significant economies of scope, either with respect to costs or revenues (cross-selling), then that will be reflected in the range of activities in which the dom- inant firms are engaged. If important linkages can be exploited across geographies or client segments, then this too will be reflected in the breadth and geographic scope of the most successful firms.
It seems clear, from a structural perspective, that a broad array of financial serv- ices firms may perform one or more of the roles identified in Exhibit 2.1—commer- cial banks, savings banks, postal savings institutions, savings cooperatives, credit unions, securities firms (e.g., full-service firms and various kinds of specialists), mu- tual funds, insurance companies, finance companies, finance subsidiaries of indus- trial companies, and others. Members of each strategic group compete with each other, as well as with members of other strategic groups. Assuming it is allowed to do so, each organization elects to operate in one or more of the financial channels Exhibit 2.7. Worldwide Financial Services Merger Volume, 1986–2001.
59% 68%
61% 63%
78%
44%
24%
25%
28% 25%
18%
34%
17%
5% 8%
16% 3%
3% 5%
4%
4% 6%
1% 1%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1986–1988 1989–1991 1992–1994 1995–1997 1998–1999 2000–2001 Banking Insurance Securities Asset Management
$36 bn $71 bn $66 bn $225 bn $671 bn $439.2 bn
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Target Institution World TotalU.S.Europe Acquiring InstitutionBanksSecuritiesInsuranceBanksSecuritiesInsuranceBanksSecuritiesInsurance Commercial banks12607163594300.330724 (52.2%)(2.9%)(2.6%)(50.9%)(2.6%)(0.0%)(47.5%)(3.1%) Securities firms1112829614182495348 (4.6%)(11.7%)(4.0%)(1.2%)(15.6%)(4.2%)(6.8%)(6.2%) Insurance companies1283636573192005012 (5.3%)(1.5%)(15.1%)(6.3%)(1.6%)(17.2%)(6.4%)(1.5%)(16.8%) 7983.7 Source:Thomson Financial Securities Data. Exhibit 2.8.Volume of In-Market Mergers and Acquisitions in the United States and Europe, 1985–2001 (US $ million and percent).
2•19 Target Institution World TotalU.S.–non-U.S.Intra-EuropeEurope–Non-Europe Acquiring InstitutionBanksSecuritiesInsuranceBanksSecuritiesInsuranceBanksSecuritiesInsuranceBanksSecuritiesInsurance Commercial banks18568115844.047918463.040.0 (25.9)%(9.5)%(1.5)%(19.1)%(14.5)%(1.3)%(28.3)%(6.5)%(1.4)%(22.7)%(14.4)% Securities firms3198.017.01061.06.0819.04740 (4.3%)(13.7)%(2.4)%(3.3)%(20.1)%(1.8)%(2.9)%(6.8%)(1.4)%(2.5)%(14.4)% Insurance companies2628.024912298243121219 (3.6)%(3.9)%(34.9)%(0.3)%(7.2)%(32.3)%(8.6)%(1.1)%(43.4)%(0.7)%(6.9)%(32.5)% Sources:DeLong, Smith and Walter (1998) and Thomson Financial Securities Data. The first figure is the dollar value(in billions) of M&Aactivity and the second number in parentheses is the percentage of the total (these sum to 100 for each 3 ×3 matrix). Figures reported are the sum of the equity values of the target institutions. Exhibit 2.9.Volume of Cross-Market Mergers and Acquisitions in the United States and Europe, 1985–2001 (US $ billion and percent).
according to its own competitive advantages. Institutional evolution therefore de- pends on how these comparative advantages evolve, and whether regulation permits them to drive institutional structure. In some countries, commercial banks, for ex- ample, have had to “go with the flow” and develop competitive asset management, origination, advisory, trading, and risk management capabilities under constant pres- sure from other banks and, most intensively, from other types of financial services firms.
Take the United States as a case in point. With financial intermediation distorted by regulation—notably the Glass-Steagall provisions of the Banking Act of 1933—
banks half a century ago dominated classic banking functions, broker-dealers domi- nated capital market services, and insurance companies dominated most of the generic risk management functions, as shown in Exhibit 2.10. Cross-penetration among different types of financial intermediaries existed mainly in savings products.
Some 50 years later this functional segmentation had changed almost beyond recognition despite the fact that full dejurederegulation was not implemented until the end of the period with the Gramm-Leach-Bliley Act of 1999. Exhibit 2.11 shows a virtual doubling of strategic groups competing for the various financial intermedi- ation functions. Today, there is vigorous cross-penetration among them in the United States. Most financial services can be obtained in one form or another from virtually every strategic group, each of which is, in turn, involved in a broad array of financial intermediation services. If cross-competition among strategic groups promotes both static and dynamic efficiencies, then the evolutionary path of the U.S. financial struc- ture probably served macroeconomic objectives—particularly growth and economic restructuring—very well indeed. And line-of-business limits in force since 1933 have probably contributed, as an unintended consequence, to a much more heterogeneous financial system—certainly more heterogeneous than existed in the United States of the 1920s or in most other countries today. This structural evolution has been ac- companied in recent years by higher concentration ratios in various types of financial services, although not in retail banking, wherein concentration ratios have actually fallen. None of these concentrations are yet troublesome in terms of antitrust con- cerns, and markets remain vigorously competitive.
A similar coverage analysis for Europe is not particularly credible because of the wide intercountry variations in financial structure. One common thread, however, given the long history of universal banking, is that banks dominate most intermedia- tion functions in many European countries, with the exception of insurance. And given European bancassurance initiatives, some observers think a broad-gauge bank- ing–insurance convergence is likely. Except for the penetration of continental Europe by U.K. and U.S. specialists, many of the relatively narrowly focused firms seem to have found themselves sooner or later acquired by major banking groups. Exhibit 2.12 may be a reasonable approximation of the continental European financial struc- ture, with substantially less “density” of functional coverage by specific strategic groups than in the United States and correspondingly greater dominance of major fi- nancial firms that include banking as a core business.
The structural evolution of national and regional financial systems seems to have an impact on global market-share patterns. With about 28.9% of global gross do- mestic product (GDP), U.S. banking assets and syndicated bank loans are well un- derweight (they are overweight in Europe and Japan), whereas both bond and stock market capitalizations, capital market new issues, and fiduciary assets under man- agement are overweight (they are underweight in Europe and Japan). One result is
2•21 Underwriting Insurance PaymentSavingsFiduc.LendingIssuance of and Risk Mgt. InstitutionServicesProd.ServicesBusinessRetailEquityDebtProducts Insured depository✔✔✔✔✔ institutions Insurance companies✔✔ Finance companies✔✔ Securities firms✔✔✔✔ Pension funds✔ Mutual funds✔ ✔minor involvement. Exhibit 2.10.U.S. Financial Services Sector, 1950.
Function
2•22
Underwriting Insurance PaymentSavingsFiduc.LendingIssuance of and Risk Mgt. InstitutionServicesProd.ServicesBusinessRetailEquityDebtProducts Insured depository✔✔✔✔✔✔✔ institutions Insurance companies✔✔✔✔✔✔✔ Finance companies✔✔✔✔✔✔✔ Securities firms✔✔✔✔✔✔✔ Pension funds✔✔✔✔ Mutual funds✔✔✔✔✔ Diversified financial✔✔✔✔✔✔✔ firms Specialist firms✔✔✔✔✔✔✔ ✔Selective involvement of large firms via affiliates. Exhibit 2.11.U.S. Financial Services Sector, 2001.
Function
2•23 Underwriting Insurance PaymentSavingsFiduc.LendingIssuance of and Risk Mgt. InstitutionServicesProd.ServicesBusinessRetailEquityDebtProducts Insured depository✔✔✔✔✔✔✔ institutions Insurance companies✔✔ Finance companies✔✔ Securities firms✔✔✔ Pension funds✔ Mutual funds✔✔ Diversified financial firms Specialist firms✔✔✔✔✔✔✔ ✔Selective involvement of large firms via affiliates. Exhibit 2.12.European Financial Services Sector, 2001.
Function
that U.S. financial firms have come to dominate various intermediation roles in the financial markets—over half of global asset management mandates, over 77% of lead manager positions in wholesale lending, two thirds of bookrunning mandates in global debt and equity new issues, and almost 80% of advisory mandates (by value of deal) in completed M&A transactions. Indeed, it is estimated that in 2000 U.S.- based investment banks captured about 70% of the fee-income on European capital markets and corporate finance transactions (see Smith and Walter, 2000a).
Why? The reasons include the size of the U.S. domestic financial market (ac- counting for roughly two thirds of global capital-raising and M&A transactions in re- cent years), early deregulation of markets (but not of institutions) dating back to the mid-1970s, and performance pressure bearing on institutional investors, as well as corporate and public-sector clients, leading to an undermining of client loyalty in favor of best price and best execution. Perhaps as an unintended consequence of sep- arated banking since 1933, institutions dominating disintermediated finance—the U.S. full-service investment banks—evolved from close-knit partnerships with un- limited liability to large securities firms under intense shareholder pressure to man- age their risks well and extract maximum productivity from their available capital. At the same time it was clear that, unlike the major commercial banks, regulatory bailouts of investment banks in case of serious trouble were highly unlikely. Indeed, major firms like Kidder Peabody and Drexel Burnham (at the time the seventh-largest U.S. financial institution in terms of balance sheet size) were left to die by the regu- lators. Subsequently, the capital-intensity and economic dynamics of the investment banking business has caused most of the smaller and medium-size independent firms in both the United States, the United Kingdom and elsewhere (e.g., Paribas in France and MeesPierson in the Netherlands) to disappear into larger banking institutions.
It is interesting to speculate what the European matrix in Exhibit 2.12 will look like in 10 or 20 years’ time. Some argue that the impact of size and scope is so pow- erful that the financial industry will be dominated by large, complex financial insti- tutions—not only for Europe but also for other markets. Others argue that a rich array of players, stretching across a broad spectrum of strategic groups, will serve financial systems better than a strategic monoculture based on massive universal banking or- ganizations. Some argue that the disappearance of small community banks, inde- pendent insurance companies in both the life and nonlife sectors, and a broad array of financial specialists is probably not in the public interest, especially if, at the end of the day, there are serious antitrust concerns in this key sector of the economy.
2.5 SUMMARY. Major parts of the financial services industry have become global- ized over the years, linking borrowers and lenders, issuers and investors, risks and risk takers around the world. In this chapter we have considered the generic processes and linkages that comprise financial intermediation and the characteristics of high- performance financial systems, and reviewed some of the structural changes that have occurred in both national and global financial systems. We noted that financial channels that exhibit greater static and dynamic efficiency have supplanted less effi- cient ones as part of a generic process of financial evolution.
We then described a range of specific financial activities that have become most heavily globalized, notably the “wholesale” end of the financial spectrum that links end users through increasingly seamless global financial market structures. This was followed by an examination of the consequences in terms of financial-sector recon- figuration, both within and among the four major segments of the industry (commer-
cial banking, securities and investment banking, insurance, and asset management) as well as within and among national financial systems.
At least so far, the most valuable financial services franchises in the United States and Europe in terms of market capitalization seem far removed from a financial-in- termediation monoculture, as Exhibit 2.13 suggests. In fact, each presents a rich mix- ture of banks, asset managers, insurance companies, and specialized players. How the institutional structure of the financial services sector will evolve is anybody’s guess. Those who claim to know often end up being wrong. Influential consultants sometimes convince multiple clients to do the same thing at the same time, and this spike in strategic correlation can contribute to the wrongness of their vision. What is clear is that the underlying economics of the industry’s microstructure depicted in Exhibit 2.1 will ultimately prevail, and finance will flow along conduits that are in the best interests of the end users of the financial system. The firms that comprise the financial services industry will have to adapt and readapt to this dynamic in ways that profitably sustain their raison d’être.
SOURCES AND SUGGESTED REFERENCES
Cumming, C. M., and B. J. Hirtle. The Challenges of Risk Management in Diversified Finan- cial Companies. Federal Reserve Bank of New York Policy Review, EPR7.01 (01), 2001.
Dermine, J., and P. Hillion (eds.). European Capital Markets with a Single Currency. Oxford:
Oxford University Press, 1999.
Kane, E. J. Competitive Financial Reregulation: An International Perspective, in Threats to In- ternational Financial Stability. Edited by R. Portes and A. Swoboda. London: Cambridge University Press, 1987.
Lamfalussy Report. Final Report on the Regulation of European Securities Markets. Brussels, February 2001.
North America Europe
Citigroup 250,143 HSBC 140,693
AIG 206,084 Allianz 86,530
GECS 194,636 ING 77,806
Berkshire Hathaway 105,238 UBS 73,497
J.P. Morgan Chase 103,133 RBS Group 60,865
Morgan Stanley 99,055 Lloyds TSB 60,663
Bank of America 82,745 Munich Re 60,532
American Express 72,069 AXA 58,235
Merrill Lynch 60,883 CS Group 57,719
Goldman Sachs 54,297 Barclays 53,630
Banc One 46,395 Deutsche 51,047
Schwab 41,609 Aegon 50,753
Bank of New York 41,466 Zurich 50,194
MBNA 33,007 BSCH 48,310
Marsh & McLennan 30,457 BBVA 46,774
Source: Financial Times, May 11, 2001.
Exhibit 2.13. 15 Most Valuable Financial Services Businesses in North America and Europe (market capitalization in US $ million, May 4, 2001).
Smith, R. C., and I. Walter. Street Smarts: Leadership, Professional Conduct and Shareholder Value in the Securities Industry. Boston: Harvard Business School Press, 2000.
Smith, R. C., and I. Walter. High Finance in the Euro-zone. London: Financial Times–Pren- tice Hall, 2000.
Smith, R. C., and I. Walter. Global Wholesale Finance: Structure, Conduct, Performance.
Paper presented at the 22nd Annual Colloquium of the Société Universitaire Européenne de Recherches Financières (SUERF), Vienna, April 27–29, 2000(a).
Smith, R. C., and I. Walter. High Finance in the Euro-zone.London: Financial Times–Pren- tice Hall, 2000(b).
Story, J., and I. Walter. Political Economy of Financial Integration in Europe. Manchester:
Manchester University Press, and Cambridge: MIT Press, 1998.
Walter, I. Global Competition in Financial Services: Market Structure, Protection and Trade Liberalization. New York: Ballinger–Harper & Row for the American Enterprise Institute, 1988.
Walter, I. “Financial Integration Across Borders and Across Sectors: Implications for Regula- tory Structures,” in Financial Supervision in Europe. Edited by Jeroen Kremers, Dirk Schoenmaker and Peter Wierts. London: Edward Elgar Publishing Ltd., 2002.
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