Convergence in the activities of European banks

Available online at www.sciencedirect.com

Int. Fin. Markets, Inst. and Money 18 (2008) 161–175

Convergence in the activities of European banks Drew Dahl a,∗ , Ronald E. Shrieves b , Michael F. Spivey c a

Department of Business Administration, Utah State University, Logan, UT 84322-3510, United States b Department of Finance, University of Tennessee, Knoxville, TN 37996-0540, United States c Department of Finance, Clemson University, Clemson, SC 29634, United States Received 2 December 2005; accepted 1 September 2006 Available online 9 October 2006

Abstract Cross-country integration of banking in Europe typically has been analyzed from the perspective of particular markets for financial products. We extend this research to consider the potential effects of market integration on the portfolio choices and financial structure of banks in seven European countries, 1994–2002. Our evidence rejects a hypothesis that banks in different countries have common activities. Distinct portfolio choices are more evident among small banks, as opposed to big banks, are more evident in Italy and are less evident in the UK and Spain. We conclude that integration of financial markets in Europe, to the extent that it has occurred, has not imposed a uniform mix of activities on European banks. © 2006 Elsevier B.V. All rights reserved. JEL classification: F33; F36; G11 Keywords: European bank structure; Financial market integration

1. Introduction Bank lending markets in Europe were expected to become more integrated in the 1990s following the implementation of regulatory reforms intended to minimize competitive inequalities among international banks. The Second Banking Directive, implemented in 1993, dismantled constraints on bank expansion within the European Community, while the financial services action plan, adopted in 1999, was intended to create a single market in financial services across the European Union. Coinciding with these and other regulatory reforms were the emergence of ∗

Corresponding author. Tel.: +1 435 797 1911; fax: +1 435 797 2634. E-mail address: [email protected] (D. Dahl).

1042-4431/$ – see front matter © 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.intfin.2006.09.002

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global providers of financial services, internet banking and other technologies that allowed banks to more efficiently manage information flows across countries. The process of integration of financial markets, which by design attempts to remove barriers to cross-border activities, will result in shifting the geographic distribution of production toward more efficient producers. An issue related to the extent of integration of financial markets is how such integration may have affected the evolution of the portfolios of product lines offered by intermediaries, such as commercial banks, and the manner in which those portfolios are financed. Have bank portfolios, or financing choices, changed over time as might occur if integration caused inefficient banks to restructure, fail or get acquired? Does the pattern of change vary by country? Do surviving banks in one country look much the same as, or very different from, surviving banks in other countries? The key to the variety of outcomes that may obtain rests in the extent to which the set of competitive strengths faced by banks in different countries persist after each stage of the financial market integration process. Over sufficient time, banks may overcome comparative disadvantage by innovations in production technology or by successfully promoting public policies that eliminate the remaining sources of their disadvantage (in effect, through better use of the relevant input factor markets or greater harmonization of institutions and legal systems). This could be expected to contribute to greater uniformity of financial structure and product lines. On the other hand, it is entirely plausible that, in the short to intermediate term, changes in product mix will reflect increasing national specialization as banks in various countries adjust their activities in response to their comparative advantage or disadvantage in each product line. The evolution of national trends in product line and financial structure following product market integration is the empirical issue examined in this paper. We recognize that attempting to measure national differences bank activities during a transitional period such as the one that has accompanied European financial integration is problematic. For example, comparing mean ratios of loans to assets at a point in time, or even over several years, is likely to be misleading due to the fact that banks are adapting to relatively radical changes in the institutional and competitive setting. The ratios, therefore, are likely to change until the adaptation process is complete, which may take a number of years. As an alternative, we introduce the concept of “activity-level convergence” as a framework for assessing the end result of the adaptive process for bank activities. Convergence in a product line is defined as a progression toward a common target proportion of activity in customer loans and securities, both expressed as a percentage of assets. Convergence in financial structure is similarly defined, with analyses of customer deposits and equity. Using a partial adjustment model, we analyze activity-level convergence in product line and financial structure in order to determine whether European financial market integration has been accompanied by a convergence of banks to a uniform portfolio composition. We use a sample of 918 annual observations, 1994–2002, on individual banks in Switzerland, the UK, Germany, Spain, France, Italy and Denmark. The sample is divided into two groups that vary by bank size. Results of our tests for both size strata indicate that target activity levels, for both product line and financial structure, differ according to a bank’s home country. Some of the differences, though not all, represent a continuation of historical activity levels. We also find that the phenomenon of divergent target activity levels is more evident among smaller banks. We conclude that integration of financial markets in Europe, to the extent that it has occurred, has not imposed a uniform set of activities on European banks. The observed differences in the relative emphasis placed on some bank product lines, and financial structures, is relevant to understanding why some countries may favor further removal of regulatory or economic barriers

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to integration, while other countries may favor the reversal of such policies. Such cross-national differences in bank product line and financing strategies are likely to complicate the implementation of regulatory policy. The remainder of the paper is organized as follows. Section 2 provides background research on European bank integration. Section 3 discusses our sample of European banks and the methodology we use to determine whether and how portfolios of bank investment and financing activities have evolved during this extraordinary period of integration in financial markets. Section 4 presents our results and Section 5 concludes. 2. Background The markets faced by European banks have evolved dramatically during the last 20 years. The evolution was accelerated by introduction of a common currency in many countries in 1999. It has coincided with technological changes that have allowed banks to more efficiently manage information flows across countries. As pointed out by Kleimeier and Sander (2003), traditional branch banking has been replaced, in some areas, by remote banking via automatic teller machines, electronic money, telephone banking, on-line security trading and internet banking. Changes in regulation have been crucial to changes in European bank markets. At the beginning of the 1980s, for instance, banking was highly regulated in Italy and France and less regulated in the UK. Such differences diminished with time. The Second Banking Directive, implemented in 1993, harmonized regulation and established mutual recognition of banks, with home country supervision of foreign banks. The Financial Services Action Plan, adopted in 1999, became a “blueprint” for financial integration. The plan had three specific objectives: (1) establishing a single market in wholesale financial services; (2) making retail markets open and secure; (3) strengthening the rules on prudential supervision. By 2002, 26 of 42 measures in the plan had been finalized (Kleimeier and Sander, 2002). Regulatory reform was intended to minimize competitive inequalities among international banks. Deregulation has the ability to stimulate competition, increase the quantity and quality of services, encourage innovation and lead to a more diversified and less risky banking environment. The implicit assumption, according to Dermine (2002), is that cross-border competition will drive away price differentials on homogenous banking products. Offsetting the impetus for integration are regulatory barriers to enter specific product markets, differences in taxation, subsidies, guarantees, loyalties to local providers and restrictive labor laws (Berger and Smith, 2003). Persistent segmentation could also reflect cultural differences in consumer preferences or differences in the organizational strategies for banks (Kleimeier and Sander, 2002). Ownership structures may also play a role, particularly for co-operative banks, which can dominate local retail markets in some countries. And advances in information technology, however pervasive, may not have necessarily led to significant integration. The dichotomy of forces allied for, and against, integration can be illustrated with cross-border lending and cross-border bank mergers, which are both considered to be “driving forces” for integration (Kleimeier and Sander, 2003). Although notable cross-border mergers have occurred, consolidation has been limited, sometimes with implicit government guidance, to within national borders and within bank types (Belaisch et al., 2001). And while cross-border lending is growing for some banks, it is not uniformly extensive. The market share of foreign banks in 2001 was relatively low, particularly in France, Italy and Germany, at less than 15% (Kleimeier and Sander, 2003).

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Further observation suggests that bank use of assets, liabilities and capital remained at least partially segmented throughout Europe. Growth rates by country are not uniform, as might be expected if the economies, cultures and regulatory structures of European countries were closely aligned; commercial banks in the UK., for instance, grew at an average annual rate of more than 12%, 1993 to 2001, which is nearly double the comparable rate at banks in Italy (Bank Profitability: Financial Statements of Banks, Organization for Economic Cooperation and Development, 2003). And although the Basle Accord was intended to harmonize capital standards, important differences remain in country-specific capital practices and capital regulation. In this regard, Jackson (1999) found that bank capital ratios differed by country in both level and how levels changed over time. A more systematic perspective on financial integration in Europe is offered by an extensive array of studies, some of which were undertaken under the auspices of the European Central Bank (2004). One branch of these studies examines how interest rate differentials vary across countries in a “price-based” approach. Adam et al. (2002) find that interest rates on the interbank market converged in the 1990s, but that interest rates on mortgages and corporate loans, and prices for bank service charges, remained segmented, even after 1999. Kleimeier and Sander (2002) and Baele et al. (2004) find segmentation in the consumer loan market. The latter study also finds evidence of growing uniformity for interest rates on corporate and mortgage lending. Another category of research focuses on a “quantity-based” approach to the analysis of the cross-border activities of European banks. Adam et al. (2002) study indicators of credit market integration such as the number of foreign banks in domestic markets, the overall share of assets held by foreign banks and concentrations of bank assets. They find that integration on the interbank market was achieved by 1999, but did not occur on the mortgage or corporate lending markets. Baele et al. (2004) also present a mixed a picture in which integration exists for mortgage lending, and for long-term corporate lending, but not for short-term corporate lending or consumer lending. They conclude that there are “clear signs of persistent home bias in lending to and borrowing from small non-financial corporations and households.” Manna (2004) analyzes the unconsolidated balance sheet data of banks, aggregated at the national level. Little variation is found in the concentration of cross-border activity after currency unification, while the gap between crossborder activity in wholesale and retail markets widened. Berger and Smith (2003) analyze time series data on European syndicated loans, ratios of domestic private credit to overall bank claims and the dispersion of non-financial goods prices across Europe. Their evidence shows a picture that has not substantially changed over time. In other studies relevant to integration within European banking, Moerman et al. (2004) find that the correlation of bank stock prices increased for large banks but decreased for small banks from 1990 to 2003. Casu and Girardone (2005) find that the degree of concentration is not necessarily related to the degree of competition or the efficiency of bank systems. DeBandt and Davis (2000) find evidence of monopoly behavior for small banks in France and Germany, monopolistic competition for small banks in Italy and monopolistic competition for large banks in all three countries. Kleimeier and Sander (2003) conclude that “cross-border lending, crossborder mergers and the promises of new technologies have not yet delivered the creation of a single retail banking market.” 3. Data and methodology Our tests examine whether the activities of European banks from 1994 to 2002 have evolved toward common levels in relation to banks’ assets. We define two product lines. Customer loans are loans, claims and advances made to individual, commercial and industrial borrowers (mort-

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gages are included);1 investment securities consist of claims on governments, other fixed income securities, equity and other “sundry” securities.2 On the financial structure dimensions, we analyze customer deposits and bank equity. Customer deposits consist of demand, savings and time deposits held by customers (and excluding deposits held by banks). Total equity capital consists of common stock, preferred stock, equity reserves, share capital, capital surplus, participation rights certificates, cumulative translation adjustment, minority interests, subordinated debt and reserves (less treasury stock and goodwill). 3.1. The data We use financial information for individual commercial banks in Denmark, Switzerland, Italy, France, Spain, Germany and the UK. These countries have relatively large banking industries. They vary by membership in the European Monetary Union (with Switzerland, Denmark and the UK excluded) and the European Union (with Switzerland excluded). Consolidated financial data on banks in the seven countries are obtained annually, 1993–2002, from Global Compustat (although our sample runs only from 1994, lagged data from 1993 is required). The banks are divided into two groups, depending on size. The two largest banks in each country in 1999, along with any others with assets in excess of $100 billion in 1999, comprise a “big bank” subsample of 204 bank-year observations. All other banks are in a “small bank” subsample consisting of 714 bank-year observations covering the 1998–2002 period.3 They include cooperative banks, regional banks and banks with government ownership. For this group, we deleted outlying observations in an attempt to control for aberrations that may arise from de novo banks or other banks with radically different product lines or financial structures.4 A preliminary overview of the mix of product lines and financial structures of banks in different countries is provided in Table 1. Substantial variation by country is apparent for some ratios. There also is a tendency for variation in ratios to differ by size category. Table 2 provides mean bank ratios by year. It is interesting to note that some ratios have changed rather dramatically. Fewer changes are apparent at smaller banks than at big banks. 3.2. A framework for assessing activity level convergence In an international context, input market imperfections, including legal and institutional factors, will potentially render cost disadvantages on producers in some countries. The process of integration of financial markets, which by design attempts to remove imperfections, may be accompanied by changes in the distribution of production. Economic theory predicts that integration lowers the cost of products and services to bank customers by making markets more competitive, and that the geographic distribution of production should gravitate toward more efficient producers. Our concern is whether the distribution of bank products and services among surviving banks 1 It is important to note that our selection of product lines and financial structure were predicated on data availability. From our data source, for instance, it was impossible to obtain consistent data on consumer loans, mortgages, commercial loans or other sub-categories within the customer loan designation. 2 Securities do not include trading account securities or unconsolidated investments in subsidiaries or affiliates. 3 The number of banks reported in our data source increased substantially in 1997. We omitted the earlier time period, therefore, to limit sampling error. 4 Banks with ratios of customer loans to assets or deposits to assets of less than five per cent or more than 90 per cent were deleted.

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Table 1 Mean bank ratios, by country Country

Customer loans/assets

Total securities/assets

Customer deposits/assets

Total equity/assets

Observations

Panel A: big banks Switzerland 0.300 Germany 0.462 Denmark 0.525 Spain 0.411 France 0.404 UK 0.549 Italy 0.493

0.200 0.162 0.245 0.253 0.203 0.144 0.107

0.343 0.343 0.388 0.455 0.396 0.531 0.398

0.050 0.060 0.072 0.096 0.075 0.074 0.082

18 32 15 18 21 68 32

Panel A: small banks Switzerland 0.649 Germany 0.365 Denmark 0.634 Spain 0.610 France 0.665 UK 0.572 Italy 0.571

0.087 0.165 0.185 0.161 0.101 0.196 0.073

0.565 0.290 0.652 0.567 0.616 0.619 0.463

0.112 0.051 0.120 0.105 0.113 0.118 0.113

100 161 102 60 87 37 167

Notes: Ratios are for 204 observations on big banks, 1994–2002, and 714 observations on small banks, 1998–2002.

becomes more or less uniform across the nations involved. The outcome depends on a complex set of factors. To the extent that integration of financial markets eliminates differences in banks’ opportunities, production technologies, and constraints, it may be expected to contribute to greater uniformity of financial structure and product lines. For instance, in a summary of studies that relate to the impact Table 2 Mean bank ratios, by year Year

Customer loans/assets

Total securities/assets

Customer deposits/assets

Total equity/assets

Observations

Panel A: big banks 1994 0.498 1995 0.500 1996 0.485 1997 0.474 1998 0.469 1999 0.473 2000 0.468 2001 0.446 2002 0.465

0.152 0.151 0.155 0.168 0.175 0.191 0.185 0.175 0.167

0.479 0.478 0.457 0.442 0.422 0.414 0.396 0.401 0.401

0.072 0.071 0.070 0.070 0.071 0.073 0.079 0.077 0.077

21 24 24 24 24 24 23 20 20

Panel B: small banks 1998 0.539 1999 0.556 2000 0.576 2001 0.569 2002 0.559

0.122 0.124 0.124 0.136 0.143

0.502 0.504 0.493 0.503 0.502

0.099 0.100 0.098 0.101 0.099

154 157 151 137 115

Notes: Ratios are for 204 observations on big banks, 1994–2002, and 714 observations on small banks, 1998–2002.

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of foreign bank entry on a host country, Barth et al. (2004) list a number of ways in which host country banks may benefit, including transfer of improved banking skills and technology to host country banks and improvements in host country banking regulation. In other words, banks in the host country would be more like foreign banks, contributing to greater cross-country similarity in relative activity levels. To the extent that market integration does not eliminate all differences in opportunities, technologies, or constraints, it may have little impact on national differences for some product lines, or even exacerbate the magnitude of existing differences.5 Idiosyncrasies in bankruptcy law may put foreign lenders at an informational disadvantage relative to local lenders when it comes to enforcing terms of a loan contract, thereby effectively insulating domestic banks from foreign bank competition for commercial loans. Differences in the extent of home country bias among bank borrowers may create an asymmetric susceptibility to foreign competition following removal of international branching restrictions. We would expect, for instance, a relative decline in lending activity by banks in a country where bias is lower, since domestic customers lost to foreign lenders are not offset with new foreign customers. Conversely, banks in countries with relatively strong home bias among borrowers would experience a relative increase in lending activity. To identify convergence, we begin by letting Xit represent the ratio of assets or liabilities in a given category to total assets for bank i in period t. We will refer to X as an “activity.” Suppose portfolio composition changes at each bank follow a partial adjustment framework. Further assume that all banks in country n have a common target ratio, Xn∗ . We model the adjustment process for bank i in country n with a country-specific rate-of-adjustment parameter ρn : Xit = Xi,t−1 +

7  n=1

ρn [(Xn∗ COUNTRYin ) − (Xi,t−1 COUNTRYin )] + εit

(1)

where COUNTRYin is a binary variable equal to unity if bank i is in country n, zero otherwise. ρn is expected to be positive. Rearranging the terms in Eq. (1) yields: Xit − Xi,t−1 =

7  n=1

ρn (Xn∗ COUNTRYin ) −

7 

ρn (Xi,t−1 COUNTRYin ) + εit

(2)

n=1

The first term on the right-hand side in the model is unique for all banks in a given country, since ρn and Xn∗ are country-specific. We define “activity-level convergence” in asset or liability composition for category X as a common target ratio and rate of adjustment of the asset level to total assets. This notion of convergence does not follow from convergence in prices, but rather is adopted because it provides a convenient benchmark for describing international differences in asset portfolio adjustments. Under activity-level convergence, common targets would imply evolution to a relatively homogeneous asset/liability portfolio composition among the banks in an international sample. In addition to the obvious question of whether portfolio composition will exhibit systematic variation in target levels (Xn∗ ), it is also of interest to note whether rates of convergence (ρn ), differ across countries. Therefore we test two hypotheses:

5 For example, deposit-taking may be less affected by integration than the interbank loan market because of the relative importance of spatial location in retail versus wholesale markets.

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• Common target hypothesis:X1∗ = X2∗ = . . . = Xn∗ . • Common adjustment rate hypothesis: ρ1 = ρ2 = · · · = ρn . Let X** be the grand mean ratio for a given activity over all banks, countries, and years. We will use X** as a convenient benchmark for comparison and discussion of individual country target ratios, that is, we will test whether each country target ratio is equal to the grand mean of the ratio over the sample period. Dividing both sides of (2) by X** gives:     Xi,t−1 Xit − X∗∗ X∗∗  ∗     7 7  Xn Xi,t−1 − COUNTRYin ) + εit . = ρn COUNTRY ρ (3) in n X∗∗ X∗∗ n=1

n=1





Writing (3) in difference form, with Xit = Xit /X∗∗ and X∗n = Xn∗ /X∗∗ , yields: 

Xi,t =

7  n=1

=

7  n=1



ρn (X∗n COUNTRYin ) − αn COUNTRYin −

7 

7 



ρn (Xi,t−1 COUNTRYin ) + εit

n=1 

ρn (Xi,t−1 COUNTRYin ) + εit .

(4)

n=1

Another explanatory variable is real growth in gross domestic product (GDP) within each of the seven countries in a particular year. Country-level GDP might matter, at least for limited periods of time, if changes in the target activity ratios reflect adaptation to local conditions as well as an attempt to reach a long-term target ratio. If the target ratio has a temporary component that responds to local economic conditions that vary by period, then the GDP change variable is valid as a measure of “local” shocks to the adjustment process that would impact the short-run component of the target, and might improve the specification. Inclusion of this variable does not alter the interpretation of the other coefficients.6 Since the common target hypothesis, as expressed in X1∗ = X2∗ = . . . = Xn∗ , involves nonlinear combinations of regression coefficients, we use a somewhat less formal, but more tractable, approach to testing that hypothesis. As a result of “normalizing” by X** , the intercept term for a  given country, αn = ρn X∗n , will be greater than (less than) the magnitude of the slope coefficient  for that country, ρn , only if X∗n is greater than (less than) unity, that is to say, only if the target ratio for country n exceeds the grand mean of the ratio. Thus, estimation of Eq. (4) provides a natural benchmark for testing the hypothesis that the target ratio for a given country is greater or  less than the benchmark ratio by testing whether αn = ρn . We estimate X∗n as the quotient of the intercept and slope coefficients (αˆ n /ρˆ n ), i.e., the ratio of the estimate of the country intercept to the negative of the country slope coefficient. Tabulation of the results for the test of equal magnitudes of slope and intercept coefficients across the seven countries will be interpreted to indicate support for, or rejection of, the common target hypothesis. We note that the latter “country-level” test only makes sense in cases where the partial adjustment model appears to be a reasonable specification for the country in question, that is, when the slope coefficient on the interaction of the country dummy and lagged (normalized) 6

We omit this variable from our results reported in Tables 4 and 5 to conserve space.

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Table 3 Descriptive statistics Mean

Standard deviation

Minimum

Maximum

Panel A: big banks Lagged customer loans ratio Lagged bank deposit ratio Lagged customer deposits ratio Lagged bank loans ratio Lagged securities ratio Lagged total equity ratio Change in customer loan ratios Change in securities ratio Change in bank deposits ratio Change in customer deposits ratio Change in bank loans ratio Change in total equity ratio

1.000 1.004 1.000 1.003 1.003 1.002 0.000 −0.001 −0.000 0.000 0.000 0.004

0.228 0.478 0.264 0.532 0.489 0.262 0.106 0.268 0.218 0.094 0.348 0.215

0.285 0.032 0.511 0.141 0.192 0.472 −0.659 −1.136 −1.014 −0.233 −2.380 −2.024

1.709 2.773 1.884 2.644 2.512 2.809 0.670 1.521 0.568 0.335 2.546 1.724

Panel B: small banks Lagged customer loans ratio Lagged bank deposit ratio Lagged customer deposits ratio Lagged bank loans ratio Lagged securities ratio Lagged total equity ratio Change in customer loan ratios Change in securities ratio Change in bank deposits ratio Change in customer deposits ratio Change in bank loans ratio Change in total equity ratio

1.001 1.002 1.001 1.004 1.004 1.001 0.000 −0.000 0.001 −0.000 −0.003 0.007

0.369 0.809 0.408 0.873 0.766 0.582 0.106 0.352 0.366 0.115 0.387 0.178

0.111 0 0.116 0 0 0.184 −0.714 −2.430 −3.949 −1.232 −1.770 −2.475

1.631 4.106 1.780 4.860 5.090 7.653 0.809 1.633 4.029 1.191 2.252 1.022

Notes: Ratios are for 204 observations on big banks, 1994–2002, and 714 observations on small banks, 1998–2002.

ratio is negative and reasonably precise (statistically significant). Only these cases are discussed in the following section. The common adjustment rate hypothesis of equal slope coefficients across the seven countries, i.e., that ρ1 = ρ2 = · · · = ρn , is linear in the regression coefficients. This hypothesis will be tested by a single F-test. We estimate four versions of Eq. (4), for each of the following key bank ratios (the “X” values): the customer loan to asset ratio; the securities to asset ratio; the customer deposits to asset ratio; and the equity capital to asset ratio. We use seemingly unrelated regression as our estimation technique.7 This method was selected because of the expected high correlation of cross-equation errors. It accounts for the likelihood that a “shock” that causes a particular bank to change its emphasis on one activity will likely be accompanied by a change in emphasis in another.   Descriptive statistics for levels and changes in the normalized variables (Xit , Xit ) for each of the two samples of banks are presented in Table 3. The lagged ratios are normalized by dividing

7 Our model also includes other equations for bank loans and bank deposits as part of the system to account for these important components of assets and liabilities. We omit these from our tables to conserve space.

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them by the grand mean ratios for all banks and changes reflect the gross change from period to period in the normalized ratios. Since, by construction, the means of the normalized ratios approach unity, and mean changes approach zero, the ranges and standard deviations are useful indexes of the cross-section and time-series variation in the ratios relative to the grand means. 4. Results Tables 4 and 5 present our results in separate panels for each variable. Evidence of uniformity in bank product lines is provided if the common target hypothesis cannot be rejected, i.e., if the tabulation of the seven tests of the hypotheses of equal slope and intercept coefficients for each country suggests that all countries have similar targets. The results of F-tests of the differences between the magnitude of county intercept and the country slope coefficients are reported under the column headed αn /ρn in the tables. Also of interest is whether the rate of convergence to targets is uniform, as reflected in the F-test for equal country slopes in each equation. The result of this test for each equation is presented at the foot of the respective panels of the table. 4.1. Overview of model performance By way of overview of the performance of the partial adjustment model, in which the slope coefficient (−ρ) is interpreted as the negative of the rate of adjustment to the target ratio, we note the frequency and statistical significance of negative coefficients. Of the 28 estimates for the big bank sample, 26 are negative and 16 of those are significant at the 5% level (one-tailed test), which suggests that banks are adjusting their product lines and financial structures toward individual normalized targets (which, under the alternative hypothesis, is not necessarily a common standard shared by all countries).8 The overall test of equivalence of the slope coefficients across all big banks is rejected for all variables. Tabulation of the rankings of countries on the magnitude of adjustment rates (not shown) reveals that big banks in France, on average, adjusted most rapidly, while big banks in the UK were slowest to adapt. For the small bank sample, 25 of the slope coefficients were negative, and 16, significantly so, at the 5% level.9 The overall test of equivalence of the slope coefficients across all small banks is rejected for all ratios. Tabulation of the rankings of countries on the magnitude of adjustment rates (not shown) reveals that small banks in Italy, on average, adjusted rapidly, while small banks in Switzerland adjusted slowly. With respect to the question of the size of individual country targets relative to the benchmark mean ratio, and considering only those quotients for countries with a statistically significant slope coefficient, we find that the quotient of the intercepts and slope coefficients are significantly different from unity at the 10% level in six cases in the big bank sample and in 12 cases in the small bank sample (out of a possible 28 cases for both). Thus, for both samples, we reject the hypothesis that country target ratios are equal. The fewer cases of countries whose target levels diverge from the grand mean ratios in the large bank sample suggests that larger banks are further along than smaller banks in the convergence process, perhaps as a result of their greater scope, which may contribute to greater similarity in investment and financing opportunities—i.e., the increase in global competitiveness has likely

8 9

Of the two positive slope coefficients, neither was statistically significant. Of the three positive slope coefficients, none were statistically significant.

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Table 4 Seemingly unrelated regression results, big banks Country

Intercept α

Slope −ρ

αn /ρn

F-statistic αn /ρn

Panel A: customer loans/assetsa Switzerland 0.046 (0.69) Germany 0.016 (0.12) Denmark 0.520 (1.77) Spain 0.183 (1.06) France 0.409* (5.27) UK 0.039 (0.71) Italy 0.339* (2.72)

−0.150 (−1.62) −0.037 (−0.28) −0.465* (−1.77) −0.172 (−0.84) −0.489* (−5.77) −0.026 (−0.59) −0.298* (−2.46)

0.30* 0.43 1.12 1.06 0.83* 1.50 1.13*

5.76 1.03 1.54 0.05 7.37 0.26 3.43

Panel B: securities/assetsb Switzerland Germany Denmark Spain France UK Italy

−0.311* −0.581* −0.645* −0.413* −0.540* −0.149* −0.252*

1.31 0.89 1.41** 1.23 1.16 0.39 0.44*

1.63 1.18 3.00 0.39 1.57 1.89 3.37

0.409* (3.56) 0.522* (2.84) 0.915 (1.89) 0.510 (1.43) 0.629* (4.14) 0.058 (0.73) 0.111 (0.97)

(−4.11) (−3.23) (−1.87) (−1.90) (−4.55) (−2.88) (−1.66)

Panel C: customer deposits/assetsc Switzerland 0.011 (0.14) Germany 0.059 (0.82) Denmark −0.060 (−0.54) Spain 0.669* (2.71) France 0.103 (1.75) UK 0.039 (0.75) Italy 0.387* (4.60)

−0.067 (−0.66) −0.117 (−1.40) 0.013 (0.11) −0.624* (2.58) −0.108* (−1.83) −0.031 (−0.79) −0.384* (−4.11)

0.16* 0.51* 4.61 1.07 0.95 27.06 1.14

2.82 5.97 2.29 2.19 0.05 0.12 0.01

Panel D: total equity/assetsd Switzerland 0.058 (0.54) Germany 0.392 1.44) Denmark −0.074 (−0.32) Spain −0.54 (−0.30) France 0.054* (8.69) UK 0.094 (0.81) Italy 0.021 (0.11)

−0.269* (−2.05) −0.536 (−1.63) −0.075 (−0.34) 0.022 (0.17) −0.907* (−10.77) −0.177* (−1.67) −0.040 (−0.24)

0.21* 0.73* −0.98* 2.45 0.95 0.53* 0.52

11.62 4.44 7.09 0.22 0.76 3.58 0.20

Notes: t-statistics are in parentheses. A negative slope coefficient, coupled with a ratio (A/(−B)) in excess of unity, is consistent with a conclusion that the target ratio for a country is above the overall mean for the seven countries in the sample. The sample consists of 204 bank observations, 1994–2002. The system weighted R-square is 25%. * indicate statistical significance at the 5% level. a F-value for common adjustment rate hypothesis (ρ = ρ = · · · = ρ ): 4.64, PR > F, .00. 1 2 n b F-value for common adjustment rate hypothesis (ρ = ρ = · · · = ρ ): 2.64, PR > F, .02. 1 2 n c F-value for common adjustment rate hypothesis (ρ = ρ = · · · = ρ ): 3.01, PR > F, .01. 1 2 n d F-value for common adjustment rate hypothesis (ρ = ρ = · · · = ρ ): 9.84, PR > F, .0. 1 2 n

contributed to greater homogeneity of operations for these banks relative to smaller banks whose main interests were concentrated more locally. It also is possible that large banks’ interest in international investment and financing would have rendered them more responsive to relatively early efforts at integration (such as Second Banking Directive of 1993).10 10 Another possible reason that we find fewer instances of significant divergence of estimated target ratios from the grand mean is purely statistical—the big bank sample size is much smaller than that for the small banks.

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Table 5 Seemingly unrelated regression results, small banks Country

Intercept α

Slope −ρ

αn /ρn

F-statistic αn /ρn

Panel A: customer loans/assetsa Switzerland 0.011 (0.43) Germany 0.106* (5.28) Denmark 0.316* (5.08) Spain 0.083 (1.48) France 0.024 (0.80) UK 0.032 (0.65) Italy 0.222* (6.81)

−0.035* (−1.88) −0.180* (−6.64) −0.293* (−5.52) −0.063 (−1.29) −0.057* (−2.59) −0.066 (−1.46) −0.203* (−6.48)

0.31* 0.58* 1.07 1.31 0.42* 0.48* 1.09*

3.19 30.19 2.46 1.13 4.61 3.20 3.87

Panel B: securities/assetsb Switzerland Germany Denmark Spain France UK Italy

−0.024 (−0.40) −0.151* (−3.97) −0.258* (−5.19) −0.156* (−3.17) −0.135* (−3.39) −0.039 (−0.88) −0.345* (−8.19)

2.54 1.83* 1.42* 0.91 0.74 3.84* 0.57*

.59 13.49 5.30 .05 .44 2.77 15.84

Panel C: customer deposits/assetsc Switzerland 0.060 (0.97) Germany 0.010 (0.55) Denmark −0.012 (−0.25) Spain 0.270* (4.00) France 0.126* (4.19) UK 0.052 (0.88) Italy 0.123* (3.93)

−0.020 (−0.37) 0.001 (0.05) 0.001 (0.05) −0.182* (−3.26) −0.078* (−3.82) −0.016 (−0.38) −0.089* (−2.80)

3.00* 10.00 12.00 1.48* 1.61* 3.25 1.38*

6.10 0.55 0.33 14.15 7.45 2.12 8.00

Panel D: total equity/assetsd Switzerland 0.034 (0.62) Germany 0.204* (8.47) Denmark 0.037 (0.61) Spain 0.241* (3.40) France 0.060* (2.02) UK 0.030 (0.64) Italy 0.195* (4.71)

0.043 (−0.99) −0.390* (−11.37) −0.205 (−0.54) −0.206* (−3.42) −0.010 (−0.68) −0.004 (−0.14) −0.156* (−4.66)

0.79 0.52* 0.18 1.16 6.00* 7.50 1.25*

0.15 65.45 0.28 1.31 4.10 0.66 5.34

0.061 (1.01) 0.277* (4.75) 0.367* (4.38) 0.142 (1.59) 0.101 (1.69) 0.150 (1.65) 0.197* (4.74)

Notes: t-statistics are in parentheses. A negative slope coefficient, coupled with a ratio (α/ρ) in excess of unity, is consistent with a conclusion that the target ratio for a country is above the overall mean for the seven countries in the sample. The sample consists of 714 bank observations, 1998–2002. The system weighted R2 is 13%. * indicate statistical significance at the 5% level (using a one-tailed t-statistic for significance of slope coefficients. a F-value for common adjustment rate hypothesis (ρ = ρ = · · · = ρ ): 8.34, PR > F, .00. 1 2 n b F-value for common adjustment rate hypothesis (ρ = ρ = · · · = ρ ): 6.03, PR > F, .00. 1 2 n c F-value for common adjustment rate hypothesis (ρ = ρ = · · · = ρ ): 2.71, PR > F, .01. 1 2 n d F-value for common adjustment rate hypothesis (ρ = ρ = · · · = ρ ): 19.79, PR > F, .00. 1 2 n

4.2. Activity convergence for big banks The results on tests of the quotients reveal heterogeneity in target levels for several activities, both on the investment and financing sides of the balance sheet. From Panel A of Table 4, we observe that Italy’s estimated target ratio for customer loans to assets is significantly higher than the benchmark average, whereas France’s is significantly lower. The rejection of the common target hypothesis for customer loans implies that, even among big banks with international scope, lending

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markets retain a national identity. This conclusion is consistent with the findings of earlier research on interest-rate differentials that European markets for mortgages, consumer loans and some corporate loans remain segmented (Adam et al., 2002; Kleimeier and Sander, 2002; Baele et al., 2004). Persistent segmentation may be due to differences in legal frameworks and tax incentives, to the localized, and less standardized, nature of credit markets (Adam et al., 2002) or to less competitive loan pricing caused by increases in bank concentration (Kleimeier and Sander, 2002). With respect to securities investments (Panel B), Denmark’s target securities-to-assets ratio is above the benchmark, while Italy’s is below. In both cases, these results appear to be a continuation of historical practice (Table 1). Even for big banks, and even in markets normally considered to be “wholesale,” rather than “retail,” convergence of interest rates across Europe apparently has not subjected banks to a uniform portfolio choice. This may be related to differences in market liquidity and in the availability of developed derivatives markets in various countries (Baele et al., 2004). In summarizing convergence from a country perspective, the most noteworthy conclusions for target investment levels are that Italy’s large banks are shifting relative emphasis from securities to customer loans, and that banks in France are deemphasizing customer loans. Our results suggest that large French banks compensate for the relatively low targets in both loan categories with higher targets elsewhere. The results in Panel B indicate an above-benchmark level of securities investments for large French banks, although the F-test does not indicate significance at 10% level. On the financing side of the balance sheet, we do not find evidence of divergence in customer deposit ratios (at least among those countries with statistically significant adjustment rates). The uniformity of deposit ratios is somewhat of a surprise given earlier evidence that retail deposits markets are characterized by “persistent home biases” in borrowing from smaller non-financial businesses and households (Baele et al., 2004). One explanation may be that big banks are less dependent than smaller banks on local markets. For equity (Panel D), big banks in two countries, Switzerland and the UK, have estimated targets that are significantly different from the benchmark. The differences suggest that the process of harmonization of capital standards under the Basel Capital Accord is incomplete. This extends a similar finding by Jackson (1999) on an earlier sample period.11 The latter study contends that differences may be attributable to a variety of factors in particular countries including the perceived magnitude of the “safety net,” the nature of the activities carried out by banks and supervisory practice. In this regard, it is interesting to note that Switzerland and the UK are typically described as having a “market-based” as opposed to a “bank-based” financial system more common in other European countries. 4.3. Activity convergence for small banks For customer loans, in Panel A of Table 5, four countries have statistically significant quotients. Switzerland, Germany and France have relatively low targets, while Italy’s target is above the European benchmark. The greater incidence of differential targets in the small bank sample (four) versus the large bank sample (two) may reflect the more localized nature of the lending markets for banks serving smaller borrowers12 . The European Central Bank (2004) has stated that, although 11 In a related study, Shrieves et al. (2006) find that equity market orientation and shareholder protection features of the country in which a bank is located are positively related to bank capitalization. 12 It may also reflect different sampling periods (our small bank small bank sample is limited to after 1997).

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“improvements” have taken place since the introduction of the euro, bank credit markets in Europe tend to be less integrated than other markets. In these markets, cross-border competition for such lending may be weaker because of the importance of idiosyncratic information (Manna, 20024). For securities (Panel B), Italian banks have a statistically significant quotient indicating a relatively low target. This, combined with the higher than average target for customer loans, suggests a shift of small Italian banks from securities investment to lending. Germany and Denmark, on the other hand, have statistically significant quotients above the European mean. For customer deposits (Panel C), Spain, France and Italy have statistically significant quotients. Recall from the earlier section that large banks exhibited uniform target ratios for customer deposits across countries. The greater incidence of differences for small banks underscores the localized nature of their retail markets. With regard to equity capitalization (Panel D), the statistically significant quotients for Germany and Italy indicate that small German banks have relatively low targets and that small Italian banks have relatively high targets. The former is confirmed by the extremely low capitalization of German banks. 4.4. Summary remarks The three countries for which targets are most often distinct – Italy, France and Germany – have banks with largely domestic orientations, as evidenced by “markedly” lower shares of crossborder activity than other countries (Manna, 2004), and often serve narrow geographic markets. In Germany, for instance, publicly-owned savings banks operate under significant geographic and product restrictions and cooperative banks serve limited local areas. Germany and Italy also are characterized by hostility to acquisition of domestic banks by foreign banks, which may have affected the extent of bank integration. Similarly, the situation in France may be affected by “the stiff competition and resulting low profitability of banking activities in France, which have not made French banks very attractive for foreigners as opposed to those of other countries (Fitch Ratings Ltd, 2001).” Our results for Italian banks are noteworthy in another respect. The greater incidence of unique targets for small Italian banks, relative to large Italian banks, indicates a greater resistance for the former to the imposition of a uniform structure of assets and liabilities. This may be related to an uneven impact of regulatory changes in Italy throughout our sample period, which caused a transformation in the range of products and services offered. For specific activities, our results indicate that convergence toward common targets is least prevalent in customer lending, particularly among smaller banks. This is consistent with prior research suggesting that integration on the product markets for retail lending is proceeding more slowly than in other areas. For specific countries, our analysis of country targets indicate that small Italian banks are the most resistant to adopting common targets, while banks in the UK and Spain evidenced the most complete adoption of common targets. 5. Conclusions We test for national differences in target levels of product lines and financial structure for a sample of banks in Germany, France, Switzerland, Denmark, Spain, Italy and the UK, 1994–2002, a period of dramatic regulatory change and the dissemination of new technologies in banking. A pooled time-series and cross-sectional methodology is used in tests to determine whether the activities of European banks are converging in the sense that banks in different countries share

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common targets in product-line mix and financial structures, and whether they exhibit common rates of adjustment toward those targets. Our evidence rejects the common targets hypothesis for all activities for small banks and for all activities except customer deposits for large banks. The common rate of adjustment hypothesis is rejected for all activities, for both samples, except for customer deposits among large banks. We conclude that banks in Europe, particularly small banks, exhibit important differences in target levels of investment and financing activities over our sample period. The rejection of the common targets hypothesis is not necessarily inconsistent with the objectives of financial market integration. Nevertheless, understanding the emerging national banking structures is essential to continuing formulation of sound policy and implementation of effective regulatory mechanisms. In this respect, whatever the extent of success in financial market integration, it has not yet, and may never, eliminate cross-national differences in bank asset and liability structures. Previous research suggests that efforts to integrate financial markets have changed the face of European banking. This paper, however, has presented evidence that the successes of market integration have not uniformly eliminated national differences in the portfolio investment and financing activities of banks in the nations studied. By implication, the persistence of national differences will complicate the continuing evolution of policy as it relates to the process of market integration. References Adam, K., Jappelli, T. Menichini, A., Padula, M., Pagano, M., 2002. Analyse, compare and apply alternative indicators and monitoring methodologies to measure the evolution of capital market integration in the European Union, Working Paper (University of Salerno). Baele, L., Ferrando, A., Hordahl, P., Krylova, E., Monnet, C., 2004. Measuring financial integration in the Euro area, Working Paper (European Central Bank). Barth, J., Caprio, G., Nolle, D., 2004. Comparative international characteristics of banking, Working Paper (Economic and Policy Analysis). Belaisch, A., Kodres, L., Levy, J., Abide, A., 2001. Euro are a banking at the crossroads, Working Paper (International Monetary Fund). Berger, A., Smith, D., 2003. Global integration in the banking industry. Federal Reserve Bulletin, 451–460. Casu, B., Girardone, C., 2005. Bank competition, concentration and efficiency in the single European market, Working Paper (University of Wales). DeBandt, O., Davis, E., 2000. A cross-country comparison of market structures in European banking, Working Paper (European Central Bank). Dermine, J., 2002. Banking in Europe: past present and future, Working Paper (European Central Bank). European Central Bank, 2004. Research Network on Capital Markets and Financial Integration in Europe. Fitch Ratings Ltd, 2001. The French Banking System. Fitch Ratings Ltd. Jackson, P., 1999. Capital requirements and bank behaviour: the impact of the Basle Accord, Working Paper (Bank for International Settlements). Kleimeier, S., Sander, H., 2002. European financial market integration, Working Paper (Universitiet Maastricht). Kleimeier, S., Sander, H., 2003. Towards a single European banking market, Working Paper (University of Melbourne). Manna, M., 2004. Developing statistical indicators of the integration of the Euro area banking system, Working Paper (European Central Bank). Moerman, G., Mahieu, R., Koedijk, K., 2004. Financial integration through benchmarks: the European banking sector, Working Paper (Erasmus University). Shrieves, R., Dahl, D., Spivey, M., 2006. Capital market regimes and bank competition: the recent European experience, Working Paper (University of Tennessee).