09/2006/#17

journal
the journal of financial transformation

Growth

Institutional
Financial

Recipient of the APEX Awards for Publication Excellence 2002-2006

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Growth
Editor
Shahin Shojai, Director of Strategic Research, Capco

Advisory Editors
Dai Bedford, Partner, Capco
Predrag Dizdarevic, Partner, Capco
Bill Irving, President, Capco
Pedro Matthynssens, Partner, Capco

Editorial Board
Franklin Allen, Nippon Life Professor of Finance, The Wharton School,
University of Pennsylvania
Joe Anastasio, Partner, Capco
Philippe dArvisenet, Group Chief Economist, BNP Paribas
Rudi Bogni, former Chief Executive Officer, UBS Private Banking
Bruno Bonati, Strategic Consultant, Bruno Bonati Consulting
David Clark, NED on the board of financial institutions and a former senior
advisor to the FSA
Gry Daeninck, former CEO, Robeco
Stephen C. Daffron, COO, Renaissance Technology Partners
Douglas W. Diamond, Merton H. Miller Distinguished Service Professor of Finance,
Graduate School of Business, University of Chicago
Elroy Dimson, BGI Professor of Investment Management, London Business School
Nicholas Economides, Professor of Economics, Leonard N. Stern School of
Business, New York University
Michael Enthoven, Chief Executive Officer, NIB Capital Bank N.V.
Jos Luis Escriv, Group Chief Economist, Grupo BBVA
George Feiger, Executive Vice President and Head of Wealth Management,
Zions Bancorporation
Gregorio de Felice, Group Chief Economist, Banca Intesa
Hans Geiger, Professor of Banking, Swiss Banking Institute, University of Zurich
Wilfried Hauck, Chief Executive Officer, Allianz Dresdner Asset Management
International GmbH
Thomas Kloet, Senior Executive Vice-President & Chief Operating Officer,
Fimat USA, Inc.
Herwig Langohr, Professor of Finance and Banking, INSEAD
Mitchel Lenson, former Global Head of Operations & Technology, Deutsche Bank Group
David Lester, Chief Information Officer, The London Stock Exchange
Donald A. Marchand, Professor of Strategy and Information Management,
IMD and Chairman and President of enterpriseIQ
Colin Mayer, Peter Moores Professor of Management Studies, Sad Business School,
Oxford University
Robert J. McGrail, Chairman of the Board, Omgeo
Andrew McLaughlin, Group Chief Economist, The Royal Bank of Scotland
John Owen, COO, Wholesale Banking, ING
Derek Sach, Managing Director, Specialized Lending Services, The Royal Bank
of Scotland
Jos Schmitt, Partner, Capco
John Taysom, Founder & Joint CEO, The Reuters Greenhouse Fund
Graham Vickery, Head of Information Economy Unit, OECD
Norbert Walter, Group Chief Economist, Deutsche Bank Group
Table of contents

Nobel Laureate View

8 How to deal with a Europe in crisis: some responses to
questions, for a different Europe.
Professor Maurice Allais, Professor Emeritus of Economic Analysis, Ecole
Nationale Suprieure des Mines de Paris, and Winner of The Bank of
Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1988

12 War and business enterprises

Angelo Gnaedinger, Director-General, International Committee of the Red
Cross (ICRC), recipient of the Nobel Peace Prize in 1917, 1944, and 1963

Institutional Financial
16 Opinion: Access to financial services: a review of the issues 98 Opinion: Creating real business intelligence: seven key
and public policy objectives principles for MIS professionals
Stijn Claessens, Senior Adviser, Financial Sector Vice-Presidency (FSE), The Laurence Trigwell, Senior Director of Financial Services, Cognos
World Bank Corporation

20 Opinion: The governance of the securities clearing and 103 Opinion: Using business intelligence to develop standard
settlement industry measures of operational risk
Daniela Russo, Deputy Director General, Directorate General Payment Jill Eicher, Managing Director, Adaptive Alpha LLC
Systems and Market Infrastructure, European Central Bank David Ruder, Managing Director, Adaptive Alpha LLC
Chryssa Papathanassiou, Senior Expert, Directorate General Payment
Systems and Market Infrastructure, European Central Bank 106 Opinion: Surviving the future: how operations and IT
transformation can be at the core of a winning strategy
24 Opinion: The day of the MiFID: applying to all, different Crispian Lord, Managing Principal, Capco
implications for each
Ian Jack, Business Development Manager, COLT Financial Services Practice 112 Opinion: Leveraging hosted middleware services to deploy
Mark OConor, Partner, Technology, Media and Communications group, DLA valuable new services quickly and easily
Piper Rudnick Gray Cary Gailanne Barth, Global Practice Leader, Easylink Services Corporation
Henry Bayard, VP Strategic Initiatives, Easylink Services Corporation
28 Opinion: Does capital mobility promote economic growth?
The link to education 115 Opinion: Why gut feeling is just not enough for building a
Hartmut Egger, Senior Assistant, University of Zurich, CESifo, and GEP successful bank?
Peter Egger, Professor, University of Munich, CESifo, and GEP Francesco Burelli - Principal Consultant, Capco
Volker Grossmann, Associate Professor, University of Fribourg, CESifo, and Kim Warren - Teaching Fellow, Strategic and International Management,
Institute for the Study of Labor (IZA) London Business School

32 Opinion: Growth and its measurement 123 Is competition in the financial sector a good thing?
Bala R. Subramanian, Chairman, President, and CEO, Synergism, Inc. Falko Fecht, Economist, Deutsche Bundesbank
Antoine Martin, Senior Economist, Federal Reserve Bank of New York
36 Opinion: The welfare implications of product patent: a simple
model 131 A bad situation getting worse the U.S. banking
Arijit Mukherjee, Associate Professor, School of Economics, University of profitability crisis
Nottingham and The Leverhulme Centre for Research in Globalisation and Adam Dener, Partner, Capco
Economic Policy Andrew Pirnie, Head of Research, Capco
Achintya Ray, Assistant Professor, Economics & Finance, Tennessee State Diane McDevitt, Managing Principal, Capco
University
141 Threshold relationships among inflation, financial market
39 Knowledge management, innovation, and productivity in
development, and growth
French manufacturing Michelle L. Barnes, Senior Economist, Federal Reserve Bank of Boston
Elizabeth Kremp, Chef du bureau des etudes structurelles, Sessi Nicolas Duquette, Senior Research Assistant, Federal Reserve Bank of
Jacques Mairesse, Professor CREST-ENSAE and Maastricht University Boston

49 Obstacles in offshoring and outsourcing investment banks 151 Manufacturing growth

research Peter Moles, Senior Lecturer in Finance, University of Edinburgh
Michael H. Grote, Klein&Coll.-Professor for Mergers and Acquisitions of SME, Management School
Finance Department, Johann Wolfgang Goethe University
Florian A. Tube, Research Associate, Innovation Studies Centre, Tanaka 161 Corporate hedging and capital structure decisions:
Business School, Imperial College
towards an integrated framework for value creation
Lutz Hahnenstein, IKB Deutsche Industriebank AG,
61 European banking consolidation: effects on competition, Kreditrisikocontrolling
profitability, and efficiency Klaus Rder, Professor of Finance, Universitt Regensburg, Lehrstuhl fr
David-Jan Jansen, Economist, Economics and Research Division, De Betriebswirtschaftslehre, insbesondere Finanzdienstleistungen
Nederlandsche Bank
Jakob de Haan, Professor of Political Economy and Director of Graduate
Studies, Faculty of Economics, University of Groningen

73 The merchant-bank struggle for control of payment systems

Adam J. Levitin is an attorney in New York City

85 The credit rating agencies and their credit ratings

Herwig M. Langohr, Professor of Finance and Banking, INSEAD
Planning for growth

For most of their productive lives human beings strive for bigger, better, faster, larger, and more especially in the
Western world. We are programmed to think in terms of growth, it is in our DNA. A Journal focused on growth will,
therefore, appeal to our readership at large, especially now that economic growth rates, with all of their embellish-
ments and accoutrements, seem to be back to stay in Europe and the Americas, as well as in Japan.

Before you start reading this 17th issue of our award-winning Journal of Financial Transformation, I want to share
three recent news snippets with you:
BNP Paribas aims for growth in Europe: preparing an ambitious expansion into Germany, Spain and the UK in

attempt to take on some of its established rivals on their home turf. (Financial Times July 26, 2006)
Hedge funds attracted a net $42.1 billion from April through June 2006, the most in one quarter since at least

2003, according to a new report from HedgeFund Research, Inc. (HedgeFundFocus.com July 24, 2006)
Hewlett-Packard to buy takeover target Mercury in USD 4.5 bln cash deal, its biggest since its ill-starred USD 21

bln acquisition of Compaq (eFinancialnews.com July 26, 2006)

As a trained economist and an entrepreneur, I share two different views on how to realize economic growth. The
age-old issue around growth is the intuitive dichotomy between government-led planning for growth versus the
individual (enterprise) initiative for newer, higher, and better.

Macroeconomic policies (classical, Keynesian demand-side fiscal or monetary policies, coupled with supply-side leg-
islation aimed at improving economic infrastructure, such as leaner labor laws or business licensing) have proved
their effectiveness. Favorable economic policies have helped the United States to outperform the countries of the
European Union in economic terms for most of the six decades since World War II. This superior growth has been
based on less rigid fiscal and above all monetary, and credit policies, coupled with favorable economic infrastruc-
ture measures. Many economists would also argue that the enormous productivity growth in the U.S. (spurred by the
ever growing numbers of immigrants and ensuing economic demand) has helped to boost the performance of the
United States economy [Finance and Development, IMF Breaking Down Barriers to Growth March 2006].

However, wearing my entrepreneurial hat, I also strongly believe in the power of the individuals or companies making
growth decisions. The news snippets I presented earlier prove just that: expanding a business into new territories,
setting up new investment vehicles to attract huge inflows of capital, or buying your way into a new line of business
are deliberate plans for growth, inspired by an idea, a vision, or a need for DNA-based more. All three are perfect
examples of the power of the individual (enterprise), not directly linked to any macroeconomic policy or measure.

The best way to achieve economic growth is as always probably a hybrid of these two competing views. Planning
for growth, however, is what mankind will continue to do for the foreseeable future. This Journal examines the insti-
tutional and regulatory framework for growth, and the impact this has on the financial services industry. It also looks
at ways and means to facilitate growth, from IT and operations to corporate hedging and capital structure decisions.
I hope the many essays on development, expansion, and enlargement in this Journal will help you advance your
insight into growth.

Yours,

Rob Heyvaert,
Founder, Chairman and CEO, Capco
It is now time to focus on growth

The last six years or so have become synonymous with efforts by financial institutions to reduce costs and improve
the efficiency of their operations. Having slashed costs to acceptable levels, financial institutions are now turning
their attention to increasing revenues and growing the business, something most of their management are better
suited to; after all, the cost-cutting exercises of most financial institutions in response to the collapse of the equity
markets do not provide best-practice case studies of how such activities should be undertaken. By contrast, increas-
ing revenues is something that comes naturally to most financial executives, and if the recent record-breaking
figures are anything to go by, they seem to have become even better at it.

However, the articles in this issue highlight two important issues that might have been overlooked in all the attention
received by the industrys record-breaking figures. Firstly, it seems that some, and by no means all, financial institu-
tions are recognizing that their huge investments in operations and technology can actually be used to help grow
the business, and that may be they can even be turned into successful businesses in their own right. Of course, mak-
ing a cost center into a profitable organization is no easy task, but there is a growing number of precedents to prove
that it can certainly be done. The other important issue is that the U.S. banking industry is in fact in the early stages
of a sustainable profitability compression, and that despite the huge strides taken in improving the efficiency of the
industry more needs to be done in order to avoid what seems to be an industry-wide problem.

This issue of the Journal is focused on an area that most financial executives are interested in, namely growth. The
articles in this issue of the journal aim to help financial executives better prepare for growth and avoid the potential
profitability compression that is being predicted. We are grateful to all the authors who contributed to this issue.

We are also very pleased to inform you that, as with previous issues, we have two wonderful contributions for our
Nobel Laureate View section. We are very grateful to Professor Maurice Allais who shares with us his views about
the problems facing the European Union and provides prescriptive solutions as to how these issues could be best
managed. Professor Maurice Allais is one of the greatest living economists. His contributions to the theory of mar-
kets and efficient utilization of resources are the foundation upon which many other laureates have based their work.
Prof. Allais is also one of the very few laureates who many believe deserves a second Nobel Prize for his contribution
to another discipline, namely physics.

For the non-economist Nobel Laureate View, we have an excellent contribution from the Director-General of undoubt-
edly the most famous humanitarian organization of them all, the International Committee of the Red Cross (ICRC),
recipient of the Nobel Peace Prize in 1917, 1944, and 1963. We are very grateful to Angelo Gnaedinger for kindly
taking the time to share with us his views about how the world of business could become a better partner for
humanitarian organizations like the ICRC, and improve the way we help those in need.

We genuinely hope that you enjoy reading this fascinating issue of the Journal and that you continue to support this
publication by submitting your ideas to us.

On behalf of the board of editors

 The Nobel Laureate view

How to deal with a Europe in crisis:

some responses to questions, for
a different Europe

Professor Maurice Allais

Professor Emeritus of Economic Analysis, Ecole Nationale Suprieure des Mines de Paris, and
Winner of The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1988

We are very grateful to both Prof. Maurice Allais and publish- exports and an increase in imports, but this effect only exists
ers Clment Juglar for giving us permission to reprint if there is no tariff limit or protection from the Euro-zone and
excerpts from Prof. Allais book (LEurope en crise, que faire?: thus could be phased out following fundamental changes by
Rponses quelques questions, pour une autre europe), pub- the International Monetary System5.
lished in 2005 in Paris, for the Nobel Laureate section of this
issue. We are also very grateful to Martyn Shone for kindly Q: Technically, modernization is perhaps inevitable, but
translating the text into English. what measures should we take to overcome its negative
effects?
Q: Is the euro essential to the development of Europe?
I have always been of the opinion that a single currency Pseudo solutions
should and could only be the final part to the creation of an There is a massive problem with unemployment today and
economic union. Therefore, from my point of view the intro- there is still no proven diagnosis, resulting in many pseudo
duction of the euro has been premature. solutions being put forward.

However, now that the euro has been adopted by the 12 E.U. We have been told it is simple. If you want to stamp out
member states1 under a set of proven regulations2 I can see unemployment, you have to reduce wages, but nobody
the advantages, as long as the regulations are maintained. tells us by how much, or mentions how feasible this could
The European Central Bank (ECB) should achieve an average be without affecting social peace. It is appalling to see
annual growth of 2% and there should be a control on capital large organizations, such as the OECD, WTO, IMF, or the
movements between foreign countries. World Bank, advocate such a solution.
We have been told that the reduction of working hours
Today, there are a large number of critics that feel this policy will reduce unemployment, but apart from the fact that
is responsible for the difficulties encountered and strongly workers are not perfectly substitutable for one another,
advocate a solution to revive the economy through inflation. such a solution ignores the fact that many urgent needs
This is a big mistake. The difficulties we come across do not are not met. Therefore, these issues cannot be resolved
come from the European Central Banks monetary policies but by workers working less. Furthermore, looking at the pop-
from free trade policies set in Brussels. The best proof of this ulation pyramid and demographic forecasts, surely a
is that in 2004 the average unemployment rate in both the reduction of working hours and a lowering of the retire-
Euro-zone and the thirteen other E.U. countries was exactly ment age will seriously jeopardize the future.
the same at 8.8%3. Some believe you can overcome the problem of unem-
ployment through inflation. However, trying to struggle
As I have been saying for the past 50 years, inflation is not a against the effects of global free trade using monetary
condition of growth. In fact, inflation will only jeopardize expansion and inflation is misguided, and shows a lack of
growth4. It is true that the stability of the euro tends to make awareness of the true causes of the problems. This situa-
it stronger against other currencies, leading to a reduction in tion is, in its nature, nothing like the Great Depression of

1 Members: Germany, Austria, Belgium, Spain, Finland, France, Greece, Ireland, Italy, 3 Bulletin from the Bank of France, April 2005
10 Luxembourg, Netherlands, and Portugal. 4 Refer to Allais, 1974, LInflation Francaise et la Croissance, Mythologies et Realite
2 Apart from Spain, Portugal, and Greece, Gross Domestic Product (GDP) per person 5 Refer to Allais, 1999, La Crise Mondiale dAujordhui. Pour de Profondes Reformes
is the same for all countries within the Euro-zone. des Institutions Financieres et Monetaires
 the 1930s. unhealthy development of capitalism.
Consider something that may appear to be a paradox: the
blind pursuit of an allegedly liberal policy that provides This pseudo liberalism and the increase in deregulation
widespread global free trade and establishes pseudo solu- has ever so slightly resulted in a global laissez- faire
tions both leads our country towards the creation of inter- havoc. But, remember the trade economy is only a tool
ventionist measures of a collectivist type and tries to and should not be disassociated from its institutional and
cover up the disruptions fueled by global free trade. political context. There would not be an effective market
economy if it did not take place within an appropriate
The established truth institutional and political context. A free market society
France today is in self-destruct mode. does not and could not exist in a state of anarchy.

How do you explain such a situation? Essentially, the extreme Globalization of the economy is certainly very profitable for a
deterioration of France since 1974 can be explained by the few groups of privileged people. However, the interests of
continuing repetition of the established truth, with those these groups may no be shared by the rest of the population.
unspoken taboos, the mistaken prejudices, accepted without Rapid and anarchic globalization will only lead to instability,
being approved, of which the perverse effects are multiplied unemployment, injustice, chaos and all sorts of misery, and
and reinforced throughout the years. will only be a disadvantage for everyone.

This control results in a non-stop attack of opinions by some The reason we are in this situation today is because the prin-
financial media, by powerful lobbyists. It is practically forbid- ciples above have been ignored. However, if the principles
den to suggest that the secret globalization of trade is a cause were implemented it would encourage a society of progress,
of unemployment. Nobody wants to and nobody can look at efficiency, and humanity.
the obvious: if all the policies of the last 30 years have failed
then they have constantly refused to look at the root cause of A mandatory condition: restoration of
the problem, the globalization of free trade. community first position
Undeniably, global free market policies put in place in Brussels
This evolution is down to the growing power of American are the major cause, and by far the most important are mass
multinationals, resulting in multinationals all over the world. under-employment and growth reduction. To solve this, the
Each of these multinationals has hundreds of subsidiaries. European project should be based on the restoration of com-
They have enormous financial resources and are able to slip munity first position and the control of capital flows: the true
through all the control barriers. They carry extortionate condition of expansion, labor and prosperity. This principle is
political power. Only they benefit from unreserved liberaliza- universally valid for all countries.
tion of trade.
A sensible objective would be to allocate a minimum per-
In fact, this evolution has come about at the same time as an centage, by product or product type, of E.U. consumption

11
 to be satisfied by E.U. production. A target average of The immediate restoration of the community first position and
80% of E.U. consumption from local production seems all it implies is absolutely necessary for the survival of the E.U.
reasonable. Looking at todays situation, we have a funda- In fact it would be very difficult from a legal or institutional
mentally liberal approach that permits an efficiently run perspective to restore a community first position. However, if
economic community safe from any external problems, that did occur, it would result in a group of members withdraw-
with everyone offering extended and beneficial links with ing from the E.U.
non-E.U. trading partners6.
In fact, total market freedom is neither possible nor desir- However, I am convinced that if the people from the extreme
able, except within regional frameworks, constituting right and extreme left united to restore the community first
countries with common economic and political associa- position, the French President would listen to their case.
tion, with comparable economic development and social
situations, and where a sufficiently large market can The rivalry between politicians and political parties for the
ensure sufficient competition to generate efficiency and 2007 election is insignificant compared to the rebuilding of
benefits. growth and employment. This can only be achieved through
the restoration of the community first position.
Every regional organization should be able to implement a
system that can protect itself from external sources, to avoid Only one compelling strategy emerges: victims of globaliza-
excessive distortions of competition and perverse effects of tion unite!
external events, and to stop unwelcome specializations that
would unnecessarily generate instability and unemployment. Unity is power and overcomes all obstacles.
These specializations are the exact opposite of a situation
where there is maximum efficiency on a global scale associ- French politics
ated with an international distribution of wealth. France cannot continue to participate in a policy of global free
trade, supported by Brussels, because it will result in an
The conditions for restoring community first unbearable situation.
position
In fact a community first position should be at the heart of Today, the only condition France will contribute to the con-
any policy if it is to restore growth and employment. It assumes struction of Europe is the restoration of the community first
a very strong political will within the current climate. It would position, that is to say a reasonable level of protection for the
not be put in place unless it was unanimously agreed to by all Common Market from external competition within a frame-
25 European Union members. This would also require a modi- work of a Charter of Confederation.
fication to the WTO. If these two conditions were not met then
the 12 Euro-zone partners would need to reestablish their own What must happen will happen? Todays shameful crisis,
community first position and leave the WTO. characterized by unbearable unemployment and the day
to day destruction of French society, is the consequence
If a solution presented itself that would require France to leave of dogmatic politics ever since the Great Rupture of 1974,
the European Union, it is quite possible they would be followed which has led us to disaster. It would be criminal to contin-
by the majority of the members from the Euro-zone, espe- ue to pursue these.
cially the six founders of European Union.
This current situation cannot last. It should not last. It will not

6 A choice between tariff protection and quota protection, refer to Allais, 1999. La
12 - The journal of financial transformation
Mondialisation, la Destruction des Emplois et de la Croissance, pp. 589-603
last. Liberalism would not lower itself to be an economic laissez-
faire: above everything it is a political doctrine, destined to
The big question today is not only about mass unemployment; provide conditions for us all to live together as a collective
it is also about the destruction of our industries, of economic group of citizens; economic liberalism is only a tool for this
growth, and the difficulties they present. political doctrine to be effectively applied in the economic
domain.
It is certain that France has no future of its own unless it is
part of Europe, but this does not mean its power should be Todays confusion about laissez-faire liberalism is one of the
reduced to a level where it is controlled by the apparatchik in biggest errors of our time. A liberal and humanist society
Brussels, nor should it be dictated by a large zone of global should not be identified with terms such as lax, laissez-faire,
free trade open for business. Nor should it be dictated by the perverted, manipulated, or blind.
U.S. who themselves are dominated by powerful American
multinationals. In reality, the global economy, which is presented to us as a
panacea, knows only one thing, money. It has only one faith,
Under no circumstances should France be involved in the money. Without all ethical criteria, it can only destroy itself.
reconstruction of Europe if its interests are dissolved within a
group where its fundamental interests are unrecognized, A crisis of intelligence
resulting in self-destruction or loss of soul. In fact, France has The opening of global business to the European Community in
no interest in continuing to participate within an organization a fundamentally unstable global framework, perverted by a
that would only result in an unbearable situation. floating exchange rate system and where the exchanges are
totally distorted by a broad range of salaries, is the main
The only condition under which we would participate in the cause of such a deep crisis which is slowly moving us towards
reconstruction of Europe is if we could explicitly reestablish the abyss.
the community first position, that is to say a reasonable pro-
tection from outside economic forces. The facts are startling. The economic analysis confirms and
explains it. The facts, as well as the theory, both confirm that
Although, by a different token, the forces of social disintegra- if a generalized policy of global free trade is continually
tion are without doubt stronger today than they were leading adopted, it will only fail and result in disaster. Todays crisis is
up to the French Revolution, and nobody knows what could essentially a crisis of intelligence. It is not good enough to just
happen if there was a breakdown of public order. Like then, look at resolving the effects. We must look at the causes.
the unconscious nature of certain feudals (old fashioned
types), who thought they were safe and who unduly benefited In overcoming this, one principle should be followed that tran-
from the privileged situation, is very apparent today. scends all others: the economy should be a service to man and
not vice versa.
Perversions of socialism have led to the breakdown of societ-
ies in the East. The laissez-faire perversion of this so-called
liberalism in the past 30 years has led us to the breakdown of
French society.

Confusion of liberalism versus laissez-faire

13
 The Nobel Laureate view

War and business enterprises

Angelo Gnaedinger
Director-General, International Committee of the Red Cross (ICRC), recipient of the Nobel Peace
Prize in 1917, 1944, and 1963

parties to a conflict must at all times distinguish between civil- ish violations committed by individuals or entities operating
ians and combatants so as to spare the civilian population and on or from their territory.
civilian property. Attacks may be made solely against military
objectives. This rule protects business installations, which are Business enterprises are increasingly concerned about
considered civilian objects, and their personnel, who unless enhancing their good name through active programs of cor-
they are part of the armed forces of a state are civilians. porate responsibility. An ever larger part of business value is
Accordingly, they may neither be targeted nor take a direct determined by brand reputation. Large companies understand
part in hostilities. If they do take part in fighting or otherwise that they should offer benefits not only to their shareholders
actively serve or support warring parties, they become a but also to society at large. A careful and sensitive analysis of
legitimate military target and may be attacked. the impact they may have while operating in conflict areas or
weak governance zones is a step towards achieving their aim
These rules are particularly relevant to private military and of being perceived as a force for good and boosting their
security firms, which are the firms most likely to be engulfed brand. Corporate codes of conduct, industry-wide codes of
in armed conflict or to take part in actual fighting. The per- conduct, and multi-stakeholder initiatives are some of the
sonnel of these firms, like the members of regular armed tools used by business enterprises to ensure that their opera-
forces, must also obey other fundamental rules. For example, tions are socially responsible. The Equator Principles a set
it is forbidden to kill or wound an adversary who surrenders of guiding principles developed by and for the financial indus-
or who can no longer take part in the fighting (because he, try provide a benchmark for assessing and managing envi-
and increasingly she, is wounded or sick). The right to choose ronmental and social risks in project financing.
methods and means of warfare is not unlimited in particu-
lar, those that are likely to cause superfluous injury or unnec- The ICRC has a mandate from the international community of
essary suffering are prohibited. Captured combatants and states to ensure that IHL is applied fully and to provide protec-
civilians who find themselves under the authority of the tion and assistance for persons adversely affected by armed
adverse party must be protected against all acts of violence conflict. To fulfill this mandate the ICRC must find ways to
or reprisal. They are entitled to exchange news with their reach those in need of help. To obtain access to conflict areas,
families and receive aid. They must enjoy basic judicial guar- it must talk to all those wielding power: not only political
antees. authorities, government armed forces, and rebel forces, but
others too, including civil society leaders, religious leaders
Although as a matter of law the staff of private military and and business leaders. For decades the ICRC has developed
security firms may be held personally responsible for viola- close relations with civilian and military authorities, interna-
tions of IHL, in practice it could be difficult to find a national tional organizations, non-governmental organizations, and
criminal court able and politically willing to exercise extrater- academic circles but has had few systematic contacts with the
ritorial jurisdiction over their alleged crimes. States too may business community, except when buying goods and services
be held responsible for violations of IHL committed by private from private suppliers. To remedy this, it is now developing a
military and security companies which they have empowered dialogue with a number of companies operating in situations
to exercise elements of governmental authority, or which are of conflict or weak governance, which is aimed mainly at mak-
de facto acting on their instructions or under their direct con- ing companies aware of their rights and obligations under IHL.
trol. Even if private contractors are not acting as state agents,
states still have a duty to ensure respect for IHL and exercise As part of its strategy of dialogue the ICRC is participating as
due diligence by doing what is necessary to prevent and pun- an observer in the initiative known as the Voluntary Principles

14 - The journal of financial transformation

Warfare has undergone profound changes since Henry alternatively, companies may have to hire private security,
Dunant, a businessman from Geneva, founded the Red Cross introducing a new armed entity into an already fragile and
in 1863. At that time wars were conducted mainly by States volatile environment. Companies may pay taxes, in one form
and their armies. Today, however, there are others, such as or another, that fill the coffers of one or several warring par-
private business enterprises, playing an increasingly signifi- ties. Companies may be tempted to use their political or eco-
cant role in conflict situations. nomic clout to steer a conflict in one direction or another. The
job creation and local development brought about by compa-
There are various ways in which business enterprises can be nies may be used as a pretext by some belligerents to move
involved in or have an impact on armed conflict. For the pur- people and alter the racial, ethnic, or religious balance of a
pose of this article we will explore two of them. Firstly, as given region. As all these examples show, there are numerous
states have relinquished their monopoly on the legitimate ways in which business enterprises, willingly or not, have an
use of violence, private military and security firms have effect on the dynamics of a conflict.
increasingly taken on functions that used to be the exclusive
resort of state bodies. Over the past three years, the public International humanitarian law (IHL) is a set of rules which
has been discovering the scope of involvement of such firms seek, for humanitarian reasons, to limit the effects of armed
in some of todays conflicts. In Iraq, for example, private con- conflict. It protects persons not, or no longer, taking part in
tractors have been not only running large chunks of the hostilities and restricts the means and methods of warfare.
logistical chain on behalf of the multinational forces but also IHL is also known as the law of war or the law of armed con-
providing protection for military compounds, public buildings, flict. It does not regulate whether a state may actually use
and government officials, in addition to manning checkpoints, force this is governed by an important, but distinct, part of
operating weapons systems, interrogating prisoners, gather- international law set out in the United Nations Charter. Some
ing intelligence, etc. The private military and security sector of the rules of IHL are similar to those of human rights law, but
has grown tremendously since the end of the Cold War. The these two bodies of law have developed separately and are
size of the global market for the firms in this sector was esti- contained in different treaties. Human rights law unlike IHL
mated at around U.S.$100 billion in 2001 and has continued applies in peacetime, and many of its provisions may be
to expand, boosted by the conflicts in Afghanistan and Iraq. suspended during armed conflict. IHL applies only during
Clients include states, armed groups, business enterprises, armed conflict and cannot be suspended.
the U.N., and NGOs even the ICRC has occasionally resorted
to private security firms to protect its premises. Some of the IHL distinguishes between international and non-international
firms are publicly traded on major stock exchanges and mar- armed conflicts. International armed conflicts, which are sub-
ket themselves as flexible tools to accomplish the security ject to a wide range of rules, are those in which at least two
goals of their clients around the world. states are involved. Non-international armed conflicts, which
are subject to a more limited range of rules, are those restrict-
Secondly, business enterprises not involved in the security ed to the territory of a single state, involving either regular
field but operating in difficult conflict environments also exert armed forces fighting groups of armed dissidents or armed
an influence on conflicts. The wealth they create or extract groups fighting each other.
may attract interest from warring parties and turn a business
operation into a military objective. Companies may have to IHL is rooted in the rules of ancient civilizations and religions
enter into security arrangements with one or several of the warfare has always been subject to certain principles and
parties to a conflict, which may directly affect its dynamics; customs. One of the fundamental rules of modern IHL is that

15
 on Security and Human Rights, which is being led by the
International Business Leaders Forum. The Voluntary
Principles are intended to guide extractive companies in man-
aging the security of their operations in a way that ensures
respect for the human rights of host populations. The ICRC is
also participating in an inter-governmental initiative led by
Switzerland that promotes respect for IHL and human rights
law among private military and security firms operating in
conflict situations. The ICRC website (www.icrc.org) now offers
a special section on this topic.

Talking to business should come naturally to the ICRC. After

all, Henry Dunant himself was a businessman. He was on a
business trip when he happened to be present at the end of
the battle of Solferino. Horrified by the sight of thousands of
soldiers left to suffer for want of medical care, Henry Dunant
appealed to the local people to help him tend the wounded.
Upon his return to Geneva he created the Red Cross and then
undertook to persuade the European states to adopt the
original Geneva Convention providing protection for wounded
military personnel. Henry Dunant was initially considered a
hopeless romantic, but by 1901 he had received the first Nobel
Peace Prize (which he shared with Frderic Passy). Dunants
whole life was guided by a passionate devotion to the human-
itarian cause. Even his Peace Prize money he bequeathed to
charitable causes rather than spend it himself, despite being
penniless. The ICRC his creation was subsequently award-
ed the Nobel Prize on three different occasions: in 1917, then
in 1944 as a tribute to its humanitarian activities during the
two World Wars, and again in 1963 on the occasion of its 100th
anniversary.

16 - The journal of financial transformation

 Institutional

Access to financial services: a review of the issues and public policy objectives

The governance of the securities clearing and settlement industry

The day of the MiFID: applying to all, different implications for each

Does capital mobility promote economic growth? The link to education

Growth and its measurement

The welfare implications of product patent: a simple model

Knowledge management, innovation, and productivity in French manufacturing

Obstacles in offshoring and outsourcing investment banks research

European banking consolidation: effects on competition, profitability, and efficiency

The merchant-bank struggle for control of payment systems

The credit rating agencies and their credit ratings

 Access to financial services:
a review of the issues and public
policy objectives1
Stijn Claessens
Senior Adviser, Financial Sector Vice-Presidency (FSE), The World Bank

important impact on the poor, we now need to try to under- ernment.

stand what access to finance means, what the current usage
of access to financial services is and what this shows about Reducing barriers to enhance supply and improve
access, what the impediments are to access and how these access
might be changed, and what role governments might play in Explaining lack of supply falls into two areas: financial institu-
improving this. tions specific constraints rather than arising from the envi-
ronment within which these institutions operate and the
Differentiation between access and usage overall institutional environment deficiencies. This distinction
To better understand issues surrounding the poors access to consequently breaks solutions down into institutional solu-
financial services, it is important to keep in mind how access tions and country actions.
and usage can differ. Access refers to the availability of the
supply of financial services at a reasonable cost, where quality Constraints specific to financial institutions mostly
and reasonable have to be defined in some objective standard relate to the non-profitability of small scale transactions. For
and costs have to reflect all financial and non-financial costs. financial service providers whether banks or micro-finance
Access thus only refers to the presence of financial services, institutions the fixed costs involved in financial intermedia-
but may say little about the degree to which they are con- tion make providing services for small clients, by small institu-
sumed. Usage refers to the actual consumption of financial tions, and in small markets, hard. High transactions costs for
services. In a standard demand-supply framework, access small volumes the fact that the underserved are new, not
refers to the presence of supply (at a reasonable cost) and experienced in business, etc. and the high costs for expand-
usage is the intersection of the supply and demand schedules. ing reach (i.e., to establish rural branches) often make it
unprofitable to cater to the poor segments and for small
There is currently very limited data on usage of financial ser- amounts. Taking into consideration economies of scale, better
vices by different income groups10, making it more difficult to cost management can lower unit costs and lead to higher
establish the determinants or impediments to access to outreach and more attractive prospects from the institutions
finance. Even basic questions like is lack of access a result of perspective. Still, catering to low-income households with
low supply or is there a supply but low usage (implied specific products will remain for many financial institutions a
demand)? can not be answered. As noted in many places dur- too high-risk, high-cost proposition.
ing the 2005 U.N. International Year of Microcredit (IYOM),
appropriate data first need to be compiled. Nevertheless, Similar constraints arise at the country level where many
based on the data available to date and anecdotal evidence, as financial systems are often very small, hindering effective
well as economic reasoning, some lessons can be drawn on financial service provision11. If the scale for effective financial
what policies can facilitate access. These lessons can be cat- services provision does not exist in all countries, at least not
egorized along the lines of reducing barriers to the efficient using traditional financial service providers, what can be
supply of financial services and a more efficient role of gov- done? Evidence suggests that internationalization of financial

1 Based on the paper by the author, Access to financial services: a review of the Morduch, J., and B. Hayley, 2002, Analysis of the effects of microfinance on pov-
issues and public policy objectives, World Bank. erty reduction, NYU Wagner Working Paper No. 1014
2 World Bank. 2001. Finance for Growth, Policy Choices in a Volatile World, Oxford 6 Honohan, Patrick. 2004, Financial sector policy and the poor: Selected findings
University Press and Washington, D.C. and issues, Working Paper No. 43. Washington, D.C.: The World Bank
3 Beck, T., A. Demirguc-Kunt and M. S. Martinez Peria, 2005, Reaching out: Access 7 Beck, T., A. Demirg_-Kunt and R. Levine, SMEs, growth, and poverty: Cross-
to and use of banking services across countries, World Bank mimeo country evidence, Journal of Economic Growth, forthcoming. Also World Bank
18 4 Littlefield, E., J. Morduch, and S. Hashemi, 2003, Is microfinance an effective Policy Research Working Paper 3178
strategy to reach the millennium development goals? CGAP Focus Note 24, 8 Rajan, R., and L. Zingales, 2003, Saving capitalism from the capitalists, Crown
January, Washington, D.C. Business Division of Random House
5 Morduch, J., 2003, Microinsurance: The next revolution? New York University.
mimeo
Finance is an important component of development, including also require poor households to be able to afford these ser-
for the poor. Indeed, much recent empirical evidence has vices, which in turn is facilitated by their access to finance4.
shown that a more developed financial system can help Indeed, studies find specific impact of access to microfinance
reduce poverty and lower income inequality. In addition to on reductions in child labor, increases in education, and better
facilitating overall economic growth, finance can help individu- insurance against shocks5. It is not just direct access to
als smooth their income, insure against risks, and broaden finance or the specific forms of access that matter. In fact,
investment opportunities. Yet, access to finance is limited in recent studies debate the direct link between microfinance
many developing countries to few individuals and firms. Policy penetration and poverty eradication6 and point to the more
questions thus arise concerning what determines access to general need for efficient inclusive financial systems.
financial services, what barriers may hinder access, whether
more general availability of financial services should be a The ability of countries, firms, and individuals to make use of
public sector goal, and, if so, what the best means of achieving (new) growth opportunities can be another positive contribu-
this are. tion to economic development and poverty reduction of
increased financial development. Finance matters to firm
Finance and growth growth, particularly of SMEs. While empirical evidence shows
Finance affects poverty and income distribution through sev- that SMEs do not cause growth, nor do they alleviate poverty,
eral channels. The first being the effects of finance on eco- evidence shows that the overall business environment accel-
nomic growth, which raises overall income levels and helps erates economic growth, more so for small firms, and particu-
reduce poverty. Empirical studies have demonstrated that a larly for the entry of new firms. A business environment which
doubling of private sector credit to GDP is associated with a includes sound property rights, proper contract enforcement,
two percentage point increase in the rate of GDP growth2. and ease of firm entry and exit is essential. But it is the addi-
This additional growth in turns translates into lower poverty. tional requirement of a well-developed financial system that
Finance also helps reduce poverty through additional chan- allows firms to operate on a larger scale, encourages more
nels, specifically by reducing income concentration and efficient asset allocation, and thus helps to level the playing
enhancing income equality, leading to a further reduction in field among firms and countries7. Because of unequal access,
poverty3. finance has been a barrier to entry (loans allocated by con-
nection and non-market criteria)8.
Indeed, it has become the common view that finance can
strongly affect the attainability of the Millennium Development There is also increasing evidence that the inequality of access
Goals (MDGs). Finance refers here to direct access of poor to finance can be a problem not only in normal times but also
people to financial services as well as to more generally inclu- in times of crisis. Research demonstrates that the cost of
sive financial systems. And the MDGs include not only poverty financial crises have been allocated unevenly, with the brunt
headcount but also those that chiefly require upgrading of being borne by the poor. Evidence has shown that financial
public services in health and education, etc. Clearly, greater transfers during crises are large and can increase income
direct access can enhance income as it provides greater inequality. They also tend to be very regressive9.
opportunity to invest and smooth shocks. It also helps people
achieve other development goals, such as education, as these Because there is clearly a case that finance can have an

9 Halac, M., and S. L. Schmukler, 2004, Distributional effects of crises: The financial 11 Hanson, J., P. Honohan and G. Majnoni, 2003, Globalization and national financial
channel, World Bank, Working Paper 3173 systems, Oxford University Press and World Bank, Oxford and Washington, D.C. 19
10 For a complete discussion of what limited data are available in certain areas,
please see Honohan, P., 2005, Measuring microfinance access: Building on exist-
ing cross-country data thinking, World Bank working paper 3606
 services can help overcome some of these scale problems. profitability micro-finance institutions may be discouraged,
Foreign banks not only improve financial system efficiency suggesting that more competition in the banking system can
and stability, with large long-run benefits, but they can also foster micro-finance institutions. Access to savings can also
enhance access. Analysis of borrowers perceptions across 36 be a function of distribution networks (postal, saving, and
countries finds that financing obstacles are lower in countries other proximity banks), suggesting that the barriers to estab-
with high levels of foreign bank penetration. This work reports lishing branches and ATMs should be kept as low as possible.
strong evidence that even small enterprises benefit and there In Brazil, some role has been found for wider branch networks,
is no evidence to suggest that they are harmed by foreign both of public and private banks, and a good mix of domestic
banks. The channels appear to both improve competition and and foreign banks distribution, in determining access.
direct provision of financial services by foreign banks. A Latin
America specific study finds that foreign banks with small Analysis of small firm access to financial services, less limited
local presence do not appear to lend much to small business- to date, has found that the quality of the legal system and
es, but large foreign banks lending often surpasses large property rights and their enforcement, and the availability of
domestic banks. information are especially important. Small firms and firms in
countries with poor institutions use less external finance,
Country-level constraints tend to be both macro- and especially less bank finance. Protection of property rights
micro-economic in nature. The overall macroeconomic envi- increase external financing of small firms more significantly
ronment is often a barrier, especially for lending, as prospects than they do for large firms, mainly due to the existence of
for profitable business and consequently viable lending more banks and greater availability of equity finance.
are limited when there is macro instability. Even when a firms Substitutes are imperfect. For example, small firms do not use
business is viable, uncertain repayment capacity given volatile disproportionately more leasing or trade finance than larger
income and expenditure and high exposure to systemic risks firms, meaning the former suffer from a lack of access as the
often make it hard for financial institutions to lend. Often this alternative forms of finance are either more costly or not
weak macroeconomic environment will be exacerbated by available.
weaknesses in the enabling and regulatory environment, such
as poor quality of the legal system, limited availability of reli- Policies like interest rate ceilings, usury laws, and credit subsi-
able information, poor payment systems, and weak distribu- dies or targeted lending, can all contribute to a distorted
tion and other infrastructures. Limited competition can make enabling environment for financial intermediation. Heavy
financial institutions uninterested in providing basic financial regulation in the forms of high minimum capital adequacy
services. Absence of credit information, lack of collateral, and requirements, exorbitant compliance costs, and rigidity in
difficulties in contract design and enforcement can make prof- chartering can endanger the institutional environment.
itable lending hard. Empirical analysis supports the impor- Regulations, such as interest rate ceilings, usury laws, restric-
tance of these barriers. tions on lending, priority lending and credit subsidies policies,
and other government interference distorts risk-return sig-
Analysis of households access has been limited to date, but it nals, and can thereby hinder access. Rigidity in chartering,
has been found that access to micro-finance credit for the (high) minimum capital adequacy requirements, limited
poor/near-poor across the country is less when GDP per capi- degrees in funding structures, too heavy regulations and
ta is higher and greater where there is better institutional supervision, too strict accounting requirements, and high
quality and the market size is larger. Also where the quality of compliance costs can hinder financial institutions from oper-
the main banking system is poor higher spreads and high ating efficiently. Costumer identification (Know Your

20 - The journal of financial transformation

Customer), AML/CFT, and other rules can be costly in terms of Conclusion
access to financial services, as was found in South Africa. Over the last decade, finance has been recognized as an
Nevertheless, trade-offs arise as regulations serve other pub- important driver of economic growth. More recently, access to
lic policy purposes. financial services has been recognized as an important aspect
of development and more emphasis is being given to extend-
Governments attempts to increase access ing financial services to low-income households. Although still
Governments can, and often have, tried to improve access. early in the analysis, there is some evidence that access is
Governments might try to encourage the use of a public infra- improving. The need for more empirical data is needed in
structure to potentially deliver private financial products. order to better track and benchmark access progress. On the
Specific interventions, such as the use of existing distribution household side, there are some data on the use of micro-
channels (postal offices in India), can help increase outreach. finance that suggest that there has been an expansion of
While this is certainly an innovation that can affect access, it, access for households. Data here have to be interpreted care-
like many innovative technologies, does not necessarily affect fully as increases may represent a better coverage over time,
underlying regulatory or systemic distortions in the system. rather than an expansion.
Increasing competition has been proved to be beneficial and
has the added benefit of improving the environment at the With better data one can learn more about the benefits of
same time as it is bringing in new technology and know-how. access, the reasons why households and firms may (or may
not) demand financial services, why financial service provid-
Because there may be a supply of financial services without a ers may (or may not) provide financial services, and, of course,
demand (access but no usage), limited use of financial servic- the costs to society of providing greater access. In this con-
es do not necessarily reflect a systemic market failure at the text, there is an interesting opportunity for the international
country level. This is one reason why trying to broaden finan- community to lead the way in better measuring access so that
cial access may not necessarily be a public policy goal. While one can better understand it. Through better understanding,
governments can foster a better environment through anti- one can develop more efficient models and offer better policy
predatory lending laws rather than usury laws and promote advice with the goal of increasing access to finance and thus
customer education, a proactive role of the government may improving development.
not be efficient. Given political economy factors, government
targeted efforts to broadening access may not relax credit
and savings constraints, when there is a selection bias, i.e.,
those households or firms with good prospects apply for
credit in any case. Subsidies can not only distort markets, but
evidence is mounting that they are captured by the relatively
well off, which often already have access. Priority lending
requirements are not the solution either, as they can also
divert resources away from the lowest segments, often
towards the less needed. Furthermore, there may not be any
additionality, as clients that have access already move to new
providers that are being subsidized. A balance of limited direct
government stimulation and an emphasis on proper regula-
tion should be a goal.

21
 The governance of the securities
clearing and settlement industry
Daniela Russo
Deputy Director General, Directorate General Payment Systems and Market Infrastructure,
European Central Bank
Chryssa Papathanassiou
Senior Expert, Directorate General Payment Systems and Market Infrastructure, European
Central Bank

this open access principle would not be in line with E.U. poli- tion. Thirdly, the horizontal integration at the level of exchang-
cies. Secondly, many want to ascertain the extent to which es, central counterparties, and central securities depositories,
governance is a tool for ensuring appropriate management of by increasing the number of markets served by each inte-
service providers that provide a wide range of services under- grated settlement system, introduces or increases the need to
pinned by very divergent risk profiles under the same legal also take into account the interests of non-resident customers
entity. Examples of such entities are international central and shareholders. Lastly, the emergence of business models
securities depositories (ICSD) that offer security depository that consolidate activities across competitive markets creates
services as well as banking services assuming credit risk, CSDs the need to investigate whether and to what extent gover-
that also perform central counterparty services, and stock nance mechanisms can contribute to preventing or mitigating
exchanges that also act as central securities depositories. the potential for the abuse of monopoly positions in the provi-
sion of some services.
Two broad issues are important for the governance of these
entities. The first relates to conflicts of interest typically aris- The second set of issues relates to the actions that authorities
ing in the securities settlement infrastructure and the mecha- can take to ensure that adequate corporate governance
nisms for their resolution. The governance arrangements for mechanisms are adopted by securities clearing and/or settle-
a clearing or settlement system must address not only the ment systems. The interest of payment and settlement system
conflicts of interest that are common to the corporate gover- regulators and overseers internationally in issues concerning
nance of all corporate entities, but also the public interest and governance is relatively recent. The first international over-
the corresponding interests of regulatory authorities. In the sight standard on governance was only formulated in 2001 in
context of the ongoing reorganization of the clearing and the Core Principles for Systemically Important Payment
settlement infrastructure within Europe, governance arrange- Systems of the Committee on Payment and Settlement
ments must also address a number of conflicts of interest Systems (CPSS) relating to institutions active in the operation
unique to operators of clearing and settlement systems. of large-value payment systems. This standard was followed
Firstly, especially with reference to CCPs and CSDs offering up by the adoption of an international standard on gover-
banking services in addition to core settlement services, it is nance for securities settlement systems (SSSs) by CPSS-
important that corporate governance mechanisms contribute IOSCO. In particular, the recommendation on governance for
to full independence of decisions concerning risk manage- SSSs and CCPs calls for governance arrangements for central
ment. In particular, corporate governance mechanisms can securities depositories and central counterparties to fulfill
contribute to a clear separation of risk management decisions public interest requirements and to promote the objectives of
from other day-to-day decisions relating to the business of the owners and customers.
system operator. Secondly, the vertical and horizontal integra-
tion among trading, clearing, and settlement systems into a The importance of appropriate SSS corporate governance
single entity or financial group calls for an investigation into arrangements for innovation and competition has also been
potential conflicts of interest between the different entities stressed in the first Giovannini Report, a report of a group of
within the financial group and mechanisms for their resolu- experts appointed by the European Commission to address

1 IOSCO Technical Committee, 2001, Issues Paper on Exchange Demutualization, Russo, D., T. Hart, M. C. Malaguti and C. Papathanassiou, 2004, Governance of
22 June; Lee, R., 2002, The future of securities exchanges, Brookings-Wharton securities clearing and settlement systems, ECB Occasional Paper No. 21, October
Papers on Financial Services, 1-33; Steil, B., 2002, Changes in the ownership and 2 In this article, the term corporate governance refers to the internal corporate
governance of securities exchanges: Causes and consequences, Brookings- structures and mechanisms by which decisions are taken in relation to the opera-
Wharton Papers on Financial Services, 61-91; Blume, M., 2002, The structure of tions of a clearing or settlement system.
the US equity markets, Brookings-Wharton Papers on Financial Services, 35-59;
Over the past few years, numerous securities exchanges have every country and offering services cross-border creates an
altered their ownership structures by transforming them- uneven playing field and does not do justice to the importance
selves from mutualized, member-owned companies into for- of the CSD and CCP function.
profit, shareholder-owned ones. Within Europe, the adoption
of the Euro, the legal and regulatory changes adopted pursu- CSDs are entities that hold securities in book-entry form. In
ant to the European Commissions Financial Services Action this respect, immobilized or dematerialized securities are
Plan, and the resulting market integration have also led to alli- deposited in CSDs, which are the ultimate holders of assets
ances and mergers among exchanges and other institutions worth several trillion Euros and provide their availability to
involved in the post-trade processing of securities transac- market participants. CCPs have a different function. They
tions to flourish. These recent trends in market integration assume credit risk by interposing in trades and becoming the
and consolidation have facilitated an increase in cross-border buyer to every seller and the seller to every buyer. The recent
trading and have brought significant increases in market effi- cases of Enron and Parmalat underlined the importance of
ciency: markets are more liquid and provide a wider range of governance for any entity and proved that weak governance
products at lower costs than in the past. The growth in col- of non-financial entities may give rise to financial turmoil. For
lateralized transactions (including repurchase agreements CSDs and CCPs, governance arrangements are important
and securities lending), many of which involve counterparties because of the impact on the decision-making process of
located in different jurisdictions, has also fueled growth in those entities, which affects the market at large. Governance
cross-border transactions. arrangements may be considered a level of self-regulation
and help self-discipline, in particular when taking decisions
Yet, market integration and consolidation create conditions in that affect market participants at large, including competitors,
which financial turmoil can spread with greater speed and with regards to risk management (eligibility criteria, and other
virulence. This process of demutualization and consolidation risk control measures) and commercial development (access,
has prompted a significant volume of work on the governance pricing, and fees).
of the new for-profit exchanges and on the mechanisms by
which a for-profit exchange should fulfill its self-regulatory Since 2001, there has been a robust E.U.-wide dialogue on
functions1. However, little work has been done on the gover- adequate governance arrangements for CSDs and CCPs for
nance2 of central securities depositories (CSD) and central two reasons. Firstly, many want to establish the extent to
counterparties (CCP) that are often associated with exchang- which vertical integration of stock exchanges with deposito-
es. The current situation is very diverse in Europe where these ries and clearing houses that all belong to a vertical silo may
entities may be a bank, a commercial entity, a public limited impede horizontal integration of those service providers
company, or a non-distinct legal entity, such a division of the across national borders. Within Europe, the aspiration is to
exchange. Some are user-owned, some for profit, and others ensure open access to those services regardless of the nation-
are group-owned. Relying merely on the governance required, ality of the participant, as the Directive on Markets in Financial
or not, by the existing legal or other rules made for each com- Instruments of 2004 has already required for CCPs (2004/39/
pany type for entities performing the same type of activity in EC). That is why structures that have the potential to hinder

23
 issues concerning securities transfers, and in a report of the corporate governance standards or best practices adopted by
European Parliament. Furthermore, the Group of Thirty or recommended for companies in the jurisdiction in which
(G30), a private sector body, has also developed recommen- they operate, as such standards or practices evolve over time.
dations on SSS governance and regulation. Lastly, the recent Generally, this would imply that securities clearing and settle-
Communication from the Commission to the Council and the ment systems at a minimum should adopt and implement the
European Parliament on Clearing and Settlement in the best practices recommended for listed companies.
European Union dated 28 April 2004 [COM (2004) 312 final] Additionally, a securities clearing or settlement system
envisages the adoption of a framework Directive addressing should adopt corporate governance mechanisms adequate to
inter alia appropriate governance arrangements for securi- address the interests of customers and the public in the
ties settlement systems and central counterparties. The operation of the system. Such mechanisms may include tradi-
European Commission also takes the view that governance tional mechanisms of corporate governance in the jurisdic-
arrangements applicable to intermediaries should be consis- tion, such as the appointment of independent board mem-
tent with those envisaged for securities clearing and settle- bers and the use of specialized board committees, or they
ment systems. All of the international standards adopted to might have been developed specifically in the context of
date reflect the fact that corporate governance mechanisms securities settlement systems, such as the use of board advi-
for securities settlement systems must be complemented by sory committees or public consultation documents. Such
adequate transparency, requirements for effective gover- mechanisms should be organized so that the criteria followed
nance irrespective of the ownership structure (whether to select members of the board or participants in specialized
mutual or demutualized), appropriate oversight, and regula- committees are established ex-ante. Board members should
tion. Standards and reports regarding the governance of also take into account the interests of customers and the
European securities clearing and settlement systems also public in board decisions, in particular those relating to sys-
generally address competition concerns and the need for tem access criteria, fair pricing, the adequacy of service lev-
greater efficiency in securities clearing and settlement within els, the integrity of the risk management system, the need for
Europe. The reports also note that the increased consolida- innovation and efficiency, and the achievement of the policy
tion and cross-border operation of securities settlement sys- objectives of competent authorities.
tems may require greater cooperation and practical protocols
among relevant authorities. Securities clearing and settlement systems should make
adequate disclosures regarding their corporate governance
In the context of securities clearing and settlement systems, arrangements so that customers and the public can ascertain
the nature of governance arrangements acquires a dimension the manner in which conflicts of interest among owners, the
that goes beyond their traditional function in corporate law. board, customers, and the public are prevented, resolved, or
They constitute a tool for regulators and central banks to mitigated. Securities clearing or settlement systems operated
achieve their respective policy goals relating to market integ- by an entity held within a financial group should disclose the
rity and systemic stability. From that perspective there are governance arrangements in place at the level of the system
points that matter for the governance of the clearing and operator as well as any relationships within the financial
settlement industry: group that bear on the financial condition of the system
operator or on its ability to fulfill its functions in the markets
Whatever the model of corporate governance used in a juris- which it serves. Disclosure should also include detailed infor-
diction, securities clearing and settlement systems should mation on the composition, rules, and procedures of advisory
adopt and ensure effective implementation of the highest bodies and their impact on management decisions.

24 - The journal of financial transformation

Furthermore, public authorities should consider the implica-
tions of the formation of these financial groups within the
clearing and settlement infrastructure and the adequacy of
their governance arrangements.

Corporate governance arrangements of securities clearing

and settlement systems should be subject to adequate regula-
tion and oversight. In this respect, the company statutes, the
by-laws, the professional qualifications and ethical integrity of
members of the boards of directors of system operators,
shareholdings and changes in shareholdings, the rules of the
system, the general system of internal controls, and the risk
management program of the system should be subject to
review or oversight by a competent authority. Regulators,
central banks, and competition authorities should also insti-
tute policies that operate in concert to ensure that services
are provided to customers at fair prices under fair and equi-
table conditions of access; that the risk management pro-
grams of system operators are effective; that risk manage-
ment decisions are not affected by considerations extraneous
to the risk management function; and that, to the maximum
extent possible, functional service providers compete in
equivalent conditions of competition. Achievement of these
policy objectives will require that regulators, central banks,
and competition authorities cooperate at a high level, either
formally or informally.

The above conclusions are an attempt to clarify the general

requirements of international standards by making them
more concrete for regulators and overseers to assess and for
the securities clearing and settlement industry to follow.

25
 The day of the MiFID: applying to
all, different implications for each
Ian Jack
Business Development Manager, COLT Financial Services Practice
Mark OConor
Partner, Technology, Media and Communications group, DLA Piper Rudnick Gray Cary

emptive approach to building a compliant infrastructure. In However, it is important to realize that non-compliance with
some cases, compliance will be achieved by simply throwing the requirements of MiFID would be severe. In our view, it is
money at the problem perhaps not the most efficient use of these smaller organizations, which have underestimated the
their resources. Our view is that many firms are underestimat- resources required for MiFID compliance, that are the ones
ing the amount of additional infrastructure required to most at risk and only urgent action will prevent potential
achieve compliance with the directive as it stands today. catastrophe.

Also, given the scale of recent initiatives, including Sarbannes Other organizations for which securities trading is only a small
Oxley and Basel II, some organizations may choose to kill a proportion of their business may opt to get out of this market
number of regulatory birds with one stone and roll their altogether, prompting a wave of consolidation. It is inevitable
responses to these into a single reworked system this may that some organizations will choose to exit the market and it is
create some efficiencies, but also introduces significant com- ironic that one of the unintended side effects of a Directive
plexity and should clearly be handled very carefully. expressly aimed at increasing competition may be to actually
decrease choice for the consumer. Interestingly, similar effects
Tier 2/3: smaller investment banks and exchang- may also result from the Single Euro Payments Area (SEPA)
es initiative, which is part of the same European Financial
Some of these organizations have invested heavily in technol- Services Action Plan: harmonized European payments charges
ogy and are closer to larger institutions in terms of their pre- may well force some mid-tier regional banks to move out of the
paredness. However, the majority lack the resources of their clearing and settlement space, and outsource this activity to
larger competitors and MiFID may be part of a long to do list the larger players, ultimately reducing the competition.
or, as the deadline for implementation may feel a long way off,
it may be filed in the important but not urgent category. The buy-side
However, these organizations are subject to the same require- A survey of buy-side organizations4 conducted by block trad-
ments as the biggest investment banks and must make the ing specialists, Liquidnet, in November of 2005 found there
same investments in systems and processes. was little consensus around the benefits of MiFID with almost
half the respondents (43.8 percent) saying their firm did not
Analysts are predicting the costs of MiFID compliance to be plan to spend any money to meet its requirements. However,
10 million (approximately U.S.$19 million) for upgraded IT MiFID requires a buy-side firm to create a policy for best exe-
systems and 12m (approximately U.S.$23 million) for new cution which must then be provided to and provable to
processes costing the industry around 1bn (approximately their clients. As Clare Vincent-Silk, the Chair of the MiFID Joint
U.S.$1.9 billion)3. Some careful thought, therefore, needs to be Working Group Buy-Side focus group, points out5, There will
given to whether or not continued participation in the securi- be a greater need for pre-trade and post-trade transaction
ties market is justified in light of the costs and disruption cost analysis tools that allow you to analyze the liquidity, price
involved. If trading in the securities market is a core business and likely market impact of trading this particular order on a
then, clearly, there is no choice but to proceed with the com- trading venue. Therefore, you are looking at the purchase of
pliance program. additional systems for the buy-side to show that you are giv-
ing your clients best dealing performance.

1 http://www.fsa.gov.uk/pubs/international/planning_mifid.pdf
26 - The journal of financial transformation 2 Ibid
MiFID is being cited as the largest shakeup of the financial 1. Tier 1: large investment banks & exchanges
markets since the Big Bang, representing a significant over- It is clear that these larger institutions have already begun
haul of 1993s Investment Services Directive (ISD). It aims to investigating MiFID and we have anecdotal evidence to sug-
create a single market in financial services across Europe by gest that some of them are confident that compliance repre-
increasing the number of services that can be passported sents only a minor hurdle. There is some logic to this belief as
and provided in markets around the Community. According to through building the systems and processes to trade in multi-
the FSAs Planning for MiFID1 document, it will affect all ple markets they will already be compliant with many of the
those currently covered by the ISD, including investment measures of the Directive. However, the devil is in the detail
banks, portfolio managers, stockbrokers and broker dealers, and there may be less harmonization than they expect.
corporate finance firms, many futures and options firms, and
some commodities firms. Crucially, the FSA also plans to There is also a potential danger if this confidence slips over
review its Handbook to accommodate the requirements of into complacency. MiFID introduces a number of new require-
MiFID and warns that, Even if your firms investment business ments, chief among which is the proof for best execution
is partly or wholly outside the scope of MiFID, this does not taking all reasonable steps to obtain the best possible result
mean that you will be unaffected by our approach to its for its clients including considerations such as price, cost,
implementation. speed and the likelihood of execution and settlement when
executing orders.2
So, in practical terms, what does this mean for you? In truth,
it is somewhat too early to provide concrete advice on this Importantly, this data must be kept for five years and available
subject as the final rules for implementing MiFID will not be in near real-time and may have to have evidential weight,
published until January 2007 (although, given that the dates such that firms must be able to demonstrate that the integrity
for compliance have been already pushed back to 1 November, of the data has not been violated. The recreation of each
2007, it would come as no surprise if this deadline slips even trade (both voice and data transactions) has immense implica-
further). However, the broad scope of the legislation is clear tions on data storage. Banks, being banks, have largely kept
and, given the sweeping changes that it ushers in, now is the their cards close to their chests when discussing anything
time to start planning for it. other than the clarification of the directives terms; however,
if there is a case for an industry-wide community-based solu-
In our view, different types of firms are in different states of tion to this problem, it has yet to present itself.
preparedness and, given that at best firms are still in the
early planning stages, perhaps it makes sense to segment the It is our view that very few if any of even the largest insti-
MiFID community into four distinct groups: Tier 1: large invest- tutions have in place the systems, such as high speed net-
ment banks & exchanges; Tier 2/3: smaller investment banks working and storage capabilities, and processes to support
and exchanges, and inter-dealer brokers; the buy-side; and, these data storage requirements. There is little doubt that a
finally, other companies currently falling outside the scope of majority will be compliant by the due date, but if Basel II com-
the ISD but who are affected by MiFID. We will then treat each pliance is any guide, the number of firms taking last-minute,
group individually. reactive measures as the deadlines approach will more than
offset the number of large sell-side firms that take a pre-

3 http://www.silicon.com/financialservices/0,3800010322,39153793,00.htm
4 Liquidnet Europe survey gathers buy-side opinion on MiFID and PS 05/9 27
5 The Banker, 2005, Cash & securities services: Buy-side ignores MiFID at its peril, 1
November
 Outsourcing Conclusion
One final word of caution: the sheer costs involved in ensuring MiFID will have a huge impact on those organizations working
compliance with MiFID and other financial regulatory require- within securities markets. The major players will most likely be
ments may well encourage many firms to consider leveraging compliant in time, although poor planning will ensure that
the capabilities of third party IT or service providers. While they pay over the odds for the privilege. Smaller investment
any new contracts will clearly need to be drawn up in the con- firms and exchanges have the most to lose by not planning for
text of the new regulation, the FSA Planning for MiFID guid- its implementation and they should act before it is too late.
ance states that firms will need to ensure that all existing Similarly, those firms that are concerned that they may fall
outsourced arrangements meet the relevant requirements as within the scope of the Directive should ensure that they are
finally agreed If this is to be taken literally, it could mean fully up-to-date with the latest guidance and prepared to act
that affected firms with extant outsourcing contracts will in their own defense if necessary. On a more positive note, the
need to implement a screed of contract changes to meet the requirements for the publication of financial data may create
new requirements when they are finally published! If so, opportunities for those able to move fast enough to exploit
does the outsourcer have to foot the bill, or does that current them.
contract mandate that the service provider meets all legal and
regulatory requirements, now known or in the future imple- Overall, while the day of the MiFID may be sooner than you
mented? think, beginning to plan for its implementation now will ensure
that you are not exposed when it arrives.
It remains to be seen what the relevant technical implement-
ing measures (Level 2 legislation) will entail, but one thing is
immediately clear: organizations currently planning to out-
source must ensure that their contractual arrangements deal
expressly with this issue in order to avoid a costly change to
services and systems in order to achieve compliance at a later
date.

6 MiFID: The Continental Shift in Markets, Securities Industry News, 3 April 2006
28 - The journal of financial transformation
The MiFID regulation is also likely to result in buy-side firms The new transparency regime relating to the real-time publi-
taking a more active role in procurement of networking ser- cation of trades falls heavily upon SIs, as they have to publish
vices, and continue the phasing out of conventional soft dol- prices for shares they internalize in a public setting at a rea-
laring. The buy-side will have to be more transparent than it is sonable commercial price. Trades in over-the-counter stocks
used to being and will need to meet the same audit require- must be published to any end-investor within three minutes
ments and is therefore subject to the same infrastructure and transactions in all instruments must be reported to a
requirements as its sell-side counterparts. The only differ- competent authority typically the national regulator by
ence here is that, as the survey showed, there is a much lower close of play the following day. Furthermore, all off-book activ-
appreciation in the buy-side that action is required. Again, the ity must be provided not only to the primary exchange, but
sooner that the problem is investigated, the sooner a relevant also to a wide variety of different MTFs and third parties.
solution can be found. Simply posting the information on a company website is
unlikely to meet these requirements and doing so will put
Other affected companies strains on systems and processes similar to those described
Given the broad scope of the Directive and the lack of clear above. A more general problem may be that many SIs are not
guidance as to the type of companies to which it may apply, aware that they qualify in this category. A large number of
it is difficult to provide firm advice concerning companies firms are waiting for Level 3 (ratification by the E.U.) before
not currently covered by the ISD. All one can really recom- taking any action a dangerously short-sighted approach.
mend is to keep a watching brief, bookmark sites like the FSA
that carry information on the Directive and read your trade There is also evidence that some SIs are considering develop-
publications so that you have the earliest intelligence on its ing (or acquiring) their own trading platforms in a bid to
ramifications. become an MTF or alternative execution venue and thereby
benefit from different rules under the Directive. However,
If it is becoming clear that your type of organization will fall according to Barry Marshall, co-chair of FIX Protocol Ltd.
under the scope of the Directive and that this will be to your (FPL), Few firms will want to [become] a multilateral trading
detriment, then this early intelligence will enable you to have facility because even though there are fewer requirements
the best possible chance of framing a response. In this case, for disclosing prices, the costs are higher and revenues are
our recommendation would be to make your representations potentially lower.6 If this is a path that an SI wishes to follow,
to your trade body and work with them and other companies they must understand that exchanges require large and
in the same position to determine a coordinated position on sophisticated infrastructures to reach their customers, which
the Directive. will have to be provisioned in order to support the banks.

A quick note about systematic internalizers (SIs) Another opportunity is to transform the requirement to pub-
A systematic internalizer is defined by MiFID as an invest- lish data from a cost center to a profit center. Given the sheer
ment firm which, on an organized, frequent, and systematic volume of data that is now required to be published, some
basis, deals on its own account by executing client orders off organizations may opt to add value to that data and become
book, (i.e., outside a regulated market or multilateral trading financial data publishers. While exchanges might be consid-
facility). Generally speaking, these SIs tend to be sell-side ered an obvious example of an organization that may go down
investment banks, so treating these organizations as a sub- this route, data vendors and MTFs may also choose to enter
set of the two categories described above seems appropri- the fray. Again, the rewards of doing so must be carefully bal-
ate. anced against the risks.

29
 Does capital mobility promote
economic growth?
The link to education
Hartmut Egger
Senior Assistant, University of Zurich, CESifo, and GEP
Peter Egger
Professor, University of Munich, CESifo, and GEP
Volker Grossmann
Associate Professor, University of Fribourg, CESifo, and Institute for the Study of Labor (IZA)

sical growth model any increase in investment at some period summarized by Rodrik (1999), todays policy literature is
(whether foreign or domestic) should raise subsequent filled with extravagant claims about positive spillovers from
growth via a larger capital stock, but whether they help FDI but the evidence is sobering. Alfaro et al. (2004) argue in
improve productivity and/or the growth potential via spillover a cross-country study that the growth effect of FDI interacts
effects, such as from adoption of new technology or increased with the degree of development of local financial markets.
management know-how associated with FDI. Their evidence suggests that domestic firms are unable to
reap the benefits of knowledge spillovers triggered by FDI
Empirical results on technology spillovers from financial inte- without being able to finance outlays for organizational
gration are mixed. For the period 1980-2000, Edison et al. changes required to raise productivity. Hu and Jefferson
(2002) do not find a robust positive effect from various mea- (2006) find that Chinese firms own research and develop-
sures of the degree of international financial integration on per ment (R&D) complements the technology transfer from both
capita income growth2. Borensztein et al. (1998) examine the domestic and foreign firms, but foreign direct investment
impact of FDI from industrial to developing countries on does not facilitate foreign technology spillovers.
growth in host countries in a panel estimation (with two time
periods, 1970-79 and 1980-89) and find that the contribution of There is convincing evidence, however, that FDI flows between
FDI to growth is greater than that of domestic investment3. developed countries can exert positive spillovers. For instance,
This is indirect evidence for a technological spillover. Bernstein and Mohen (1998) show that a higher stock of R&D
Interestingly, the paper suggests a positive interaction between capital by Japanese firms in the U.S. raises productivity in
FDI and human capital for growth and argues that technology Japan and lowers unskilled labor intensities there. However,
spillovers occur only if human capital in a host country exceeds there seems to be no significant spillover effect to the benefit
some minimal level. This lends support to the idea that human of U.S. firms holding R&D capital in Japan. Also addressing
capital in the host country is needed to render it capable of spillovers from FDI inflows to the U.S., Roy and van den Berg
absorbing knowledge embodied in FDI inflows. Moreover, (2006) provide time-series evidence on a bi-directional rela-
human capital seems to be important for attracting foreign tionship between U.S. growth and FDI inflows. In another
investment in the first place, as argued by Lucas (1990). recent study, Branstetter (2006) attempts to identify techno-
logical spillovers from FDI more directly. He exploits data on
Focusing on FDI effects at the firm level within specific devel- citations of patents held by U.S. firms which are made by
oping countries, the evidence on knowledge transfers is, at Japanese firms when applying for a patent in the U.S. By
best, weak. For example, in a widely-recognized study, which regressing the (log of) number of patent citations of Japanese
employs plant-level data from Venezuela, Aitken and Harrison firms on their FDI stock in the U.S., he finds considerable
(1999) find that the net effect of FDI inflows on productivity evidence that Japanese firms which hold FDI capital in the
is small, being negative for domestically owned plants. As U.S. indeed cite U.S. patents more frequently.

1 Note that a small capital stock ceteris paribus should imply a high marginal prod-
30 - The journal of financial transformation uct of capital, such that all other things being equal capital should flow to poor
countries.
We provide a brief account of the ongoing debate on the have surged (including FDI, on which we should mostly focus
relationship between international capital flows and eco- here) and they mainly came from developed countries. It is
nomic growth. In particular, we argue that the current debate true that the U.S. is still at least, until recently it was the
may be enriched by looking more closely at the relationship largest recipient of FDI (followed by the U.K.), with an inflow
between these key variables and educational choice and pub- of over U.S.$95 billion in 2004 (about 15 percent of world FDI
lic education policy. inflows), now hosting about one sixth of the worlds FDI
inward stock [UNCTAD (2005)]. But in 2004 developing coun-
The sharp reduction of barriers to cross-border investments tries received the considerable amount of U.S.$233 billion (36
during the last few decades has led to a breathtaking increase percent of world FDI inflows). Between 1981-85, the annual
in international capital flows. For instance, this development average inflows into these countries was only U.S.$13 billion.
becomes evident in the sheer number of bilateral investment For example, FDI inflows into China and Hong Kong combined
treaties, more than 2000 by 2005 [UNCTAD (2006)], that are amounted to almost U.S.$95 billion in 2004 [UNCTAD
designed to protect foreign investors against expropriation. (2005)], which is roughly similar to the U.S. figure. And by
Valued at current prices, foreign direct investment (FDI) 2005/06 China is said to have taken the leading position of
inflows at the global level have risen from U.S.$59 billion in being the largest recipient of FDI from the world economy.
1982 to U.S.$1,271 billion in 2000, although declining thereaf-
ter to U.S.$648 billion in 2004 [UNCTAD (2001, 2005)]. This On the second issue, the determinants of the direction of
corresponds to an increase in the FDI stock from U.S.$ 628 international capital flows, one may again refer to the analy-
billion to U.S.$8,902 billion between 1982 and 2004 [UNCTAD sis of Lucas (1990). Given that capital flows into a country
(2005)]. when its marginal product of capital (or the return to capital,
respectively) is relatively high, Lucas has pointed out that
International capital market integration raises at least three due to typically low levels of human capital and low produc-
important questions: Firstly, who are the recipient countries tivity in poor countries, capital returns may be low in spite of
of international capital? Secondly, what determines whether the low capital stock1. Moreover, the costs of financing capital
or not a country attracts foreign capital? And finally, what are inputs in a host country also depend on possible business
the effects of international capital flows on the macroeco- risks and legal barriers to investment (i.e., on various eco-
nomic performance of both host and source countries? nomic and political institutions).

Related to the first question, Nobel laureate Robert E. Lucas Regarding the third question, an important ongoing debate is
famously asked, less than two decades ago, Why doesnt the impact of FDI flows on an economys rate of GDP growth.
capital flow from rich to poor countries? [Lucas (1990)]. The question is not as much about whether FDI inflows posi-
Since then, however, capital inflows to developing countries tively affect growth, since according to the standard neoclas-

2 Focusing on FDI plus portfolio investment inflows over GDP as measure of financial 3 Including also outward investment of developing countries, Khawar (2005) finds a
integration, Schularick and Steger (2006) reproduce this result for a similar time similar result in a cross-section analysis for the period 1970-91. 31
period. Interestingly, however, they find a positive impact for the globalization era
before World War I.
 References
Aitken, B. J., and A. Harrison, 1999, Do domestic firms benefit from direct foreign
investment, American Economic Review, 89, 605-618
Alfaro, L., A. Chanda, S. Kalemli-Ozcan, and S. Sayek, 2004, FDI and economic
growth: The role of local financial markets, Journal of International Economics,
64, 89-112
Bernstein, J. I. and P. Mohen, 1998, International R&D spillovers between U.S. and
Japanese R&D intensive sectors, Journal of International Economics, 44, 315-338
Borensztein, E., J. De Gregorio, and J.W. Lee, 1998, How does foreign direct invest-
ment affect economic growth, Journal of International Economics, 45, 115-135
Branstetter, L., 2006, Is foreign direct investment a channel of knowledge spill-
overs? Evidence from Japans FDI in the United States, Journal of International
Economics, 68, 325-344
Edison, H., R. Levine, L. Ricci and T. Slok, 2002, International financial integration
and economic growth, Journal of International Money and Finance, 21, 749-776
Egger, H., P. Egger, J. Falkinger, and V. Grossmann, 2005, International capital
market integration, educational choice and economic growth, CESifo Working
Paper No. 1630
Gradstein, M., and M. Justman, 1995, Competitive investment in higher education:
The need for policy coordination, Economics Letters, 47, 393-400
Hu, A. G. Z. and G. H. Jefferson, 2006, R&D and technology transfer: Firm-level
evidence from Chinese industry, Review of Economics and Statistics, forthcoming
Khawar, M., 2005, Foreign direct investment and economic growth: A cross coun-
try analysis, Global Economy Journal, 5, Article 8
Lucas, R. E., 1990, Why doesnt capital flow from rich to poor countries, American
Economic Review, 80, 92-96
Rodrik, D., 1999, The new global economy and developing countries: Making open-
ness work, Overseas Development Council (Baltimore, MD) policy essay No. 24
Roy, A. G., and H. F. Van den Berg, 2006, Foreign direct investment and economic
growth: A time-series approach, Global Economy Journal, 6, Article 7
Schularick, M., and T. M. Steger, 2006, Does financial integration spur economic
growth? New evidence from the first era of financial globalization, CESifo Working
Paper No. 1691
UNCTAD (2001), World Investment Report 2001, United Nations, New York
UNCTAD (2005), World Investment Report 2005, United Nations, New York
UNCTAD (2006), Treaty Database 2005, United Nations, New York
Viaene, J-M, and I. Zilcha, 2002, Public education under capital mobility, Journal
of Economic Dynamics and Control, 26, 2005-2036

32 - The journal of financial transformation

Abstracting from the issue of spillover effects, recent studies just defined, for given public education expenditures, an
on capital market integration have emphasized a further increase in net capital inflow raises the incentives to acquire
channel through which FDI flows may affect economic education by raising the relative marginal product of skilled
growth: human capital formation. The key assumption, which labor, FS/FL. To the extent that a higher share of skilled labor
gives rise to a link between capital flows and education and promotes the growth rate of total factor productivity, A, this
therefore to human-capital driven growth, is the empirically provides novel insights in how capital market integration can
well-supported capital-skill complementarity. To fix ideas, impact the growth rate of GDP per capita. Moreover, public
consider a three factor model of a perfectly competitive education expenditures raise the share of skilled labor in an
economy, where skilled labor (S), unskilled labor (L), and integrated economy primarily through attracting foreign
physical capital (K) enter an aggregate production function. capital investment. Finally, treating education expenditure as
That is, output Y is produced according to Y = AF (K,S,L), endogenous, the analysis suggests that, under optimal
where A is a total factor productivity parameter which cap- adjustment of public education policy, educational attain-
tures the state of technology and F is a linearly homoge- ment typically rises after capital market integration unless
neous, increasing, and concave production function. Capital- unfavorable initial conditions induce large capital outflows
skill complementarity may be defined to exist if the following after integration. These predictions are then tested by using
two conditions are met: firstly, the marginal product of capi- data for the period 1960-2000 from 87 countries, focusing on
tal, AFK, is increasing in skilled labor S (but not in L) and, FDI as a measure of international capital flows. Net capital
secondly, the relative marginal product of skilled to unskilled flows are instrumented by a measure of international invest-
labor, FS/FL, is increasing in K. ment barriers, provided by the Business Environment Risk
Intelligence. The empirical analysis largely confirms the main
Building upon the assumption of capital-skill complementari- hypotheses derived by Egger et al. (2005): firstly, net capital
ty, Gradstein and Justman (1995) and Viaene and Zilcha inflows whether or not they are treated as endogenous
(2002) investigate the incentives to increase public expendi- significantly affect participation in higher schooling (using
tures if a better skill supply leads to a capital inflow with various measures thereof). Secondly, changes in investment
positive effects on national income. In such a setting, loca- barriers and public education spending are important deter-
tional competition for mobile capital gives rise to an over- minants of net capital flows and through this channel affect
provision of public education expenditures, calling for policy the participation in higher education. Thirdly, capital flows
coordination. Egger et al. (2005) complement this literature significantly affect economic growth through their effect on
by elaborating on the individual incentives to participate in higher education.
non-compulsory, though publicly financed, higher education.
In their analysis, they distinguish between the share of edu- These promising results should motivate further research on
cated workers, determined by private incentives, and the the links between FDI and growth to education. While the lit-
quality of human capital, which depends on public education erature has mainly focused on technological spillovers from
policy. The model predicts that capital market integration gross FDI inflows so far, the impact of financial integration on
induces positive net capital inflows if human capital S is suf- education incentives and human capital-based growth
ficiently abundant, if productivity A is sufficiently high, or if depends on the size of net capital inflows and how govern-
(institutional) impediments to investment are low. That is, the ments use education policy in order to attract foreign capital.
direction of capital flows depends on the economys initial These insights may be used in future studies to reconcile the
conditions (relative to the rest of the world) at the time capi- conflicting evidence on the relationship between capital
tal markets open up. Due to capital-skill complementarity, as mobility and growth.

33
 Growth and its measurement
Bala R. Subramanian
Chairman, President, and CEO, Synergism, Inc.

outcome of human survival. What about providing warnings able to the highest bidder. Anyone that deciphers the DNA of
and adjustments before catastrophic and irreversible out- time would be awestruck by its intelligent design, marvel at its
comes? In a sense, migration methodologies, such as the one consistency, and the ability to function in any and all environ-
proposed here, will become automatic and evident long before ments.
language induced reactions that may fail to avert the forces of
destructions. The speed or the rate of transformation would It is natural to wonder who or how will this time-technology be
be the only self-adjusting mechanism to accommodate the built? The answer is as obvious as the question itself.
capabilities of the participants. Using this lone characteristic Eventually our data mining tools will decipher these patterns
of change it ought to be possible to manage any transforma- from the vast amounts of data that are constantly collected
tion. and stored in data warehouses. Let us hope that these pat-
terns will not be misrepresented, distorted, or misinterpreted
Poverty in a human society is the result of limiting human by our biologic. Barring that eventuality, time-technology is
capabilities to the view of biological universes. When non-bio the next step beyond the information age. Financial service
universes are included poverty will not only disappear but enterprises that choose to use mathematical techniques to
along with it human philosophies that constrain human poten- decipher these patterns at societal, community, business, and
tial to a non-existent strife of human conditions. enterprise levels to ensure societal well-being and harmony
sooner than the others will profit greatly and survive any con-
Making the transactional tools available when and where solidation movements. MIS and CIO functions will have to
needed by the humanity is the function of the intellectual widen their horizons beyond the customer data to look for
institutions of any society. Having created the banking and the these patterns. It is likely that even large regional trading
financial institutions of modern economies, the next step is to blocks of many nations will not be able to ensure adequate
empower these institutions with the ability to offer services growth of their economies because the forces that propel
that are relevant and enhance their creativity to absorb the change are the result of human relationships. A new industry
many shocks likely to result from many divergent views. capable of mapping many ideas, thoughts, and motivations of
Linking and holding these processes tight to the known phe- human psyche may have to emerge as the feeder industry to
nomena of bio-universes will only result in greater poverty enable this vast transformation from material wealth assets to
among the many and a concentration of wealth in the unnec- human relationship assets that take into account the meaning
essary and outdated philosophies of the past. of life as perceived by various generations of humanity. Many
scientists from all walks of human endeavors may have to col-
Business cycles are the outcome of the structural zigzags of laborate to peer beyond the biospheric atmosphere of the
relationships. Using a time-technology framework it will not civilizations up to the 21st century to bring about this vast leap
only be possible to understand this phenomenon but also to forward. Educational institutions may have to delve deep into
take actions when warranted to streamline growth of societal their intellectual pockets to create new academic disciplines
well-being. Societal well-being consists of harmonious rela- that move away from behavior modification education to a
tionships among many variables, biological as well as other behavior identification, explanation, and learning environ-
forms of energies. To restrict our horizons to the languages ment to facilitate innovation. Governments and religious insti-
designed to deal with only the biosphere is likely to prolong tutions may have to abandon mere enforcement of laws and
the human strife and the gloom and doom associated with traditions to, instead, favor inquiry and adjustment as change
that view. With time-technology information will be available and transformation dictate for universal well-being. National
as and when needed without it becoming a political tool avail- and sectarian perspectives may have to yield to pragmatic

34 - The journal of financial transformation

It is interesting to see change being perceived as either growth non of nature, especially the solar system-based nature; the
or decline from different points of views. It is interesting also, word time is much more complex and meant to include non-
given the nature of this universe, where there are only trans- biological nature as well. Time, viewed in this manner, is a
formations since energy is neither created nor destroyed and derivative of a relationship. Any change in that relationship is
the sum is a constant how human languages and vocabular- measured as a phenomenon of time. Intellectually, words and
ies have evolved to describe only the immediate and the tran- phrases in any language are disjointed concepts leaving cir-
sient to have them appear as permanent and absolute. Of cumstances to determine their meaning, relevance, and the
course, these myopic vocabularies enable us to stay focused perception of facts, as truths, by the participants of that lan-
on what needs to be dealt with here and now and hence admi- guage. Time-technology framework provides a mechanism
rable and convenient. However, from many strategic points of that is independent of spoken, written, or any other form of
views the transformational aspect is more relevant to ensure languages; thus providing a new medium of communication.
efficacy of designs, plans, and programs. This paper will Use of time-technology would be essential to measure growth,
address the opportunities available to manage transforma- or lack thereof, especially in the wealth management industry,
tions in a way that will be conducive to both the businesses since wealth is an intellectual concept and its use in a modern
that are supposedly only concerned with the immediate and society is not just limited to providing an income or growth to
the humanity at large that strives at least, intellectually to its holders. Growth occurs in the absence consumption, or
ensure its eternal survivability. Is it politics, then, that strives to more likely smaller rates of consumption than the increments
strike a middle ground in this battle? In any sense, truth which in inputs. In either case, the underlying relationships are per-
is perhaps a perception of known facts gets determined by a ceived to be constant and are not validated in reality.
judicial process that strives to balance fairness against mercy Economic bubbles are the outcome of such misperceived con-
at a given point, that is also transitory, in these dynamic rela- stancy of relationships.
tionships. So, why does any one pay attention to only growth
and its measurement while leaving out the dynamic aspects of Having outlined in the discussion above the topography of
relationships? The only answer I could come up with is, per- human perceptions and the communication limitations of the
haps, because it customary to do so. language mechanisms we could delve into the solutions that
can protect and enhance measurement of values, be they
By bringing into this discussion the customary and the tradi- cultural, financial, and social or of any other statistical or non-
tional framework, I have established the on-going nature of statistical groupings. The significant advantage, by the depar-
relationships, be they long or short, and the component of ture from the language mechanisms to the time mechanism,
wisdom in the aforementioned judgmental processes. is the elimination of the need for a hierarchical view of rela-
Management of growth or any other similarly observed phe- tionships that constrain and obscure other significant and
nomenon is a continuum in the many and variegated relation- dynamic factors that underlie any relationship. Another
ships spectrum. How does one measure and keep track of advantage might be the elimination of the need to trade off or
relationships that barely budge in ions of existence alongside prioritize options and have them available for comparison
those that change in micro- or milliseconds and bring wisdom throughout any relationship.
to the individual responses at a point of decision making? The
answer, perhaps, lies in the creation and use of a new method- These two advantages alone could and should justify its cre-
ology I have chosen to call time-technology. ation and adoption and pave the way for human existence
without the need of politics. The physics of the dynamical
While we are accustomed to thinking of time as a phenome- forces in all relationships would alone determine the final

35
 to help make correct decisions in real time and ought not to Economic growth has to be defined in terms of core activities
produce any unintended repercussions to any members of the that are essential for human well-being and then categorized
community and society as a whole. The fact gathering and the to help evaluate those that are temporary, such as the ones
educational processes ought to be neutral to any philosophies attributable to wars, famines, and disasters of one kind or
and the resulting actions clearly sustainable at all strategic another, much like the one time events in corporate annual
levels. The end goal of education ought to make each and reports. Lumping them all together not only misrepresents
every societal member a statesman; not just the likes of Jack the truth but also leads to incorrect policy making in the name
Kennedy alone3. Just as the process of making the air and of job creation.
water and having it available to all is a secret and mystery of
nature, the data source and its integration in the societal pro- With such undistorted measurement of growth we will be able
cesses ought to remain a mystery but nevertheless available to allocate the resources to help improve societal welfare in a
for users. Our present day IT combined with these concepts of manner that is both efficient and effective from a strategic
time-technologies could bring about the utopia dreamed in point of view. If our philosophers and theologians are yet to
the literature. All we need now is the will to use the informa- conclude the meaning and purpose of life, the only framework
tion as a solution to every individual so that the institutions that would make sense is to be able to map all of the thoughts
can fulfill their missions and societies can function without and actions of every individual without violating their priva-
systemic failures. Since statesman citizens have to remain so cies against the backdrop of not only a few specimens but the
throughout their lifetime and beyond, software agents repre- entire communities.
senting them will have to be educated and kept abreast of the
ever changing circumstances; hence, the need for artificial One of the uncertainties is the human perception. We need to
intelligence in every walk of life and everyday use. If we want resolve this through the exploration of the inner spaces, much
peace and no strife to obtain it, there is no other cheaper and like the outer space of the earth, of mind, body, and the spirit
efficient way than developing a time-technology framework. before any progress or growth could even be conceived. The
Our investment in the space technologies has produced great notion of individual wealth could only exist after we are able
dividends. In a similar vein, investment in time-technologies to conceive of human values independent of biologic forms to
will help us navigate through difficult periods of human devel- compare and improve its deficiencies, real or imagined.
opment. Use of AI agents will eliminate the need for behav-
ioral modifications of humans and instead provide the leisure
and luxury which, at least in the present day perspective, is
not affordable by all members of any community even after
declaring a war on poverty many decades ago by the most
powerful. Will leisure and luxury alone result in a more con-
templative and peaceful behavior on everyones part? We do
not know and probably can not predict; but at least we could
feel better that knowledge and wisdom are applied in every-
day decision making using objective technologies and no lon-
ger remain as concepts in the ivory towers of academia, and
economic growth is not measured in meaningless statistics, or
that wealth is not attributed to hollow economies.

1 CBC Community based consulting is a conceptual framework proposed by this

36 - The journal of financial transformation author to help utilize the local resources of the communities before reaching out-
wards in increasing geographical or virtual circumference in case of emergencies
or need of cooperative efforts from a point of need.
and wiser human attributes. Products and services created to apparent for the need of a permanent backdrop against
these newer markets might sustain the economies be they which growth measurements are understood and interpreted.
urban or rural, domestic or foreign and perhaps in the fore- When nations declare wars on one another or undertake civil
seeable future eliminate poverty in the bio-universe. Universal reforms of one kind or another we need to measure their
wisdom may have to precede universal affluence. To bring costs against an enduring background of human well-being.
about this universal wisdom it will be necessary to link human- Otherwise, human efforts at progress might turnout to be
ity with its past and future alongside its literature, laws, tradi- more illusionary than real. The value of the national curren-
tions, convictions, beliefs, and faith in a transcape that is cies in the international currency markets might be based on
visual and accessible to everyone all the time. the short-term demand and supply for those currencies but
to gain true importance as a currency of substance for its
Education and cooperative work among all the cultures with universal respect, a gold standard if you will, their economies
universal respect to every individual would have to be the might have to show sustained growth without bubbles of any
foundation of this transcape. The maturing generations of the kind at all levels of societal memberships. Investment in the
affluent east and the west provide the unique opportunity for building of this infrastructure to measure the well-being may
the next 50 years to start on this wiser path to human well- have to precede the aspirations for the universal wisdom that
being. If the younger generations could be led by the wise was mentioned earlier. Universal affluence might follow uni-
counsels of the transformed aged, then, the increasing life versal wisdom. If our national governments were to function
expectancy of the affluent societies will turnout to be not a and fulfill their intended roles, our information systems of
burden on the exchequer but a resource to devise a system today will have to include every individual and that individu-
that could make the transformation permanent. als life and its interaction with the rest of the universes dur-
ing that life-time. Our information technology (IT) needs to
Few examples of bubbles in the measurement of growth are create these linkages in a timely manner to provide depth to
in the linear relationship of eating habits and health. As the the census data. Decision making based on events and hap-
societal members indulge in higher caloric food, let us say penings need to be refined to a point where data is not
due to heavy advertising by a company that is part of the deceiving or misleading but provides the correct sense from
restaurant industry, and there is a demand for fitness prod- every perspective. Data and computing, in this scheme of
ucts by a percentage of the population that succumbs to its design, become a utility that needs to be available to all com-
enticement, and there is an increase in the demand for medi- munities just like water and air is essential for human exis-
cal services by another percentage of the population that tence. Knowledge economies can become sentinel and pro-
falls victim to the product promotion, there is a cause and vide warnings long before catastrophes emerge and destroy
effect. In a free enterprise system, product innovations and its well-being. Community Based Consulting (CBC) that link
product promotions are expected and even encouraged. So, innovations to people, their needs, and their societal process
there is a new equilibrium in the markets and there is growth times are likely to produce the sustainable well-being of the
in multiple sectors of the economy. Is there a higher human entire community and help all of the ecosystems of the uni-
well-being or is this a bubble? If there is a crime and it verses1.
becomes a wave and the institutions that deal with it all
respond to solve those problems, there is growth in related Linking of data to people, in a utility model might cause pri-
sectors. Do these activities foster human well-being? If yes, vacy concerns. Such concerns ought to be addressed by an
how is that computed? What is the final benefit to the sum intermediary layer of a middleware that will hide the actual
total of the economy? The above examples should make it identity of individuals. The purpose of using the actual data is

2 Leaming, B., 2006, Jack Kennedy: the education of a statesman, W.W. Norton
37
 The welfare implications of
product patent: a simple model
Arijit Mukherjee
Associate Professor, School of Economics, University of Nottingham and The Leverhulme Centre
for Research in Globalisation and Economic Policy
Achintya Ray
Assistant Professor, Economics & Finance, Tennessee State University

economy (which is the sum of industry profit and consumer F1 under a product patent without licensing, under a product
surplus) is Wpr = 2D + CSd, where CSd is the consumer surplus patent with licensing, and under a process patent are respec-
for the duopoly market with F1 and F2. Note that F2 does not tively M-R, 2D-R, and D+K-R. Hence, F1s incentive for R&D is
invent a non-overlapping technology and instead both F1 and highest under product patent without licensing and lowest
F2 use the same technology to produce the product. under process patent. The incentive for R&D under product
patent with licensing is lower than the incentive for R&D under
Under the product patent system, F2 cannot enter the market product patent without licensing but higher than the process
and F1 gets the monopoly profit, M. Let us assume that M>2D, patent, since D>K and M>2D>D+K.
i.e., the industry profit reduces as the number of firms in the
product market increase5. Hence, it is trivial that F1 will not Therefore, if the cost of R&D is very small, i.e., R<D+K, it is
license its technology to F2, since licensing will create compe- clear that F1 will always innovate the product, and welfare is
tition and will lower the industry profit. Therefore, under the same under process patent and product patent with
product patent, profit of F2 is 0 and welfare of the economy licensing. If the cost of R&D is moderate, i.e., D+K<R<2D, F1 will
is Wpd = M + CSm, where CSm is the consumer surplus for the not strive to invent the product under process patent, but will
monopoly market structure with F1 as the only producer. try to invent it under product patent irrespective of licensing
Since monopoly creates higher deadweight loss than duopoly, regulations. Hence, in this situation, it is optimal for the gov-
we have Wpr > Wpd, which demonstrates that the concern ernment to impose product patent but with compulsory
about the welfare reducing effect of product patents, as com- licensing. If the cost of R&D is very high, i.e., 2D<R<M, F1
pared to process patents, may not be entirely baseless. invents the product only under product patent without licens-
ing, and it is optimal for the government to impose product
Let us now assume that, under product patent, industrial patent without compulsory licensing.
regulations compel F1 to license its technology to F2 against a
lump-sum fee. Therefore, under this compulsory licensing Hence, it is clear from the above analysis that product patent
scheme, there will be duopoly in the product market, and prof- is necessary if innovation does not happen under process pat-
its of F1 and F2 will be respectively D+L and D-L, where L is the ent. However, the welfare of an economy under product patent
licensing fee charged by F1. F1 will charge L=D and the profits with compulsory licensing could be the same as it would be
of F1 and F2 will be 2D and 0 respectively6. Therefore, under under process patent when the innovation could have occurred
product patent with compulsory licensing, welfare is given by under process patent. Even if an economy needs to switch
Wpd,cl = 2D + CSd, which is equal to Wpr. Therefore, the pres- from the process patent regime to the product patent regime
ence of compulsory licensing eliminates the welfare reducing when innovation occurs under process patent, the presence of
effect of product patents, as compared to process patents. compulsory licensing can make the same welfare under these
patent systems, thus eliminating the welfare reducing effect
So far we have not considered F1s incentive for R&D. Given of product patent.
that R is the cost of doing R&D, we find that the net profit of

1 We refer to Mazzoleni and Nelson (1998) for an overview of the benefits and costs 4 We assume that the lack of enforcement does not make it possible for F1 to com-
of patent protection. mit that it will not enter the market after licensing. Under the process patent
2 We do our analysis with the reduced form profit functions, and therefore, our anal- regime, F1 may produce this product with a slightly different product and may
ysis is not dependent on a particular demand structure. Further, our results hold enter the market even if it agrees to not enter the market while licensing the tech-
38 for both Cournot and Bertrand competition in the product market. If the competi- nology. F2 would anticipate this possibility, and would not be interested to pay
tion is characterized by Bertrand competition, we assume that the products of the more than K for the licensed technology. Because, otherwise, F2 would prefer imi-
firms are symmetrically differentiated. tation than licensing. Furthermore, we assume for simplicity that the licenser has
3 If D<K, imitation is unprofitable to F2. Hence, to make the threat of imitation credi- full bargaining power and, therefore, gets K as the licensing fee.
ble, we should consider D>K.
One important discussion in the contemporary world is the may not have the incentive to sell their product in the devel-
standardization of the patent system. More specifically, it has oping country if the developing country practices product
been suggested that all countries should adopt product pat- patent. But, process patent in the developing country could
ents instead of process patents. Under the process patent create the threat of competition from a developing country
regime, a particular way of making a product is patented. In firm and the product could be sold in the developing country.
other words, a single product may be made using different Hence, product patent in the developing country could pre-
proprietary technologies under the process patent. In the vent the product from being sold in that country, thus reduc-
product patent regime, a particular product is patented no ing its welfare compared to process patent.
matter how it is produced.
While the switch from process patent to product patent is
Supporters of product patent argue that this regime actually important, the existing literature has not paid much attention
provides more comprehensive protection to the inventor since to it. Instead, it has mainly looked at the effects of strengthen-
the product itself is protected. Supporters of process patent ing the process patent regime1. In this paper, we use a simple
argue that this regime promotes competition and may also model of product and process patents to show that product
inspire innovation of new technologies that are more efficient. patents help to increase welfare in presence of compulsory
Since there is a considerable threat of imitation in the process licensing. There is no need to be overly concerned about the
patent regime, patent protection may be less effective. As a welfare reducing effect of a product patent regime.
result, the WTO has called for a product patent regime rather
than a process regime under TRIPS. Many countries, who up The model and the results
to recently were following process patent systems, have been Consider a market with two firms: Firm 1 (F1) and Firm 2 (F2).
forced to change their laws and start pursuing product patent Assume that F1 can invent a new product, whereas F2 cannot
regimes. For example, India moved from a process patent sys- invent this product by itself. However, if the patent system
tem to a product patent system in 2005. permits (i.e., under the process patent regime), F2 can pro-
duce the product of F1 by adopting a non-infringing technol-
While the R&D increasing effect of product patent is easy to ogy that does not overlap with F1s production techniques. But
understand [Maskus (1990) and Subramanian (1990)], the to do so, F2 will have to make a fixed investment of K. If there
developing countries are skeptical about its welfare implica- is a product patent, F2 cannot imitate the product of F1.
tions. For example, Marjit and Beladi (1998) showed that the
imposition of product patent in the developing countries may Let us first consider the process patent regime. Assume that,
reduce welfare of these countries by discouraging the innova- under imitation, F1 earns a profit D, and the profit of F2 net of
tors from the developed countries to sell their products in the imitation cost is (D-K)2. Assuming that D>K,3 F1 will license its
developing countries with small markets. If the developing technology to F2 against a lump-sum payment of K. F1 realizes
country market is sufficiently small compared to the rest of that it needs to compete with F2, since F2 will imitate and
the world and the markets are integrated to the extent that enter the market. Therefore, F1 finds it optimal to allow F2 to
they prevent the innovator from the developed country to use the technology against a fee K4. Therefore, the profits of
charge different prices in different countries, the innovator F1 and F2 are respectively D+K and D-K, and welfare of this

5 Later, we will discuss the implications of M<2D. ate competition in the product market. Additionally, the government always has
6 It may be reasonable to assume that, under compulsory licensing, F1 will not be the option to tax F2 and redistribute the tax revenue to F1, thus generating net 39
able to extract entire profit of F2, since it can produce the product only if it licens- profit of F1 and F2 as 2D and 0 respectively. As a simplification, we assume that F1
es its technology to F2. However, we assume that the purpose of this licensing can charge D as the licensing fee, which generates the same net payoffs for these
scheme is not to give higher bargaining power to F2, rather the purpose is to cre- firms.
 It is worth mentioning that, so far, we have assumed M>2D. References
Marjit S, and H. Beladi, 1998, Product versus process patents: A theoretical
However, if the products of these firms are sufficiently hori-
approach, Journal of Policy Modeling, 20, 193 99
zontally differentiated, we can have M<2D. Hence, in this situ- Maskus, K., 1990, Normative concerns in the international protection of intellectual
ation, F1 will have a natural incentive for licensing its technol- property rights, The World Economy, 13, 387 410
Mazzoleni, R. and R. Nelson, 1998, The benefits and costs of strong patent protec-
ogy to F2 even under product patent, since licensing will tion. A contribution to the current debate, Research Policy, 27, 273 84
increase the industry profits. Therefore, in this situation, com- Mukherjee, A. and A. Ray, 2006, Patents, imitation and welfare, Economics of
Innovation and New Technology, Forthcoming
pulsory licensing may not be required to maintain competition Subramanian, A., 1990, TRIPS and the paradigm of GATT: a tropical temperate
in the product market. view, The World Economy, 15: 509 22

Conclusion
While many countries need to change their patent system
from process patent to product patent, there is not much for-
mal analysis about the regulations that should be contem-
plated while making the switch. We use a simple model to
show that the countries may not need to be worried about the
adverse welfare impact of product patent, as suggested by the
earlier work. If there is compulsory licensing, it can help to
eliminate the welfare reducing effect of product patents, as
compared to process patents. This is the key contribution of
our paper.

We have abstracted several important factors in our analysis,

such as entry and exit of firms in the market, uncertainty in
R&D, and the dynamic aspects of production and R&D, which
may have important implications for the number of innova-
tions, cooperative R&D, and collusion in the product market7.
These issues and other related matters deserve careful atten-
tion for improving our understanding of the impact of product
patents on market outcomes and welfare.

Our paper may be used as a guideline while doing empirical

studies about the welfare implications of patent related policy
changes. As we have indicated, compulsory licensing may or
may not be required but that decision will depend on the
industrial structure.

7 In a duopoly market with R&D competition, Mukherjee and Ray (2006) show the
40 - The journal of financial transformation effects of product and process patents on R&D and welfare, with and without
licensing and collusion in the product market.
 Institutional

Knowledge
management,
innovation, and
productivity in French
manufacturing1
Elizabeth Kremp
Chef du bureau des etudes structurelles, Sessi

Jacques Mairesse
Professor CREST-ENSAE and Maastricht University

Abstract
In modern knowledge driven economies, firms are increas- ly accounted for by firm size, industry, research & develop-
ingly aware that individual and collective knowledge is a major ment (R&D) efforts, and other factors, but persist to a sizeable
factor of economic performance. The larger the firms the extent after controlling for them. These practices also appear
more likely they are to set up Knowledge Management (KM) to be strongly complementary, since firms tend to adopt them
policies, such as promoting a culture of information and jointly and their impacts on firm performance tend to be
knowledge sharing, motivating employees and executives to cumulative. What seems to matter for innovative performance
remain with the firm, forging alliances and partnerships for is knowledge management intensity as simply measured by
knowledge acquisition, and implementing written knowledge the number of different KM practices implemented by the
management rules. Based on the French 2000 Community firm. For labor productivity, however, the estimated individual
Innovation Survey (CIS3), which has surveyed the use of these impact of an incentive policy to retain employees and execu-
four KM policies for a representative sample of manufacturing tives is clearly largest, that of promoting a culture of knowl-
firms, our microeconometric analysis tends indeed to confirm edge sharing is about twice smaller, while the impacts of the
that knowledge management contributes significantly to firm other two policies are not statistically significant.
innovative performance and to its productivity. The estimated
impacts of adoption of these four practices are not complete-

1 We are grateful to Dominique Foray and Fred Gault for encouragement to perform
this study and to Rachel Griffith, Bronwyn Hall and Kathryn Shaw for comments. 41
This is a shorter version of Kremp-Mairesse (2004).
 Knowledge management, innovation, and productivity in French
manufacturing

In the knowledge driven economy, firms are becoming more 100

and more aware of the fact that knowledge is a resource 80

60
requiring explicit and specific management policies and prac- 40 28 27
23
tices to be acquired, processed, and exploited efficiently. 20 17
0
Among other objectives, the role of knowledge management C: Knowledge R: Incentive policy A: Alliances for W: Written KM
sharing culture to retain knowledge policy
(KM) policies and practices is to foster all types of firm innova- employees acquisition
tion, whether process or product oriented or mainly organiza-
20 to 49 employees 250 to 499 employees 2,000 employees or more
tional, and to improve firm productivity and competitive 50 to 99 employees 500 to 999 employees Total
advantage2. 100 to 249 employees 1,000 to 1,999 employees

Figure 1 Diffusion of knowledge management practices by firm size

In this study, we try to assess the effective impact of such KM
policies on firm innovative and productive performance. To do
so, we take advantage of the introduction of four new ques- tous, creating new needs and requiring appropriate organiza-
tions on four relatively well-defined KM policies, in the French tional structures, facilitating the automation of some tasks and
Community Innovation Survey covering the years 1998-2000 the outsourcing of others, supporting technological watch and
(CIS3) for manufacturing firms.3,4 These questions concern improving access to external knowledge. Firms have to react
the existence in the firm of a written policy (W) of KM, of a faster to keep their competitive edge and to be able to build on
culture (C) of knowledge sharing, of a policy of retention (R) of all or part of their past experiences. They are more and more
employees and executives, and of alliances (A) and partner- aware of the fact that their competencies largely rely on indi-
ships for knowledge acquisition. In the first section of the viduals and on tacit knowledge special to the company. They
study, we provide evidence on the diffusion of the four KM are worried about the loss of skills caused by the mobility of
policies and on their complementarity, in the sense that firms their personnel and are striving to motivate their employees
tend to adopt them jointly. In the second, we estimate their and executives to remain within the company, improving their
specific impacts on four indicators of firm innovation and on career and remuneration prospects, setting up training cours-
labor productivity, controlling for a number of factors, and es and encouraging professionalism. Firms are also aware that
show they are complementary also in the sense that their they cannot maintain and develop their knowledge by relying
impacts tend to be cumulative. We briefly conclude in the last only on internal forces. They have to form alliances and part-
section. The exact wording of the four new questions on the nerships with other firms, competitors as well as suppliers and
four KM policies in CIS3 (and that of three other related ques- clients, to acquire new knowledge and expertise.
tions on the implementation of new managerial methods and
the use of Internet and ICT resources) is documented in the Over the past years, French manufacturing firms have adopted
Appendix.5 different KM practices. In 2000, nearly one out of two had
implemented at least one of the four KM policies (Figure 1).
Diffusion and complementarity of knowledge Roughly one out of four of them had a culture of promoting
management practices knowledge sharing (C), had an incentive policy to keep employ-
Several reasons explain the increasing concern of firms for ees and executives in the firm (R), or forged alliances or part-
knowledge management. Firms have to deal with a more com- nerships for knowledge acquisition (A), and one out of six put
plex world because of rapidly changing technologies. into practice a written knowledge management policy (W).
Information and communication technologies (ICT) are ubiqui-

2 We use the words KM policies and practices (or even methods or strategies) inter- a presentation of this project and its main results, see Foray and Gault (2004).
changeably. 5 The descriptive statistics given in the first section are weighted to be representa-
3 The CIS3 survey for French manufacturing firms has been performed by SESSI tive of French Manufacturing as a whole (for firms with 20 employees or more).
42 (Service des Etudes et Statistiques Industrielles). For a summary presentation of The econometric estimates given in the second section are not weighted, but we
its overall results, see Lhomme (2002). We are grateful to SESSI for providing us have introduced size and industry indicators in all our estimated models. We have
with access to the French CIS3 firm data. checked that the weighted econometric estimates were not meaningfully different
4 The introduction of the four KM questions in the French CIS3 was part of a pilot from the unweighted ones.
project initiated by OECD and Statistics Canada to document firm KM behavior. For
 Knowledge management, innovation, and productivity in French
manufacturing

50 have adopted a knowledge written policy (W). The diffusion of

40 KM policies is about half as prevalent in the low-tech indus-
30
20
tries, such as clothing and leather, publishing, printing and
10 reproduction, or home equipment.
0
C: Knowledge R: Incentive policy A: Alliances for W: Written KM
sharing culture to retain knowledge policy
employees acquisition
From 1998 to 2000, one manufacturing firm out of five had
Low technology Medium-High Total implemented new methods of management in the broad
Medium-Low High sense, that is, with respect to other corporate functions,
rather than just KM. A good example is the development of
Figure 2 Diffusion of knowledge management practices by technology intensive
industries
project-based management practices that altered existing
work relations within companies, and led to the progress of
As could be expected, the diffusion of KM policies is much corporate cross-departmental culture. Unsurprisingly, KM is
more widespread in large than in small firms. Setting up a more widespread in firms that have adopted such new man-
special organization is less critical, and more costly, in small- agement methods (Figure 3). Among these firms three out of
er firms where information circulates more easily and infor- four have also implemented at least one of the four KM prac-
mal procedures can be efficient. In the larger firms, on the tices, while among firms that have not adopted new manage-
other hand, identifying the experts (the knowledge holders) ment methods, this is the case of less than two out of five.
within the company is essential vis--vis other employees and
working with outside experts is an important asset. In 2000, Knowledge management is also prevalent among firms
almost four out of five of French manufacturing firms with investing in R&D, innovating, and patenting. In 2000, 30% of
2,000 employees or more declared they had a knowledge French manufacturing firms had invested in R&D, and 20%
sharing culture (C) or alliances for knowledge acquisition (A), had patents on products protecting part of their output, while
while only one out of five of those with 20 to 49 employees about 35% had generated innovations on products or pro-
said so. Likewise, adopting a written knowledge management cesses. The diffusion among these firms of all four KM prac-
policy (W) is much more frequent in the large firms. By con- tices is at least twice that of those firms that were not innova-
trast to large firms, small firms are likely to be more depen- tive or had low R&D focus, and at least 60% higher than
dent on the expertise and know how of a few number of their non-patenting firms (Figure 3).
employees, and much more concerned if they leave. That is
possibly why the adoption of a policy to retain employees in As part of their strategy to foster innovation, firms make spe-
the firm (R), even if much less common in the smaller firms cific efforts to gain better information on technologies, prod-
than in the larger ones, is somewhat more frequent relative ucts, and materials, as well as about their customers, suppli-
to the adoption of the three other policies. ers, and competitors. They find such information from a wide
range of sources: from universities and public or private
KM policies are also particularly widespread in the high and research laboratories, in technical and economic databases, in
medium-high tech industries, such as the pharmaceutical professional journals and conferences, trade fairs, and exhibi-
industry, aeronautic and space construction, or electronic tions. Indeed, 40% of innovating firms state that they use the
component manufacturing (Figure 26). In these industries, Internet to acquire information for their innovating activities,
40% to 45% of the firms have implemented policies to foster 35% take advantage of ICT resources to share such informa-
knowledge sharing (C), to retain employees (R), or to estab- tion between employees, and 25% do both. Among this last
lish partnerships to acquire knowledge (A), and about 25% group, about 60% have a knowledge sharing culture (C) and

6 Definition: The classification of industries by technological intensity is mainly

based on the average ratio of R&D to output of the industry at the CITI rev2 level 43
[OECD (1997)]. Scope: Manufacturing firms with 20 employees or more (excluding
the food industry), weighted results. Source: SESSI, CIS3 Survey.
 Knowledge management, innovation, and productivity in French
manufacturing

Among % of firms % of firms having KM intensity

Knowledge Incentive policy Alliances for Written At least one
sharing culture to retain knowledge KM policy of the four
employees acquisition policies
All firms 28 27 23 17 45 0.9

R&D-doing firms 30% 45 42 39 28 71 1.6
Non-R&D-doing firms 70% 20 20 15 12 34 0. 7

Innovating firms 34% 41 42 38 26 68 1.5

Non-innovating firms 66% 19 19 14 12 34 0.7

Firms with patents 20% 40 39 35 26 62 1.4

Firms with no patents 80% 25 24 20 15 41 0.8

Firms having adopted
new management methods 21% 51 47 42 29 76 1.7
Firms not having adopted
new management methods 79% 21 21 17 14 37 0.7
Innovating firms which are:
--using the Internet and ICT for
acquiring and sharing information 28% 62 56 51 39 82 2.1
--not using the Internet and ICT for
acquiring and sharing information 68% 37 36 34 21 63 1.3
Among all firms, 28% of them have implemented a knowledge sharing culture, 45% have adopted at least one of the four KM policies. Among all firms, 30% of them do R&D.
Among the R&D-doing firms, 45% of them have implemented a knowledge sharing culture.
Definitions:
The innovating firms are firms earning a turnover from new or significantly changed products on the market from 1998 to 2000 (in %).
The firms with patents are firms having patented products in 2000 (in %).
Scope: Manufacturing firms with 20 employees or more (excluding the food industry), weighted results.
Source: SESSI, CIS3 Survey.

Figure 3 Diffusion of knowledge management practices

40% a written knowledge management policy (W), twice as have a culture of knowledge sharing, only one out of eight set
many as for all manufacturing firms. up partnerships for knowledge acquisition (A) or implement
an incentive policy for employees retention (R).
Looking at the occurrence of joint adoption shows that firms
view them as complementary and suggests that the basic The complementarity of KM practices is reflected in the high
reasons for their adoption are similar. Firms that implement correlations, ranging from 0.30 to 0.50, between the corre-
one KM policy are much more likely to adopt a second one sponding binary indicators of adoption. It is also confirmed by
than firms which have not implemented the first one. Three the fact that such correlations remain high, in the range of
out of five firms, among the 28% which have a knowledge 0.15 to 0.40, when we try to control for various factors of
sharing culture (C), also implement an incentive policy to adoption (Figure 4). The easiest way to take into account this
keep employees (R); one out of two also develop partnerships complementarity is to define a KM intensity indicator (KMI) as
to acquire knowledge (A), and about one out of two also have being simply the number of adopted practices.7 It increases
a written knowledge management policy (W). On the other strongly with size as well as with the industry technology
hand, among the 72% of firms declaring that they did not intensiveness. It is about 2.7 in firms with 2,000 employees or

7 It can be shown that KMI roughly corresponds to the first component in a principal
44 - The journal of financial transformation
factor analysis (or multiple correspondence analysis) of the correlation matrix (or
the contingency table) of the four KM policies binary indicators.
Knowledge management, innovation, and productivity in French
manufacturing

Raw correlations
(before any controls) Knowledge sharing Incentive policy to Alliances for Written KM policy KM intensity
culture retain employees knowledge acquisition
Knowledge sharing culture 1 0.47 0.40 0.48 0.81
Incentive policy to retain employees 0.47 1 0.40 0.28 0.74
Alliances for knowledge acquisition 0.40 0.40 1 0.27 0.71
Written KM policy 0.48 0.28 0.27 1 0.68
KM intensity 0.81 0.74 0.71 0.68 1
Partial correlations
(after controlling for size, industry, and other relevant factors)
Knowledge sharing culture 1 0.36 0.28 0.39 0.76
Incentive policy to retain employees 0.36 1 0.29 0.16 0.68
Alliances for knowledge acquisition 0.28 0.29 1 0.16 0.64
Written KM policy 0.39 0.16 0.16 1 0.62
KM intensity 0.76 0.68 0.64 0.62 1
The (raw) correlation between the binary indicator of firm adoption of a culture of knowledge sharing (C) and incentive policy to retain employees (R) is of 0.47, while the partial
correlation is of 0.36, after (linearly) controlling for size, industry, and other factors (included as controls in the firm performance equations).
Scope: Manufacturing firms with 20 employees or more (excluding the food industry), weighted results.
Source: SESSI, CIS3 Survey.

Figure 4 Correlations between knowledge management practices

more as against 0.7 in firms with 20 to 49 employees. 15% for the innovating firms and the average patent intensity
Likewise, it averages about 1.6 in high-tech industries and about 30% for the firms with patents.
about 0.7 in low-tech intensity industries.
The fact that the innovation and patent intensity variables
Knowledge management, innovation, and can only be known for the innovating and patenting firms is a
productivity likely source of selectivity, which would result in biased esti-
The diffusion of KM practices is far from being complete mates if we were to estimate the intensity relations sepa-
among innovating firms or firms with patents, although much rately from the propensity relations. Thus, we consider jointly
more advanced than among non-innovating and non-patent- the propensity and intensity relations within the framework
ing firms. It thus makes sense to estimate the specific impact of a generalized Tobit model, which allows for correcting of
of adoption of KM practices on firm innovative performance, possible selectivity biases8. As control variables, we use the
controlling for other factors and firm characteristics. To firm size, industry indicators, R&D intensity for R&D-doing
assess firm innovative performance, we use four variables firms, and three other binary indicators for belonging to a
from CIS3. The first two are the propensity to innovate and group, using new management methods, and not doing R&D.
the (product) innovation intensity, that is the binary indicator We also introduce a control for the acquisition and sharing of
of whether the firm has introduced during the period 1998- information using the Internet and other ICT tools. In view of
2000 any new or significantly improved products, and if yes the strong complementarity of KM practices, we consider
the share of turnover from these new or significantly four specifications. In the simplest specification (Model 1), we
improved products in the overall turnover of the firm in 2000. use our KM intensity variable (KMI) as the only KM explana-
The other two variables, defined in an analogous way, are the tory variable in the propensity and intensity equations,
propensity to patent and the patent intensity. The average assuming that the individual impacts of the four KM practices
propensities to innovate and to patent are respectively about are both (roughly) equal and linearly cumulative in the two
35% and 20%, while the average innovation intensity is about equations. In the next specifications, we introduce, instead of

8 Since the observed innovation and patent intensity variables are share variables, the 0 to 1 interval). We estimate this Tobit model by the method of maximum likeli-
we use in fact as the dependent variable in the outcome equation their logit trans- hood, making sure that we reach the absolute maximum (using TSP international 45
formation [i.e., z = log(y/(1-y))], so that the distribution of the logit-shares are version 4.5).
(approximately) consistent with the assumed normal distribution (and limited to
 Knowledge management, innovation, and productivity in French
manufacturing

Impacts in % Propensity to innovate Innovation intensity Propensity to patent Patent intensity Labor productivity
Number of firms 3,474 1,635 3,474 1,125 3,419
Mean of left hand variable 47.1 15.8 32.4 30.5 5.64

Model 1 regression with

the KM intensity variable
KM intensity 4.0a 1.6a 1.6a 3.1b 3.0a
Log likelihood -4226.49 -4089.63 -1650.55
Root MSE 1 19.18 1 67.73 39.36
Rho 0.73 0.94

Model 2 regression with
4 KM intensity binary indicators
KM intensity=1 6.3a 3.5b 1.3 5.8 7.1a
KM intensity=2 10.0a 3.8a 2.7 5.4 5.6a
KM intensity=3 11.6a 4.4a 4.1c 7.6 9.0a
KM intensity=4 15.7a 7.5a 7.1a 14.9b 13.3a
Log likelihood -4224.00 -4088.84 -1647.80
Root MSE 1 19.18 1 67.77 39.35
Rho 0.73 0.94

Model 3 regression with

the 4 KM practices indicators
(C): Knowledge sharing culture 2.8c -1.6 0.5 -1.2 5.0a
(R): Incentive policy to retain employees 6.4a 3.2a 3.3b 7.7b 10.3a
(A): Alliances for knowledge acquisition 4.9a 1.8c 0.5 1.0 -1.8
(W): Written KM policy 1.6 1.7c 2.3 5.0 -3.5c
Log likelihood -4222.26 -4088.34 -1632.72
Root MSE 1 19.13 1 67.62 39.17
Rho 0.73 0.94

Model 4 regression with

fully interacted KM practices indicators
Log likelihood -4208.16 -4080.53 -1623.96
Root MSE 1 19.02 1 67.11 39.14
Rho 0.73 0.94
a, b, c significance at the 1%, 5%, and 10% levels
Scope: manufacturing companies with 20 employees or more (excluding the food industry), not weighted.
Source: SESSI, CIS3 Survey.

Figure 5 Estimated impacts of knowledge management on firm innovation and productivity, controlling for other relevant factors

KMI, four binary indicators in the propensity and intensity the KM indicators, all their possible interactions, that is elev-
equations. In Model 2, these indicators respectively corre- en other binary indicators. Clearly Model 1 is nested in the
spond to the use of only one, two, three, or all four KM prac- other three models, while Models 2 and 3 are also nested in
tices, still implying that the impacts of the four practices are Model 4, permitting us to test whether the four KM policies
equal but allowing them to be more or less cumulative. In appear interchangeable and more or less cumulative, in
Model 3, they simply correspond to the separate use of each terms of their impacts on firm innovative performance.
of the four KM practices, allowing the impacts of the four
practices to be different as well as cumulative. In the most The estimated impacts of the KM indicators on the innovation
general specification, Model 4, we introduce, in addition to and patent propensities and intensities are all statistically

46 - The journal of financial transformation

Knowledge management, innovation, and productivity in French
manufacturing

Innovation Patent Productivity

firms10. These estimated impacts are quite substantial and
propensity propensity seem cumulative. They are, however, not so huge that one
and intensity and intensity
Model 1 against Model 2
would have to conclude that they are necessarily wrong. It is
Chi2(n) 2.49 (6) 0.79 (6) 2.8 (3) true that all the usual reasons of econometric misspecifica-
P-value in % 87% 99% 43%
tion potentially apply: omitted control variables, unobserved
Model 1 against Model 3
Chi2(n) 4.23 (6) 1.29 (6) 17.8 (3) firm characteristics, and endogeneity of right hand variables.
P-value in % 65% 97% 0%
These problems may be particularly serious with cross-sec-
Model 1 against Model 4
Chi2(n) 18.33 (28) 9.1 (28) 26.6 (14) tional data. There is not much that we can do to address them
P-value in % 92% 100% 2% very effectively, short of being able to gather more and bet-
Model 2 against Model 4
Chi2(n) 15.84 (22) 8.3 (22) 23.8 (11) ter data. On the other hand, an extreme degree of disbelief is
P-value in % 82% 100% 1% not warranted. Even if the adoption of KM has become fash-
Model 3 against Model 4
Chi2(n) 14.1 (22) 7.8 (22) 8.8 (11)
ionable among firms, one will expect that on average firms
P-value in % 90% 100% 64% will not go through the various costs of implementing KM
Chi2(n) test statistics are directly computed on the base of the maximum policies unless they have some real impacts on their perfor-
log-likelihood values given in Figure 5. The number of degrees of freedom n is the
difference in the number of KM parameters between the encompassing model
mance. Anyhow, whether one views our findings with exces-
and the model tested. sive skepticism or is willing to give them some causal mean-
Scope: Manufacturing companies with 20 employees or more (excluding the food
ing, in both cases they remain statistically informative. At the
industry), not weighted.
Source: SESSI, CIS3 Survey. minimum, they reflect significant positive correlations, condi-
tional on a fair number of relevant factors.
Figure 6 Tests of the regression model with KM intensity against models with
four KM intensity binary indicators, and the four KM practices binary indicators
alone or fully interacted We also investigate whether KM practices have a specific
impact, both statistically and economically significant, on
very significant for Model 1; most of them are also very sig- labor productivity, using basically the same models as for
nificant, for Models 2 and 3, while only a few are for Model 4 innovation and patenting with two differences. Firstly, instead
(Figure 5).9 The Chi2 tests of specification show clearly that of a generalized Tobit, we can rely on a log-linear regression
the more parsimonious Model 1, with the KM intensity specification, which can be viewed as a simple extended pro-
variable, cannot be statistically rejected against the other duction function of current use in studies of R&D productivity.
three models, even with a very low level of significance Secondly, we introduce physical capital per employee as an
(Figure 6). Model 1 can thus be viewed as the preferred additional control variable, since this is the major variable
model. accounting for productivity differences among firms.

Firms do tend to innovate and patent more extensively, if The estimates and specification tests of the four models, cor-
they have adopted KM policies, regardless of their size and responding to the different ways of entering knowledge man-
industry, of their R&D efforts, whether they belong to a agement in the productivity equation, tell us a somewhat
group, and have implemented new management methods. All different story than for innovative performance (Figures 5 to
else equal, when KM intensity increases by one, the propen- 7). Model 3, in which the four KM policy indicators are includ-
sity to innovate increases by 4% at the sample mean and ed separately, performs slightly better than the others: it is
innovation intensity increases by 1.6% for the innovating statistically different from Model 1 using our simple measure
firms. Similarly the propensity to patent increases by 1.6% of KM intensity, but it is not statistically different from the
and patenting intensity increases by 3.1% for the patenting less parsimonious Model 4 with fully interacted KM policy

9 We do not report the estimated impacts for model 4, since they are not significant, already adopted one such policy the impact on its performance of adopting anoth-
with very few exceptions, for the eleven indicators of KM interactions (and practi- er one would be higher (or weaker). 47
cally not different for the four non-interacted KM indicators from the estimated 10 The orders of magnitude of the control variables estimates (reported in Figure 7
impacts in Model 3). We thus do not find evidence of complementarity (or substi- for Model 1) are also statistically significant and fairly reasonable, although the
tutability) between the four KM policies, in the specific sense that if a firm has specific impact of R&D intensity may seem on the low side.
 Knowledge management, innovation, and productivity in French
manufacturing

Impacts in % Propensity to innovate Innovation intensity Propensity to patent Patent intensity Labor productivity
KM intensity 4.0a 1.6a 1.6a 3.1b 3.0a
(0.5) (0.4) (0.5) (1.3) (0.6)
R&D intensity 1.7a 1.2a 2.8a 5.3a 1.6b
(0.6) (0.4) (0.6) (1.4) (0.6)
Non-R&D-doing indicator -43.4a -19.8a -30.3a -48.3a -13.9a
(3.1) (2.3) (3.0) (7.3) (3.2)
Group indicator 3.3b 2.1 5.2a 13.0b 3.8a
(1.6) (1.3) (1.8) (5.0) (1.7)
New management methods indicator 6.5a 3.9a 2.6c 9.3b -3.2c
(1.5) (1.0) (1.5) (3.6) (1.6)
Internet and ICT for information acquisition
and sharing indicator -- 1.5 -- -0.8 --
(0.9) (2.9)
Physical capital intensity -- -- -- -- 15.4a
(0.7)
Log likelihood -4226.49 -4089.63 -1650.55
Root MSE 1 19.18 1 67.73 39.36
Rho 0.73 0.94
Number of firms 3,474 1,635 3,474 1,125 3,419
Mean of left hand variable 47.1 15.8 32.4 30.5 564.0
a, b, c significance at the 1%, 5%, and 10% levels
Scope: Manufacturing firms with 20 employees or more (excluding the food industry), not weighted.
Source: SESSI, CIS3 Survey.

Figure 7 Estimated impacts of knowledge management intensity, R&D intensity, and other control variables on firm innovation and productivity

Less desirable and somewhat puzzling is the observation that

our specific KM practices are not only cumulative, but also
apparently interchangeable in the case of innovative perfor-
mance. The model with KM intensity, simply defined as the
number, varying from zero to four, of KM practices imple-
mented by firms, performs statistically as well as the one with
the four individual KM indicators. An explanation may be
found in the collinearity of these indicators reflecting the
complementarity of KM practices, but also in the intrinsic
crudeness and subjective nature of such binary survey indi-
cators, which is a likely source of measurement errors. Also
rather puzzling is the finding that the estimated impacts of
implementing new management methods in the broad sense
are about as large as the impacts of KM practices on firm
innovative performance, while they are if anything negative
on firm productivity, unlike the positive significant impacts of
employees retention and knowledge sharing culture policies
(R and C).

11 The estimated elasticities of the physical capital intensity and of R&D intensity are
48 - The journal of financial transformation
consistent with what could be expected from previous productivity studies (report-
ed in Table 5 for Model 1). Contrary to what we find for innovation and patenting,
the estimated impact of the implementation of new management methods on pro-
ductivity is barely statistically significant and if anything negative.
Knowledge management, innovation, and productivity in French
manufacturing

indicators (while Model 2 differs statistically from Model 4, performance of KM policies, we have found some not very
n o t surprising results, some more surprising ones, some of them
from Model 1). It is clear that the four KM policies do not satisfactory, while others are puzzling.
appear exchangeable anymore and remain only partly cumu-
lative. All else being equal, labor productivity is higher, and Among the expected results, the diffusion of KM policies is
very significantly so, by about 10% for firms implementing a much more advanced in the larger firms and in the technol-
policy to retain executives and employees (R) than for firms ogy intensive industries. As expected also these practices
which do not, and by about 5% for firms promoting a culture appear highly complementary, firms tending to adopt them
of knowledge sharing (C) than for firms which do not. At the jointly. Among the less obvious but satisfactory findings, the
opposite, all else equal, labor productivity is not statistically impacts of KM practices on firm performance are in general
different between firms declaring that they have or have not statistically and economically significant and more or less
a policy to establish alliances to acquire knowledge (A), and a cumulative, even controlling for firm size, industry, and other
written knowledge policy (W)11. important factors, such as R&D intensity and physical capital
intensity. These estimated impacts are on the high side, but
Conclusion still in the range of values that one is a priori ready to accept
In this exploratory study of the diffusion and impact on firm as plausible.

Appendix:

A) Definition of the four Knowledge Management (KM) indicators and of two B) Definitions of other variables
other directly related indicators on adoption of new management methods The propensity to innovate variable is measured by the proportion of firms
and on the use of Internet and ICT for information acquisition and sharing. earning a turnover from new or significantly changed products on the market
from 1998 to 2000 (in %).
The four KM binary are based on four questions introduced in the Third The propensity to patent variable is measured by the proportion of firms hav-
Community Innovation Survey (CIS3) for Manufacturing firms, conducted by ing patented products in 2000 (in %).
SESSI (Service des Etudes et Statistiques Industrielles). It is a mandatory sur- The innovation intensity variable is measured by the logit function of the share
vey for some 5500 manufacturing firms with 20 employees or more, which (or logit-share), in the firms total turnover in 2000, of the turnover from new
have been chosen randomly using the legal business register and a stratified or significantly changed products introduced on the market from 1998 to
sampling design (exhaustive for firms with 500 employees or more, and with 2000 (in %).
a decreasing sampling rate from 1/2 to 1/8 for firms from 100 to 499, 50 to 99 The patent intensity variable is measured by the by the logit function of the
and 20 to 49 employees). The overall rate of response was of 86%. share (or logit-share), in the firms total turnover in 2000, of the patented
products sales (in %).
The four questions directly referring to firm KM policies have been chosen as The labor productivity variable is measured by the logarithm of the firms
particularly meaningful among the 23 questions considered in the KM pilot value added to the total number of employees in 2000 (in K per person).
survey by Statistics Canada [Earl and Gault (2003)]. They are the following: The physical capital intensity variable is measured by the logarithm of the
firms gross book value to the total number employees in 2000 (in K per
By the end of 2000, did your firm have a written knowledge management person).
policy? (W) The R&D intensity variable is measured by the logarithm of the share of the
Did it have a culture to promote knowledge sharing? (C) firms R&D expenditures in the firms total turnover in 2000.
Did it put into practice an incentive policy to retain employees and execu- The knowledge management intensity variable is measured by the number
tives in firm? (R) (from 0 to four) of knowledge management practices implemented by firms.
Did it forge partnerships or alliances for knowledge acquisition? (A) The group, new management methods, Internet and ICT for external data shar-
ing use, and non-R&D-doing variables are binary 0-1 indicators (respectively
The survey also includes other questions related to the KM policies, only asked equal to 1 if the firms belong to a group, have adopted new management
to the innovating firms. They concern the adoption of new management prac- methods, Internet and ICT for external data sharing use, or are not doing R&D).
tices in general and the use of Internet and ICT resources to acquire and share The 14 industry and 7 size binary indicators are defined on the basis of the
information for innovation purposes. Since the answers to these last two ques- classification of industries and of the groupings by total number of employees.
tions are strongly correlated, we pooled them as only one binary indicator.

49
 References
Commissariat gnral du Plan, 2002 : La France dans lconomie du savoir : pour
une dynamique collective, La Documentation franaise, Novembre.
Earl, L., and F. Gault, 2004, Knowledge management: size matters, in Measuring
Knowledge Management in the Business Sector; First Steps, Foray and Gault eds,
OECD
Foray, D., 2003: The Economics of Knowledge, MIT Press, Cambridge,
Massachusetts
Foray D., and F. Gault, 2004, Measuring Knowledge Management in the Business
Sector; First Steps, OECD
Galia, F., and D. Legros, 2005, Knowledge management and human resource prac-
tices in an innovation perspective: evidence from France, Journal of Knowledge
Management, Vol.III, No. 2, 54-73
Kremp, E. and J. Mairesse, 2004, Knowledge management, innovation and produc-
tivity: a firm-level exploration based on French manufacturing CIS3 Data, in
Measuring Knowledge Management in the Business Sector; First Steps, Foray and
Gault eds, OECD
Lhomme, Y., 2002, Technological innovation in industry, The Newsletter of
Industrial Statistics, SESSI, no. 168 December
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studies at the firm level, Science-Technology Industry Review, Paris, OECD, n 8,
1991, 9-43

50 - The journal of financial transformation

 Institutional

Obstacles in
offshoring and
outsourcing
investment banks
Michael H. Grote
research
Klein&Coll.-Professor for Mergers and
Acquisitions of SME, Finance Department,
Johann Wolfgang Goethe University

Florian A. Tube
Research Associate, Innovation Studies Centre,
Tanaka Business School, Imperial College

Abstract
Outsourcing is high on the agenda of firms seeking to cut
costs. Based on an enhanced value-chain concept we develop
a model that determines the conditions under which outsourc-
ing and offshoring are not expedient. Equity and country
research in investment banks and their outsourcing potential
are used as case studies. We draw mainly on qualitative evi-
dence from interviews with investment bank analysts as well
as data on locations of research units of foreign investment
banks in India. The option of outsourcing certain stages of
business processes and offshoring parts of the value chain
within firms to low-wage locations depends crucially on how
processes are embedded in relation to other departments
within and to corresponding actors outside the firm. Our
analysis shows that there is little, if any, scope for outsourcing
but some potential for low-level research activities to be off-
shored to low-cost regions.

51
 Obstacles in offshoring and outsourcing investment banks research

The concept of value chains provides a simultaneous and dis- however, no clear-cut distinction between tacit knowledge and
aggregated analysis of process and actors, allowing for the information: the degree of tacitness [Nelson and Winter
appraisal of competitive advantages of firms (looking for pro- (1982)] is determined by time, complexity, and depth of expla-
cesses that could be outsourced) and comparative advantages nation needed. Whether a specific type of knowledge could in
of countries or regions [looking for places to which they could principle be codified and transferred via ICT is not considered
be offshored see Kogut (1985)]. The concept of value chains here; when the costs of codifying become prohibitively high,
is mostly used for the analysis of production systems, while the use of ICT becomes de facto impossible. ICT allows for
services are regarded merely as facilitating links between more and more knowledge to become codified and thus trans-
production stages [Dicken (1998)]. We build upon an approach ferable in space. However, to interpret this codified knowledge,
suggested by Grote et al. (2002) that allows for analyzing most often a specific code which has to be learned by actors
those junctures (breaking points) where production stages beforehand is needed with that learning process itself being
can be separated, either spatially (offshoring) or organization- based on tacit knowledge [Nelson and Winter (1982), Cowan
ally (outsourcing). While traditional value chain analyses con- and Foray (1997)].
centrate on vertical relationships, this enhanced approach Knowledge with a high degree of tacitness is still passed on
integrates also horizontal links to firms, customers, or other only between co-present actors, or those who know and trust
sources of information and knowledge. Grote et al. (2002) each other. Therefore, face-to-face contact is an efficient
utilize a combination of vertical analysis with horizontal con- communication technology, where verbal, physical, contex-
nections in order to locate the different stages of financial tual, intentional, and non-intentional levels of communication
production. Thus, each stage is regarded as a node which is are addressed at the same time [Storper and Venables
in itself a network connected to other nodes concerned with (2004)]. The higher the need for spontaneous meetings and/
related activities [Appelbaum et al. (1994)]. or regular informal contacts, the more important spatial prox-
imity becomes. In addition, face-to-face contacts display sev-
The ability to slice up the value chain and to outsource certain eral other advantages, such as the possibility of judging other
stages or phases of business processes and to offshore parts persons and being judged by others, thereby facilitating the
of the value chain within their firms to low-wage locations building up of trust and the detection of lies, and better moti-
depends crucially on how the processes are embedded in vation in co-presence [Storper and Venables (2004)].
relation to a) other departments of the bank and b) to corre- Especially when new and ambiguous information has to be
sponding actors outside the bank. The need for the exchange interpreted, processed, and communicated extremely fast, a
of information and knowledge between research departments constant co-presence between the actors i.e., not more than
and actors outside, as well as inside their banks in other a couple of meters distance remains necessary.
departments, such as along the value chain, determines the
possibility of reorganizing and relocating activities. We argue Other proximities play a role in the spatial organization of
that different kinds of proximity are necessary for the com- financial research as well. Since nation-states create those
munication of complex information or knowledge spatial, institutions which actively define and maintain distinct indus-
organizational, cultural, and professional proximity. trial practices, [Gertler (1993)] it is a kind of cultural or
national proximity that is needed to understand certain busi-
Information (and codified knowledge) is easily transferable ness practices, local regulations (or local interpretations of
between actors via ICT, while tacit knowledge is not. Tacit international regulations), and not least the language of the
knowledge is strongly linked to subject and context, and thus actors. The less transparent an object or transaction, the
difficult to pass on [Nonaka and Takeuchi (1995)]. There is, higher is the relevance of cultural proximity. Face-to-face con-

1 The financial sector is heavily regulated and the decision to outsource and off-
52 - The journal of financial transformation
shore activities is often subject to approval of regulatory bodies in charge of the
stability of the financial system. However, regulators do not consider research
activities to be critical to the survival of financial institutions and will not be con-
sidered here.
Obstacles in offshoring and outsourcing investment banks research

Introduction
Value chain
Outsourcing and offshoring are high on the strategy agenda
of banks seeking to cut costs. For the first time even complex
Phase Phase Phase
tasks at the core of financial services firms, such as equity and
country research, are considered to be outsourced or off- Bank Type of Bank Type of Bank
department proximity department proximity department
shored [Irving et al. (2003)]. Will there be a World Financial
Research Centre in Mumbai (formerly called Bombay), rising Type of Type of Type of
proximity proximity proximity
at the cost of other financial centers around the globe?
Investment banks seem reluctant to rely fully on outsourced
Corresponding Corresponding Corresponding
and/or offshored analysis only. This indicates some hidden actor actor actor

obstacles for such restructuring that we carve out in this

Figure 1 Proximities in value chains
paper. Based on an enhanced value-chain concept we develop
a model that determines the modularity of business process-
es, and apply it to two activities in investment banks institu- more costly for the securities business units because it must
tional equity and country research as illustrative case stud- not be cross-subsidized by other investment banking units any
ies. The options of outsourcing certain stages of business longer arguably a push towards offshoring. In this context,
processes and offshoring parts of the value chain within firms sourcing strategy, comprising contract and location decisions,
to low-wage locations depend crucially on how processes are has attracted the attention of top executives within invest-
embedded in relation to other departments within and to ment banks. Yet, one can witness that most investment banks
corresponding actors outside the firm. retain their in-house equity research units, and mostly in
Western financial centers. It is a puzzle why outsourcing and
Research is an important cost factor in the financial industry: offshoring of equity research activities of investment banks
the total equity research budget for seven large investment happens only on very rare occasions.
banks amounted to U.S.$2.7 billion in 2001. Compensation of
equity analysts is among the highest in investment banking Outsourcing is understood here as a process in which certain
with salaries accounting for up to three quarters of the total service providers external to the firm take over business pro-
costs of research [CGE&Y (2004)]. Salaries for analysts with a cesses formerly conducted within the firm. A relocation of
comparable background for example, in India typically these processes is thus not required for outsourcing.
reach only 30-40% of a U.S.-based analyst. In the so-called Conversely, offshoring means the relocation of activities from
Spitzer-Settlements in 2003, ten of the largest investment one site to another, which is often in low-cost regions, within
banks have been forced to contract with at least three inde- the same firm or at least the same corporate group. Offshoring
pendent research firms and make that research available to can occur in combination with outsourcing, but not necessar-
their customers. The agreement is in effect for five years and ily so. It is argued here that the amount and sort of informa-
bears costs of more than U.S.$400 million [SEC (2005)]. Each tion and communication exchanged in business processes is
stock that is covered by the banks own research has to be crucial for the possibilities of outsourcing and offshoring
covered by an additional independent analysis, which is linked research activities1.
on the banks website. Investment banks have been pushed by
regulators to duplicate their in-house research with outside Value chains and proximities
research providers, paving the way to completely outsource An analysis of the spatial consequences of reorganization
these activities. At the same time, in-house research gets decisions has to take into account firm and department levels.

53
 Obstacles in offshoring and outsourcing investment banks research

through twelve in-depth interviews with analysts from eight understanding analysts embeddedness in the firm.
banks that lasted from one to two and a half hours between
winter 2003 and winter 2004 in Frankfurt. In addition, it is Institutional equity analysts work within the wholesale broker-
supplemented by findings of interviews carried out during age departments. Institutional equity analysts typically cover
certain former research projects of the authors on the spatial not more than five big companies in depth and up to about the
organization of the financial industry (references omitted for same number of smaller ones, mostly in related industries.
anonymity reasons). All interviews were semi-structured and The value of a company depends on its future earnings pos-
open ended; notes were taken during the process. The inter- sibilities; therefore, a large part of what analysts do is project
viewees are research analysts and senior analysts in invest- the future. All available data about the company are taken into
ment banks based in Frankfurt and London. We asked the account: company sources, analyst meetings, road shows,
interview partners to reflect on other industry practices and talks with investors, specialized data providers, newspaper
former work experiences, which yielded no different results. articles, etc. [Wrigley et al. (2003)]. Almost as important are
Indeed, the answers we got in the interviews showed a very the consequences for the company ensuing from any other,
consistent picture with only little variance. Industry standards also seemingly unrelated, events. Analysts interpret a wide
were referred to quite often and actually shape analysts work range of signals, including price movements of the companys
to a large extent. Nevertheless, this part of the survey is not or other stocks, market rumors, and the mood, etc. There is a
intended to furnish a quantitative analysis of the spatial lot of number-crunching involved, but this is used merely as a
restructuring of financial research activities, but to reveal the tool. Data gathering and entering the data into the firm-spe-
underlying rationales, possibilities, and targets for outsourcing cific (and sometimes analyst-specific) format and programs is
and offshoring different research activities in banks. a job frequently done by the analysts themselves and by assis-
tants. To carry out these tasks, organizational and sometimes
Research in investment banks is a heterogeneous field and only professional proximities would be enough. However, it
quite different from research and development in other indus- was repeatedly stressed in the interviews that understanding
tries in that it is much more short-term in nature. In our what is going on and what will be going on in the company
analysis we concentrate, for illustrative purposes, on two and in the industry is most important [see Agnes (2000) for
examples of research analysts that are the most and least analogous results for swap traders]. Contrary to the general
embedded respectively: institutional equity analysts and impression, the most significant inputs used by analysts are
country analysts. By asking analysts in open interviews about not codified knowledge and information but qualitative, soft
their daily work, their data gathering, their contacts and fre- information and knowledge about future developments. To
quency thereof, a picture of their embeddedness in local and exchange the latter, recurrent face-to-face contacts are need-
organizational structures emerges. Institutional equity ana- ed with all kinds of actors, albeit at different frequencies.
lysts output consists of three main areas. Firstly, they write
research reports on specific firms and update them every In order to get as much information as possible from the cur-
time a major event is happening, either economy-wide, indus- rent market situation institutional equity analysts are com-
try-wide, or firm specific. Secondly, they visit large investors monly located right within the trading room of banks and
to present their results. Thirdly, they give short-term advice to communicate with all sorts of traders intensively. Since com-
the traders of the bank, both for the banks own account (pro- pliance regulations do not allow even traders of their own
prietary trading) or for those of the clients (sales trading). bank from seeing the written recommendations before they
Each of these areas mutually benefits from each other; there are officially published, the analysts desk is situated on a dais
are economies of scope in production which are critical for about one and a half meters high above the traders level with

54 - The journal of financial transformation

Obstacles in offshoring and outsourcing investment banks research

tacts and cultural proximity can be partially compensated same bank. She is losing the spatial proximity even though she
through vertical integration or organizational proximity maintains cultural, organizational, and professional proximity
[Lundvall (1988)]. Organizational proximity exists between with her colleagues. The second analyst decides to become a
actors working in the same company regardless of their geo- freelancer. He stays in London, visits the old colleagues fre-
graphical location and thus gains a new relevance with the quently and delivers research reports on the very same com-
implementation of ICT [Yeung (2005)]. It refers to firm-specif- panies that he has analyzed before i.e., his work has been
ic information and the way one deals with it: corporate iden- outsourced but not offshored. He now shares only part-time
tity, corporate philosophy, organizational rules, and codes play spatial proximity, as well as cultural and professional, with his
a significant role [Blanc and Sierra (1999)]. In a similar man- former desk mates, but has lost organizational proximity. The
ner, proximity between actors in the same type of job can third analyst is fired. Part of her work is offshored (but not
bridge spatial and cultural distance to a certain extent. Actors outsourced) and now done by a newly hired Indian colleague
in close professional proximity possess an understanding of in the Bangalore office of the same bank. She will not have
each others methods, practices, and aims, share similar inter- cultural proximity (i.e., to understand and interpret messages
ests, and professional language. Both organizational and pro- from Chief Financial Officers of Indian and U.K. companies
fessional proximity facilitate the building up of trust and fur- respectively, different cultural backgrounds have to be taken
nish a common background for the actors and hence a context into account) but shares organizational and professional prox-
for interaction, thereby simplifying knowledge exchange. They imity with the analysts in the London office. Lastly, also the
are based on shared conventions, thereby providing a com- fourth analyst is fired. His work is now done by an analyst in
mon framework of action [...] with other actors engaged in an Indian consultancy company in Bombay, which is special-
that activity [Storper (1997)]. Professional proximity favors izing in collecting and streamlining financial information
also outsourcing, since the common framework is the same about firms. The work has been outsourced and offshored; the
across firm boundaries. In contrast, the requirement of spatial Indian analyst only has professional proximity to the analysts
and cultural proximity acts predominantly to keep activities in London. These hypothetical reorganizations appear in
within a certain territory. However, parallel to organizational order of their feasibility, with the last one, outsourcing and
proximity, ethnic networks also create a common background offshoring, being quite infeasible.
and thus help in extending communication from a local,
regional, or national dimension to a transnational one, as In general, outsourcing becomes an option only when organi-
exemplified in the case of the Indian software industry and its zational proximity is not necessary. Moreover, the content of
connections with Silicon Valley [Saxenian et al. (2002), Taeube the processes to be outsourced ought not to be of strategic or
(2005)]. otherwise critical value to the outsourcing company [Cronin et
al. (2004)]. Offshoring of complex tasks is possible for parts
To illustrate the different concepts of proximity introduced in of the value chain that do not require cultural proximity and
this paper imagine five young British analysts sitting together face-to-face contacts and where professional and organiza-
at a desk in a major investment bank in London. Their tional proximity ensures sufficient common background for
exchange of information and knowledge is based on all four communicating. In what follows we analyze why most of the
proximities: they are spatially very close together, share the hypothetical outsourcing and offshoring actions in our story
same cultural background, work for the same firm, possessing do not actually materialize in investment banks.
organizational proximity, and do the same jobs and are there-
fore also professionally close to each other. Now think of one Embeddedness of research analysts
of the analysts being moved to the Edinburgh office of the Empirical evidence pertaining to analysts were compiled

55
 Obstacles in offshoring and outsourcing investment banks research

board members of the firms they cover. Our results show a informational input is based on codified knowledge and infor-
strong need for cultural proximity between analyst and man- mation, thus at first glance the jobs might be outsourced as
agement of the covered firms. This is consistent with the find- well almost identical reports can be bought from commercial
ings by Bae et al. (2005), who observe that geographically vendors.
proximate analysts give more accurate forecasts; a finding
which is even true on a regional level [Malloy (2005)]. Here again economies of joint production come into play.
Since the main task of country analysts is to feed the propri-
Country analysts are to be found on the opposite side of the etary risk management systems of banks, organizational
scale of embeddedness. They assess country risks and pros- proximity plays an important role. Therefore, outsourcing is
pects for further regional development. Findings are some- not likely at all; crucial inputs for the risk position of banks are
times published in public country reports distributed by banks. provided in-house. The offshoring and/or outsourcing poten-
Their main output, however, consists of updating the proprie- tial of the different types of analysts depend on their embed-
tary information and risk management systems of banks. Here dedness in local or organizational structures. The two types of
they are used as inputs in a variety of decisions: in assessing analysts described above are two extreme cases of embed-
the credit risk of countries and thus the loan terms for lenders dedness, with many other kinds of economic and financial
in that country, in generating a benchmark world-portfolio of research in between possessing characteristics of both sorts.
equity investments, or in advising clients before large real or
financial investments. These evaluations are updated frequent- Institutional equity analysts need cultural proximity to the
ly on the margin but have an average time horizon of half a firms they cover and maintain sporadic face-to-face contact
year to even a few years. Typically, a certain number of coun- with the firms as well as investors. This requirement confines
tries in one region are covered simultaneously, depending on them to the same nation or at least region as the firms they
their importance to the bank. For example, there might be two cover, such as the E.U. The smaller the firms get, the more
or three country analysts for South America in a bank and five important is cultural proximity [Bae et al. (2005)]. Since a lot
for the U.S. and Canada alone. Clients of country analysts are of tacit knowledge is frequently exchanged with traders and
almost exclusively other departments of the same bank. Being salespersons, outsourcing as well as offshoring away from
far from sales, earnings potential for the banks is much lower these departments seems highly unlikely. Banks trying to
and thus country analysts are paid considerably less than their reduce costs in their investment banking departments, there-
equity peers which reduces the pressure for outsourcing and fore, try not to outsource or offshore the expensive equity
offshoring in the first place. The potential for offshoring, how- analysts themselves, but to relieve them from a lot of non-
ever, is higher as face-to-face contacts almost never occur. essential work. Organizational and professional proximity
Sometimes, a department has a specific question regarding a allow for offshoring tasks that are more than just data pro-
particular development, but in general this is solved via tele- cessing: Internet searches, processing of data from publica-
phone. Information is gathered from a variety of sources, tions of firms into proprietary databases, standardized calcu-
mostly Internet, newspapers, and research reports from spe- lations, and preliminary firm valuations can be offshored,
cialized vendors. New developments are discussed with col- since very little face-to-face contact is necessary.
leagues via telephone, email, and face-to-face when they are
close by. In large banks, the analysts covering a specific area, Country economists do not have to be close to the countries
like South America, are scattered across different financial they cover and face-to-face contacts hardly play a role in their
centers. Analysts visit the countries they cover to confer with daily business. Incoming and outgoing information is mostly
government officials about once a year. In general, much of the processed electronically. Since they feed mostly proprietary

56 - The journal of financial transformation

Obstacles in offshoring and outsourcing investment banks research

access restricted only to analysts. The interchange and testing via email. You have to show a commitment. This confirms the
of ideas with other equity analysts of their own bank is consid- findings of Storper and Venables (2004), who conclude: []
ered as absolutely necessary; analysts sit cheek by jowl on the for complex context-dependent information, the medium is
dais in the trading room. Thus, analysts get to know what is the message. But here information is flowing in both direc-
going on in the trading room without any trader being able to tions: when talking with investors, analysts learn about the
see what they are writing. In turbulent markets say, the market, i.e., the future demand for and/or supply of shares.
share price of a firm increases strongly against the market
traders and analysts gather spontaneously in order to try to The close connection to salespeople and clients is crucial for
understand the situation and come up with a trading strategy. the profit-generation of analysts. Clients do not pay the banks
In these situations many ambiguous signals from various a set fee for the analysis but route trading volume to that bank
sources have to be interpreted quickly (typically in less than in exchange (these are the so-called soft dollars, a practice now
an hour) and spatial proximity with other analysts and traders under interrogation by several regulatory authorities [Financial
is considered inalienable. Since meetings are scheduled at few Services Authority (2003)]. Analysts are paid according to the
minutes notice, a location in close spatial proximity is essen- amount of trading volume they generate and their position in
tial. Interestingly, contact with economists of their own bank ranking lists, which are compiled by industry observers.
who make long-term, macroeconomic projections about Suppose an institutional investor asked her salesperson for
business cycles and growth, both country- and industry-wise, in-depth information by the equity analyst on a potential port-
that analysts use as inputs in their studies is mostly via folio firm. If the analyst is able to convince the investor of the
email and reading and writing reports. trading ideas generated during the production of the research
report, the bank profits through revenues from trading com-
Also of interest is the demand side, viz. investors or potential missions. On the other hand, if this analyst was external and
investors. Analysts frequently speak to the salespersons of the client is interested in getting in contact with the analyst
the bank. Ultimate clients are big, mostly institutional inves- directly, future business with this client might be foregone.
tors, like pension funds or insurance companies, investing Decoupling of the research analyst from the sales-trader, i.e.,
large sums of money. Analysts get in touch with them often outsourcing, would mean loss of profits for investment banks.
together with salespersons who maintain relationships with
the clients. An analysts main task is to generate trading Equity analysts have regular and frequent contacts with firms
ideas for their clients, on which they could (or should) trade. they are covering [Palmer and Sparks (2004)]. They use their
These trading ideas have a time horizon that could last from homepages, have telephone contacts with the investor rela-
one day to a few months. In general, analysts are paid to know tions department, attend analyst meetings, and sometimes
more than the market does or at least, before the market visit the sites physically. A close understanding of local regula-
does. When new studies come out, instead of just mailing tions and the interpretation of accounting regulations is
them to investors and informing them of trends, most often viewed as essential. Personal contacts with the heads of inves-
they are presented face-to-face to investors (sometimes in tor relations and the chief financial officers (CFOs) are com-
one-to-one meetings) to brief them about the companies and mon and regularly renewed at investor conferences. That
potential developments relative to the market. This involves allows analysts to solve problems with the data and to confirm
traveling to meet clients who might be located in Europe, the rumors via telephone more easily. Two analysts stressed that
U.S., or Asia as often as three to four times a year. Asked for when talking to CFOs, it is crucial how they express something
the reason, one interviewee answered, They wont take you and what the CFOs do not say. All interview partners empha-
seriously otherwise. Theyre getting loads of studies everyday sized the high relevance of close and personal contacts to

57
 Obstacles in offshoring and outsourcing investment banks research

which 131 of those 133 deals take place; we exclude the remain- persion in the data (many urban areas do not receive any M&A
ing two transactions. The number of IT companies per larger transactions). Thus, our estimation model adopts the follow-
metropolitan area is taken from the National Association of ing form: TRANS = 1ITCAP + 2FIN + 3BANK + 4log(POP) +
Software and Service Companies, NASSCOM, for September 5EDUCAP + . The results are displayed in Figure 2.
2003. In order to avoid problems of multicollinearity, the num-
ber of IT firms per million inhabitants in the metropolitan The results for ITCAP, the number of IT firms per million
areas have been calculated (ITCAP). Data about the local inhabitants in the metropolitan areas, are highly significant.
financial sector (BANK) as of 30th September 2003 is taken Even when we control for the financial center (Mumbai)
from the Reserve Bank of India; the enrollment in higher edu- which is also highly significant the presence of other banks,
cation per 1000 capita (EDUCAP) at the state level in 2001 is the size of the population, and the general educational level,
provided by the Indian Ministry of Education; and population ITCAP is robust in the positive coefficient and highly signifi-
data is taken from the Census of India 2001. The dummy for cant (models 2-5). The number of banks in the state turns out
the Financial Centre (FIN) is 1 for Mumbai and 0 for all other to be negatively significant, but with a small coefficient. We
metropolitan areas. conducted a variety of robustness checks for the size of the
local banking sector without any qualitative change in the
Foreign direct investments by banks are concentrated in very results: neither the number or the share of employees in the
few cities only (the top three are Mumbai with 49 transac- financial sector of the respective states, the size of the finan-
tions, Bangalore with 24, and Delhi with 21), as could be cial sector relative to the state GDP, and the state relative to
expected from the literature. The main hypothesis inferred the national GDP in banking explain the attractiveness of met-
from the interviews and reasoning above states that the local ropolitan areas very well, nor does it change the coefficient
concentration of IT firms should strongly influence the local- and the significance of ITCAP-variable qualitatively. Whereas
ization of banks investments in India. Due to strong agglom- banks tend to invest in the predominant financial center, other
eration forces in the financial sector, however, investments are smaller financial centers do not influence the number of
also expected to take place in locations with an already strong investments in a statistically significant way. Conversely, the
presence of other banks. We control for the number of com- locations of foreign banks investments in India are strongly
mercial banks in the state and also include a dummy for influenced by the local density of IT firms in the metropolitan
Mumbai as the predominant financial centre in India to take area.
care of the other financial activities (i.e., stock exchange trad-
ing and investment banking) that are predominantly located in On top of the Brownfield investments made by foreign banks,
Mumbai [Derudder et al. (2003), Poon (2003)]. The size of the more recently there is also some (anecdotal) evidence of
local economy is controlled for (approximated by the popula- investment banks relocating their research activities [Atal and
tion of the larger metropolitan areas) as well as the regional Niranjan (2004), Kulkarni (2004)]. We have collected data
educational level (measured by enrollment in higher educa- from newspaper articles and the Internet on Greenfield invest-
tion per capita at the state level). Since we regress on count ments. The dataset focuses exclusively on the setting up of
data the number of FDI transactions in a city being the research activities of financial firms without the acquisition of
dependent variable we estimate the parameters of the an Indian company. We find that most of the Greenfield invest-
model using quasi maximum likelihood of a negative binomial ments take place in the existing IT centers Bangalore,
specification. Quasi-maximum likelihood estimators are robust Hyderabad, and Chennai (Madras) as well as the financial
in incorrectly specified distributions. We use generalized lin- capital Mumbai and the national capital region Delhi. These
ear models estimates for covariances to account for overdis- data show a pattern quite similar to the distribution of

58 - The journal of financial transformation

Obstacles in offshoring and outsourcing investment banks research

information systems, offshoring seems to be the best option to cate their existing research departments completely, or, as our
cut costs. However, there is not much evidence on such a move interviews suggest, to shift only junior analysts tasks.
besides sporadic newspaper reports of single banks and con- Investment banks research, whether junior or not, is a com-
sulting firms that open economic research departments in plex task that requires capabilities and training which is not
India. One reason for this missing offshoring activity might be available ubiquitously, contrary to, say, call center activities.
the small size of these departments (even the largest interna- So just moving to the cheapest locations in the countryside is
tional banks employ not more than about 30 country analysts) not an alternative: banks shift their research activities to
and the fact that they are paid considerably less than their places where there is already a pool of adequately trained
investment banking peers. Summing up the findings so far, staff i.e., to clusters, to exploit external knowledge [Cohen
offshoring of wholesale equity research is not a straightfor- and Levinthal (1990)]. Hence, one would expect localization of
ward undertaking due to the strong embeddedness, both local higher value-added activities to take place in those existing
(within the bank) and regional (with the analyzed firms). clusters exhibiting features, such as labor markets, with expe-
Country analysts could be moved more easily but they are not rience specific to the banks requirements. For junior analyst
a big cost factor anyway, so the pressure to offshore is not tasks, however, Indian IT clusters, in addition to the financial
high. Hence, the main strategy of banks could be to offshore center, seem to be prepared quite well: financial services
junior analysts work, like gathering and preparing data, per- already make up the largest part of the business of Indian
forming standardized calculations, and putting together pre- software companies and still increasing in market share
sentations. [Nasscom (2003)]. However, investment banks which try to
enter the fast growing Indian domestic capital market will
International corroboration: case study India move towards the predominant Indian financial center, Mumbai
India is the predominant location for the offshoring and/or [Shah (2004)]. Since research units there will prepare whole-
outsourcing activities of U.S. and U.K. banks. In general, sale analysis for the domestic market anyway there might be
investment banks that set up research units in India do so attempts to use the existing manpower and facilities to con-
mainly for three reasons: to enter the Indian market, to relo- duct research on foreign firms too.

We use a stepwise regression analysis to explore the factors

Independent variables (1) (2) (3) (4) (5) that might attract Brownfield FDI (i.e., inward M&A transac-
ITCAP 0.22a 0.15a 0.28a 0.27a 0.28a tions) into India by financial institutions. There is only anec-
(5.10) (4.88) (3.93) (4.24) (3.41)
FIN 2.53b 3.24b 5.56a 4.19a dotal evidence for Greenfield investments of banks, but there
(2.39) (2.36) (2.80) (2.78) are data available on M&A transactions of foreign financial
BANK -0.02b -0.04b -0.03c
(-2.37) (-2.27) (-1.85)
institutions in India. Both are analyzed in order to verify the
log(POP) 0.08 0.17 findings of our interviews with analysts. The dependent vari-
(1.23) (1.49)
able is the number of transactions (TRANS) that take place in
EDUCAP -0.25
(-1.19) larger metropolitan areas in India with more than 1 million

inhabitants between 1992 and 2004. Financial institutions
No. of observations 35 35 35 35 34
Akaike info criterion 3.49 3.24 2.98 2.98 2.68 pursued 133 inward M&A transactions in India with a known
Schwarz criterion 3.53 3.33 3.12 3.16 2.91 target location (data from Thomson Financial), the majority of
z-statistics in parentheses; a, b, c indicate significance at the 1, 5, 10% level respec-
deals occurred after 1997. We use data provided by The World
tively
Gazetteer for the number of inhabitants (POP) in each larger
Figure 2 Regression findings (dependent variable: TRANS) metropolitan area in 2004. There are 35 of these areas in

59
 Obstacles in offshoring and outsourcing investment banks research

companies create the dynamics, Oxford University Press, Oxford

Palmer, M., and L. Sparks, 2004, Investment bank analysts and retail research,
more recently.
Environment and Planning A, 36, 1521-1528
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60 - The journal of financial transformation

Obstacles in offshoring and outsourcing investment banks research

Brownfield investments and thus substantiate the findings Conclusion

from the regression analysis above. Our results are consistent One of the most critical decisions for managers is to evaluate
with banks that a) want to enter the Indian market and b) how, and where, goods and services are procured; recently
settle in IT-centers in India to source junior analysts tasks. this became true also for investment bank managers, particu-
larly after regulators demanded fresh answers to flawed
research reports that have been published in recent years.
Outsourcing and offshoring of research departments is an
issue discussed at the boards of many investment banks. This
study contributes by providing empirical guidance for manag-
ers in investment banks that institutional research is almost
impossible to outsource and difficult to offshore. Our analysis
of research departments in Western financial centers revealed
a degree of embeddedness of the highly debated wholesale
equity research analysts that makes even offshoring unlikely.
The results provide specific managerial directions. Despite the
ubiquity of information and communication technologies,
knowledge is still passed on best via face-to-face contacts.
Continuous direct interactions with traders, other analysts,
and sales people are regarded as absolutely necessary by
institutional equity analysts for developing their trading ideas.
In other words, there are limits to modularity [Ernst (2004)].
Other analysts covered here are country analysts are
embedded only to a rather low extent and could therefore be
transferred to a low-wage country like India without greater
loss of information and knowledge. Due to the organizational
proximity needed to feed the internal risk-management sys-
tems, offshoring is much more feasible than outsourcing.
These analysts are fewer in number and significantly less
expensive than their equity peers, so the pressure to find a
new sourcing strategy for their work is considerably lower. For
equity analysts, the obstacles to outsourcing and offshoring
stem from the economies of scope of their different tasks.
Long-term reports and short-term advice are heavily interre-
lated. Clients regard original research as the main asset they
are paying for and demand face-to-face contacts with ana-
lysts, as well as with sales persons. Most feasible, therefore, is
the relocation of technical analyses and data gathering assis-
tant work to India to save some costs this might even take
place in combination with outsourcing as has been witnessed

61
 Institutional

European banking
consolidation:
effects on
competition,
David-Jan Jansen
profitability, and
efficiency
Economist, Economics and Research Division,
De Nederlandsche Bank

Jakob de Haan
Professor of Political Economy and Director of
Graduate Studies, Faculty of Economics,
University of Groningen1

Abstract
The consolidation trend in the European banking sector has
raised concerns about competition in this sector. This article
analyses the relationship between concentration, competitive-
ness, efficiency, and profitability of national banking markets
of European countries. We use panel regressions in which
estimates from previous studies on competition and efficiency
in national banking sectors are related to concentration and
profitability indicators for these sectors. Our results do not
suggest the existence of any connection at the country-level
between concentration and competition. There is also no
robust relationship between concentration and profitability.

1 Jakob de Haan worked on this paper while he was visiting scholar at De

Nederlandsche Bank. The authors would like to thank Linda Toolsema, Peter van 63
Els, Jaap Bos and Maarten van Rooij for valuable comments. Views expressed are
those of the individual authors and do not necessarily reflect official positions of
De Nederlandsche Bank.
 European banking consolidation: effects on competition, profitability,
and efficiency

the 1997-1998 period, for example, five times as many merg- between the assets of the five largest banks and total bank
ers and acquisitions occurred in the U.S. as in the Euro-area. assets (C5 ratio) is used5. Instead of all assets, also specific
The general trend seems to be that the number of acquisi- assets (like loans) or liabilities (like deposits) can be used for
tions in Europe is declining while the total value is on the calculating the C5 ratio. The advantage of the C5 ratio is that
increase. Consequently, the average value per acquisition has it is relatively easy to calculate, but the disadvantage is that
risen. That is not surprising since it is likely that, initially, not all information about the market is used. As an alterna-
small banks were the main targets for acquisition. tive we, therefore, also use the Herfindahl Index (HI), which is
Consolidation in the Euro-area grew strongly in 1997/98 as calculated as the sum of the squares of the market shares of
illustrated by the sharp rise in the value of the transactions. all banks in the sector [Bikker and Haaf (2002b)].
Using data provided by the European Central Bank (ECB),
Figure 2 shows that bank acquisition activities in Europe tra- Figure 3 shows the C5 ratio and the HI for 15 E.U. countries
ditionally have a national focus3. The number of mergers for selected years. Both indicators show similar develop-
exclusively involving domestic parties is given in parentheses. ments. In eight countries the C5 ratio clearly increased
Spain is one of the few countries where international mergers between 1985 and 1999. Between 1995 and 1999 the C5 ratio
and acquisitions figure strongly. In 1999, for example, only 5 only declined in two countries, Portugal and Ireland. Likewise,
of the 17 mergers involved two Spanish parties. Dutch banks the Herfindahl Index declined in these two countries and in
also appear to have a relatively strong international orienta- Greece between 1995 and 1999, whereas it increased in other
tion. The 2005 developments in the Italian banking market, countries, except for Sweden where the index remained sta-
where Dutch bank ABN AMRO and Spanish BBVA tried to ble. Figure 3 also illustrates existing differences in the bank-
acquire Italian banks strengthens this impression4. ing sectors in the various European countries. In 1999
Germany, Luxembourg, and the U.K. had C5 ratios of less
An important characteristic of a national banking market is than 30 percent, while Sweden, say, had a ratio of almost 90
its degree of concentration, which can be measured in vari- percent. So, despite the European integration process there
ous ways [Bikker and Haaf (2002b)]. Generally the ratio are still large differences between national banking sectors

Number Value
Country 1991-92 1993-94 1995-96 1997-98b 1991-92 1993-94 1995-96 1997-98b
United States 1,354 1,477 1,803 1,052 56.8 55.3 114.9 362.4
Euro-areaa 495 350 241 203 17.5 14.6 19.1 100.4
France 133 71 50 36 2.4 0.5 6.5 4.0
Germany 71 83 36 45 3.5 1.9 1.0 23.2
Italy 122 105 93 55 5.3 6.1 5.3 30.1
Netherlands 20 13 8 9 0.1 0.1 2.2 0.4
United Kingdom 71 40 25 17 7.5 3.3 22.6 11.0
Switzerland 47 59 28 22 0.4 3.9 1.0 24.3
a excluding Austria, Ireland, Luxembourg, and Portugal
b as at 30 October 1998
Source: Bank for International Settlements (1999)

Figure 1 Bank mergers and acquisitions: number and value (U.S.$ billions)

2 A highly concentrated banking sector may also entail benefits. Using data on 70
64 countries from 1980 to 1997, Beck et al. (2003) find, for instance, that systemic
banking crises are less likely in economies with more concentrated banking sys-
tems, fewer regulatory restrictions on bank competition and activities, and nation-
al institutions that encourage competition.
European banking consolidation: effects on competition, profitability,
and efficiency

Country 1995 1996 1997 1998 1999 2000 C5 ratio Herfindahl Index

Austria 14 (14) 24 (24) 29 (27) 37 (37) 24 (20) 8 (5) Country 1985 1995 1999 1985 1995 1999

Belgium 6 (6) 9 (8) 9 (7) 7 (6) 11 (6) 3 (0) Austria 35.9 39.2 50.4 - 0.04 0.10
Denmark 2 (2) 2 (2) 2 (1) 1 (1) 2 (0) 2 (1) Belgium 48 51.2 77.4 - 0.06 0.16
Finland 9 (7) 6 (6) 5 (5) 7 (5) 2 (2) 5 (3) Denmark 61 72 77 - 0.12 0.14
France 61 (60) 61 (61) 47 (46) 53 (52) 55 (51) 25 (21) Finland 38 70.6 74.3 - 0.18 0.20
France 46 41.3 42.7 - 0.04 0.05
Germany 122 (100) 134 (117) 118 (109) 202 (189) 269 (240) 101 (91)
Germany - 16.7 19 - - 0.01
Greece 0 (0) 1 (0) 3 (3) 9 (7) 8 (3) 1 (0)
Greece 80.6 75.7 76.6 0.25 0.18 0.15
Ireland 3 (1) 4 (1) 3 (0) 3 (2) 2 (1) 0 (0)
Ireland 47.5 44.4 40.8 - 0.07 0.05
Italy 73 (68) 59 (56) 45 (45) 55 (52) 66 (64) 30 (30)
Italy - 32.4 48.3 0.02 - 0.06
Luxembourg 3 (3) 2 (1) 3 (3) 12 (9) 10 (6) 8 (6)
Luxembourg 26.8 21.2 26.1 - - 0.02
Netherlands 7 (2) 11 (2) 8 (5) 3 (0) 3 (1) 5 (2) Netherlands 72.9 76.1 82.3 0.13 0.16 0.17
Portugal 6 (5) 6 (5) 2 (1) 5 (1) 2 (0) 9 (6) Portugal 61 74 72.6 0.11 0.14 0.12
Spain 13 (4) 11 (4) 19 (1) 15 (5) 17 (5) 29 (3) Spain 35.1 47.3 51.9 0.04 0.05 0.07
Sweden 1 (1) 2 (2) 5 (2) 1 (1) 7 (1) 2 (0) U.K. - 28.3 29.1 0.02 0.02 0.03
U.K. 6 (2) 11 (4) 21 (15) 24 (16) 19 (14) 6 (4) Sweden 80.8 86.5 88.2 0.20 0.20 0.20
Source: ECB (2000) Source: ECB (2000)

Figure 2 Mergers and acquisitions of credit institutions: total and domestic (in Figure 3 C5 ratio and Herfindahl Index (based on total assets) for credit institu-
parentheses) tions in the EU15

Since the early 1990s, the merger and acquisition activities of increased concentration) in the national banking sectors of
European banks have increased [Walkner and Raes (2005)]. various European countries on competition, profitability, and
By increasing the scale of operations banks may generate efficiency. We use country level data taken from various pre-
efficiency gains and improve profitability. There are good rea- vious studies on competition in and efficiency of national
sons to expect the process of consolidation to continue in the banking markets. Our results are as follows: we find no evi-
near future. The number of banks per capita in Europe is still dence that competition indicators are linked to profitability
relatively large compared to the United States and there are measures. A similar conclusion holds for concentration and
still important differences between national banking markets competition. Moreover, we do not find a robust relationship
in Europe, suggesting the existence of possible gains from between concentration and profitability. We report only
consolidation [Altunba and Marqus Ibez (2004)]. mixed evidence for a positive connection between efficiency
Academics and policy makers have expressed some concern indicators and profitability.
about the increase in market shares of the larger European
banks, as high levels of concentration could have a negative Trends in the European banking sector
impact on competitive conditions, which, in turn, may lead to What are some of the characteristic developments in the
excessive bank profits. Indeed, Bikker and Groeneveld (2000) European banking sector since the beginning of the 1990s?
conclude that the increase in the degree of concentration in Firstly, we provide evidence on trends in M&As. Figure 1 pro-
the European banking sector is negatively related to competi- vides data on the numbers and value of acquisitions for vari-
tion2. ous European countries and compares them to figures for the
United States. Both the number and value of mergers and
This article studies the effects of consolidation (defined as acquisitions in the United States are higher than in Europe. In

3 The ECB does not apply a uniform definition of the term credit institution and A fairly comprehensive list of existing obstacles and their impact on the main ave-
collects the data based on national standards. This explains the inconsistency nues for cross-border banking integration is provided by Walkner and Raes (2005). 65
between Figures 1 and 2. 5 Sometimes the C3 ratio is used; see, for example, Goldberg and Rai (1996).
4 The lack of progress in cross-border integration can be attributed to various fac-
tors, including national differences in market practices, regulation, and taxation.
 European banking consolidation: effects on competition, profitability,
and efficiency

Recently, a number of studies have been published in which

+ +
the banking sectors in the various European countries are SCP: Concentration Non-competitive behavior Profitability

compared to each other in terms of efficiency. While various +

EFF: Efficiency Profitability
efficiency studies had been carried out before they generally
related to a single country. Bikker (2001), Wagenvoort and +
Concentration
Schure (1999), and Altunba et al. (2001) estimate cost func-
tions in order to measure the so-called X-inefficiencies6. Figure 4 SCP versus efficiency hypothesis
Bikker (2001) analyzes 3085 banks in 9 European countries in
the period 1989-97. The study by Wagenvoort and Schure
(1999) relates to 1974 European banks in the E.U. countries Methodology and data
for the period 1993-1997, while the study by Altunba et al. We investigate the connections between concentration, com-
(2001) analyzes 15 European banking markets between 1989 petition, profitability, and efficiency at the macro-level by
and 1997. All three studies conclude that there are major dif- using panel regressions. We use estimates from previous stud-
ferences in efficiency, but their findings differ widely as to ies on competition and efficiency in national banking sectors
which country has the most efficient banking sector. Bikker and study to what extent these are related to concentration
(2001) concludes that banks in Luxembourg, Belgium, and and profitability indicators for these sectors. Our methodolo-
Switzerland exceeded the average European level of effi- gy resembles that of Bikker and Groeneveld (2000). These
ciency. According to Wagenvoort and Schure (1999), banks in authors examine the relationship between indicators of com-
Belgium, the Netherlands, Austria, and the U.K. are the most petition and concentration in the national banking sectors in
efficient. In contrast, Altunba et al. (2001) reach the conclu- Europe. However, they only employ one indicator for competi-
sion that the most efficient banking sectors are those in tion and use only one indicator for concentration (C5 assets).
Denmark, Germany, Italy, and Austria. These major differ- As discussed previously, there are other estimates of the
ences between studies on the efficiency of the banking sec- degree of competition in the European banking markets and it
tors suggest caution when examining the connection between is also possible to use other indicators of concentration (like
efficiency and concentration. the Herfindahl index). By using a wider range of indicators we
can check to what extent the conclusion of Bikker and
Groeneveld (2000) is robust. Furthermore, there are other
interesting relationships that can be examined than just the
relationship between concentration and competition.

We test 5 connections implied by the SCP paradigm and the

efficiency hypothesis. The SCP paradigm implies 3 hypotheses:
H1: A higher degree of concentration leads to less competi-
tive behavior.
H2: A higher degree of concentration leads to greater profit-
ability.
H3: Less competitive behavior will lead to greater profitabil-
ity.

The efficiency hypothesis implies the following 2 hypotheses:

66 - The journal of financial transformation

European banking consolidation: effects on competition, profitability,
and efficiency

[Gual (2004)]. profitability. According to Goldberg and Rai (1996), this para-
Research on E.U. banking digm provides an explanation for the positive connection
In this section, we discuss recent studies on concentration, between concentration and profitability often found in the
competition, efficiency, and profitability within the European American banking sector. The reasoning is as follows: in mar-
banking sector. In a nutshell, we discuss the following: the use kets with a high degree of concentration, firms have more
of the Panzar-Rosse methodology to measure competition, market power, which allows them to set prices above mar-
studies of the structure-conduct-performance (SCP) para- ginal costs and achieve higher profits. Another explanation
digm and the efficiency-hypothesis, and finally, research on for the connection between concentration and profitability is
banking efficiency. the efficiency hypothesis. The efficiency hypothesis states
that more efficient enterprises will be capable of expanding
The method developed by Panzar and Rosse (1977) constructs their market share and will have higher profitability. The pos-
a measure of competition. This measure is called the ited connections are clarified in Figure 4.
H-statistic, which is defined as the sum of the factor price
elasticities of interest revenue with respect to borrowed capi- Both the SCP and the efficiency hypothesis have been exten-
tal, labor, and physical capital. The value of H can be inter- sively tested for the United States. Fewer studies are avail-
preted as follows. In case of a monopoly, H is lower than or able for Europe. Molyneux and Forbes (1995) estimate a
equal to zero. This also applies to an oligopolistic market with model for banking profits in which the degree of concentra-
cartels or complete imitation of each others behavior. A value tion, market share, and a number of control variables are the
of H between zero and one indicates monopolistic competi- explanatory variables. They find a positive significant con-
tion. A value equivalent to one points to perfect competition nection between concentration and profitability, while mar-
[De Bandt and Davis (2000), Claessens and Laeven (2004)]. ket share appears to have no influence. On the basis of these
findings, the authors reject the efficiency hypothesis in favor
Using this methodology, De Bandt and Davis (2000) study the of the SCP hypothesis. Goldberg and Rai (1996) make some
market structure in Germany, France, and Italy at the start of justified criticisms of this method. It is confusing to use the
EMU. For the first two countries, they find that monopolistic market share variable as an efficiency indicator, given that
competition characterizes the market for large banks while this variable may also refer to market power. It is better to
the market for small banks looks like a monopoly. In Italy, the directly include efficiency variables into the model. Goldberg
market form in both sectors is monopolistic competition. On and Rai (1996) do this for a set of large banks from various
the basis of these results, these authors conclude that at the European countries and find no connection between profit-
start of EMU perfect competition was virtually nonexistent. ability and concentration but report support for the effi-
According to Bikker and Groeneveld (2000) and Bikker and ciency hypothesis. Bikker and Haaf (2002a) also explore the
Haaf (2002a), monopolistic competition is the dominant mar- SCP-hypothesis, investigating the relationship between mar-
ket form in the European banking sector. Interestingly, these ket structure and conduct. To this end they relate the H sta-
authors find a negative connection between a concentration tistic, estimated following the Panzar-Rosse method, to the
index and their estimated H statistic. Both studies, therefore, degree of concentration in the market. These authors find a
conclude that further consolidation could reduce competition negative connection between the two variables, leading
in Europe. them to conclude that increasing concentration in Europe
would harm competition. Bikker and Groeneveld (2000)
The structure-conduct-performance (SCP) paradigm postu- reach the same conclusion on the basis of a similar analysis.
lates a connection between market structure, behavior, and

6 Wagenvoort and Schure also measure scale inefficiency.

67
 European banking consolidation: effects on competition, profitability,
and efficiency

rithm of) the number of banks as a control variable, as sug- (1987, 1995, and 1999). We use both the return on assets and
gested by Bikker and Haaf (2002a). the return on equity, available for 1980, 1985, and 1988-97.
Data on the efficiency of banks are obtained from Wagenvoort
As concentration indicators, we use the C5 ratio and the and Schure (1999) and are available for the period 1993-1997.
Herfindahl Index. For profitability, we use both the return on In addition, we use the efficiency estimates from Altunba et
assets and the return on equity. Like Bikker and Haaf (2002a) al. (2001), which are available for the period 1989-97. The
and Bikker and Groeneveld (2000), we apply the H statistic control variables are obtained from the OECD and the IMF
from the Panzar and Rosse method as a competition indica- International Financial Statistics.
tor. As explained above, the estimates of efficiency in the Results
banking sectors in the various European countries differ Does more concentration imply less competition? (H1)
widely. As indicators for the efficiency of the banking sector A higher degree of concentration could lead to anti-competi-
in the various countries we therefore use the estimates of tive behavior. To investigate this connection, we estimate
Wagenvoort and Schure (1999) as well as those of Altunba fixed effect panels for 1989, 1996, and 1997 with the H statis-
et al. (2001). Since Bikkers study (2001) included only seven tic as dependent variable8. Figure 6 shows our results. We
E.U. Member States, his efficiency figures were not used. have used various proxies for concentration: the C5 ratios
(column 1) and the Herfindahl Index (column 2). These con-
We use a number of data sources. The ECB (2000) provides centration indicators can be calculated on the basis of assets
various data on the degree of concentration in the European (columns a), deposits (columnss b), or loans (columns c).
banking sector. We use C5 ratios and Herfindahl indices cal- Corvoisier and Gropp (2002) argue that conditions may be
culated on the basis of total assets, deposits, and loans of the different in deposit and loan markets and we therefore use
banking sector. These indicators are available for 1980, 1985, various proxies for concentration. In most cases we do not
1990, and 1995-99. The H statistics were taken from the stud- find a significant relationship between concentration and
ies by Bikker and Groeneveld (2000) and Bikker and Haaf competition. This result differs from the findings by Bikker
(2002a) and are available for 1989, 1991, 1996, and 1997. and Groeneveld (2000). Column 3 shows that if we solely use
Profitability figures are based on publications by the the Bikker and Groeneveld figures for competition (which are
Organisation for Economic Cooperation and Development available for 1989 and 1996) we find a significant negative

H2

Efficiency Concentration Competitiveness Profitability

H5 H1 H3

H4

Figure 5 Five testable hypotheses

7 Demirg-Kunt and Huizinga (1999) use similar variables in their analysis of bank excluding this variable. Results including bank assets are available upon request
68 profitability in 80 countries. They find that a higher ratio between banks and GDP from corresponding author.
and a lower level of concentration reduce profitability. We find that bank assets
relative to GDP are not related to profitability. Therefore, we report our results
European banking consolidation: effects on competition, profitability,
and efficiency

H4: Greater efficiency in the banking sector leads to higher

profitability. proxy for the degree of concentration as the explanatory
H5: Greater efficiency will eventually result in a higher con- variable. We try to make our sample as large as possible. In all
centration in the banking sector. regressions we have the 15 E.U. countries. The number of
years we can use ranges between 2 (when we use the H sta-
We investigate the connection between indicators of concen- tistic) and 9 (when we study efficiency and profitability). In all
tration, profitability, competition, and efficiency. To make as cases, we estimate fixed effects panels.
much use as possible of the available data, we estimate panel
regressions. We only test for a connection between these In addition to the variables shown in Figure 5, we use a set of
variables, which is not quite the same as a causal explanation. control variables. When profitability is the dependent variable
However, absence of a connection would be in conflict with we use the interest rate (the money market rate), inflation
the hypotheses. We test every relationship shown in Figure 5. (the change in the consumer price index), GDP growth, and
For example, H1 is tested by running panel OLS regressions (the natural logarithm of) the number of banks7. When com-
with a proxy for competition as the dependent variable and a petition is the dependent variable we use the (natural loga-

(1a) (2a) (3a) (4a)

Years: 1989,96,97 1989,96,97 1989,96 1989,96
C5 ratio assets 0.02 (0.07) - -0.53 (-2.24)b -
Herfindahl Index assets - 0.88 (0.94) - -0.42 (-1.42)
Log # banks -0.15 (-0.60) 0.33 (0.89) -0.51 (-2.32)b -0.24 (-1.99)c
F statistic 100.70a 81.11a 219.83a 1054.53a
Adj. R2 0.67 0.65 0.89 0.98
# observations 42 36 27 21

(1b) (2b) (3b) (4b)

C5 ratio deposits -0.36 (-0.91) - -0.78 (-2.65)b -
Herfindahl Index deposits - 0.50 (0.51) - -0.36 (-1.10)
Log # banks -0.22 (-0.84) 0.27 (0.72) -0.56 (-2.66)b -0.23 (-1.80)c
F statistic 104.83a 77.93a 251.01a 948.54a
Adj. R2 0.68 0.64 0.90 0.98
# observations 42 36 27 21

(1c) (2c) (3c) (4c)

C5 ratio loans 0.01 (0.03) - -0.63 (-1.94)c -
Herfindahl Index loans - 1.36 (1.39) - -0.45 (-1.36)
Log # banks -0.16 (-0.62) 0.37 (1.01) -0.49 (-2.14)b -0.25 (-2.01)b
F statistic 100.68a 86.38a 200.19a 1032.84a
Adj. R2 0.67 0.67 0.88 0.98
# observations 42 36 27 21
Notes: t-statistics in parentheses, a/b/c significant at 1/5/10% level

Figure 6 Concentration and competition: panel regressions, 1989, 1996, and 1997 (dependent variable: H statistic)

8 As we have no data on concentration for 1989, we used the figures of 1990

instead. The same conclusion is reached when the data for the H statistic for 1991 69
and the concentration data for 1990 is combined with figures for 1996 and 1997.
 European banking consolidation: effects on competition, profitability,
and efficiency

(1a) (2a) (3a) (4a)

Dependent variable: ROE ROA
C5 ratio assets -0.27 (-1.81)c - -0.02 (-1.31) -
Herfindahl Index assets - -0.81 (-1.05) - -0.01 (-0.22)
Interest rate -0.79 (-1.94)c -0.58 (-0.95) -0.02 (-0.60) 0.01 (0.34)
Inflation 0.38 (0.83) 0.11 (0.20) 0.01 (0.17) -0.03 (-0.83)
GDP growth 0.83 (1.62) 0.90 (0.86) 0.06 (1.31) 0.06 (1.03)
Log # banks 0.07 (0.78) -0.01 (-0.11) 0.00 (0.60) 0.00 (0.40)
F statistic 13.24a 10.91a 10.84a 15.03a
Adj. R2 0.35 0.36 0.29 0.48
# observations 65 47 64 46

(1b) (2b) (3b) (4b)

C5 ratio deposits -0.73 (-3.58)a - -0.05 (-2.60)b -
Herfindahl Index deposits - -1.32(-2.46)b - -0.05 (-1.60)
Interest rate -0.69 (-1.72)c -0.46 (-0.85) -0.04 (-1.13) 0.01 (0.27)
Inflation 0.05 (0.12) 0.03 (0.06) 0.01 (0.29) -0.03 (-0.80)
GDP growth 0.88 (1.71)c 0.70 (0.73) 0.08 (1.85)c 0.05 (0.88)
Log # banks 0.05 (0.59) 0.05 (0.42) 0.01 (1.19) 0.01 (0.79)
F statistic 17.80a 13.97a 13.11a 17.06a
Adj. R2 0.46 0.45 0.36 0.53
# observations 63 47 62 46

(1c) (2c) (3c) (4c)

C5 ratio loans -0.51 (-2.33)b - -0.05 (-2.66)a -
Herfindahl Index loans - -2.22 (-2.90)a - -0.10 (-2.06)b
Interest rate -0.96 (-2.05)b -0.62 (-1.16) -0.08 (-1.86)c -0.00 (-0.04)
Inflation 0.33 (0.68) -0.00 (-0.01) 0.03 (0.72) -0.03 (-0.76)
GDP growth 0.94 (1.71)c 0.30 (0.32) 0.09 (2.01)c 0.03 (0.57)
Log # banks 0.13 (1.41) 0.01 (0.04) 0.02 (1.99)c 0.00 (0.60)
F statistic 14.05a 15.40a 13.25a 18.41a
Adj. R2 0.42 0.49 0.36 0.55
# observations 63 47 62 46
Notes: t-statistics in parentheses, a/b/c significant at 1/5/10% level

Figure 7 Concentration and profitability: panel regressions, 1980/85/90/95-97

observations from the 1980s and those from the 1990s are Are competition and profitability correlated? (H3)
too different to be included in one sample, we have reesti- The final building block of the SCP paradigm is the relation-
mated the relationship between concentration and profitabil- ship between market conduct and profitability. Figure 9 pres-
ity using only observations for the period 1995-1997. It turns ents the results of regressions of the H statistic and the
out that in this period there is no connection between con- control variables on profitability (return on equity or return
centration and profitability. As a matter of fact, all indepen- on assets). We have used three different samples. In the first
dent variables lose their explanatory powers for this sample we use all available estimates for the H-statistic (column a).
period (Figure 8). As these estimates are from two different studies, we have
also used the H estimates from our two sources separately. In
column (b) we employ the data of Bikker and Groeneveld
(2000), while in column (c) the estimates of Bikker and Haaf
(2002a) are used. Figure 9 shows that there is no connection

70 - The journal of financial transformation

European banking consolidation: effects on competition, profitability,
and efficiency

(1a) (2a) (3a) (4a)

Dependent variable: ROE ROA

C5 ratio assets 0.19 (0.45) - 0.01 (0.56) -
Herfindahl Index assets - 0.42 (0.34) - 0.03 (0.39)
Interest rate -0.42 (-0.49) -0.50 (-0.52) -0.01 (-0.14) -0.01 (-0.23)
Inflation 0.87 (0.63) 1.40 (0.87) 0.03 (0.48) 0.07 (0.83)
GDP growth 0.55 (0.79) 1.12 (0.95) 0.03 (0.82) 0.08 (1.32)
Log # banks -0.05 (-0.16) 0.04 (0.11) -0.00 (-0.05) 0.01 (0.0)
F statistic 19.20a 13.71a 25.94a 21.21a
Adj. R2 0.59 0.51 0.68 0.65
# observations 42 37 42 37

C5 ratio deposits 0.26 (0.46) - 0.01 (0.46) -

Herfindahl Index deposits - -0.37 (-0.24) - -0.01 (-0.08)
Interest rate -0.42 (-0.50) -0.50(-0.52) -0.01 (-0.16) -0.01 (-0.24)
Inflation 0.93 (0.69) 1.58 (0.95) 0.04 (0.56) 0.08 (0.88)
GDP growth 0.50 (0.70) 0.97 (0.83) 0.03 (0.74) 0.08 (1.22)
Log # banks -0.04 (-0.12) -0.00 (-0.01) -0.00 (-0.02) 0.00 (0.20)
F statistic 19.21a 13.65a 25.81a 21.01a
Adj. R2 0.59 0.50 0.68 0.65
# observations 42 37 42 37

C5 ratio loans 0.11 (0.36) - 0.00 (0.14) -

Herfindahl Index loans - -1.81 (-1.77) - -0.09 (1.59)
Interest rate -0.46 (-0.55) -0.64 (-0.73) -0.01 (-0.21) -0.02 (-0.39)
Inflation 0.98 (0.73) 1.74 (1.17) 0.04 (0.62) 0.09 (1.11)
GDP growth 0.50 (0.70) 0.56 (0.52) 0.03 (0.77) 0.05 (0.93)
Log # banks -0.07 (-0.20) -0.02 (-0.06) -0.00 (-0.08) 0.00 (0.15)
F statistic 19.12a 16.73a 25.55a 24.57a
Adj. R2 0.59 0.58 0.67 0.69
# observations 42 37 42 37
Notes: t-statistics in parentheses, a/b/c significant at 1/5/10% level

Figure 8 Concentration and profitability: panel regressions, 1995-97

connection between competition and concentration. However, return on equity (columns 1 and 2) and return on assets (col-
this only applies to the C5 indicator for assets (column 3a) umns 3 and 4). Concentration is again proxied by the C5 ratio
and deposits (column 3b). If we use the Herfindahl index, (columns 1 and 3) and the Herfindahl Index (columns 2 and 4)
there is again no significant connection between competition using assets (column a), deposits (column b), or loans (column
and concentration (column 4). Our conclusion is that the con- c). Our results provide only partial support for the second
nection found by Bikker and Groeneveld is not robust: more hypothesis. In 7 out of 12 cases the coefficient is negative
observations and/or another indicator for concentration lead rather than positive. We also find evidence that there is a
to a completely different result. So, all in all, we find little sup- negative relationship between interest rates and profitability.
port for hypothesis H1. This effect is the strongest if we relate C5 ratios and the
Is concentration positively related to profitability? (H2) return on equity. There is also evidence for a positive rela-
Figure 7 gives an overview of the results obtained by regress- tionship between GDP growth and profitability. This effect is
ing profit on concentration. We use two indicators for profit: also strongest for the C5 ratios. As it can be argued that

71
 European banking consolidation: effects on competition, profitability,
and efficiency

Dependent variable: ROE

between X-inefficiency and profit in the data of Altunba et
(1a) (1b) (1c) al. Given the large differences in the estimates of X-efficiency,
Years 1989,91,96,97 1989,96 1991,97
it is not surprising that the results of the regressions are
H 0.08 (0.63) 0.32 (1.33) -0.40 (-0.25)
Interest rate -1.45 (-2.34)b -2.07 (-1.48) -2.79 (-2.10)b widely divergent. We conclude that there is no robust rela-
Inflation 2.26 (2.52)b 0.45 (0.41) 5.8 (2.97)b tionship between inefficiency and profitability.
GDP growth 0.43 (0.78) 1.86 (1.04) 1.04 (1.06)
Log # Banks -0.05 (-0.31) 0.59 (2.07)c 0.00 (0.00)
Adj. R2 0.25 0.05 0.08 Are efficiency and concentration related? (H5)
Observations 52 26 26
The connection between efficiency and concentration was
Dependent variable: ROA examined by regressing the C5 ratio (columns 1 and 3 of
(2a) (2b) (2c)
Years 1989,91,96,97 1989,96 1991,97
Figure 11) or the Herfindahl Index (columns 2 and 4) on the
H 0.00 (0.65) 0.02 (1.37) -0.05 (-0.77) inefficiency measures of Wagenvoort and Schure (columns 1
Interest rate -0.05 (-1.42) -0.04 (-0.45) -0.13 (-2.35)c
Inflation 0.12 (2.38)b 0.00 (0.01) 0.32 (3.98)a
and 2) and those of Altunba et al. (columns 3 and 4). The
GDP growth 0.05 (1.51) 0.08 (0.63) 0.08 (1.98)c concentration measures refer to assets (column a), deposits
Log # Banks -0.01 (-1.14) 0.01 (0.66) -0.01 (-0.63)
(column b), or loans (column c). We observe no significant
Adj. R2 0.43 0.04 0.76
Observations 51 25 26 connection between efficiency and concentration. Our
Notes: t-statistics in parentheses, a/b/c significant at 1/5/10% level results, therefore, provide no support for the second link in
the efficiency hypothesis.
Figure 9 Competition and profitability: panel regressions, 1989, 1991, 1996, and
1997

(1a) (2a)
Dependent variable: ROE ROA
Years: 1993-97 1993-97
Wagenvoort-Schure:
Scale-inefficiency 0.54 (0.75) 0.04 (0.98)
X-inefficiency -0.56 (-3.39)a -0.02 (-2.53)b
Interest rate -0.23 (-0.39) -0.03 (-1.02)
Inflation 0.34 (0.30) 0.07 (1.15)
GDP growth 0.47 (0.95) 0.05 (1.80)c
Log # banks 0.04 (0.15) 0.01 (0.89)
F statistic 25.47b 27.73a
Adj. R2 0.62 0.65
# observations 67 66

(1b) (2b)
Years: 1989-97 1989-97
Altunba et al.:
X-inefficiency 0.23 (1.09) 0.01 (1.16)
Interest rate -1.13 (-3.16)a -0.06 (-2.71)a
Inflation 1.83 (3.23)a 0.13 (3.68)a
GDP growth 0.63 (1.52) 0.06 (2.45)b
Log # banks 0.21 (1.87) 0.00 (0.59)
Adj. R2 0.44 0.47
# observations 115 111
Notes: t-statistics in parentheses, a/b/c significant at 1/5/10% level
Is efficiency related to profits? (H4)

Figure 10 Efficiency and profitability: panel regressions, 1993-97 and 1989-97

72 - The journal of financial transformation

European banking consolidation: effects on competition, profitability,
and efficiency

Wagenvoort-Schure Altunba et al
(1a) (2a) (3a) (4a)
1995-97 1990, 1995-97
Dependent variable: C5 ratio assets Herfindahl Index assets C5 ratio assets Herfindahl Index assets
Scale inefficiency -0.59 (-1.04) -0.32 (-0.93)
X-inefficiency -0.05 (-0.60) 0.01 (0.2) 0.21 (1.15) -0.03 (-0.39)
Log # banks -0.04 (-0.25) -0.05 (-0.76) -0.20 (-1.44) -0.17 (-2.42)b
F statistic 2704.60a 1043.82a 845.59a 693.47a
Adj. R2 0.99 0.98 0.94 0.94
# observations 45 40 57 48

(1b) (2b) (3b) (4b)

Dependent variable: C5 ratio deposits Herfindahl Index deposits C5 ratio deposits Herfindahl Index deposits
Scale inefficiency -0.37 (-0.78) -0.03 (-0.11)
X-inefficiency -0.02 (-0.28) -0.01 (-0.12) 0.16 (1.18) -0.03 (-0.42)
Log # banks -0.06 (-0.51) -0.04 (-0.75) -0.23 (-2.15)b -0.16 (-2.37)b
F statistic 3953.83a 1698.66a 1729.16a 1037.49a
Adj. R2 0.99 0.99 0.97 0.96
# observations 45 40 57 48

(1c) (2c) (3c) (4c)

Dependent variable: C5 ratio loans Herfindahl Index loans C5 ratio loans Herfindahl Index loans
Scale inefficiency -0.34 (-0.45) -0.19 (-0.48)
X-inefficiency -0.04 (-0.34) 0.02 (0.49) 0.14 (0.90) -0.08 (-1.23)
Log # banks 0.05 (0.23) 0.01 (0.17) -0.11 (-0.92) -0.13 (-1.96)c
F statistic 1449.41a 741.70a 120.50a 693.21a
Adj. R2 0.98 0.97 0.95 0.94
# observations 45 40 57 48
Notes: t-statistics in parentheses, a/b/c significant at 1/5/10% level

Figure 11 Concentration and efficiency: panel regressions, 1995-95 and 1990, 1995-97

between competition and profits. In none of the regressions Is efficiency related to profits? (H4)
do we find a relationship between competition and profits. The efficiency hypothesis assumes a positive connection
The coefficients do have the right sign, but are never signifi- between efficiency and profits. Since Wagenvoort and Schure
cantly different from zero. We do find, once again, a negative (1999) and Altunba et al. (2001) calculate the degree of inef-
connection between interest rates and profits. In addition, ficiency the hypothesis implies negative coefficients in the
there is also evidence that inflation and bank profitability are regression. The estimated equations have profitability as the
positively related. dependent variable (ROE in column 1 and ROA in column 2 of
Figure 10) and the inefficiency measures and control vari-
ables as the independent variables. In column (a) the indica-
tors of Wagenvoort and Schure are used, while in column (b)
the indicator of Altunba et al. are employed. The results are
mixed. On the basis of Wagenvoort and Schures data, the
expected negative connection between X-inefficiency and
profit does indeed show up. However, it emerges that no con-
nection exists between their measure for scale inefficiency
and profit. We also fail to find a significant relationship

73
 European banking consolidation: effects on competition, profitability,
and efficiency

Conclusion defensible, but it should be remembered that certain informa-

There was a sharp increase in the merger and acquisition tion will be lost in this way. The second simplification is that
activities of European banks during the 1990s. It is likely that cross-border activities between banking sectors are left out
this process of consolidation will continue in the coming of consideration. Since earlier studies concluded that there
years. This raises questions on possible detrimental effects of was no European market in place for most banking services,
a higher degree of concentration in European banking mar- this assumption can also be defended.
kets. Earlier research pointed to the existence of monopolistic
competition in the European banking markets [De Bandt and
Davis (2000)] and the possibility of a negative relationship
between the degree of concentration and profitability [Bikker
and Groeneveld (2000)]. However, our country-level analysis
suggests that caution is in order. For the largest possible
sample, we do indeed find some evidence for a positive rela-
tionship between concentration and profitability [cf.
Demirg-Kunt and Huizinga (1999)]. However, this finding is
not robust as it is not confirmed if data for a more recent
sample are used. Furthermore, our results suggest that there
is no connection between concentration on the one hand and
market competition on the other. We also find no evidence
that competitive conditions are related to profitability. We
only report mixed evidence for the hypothesis that efficiency
improves profits. Our data does not show a connection
between efficiency and concentration, while the relationship
between efficiency and profits strongly depends on the cho-
sen efficiency indicator.

Finally, two caveats are in order as to the nature of the analy-

sis. One problem is the limited availability of data for the E.U.
countries. Data on profitability are relatively easy to obtain,
but there is a lack of good data on concentration, H values,
and efficiency indicators. This restricts the number of years
that can be examined and makes it difficult to determine the
extent to which the results are generally applicable. Another
problem lies in the question of what exactly is meant by the
European banking market. The above analysis assumes that,
in the period under review, the banking markets in the fifteen
E.U. countries were homogenous and distinctly separate from
each other [Neuberger (1998)]. The first simplification is that,
say, the difference between the corporate and consumer
markets is not taken into account. Such an assumption is

74 - The journal of financial transformation

 Institutional

The merchant-bank
struggle for control of
payment systems

Adam J. Levitin
is an attorney in New York City

Abstract
Merchants and banks are currently engaged in a wide-ranging
struggle for control over payment systems. The conflict is
playing itself out in business practices, in banking regulation,
in corporate governance, in corporate restructuring, and in
the biggest antitrust litigation since AT&T. Yet, it is possible
that the extraordinary energy being spent in this fight is for
naught, as the growth of national bank brands, technological
developments, and innovative business models are likely to
result in a radical reshaping of the payments world. This arti-
cle reviews the factors behind the struggle between mer-
chants and banks and the strategies adopted by each, and
questions what impact changes in the payment card indus-
trys structure and the emergence of new payments technolo-
gies and business models will have on the merchant-bank
contest.

75
 The merchant-bank struggle for control of payment systems

ciation keeps part of this and remits some in turn to the issu- Market share
ing bank. The purpose of these fees is to cover the costs, 70%
60%
particularly chargeback (returns) and fraud risks. The inter-
50%
change rate is set by the network. 40%
30%

The fee level within this network is based on the interchange 20%
10%
rate; the merchant discount rate will always be the inter-
0%
change rate plus a percentage for the acquirer bank.

ct 6

ct 8
00

04
02
90

98
94

96
92

di 00

di 0
)

)
ed

ed
re 20
20

20
20
19
Interchange rates vary not on networks costs but on the

19

19

19
19

re 2
(p

(p
merchants risk profile and the level of rewards points
Personal checks Credit cards Other payment
systems
Cash Debit cards (all types)

Checks Credit cards Online (PIN) Cash Figure 2 U.S. payment systems market share by dollar volume
& offline debit cards
Source: Nilson report
(signature)
debit cards
Cost per transaction $0.36 $0.72 $0.34 $0.12
regardless of different business models (Internet store, main-
Cost per $100 sales $0.80 $1.80 $0.80 $0.90 line retail, discount outlet). Finally, the card associations for-
Source: Humphrey et al., (2003) bid some forms of factoring, so merchants are not always
able to take advantage of a factors superior credit-worthi-
Figure 1 Retailer payment costs in U.S. in 2000
ness and willingness to assume payment risk to obtain a
lower discount rate. Visa has additional rules that require
attached to the payment card. Thus, interchange rates are merchants to use its proprietary payments clearance system
lower for low-margin industries like groceries, but extremely and to purchase its payment guarantee services.
high for adult Internet sites.
The net effect of these rules is to force merchants to charge
The bank card associations employ a number of contractual the same price regardless of a consumers payment method.
merchant restraints to increase card usage at the expense of Accordingly, consumers do not take price into account in
other payment systems and to allow them to charge higher their decision as to which payment system to use. Instead,
interchange rates. Firstly, merchants are forbidden from they decide based solely on factors such as convenience,
imposing a surcharge for the use of credit or debit cards, bundled rewards, image, and float. These factors tend to favor
even though card transactions cost merchants more than bank card transactions over other payment systems. Higher
other payment systems. Secondly, merchants are required to purchase volume increases the banks income on the front-
take all credit cards bearing the card associations brand. end in terms of interchange income and on the back-end in
Different types of cards of the same brand have different terms of more interest, late fees, and penalties. Interchange
costs to merchants premium rewards cards cost merchants accounts for only 15% of MasterCard and Visa issuers reve-
more in interchange fees than non-rewards cards. Indeed, nues,7 but are the engine that pulls consumers toward more
some card issuers account for the cost of rewards programs card transactions, thus increasing interest and late fees,
in their financials as reductions in their interchange income. which account for 70% and 15% of revenues, respectively.
Thirdly, merchants are forbidden from imposing a minimum Thus, interchange is estimated to account for one-third of
charge amount, although this rule is widely flouted. Fourthly, card issuer revenues in the U.S.8
merchants are required to accept cards at all their locations,

1 Levitin, A., 2005, The Antitrust Super Bowl: Americas Payment Systems, Consumer payment choices and bank relationships, key results, May
76 No-Surcharge Rules, and the Hidden Costs of Credit, Berkeley Business Law 4 Merchants payments coalition, 2006, Merchants welcome congressional hearings
Journal 3:1 265, 272-73 on secret fees charged by credit card companies, Press Release, Feb. 14
2 Humphrey, D., M. Willesson, T. Lindblomand, and G. Bergendahl, 2003, What does 5 Haddad, A., 2006, The interchange industry is bigger than . . ., Aneaces Blog,
it cost to make a payment? Review of Network Economics, 2:2, 159-174 May 12
3 Association of Finance Professionals, 2005, Retail industry forum survey: 6 CardTrak, 2004, Card Networks Q3, Dec
The merchant-bank struggle for control of payment systems

At the core of the merchant-bank dispute is the fact that dif- per year is involved in the U.S. alone,4 which makes the inter-
ferent payment systems have different acceptance costs for change component of the payments industry larger than the
merchants. Precise quantification of these costs is difficult music industry, the microprocessor industry, the electronic
and varies by merchant, but credit cards are by far the most game industry, Hollywood box office sales, and worldwide
expensive payment system for merchants, followed closely by venture capital investments5.
signature-based (offline) debit cards. Next come PIN-based
(on-line) debit cards, then checks, and finally cash [Levitin Structure and costs of bank payment card
(2005)]1. A credit card transaction costs a typical retailer networks
about six times what a cash transaction does and twice as Most credit and debit cards in the United States are run on
much as a PIN-based debit card2. bank-controlled networks, such as MasterCard, Visa, American
Express, and Discover. In 2004, Visa had a 53.6% market
Normally, when goods or services have different costs to share of the U.S. payment card purchase volume, followed by
merchants, the cost differences are reflected in the price MasterCard with 29.2%, American Express with 12.9%, and
charged to consumers. Payment systems are different. Discover with 4.3%6. Visa and, until recently, MasterCard are
Merchants are unable to pass along the relative costs of dif- joint ventures owned by their member banks, while American
ferent payment systems to consumers because the rules of Express and Discover are owned by individual banks.
the major payment card networks MasterCard, Visa, MasterCard and Visa have a 95% overlap in bank member-
American Express, and Discover functionally require mer- ship. These networks consist of the banks that issue the cards
chants to charge consumers the same price, regardless of the and have the consumer relationship and banks that acquire
payment system [Levitin (2005)]. Therefore, merchants must the card transactions from merchants. Often the acquirer
either absorb the cost of higher priced payment systems or bank will outsource the actual processing operations.
raise the cost of all goods and services to the level necessary Intermediating between the issuer and the acquirer is the
to cover the cost of the higher priced payment systems, but network association, which performs authorization, clearing,
at the expense of sales volume. This problem has been exac- and settlement (ACS) services. In the case of American
erbated in recent years as the cost of accepting payment Express and Discover, the issuer, acquirer, and network asso-
cards has increased, as has the number of payment card ciation have traditionally been the same entity.
transactions and the percentage of transactions made on
payment cards. The average cost of accepting payment cards There are several components to the cost of a bank card
has increased since 2003 by at least ten percent for almost transaction. When a consumer makes a purchase with a card,
two-thirds of retailers, and by at least twenty-five percent for the merchants account at the acquiring bank is credited with
over a quarter of retailers3. the purchase amount less a percentage, known as the mer-
chant discount fee, typically in the nature of 100-200 basis
The rising cost, number, and percentage of payment card points, but sometimes as much as 1200 basis points for mer-
transactions have combined to squeeze many merchants chants who present a particularly high risk either because of
profit margins without providing any corresponding increase low transaction volume, limited credit history, or the nature
in the benefits of card acceptance. In fact, for many mer- of their business. Of the merchant discount fee, part is
chants, payment card acceptance has become the fastest retained by the acquirer bank, and part is remitted to the
growing cost of doing business. While the cost of payment network association. The remittance to the network associa-
acceptance is only a few cents or dollars per transaction, tion is called the interchange fee, although this term is often
these costs accumulate quickly. As much as U.S.$40 billion applied to the merchant discount rate too. The network asso-

7 Whats at stake in the interchange wars, The Green Sheet, Nov. 28, 2005
8 Patti Murphy, 2004, ATM cards + bill pay = winning play, The Green Sheet, Issue 77
04:04:02, 14, 16, April 26
 The merchant-bank struggle for control of payment systems

bank-controlled payment card systems are still in their infan- ILCs have recently received attention because Wal-Mart,
cy and face many obstacles, including the possibility that ACH Americas largest retailer, has filed an application to open an
networks will impose interchange fees of their own. In the ILC in order to reduce its costs of processing payments, and
long-run, merchant-based systems offer the most viable non- the Home Depot, Americas second largest retailer, is seeking
bank strategy. At present, though, non-bank payment sys- regulatory approval for its acquisition of an existing ILC. With
tems have neither gained sufficient merchant nor consumer an ILC, Wal-Mart and Home Depot could process payments
acceptance to be viable alternatives to bank payment cards. in-house. Moreover, they could then join MasterCard and Visa
and issue their own Wal-Mart and Home Depot card
Neither opt-out nor imitation strategies are particularly MasterCard and Visa cards, rather than co-brand.
effective, because consumers want to use bank payment
cards because of convenience and float. While multi-mer- Finally, as the ultimate opt-in strategy, the biggest retailers
chant non-bank payment systems hold promise for the can contemplate buying existing credit card networks. Wal-
future, they do not answer merchants problems of increased Mart, for example, has been mentioned as a possible buyer of
payment costs at present. the Discover network, which was formerly owned by Sears.

Opt-in strategies The opt-in strategies are workable, but not for all merchants.
Other merchants have taken if you cant beat em, join em A merchants size is the key factor in determining its pay-
approach. Some merchants co-brand with an individual bank ments strategy options. Co-branding is only an option for
that is a member of a card association, such as the American larger merchants, and only the largest merchants have
Airlines Visa or Wal-Mart Discover card. These merchants undertaken acquisition of ILCs or can consider buying an
then split a percentage of the issuers income from the co- existing network. Similarly, although the possibility of opt-in,
branded cards. Co-branding benefits the card issuer by imitate, and opt-out strategies gives merchants leverage in
increasing purchase volume on the card, typically because of negotiating better interchange rates with banks, the extent of
a bundled rewards program involving the co-branding mer- this leverage is determined by the size of the merchant. Wal-
chants products. The difficulty with co-branding is that con- Mart, for example, is large enough that banks care about
sumers tend to carry a limited number of credit cards, so co- retaining its business. It has managed to squeeze interchange
branded cards compete with each other for consumer loyalty. rates from the banks lower, much like it squeezes all other
suppliers. A single local retailers individual payments strate-
Other merchants go beyond co-branding, and become banks gy, by contrast, is inconsequential. In some industries, mer-
themselves by creating an affiliated industrial loan company chants have tried to overcome the size problem by banding
(ILC). ILCs are obscure banking entities that may issue credit together to negotiate industry-wide interchange rates. This
cards, take deposits, and make loans, as well as transact busi- leaves few business strategy options for smaller merchants
ness for their own account. With limited exceptions, ILCs may that are not in well-organized or franchised industries. The
not offer checking accounts. ILCs are not subject to the heavy smaller, independent merchants have, therefore, turned to
regulation of full-service commercial banks. They are subject litigation and lobbying for regulatory intervention.
to the safety and soundness regulations of the Federal
Deposit Insurance Corporation and state banking regulators, Merchant antitrust litigation
but are not under the purview of the Federal Reserve system The credit card industry has been besieged by antitrust litiga-
or the Office of the Comptroller of the Currency. tion for several years. The Department of Justice success-
fully sued to end MasterCard and Visas exclusivity rules10,

9 Bezard, G., 2004, Are merchant-controlled debit networks the next big thing?
78 - The journal of financial transformation
FinanceTech, Aug. 17
The merchant-bank struggle for control of payment systems

The payments industrys fee structure is designed to avoid Some merchants simply refuse to accept payment cards. This
commoditization because profit margins tend to be lower in is not a viable option for most merchants, particularly those
commoditized industries, since competition is solely on price. with e-commerce operations or large ticket items. Moreover,
Card companies attempt to avoid commoditization by divert- card usage increases the frequency and volume of transac-
ing competition from the obvious price points cost at point- tions, which merchants do not want to surrender. Ultimately,
of-sale and, for credit cards, interest rate to bundled merchants who want to stop accepting payments cards find
rewards, which are less prone to commoditization [Levitin themselves in a prisoners dilemma they do not want to
(2005)]. No-surcharge rules mask the point-of-sale cost of stop accepting cards unless their competitors do, lest they be
payment systems to consumers. Interest rates too are at a disadvantage. Other merchants accept payments cards
masked to consumers through teaser introductory offers, but attempt to steer customers toward other payment meth-
often of 0%, and inscrutable card holder agreements with ods by offering discounts or asking customers for a specific
universal cross-default clauses make it impossible for a con- payment type. Card network no-surcharge rules (and state
sumer to understand the true interest rate on a card. law in several states) prevent merchants from imposing a
surcharge on credit or debit cards, but do not prevent them
From a merchants perspective, payment services should be from doing the economic equivalent of offering a cash dis-
commoditized. Payments are the ultimate transaction cost. count. Cash discounts are rarely used by merchants because
Merchants do not see the bundled rewards or credit card they are not particularly effective in affecting consumer
interest rates and no-surcharge rules only mask point-of-sale behavior, unlike a surcharge for credit use [Levitin (2005)].
price to consumers, not merchants. The non-price differences
to a merchant between card brands and card types are insig- Imitation strategies
nificant. Therefore, merchants expect competition to be on A variant of the opt-out approach is for merchants to imitate
the basis of efficiency and price. Yet, it is precisely the ability bank payment card systems. Thus, some merchants, like JC
to treat payment cards as commodities that the card net- Penney and Macys, offer a private label credit card. Such
works rules curtail. cards are nothing more than old-fashioned store credit,
accessed through a card, although sometimes a financial
Merchant strategies to minimize payment costs institution like GE Consumer Finance is involved. Private label
For a merchant who wishes to accept payment cards, the card credit cards are of limited appeal, however, because they only
networks rules are an all-or-nothing proposition. Most mer- provide a line of credit for one merchant, and consumers
chants feel like they have little choice but to accept cards loathe carrying too many cards with them. Other merchants
because consumers like the convenience, bundled rewards, offer pre-paid cards, which involve an extension of credit not
and float, all without a perceived cost. Therefore, many mer- by the merchant, but by the consumer.
chants simply absorb the cost of accepting payment cards or
pass it on to their consumers, at the cost of lower sales vol- Some merchants, including Wal-Mart, are working to develop
umes. Many merchants attempt to minimize their payments a broader merchant-based payment card network, modeled
costs through various business strategies, litigation, and lobby- on the system in Germany, where half of debit card transac-
ing for regulatory intervention. The payment cost reduction tions are processed on a no-interchange merchant-owned
business strategies can be categorized as opt-out, imitate, and debit card system that piggybacks on interchange-free
opt-in. Automated Clearing House (ACH) technology9. A company
called Debitman is attempting to develop a similar shared
Opt-out strategies network, retailed-issued PIN debit system in the U.S. Non-

10 United States v. Visa U.S.A., Inc., 344 F.3d 229 (2d Cir. 2003), cert. denied, 543 U.S.
811 (2004). 79
 The merchant-bank struggle for control of payment systems

attack on the collusive setting of the interchange rates in

MasterCard has gone further and has undertaken an IPO terms of prospective, injunctive relief. From a legal standpoint
whose unusual deal structure is driven by antitrust concerns, it should have no effect on a determination of liability for past
as the banks attempt to limit their liability by limiting their behavior, damages for which could be ruinous. Yet, the
control over the network. The MasterCard IPO will result in a restructurings might even blunt liability for past behavior
corporation with three classes of stock: publicly-held Class A because MasterCard and Visa will appear to have defanged
shares with a 49% economic interest and an 83% voting themselves.
interest; bank-held non-voting class B shares with a 41% eco-
nomic interest; and bank-held Class M shares that have veto Neither associations plan addresses the antitrust suit com-
power over major transactions. A new charitable foundation plaints about merchant restraints that insulate the inter-
will receive stock with 21 year alienation restrictions that change rate, no matter how it is set, from the pressures of the
constitutes a 10% economic interest and 17% voting interest. free market. MasterCard and Visa have focused on the graver
The new board will consist of eight independent, publicly threat, but not the more likely threat. A successful attack on
elected directors, the CEO, and three bank-elected directors. the collusive setting of the interchange rate would be the
Additionally, European issues will be controlled by a special death knell for the card associations, because it would take
board elected by MasterCards European bank members that away the networks ability to set their services prices. For
can be overridden only by a 75% majority vote of the regular that very reason, a court would think twice about ruling
board. against MasterCard and Visa. It is only with great caution that
a court would grant a decisive ruling against such a corner-
The MasterCard IPO is a hedging strategy. The banks will stone of the American economy.
retain an ownership interest in MasterCard that allows them
to receive a large share of its profits and veto power over In the case of merchant restraints, though, a court would feel
major transactions. They have also insured against major no such trepidation. MasterCard and Visa can survive without
institutional change through the charitable foundations the merchant restraints, as shown by MasterCards unilateral
stock alienation restrictions. The lockup restricts new share- rescission of its no-surcharge rule in Europe and the continu-
holders powers and limits the likelihood of major changes at ing (although lower) profitability of MasterCard and Visa in
MasterCard by putting a large chunk of the stock in the hands Australia after the Reserve Bank of Australia banned several
of a long-term shareholder. Finally, no party is allowed to merchant restraints. Accordingly, the suits aimed at mer-
acquire more than 15% of the public corporation. Thus, the chant restraints have a better chance of succeeding than
banks have kept functional control over the association, but those that focus on the collusive setting of interchange rates.
brought in outside investors to share the risk. Meanwhile, the The card associations restructurings provide no protection
banks have retained their stake in Visa, the larger, more prof- against merchant restraint suits.
itable card association, with superior market position for
debit cards, although there is speculation that a Visa IPO Merchant-initiated antitrust litigation is ultimately a business
could follow if MasterCards is successful19. strategy to reduce payment acceptance costs. Merchants
goal is not the elimination of the payment cards industry, just
Will these plans work? Yes and no. The restructuring of Visas a lowering of payment costs. Litigation is a leverage point
board and MasterCards ownership will blunt the merchants that opens the door to negotiated settlements. If MasterCard

11 Visa U.S.A., Inc. v. First Data Corp., 2005 U.S. Dist. LEXIS 34281 (N.D. Cal. Aug, 16, 16 MasterCard 10-Q, Mar, 31, 2006
2005). Manfred, L. 2005, The Kansas City FED conference: Another skirmish in the inter-
12 PSW, Inc., 2004, PSW, Inc. files antitrust lawsuit against MasterCard and Visa, change controversy, First Annapolis Navigator, May
Press Release, Aug. 16 Dagan, R, 2006, Chevrot ha-bituach yishaveiku kartisei ashrai (Insurance compa-
13 Payment card interchange fee & merchant discount, Antitrust Litigation, 398 F. nies will market credit cards), Haaretz, May 11 (Israel)
80 Supp. 2d 1356 (J.P.M.L. 2005) 17 Breitkopf, D., and I. Lindenmayer, 2006, Visa reorganization vote near; where
14 International Cards & Payments Council, 2006, US cards industry lawsuits cause does Bank of America sit? American Banker, Apr. 27
international concern, Press Release, Jan. 23 18 Nilson Report, 2005, Visas 1,700 principal members vote proportional to their
15 Breitkopf, D., and H. M. Jalili, 2006, Visa advances, but . . . A lawsuit looms; small Visa USA sales volume, 845, Nov
issuers gain a seat, American Banker, May 1
The merchant-bank struggle for control of payment systems

and American Express and Discover have since sued for dam- The member banks are on the line too. The merchant suits
ages from the rules. First Data Corporation has challenged name the leading member banks as defendants, alleging a
Visas requirement that all Visa transactions be authorized, conspiracy by the banks to fix prices through the card asso-
cleared, and settled on Visas proprietary system11. PSW Inc., ciations. Nor will the card associations corporate form neces-
an aggregator for Internet merchants, has sued MasterCard sarily provide the banks with protection. Visas by-laws allow
and Visa over the setting of chargeback fees12. And mer- it to assess its members for its litigation losses15. MasterCard
chants have brought a variety of antitrust litigation, most surrendered its assessment rights as part of its IPO, but the
notably a suit brought by Wal-Mart, Sears, and other retailers merchant litigation has claimed that this was a fraudulent
alleging that MasterCards and Visas Honor All Cards rule, as conveyance in light of MasterCards potential insolvency.
applied to debit cards, was illegal. The rule required mer-
chants that wished to accept MasterCard and Visa credit Watching the struggle play out from afar are the various
cards to also accept MasterCard and Visa offline (signature) American bank and competition regulators. Internationally, a
debit cards, which are more expensive than online (PIN) debit movement is afoot for intense regulatory scrutiny of credit
cards. MasterCard and Visa settled for a total over U.S.$3 bil- card networks. Australia led the way in 2003 with a sweeping
lion, plus a partial rescission of the rule, the largest antitrust series of ongoing reforms. These reforms banned many of
settlement in history. the card networks merchant restraints, and interchange fees
fell by nearly half. Regulatory authorities in Argentina,
Numerous antitrust suits have been filed relating to inter- Brazil, the E.U., Columbia, Hungary, Israel, Mexico, New
change rates13. These antitrust suits have several basic Zealand, Norway, Poland, Portugal, South Africa, Spain,
charges. Firstly, they contend that the member banks of Sweden, Switzerland, and the U.K. are reviewing interchange
MasterCard and Visa are engaged in collusive price fixing in fees and related practices with an eye toward possible regu-
the setting of interchange rates. Secondly, they allege unfair lation16. In the United States, there is no government agency
business practices in the form of the various merchant with authority to regulate interchange rates or card associa-
restraints. Thirdly, they allege the bundling and tying of dif- tion rules, although the Department of Justice could bring
ferent products (premium and regular credit cards; payment litigation. Even if merchant-initiated litigation fails, regula-
clearing and payment guarantee services). And, finally, they tory changes or government-initiated litigation could accom-
allege attempted monopolization because the merchant plish similar ends.
restraints increase the card associations market share at the
expense of other payment systems. MasterCard and Visa are Bank reactions
the suits main targets, although American Express is a defen- The bank card associations and their member banks have
dant in a few. reacted to the litigation threat in different ways. Visa U.S.A.
has reorganized its corporate governance structure to deflect
The merchant litigation and regulatory threats to the pay- collusive price fixing charges. Its new board has increased the
ment card associations and member banks are serious. They number of independent directors, who will have sole authority
are the biggest and most important antitrust litigation since to set interchange rates17. Rule-making, which would cover
the governments cases against AT&T, IBM, and Microsoft. As merchant restraints, however, continues to be the purview of
much as U.S.$100 billion in damages and the very survival of the full board, where the banks retain a significant presence,
MasterCard and Visa is on the line14. An adverse judgment and other issues are reserved solely for the bank directors18.
could bankrupt the card associations, and injunctive relief Visas reorganization appears to be aimed solely at blunting
could prevent their future operations. claims of interbank collusion in interchange rate setting.

19 Kelleher, J. B., 2005, Visa can sit out MasterCards IPO for a while, Reuters, Dec. 9
81
 The merchant-bank struggle for control of payment systems

share in terms of credit card outstandings, far ahead of On the other hand, there is tremendous brand value to
American Express, at 9.8%, and Discover, at 6%23. It would MasterCard and Visa, and, at least in the case of Bank of
also deprive MasterCard and Visa of seven and twenty per- America, the profits from creating an independent network
cent of their business, respectively [Bauerlein (2006)]24. are relatively small [Bauerlein (2006)]. The answer may
There has also been speculation of a merger between Bank of depend, in part, on the manner in which the antitrust litiga-
American and Morgan Stanley. Such a merger would not only tion proceeds. If the big banks desert MasterCard and Visa, it
give Bank of America the major investment banking presence will increase the relative power of the smaller banks, as well
it lacks, but also control of Discover. as the relative power of any big bank that remains in these
networks. Already, Bank of America has lost its Visa board
JPMorgan Chase has put itself in a similar position to Bank of seat in Visas board reshuffling, while small issuers have
America. It has leading presences on the issuer and acquirer gained a seat, and the MasterCard IPO is an opportunity for
sides. JPMorgan Chase is the second largest issuer in the banks to increase their relative control beyond their current
country and holds a majority interest in the nations largest sales volume-related control share. On the other hand, small
acquirer, Chase Paymentech Solutions, a joint venture with banks will more likely become acquisition targets of big banks
FDC. Besides its minority interest in Chase Paymentech with independent networks that seek to expand their net-
Solutions, FDC maintains other significant acquirer and pro- works reach. Although new, independent card networks
cessing operations. FDC owns the STAR debit card network, could impose the same merchant restraints as the existing
and although it does not have a credit card issuer presence, networks, their existence would reduce the market power of
it is rumored to be another possible purchaser of Discover. MasterCard and Visa, which would in turn help the associa-
FDC has also been developing a variety of non-card based tions in the antitrust litigation.
payment systems, including a partnership with Wal-Mart for a
real-time check verification system. Finally, if FDC wins its Can the bank card associations offer more than financial
litigation challenge to Visas requirement that all transactions services?
be authorized, cleared, and processed through its proprietary The energy spent on the struggle over payment costs may
system, FDC could easily increase its lower cost on-us trans- not matter because the scope of the bank-merchant relation-
action capability and set itself up as a rival ACS system. ship could change to allow new pricing parameters and a
mutually beneficial relationship. The expansion of electronic
If major players like Bank of America, JPMorgan, and FDC payments has created the potential for banks to provide
jump ship, the question will become what the other large more than financial services. With the growth of electronic
banks will do. Will Citibank, Washington Mutual, Wells Fargo, payments, banks are poised to provide information services
HSBC, Wachovia, and Capital One remain in MasterCard and to merchants as well.
Visa, or will they too seek to set up as independent networks?
There will certainly be a temptation for the big boys to set up Consumer data has tremendous value for merchants.
as independents, if only for prestige and control. Capital Properly analyzed, it can be a highly effective marketing tool.
Ones 2005 purchase of Hibernia, a sizeable retail bank, and Paper payments do not readily lend themselves to data min-
its reported interest in purchasing another retail bank indi- ing, but electronic, card-based payments do. To capitalize on
cate that it too may be setting itself up to have the merchant payments data, however, banks and merchants must adopt
and consumer relationships necessary to become an inde- cooperative strategies. The banks are in the best position to
pendent network. capture and mine the data, but the data is primarily valuable
to the merchants. This situation creates an opportunity for

20 Nilson Report, 2005, Issue 827, Feb

82 - The journal of financial transformation
21 Nilson Report, 2005, Issue 831, Apr
22 United States v. Visa U.S.A., Inc., 344 F.3d 229 (2d Cir. 2003), cert. denied, Visa
U.S.A., Inc. v. United States, 543 U.S. 811 (2004), Mastercard Intl, Inc. v. United
States, 543 U.S. 81 (2004).
23 Nilson Report, 2006, Issue 850, Feb
The merchant-bank struggle for control of payment systems

and Visa can defeat the life-or-death interchange rate setting dent payment networks. Currently five banks Bank of
attacks, they will have room to settle the merchant restraint America, JPMorgan Chase, Citigroup, Washington Mutual,
suits because the restraints are not vital to the viability of the and Capital One account for 65% percentage of card issu-
card associations, just their level of profitability and market ance, and the top ten issuers account for 85%, as compared
share. A settlement might be expensive, but it is also an to 36% for the top five banks and 54% for the top ten banks
opportunity for the banks to co-opt merchants into the card in 199520. A similar story has emerged on the acquirer side.
associations. Visa has already made a move in that direction First Data Corporation is involved with over half of the
by appointing a board member of one of the merchants that nations card transactions, both directly and through joint
has initiated litigation as an independent director. ventures and alliances, while Bank of America accounts for
MasterCards IPO could also open the door for merchant another seventeen percent of the acquirer market21.
involvement in the card associations. There is nothing that
prevents Wal-Mart, Microsoft, Google, or Verizon from pur- The development of national bank brands and the consolida-
chasing a large stake in MasterCard as part of the IPO, as tion in issuer and acquirer markets has set the stage for
could individual banks looking to increase their influence in larger banks to desert MasterCard and Visa and set up their
the association. own, independent, on us payment networks. The ground-
work for bank desertions has also been laid by antitrust litiga-
Does any of this matter? tion by the Department of Justice that forced MasterCard
Do the big banks need the card associations? and Visa to rescind their exclusivity rules22. These rules pre-
The struggle between merchants and banks over payments vented issuers of MasterCard and Visa cards from issuing
costs has spilled over into business practices, litigation, cor- American Express or Discover cards. The end of exclusivity
porate governance, and corporate restructuring. Does any of means banks are not tied to dealing with one card network,
it really matters in the long run? Other developments in the thus reducing bank loyalty to particular networks.
banking industry, the changing business landscape, and the MasterCards IPO will further reduce bank incentives to sub-
emergence of new payment technologies and business mod- ordinate their brand to the card associations. Accordingly, if
els might well make the energy spent on the interchange the card associations litigation outlook is unpromising, banks
struggle all for naught. will desert them for greener pastures.

Changes in the card industry mean that the interests of indi- Already Bank of America, FDC, and JPMorgan Chase have
vidual banks, particularly large banks, are no longer aligned positioned themselves to become independent networks on
with the card networks. The Gramm-Leach-Bliley Act of 1999 the model of American Express and Discover. In 2004, Bank
allowed for greater affiliation between different types of of America purchased National Processing Inc., the nations
financial institutions and facilitated the establishment of second largest acquirer. It followed up this acquisition by
banks with national reach and brand recognition. The large purchasing MBNA, the third largest credit card issuer. These
banks are eager to exploit their new brand value and are reluc- acquisitions, which followed Bank of Americas 2003 pur-
tant to put the card associations brands ahead of their own. chase of Fleet Bank, another large issuer, have resulted in
Bank of America becoming the largest card issuer and the
There has also been tremendous consolidation in both the second largest acquirer in the country, which gives it the
issuer and acquirer markets, which has not only contributed access to both consumers and merchants necessary to create
to brand building but also positioned some banks to be able an independent network. If Bank of America were to split off
to break off from MasterCard and Visa and set up indepen- from MasterCard and Visa, it would have a 20.2% market

24 Bauerlein, V., 2006, Bank of America might create credit-card processing net-
work, Wall Street Journal, Apr. 26, B2; 83
Mildenberg, D., 2006, Bank of America ponders card to rival giants, Charlotte
Business Journal, April 14
 The merchant-bank struggle for control of payment systems

arrangements, though, PayPal commits to purchase the

receivables as an output contract. How PayPals move into brick-and-mortar processing will
work is an open question. PayPal offers an option for mer-
Transactions on PayPal can be made in a number of forms, chants to receive non-Internet payments via a virtual termi-
including payment cards. The consumer never sees that nal, for which it charges a small monthly fee. It may well be
PayPal is involved, unless payment is made with a PayPal that PayPal remains best suited for e-commerce solutions for
account, and the merchant never sees the consumers pay- small businesses rather than for the general marketplace. To
ment information. PayPals intermediary status creates a the extent that PayPal attempts to expand its brick-and-
level of financial privacy and security that makes it an attrac- mortar presence or the banks eye the e-commerce market,
tive system for many consumers, although there are issues PayPal will come into more direct competition with banks.
regarding what law governs consumers rights in PayPal Even if PayPal is unable to expand effectively beyond e-com-
transactions. Merchants are willing to use the service because merce payments, it has snatched away a developing sector of
PayPals fees are lower than that they would pay in a tradi- the payments economy from the banks by offering merchants
tional acquirer relationship. a payments solution at a lower cost than the traditional
acquirer relationships. The merchant-bank struggle over con-
By allowing PayPal to stand between them and payment card trol is ultimately about cost, and PayPal demonstrates that
networks, merchants are also able to hedge the costs of high there is room for a restructuring of payments costs through
and low cost payment systems and of premium and regular innovative business models like credit risk arbitrage through
payment cards. Rather than paying higher rates for transac- factoring.
tions on American Express cards than on MasterCards or on
Signature Rewards Visa cards than on regular Visa cards, Innovation and acquisition of innovation by the
merchants pay PayPal the same rate for all cards. In this man- card networks
ner, PayPal allows merchants to circumvent the impact of the Of course, the card networks themselves develop new tech-
card associations requirements that the merchants accept nology in-house and buy-out competitors and promising
all cards if they accept any and that they accept them at all start-ups. The card networks have significant financial ability
locations. to purchase potential rivals and thus control the development
of technology. If litigation costs drain the card networks
The first key to PayPals business model is that it presents a resources, it will be harder for them to compete on the tech-
lower credit risk than the merchants its services. PayPal has an nology front.
extensive credit history, some of the lowest fraud rates in the
industry, and an enormous sales volume. PayPals low credit A major advantage the bank networks have against new
risk allows its acquirer, Wells Fargo, to offer it an extremely would-be rivals is the high costs of creating a dual-sided net-
favorable discount rate. The second key to PayPals business work. It is not enough to sign up merchants or consumers. The
model is its funding mix. PayPal lets consumers use a wide participation of both is needed to make a successful network,
array of payment methods, some of which have very low cost and merchants are reluctant to sink costs into participating in
to PayPal and some of which have high cost. PayPal, however, a new network if consumers are not demanding to use it and
charges merchants the same fee regardless of the means of vice-versa. If technology makes the interchange/clearing
transaction. PayPals funding mix allows it to accept lower house function of the card networks less vital or if it allows for
profit margins on credit card transactions because of the cheaper formation of dual-sided consumer and merchant net-
higher profits it makes on ACH and bank account transactions. works (as the Internet already promises to do), then the card

84 - The journal of financial transformation

The merchant-bank struggle for control of payment systems

banks to expand their supporting roles for merchants. Banks small ticket merchants more amenable to card transactions.
could provide not only payment services, but also information Internet-based payment systems like AliBaba, 2Checkout,
services via targeted advertisements on billing statements, and e-Bay-owned PayPal provide payment services for mer-
direct mail campaigns, or targeted rewards offers. When chants without merchant banking accounts, and Google is
banks and merchants partner to analyze consumer data, as developing a payment system. Even within the banking
they already do in co-branding and private label credit card world, companies like FDC are developing technologies for
arrangements, they can produce highly effective marketing real-time debit and check or ACH transactions that do not
campaigns that increase advertising value. The question is depend on the existence of the card networks. Microsoft
whether banks can successfully expand this type of partner- could easily join the fray, while telecommunication and cable
ship to general purpose credit cards. Visa looks to be moving networks are in some ways well-situated for entering the
in this direction through the Visa Incentive Network, a pro- payments world, as they already have portal access to mer-
gram that allows more tailored discounts and promotions to chants and consumers and national data transfer and pro-
cardholders based on cardholder behavior. cessing networks.

To be sure, there are numerous business and regulatory chal- The case of PayPal
lenges, particularly data privacy concerns, that banks will The example of PayPal illustrates how non-bank parties are
have to address if they are to move into the information ser- using technology to step into the merchant-bank struggle
vices area. Nonetheless, the inclusion of new, bundled finan- and offer improved packages of services for both consumers
cial and information services would reshuffle pricing in the and merchants at a lower cost than the traditional merchant-
merchant-bank relationship. Increasing the size of the pie to bank-consumer relationship. PayPal is not a bank. It began as
be divided among merchants and banks could defuse the an online payment service that allowed consumers to make
merchant-bank struggle, at least temporarily. transactions using PayPal accounts. That is, the merchant
was accepting PayPals credit risk, not the consumers, and
Will technological developments mean merchants have merchants did not need to be equipped to accept payment
more options? cards to accept PayPal payments. Since then, PayPal has
Perhaps most crucially, technological developments are likely expanded to offer a full array of merchant payment services
to recast the merchant-bank dynamic. Speculation on the in all locales.
state of payment technology in five years, much less a
decade, is little more than augury, but it is hardly farfetched PayPal offers merchants a variety of services from lines of
to envision ACH networks being seamlessly integrated with credit (through GE Money Bank) to accounting. At its core,
PDAs, i-Pods, and cellular phones. The number of ACH trans- though, it is a credit arbitrage operation. PayPal arbitrages its
actions has been rapidly growing and wireless technology own credit risk to offer high credit risk merchants lower dis-
allows access to most consumer transactions. count rates than they could otherwise obtain.

Going hand-in-hand with the development of new payments The model of a PayPal transaction is that when a consumer
technology is the development of new payments competitors makes a purchase from a PayPal serviced merchant, the con-
from the non-bank sector. Aggregating services like sumer actually pays PayPal, who then relays the payment on
Peppercoin allow merchants to reduce the flat-fee portion of the merchant for a fee. PayPal is not an acquirer. Rather, it
interchange rates by aggregating several payments from a operates like a factor, purchasing receivables and collecting
single consumer into one larger one. Such services make them itself, through acquirer banks. Unlike many factoring

85
 The merchant-bank struggle for control of payment systems

networks will lose much of their advantage. Instead, they will lot like landline telephone companies that have clung on to a
be forced to compete with a broader field of payment options core business, but are becoming obsolescent in the face cel-
and accept smaller profit margins. lular and VoIP technology.

This is not to say that the card networks will not still have Conclusion
huge advantages. They have existing business relationships Antitrust suits present a significant short-term threat to
with merchants and consumers, and the trade cachet of their MasterCard and Visa and are spurring the reshaping of the
names is of tremendous value in getting the market to accept U.S. payments industry. In the longer term, however, the anti-
a new payments technology. Still, technological develop- trust threat may not particularly matter, as the growth of
ments might ultimately present perhaps the greatest threat national bank brands has created the possibility of large
to banks control over payment networks. banks splitting off and forming their own independent pay-
ment networks, while developments in payments technology
Innovation has long been a problem for payment card compa- and Internet commerce have created a competitive threat to
nies. There have been relatively little changes in cards over MasterCard and Visa. The ultimate outcomes of these devel-
the past quarter century. Some improved security features opments are uncertain, but one thing is not: the payments
have appeared, and PIN-based debit cards have emerged, to industry will look very different in a decade.
be sure. The essential concept and technology has remained
the same, however, since 1979, when electronic dial-up termi-
nals and magnetic striped cards that made payment cards an
electronic payment system and offered noticeably decreased
transaction time25. The card companies have been trying to
change this of late, with the introduction of contactless cards
that decrease transaction time and increase spending. It is
unlikely that contactless cards will be sufficient, though, for
merchants to feel that they are getting enough new value out
of card acceptance to justify increased card acceptance costs.
Unless MasterCard and Visa can offer merchants increased
payments value, either through technology or through bun-
dled information services, their businesses will start to look a

25 Aneace Haddad, 1979: Year of the Last Major Payment Card Innovation? ANEACES
86 - The journal of financial transformation
BLOG (Mar. 30, 2006).
 Institutional

The credit rating

agencies and their
credit ratings

Herwig M. Langohr
Professor of Finance and Banking, INSEAD1

Abstract
This paper is based on an address given to the Bond Market
Association in Paris in February 2006, an outsiders perspec-
tive on the credit rating agencies (CRAs) and their credit rat-
ings. It examines the CRAs valued-added, some of the chal-
lenges they face today, and the experience of other codes of
conduct. I focus on what I believe is the striking value-added
of the agencies to three of their direct constituencies: the
issuers (the purchasing clients), the investors (the main users
of credit ratings), and the shareholders.

1 The author thanks Rupert Atkinson, Managing Director at Morgan Stanley, and I acknowledge the following sources of data used in this paper and the figures:
Patricia Langohr, Professor of Industrial Organization at ESSEC, for many valuable Thomson Datastream, Financial Times financial statements, Moodys, S&P 87
comments on previous drafts of this paper, and Arindam Chatterjee (Insead MBA CreditPro.
2005) for the competent numerical solutions and computations of France
Telecoms default probabilities and related metrics. All errors are mine.
 The credit rating agencies and their credit ratings

per cent in July 2002. agement to moderating the markets. Interestingly, the rating
never went through the investment grade floor, even though
Something else that was critical to creditors happened con- several measures suggested it should.
currently. The value cushion of France Telecoms assets was
deflating. The ratio of France Telecoms market value of assets One such set of measures are default probabilities based on
to the book value of its debt the value cushion per Euro of market prices or mechanical credit scores. They are market
debt, or cushion ratio became very dynamic. This ratio had credit spreads (Figure 3), structural Merton type models
reached a comfortable peak of 4.2 by 31 March 2000. But (Figure 4), or Altman Z-scores types of models. These all
then, in just four months, it dropped dramatically to 2.1 by 31 hinted that from June 2002 through March 2003 France
July. It is worth noting that this happened two years before Telecoms near default probability was around 50 90 percent
Moodys two-notch in June 2002, which, according to Michel (depending on the metric used).
Bon, supposedly triggered FTs crisis. The ratio continued its
downdrift uninterruptedly from there. It hit the sensitive floor Another market measure is France Telecoms net market
of 1.0 by 31 March 2002 and made a hard landing of 0.5 on 30 worth, the implied market value of its assets minus its default
September. Fortunately, it quickly bounced back to start a point. The former became negative during the third quarter of
subsequent slow and gradual recovery. 2002, as Figure 5 shows. The light blue area beneath the zero
line is France Telecoms debt due within a year, and the short-
Figure 2 illustrates that the ratings first anticipated and then fall in net worth is the negative dip in 2002.
tracked the path of that critical ratio. Once the ratio had
reached its trough, the ratings stabilized, for 21 months skirt- Figure 6 shows a last indicator of the path, and the extremes
ing alongside the below investment grade level. Until the of market reaction to France Telecoms fortunes: the market
trough, the CRAs exercised a moderating influence on man- value of the put option on France Telecoms assets that the
agement, first anticipating, then feeding back to management companys creditors implicitly shorted. This put option was
that it was entering a dangerous path. But then, at a critical almost worthless until April 2002. Then, six months later,
juncture, the CRAs direction shifted from moderating man- when the time-discounted value of France Telecoms debt was
about 112 billion, it shot up to about 51billion, reducing the
overall value of France Telecoms debt by about 54 percent.
Annual volatility
The debasement of the debt rapidly and almost completely
140% disappeared within six months.
120%
100%
In order to make the different market measures of default
80%
60%
probability as comparable as possible to France Telecoms
40% long-term issuers rating, consider the following. Invert the
20% traditional ordinal scale and map it on the cardinal scale of
0% the average expected default frequency that corresponds to
8

98

99

00

01

02

03

04
r0

the ordinal ratings. Figure 7 plots the result from 1997

r9

r0
r0

g
g
c

c
c

au

ap
ap

ap
de
ap
de

au

de
de
au

Volatility of Equity (Annualized) through 2004. The fundamental credit rating cycle shows
Asset Volatility (From C program)
similar contours to the previously shown market implied
Figure 1 France Telecoms Black-Scholes asset and equity return volatility (1997-
default probabilities. But there is one distinctive difference. It
2004) is considerably attenuated, in three ways. Firstly, it starts

2 France Inc. is fuming at top rating agencies, Wall Street Journal, 20 November
88 - The journal of financial transformation
2002.
 The credit rating agencies and their credit ratings

Fundamental credit ratings: weather or

Aaa
Aa1
weathermen?
Aa2 In the CRA industry, France is infamous as the country where
Aa3
issuers complain more than anywhere else that CRAs create
A1
A2
bad weather, rather than being the weathermen who report it.
A3 In the Wall Street Journal Europe, Alcatel SA CEO Serge
Baa1
Tchuruk likened the agencies to pyromaniac firemen, while
Baa2
Baa3
Vivendi Universal SA CEO Jean-Ren Fourtou called them
executioners, and France Telecom SAs former CEO, Michel
Bon, said an unjustified downgrade by Moodys helped initi-
5

4
/0

/0

/0
/9

/9

/9

/0

/0
/0

09
02
07

06
09
06

03
12

12

ate a debt crisis that cost him his job2.

Figure 2 France Telecom: Moodys long issuer rating (1995-2004)
However, the fact of the matter is that the 19952004 rating
cycle of France Telecom illustrates exactly the opposite of
Redemption yield what Michel Bon claims. This cycle is a case of rating actions
12%
and inactions demonstrating great moderation, and of ratings
10%
8% setting themselves apart from credit spreads and changes in
6% them. It shows credit ratings conveying a forward-looking
4% perspective and degree of anticipation akin to the traditional
2%
perspective of bank credit committees. These committees had
0%
to gauge the consequences of the lending bank being exposed
9

4
/0

/0

/0

/0

/0

/0

/0

/0

/0
/9

/9

/0

/0

/0
/0

/0

/0

09
05
01

09

09
05

05
09

01

01

09
09
05

05
05

01
01

to the borrower over the whole lifetime of the loan. For medi-
FT 1993-2006 6.25%
Equivalent Benchmark Yield um- to long-term lending, the perspective taken was unavoid-
Credit Spread ably a long-term one.

Figure 3 France Telecom 1993-2006 6.25% and its credit spread (1999-2004) The bond trader tends to focus on the arrival of new informa-
tion. Anticipating this correctly is critical for dealing purposes,
regardless of how transient the information will be once it
EDF arrives. While forward-looking in his pricing decisions in the
0,9
0,8
bond market, the traders perspective is essentially short-
0,7 term.
0,6
0,5
0,4 Like many of its competitors, France Telecom was in turmoil. It
0,3
0,2 over-levered itself to finance acquisitions, and continued to
0,1
0
borrow heavily from June 2000, after the market value of the
assets in which it had invested started going down a few
8

98

99

00

01

02

03

04
r0
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r0
r0

g
g
c

c
c

au

ap
ap

ap
de
ap
de

au

de
de
au

Ratings (MKMV:Cardinal) months earlier, accelerating the downturn in its equity. Figure
Default Probability (C) [Assumed Normal] (Equation 13) 1 shows France Telecoms asset and equity volatility. Both
moved in tandem until June 2000, when equity volatility
Figure 4 France Telecom: Black-Scholes default probabilities (1999-2004) started diverging upwards from asset volatility, to about 120

89
 The credit rating agencies and their credit ratings

behavior the reasons for which might, in fact, have been

250000
excellent. It was then up to France Telecom management to
200000

150000
integrate its awareness of risk-shifting activities in optimal
100000 decision-making.
50000

0 Briefly, ratings provide management and boards feedback

-50000 about the long-term implications of the risk stance they main-
-100000 tain or alter. This long-term perspective, relative to the short-
8

98

99

00

01

02

03

04
r0
r9

r0
r0

term perspective of bond spreads, shows up in the compari-

g

g
g
c

c
c

au

ap
ap

ap
de
ap
de

au

de
de
au

Implied Market Value of Asset (BS) son between the average annual volatility of ratings versus
Default Point (C) (Moodys Definition)
Market Net Worth bond yield implied ratings. Figure 8 tabulates comparative
Figure 5 France Telecoms default points and market net worth (1997-2004)
average annual volatility statistics for 19992002.

This long-term perspective on a borrowers downside risk is

Euro Millions nothing new. Years ago, before disintermediation, commercial
150000
banks used it. They incurred the costs of highly labor-intensive
100000 credit diligence, charging the borrower for it a little bit in
50000 commission, a little bit in spread. Nowadays, commercial
0 banks for a variety of reasons have withdrawn from long-

-50000
term lending to corporations. The bond market does that now.
The CRAs have stepped into the credit diligence vacuum that
-100000
the commercial banks left, conducting in their place the costly
8

98

99

00

01

02

03

04
r0
r9

r0
r0

g
g
c

c
c

au

ap
ap

ap
de
ap
de

au

de
de
au

PV(X)
credit risk diligence on these bonds, and they charge the bor-
Market Value of Liabilities (Implied) (A) rowers for it in the same way that the commercial banks did
Put Price
on a commission basis.
Figure 6 France Telecoms debt implied short put market value (1997-2004)

Nowadays CRAs position an issuer on the long-term default

risk spectrum. Figure 9 shows the fine rating class distribu-
EDF Moodys ratings tions of issuers in the four major regions of the world on 30
0,20%
0,18% Baa3
0,16%
Baa2
0,14% Moodys Bond yield-
0,12% Baa1 ratings implied ratings

0,10% A3 Rating changes 25% 91%

0,08% A2
Large rating changes (more than 2 notches) 7% 43%
0,06% A1
Rating reversals 1% 76%
0,04% Aa3 Memo item: average number of rating 1.2 4.5
0,02% Aa2/Aa1/Aaa changes over 12 months for each issuer
0,00% that experiences a rate change
8

98

99

00

01

02

03

04

Source: R. McDaniels, President of Moodys, Annual Meeting of the IOSCO Panel

r0
r9

r0
r0

g
g
c

c
c

au

ap
ap

ap
de
ap
de

au

de
de
au

on the Regulation of Rating Agencies, Seoul, 17 October 2003

Figure 7 France Telecom: Moodys ordinal and cardinal rating histories (1997-
2004)

90 - The journal of financial transformation

 The credit rating agencies and their credit ratings

16%

14%

12%

10%

8%

6%

4%

2%

0%

Emerging Markets (total rated: 659) Europe (total rated: 1010) North America (total rated: 3198) Asia (total rated: 715)

Figure 9 Four regions S&P related corporate issuer by rating class as of June 30, 2005

going up sooner but climbs more gradually. Secondly, it France Telecoms new management team when it was working
reaches a plateau of relatively high default probability but it hard to see the bond markets opening again for France
never goes through the roof. Thirdly, it declines gradually, not Telecom in the fall of 2002. Ratings thus assess the issuer
abruptly. In other words, rating cycles are a moderating fac- from a fundamental measuring perspective, rather than from
tor, almost like central bank interest rate movements. a cyclical taste-for-risk one. They endeavor to anticipate an
issuers relative long-term resilience and staying power, rather
Fundamental credit ratings, in other words, aim to be weather- than express a view on the attractiveness of its bond prices.
men, not weather makers. They tend to keep management on
a leash when it risks running ahead of what is sustainable. Conversely, when the CRAs started to anticipate structural
They also tend to tame markets when they overshoot during weakening in France Telecoms creditworthiness, because of a
periods of irrational depression. complex interaction of different forces, they did not hesitate
to downgrade gradually, thereby acknowledging that France
The CRAs value-added Telecom was migrating from being a low-risk issuer to becom-
The value-added of CRAs to the issuers ing a high-risk one. It was not the notching down of the rat-
How valuable is all of that to issuers who pay the ratings bill? ings that changed France Telecoms risk profile; it was France
Corporate treasurers are sometimes quick to complain that Telecoms environment and expansion strategy, and the way
companies only incur these costs because they are forced to, they were financed. The rating changes were sending a series
and that credit ratings are worthless to the company. Is this of valuable warning signals to France Telecoms CEO and
really so? board of directors. These were not signals about the appro-
priateness of France Telecoms business conduct, nor about
Let us consider what the France Telecom case illustrates, as it the pricing of its bonds. They were signals about the long-
is an excellent example. In the face of market implied ratings term implications of its approach to its business development
that rated France Telecom as junk, the CRAs fundamental and financing. That the ratings went down did not imply that
perspective allowed them to maintain France Telecoms invest- France Telecoms business conduct somehow became bad. It
ment grade status. This moderating stance was a comfort to only meant that France Telecom was involved in risk-shifting

91
A3 aa1 a2 3
B Ba aa Ba1 a2 3
B B Ba B1 B2 3 C
B a-
Ca

The credit rating agencies and their credit ratings

80 observe. So we are obliged to focus on Moodys.

Default
70
rate %
60 For the period 200004, Moodys reported average ROA of
50
over 45 percent per year and average growth in EPS of

?
40
around 25% percent per year. Through 2005 it repurchased
30
20
stock worth about U.S.$1.5 billion and reached stock market
10 capitalization of around U.S.$18 billion, more than quadrupling
0 its U.S.$4 billion IPO value. Moodys is a real free cash-flow
1 year generating engine, and financial analysts describe it as one of
Rating scale 5 years
the best performing stocks in the business services/publishing
10 years
sector.
Figure 10 One-, five- and ten-year average issuer weighted-cumulative default
rates by rating category (1983-2004)
It is unclear to what extent Moodys performance is typical of
ordinal rating scales in cardinal expected default frequencies, a CRA. Figure 11 shows the stock price evolution of Fimalac,
which is similarly exponential for the same reasons. Is the McGraw-Hill, and Moodys, and some indexes from October
highly non-linear path the most useful one for bond investors? 2000 through December 2005. Is Moodys credit rating busi-
It is a useful question, and the CRAs should give it serious ness really outperforming Fitch (a business line of Fimalac)
80

70

thought before dismissing it. and S&P (a business line of McGraw-Hill)? Or are Fimalac and
60

50
McGraw-Hill internally reinvesting the free cashflows that
The value-added of CRAs to shareholders their equally well-performing credit rating business gener-

?
40

It is impossible to dismiss the value that CRAs add to their

30
ate?
shareholders as a relevant topic for discussion about the role
20

of CRAs. In corporate finance we teach that it is hard to gener- Looking at Moodys stock market history raises some interest-
10

ate sustainably valuable free cash flows that translate as

Aaa
Aa1
Aa2 Aa3
A1
A2
A3 10 Years
ing questions. Are Moodys extraordinary shareholder results
Baa1
Baa2

shareholders value-added without competitive products and just a temporary consequence of the demand for ratings
Baa3
Ba1
Ba2 1 Year
Ba3
B1
B2
B3
Caa-

services that satisfied clients are willing to purchase at a good expanding at a speed that supply cannot match? Is this mar-
price. Growth in revenues and in shareholder value could thus velous performance a competitive result of significant and
be key indicators of CRAs value-added. And that growth has sustainable comparative advantage? Does it represent a rent
been terrific and highly profitable, as publicly available data accruing to a few oligopolistic players protected behind barri-
suggest. ers to entry? Are these barriers natural or are they artificial,
the consequence of regulations that protect incumbent
Aggregated credit rating revenues of Fitch, Moodys, and S&P CRAs?
grew at a compounded annual growth rate of 14.9% during
19992004, reaching U.S.$3.9billion. What about free cash- Is it all due to the Nationally Recognized Statistical Rating
flow generation, profitability, and shareholder value creation? Organization (NRSRO) factor? Some of it, maybe, but gener-
Since 20 September 2000, Moodys has been listed on the ally NRSRO is a relatively irrelevant explanation for CRA
NYSE. It is the only pure credit rating company the stock mar- industry concentration, which existed before NRSRO was
ket plays. The results of Fitchs and S&Ps credit rating busi- introduced in 1975 and exists today in the E.U., in which
ness are confounded with those of other lines of business of NRSRO does not apply. Rather, this concentration is largely
Fimalac and McGraw-Hill, respectively, and thus harder to due to natural barriers to entry: reputation, first mover advan-

3 Partnoy, F., 2006, Take away the credit rating agencies licences, Financial Times,
92 - The journal of financial transformation
13 March.
 The credit rating agencies and their credit ratings

June 2005. By helping a company to identify its place in these to apply large sample statistical inference techniques to evalu-
distributions, in a sense CRAs provided access to global capi- ate the accuracy of ratings, and that the power of ratings to
tal markets. CRAs could be regarded as gatekeepers of the discriminate between defaults and non-defaults increases
capital markets arena. Obtaining a credit rating for a corpora- with sample size and with time. These elementary rules of
tion has become a normal, unavoidable necessity, although it inference are completely missed by Frank Partnoy when he
has also been suggested that the excess of information about claims that rapid ratings have far outperformed Moodys and
creditworthiness now means that little attention is paid to the S&P in assessing credit risks. It predicted financial distress at
rating itself and that, for corporates at least, the fine rating Enron and Parmalat well before [these agencies] downgraded
does not much matter. To borrow an analogy, a rating is like a their debt3.
nose. As long as you have one, nobody notices it whatever it
looks like. But beware of not having one. But for the segment of bond portfolio holders, the default
distributions that CRAs produce, according to several differ-
The value-added of CRAs to investors ent views, are an invaluable input for portfolio construction.
Ratings temporarily anchor the default risk of an issuer or Figure 10 shows one-, five- and ten-year average issuer-
issue in an ordinal space. They measure long-term default risk, weighted cumulative default rates for 17 fine rating categories
rather than instantaneous taste for risk. What value do these for the period 19832004. This mimics the typical default
data points on default risk have for corporate bond portfolio experience for a systematic investor over an extended period
holders? The question addresses bondholders (as distinct of time in any one of the 17 rated corporate bond categories
from short-term bond investors) and portfolio investors (as on offer in the market. These data are invaluable inputs for
distinct from event, name, or spread traders). Short-term long-term bond portfolio management, inasmuch as the fore-
investors and traders bet on singular events that unwind over casting ability of the historical frequency distributions associ-
a relatively short time span. They very willingly take diversifi- ated with the rating categories is reasonably powerful.
able risks on the basis of their beliefs. For these market par-
ticipants, fundamental credit ratings cannot be all that impor- Bond investors may find that the granularity on the left side
tant because these ratings say relatively little about near- of the scale is too fine and that it is too abrasive on the right.
term singular events. One has to bear in mind that one needs The scale offers fine nuance in default probability as the rating
goes down from Aaa to A3. But beyond that, default frequency
nearly doubles with each downward notch. One must ask
70 whether there is not excessive investing in more risk measure-
60
ment information to obtain further refinements at the left end
50
40
of the scale and thus very low marginal return and wheth-
30 er or not there would be scope for potential high marginal
20
return on investment if the right, or really risky side of the
10
0 spectrum, were better understood.
2

5
0

5
/0

/0

/0

/0

/0

/0

/0

/0
/0

/0

/0

/0
/0

/0

/0
/0

08
04

12

08

08
04

04
12

12

04

08
08
04

12
12
12

Moodys (MCO) price-close McGraw-Hill indexed to Fimalac indexed to MCO The scales might be more useful to bond investors after
MCO
broadening the bands on the left-hand side and narrowing the
S&P indexed to MCO SP500 DVSF FIN indexed
to MCO bands on the right-hand side. The distribution would then
Figure 11 Stock price evolution of Fimalac, McGraw Hill, Moodys and some Indexes probably look more like a straight upward sloping line, as
Source: Thomson Datastream and Compustat Figure 10 indicates (with a question mark). One could also map

93
 The credit rating agencies and their credit ratings

alternative forms of competition, or a state monopoly? Do barriers to entry sunk costs, network externalities, and repu-
CRAs, as a consequence, generally exercise undue rent gener- tation. Fortunately, the profit potential is sufficiently large to
ating pricing power? Are there no threats of new entrants to entice entrepreneurs who already have a toehold in the mar-
discipline the behavior of incumbents? ket to aspire to occupying larger parts of the space.

It is not essential for the public good for incumbents to be Current challenges faced by CRAs
prevented from maximizing profits subject to demand charac- Like most companies, CRAs continuously face challenges. I
teristics and the nature of competition. But it is essential that will comment on just a few of them. The CRAs legitimacy and
no artificial barriers should encumber or prevent rivals from acceptability have been questioned. Are codes of conduct the
entering, and that the large profit potential should be suffi- answer? Innovations in financial engineering and in the tech-
ciently transparent to attract new rivals (as they are at nological infrastructure of information economics are chal-
Moodys). Under these circumstances, CRA industry concen- lenging the traditional methods of CRAs. In the face of that,
tration does not need to be societally suboptimal. And rivals how could CRAs strengthen their uniqueness as an infomedi-
do enter, nibbling at the market share of incumbents. When ary? Is growth a curse for CRAs?
one compares the revenue growth of both Fitch and Moodys,
it becomes evident quite quickly that they have outpaced the Legitimacy and acceptability
S&P during the last five years. Consider the recent formation Credit ratings are part of the soft infrastructure of capital
of the International Ratings Group (IRG), creating a global markets. When they reduce information asymmetry, and are
network of independent rating agencies operating under one independent and objective, they strengthen it. When these
brand throughout emerging markets, and the recent decision qualities are lacking, they damage it. In addition, there are
of Dominion Bond Rating Service (DBRS) to launch sovereign many regulatory uses of the CRAs product that inevitably
ratings operations, expecting to establish coverage in 15 coun- affect the demand for credit ratings, possibly but not defi-
tries by 2008. nitely making that demand stronger than it might otherwise
have been. But beyond any doubt, credit ratings generate
The key is that regulators do not prevent entry or slow down public interest externalities. CRAs play a public interest role.
the entry process, as some U.S. regulations do. Indeed, there
are rent-generating artificial barriers to entry in the U.S. that How can this be managed from a societal perspective? Do
should be abolished. The E.U. deserves praise for refraining these externalities create a structural misalignment with
from intrusive and obstructive regulation. It has relied instead CRAs business conduct, from the perspective of maximizing
on the principle that the International Organization of shareholder value? There are few industries that do not pres-
Securities Commissions (IOSCO) adopted in December 2004 ent some public interest externalities, and in the financial
with respect to the reinforcement of the Fundamentals of a sector, there is not a single subsector that does not: banks,
Code of Conduct for Credit Rating Agencies4. At the heart of insurance companies, stock exchanges, equity analysis, audit-
the code is a disclosure mechanism to monitor compliance: ing, etc.
comply or explain. Rating agencies must disclose how they
implement the various provisions of the code fundamentals. The question is not whether CRAs should be regulated to
ensure they conduct their business in a way that will strength-
CRAs are profitable for their shareholders. To some extent en their contribution to the infrastructure of capital markets,
this profitability results from artificial barriers to entry in the but how to regulate them. The E.U. has decided to stay away
U.S. But it is mainly the consequence of significant natural from the issue of licensing, and from intrusive prescriptions

4 The technical committee of the international organization of securities commis-

94 - The journal of financial transformation
sioners, 2004, Code of conduct fundamentals for credit rating agencies, IOSCO,
December, 11 pages, to be found at www.iosco.org (IOSCOPD180)
The credit rating agencies and their credit ratings

tages, networking externalities, and sunk costs in the busi-

1. Rating actions should reduce information assymetry
ness.
2. Rating actions should be independent and objective
3. CRAs should pursue transparency and disclosure
4. CRAs should keep confidential all non-public information

Source: IOSCO Statement of Principles Regarding the Activities of Credit Rating

Agencies, a statement of the technical committee of IOSCO, September 25, 2003

Figure 12 Principles for the activities of credit rating agencies

Reputation
The value of a rating to the markets depends on its statistical
ability to gauge the likelihood of default. That ability and the
reputation for it result from the CRAs continuous lifting of
their learning curve on how-to-do ratings. This, in turn, repeat-
edly reasserts incumbents first mover advantages.

Networking
Market participants use the ratings of a particular CRA
because other market participants do. Issuers want a lot of
bond investors to notice their rating. Bond portfolio managers
look for complete coverage of investment opportunities.
Portfolio sponsors want to be in good company when setting
portfolio constraints. Ratings are thus full of network exter-
nalities.

Sunk costs
Sunk costs are unrecoverable and they dominate the rating
production function. Ratings are made from the labor time
spent in producing them, for which there is no secondary
market (who can sell used time?). These costs are, therefore,
sunk, and there are large amounts of them. Moodys 2004
accounts show that operating, general, and administrative
expenses represented 94.9 percent of expenses, of which
compensation amounted to about 71 percent. Capex used just
12.6 percent of total sources of cash in the period 19982004.

The nature of the credit rating business, therefore, leads to

industry concentration characterized by oligopolistic competi-
tion, as is the case of most industries with high natural barri-
ers to entry. Is this in any sense bad, or indeed worse than

95
 The credit rating agencies and their credit ratings

tective regulation. But CRAs themselves are first and fore- of the firm are not of primary importance they most defi-
most responsible for the conduct of their business on a play- nitely are. It is because an assessment, based on all currently
ing field that regulators need to keep or make as level as fea- available information of the companys future, has already
sibly possible. Transparency should, of course, be the over- been made by the aggregate of market participants, and
arching principle. reflected in the firms current market valueWe do not
assume that this assessment is accurate in the sense that its
Information economics and financial engineering implicit forecasts or future prospects will be realized. We only
Innovations in financial engineering and in the technological assume that any one person or institution is unlikely to arrive
at a superior valuation. The most junior claim on the firms
assets is equity. If the future earnings of the corporation start
1.11 The CRA and its employees should comply with all applicable laws and looking better or worse than before, the stock price will be the
regulations governing its activities in each jurisdiction in which it oper-
ates. first to reflect the changing prospects. Our challenge is to
1.12 The CRA and its employees should deal fairly and honestly with issuers,
properly interpret the changing share prices.5
investors, other market participants, and the public.

1.13 The CRAs analysts should be held to high standards of integrity, and the In other words, do away with fundamental credit analysis,
CRA should not employ individuals with demonstrably compromised observe stock prices, and extract all information that is
integrity.
embedded in them, including an issuers probability of default.
Figure 13 Integrity of the rating process

With all due respect to the mathematical creativity and rigor

of Vasiceks many highly valuable contributions to our under-
infrastructure of information economics are challenging the standing of credit valuation, and the probabilities of loss of an
traditional methods of CRAs. In the face of that, how can CRAs issuer or a whole portfolio of them, his recommendation is
strengthen their uniqueness as infomediaries? based on three fundamental flaws in thinking. Firstly, Vasicek
confounds the measurement of risk with the appetite for risk.
Nowadays, as the France Telecom case showed, there are sev- Stock prices do not only reflect expectations of free cash-flow,
eral mathematical financial models that, fed with the proper but also the market price for risk at which they are being dis-
data, extract issuer default probabilities from market prices. counted. Prices are different beasts from analysis. They play
These probabilities are highly sensitive to changing market as much in the field of appetite for risk as in the field of risk
conditions, as I indicated earlier. Agencies are now under pres- measurement. Credit analysis plays only in the field of risk
sure to show the same responsiveness in their credit rating measurement. Secondly, the purpose of credit analysis is not
actions by changing their ratings at the same speed and to the to achieve superior valuation. It is to produce relevant insight
same extent as default probabilities extracted from market in the lasting downside characteristics of free cash-flow distri-
prices change. butions. Thirdly, changes in information do indeed tend to lead
to changes in prices. But there is the other side of the coin as
This pressure started in 1984 when Oldrich Vasicek recom- well, which is that prices occasionally change independently
mended parting ways with some of the traditional credit of changes in information.
analysis. Conventional analysis involves detailed examination
of the companys operations, projection of cash flows and CRAs should have the self-confidence to dismiss any chal-
assessments of the future earning power of the firm. Such lenges that come from that corner. They should stick to their
analysis is not necessary. This is not because future prospects guns of fundamental credit analysis, undisturbed by market

5 Vasicek, O.A., 1984, Credit valuation, March 22, KMV, San Francisco, 1-2
96 - The journal of financial transformation
The credit rating agencies and their credit ratings

about how to reach a credit rating, leaving the market open to of things to do, can simply check them off without worrying
entry subject to registration and relying instead on self- about the principles involved. If something does not appear on
reinforcing transparency about respecting the IOSCO code the code list, you do not have to think about it. So there is an
about the conduct of a ratings business. This is a wise deci- issue. Is life after the code really more principled and respon-
sion, subject to three important caveats. Firstly, to appreciate sible, or less?
the impact of such codes of conduct, one has to distinguish
between two phases: the construction and initial implementa- There is a second caveat. The markets want agencies to be
tion of the code, and life afterwards. Stakeholder efforts to different from each other. There is no value-added in cloning.
construct the code in a consensual way are genuinely energiz- Just as financial diversification improves the risk-return effi-
ing. They create a period of intense re-awareness in the ciency of financial portfolios, so method and opinion diversifi-
industry. They make stakeholders take stock of what the cation across CRAs improves the mapping efficiency of the
industry is all about and develop a better understanding of the long-term default risk spectrum available in the bond markets.
minimum degree of coordination in the conduct of the busi- The markets also want agencies to innovate, improve their
ness that is required to best serve issuers and investors. In methods, and ameliorate their techniques. There is a danger
other words, they help stakeholders reach a level of agree- that excessively prescriptive codes of conduct could reduce
ment about industry standards without colluding over pricing. this ability to differentiate and innovate.
In this regard, preparation work under the guidance of IOSCO
has been highly expert and insightful. And emphasizing the The last caveat is that some provisions in these codes are
fundamentals of the industry at the beginning of the consulta- overbearing, and undermine the basic sense of self-responsi-
tion process, as summed up in Figure 12, has certainly been bility at the top of hierarchies. For example, articles 1.11 to 1.13
extremely useful. of the IOSCO code on The integrity of the rating process,
shown in Figure 13, are elementary and obvious. They state
Senior management of CRAs, fully aware of these principles, that CRAs and their employees are not above the law and that
seized the opportunity offered by the code to implement or CRAs should not recruit criminals. No code should need to
accelerate changes within their own organizations that they state this. Putting articles like these in a code, superseding
intended to make anyway. By facilitating internal change in general law, only creates an undeserved and counterproduc-
this way, codes of conduct are part of the change equation tive atmosphere of general suspicion of unethical conduct by
towards the better. CRAs. Regulators who approve such codes must remain mind-
ful of a codes subsidiarity.
But what about life afterwards? There is a real danger that
codes and regulations could undermine the responsibilities of Self-reinforcing consensual codes of conduct based on the
boards and senior management who, now that they have lists principle comply or explain are superior to intrusive and pro-

97
 The credit rating agencies and their credit ratings

exuberance or depression and by the perpetually-moving investors, the independence and expertise of CRAs reduce
pendulum of market liquidity. otherwise dangerous information asymmetries. To share-
holders in their firms, CRAs offer an attractive business
By analogy, CRAs should follow the lead of Nobel Prize win- model. Among the many challenges CRAs face, they must
ner Harry Markowitz who discovered the famous separation assume their public role through impeccable business con-
theorem in portfolio theory, which states that your appetite duct. This business is unique, and should remain so, and its
for risk should not influence the composition of your portfo- unique culture should be transmitted to ever larger numbers
lio of risky assets, but only the fraction of your wealth that of new hires.
you put in that portfolio. The composition of the portfolio is Appendix I
purely analytical, unrelated to your appetite or taste for risk. Congress Committee opens up the credit rating
Similarly, CRAs should continue to decide their rating industry.
actions, unrelated to the appetite for risk in capital markets
Herwig M. Langohr, Professor of Finance and Banking, INSEAD
or among analysts. Patricia T. Langohr, Professor of Industrial Organization, ESSEC

The U.S. House Committee of Financial Services recently adopted Mr. Oxleys
Growth version of HR2990: the Credit Rating Agency Duopoly Relief Act of 2006. This
Lastly, CRAs have been growing extremely rapidly. Could this act forces a regime change in the way credit rating agencies (CRAs) compete in
the U.S. Why? What should we expect from it?
be a curse? And if so, why?
Catastrophic default disasters struck South-East Asia in 1997, the U.S. in 2001-
2002, and Europe in 2002-2003. The CRAs only spotted these at the last min-
Credit rating is a labor-intensive activity. There are relatively ute, and the world berated them for failing to give issuers sufficient lead time
limited economies of scale in the production of ratings. As a to protect themselves from credit losses. But CRAs do not have crystal balls in
which they can see what issuer shall default when. Nevertheless, legislators
CRA needs to produce more ratings, it needs to recruit more
seized the opportunity to rein in the CRAs. Since 2002, thousands of pages of
people and provide them with the tools to work. How does a hearings, interviews, testimonies, and studies have appeared in a seeming
CRA respond to the conflicting needs to expand rapidly the attempt to exorcise the evil influence of CRAs as the masters of capital. The
committee adoption is the first concrete result at Congress level of this effort.
number of analysts they put to work on the one hand, and to
preserve a relatively homogeneous and consistent credit HR2990 is a mixed bag. It reinvents the wheel by codifying the current prac-
tices of CRAs, such as disseminating rating criteria and performance, and
analytical culture across regions, offices, sectors, products, establishing policies for dealing with conflicts of interest and non-public infor-
etc., on the other? Inevitably, the ratio of highly-seasoned mation, already well-documented on the CRAs own websites. It includes dan-
gerous features, such as granting the SEC intrusive regulatory authority over
analysts to junior ones has to decrease, making it extremely CRAs and prohibiting aggressive competitive practices among CRAs. But most
difficult to absorb incoming talent while preserving the tried importantly, it contains one unusually significant breakthrough: it abolishes a
major catch-22 in SEC dealings with CRAs. The current criterion of the SEC to
and tested fundamental credit rating culture. This presents a
grant Nationally Recognized Statistical Rating Organization (NRSRO) status to
knotty problem for the management of a credit rating a CRA to license its ratings for regulatory uses is a classic catch-22. As
agency, for which, unfortunately, I can offer no cheap or easy Chairman Shelby of the U.S. Senate put it poignantly on March 7, to receive the
license, a firm must be nationally recognized, but it cannot become nationally
solution. recognized without first having the license.

Used only once in 1975, this regulation was originally harmless. Fitch, Moodys,
To conclude, CRAs add value to issuers because they help and Standard & Poors were the first to be licensed, a much-deserved stamp of
them to be noticed and to identify their own risk profile. To approval for 75 years of successfully assessing borrowers credit-worthiness.

98 - The journal of financial transformation

 Financial

Creating real business intelligence: seven key principles for MIS professionals

Using business intelligence to develop standard measures of operational risk

Surviving the future: how operations and IT transformation can be at the core of a winning strategy

Leveraging hosted middleware services to deploy valuable new services quickly and easily

Why gut feeling is just not enough for building a successful bank?

Is competition in the financial sector a good thing?

A bad situation getting worse the U.S. banking profitability crisis

Threshold relationships among inflation, financial market development, and growth

Manufacturing growth

Corporate hedging and capital structure decisions: towards an integrated framework for value creation
 Creating real business
intelligence: seven key principles
for MIS professionals
Laurence Trigwell
Senior Director of Financial Services, Cognos Corporation

which use different schemas and data definitions, inherently ment enterprise information architectures that employ differ-
presents inconsistencies, gaps, and discrepancies when it con- ent data structures, schemas, and environments. It is impos-
solidates data from those varying sources. Inevitably, analyses sible to deploy a single database for a financial services
and strategic discussions devolve into questions about the organization, for example. The result would be an unwieldy
provenance of the underlying data. compromise. However, without proper alignment and consis-
tency of data from many different sources, business intelli-
One of the fundamental issues with these data aggregations gence efforts cannot succeed, and that is an area where MIS
is that the individual participants providing the separate data professionals must provide leadership. Based on engage-
components the department heads, customer, channel and ments with financial services firms around the world, here are
product line managers, controllers, and directors have an some best-practice recommendations for MIS professionals
incomplete view of the entire data picture. To borrow from the seeking to facilitate and strengthen enterprise BI initiatives:
clichd fable, they only see their portion of the elephant.
Conversely, the senior-level consumers of this information, First recommendation carefully define BI
such as company officers and senior executives, are left to expectations
reconcile conflicting and disparate views without any insights It is essential to think about what the end-game of information
as to the nature of the underlying data. The information lacks delivery will be who will consume the information and how
consistency, and this is unfortunate because truly strategic are they expected to act on it. This will help you align your BI
decisions cross boundaries. A simple query, such as who are design with business needs.
the most profitable customers, leads to more meaningful que-
ries such as: Banks need to think about the balance between knowing what
is transpiring in their institutions and acting on that informa-
What makes them profitable? tion. What people in the enterprise will have access to the BI
What channels do our profitable customers use most? system? What are their roles and responsibilities? Will they be
What is the ideal product and channel mix to optimize accountable for the data presented by the BI system? What do
profitability? senior managers and executives expect to see on their BI
Can we service marginally profitable customers differently screens?
and more appropriately to increase profitability?
Are we attracting customers that our competitors are It is perfectly reasonable for senior managers to demand con-
happy not to service because of the complexity of their sistent visibility across the organization, but they gain even
transactional demands and the impact on the back-office? greater confidence when appropriate information is also avail-
Are we providing services to customers that are not val- able to those in the trenches who run the business and inter-
ued? act with customers.
What is the true cost for our most popular products?
Consider how widely you want to deploy your BI system. Highly
MIS leading the BI charge centralized management teams, of course, do not need to
Of course, owing to the divergent goals of transaction perfor- worry about broad deployments. But as your BI system pushes
mance and complex reporting and analysis, banks must imple- lower into the organization you will need to carefully balance

100 - The journal of financial transformation

For MIS professionals, an enterprise-wide business intelli- systems, authorized access to the information, the extraction
gence initiative is an opportunity to play a strategic role. By of that information, manual aggregation, presentation of the
helping to set expectations, working closely with business combined information, validation from interested parties, and
units, providing technology leadership, devising new initia- a statement of the assumptions made before the information
tives, and furnishing insights into underlying data, MIS can can be used. Such an unwieldy, time-consuming, and error-
help financial institutions achieve new levels of competitive- prone process limits analysis to infrequent use for highly
ness and efficiency. strategic issues or senior-management requests.

Business intelligence: a centerpiece of optimized BI provides a structured approach for collecting, analyzing,
financial services performance and acting upon business information all supported by a
In the past 15 years, business intelligence has emerged as an foundation of sophisticated software that can aggregate, cal-
enduring component of the forward-thinking CFOs agenda culate, distribute, and securely display analyses from a variety
for numerous good reasons. Implemented properly, business of perspectives. While each implementation varies, many BI
intelligence provides unique and timely insights that can deployments feature a range of functions, including score-
directly affect strategic corporate decisions in all areas of a carding, geographical mapping, information visualization,
banking organization: finance, sales, product, marketing, IT, data mining, business planning, and end-user querying and
human resources, back office, support services, and many oth- reporting. Successful BI applications often feature visual
ers. Additionally, tighter regulation demands greater levels of interfaces that encapsulate and greatly simplify vast quanti-
visibility and control for senior management and external ties of information. Users can drill down to succeeding levels
stakeholders. of detail and discover new insights and interrelationships
among what previously seemed to be disparate data points.
In fact, IDC Financial Insights (IDC FI) has ranked performance
management, including business intelligence, as the No. 1 or Business intelligence provides the enterprise with the frame-
No. 2 issue for global retail bankers [Bradway (2005a)]. This work for maximizing the institutions existing investment in
assertion was reinforced in two more in-depth 2005 IDC FI highly tailored operational and transactional systems and
studies of more than 30 global banks [Bradway (2005a, b)]. satisfy the demand for consistent information regardless of
That research uncovered several factors and pressing issues ones role in the organizational matrix.
that underscored the need for business intelligence, including
complex ranges of business units, operations in multiple geog- It all starts with the data
raphies, multiple customer segments and distribution chan- Of course, any seasoned MIS professional knows that sustain-
nels, development of increasingly sophisticated products, and able BI systems solutions that can deliver ongoing value to
cost structures. Collectively, these create complex matrices the enterprise are predicated on the timeliness and accura-
where traditional organizational structures, systems, and pro- cy of the data feeds that populate those visual interfaces. And,
cesses struggle to provide a consistent view of performance. for most companies, that is the rub. MIS typically has informa-
For example, identifying which client generates the most tion stored in many different systems, databases, files, data
transaction income from products in two business units might warehouses, and other locations. A jury-rigged, massively
involve a manual assessment of information from separate manual process that aggregates data from different sources,

101
 Link that to an incentive program and you can start to identify in the right data feeds to accurately populate those calcula-
and change process and behavior as part of the information tions? Equally important: capturing the organizational knowl-
you are giving people. Link that to marketing investments and edge about how one performance indicator drives another.
you can correlate marketing dollars with customer return
(retention, profitability, cross-sell). It becomes much more than Seventh recommendation
a simple report about account activity and evolves into a think about new initiatives and plans
mechanism to drive client servicing strategy, account manage- Beyond a roadmap for consistently delivering accurate and
ment behavior, and maximizing the impact of marketing. timely information about what happened to the right people,
institutions also need alignment with their future initiatives
Fifth recommendation consider related tech- and plans. The first step: getting a matrix-wide view of the
nologies performance indicators (and their interrelationships) impact-
In virtually all BI implementations there are related enterprise ing the business.
technologies and systems that can dramatically enhance BI
value. For example, activity-based costing, data warehousing, When you consolidate those KPIs, think about how you can
or enterprise risk management are some of the systems that apply that data to new initiatives that tie into financial goals
manage and generate high-value data. Look beyond the classic or forecasts. Now, take it to the next level by anticipating and
application silos that are typically purchased and deployed controlling what will happen. This means disciplines, such as
tactically to get information that has strategic value. Too often, business planning, financial planning, budget creation, and
companies think about operational/transaction silos first and forecasting, which collectively raise the strategic profile of
the reporting and analysis needs later. MIS has to be a leader business intelligence. That might mean more effective use of
in changing that sequence. For example, one European invest- budgets for existing initiatives or larger plans that extend to
ment bank had all the systems it needed to service and execute acquiring a wealth management business in a new region. For
the demands of its customers. The systems had been carefully example, if the bank is about to acquire a wealth management
selected specifically for this purpose and highly skilled practi- business in Eastern Europe, how will the bank unlock the value
tioners and technologists invested significant intellectual capi- of that investment by appropriately driving more revenues
tal optimizing the services offered. However, understanding from those customers or increasing customer retention?
the fully costed profitability of that customer required complex Inevitably that is going to require an aggregated business plan
cost allocation for a range of services, such as direct transac- that links strategic objectives with performance measures.
tions costs and third-party fees, funding, commission, client
T&E, research costs, IT, and back-office. Whether it is a new initiative or deriving greater value from
existing assets, taking an understanding of what drives
Sixth recommendation measure what matters improved performance in a particular geography, customer
Make sure your BI initiative is designed to measure the met- segment, or product and incorporating that into the appropri-
rics that matter most up and down the organization. For ate investments, plans, forecasts, and budgets is proven to
instance, scorecarding the use of simple stoplight charts is deliver improved ROI. This allows finance to manage the gap
a popular and proven BI strategy. But does your BI solution between the planning process and actuals without wrestling
scorecard the right things? Have you identified the right key control away from the business manager.
performance indicators (KPIs), the ones that drive divisional
and enterprise performance across geographies, business Conclusion
units, channels, and products? And have you properly mapped For MIS professionals, business intelligence represents an

102 - The journal of financial transformation

conflicting expectations and requirements. That means not What would a sensible first-phase delivery look like? Try to
only delivering information to less-senior staff members, but reach a critical mass of useful value to generate initial
also understanding how capable those lower-level managers momentum. However, be careful of success! Although you
are at consuming this information and making decisions. Are may have carefully assessed the organizations stated appe-
they empowered to act on what they see? If not, is there a use- tite for information, often there is a latent, pent-up demand
ful purpose in presenting that information? Clarity here will that surfaces quickly once a successful BI system begins to
pay dividends. For example, one European bank is distributing have impact. Once decision makers see the kinds of informa-
daily customer reports to its relationship managers that reflect tion BI can produce in one area, they usually can immediately
the performance measurement criteria and expected behav- think of dozens of other strategic uses for the system. That
iors. This does not include analysis capability. Conversely, the can quickly fuel a rapid expansion that you need to be ready
larger corporate banking account teams receive analysis tools for.
to identify profitable product/service mixes.
Fourth recommendation work with business-
Second recommendation take stock of your unit owners
current corporate MIS landscape Owning and managing the data that populates BI systems is
Before embarking on any BI initiative, first assess your cur- only effective if MIS understands what data is valuable to
rent data processing environment and your enterprises data users and why. The key strategy here is to forge strong part-
capabilities. Do you have the information you need to popu- nerships with the business units to understand the strategic
late a BI system with useful information; information that (not technical) issues, and the business and performance chal-
people will want to see and that has a high likelihood of yield- lenges so that you can make meaningful contributions that
ing valuable, strategic or operational insights? What aggrega- effect the most positive changes. It could be as simple as
tion mechanisms, a crucial enabler of BI, are in place to pull understanding the inputs into product margins or customer
all of the vital data together and index it in a uniform format? profitability. It might involve gaining a truer understanding of
Do you have the infrastructure in place today to deploy BI to back-office efficiency and third-party servicing costs. It can
the right people? involve gaining a deeper understanding of market-share goals.

Does the organization have the definition of the right metrics? This partnership ideally involves a series of mutually agreed
Is revenue the right measure? For example, an investment upon milestones that create demonstrable proof points, ongo-
banks use of production credits ensures a consistently ing validation of the deployment project, and lower risk. A
defined and calculated value measure to support a single view journey that involves multiple small steps has a much better
of the customer or channel across multiple products. This is a chance of success than a three-year, all-or-nothing project
critical area for obvious reasons and one that often comes cycle that carries too great a risk of ending with a thud.
under scrutiny from colleagues. Increasingly we are seeing
the CFO and CIO play critical roles. These key players must Start with simple milestones that deliver basic value. For
demonstrate transparency and have sufficient muscle to example, a business banking account manager might receive
stand by the results. simple customer information account status, credit utiliza-
tion, or product and services offered. Next, you might want to
Third recommendation beware of success provide service metrics to business banking managers which
In many instances, phased deployments can be a sensible account managers have the best rankings, customer retention/
approach; there is no need to have it all in place on day one. profitability, crosssell/up-sell performance, or productivity.

103
 ideal intersection of technology and business strategy that
can drive new levels of performance for financial institutions.
By injecting itself into a central role, MIS can be both a tactical
facilitator (through its ownership of data and technology) and
leader of a strategic process that can yield significant com-
petitive advantage to the institution.

References
Bradway, B., 2005a, Performance management drives improvement at U.S. Banks,
Financial Insights, an IDC Company, December
Bradway, B., 2005b, Performance management drives improvement at European
banks, Financial Insights, an IDC Company June

104 - The journal of financial transformation

Using business intelligence to
develop standard measures of
operational risk
Jill Eicher
Managing Director, Adaptive Alpha LLC
David Ruder
Managing Director, Adaptive Alpha LLC

Operational risk is now a key concern of constituencies within enhance performance and better manage and mitigate risk by
the asset management industry. One driver of that concern is strengthening the operational infrastructures of their firms.
the realization that as investment strategies of hedge funds As the investment industry becomes more competitive, the
and traditional asset managers become increasingly complex, effectiveness of an asset managers infrastructure becomes a
the underlying operational infrastructures supporting those strategic differentiator not only for the managers themselves,
strategies may be inadequate or underresourced, thus increas- but also for their clients and counterparties. At some point in
ing the risk associated with the asset manager. More concern- the near future, institutional clients will require asset manag-
ing for many, however, is that constituencies in the asset ers to demonstrate the effectiveness of their infrastructure in
management industry, including asset managers themselves, order to be hired to perform complicated derivative transac-
are generally in the dark about the strengths and weaknesses tions or pursue a multi-strategy approach. Likewise, counter-
of operational infrastructures. party risk will be evaluated not only in terms of a counter-
partys financial balance sheet, but also by their ability to
Currently, asset managers are evaluated by investment per- execute, clear, and settle transactions.
formance and risk via standard measures, such as Sharpe
ratios and VaR, but there are no comparable standard mea- With standard measures of operational risk and performance,
sures for operational performance and risk. As a result, the objective operational evaluations of managers and counter-
majority of the quantitative evaluations of asset managers are parties are possible. There are other benefits as well. One is
focused on investments, while operational evaluation is large- that managers can make better business decisions about their
ly anecdotal. It is a well respected axiom that you cannot man- infrastructures and improve the management of their opera-
age what you cannot measure, and the lack of standard tions. Another benefit is that direct comparisons can be made
operational measures has led many industry constituencies to between managers on the basis of performance and risk.
reach the erroneous conclusion that operational risk cannot Ultimately, though, the most compelling benefit is that man-
be measured or managed. agers and counterparties with the soundest operational infra-
structures will be able to warrant premium pricing for their
Fortunately, with advancements in the understanding of busi- services.
ness processes and business intelligence technology, the
development of operational standards is now possible. There Limitations of current approaches to operational
is a vast supply of operational data that can be used to quan- risk
titatively evaluate operational risk and performance in a stan- There are currently two widely adopted approaches to under-
dard way across the industry. To start developing industry standing operational risk: standard due diligence of asset
standards, however, the industry must embrace a new managers, via interviews and surveys, and the Basel II focus
approach to operational risk. on capital-at-risk. Each serves a purpose, but neither was con-
ceived to lend themselves to the development of industry
The case for operational risk standards standard measures.
It has become conventional wisdom that asset managers can

105
 Due diligence moment in time. This process, however, is compromised by its
The primary focus of due diligence practices today is on the labor intensive and subjective nature, as well as an inability to
investment strategy and performance of an asset manager, provide continuous monitoring. Ultimately, the most efficient
not the operational infrastructure. In fact, most due diligence and objective way to understand operational performance and
processes involve only a cursory examination of an asset man- risk is through the continuous, automated measurement and
agers infrastructure through interviews and/or written sur- evaluation of operational business processes.
veys. This examination generally is performed when a man-
ager is hired and then on a periodic basis. Due diligence is The Basel II approach
often outsourced to intermediaries, such as investment con- Under the Basel II initiative, significant efforts have been
sultants or funds of funds with limited operational knowledge. made to appreciate the impact of operational failures on capi-
Thus, from an informational standpoint, the due diligence tal, and these efforts have advanced the industrys under-
process as it exists today has severe limitations to achieving a standing of operational risk. Through the development of loss
quantitative estimation of operational risk. To begin with, event databases, banks have adopted practices crafted to
scant verifiable data is collected that pertains to operational effect a continuous monitoring of operational risk as it relates
performance and risk. What can largely be learned from sub- to capital loss. This approach has made it possible to assess
jective interviews and written questionnaires are whether how often certain types of operational failures have occurred,
elements of an operational infrastructure (such as a portfolio and the negative impacts or losses that stemmed from them.
accounting system, trading system, or risk management sys-
tem) are in place and whether operations personnel are on The lessons learned from these databases, however, are lim-
staff. Additionally, conventional due diligence provides a snap- ited to their impact on capital loss and stop short of providing
shot at one point in time and precludes ongoing monitoring of firm-wide perspective and insight related to risk either inter-
the stability of the asset managers infrastructure. nally (to managers) or externally (to investors). Basel II compli-
ant firms are able to categorize losses by type, frequency, and
Another limitation of the due diligence process is that there is impact, and new sophisticated models (incorporating tech-
no way of verifying the adequacy of the asset managers infra- niques such as binomial distributions, probabilities, and
structure in terms of its support of the managers investment Operational VaR) enable them to project what types of losses
strategy. Because of the standard ways for measuring perfor- might occur in the future.
mance, a managers investment returns can readily be ascer-
tained at any moment in time; however, there are no mecha- The strengths of the Basel II approaches relate to efforts to
nisms in place for a corresponding evaluation of operational create a continuous monitoring of operational failures and
effectiveness. An asset manager can believe that everything their impact on capital. The weaknesses relate to the data that
is running well from an operational standpoint and communi- is generated by these approaches, which falls short of inform-
cate this during a due diligence process, but the actual levels ing managers and investors of the soundness of operational
of operational performance and risk will only be known to an infrastructures.
investor should an operational failure occur and result in a
loss to the investment portfolio, which is when it would be too Loss databases and capital-at-risk modeling emphasize under-
late. standing the potential exposures of operational failures rather
than the prevention of failures. As a result, they can be useful
At best, a thorough due diligence assessment can reveal high- neither as proactive management tools nor as industry stan-
level deficiencies in an operational infrastructure at one dard measures. At the heart of these approaches are assump-

106 - The journal of financial transformation

tions or subjective assessments that preclude standardization tion and analysis of business process data from a myriad of
and therefore, comparison. The calculation of potential loss systems. Business process data that it is drawn from the sys-
events provides no insights into the actual level of operational tems of the firm lends itself to objective analysis over time on
performance or risk of asset manager infrastructures. From a continuous basis. Most importantly, with the objective mea-
the perspective of an investor or asset manager, understand- sures that emerge from business process analyses, industry
ing what could be lost is not as imperative as preventing the standard measures can be introduced and the operational risk
opportunity for loss. and performance levels of asset management firms can be
compared.
Using business intelligence to create a common
denominator
Ultimately, the greatest weakness of the current approaches
to operational risk is the lack of a common denominator upon
which constituencies in the industry can agree. This deficiency
precludes objectivity, verification, and most importantly,
industry standards. Without common denominators, there is
inconsistency and confusion as managers and investors dis-
cuss operational risk.

The solution to this problem lies within the understanding and

monitoring of business processes. All asset managers use
business processes to run their businesses, whether it is for
generating a research idea, executing a trade, or settling a
transaction. Tracking and monitoring the consistency and
performance of these business processes can generate pow-
erful insights into the operational performance and risk of
asset managers. For instance, if a manager has a 90% success
rate in settling credit default swaps transactions one month,
but that rate falls to 75% the next, one can surmise that there
might be a problem in the settlement business process. If
these transactions are left as open positions and not resolved,
then operational risks have increased. Conversely if the credit
default swap settlement rate increases to 99%, one could feel
confident that the business processes supporting credit
default swaps are sound.

Measuring and monitoring business processes is not only

achievable, but has been a key competitive driver for manu-
facturing and outsourced service providers in a variety of
industries. There is a large and growing market for business
intelligence applications, and technologies exist for the extrac-

107
 Surviving the future: how
operations and IT transformation
can be at the core of a winning
strategy
Crispian Lord
Managing Principal, Capco
20 3
96

20 9

02
98

20 1

04
97

00

0
9

20

20
19
19
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differentiation. Competitive costs and quality service will con- er than on the customer, as well as a reliance on people
tinue to be factors that are important, but are more likely to with product, firm, and infrastructure knowledge to com-
be prerequisites to merely stay in the game. A clearer strat- plete any transaction.
egy that focuses on areas of real differentiation be they by Unstructured and complex interactions with sourcing
market, product, or customer segment are more likely to be partners poorly executed outsourcing and service level
winning overall strategies. agreements and a lack of definition of interaction points.

Clearly the overall strategy is imperative, but within opera- These factors make institutions inherently slow to respond to
tions and IT, the engine room of the bank, there lays the change either from competitors, new entrants, regulations, or
potential to truly out compete the competition. Banks today macro trends. An example in the U.K. was the introduction of
are a product of the last 30 years of operations and IT trends, the offset mortgage more than six years ago. The response to
and suffer from a number of challenges: the introduction of this product was slow and one of the
Legacy infrastructure the spaghetti of applications larger banks took the step of acquiring the institution that
supporting specific products and functions with various introduced it. Other banks have either introduced a competi-
point-to-point and network connections. tor product, but rely upon poor quality workarounds which are
Poor overall MIS limited visibility of end-to-end product obvious to the customer, or have been unable to launch any-
profitability and multi-dimensional drill down on cost driv- thing at all.
ers.
Business unit silos and reliance on specialist knowl- Furthermore, the engine room is focused on cost reduction
edge continuing business and product-based focus rath- and has sought to achieve this by taking each new product
and seeking scale benefits through automation and standard-
15.000 izing processes. If we look at this product silo mentality in
detail we find that it is often not successful at reducing costs,
10.000 as these cost mitigation exercises are gradually eroded by
changes from the front office. This phenomenon is shown in
5.000
Figure 2, which illustrates the effect of front office pressure to
0 deliver additional client requirements, such as one off work-
arounds or special servicing requirements for certain clients.

European institutions average cost/income ratios

The net result is an upturn in the unit costs to accommodate
US Institutions average cost/income ratios these additional client service requirements.
Europe
USA
As well as the additional client fulfillment costs there is a gen-
Figure 1 Historical graph of cost/income ratios and number of banking institutions
eral layer of waste within the organization that arises from
Source: FDIC (Commercial banks only), OECD, Capco analysis exception processing, duplication of activities, and inefficien-

108 - The journal of financial transformation

Why is your bank at risk? used to provide domestic banks is breaking down through
In most markets, banks have faced some form of competition globalization and supra-regional initiatives. The most obvi-
from local competitors and whilst some executives continue to ous evidence of this is in the European Union where the
characterize their market as difficult and competitive they E.U. Commission is becoming almost apoplectic with the
are not faced with the type of competition that impacts many industrys progress towards breaking down the national
other industries. The barriers to entry of the banking market, borders. The forcing through of the ABN AMRO bid for
in the form of regulation and the need to establish credibility Antoveneta may have turned the tide in this area and
and trust, as well as the distribution network requirements, I would expect to see further initiatives from the
have limited the success of new entrants. Evidence here Commission around topics, such as SEPA, and a general
comes from the limited success of many of the e-banks and acceleration of progress as the Lisbon agenda deadline
the lack of penetration of the supermarket banks in the U.K. In approaches in 2010.
reality the competition that the industry has faced has been Cross-border competition The regulatory changes men-
limited and has tended to come from within its own market. tioned above facilitate increased cross-border competition
Where banks have been taken over it has been because they and the scale players will increasingly be looking further a
have been inefficient and the result has been a focus on con- field to diversify revenue streams and to improve efficien-
solidation and efficiency, especially given the limited top line cies through scale. Additional drivers, such as the fact that
growth potential in the major players developed markets. some of the large U.S. banks are reaching the regulatory
limit of holding 10% of the total U.S. bank deposits,
The focus on consolidation and efficiency has resulted, over increase the likelihood of cross-border M&A activity as
the past decade, in the decrease in the number of institutions these banks seek growth outside their local market.
in the European banking market, by an average annual rate of As a result of these trends I would expect to see the death rate
5%. In the U.S. and other markets we see similar trends. So of banks double and then triple over the next 5 and 10 years,
whilst some banks have succumbed to this relatively benign respectively, and that this trend will probably be on a logarith-
level of competition, the death rate is likely to increase for mic basis as the impact will create its own momentum. So,
three reasons: how can you ensure that your bank is one of those that will
survive and how can operations and IT facilitate this strategy?
Efficiency trends There is a widening gap between the
cost/income ratios of the top quartile banks (44.9%) and The survival strategy
the average bank (58.7%). As consolidation increases this The overall strategy of the bank is crucial in terms of focusing
gap is likely to get larger and will be the focus of the larg- in on how it can successfully compete in this future environ-
er scale players. Furthermore, with Wal-Mart intent on ment. How will it differentiate its offerings in products that are
entering the industry we could see a new player that difficult to differentiate? The latest view appears to be that we
might target a ratio in the low 20 percentiles? can all differentiate on service hardly most banks core com-
Regulatory change The protection that local regulators petency but if everyone targets this area then there is no

109
 Unit ing model with location independent supply chains. In one
cost
institution 40% of the cost base was taken out during this
Economies driven by scale can stage whilst at the same time the underlying technology infra-
be offset by the increased cost
of satisfying unique client structure was retained through the establishment of a layered
demands that cannot be
fulfilled through existing pro- architecture.
cesses

Elements of alignment continue to be critical as the program

Additional client
fulfillment costs begins to develop the operating model. It is critical that the
Economy of interaction points with the front office are established and
scale
Costs attributable to lack Cost of
operate effectively. The front office needs to be involved in the
of automation and inefficiency
processing exceptions planning, initiative selection, change roll out, and funding
Scale
decisions. The development of a client layer that can focus on
Figure 2: Illustrative view of the challenge faced by Ops & IT when trying to reduce
business unit needs and ensure that they are fully involved
product processing costs and understood is one way of facilitating this process.

Once control and scope is established, the alignment phase Transform

focuses on the evaluation of the areas for potential value The transform phase will begin in earnest as the value release
release through the establishment of a baseline fact base phase begins to deliver the synergies. This phase is focused on
which will be critical in defining the business case for the next the deep transformation of the operations to one that is agile.
phase. It will also provide the baseline from which quantified We believe that there are three themes around which an orga-
benefits can be demonstrated as the operating model chang- nization can focus when facing the challenge of this phase:
es. Clearly identifying and quantifying these benefits is critical Engineering operations Bringing the philosophy of
if the change program is to receive senior sponsorship and leading service and manufacturing companies into opera-
funding. tions. This focuses on the reevaluation of operations
through the use of engineering concepts as demonstrated
Value release in other leading organizations. Initiatives in this area will
The value release phase is focused on consolidating control by begin to evaluate the unbundling of value chains and the
delivering savings. It is important to demonstrate quick wins creation of horizontal scale at a functional level. In addi-
or success nuggets to prevent opponents seeking to destroy tion, a focus on the operating model should seek to
the operating model concept through typical anti-centraliza- ensure that the transition to a client and commercial ori-
tion rhetoric. Ideally these savings would utilize some of the entation is firmly embedded within the culture.
transformation thinking around engineering, but the length of Dynamic sourcing Building an effective dynamic and
time required to embed the deep change will typically mean responsive global operations sourcing strategy. This is a
that synergy capture will focus on areas such as offshoring, fundamental shift towards supply chain management and
system consolidation, and de-duplication of some functions. requires these types of skills to facilitate the establish-
The initiatives that begin to deliver later in this phase and ment of continuous monitoring and benchmarking of ser-
facilitate the transform phase include reengineering the archi- vice cost, quality, and control. The organization develops
tecture using workflow, both light and heavy versions, as well the ability to work closely with partners that can deliver
as service orientated architecture concepts and distribution elements of the value chain at a lower cost and higher
technologies which are key enablers to creating a manufactur- quality because of their focus on this service.

110 - The journal of financial transformation

cies. The overall result is an engine room composed of a large pates the customers strategies and demands, and has scale-
number of these types of single product focused sets of pro- able and flexible processes, as well as the adaptability needed
cesses that are tightly linked and create an architecture where to deliver change in a time period that delivers competitive
it is difficult to reduce cost. Most importantly, and this is the advantage to the bank. A transformed organization would be
key point, the organization lacks the agility to respond to big- able to operate like a Toyota with multiple manufacturing
ger picture change, such as new products or market entry hubs spread across the globe that can deal with change
opportunities, as well as the need to quickly absorb acquisi- because the process components are so well understood and
tions whilst retaining customers. can be deployed across multiple products. Supply and demand
are understood and controlled through detailed MIS so that
So what would agility mean to a bank and how would it deliver spikes in demand can be load balanced across different teams
competitive advantage? If the banks board had the ability to and even locations. The supply chain is run like a manufactur-
look at the portfolio of products, markets, and business lines ing supply chain with the connection between internal and
it owns and then assesses profitability trends it would look at external suppliers practically seamless and the MIS provides
the opportunities and threats and decide to exit or enter dif- the ability to continuously benchmark and switch between
ferent aspects of its portfolio. Imagine a situation where it them.
could quickly divest a product and launch a different one in
weeks, visualize a bank that could bolt on an acquisition in 6 Making transformation happen
months rather than 3 years, or enter a new market in a couple Is this the sort of thing that can be delivered tomorrow?
of months. Perhaps not, but this is a strategic vision of the end state and
the journey to get there is as important as the vision. A useful
What would this look like in terms of operations and IT? way to look at this journey is through three phases:
Essentially, the concept of transformation is the creation of
an agile operations and IT organization, which involves a fun- Alignment
damental shift to something that is closer to a modern manu- The alignment phase is about bringing together a sufficient
facturing concern. Ops & IT becomes an entity that funda- proportion of Ops and IT around a shared services model and
mentally understands its customer (the front office), antici- under the same governance.

Critical to large scale transformation is obtaining sufficiently

senior level sponsorship, almost certainly meaning board
Focus

Transform level. This provides the top cover required to establish suf-
ficient scope for the program, as this needs to be sufficiently
Value release large so that real scale can be achieved when identifying

ion
s synergies from the different sets of Ops and IT within the
rat
Alignment g ope group. The extent of Ops and IT included from the various
in
orm
nsf product lines and business units (i.e., how close to the cus-
Tra

tomer is considered operations) is a matter for each indi-

vidual institution and will inevitably also depend on the
strategy of the firm (i.e., there may be plans for certain areas
Time
to be divested).
Figure 3: The three phases of the transformation journey

111
 cess may not even have or need a quality control point as a result.

At the core of the cultural challenge is the need to focus operations staff on bad
news meetings rather than good news meetings. Operations should be about
focusing in on waste, the failure points, and quality control problems to continu-
ously improve. This starts to move operations more towards the manufacturing
environments of companies like Toyota and the goal of professionalizing the
workforce.

Results
LTSB have not used armies of consultants or hired great swathes of manufactur-
ing experts to undertake the Lean program. Indeed, there are a large number of
people who claim to be experts in this field, but these are typically just six sigma
experts and are often from finance or financial services companies, and not from
real manufacturing backgrounds. LTSB have utilized the experts that they have
recruited by asking them to work closely with the workforce to get them to look
at their jobs differently. The results have been impressive:
Quality A Lean process places the customer at the centre and seeks to
ensure that the end output is a positive customer experience. This is resulting
in increased customer satisfaction amongst clients and much improved pro-
cess sigma scores.
Effectiveness Typically LTSB is generating double digit (15 30%) cost
savings over a 12-month period in each of the areas where Lean has been
deployed.
Adaptability This would appear to be reduced as the Lean process seeks to
create standard repeatable processes. However, LTSB have found that the
workforce have much more control and understanding of their processes as a
result of Lean and when new products or processes are required they are
looked at through Lean eyes, i.e., they are rapidly industrialized and estab-
lished.

Whats next?
Lean continues to be rolled out across the LTSB group and there are a number of
areas that are yet to be targeted. In the longer term the team at LTSB believes
that the next step will be improving the componentization of processes and
releasing the value that can be achieved from this level of process break down. In
addition, they are seeing signs that suppliers are improving their business and
technology process offerings. Although the environment for rolling out fully
dynamic sourcing is not there at this point, they believe that this concept will
offer substantial opportunities for operations in the future and are already pilot-
ing some of these ideas.

112 - The journal of financial transformation

 People Tooling, developing, and motivating people to Appendix I Case Study: Lean manufacturing at
design, deliver, and share best practices for operations. Lloyds TSB
A fundamental shift needs to take place from an organiza-
Why lean manufacturing?
tion that has process and product specialists to one where
Lloyds TSB (LTSB) has been successfully utilizing lean manufacturing concepts
engineering evaluation, design, and change are core skills. over the last few years and its use is spreading across the group. The adoption of
In addition, the importance of having people that can Lean was driven from within the organization through the trialing of the tools
during the consolidation and centralization of the branch network back offices.
operate in a commercial way and treat the front office as As the benefits of the approach became clear and created incontrovertible
valued clients also requires skills that are not typically examples of improved effectiveness, LTSB operations began to recruit a small
group of experts to work with project teams and operations staff to tackle some
available within operations. Initial competency mapping of the issues it saw within the bank:
and gap analysis versus future requirements are often a The need to professionalize operations Typically an organization will pick
specialists to undertake certain functions, such as marketers for the market-
first step in this area. ing department, accountants for the finance department, etc. In the banking
industry the operations area has typically used bankers and asked them to
run and operate the processes. Although these people have typically done a
Conclusion
good job, they are not professional operations staff who would approach this
The trend in the bank death rate is likely to increase over the role in the same way as a manufacturing engineer or an operations specialist
next 10 years and merely tinkering with the strategy and would.
The need to increase effectiveness Lean manufacturing is in some
implementing a cost efficiency exercise is unlikely to prevent respects the wrong word as it has connotations of efficiency and cost savings,
a bank from becoming one of these statistics. Operations and which are the usual focus of operations programs and create distrust
amongst staff. Instead, LTSB has focused on the effectiveness improvements
IT can be at the core of the survival strategy by delivering the that Lean can bring to a set of processes. The various tools of Lean are used
kind of agility, flexibility, and adaptability a bank requires to to identify process standardization opportunities and better ways of creating
the output so that the end result is an improvement in relative cost due to an
obtain a competitive advantage. It is only through transforma- increase in output.
tion that this can be delivered as the end state is a fundamen- The need to create more shelf space and offer better customer service
Competing in the current environment means differentiating by delivering
tal shift in mindset, structure, and capability.
better products and, perhaps more importantly, offering the best customer
service. Lean provides this by rationalizing the operations required for exist-
ing products and workarounds, as well as reducing the likelihood of poor
end-customer experiences through improved processes with embedded qual-
ity controls.

Making it happen
LTSB operations team believes it was critical to create a shared sense of owner-
ship between the operations teams and the business. On more recent projects,
Lean has become embedded and driven by the business, and the selection of a
senior high flyer to lead the initiative has sent a clear message about the organi-
zations commitment to the program.

As with many of these types of initiatives, the key has been in changing the cul-
ture of the organization. Process owners like to think that their process is very
different and difficult. Challenging this with the tools that Lean provides is the
first step towards the end goal of standardized repeatable processes. It also chal-
lenges the quality control approach that is typified by a banks processes, for
example, the quality control aspect may happen towards the end of the process
at the customer touch point or not at all. Lean seeks to embed the quality con-
trols within the process, as well as identifying the cause of problems to ensure
that defective outputs are minimized towards zero defects and any that arise are
rapidly corrected long before the end of the process. Indeed, the end of the pro-

113
 Leveraging hosted middleware ser-
vices to deploy valuable new ser-
vices quickly and easily
Gailanne Barth
Global Practice Leader, Easylink Services Corporation
Henry Bayard
VP Strategic Initiatives, Easylink Services Corporation

but it should be. projects, i.e., no stranded capital if the project does not work,
quick time-to-market, and added flexibility. Financial institu-
Hosted middleware can help tion product managers looking to create new value for cus-
However, this situation is beginning to change. One of the tomers can focus more on the information asset to be lever-
technological approaches being used to drive growth in addi- aged and how to best package it for customers than the cur-
tion to cost savings is hosted middleware services. We are all rently daunting tasks of navigating internal IT governance of
familiar with middleware. In simple terms, middleware denotes project resources needed to build the systems to deliver it.
a range of interoperability technologies (software, servers, Not to be underestimated is the advantages hosted middle-
APIs, etc.) that support application development and delivery ware provide product managers in developing and deploying
enabling integration among disparate systems/infrastruc- point solutions for segments of customers focused, high-
tures. Today, financial institutions are moving to distributed value projects that all too often fall by the wayside because IT
Unix-based or Linux-based environments deploying grid com- resources are substantially consumed by larger, longer-cycle,
puting and Service Oriented Architecture (SOA); expanding farther reaching projects. Most of the recent projects we have
their ability to scale applications. Complementing this infra- seen with our large financial industry clients have been of this
structure is middleware which allows the interoperability of type something people have wanted to do for a long time,
information and customer. Middleware is fast becoming part but traditional resourcing and deployment models could not
of the DNA of financial institutions and they are using it in a deliver. Additionally, hosted middleware solutions provide
myriad of ways, such as, as a key architectural component to transparency, especially during the implementation phase of a
integrate complex IT infrastructures and as a tool to acceler- service. End-users enjoy a hassle-free implementation, afford-
ate delivery of new products and services to leapfrog com- ing financial institutions a customer-friendly new service.
petitors. Middleware is the glue between diverse applications, Transparency also reaches into information flow and business
i.e., databases and web servers. Middleware takes many forms processes; providing value add in an ever increasing regula-
that of enterprise solutions, and as application service pro- tory environment.
viders (ASPs), which give global reach to information and
Figure 1 Fueling growth bridging content and customers
customers.

Hosted middleware services take this functionality a step fur- Engineering growth by bridging content and
ther by delivering these capabilities on high-capacity, secure, customers
highly configurable infrastructure deployed in a hosted envi- Enterprise-based middleware and hosted middleware solu-
ronment. The benefits to financial institutions are that it has a tions are allowing financial institutions to be nimble, avoiding
very fast time-to-market with little or no upfront capital complex, protracted integration projects, managing costs, and
investment, a usage based pricing model, and deployment and accelerating time to market. For example, in the face of heavy
maintenance responsibilities are shifted to the service pro- competition, financial institutions are rolling out new types of
vider. As such, hosted middleware services take the risk out of financial products and services (like derivatives, hedge funds,
expensive data integration and new product development etc.) implemented on a fast track with minimal infrastructure,

114
Financial Institutions have an unutilized strategic asset in the Consider for a moment the strides taken by the travel industry
information that lies dormant, or worse yet, trapped inside over the course of the past several years in providing much
complex IT infrastructures. At the same time, their customers more convenient and useful access to information, such as
are becoming increasingly accustomed to having ready access multi-carrier flight schedules, single session booking for air
to information and being notified/informed of information and travel, hotel, car, and even special event booking, online
developments in other areas of their business and personal check-in, SMS notification of flight delays, and even e-mail
lives. Financial Institutions are starting to find that they can itinerary distribution to the person picking you up at the air-
harness information technology to tap this unutilized asset to port. Until a few years ago much of this information was simi-
introduce new, innovative products, better satisfy customers, larly locked away in disparate legacy infrastructures, with
and fuel business growth. Infrastructure

Hosted
Background middleware
services
Infrastructure
Financial institutions have employed multiple business models
Information silos

to achieve growth by merger-acquisition, outsourcing/

Multiple
insourcing, white-labeling, etc. each of which has contribut- Infrastructure products/services
Enterprise
ed to the creation of a complex IT infrastructure. More often middleware

than not, this infrastructure is wrapped around siloed busi-

ness services that access disparate technology platforms and Infrastructure
Hosted middleware services attributes
legacy systems. Keeping these systems running and making Middleware attributes
Interoperability
Pre-existing
Pay per transaction
Flexibility
them more cost efficient has been the technology focus of Time to market
Transparency

Cost effective
many financial institutions, more so than improved serving of
customers with better access to their financial information.
Not surprisingly, technology has not been a major driver of pieces of it only available to highly trained professionals
market share or revenue growth, or minimally, it has not within the travel industry, using green-screen terminals con-
achieved its potential in these areas for most companies in the nected to mainframes.
industry.
Today, driven partially by the strides made by industries such
Perhaps one of the biggest missed opportunities stems from as travel, customers want information quickly, proactively
the creation of fragmented segments of users accessing/ delivered, and in a manner and format that fits the way they
sending information but unable to extract value from this do business today. One of the best places financial institutions
information. A dichotomy has emerged. On the one hand, we can look to for growth is through the vast information assets
have financial institutions with embedded infrastructure and they control, but have historically not harnessed to their full
islands of information. On the other hand, there are custom- potential to both win new customers and drive new revenue
ers with varying demands for information that adds value to streams from existing customers. Information technology has
their world. not primarily been thought of as an engine of revenue growth,

115
 few interchangeable parts, and less variables. For such varied The solution: the bank implemented a hosted middleware
and demanding rollouts, middleware, either enterprise or solution, which automated the entire process improving the
hosted, is becoming a preferred form of information technol- institutions existing service. The global service automatically
ogy, ultimately delivering products, services, and information accepts an XML-based data feed directly from the banks back-
to customers in the way their businesses want and need it. office applications, parses the data on a per-recipient basis,
converts the data and creates two files with custom branding,
Enterprise middleware has many practical applications. One logos, and security statements (a PDF to serve as an elec-
typical scenario is transforming data from a web server to tronic original, and an Excel file allowing the clients to copy or
input directly into multiple back office legacy systems. A spe- manipulate the data into their own personal accounting appli-
cific example of a hosted middleware application in use today cations), password-protects and encrypts the files, securely
in international trade finance uses middleware to transform a delivers the files based on the information in the original XML
purchase order or letter of credit from an EDI-formatted mes- feed, and provides the bank with a handy tool to track and
sage into a SWIFT-formatted one. Similarly, a securities trade report on message disposition.
confirmation can be captured as an image and converted into
an XML format for delivery into a back office system. As a result of the deployment of this application, the institu-
tion was able to increase market share. The combination of
Middleware is increasingly providing flexible solutions to lega- information and content, made available and delivered to cli-
cy environments. In such environments, middleware is facili- ents using hosted middleware, enabled the creation of a new
tating information flows for application integration required and improved statement, one that got to customers faster and
for straight through processing (STP). It can extract informa- provided them with the capability to import statement infor-
tion from documents and forms, convert it into a usable for- mation into their own financial applications. The bank was
mat, and securely deliver the information as a new service to able to extend the new service offering from its E.U. commu-
customers globally capturing new customers and maintain- nity to a new customer base in the Pacific Rim. As an added
ing existing customers while creating a new revenue stream benefit related to business process improvement (BPI), the
for the institution. institution was able to address issues relative to security and
compliance, such as audit trails, archiving, and securing the
The added functionality of a hosted middleware service is tak- customer information.
ing STP one step further. For example, an international money
center bank was able to acquire new revenue by securely dis- Conclusion
tributing statements to clients all over the world it had to In todays highly competitive environment, financial institu-
ensure that only the intended recipient could view the infor- tions will be hard-pressed to fund capital investments, system
mation while preventing manipulation of the original elec- upgrades, new projects, state-of-the art infrastructures, and
tronic content. Under the banks old business processes, per- ultimately new products and services. They will, however, be
sonnel had to manually rekey data to create the statements, expected to grow their businesses in the double digits! To suc-
manually convert them to another file format, and then manu- ceed, business owners need to capitalize on stores of informa-
ally encrypt and distribute the files. This was a very expensive tion that have long sat dormant, inaccessible. By bridging
system which would have required substantial investment to information housed in disparate infrastructures and delivering
upgrade. The process was slow, error-prone, painfully outdat- it to customers on demand in the format the customer wants
ed, and not compliant. it, financial institutions will be able to acquire new customers
and retain existing customers thereby achieving double digit

116
Why gut feeling is just not enough
for building a successful bank?
Francesco Burelli
Principal Consultant, Capco
Kim Warren
Teaching Fellow, Strategic and International Management, London Business School

Like firms in other industries, every financial services organi- differently from how they were in the past; organizational
zation is characterized by a specific culture and ways of man- inertia and the effort needed to evaluate, learn, and adopt
aging its own business from the highly competitive and anything different from the-way-things-have-always-been-
confrontational culture of Citibank to the more risk adverse done-round here still drive the way decisions are taken in
one at HSBCs. Despite the differences in culture, manage- many instances. The problems of unreformed decision-mak-
ment styles, and preferred controls, all banks operate in ing, together with the cumulative effects of decisions taken in
number-driven industries in which the core business consists the past, continue to create problems with organizations
of managing risk. achievement of seemingly realistic aspirations.

After the dot-com crash and the subsequent market down- There are a number of well known cases of planning gone
turn, banks employed many staff with consulting backgrounds, wrong. Egg PLC could perhaps be forgiven for not anticipating
who typically had a highly analytical, fact-based, quantitative exactly the huge response to its initial launch in 1998, but
approach to problem solving. We should, therefore, have much of its initial subsequent response made matters worse
expected to see banks shifting gears and becoming more suc- before moving customers from call centers to the Internet and
cessful in their strategies and decision making and conse- ending up being an Internet bank out of the initial telephone
quently achieving superior financial performance. Yet it banking aspirations. Then came the disappointing results of
seems that these changes in the skills base of the banks have its expansion into France, when again the early miscalculation
not made any significant impact on the performance of indi- paled into insignificance when compared with its refusal to
vidual banks1. respond when real-time data showed the scale of error.
HypoVereinsbanks trailing and inflating portfolio of bad debt
Capco has researched the financial results of the top 100 U.S. that led to its acquisition by Unicredit is another example of
and European banks over the past 5 years and identified two decision making that did not deliver the expected perfor-
key trends between two groups of financial services institu- mance. Even CapitalOne, whose strategic development has
tions. They found that banks which stick to the traditional generally been admirable, tripped over when its formula did
retail business of lending and deposit taking are largely not work as expected in parts of its European expansion in the
immune to the vagaries of the financial markets. The same early 2000s.
does not hold true for the investment banks that derive a
much higher proportion of their income from fees. Regardless Another initiative that did not live up to expectations was the
of stock market turbulence, banks have shown relatively con- Barclays B2 proposition, launched in late nineties. This direct
sistent profitability over the last few years, although one retail investment proposition was set up under separate
might question how long efficiency drives and opening of new branding and with significant above the line marketing spend.
revenue streams can sustain this momentum in the longer The business never really took off for a number of reasons.
term. A key assumption of the Capco research is that neither Firstly, at the time the market for this type of direct, execu-
changes in the skills base of the banks nor the performance of tion-only style, of selling for investments did not really exist.
financial markets has any significant impact on individual Secondly, the main product was a guaranteed-style invest-
bank performance. ment that relied heavily on hedging of positions to avoid
capital loss. It was, therefore, too complex and did not provide
So far there is little evidence that decisions are being taken great value. The B2 brand eventually moved into more main-

1 Dener, A., A. Pirnie, D. McDevitt, 2006, A bad situation getting worse The U.S.
banking profitability crisis, Working paper, the Capco Institute 117
 financial services industry is no exception. If we set aside for exempt from such pressures. In fact, for them the line between
now those emerging markets where undeveloped opportuni- pleasing shareholders and becoming a potential take-over
ties are significant and where growth arises from simply serv- target is thinner than for the larger banks.
ing an unmet need, companies in developed economies face
an industry that has largely reached maturity. Without disrup- When working out a path to substantial, profitable growth, the
tive innovation, opportunities for noticeable bottom line number of variables that need to be taken into account is high,
growth are limited, so there is little option but to take business such as pricing, price sensitivity, product offering, operational
from tough competitors by winning ever more savvy custom- resources, competitors pricing decisions, staff turnover, and
ers. With investors expecting, say, 10% growth in returns on capital requirements. Furthermore, these are not isolated fac-
investments, shared between dividends and capitalization tors, but are linked in a complex web of direct and indirect
growth, and a limited pool for potential growth that is far dependencies. Even companies that are highly analytical in
short of two digits, financial services companies face the chal- their approach sometimes misunderstand how these linkages
lenge of finding the demanded earnings growth. Cost-saving work through the whole system, and consequently fail to meet
only goes so far few companies in other markets have their aspirations. Analytics are quoted to have been instru-
shrunk their way to industry leadership, so developing growth mental to Capital One to exceed 20% earnings per share
strategies have to be found in markets where the differential every year since it became public2. Despite this, their recent
between firms is marginal and products are replicated ever efforts to expand within continental Europe have not proved
more quickly. Growth brings further challenges to manage- as successful as expected and the Italian operations, which
ments decision-making capability. Meeting sales and profit- started in 2001 with an initial pilot together with Clarima, fol-
ability budgets in a bank branch under business as usual lowed by the set up of independent operations in 2003, were
conditions is tough enough, but leading from the front to meet closed in 2005. Strategy had to change after the anticipated
the growth expected from shareholders is even more difficult overnight growth of revolving credit on credit cards did not
because many more variables come into play. Only the few materialize. Other banks have also invested heavily in analyt-
largest banks have the luxury of being able to leverage large ics, from Wachovia in the U.S. to Barclaycard in the U.K., which,
pools of resources, brand strength, and global reach in order spent five years executing its plan to apply analytics to the
to keep increasing their bottom line while sticking to their marketing of credit cards and other financial products.
ways of doing business.
There is nothing inherently wrong with those analytical
Share price performance of banks and hence their capital- approaches to profiling customers. It is just that quite differ-
ization appears to be unrelated to their underlying business ent methods are needed to steer a strategic business unit or
models. A concern we have from the Capco analysis of U.S. a whole organization to a successful growth path. Those mul-
and European Banks is that investors are enchanted by head- tiple interdependencies amongst the many factors involved
line grabbing performance figures rather than long-term create chains of causalities that are not linear but circular,
financial stability. This may be understandable from an inves- with feedback loops that reinforce the outcome of the interde-
tor perspective, as shares can always be sold if results stop pendency in a cumulative manner. The outcome of such feed-
coming in. The impact on CEOs is much less satisfactory, as it back loops could be both good or bad. For example, the
forces a focus on surpassing the last record profits announce- strength of a brand that outperforms competitors by employ-
ment, rather than solving fundamental business problems or ing exceptional staff makes the organization attractive to the
building solid platforms for the future. The larger the bank the best potential employees. The stronger the brand, the more
more this pressure arises. However, mid-sized banks are not attractive it is to top quality candidates, so the tougher the

118 - The journal of financial transformation

stream style investments and was even pushed through the such as value-based management, are persuasive and
branch network in an attempt to build sales which effec- methodical, but do not offer any real grasp of the balance
tively destroyed the value of the direct business model. between short-term performance and long-term robustness.
Eventually the business was closed down. Balanced score-cards make some attempt to look at non-
financial factors that may impact on future performance, but
Now banks are once again looking for growth, after spending generally lack any means to assess, systematically and quan-
the first few years of the new century focusing on reducing tifiably, any link between decisions taken now and their medi-
costs, streamlining processes, and overhauling their opera- um to long-term consequences.
tions. Unfortunately, the effects of poor decision makings of
the past are becoming manifested in widespread failure to Without any decent tools to help their decision-making, what
restart profitable growth, making some organizations easy do managers do? Doing nothing is often not an option [though
take-over targets. Unicredits acquisition of the ailing HBV has frequently it would be better than what is done], so they do
received a lot of attention from the press and was one the larg- the best they can, based on what experience tells them about
est cross-border deals in continental Europe. Bank of Americas how the world works. Unfortunately, unless they happen to
take over of MBNA at the end of 2005 will enable the two have discovered a business model that is successful, and sta-
organizations to leverage each others assets for cross-selling ble in the face of external changes, that experience is unlikely
purposes. These are just two of the major deals that have to be appropriate. First Direct landed on a successful formula
occurred recently and the rate of M&A activity taking place over a decade ago, and has continued to thrive albeit at
across the sector is now substantial. Fortis Banks takeover of modest scale ever since, and is now seen as an example of
Von Essen Bank, ABN Amro and Antonveneta, BNP Paribas and best practice within its industry and the HSBC group. Egg too
BNL in Rome, Woori bank and Yegaram bank are a few exam- found a strong sustainable model within a few years of its
ples of the deals that have been hitting the industry news- frenetic launch, although not before burning large quantities
rooms in the last weeks. The U.K.s Lloyds-TSB is another bank of its parent groups cash. Fineco Online Bank developed its
that is now being mentioned as a viable target. It is remarkable niche business mirroring the models of U.S. and U.K. banks
thing, when one considers that not that long ago the bank was during the dot.com boom and is now a successful part of the
very much admired for its exemplary cost-efficiency. bigger Capitalia group, after undergoing a period of difficulty
subsequent to the dot.com crash.
In our experience and on the basis of what we have observed
frequently at levels immediately below the board, decisions For most other financial institutions, though, strategy contin-
are often taken for the sake of short-term results without ues to be a worrisome tip-toe from one mine-field to the next.
considerations given to their longer term effects. Todays It is surprising, then, to find little interest in more professional,
admirable cost-efficiency is tomorrows incapacity to develop analytical approaches to strategic management and decision-
or even to sustain todays business. Moreover, many deci- making. This is especially puzzling, given that the products
sions reflect arbitrary assumptions, qualitative analysis, and these institutions trade are so deeply quantitative in nature
gut-feel far short of what we would consider to be a best making profit out of risk is hardly an activity for which check-
practice management style. lists and two-by-two grids would be the tools of choice!

Why do they do it? The quest for growth makes good decisions more
This saga of strategic and decision-making errors cannot critical, but also more difficult!
entirely be blamed on management. Financial control tools, Competition is tough in just about every business and the

2 Thomas H. D., 2006, Competing on Analytics, Harvard Business Review

119
 every customer you ever won minus those you ever lost, it tion attached to the card. The more appealing the promo-
cannot be explained by any current feature of the business, tion, the quicker the product uptake. The longer the interest
neither your pricing, your marketing, nor the appeal of your free period, the higher the funding costs that the issuer will
products or services. Factors such as these affect how rapidly have to sustain as a consequence of the promotion. The
you win or lose customers [plus how much they buy]. This market reaction to the launch of interest free period credit
accumulation phenomenon is captured by what is known as cards can vary depending on the other products offered by
the bathtub metaphor, because customers flow in and out of other issuers. Small differences in the percentage split of
your business like water into or out of a bathtub. This princi- card usage behavioral profiles can make a significant differ-
ple is illustrated in Figure 1, taken from a real case concerning ence for the issuer in terms of the cost of the product during
a company selling investment products to wealthy individuals its promotional period. Similarly, variations of the interest
through brokers. free period offering (interest free period number of months)
and the nominal APR applied to the revolving balances (com-
Each months movement in the stock of brokers is exactly pared to the market APR) after the initial interest free period
equal to the number gained and lost in that month, and the makes a significant difference to the overall product adop-
number at the end of 2004 [~85] reflects the number it tion, numbers of cardholders who will move off to other
started with two years previously, plus/minus all those gains similar offers (called Gamers or Rate Tarts), and revolvers
and losses since. Needless to say, this particular business was applying for the card with the addition of word of mouth
in some trouble, and the project focused on how to reverse feedback from current cardholders. The word of mouth
this situation. Interestingly, this company believed that it had effect was crucial to attract other potential cardholders in
over 200 brokers, because that was the number of accounts order to leverage the launch of a product that was nearly
on its database, whereas in fact, brokers who had not traded new to the market and planned to be very appealing to card-
for 6 months were effectively lost. holders with significant revolving balances. During the proj-
ect it was found that the word of mouth positive and nega-
So fundamental is this basic principle that if your plans do not tive effect ratio differed widely amongst the various card-
explicitly recognize these mechanisms for staff, products, holders behavioral profiles. Intuitively, it was expected that
and other resources as well as customers there is little as the value proposition to a cardholder became more inter-
chance they will turn out as you hope.

What does getting it right look like

We can illustrate the power of the approach with two exam- Brokers won Active brokers Brokers lost
per month per month
ples one concerning new product development in credit 150

cards, and the other an opportunity to initiate a competitor 100

destruction strategy.
50

The first case concerns a project to evaluate in advance the 0

20 20
launch of an introductory interest free card, where the eco-
nomic performance, in terms of cash flow and profitability, of 10 10

the card has to be balanced against the attractiveness of its

0 0
promotional features in order to ensure rapid uptake. The
expected performance is heavily influenced by the promo- Figure 1 Winning and losing customers

3 Warren, K., 2002, Competitive Strategy Dynamics, Wiley

120 - The journal of financial transformation
selection can be and the quality of those employed increases direction.
further. On the other hand, unexpected success in sales can How those revised plans and decisions will alter that
bring in business way beyond the capacity of the business to future for the better is, of course, the overriding question
cope, leading to bad service that destroys the very success to be answered and answered with evidence-based con-
that started happening. fidence, not merely wishful thinking.

Tools are required that are fit-for-purpose The good news is that tools are available that can both make
Whilst these kinds of feedbacks are common sense and easy explicit this performance-over-time and deal with the tricky
to grasp, they are often ignored when management comes to issues of feedback and delay. Those tools are not too complex
forecast business performance, when the tendency is to or arcane either; they are certainly within the grasp of reason-
revert to assumptions based on historical, linear analysis. It is ably skilled business analysts. They work on some basic
certainly rare that any attempt is made to actually quantify underlying principles:
such effects and set the scale and timing of decisions accord- Performance depends on resources customers drive
ingly. Some such effort is essential, not only because of the sales, staff drive costs, for example.
interdependencies involved, but also because the delays Resources accumulate over time the number of cus-
between action and response can be considerable. To make tomers today is the sum of all those you ever won, minus
the point simply, if you need people with 5 years experience, all those you ever lost and the same principle is true for
and neither you nor your competitors hired those people 5 staff, processing capacity, product range, and so on.
years ago, you can wish for them all you like, but they just How quickly resources build up, or are lost, depends on
would not exist. Resource-building delays are the second what is currently in place customer losses each month
important characteristic of strategic decision-making that is reflect the processing capacity and number of staff avail-
usually ignored or underestimated, and not factored into the able to serve their needs
evaluation of business development.
Put these principles together, and you can create a complete-
Before going further, we need to be clear what the perfor- ly transparent, fact-based, and quantified picture of your busi-
mance result we are trying to estimate is exactly, so that we ness. Its use for planning business development or tackling
can make the decisions most likely to bring it about. Neither major challenges is known as Strategy Dynamics3, and it can
some absolute profit figure, nor some linear growth rate in be done at a simple, high level on paper or a whiteboard. As
profit is realistic. Any real-world initiative whether to exploit the detail increases, more powerful methods are needed, and
a potential opportunity or to resolve a problem will exhibit although the analysis can be done with spreadsheets, you
continually changing results, as resources and expenditures would not want to, as much better tools are available. These
are added or reduced, and as cash in-flows develop. What we make explicit the feedback and delays that result from the
really need are answers to the following three questions: principles above, and although their use is entirely common in
Why profits are at the present level is not answered by other complex situations, such basic simulation methods
other information about our current situation the busi- rarely make it into a board level toolbox.
ness is on a trajectory through time which reflects histori-
cal events and decisions. At the heart of this approach, and the simulation tools that
Where is it headed if we do nothing also needs to be clear, make it usable, lies a critical feature of the second principle
as any impact of our revised plans or decisions will be above, for example, that resources accumulate over time.
moderated by forces that are pushing performance in that Because, for example, your customer-base is the sum of

121
 unlikely to join up mid-range customer losses in, say, manufac- sible without some basic ongoing intelligence and continuing
turing industry in Southern Italy with media-sector losses in fact-based decisions on how to respond as events unfolded.
Belgium and realize that this is a deliberate plan against their
corporate banking unit. Conclusion
The recent performance of most financial service companies
This approach can be used in both B2B and B2C cases, though suggests that there is substantial room for improvement in
the tactics and mechanisms vary considerably. In one case, a the strategies and decisions they make in their efforts to
company offering an investment product for high-net-worth develop. Making the right decisions to make it possible to ful-
individuals through brokers found itself competing with sev- fill those aspirations is not easy, because of the complexities
eral established competitors. Rather than simply send its sales that arise from accumulation effects, interdependencies, and
force after the best brokers in every locality, the company feedback in the business systems we run.
identified that one particular competitor had a broadly-
spread, but substantial set of broker relationships throughout This is especially challenging when seeking growth, as many
the country, but did not have an especially attractive product. more factors must be understood and manipulated than when
It was a relatively easy matter to estimate the mid-ranking running business-as-usual. Fact-based, numerical decision-
brokers in this competitors account base. From this knowl- making is essential for tackling these complexities, and can
edge, a sales force deployment plan was hatched that picked give real competitive advantage when it is thoroughly and
off just a few brokers each quarter, in each territory. This was professionally applied, using tools that are fit-for-purpose.
backed up by consumer promotions, targeted using census- Success stories demonstrate that the rigor of the Strategy
based profiling on just those streets in those localities where Dynamics approach can make sense of complex situations
the key consumers were most concentrated. This increased with high levels of uncertainty, and build estimates of future
hugely the likelihood that, when such an individual was seek- performance that have much higher levels of confidence than
ing this kind of investment product, they would be most likely can be achieved by traditional methods.
to contact a broker who had been targeted by the companys
sales rep. Piece by piece, broker by broker, the competitor
found its business base picked apart until finally there was
nothing valuable left. Of course, it took a couple of years, but
the prize was well worth the patience.

Then came the consequential damage. The competitors best

sales people were demoralized, with many joining the attacker,
who then, of course moved on to target the next line of busi-
ness and the next rival in its progress to leadership in the
sector. Throughout this episode, management were able to
monitor the plans progress with week-by-week information on
business gains and losses. Not even the sales force them-
selves knew of the plan. They simply thought they were being
given good prospects to pursue which of course they were.
Management, though, knew exactly the rate at which the plan
was coming to fruition, none of which would have been pos-

122 - The journal of financial transformation

esting, the more pronounced the word of mouth leverage quality distribution of your rivals customer-base. This simply
across all behavioral segments would have been. Our analy- shows the cumulative profit you think they make from each
sis outlined that only the gamers were particularly active in customer in their business, from best to worst. Secondly, a
spreading the word concerning the interest free offer, conse- segmentation of their business into customer groups by
quently attracting other unprofitable customers interested industry and/or territory, for example.
in using the card to get free funding at the expense of the
issuer. By analyzing the product launch challenge and model- Few companies seem to have such intelligence. You may need
ing the economic effect of various scenarios on the basis of to do a bit of work, or spend a bit of money, and just ask your-
the cardholder response, it was possible to test the results of self this: what is the size of the prize you can take by decimat-
various product configurations on the overall economic per- ing chosen competitors in your space? It does not need to be
formance projected over a number of months from product 100% accurate, just near enough to choose your priorities.
launch. The effectiveness of this approach to product design
on the performance of the card was highly positive, with the So you now have some rough information on where each
actual performance during the initial months after product competitor makes money. Which are you going to attack,
launch being close to those that were simulated. It was also where, and how? Taking on the strongest could be a bloody
possible to anticipate the impact of reactive initiatives by battle, and hurt you more than them. Often, the best choice
competitors that changed the initial assumptions underlying is a competitor who is about the same size as you, but clearly
the product development model. weaker in some important parts of their business. Taking
significant revenue from them makes a worthwhile contribu-
Beating competitors is widely thought to be a good thing to tion to your own aims, and may so weaken them that they
do, but few organizations display the focus or determination collapse entirely.
to do it properly. Mostly, firms seek to offer a better value
proposition to customers, in the hope that this will win per- Choosing where to target their business is where the cus-
centage points of market share. This is way short of what can tomer quality curve and segmentation come into use. Often,
be done why? Firstly, it spreads efforts too thinly, when companies aim for the big targets competitors key custom-
higher impact can result from focusing on where gains are ers who contribute most to their profits. There are two prob-
easiest. It is also costly to try and win on all fronts at the same lems with this: firstly, they will probably notice, and secondly,
time. Secondly, if your market is growing slowly, stretching they will likely defend them to the death, or worse, retaliate in
targets might imply taking substantial share from everyone, kind. It is often better to pick your competitors mid-range
and few will sit back and let this happen. Thirdly, competitors customers. It is usually best if your victim does not realize you
can differ widely in both the profile of their business and their are after them, so aiming across a large number of not-so-
ability to compete, so some are easier to beat than others. large customers allows you to pick targets in a seemingly
Lastly, many markets include competitors who make life more random manner that will not be noticed.
difficult for everyone, customers included offering foolish
prices they cannot sustain, promising services they cannot You can make the attack still harder to detect by using your
fulfill, and so on. You would be better off if they were not there segmentation of the competitors business. Most organiza-
and you do not have to do anything that falls foul of compe- tions divide up business development efforts in some way,
tition rules to make this happen. whether by industry-served or by region, for example. You can
use this knowledge to randomize further the customers you
You need two pieces of information: firstly, an estimate of the target. Unless your rival is highly sophisticated, they are most

123
124 - The journal of financial transformation
 Financial

Is competition in the
financial sector a good
thing?1

Falko Fecht
Economist, Deutsche Bundesbank

Antoine Martin
Senior Economist,
Federal Reserve Bank of New York

Abstract
We argue that increased competition in the financial sector
may not be beneficial, at least in some cases. Increased com-
petition has the benefit of reducing inefficiencies associated
with monopoly rents. However, increased competition
between banks and the financial markets also limits the
amount of risk-sharing that banks can provide. If competition
between banks is not very strong, then increased competition
with the financial markets may well be beneficial. Indeed, in
this case the benefit of reducing the inefficiencies associated
with monopoly rents is likely to be greater than the costs of
reduced risk-sharing. In contrast, if competition between
banks is already strong, then increased competition with the
market could be negative. In this case, competition with the
market primarily reduces the amount of risk sharing banks
can provide.

1 The views expressed here are those of the authors and not necessarily those of
the Deutsche Bundesbank, the Federal Reserve Bank of New York, or the Federal 125
Reserve System.
 Is competition in the financial sector a good thing?

particular, if the benefit arising from a reduction in monopoly We can derive the consumption of households if financial mar-
rents more than compensates for the decrease in the amount ket access is unrestricted. Impatient households, who care for
of risk-sharing banks can provide. The optimal level of compe- consumption at date 1, consume an amount equivalent to the
tition with the financial markets equalizes the marginal bene- return of their endowment invested in T-bills. Patient house-
fit and cost of such competition. holds, who care for consumption at date 2, consume an
amount equivalent to the return of their endowment invested
In contrast, increasing competition with financial markets is in a long-term project. This result is a consequence of arbi-
not likely to be beneficial if competition between banks is trage.
already very strong. When competition between banks is
strong, the monopoly rents are already very low. Thus, the Arbitrage imposes that the price of a claim on a long-term
cost of decreased risk-sharing is likely to be greater than the project is the same as the price of a T-bill, at date 1. To gain
benefit of increasing competition. some intuition, assume that the price of a claim on a long-
term project is in fact greater than the price of a T-bill. If that
A stylized environment were true, all households would have an incentive to invest all
To provide some rigor to our argument, we describe a stylized their endowment in long-term projects. Impatient households
environment2. Consider an economy that lasts three periods, could sell their projects for more T-bills than they would be
0, 1, and 2. There are several regions or neighborhoods, each holding, had they invested in T-bills at date 0. Patient house-
containing a bank and a large number of households. holds could hold on to their projects until they want to con-
sume. But if all household invest in long-term projects, there
Households are endowed with some resources at date 0. will be nobody to trade with at date 1. This contradiction shows
These resources can be deposited in a bank, invested into a that the price of long-term projects cannot be greater than
short-term asset, say a T-bill, or invested into a long-term the price of T-bills at date 1.
project. The long-term project reaches maturity at date 2 and
has a higher return than T-bills if it reaches maturity. However, Could the price of long-term projects be smaller than the price
if the project must be liquidated early (at date 1), then its of T-bills at date 1? If this were true, all households would have
return is lower than that of the T-bills. an incentive to invest in T-bills only. Patient households could
sell their T-bills for more long-term projects than they would
Households do not know at which date they will want to con- be holding, had they invested in long-term projects at date 0.
sume. They want to consume either at date 1 or date 2 but not Impatient agents can simply sell their T-bills to consume.
both. However, households know the probability with which However, if all households had invested in T-bills, then there
they want to consume at date 1. They find out at date 1 the would be no long-term projects to be traded at date 1. This
exact date at which they would like to consume. shows that the price of long-term projects cannot be smaller
than the price of T-bills at date 1. The prices must thus be the
same.
Deposit Equity + bonds Fund shares Branches CR5
(% of GDP, (% of GDP, (% of GDP, (per million (1999)
2002) 2002) 2002) inhabitants, In summary, when households have unrestricted access to
2001)
financial markets, they invest their endowment in a mix of
USA 34 48 18 272.9 26.2
Germany 53 31 17 640.5 18.8 T-bills and long-term projects. At date 1, impatient household
sell their long-term projects to patient households for T-bills.
Figure 1 Comparison of the German and the U.S. financial system

126
Is competition in the financial sector a good thing?

This paper argues that the effect of increased competition in In summary, while the market-oriented financial system of the
the financial sector may not be beneficial, at least in some U.S. is characterized by a high degree of competition between
cases. Our theory suggests that the benefits of increased banks and markets, the German bank-dominated financial
competition between banks and financial markets depend on system is best described as having intense competition among
the competition that may already exist between banks. If banks.
banks are already very competitive, increasing competition
from financial markets can have a negative effect. In our model, banks provide risk-sharing. They offer liquid
deposit contracts to agents who are not sure at what time
Our study is motivated by the differences that exist between they will want to consume. In other words, banks can provide
the financial systems of different countries. For example, some insurance to depositors against the risk of having to
households in the United States typically hold relatively large consume early, before high yielding projects have matured
parts of their portfolio in market related investments. These [Diamond and Dybvig (1983)].
are typically in the forms of stocks and corporate bonds, but
shares of money market funds and investment funds also play In contrast, financial markets are unable to provide insurance.
an important role within the portfolios of private households. Contracts cannot depend on depositors desire to consume
Bank deposits are relatively less important. The small share of early or late because this trait is not observable. Moreover, if
bank deposit may reflect, in part, a lack of competition depositors have unrestricted access to financial markets, the
between banks for households funds. banks can no longer offer a deposit contract that provides
insurance [Jacklin (1987), Diamond (1997)].
In contrast, Germany has a dense network of competing bank
branches. Competition indicators, such as a low Herfindahl Financial markets allow depositors to renege on an implicit
index and the concentration ratio of the 5 largest banks (CR5), commitment they make when they accept a deposit contract
suggest a high degree of competition among banks for house- from a bank. Indeed, banks provide risk-sharing by offering
holds savings. This may also account for the fact that German depositors who withdraw early more than they would get on a
households still hold a large part of their portfolios as bank financial market. Consequently, they must offer less to depos-
deposits. Only a relatively low fraction is invested in non- itors who withdraw late. Financial markets provide patient
intermediated assets and shares of market-related financial depositors with an outside option and thus undermine the
intermediaries, such as investment and money market funds. efficient contract offered by banks.
Figure 1 provides some numbers illustrative of these observa-
tions. Increased competition between banks and financial markets
can have negative welfare consequences. This is because risk-
sharing opportunities disappear as access to market improves.
The deposit contract offered by the banks provides less insur-
ance. However, increased competition has the benefit of
reducing monopoly rents. In turn, the welfare losses associat-
ed with these rents are reduced. Our paper studies the trade-
off between these two effects of increased competition.

Increased competition by financial markets is likely to be ben-

eficial if competition between banks is not very strong. In

2 The formal model can be found in Fecht and Martin (2005)

127
 Is competition in the financial sector a good thing?

ciently. As a consequence, monopoly profits are associated of becoming a sophisticated investor do not affect welfare in
with an inefficiency. that case.

With all the elements of our environment in place, we can In the interval between
and , the cost of becoming a
study the interaction of a monopolistic bank with a financial sophisticated investor is sufficiently low that this is now
market. the relevant outside option for households. Thus, with a lower
cost the banks monopoly position is constrained further.
A monopolistic banking system The regional bank must increase the amount paid out by its
Households have unrestricted access to the bank that oper- deposit contract to reduce the incentives of households to
ates in their region. However, households must pay a cost to become sophisticated. The profits of the regional bank
deposit their resources in banks that operate in other regions. decrease as the amount paid out by the deposit contract
This cost may reflect the effort necessary to gather informa- increases. Therefore the inefficiencies associated with monop-
tion about banks situated outside of the households region. In oly rents also decrease. In summary, improved financial mar-
this section, the cost is assumed to be so high that no house- ket access improves welfare because it limits inefficiencies
hold would consider paying it. In other words, each bank is a due to monopoly rents if the cost belongs to the interval
local monopoly constrained only by the households ability to between
and .
invest in the financial market.
Finally, consider the interval between 0 and . The inefficien-
We let denote the cost that households must pay to become cies associated with monopoly rents continue to decline as
sophisticated and thus have access to the financial market. If the deposit contract pays out more. However, in this region
this cost is high, few households will choose to become sophis- increased financial market access also reduces the amount of
ticated and the local banks monopoly position is little con- risk-sharing that can be provided by the deposit contract.
strained. In contrast, if is low, many households will choose
to have access to the financial market and the local bank will For such low values of , all households have an incentive to
be more constrained. deposit their resources in the bank. Patient depositors can
pretend that they are impatient, withdraw their deposit at
The welfare implications of improved access to a financial date 1, and invest in the financial market. To reduce the incen-
market are summarized in Figure 2. The horizontal axis tive to do so, the regional bank must decrease what it pays out
denotes the cost, , that households must pay to become at date 1 and increase what it pays out at date 2. In other
sophisticated and have access to the financial market. The words, it has to reduce the liquidity insurance or the amount
vertical axis denotes the expected utility, or the welfare, of risk-sharing provided by the deposit contract. Hence, some
received by households in this economy. costs are associated with an improved financial market access
in this interval.
If the cost of becoming a sophisticated investor is very high
(higher than ) then becoming a sophisticated investor is At the point denoted by *, the marginal welfare benefit from
prohibitively costly. The only relevant outside option for reducing the inefficiencies due to monopoly rents is equal to
households in that case is to invest in T-bills. Knowing that, the the marginal welfare costs from the reduction in risk-sharing.
bank can offer a deposit contract that pays out very little. This is the value of the cost that maximizes overall welfare in
Because the banks profits are high, the inefficiencies associ- this case.
ated with monopoly rents are high. Slight changes in the costs

128 - The journal of financial transformation

Is competition in the financial sector a good thing?

insight is due to Jacklin (1987). Diamond (1997) also studies

EU
this problem.

In our story, households access to financial markets is related

to their ability to monitor long-term projects. Sophisticated
households are able to select good long-term projects and

monitor them effectively. This allows them to realize a high
return. In contrast, naive households are likely to select poor
Figure 2 Welfare in a monopolistic banking system
projects and may be unable to monitor them properly. The
expected return that naive households receive from a long-
The role of banks term project is so low that these households prefer to invest
We assume that our households are sufficiently risk-averse. in T-bills or deposit their resources in a bank.
Specifically, we assume that at date 0, before they know
their type, households would be willing to give up a little bit Households can pay a cost to become sophisticated. This
of consumption if they are patient, in which case they benefit cost reflects the effort needed to acquire the knowledge
from the higher returns of the project, for a little bit more necessary to screen and monitor projects. We assume that
consumption if they are impatient, in which case they only the banks ability to select and monitor projects is equivalent
realize the lower return on T-bills. In other words, households to that of sophisticated households.
would like some insurance against the risk of being impatient
and consuming only the equivalent of the return on T-bills. Monopoly rents
Each region has one bank. Many bank managers compete for
Banks deposit contracts are able to provide risk-sharing, if the license to run a bank. They compete by promising to pay a
households do not have access to financial markets. The share of the banks profits to its owners. We assume that
deposit contract allows all households to withdraw at date 1. households own banks and that each household has a diversi-
Only impatient households will want to withdraw early if the fied portfolio. Competition spurs bank managers to promise
deposit contract promises a higher return at date 2 than at the maximum pledgeable share of profits.
date 1. Diamond and Dybvig (1983) first studied this role of
banks. Bank managers are unable to promise the entire realizable
profits because of informational frictions. One story might be
We can show that financial markets are unable to provide that higher bank profits lower the pressure on the bank man-
this kind of insurance because a households type is unob- ager to spend his/her full effort on managing the bank effi-
servable. Worse, household access to financial markets
EU
undermines banks ability to offer a deposit contract that 1 > 2
1
provides risk-sharing. Indeed, patient households that have
access to financial markets can pretend to be impatient in 2
order to receive the high return promised by the bank at
date 1. These households can then trade what they have
received on the market for long-term projects. In other

words, patient households are not willing to accept the low
return offered by banks at date 2 if they can avoid it. This Figure 3 Welfare in a competitive banking system

129
 Is competition in the financial sector a good thing?

that can be achieved with a high value of in a bank-based

EU
system depends on the intensity of bank competition. As =1
shown in Figure 4, a bank-based system can achieve higher
welfare than a market-based system if the intensity of compe- 1

tition between banks is sufficiently high ( smaller than ).

In our simple environment, the highest achievable level of

welfare can only be reached in a fully competitive bank-based
Figure 4 Comparing the efficiency
system. This corresponds to the case where interbank compe-
tition is at its highest level ( = 1) and the competition with the
market is not too high ( greater than
). In other words, it is be few benefits from increased market access.
a system in which banks do not have any regional market
power and households do not have an efficient market access. Consequently, the developments in households portfolios in
In that case banks do not realize monopoly rents that cause Germany and the U.S., as depicted in Figures 5 and 6, might
inefficiencies nor does the threat of financial market invest- have very different welfare implications. While the greater
ments constrain the amount of risk-sharing offered by the bank dominance in Germany is reflected in the structurally
optimal deposit contract. larger fraction of cash and deposit holdings of households, in
both countries this position experienced a remarkable decline
Conclusion in the recent decade. At the same time direct capital market
In summary, in a monopolistic banking system an optimal investments and particularly more market oriented intermedi-
degree of financial market access exists that trades-off the aries gained substantially in importance.
benefits of risk-sharing with the costs of monopoly rents. In a
competitive banking system, improved financial market access If these changes reflect an intensified competition between
can only reduce risk-sharing because monopoly rents are banks and other market related investments our analysis sug-
already small. Reducing the costs of financial market access gests that this might have been welfare improving in the U.S.
cannot be beneficial in this case. Here this development might have contributed to a reduction
in banks market power leading to greater efficiency in the
If competition among banks is sufficiently intense, monopoly banking sector. In contrast, in Germany where banks have had
rents are so small that the cost associated with reducing risk- historically low market power in the retail business anyway,
sharing is greater than the benefit of a further reduction in the increased competition by more market related invest-
the monopoly rents. In that case, a financial system with com- ments might have only reduced the risk-sharing provided by
petition among banks but no competition between banks and banks deposit contracts.
markets is more efficient than a system with competition
between banks and markets but not sufficient competition References
Diamond, D., 1997, Liquidity, banks, and markets, Journal of Political Economy, 105,
within the banking sector.
928-956
Diamond, D., and P. Dybvig, 1983, Bank runs, deposit insurance, and liquidity,
Our analysis suggests that improved access to financial mar- Journal of Political Economy 91, 401-419
Fecht, F., and A. Martin, 2005, Bank, markets, and efficiency, Staff report 210,
kets is likely to be beneficial in market-based systems if the Federal Reserve Bank of New York
risk-sharing provided by banks deposit contract is not reduced Jacklin, C. J., 1987, Demand deposits, trading restrictions, and risk sharing. In
Prescott, E.C. and N. Wallace, Contractual arrangements for intertemporal trade,
too much. In contrast, in bank-based systems there appear to 26-47, Minneapolis, University of Minnesota Press

130 - The journal of financial transformation

 Is competition in the financial sector a good thing?

100% The horizontal and vertical axes have the same interpretation
as in Figure 2. With competition between banks, access to the
80%
financial market is no longer necessary to reduce monopoly
60%
rents of the local bank. Such rents are constrained if the cost
40% is sufficiently low to make the option of going to a non-
20%
regional bank enticing. In this case an increasing competition
between banks and financial markets does not have any ben-
0%
eficial effects a reduction in never improves welfare. But
91

97
94

01
98
95
92

02
99

improved financial market access (a reduction in ) may still

96
19

93

03
00
20
19
19

19

20
19
19

19

19

20
19

20

Mutual fund shares Shares reduce the amount of risk sharing that banks are able to offer.
Credit market instruments Cash and deposit By the same reasoning as above, banks must decrease the
Other equity
amount they pay out at date 1 and increase the amount they
pay out at date 2 if competition with the financial market is
Figure 5 Households portfolio in Germany
more intense. The reduction in risk-sharing lowers welfare.
A competitive banking system This can be seen in Figure 3 in the region where is lower
100% than
.

80%

If the cost of going to a bank from a different region decreas-

60%
es from 1 to 2, as in Figure 3, welfare increase as monopoly
40%
rents are squeezed out by the increased competition.
20%

0%
Comparing bank-based and market-based
systems
90

96
93

03
00
97
94
91

01
98
95
92

02
99
19

19

20

We can think of the financial structures described above as

19

19

20
19
19

19

20

20
19

19

19

Mutual fund shares Shares polar cases of market-based versus bank-based systems. In
Credit market instruments Cash and deposit
one section we assumed that there is no competition
Other equity
between banks and only the financial market provides an
Figure 6 Households portfolio in the U.S.
outside option to local households. In the following section
we assumed that there is intense competition between banks
as well as, possibly, competition with the financial market. In
The welfare implications of improved financial market access this section we compare the welfare implications of the two
are quite different in a competitive banking system. In this systems.
section, we assume that the cost for households to deposit
their funds in the bank of another region is not too high. In Figure 4, we have merged Figures 2 and Figure 3 together
Competition between banks increases as the cost, denoted by for ease of comparison. The optimal degree of financial mar-
, decreases. Of course, the financial market continues to ket access for a system with insufficient competition among
compete with all the banks in the system. banks is given by *. This point corresponds to the highest
level of welfare achievable in a market-based system. In a
The welfare implications of improved access to a financial system with competitive banks welfare is maximized when the
market and increased competition are depicted in Figure 3. cost of financial market access is higher than . The welfare

131
132 - The journal of financial transformation
 Financial

A bad situation
getting worse
the U.S. banking
profitability crisis
Adam Dener
Partner, Capco

Andrew Pirnie
Head of Research, Capco

Diane McDevitt
Managing Principal, Capco

Abstract
Dener (2004) suggested that the U.S. banking industry was in some of the underlying causes for this negative trend. Our
the early stages of increasing and sustaining profitability findings suggest that improvements in productivity are insuf-
compression. The issues facing banking are numerous, com- ficient to offset the constrained revenue dynamics of banking
plex, and onerous, spanning commercial, competitive, and and that revenues generated from the migration towards
regulatory challenges which have resulted in average returns increasing fee income as a percentage of total income cou-
on equity (ROE) for the banking industry when compared to pled with inadequate operational leverage and compensation
other industries. This paper will extend on the findings of dynamics provide limited relief to the pressure on profitabili-
Dener (2004) and illustrate that the negative momentum in ty that we see today.
sustaining profitability is continuing. It will also highlight

133
 A bad situation getting worse the U.S. banking profitability crisis

Dener (2004)1 suggested that the U.S. banking industry was tive in managing the profitability of the chosen business
at the early stages of a prolonged period of profitability com- models. The industry has only made improvements around
pression. This paper aims to extend on Dener (2004) and the edges without achieving fundamental change.
provide detailed analysis of the financial results and trends in
the U.S. banking marketplace. Together with industry-wide These issues require focused attention from bank manage-
analysis, and qualitative research into key trends and drivers ment to stimulate growth and profitability. Urgent action is
that are impacting the U.S. banking industry, this paper looks required because of the expense trend. Clearly, management
at the evolution of the change in how banks generate reve- needs to manage the efficiencies that should be generated
nues and the nature of the underlying expenses associated from scale. If banks prove incapable of managing cost, driving
with them over the last twenty years and undertakes a closer revenues, and sustaining profitability organically, mergers and
examination of expenses, productivity, and profitability of the acquisitions remain a viable alternative. However, manage-
business models deployed to determine their effectiveness. In ment will need to drive harder for performance resulting from
addition, this paper will asses the effectiveness of the merger these mergers. If underperformance vis--vis other industries
and acquisition strategies deployed over the past ten years, as investment opportunities continues and is due to lack of depth
measured by the efficiency ratio, and takes a closer look at the of management expertise, investors might consider alterna-
concentration of asset and deposit market shares. tive investments or action to effect the fundamental change
needed to drive towards comparable investment performance
The results of the analyses are insightful. Firstly, we find that and profitability. Investors will demand change.
banking profitability is caught between a high, largely inflexi-
ble, fixed cost base unable to cope with slower growth in rev- Crisis, what crisis?
enues and faster growth in expenses. Projected revenue and The banking industry has recorded significant headline grab-
cost growth figures suggest that expenses will outstrip reve- bing gross profits in recent years. While the news suggests
nues between now and 2007, which will be the first time this that the industry is experiencing positive momentum, closer
has happened for almost thirty years, and that bank revenues examination reveals that there is a dangerous shift away from
will continue to shift from interest generated sources to fee- sustainable profitability. Real banking revenues have been flat
based ones. Secondly, we see that projected average profit- and are experiencing limited growth (Figure 1).
ability growth is declining and 2007 will likely mark the start
of a profit compression that could leave some banks seriously
exposed to underlying market conditions. Finally, business 500 5.00%
models and strategies are important considerations as banks 400 4.00%

that are predominantly reliant on corporate and institutional 300 3.00%

fee-based businesses continue to consistently underperform 200 2.00%

100 1.00%
their interest income oriented peers.
0 0.00%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
This is an alarming trend toward the declining profitability of
the financial services industry. The modest improvements Commercial Banks
Savings Institutions
made in bank efficiency over the last couple of years have
Revenue/GDP
masked a deeper problem in profitability. The banking giants
have not obtained adequate rewards through greater produc- Figure 1 U.S. Financial services revenues U.S.$ bln 1994-2004 as % of GDP
tivity from industry consolidation nor have they been effec- Source: FDIC, IMF, Capco analysis

1 Dener, A. L., 2004, The emerging crisis in U.S. banking profitability, working
134 - The journal of financial transformation
paper, Capco Institute
 A bad situation getting worse the U.S. banking profitability crisis

There has been a fundamental shift in revenue generation Nevertheless, it is important to note that non-interest income
from interest income sources towards nontraditional busi- is also cyclical and has business cycle dynamics that may be
nesses that generate fee income, such as trading services and similar or different from those of the credit cycle.
other transaction and fee-based products that provide non-
interest income. As illustrated in Figure 2, commercial banks An implication of these changes is the need to generate
now generate approximately 40% of their revenues from non- increasing amounts of non-interest-based revenues to offset
interest sources; up from 25% in the mid-1980s. the reductions in gross margins. This move towards a shorter
term view has implications for medium-term profitability, as
On the surface, this diversification trend would appear benefi- the core interest income revenue streams dissipate with the
cial, with several important trends having contributed to this shift. Furthermore, there are other implications of the revenue
evolution. Firstly, business model integration of traditional shift that are of importance as well, such as increased costs.
banking and investment banking products has increased the The underlying scalability of the new revenue sources and the
overall fee income opportunity for a number of the larger operational infrastructure requirements of the underlying
banking institutions. Secondly, the rise of securitization, par- businesses are important components in assessing the overall
ticularly of consumer credit pools, has reduced interest profit viability of the shift in the industrys income statement
income statement centricity for many institutions. And, finally, as a whole. The industry is now facing a challenge of matching
the migration from interest income to non-interest income fixed and variable cost structures of the supporting business-
represents a shift from a longer term income source (interest es in line with the variability of the revenue streams.
income is recognized over the life of a loan obligation) towards
a shorter term one (non-interest income is often recognized A shift in making a buck
upon a transaction or event). Looking back over the past 20 years and the evolution of how
revenues have been generated and the nature of the expenses
Many might argue that this shift is healthy, as interest income involved in that revenue generation process offers us a strik-
is cyclical. A mechanism used to maintain revenues during ing perspective, as Figure 3 demonstrates. Several issues are
difficult times in the credit cycle is to lower credit standards. noteworthy about the data. Firstly, interest income is down by
approximately fifty percent. Secondly, provision for loan loss-
100%
es is down three fold. Thirdly, the mix between interest and
non-interest income has shifted considerably. Finally, taxes
80% and extraordinary items have approximately doubled.
60%
Banks have experienced a dramatic reduction, of over 50%, in
40%
interest income between 1984 and 2004. This shift and the
20%
greater dependency on non-interest revenue streams mark a
fundamental shift in the way banks earn their money. Interest
0%
income is derived from what could be called traditional bank-
1984 1987 1990 1993 1996 1999 2002 2004
ing products mortgages, personal lending, bank account
Interest income
balances and so on. These lending and deposit taking func-
Non interest income
tions are represented on the balance sheet as assets and lia-
Figure 2 U.S. commercial banks interest vs non-interest income 1984-2004
bilities, so a large bank by assets could reasonably derive a
Source: FDIC, Capco analysis significant portion of its income from such products.

135
 A bad situation getting worse the U.S. banking profitability crisis
es

e
he

m
ss

co
ot
lo

in
&
n
oa

et
xe

N
rl

Ta

$8 present day revenue is only 0.3%, or 30 basis points, ahead of

$7
1.71 2.38 expense growth.
1984
$6
5.24
Projecting these trends forward, between 2006 and 2007
$5 0.77
1.62
long-term expense growth will likely outstrip revenue growth.
$4
This last happened in 1987 which was also the only year in
$3
0.89 the last twenty years when the combined commercial and
$2
0.29 savings banking industry reported a loss. The 1987 loss was
1
$1
driven primarily by heavy losses by savings banks, although
$0
commercial banks also reported their worst results since the
($2.86) $0.05 ($1.32) ($0.46) ($0.53) ($0.64) $0.14 Change mid-1960s.
$8

$7 This view of the past and the glimpse into the future helps us
2004
$6 focus today on the performance of the chosen business mod-
$5 els to better understand its inherent ability to sustain longer
1.76 1.06
$4
term profitability.
0.31
$3 1.09
2.38
0.25
Is scale helping?
$2
0.43
1 Another important trend for the industry is consolidation. The
$1
overall number of banks has declined in recent years due to
$0
mergers and acquisitions within the U.S. industry, running at
4%. Clearly M&A has been a preferred strategic tool over the
past decade and a half as banks have executed numerous
horizontal mergers and product acquisition transactions.
Whether or not the outcomes have been effective is open to
debate. Nevertheless, close examination of the relationship
Figure 3 U.S. commercial banks how to make a $1 in 1984 & 2004
Note: Taxes & other other is extraordinary items and securities gains & losses between the number of banks and efficiency ratio suggests a
Source: FDIC, Capco analysis linear relationship.

which have invested in higher paid staff and fewer offices, In addition to the absolute numbers of banks, manifestations
against the traditional retail banks, which are reliant on a of consolidation are also reflected in reviewing elements of
higher fixed cost base of branches and large, stable work- the industrys concentration in balance sheet accounts. A
force. review of deposits indicates that the top 10 banking compa-
nies now control 35% of all industry deposits, up from 20%
Elements of these issues are apparent in a comparison of ten years ago.
revenues, expenses, and profit growth over the last 20 years.
Figure 4, which provides the five year Compound Annual In terms of asset concentration, the top 10 banks now hold
Growth Rates (CAGRs) for each, illustrates that while in the over 51.5% of all bank assets, up from 18.5% ten years ago.
mid 1990s strong profit growth was supported by revenue Clearly this is a concerning relationship. The largest banking
growth which was 2% per annum above expenses growth, companies have been able to concentrate their assets faster,

136
 A bad situation getting worse the U.S. banking profitability crisis

600 $ Billions 4.2%

of revenue risk or higher credit provisions in the event of poor
lending decision making in economic downturns.
500 5.1%

400 8.7%
4.7%
Banks have traditionally depended on a broad branch infra-
300 4.8%
structure and stable headcount to support this business mix,
6.8%
7.8% both of which are largely reflected in the income statement as
6.8% 9.5%
200
4.7% fixed costs. In essence, interest income requires infrastructure
6.4% 11.8%
100 7.9% which equates to a certain level of fixed costs.
28.4%
-2.1%
0
Non-interest income (largely fee-based) tends not to be as
-100
broadly reflected in the balance sheet and depending on the
type of business activity requires a lower fixed asset base.
Revenues Expenses Profits
80% 20,000
18,000
Figure 4 U.S. commercial bank revenues, expenses, and profits 1984-2004, pro- 75% -4.0% 16,000
jections to 2010 and 5-year CAGRs 14,000
70% -4.7%
Source: FDIC, Capco analysis -1.8%
12,000
-3.6%
65% -2.4% 10,000

Fluctuating interest rates have a significant impact on the -2.6% 8,000

60%
-1.2% 6,000
business, with rate trends reducing credit availability, interest -0.4%
4,000
55%
income, and potentially deposit taking during different cycles. 2,000

The converse in different parts of the economic cycle is also 50% 0

true. While rates shift product margins are largely unaffected,

as most changes are passed on to customers and investors in Efficiency Ratio Institutions
800
Figure 6 U.S. banks efficiency ratio 1984-2004 and 5 year CAGRs
700
Source: FDIC, Capco analysis
600

500

400
Additionally, fee-based incomes are not as balance sheet
300 intensive, which means that banks are not required to hold as
200 much regulatory capital, which in turn allows the industry to
100 more flexibly finance these businesses. The cost of generating
0
this income, however, is more dependent upon human capital.
In this way, fee-based banks have a greater degree of financial
Mergers New charters leverage than interest income-based banks with arguably
more flexibility in their cost base.
Figure 5 U.S. banks merger and de novo banks 1990 -2005
Source: FDIC, Capco analysis
On the surface, non-interest (fee-based) income, which is not
dependent on balance sheet size, is arguably less dependent
the form of higher (or lower) charges and return rates on on the extensive infrastructure which serves to support the
credit, securities, and deposits. In this sense, interest income asset-based business model. This perspective is supported by
is a secure revenue stream with the largest risks being those the relative performance strength of the investment banks,

137
 A bad situation getting worse the U.S. banking profitability crisis

40%
ates of the applicant) controls, or upon consummation of the
35% CAGR 1994-2004
Top 5 14.0% acquisition for which such application is filed would control,
30% Next 5 7.9% Next 5
Top 10 12.1% more than 10 percent of the total amount of deposits of
Industry 5.6%
25% Citigroup insured depository institutions in the United States while on a
20% JPMorgan statewide basis immediately before the consummation of the
15% Next 5
Wachovia
acquisition for which such application is filed, the applicant
10%
Citicorp Wells Fargo (including any insured depository institution affiliate of the
Banc One
Chemical Bank applicant) controls any insured depository institution or any
5% Nationsbank Bank of America
Bankamerica branch of an insured depository institution in the home State
0%
1994 2004 of any bank to be acquired or in any host State in which any
Figure 7 Market share of top ten U.S. banks as % of total U.S. banking deposits
such bank maintains a branch; and (ii) the applicant (including
1994 & 2004 all insured depository institutions which are affiliates of the
Source: FDIC at June each year, Capco analysis
applicant), upon consummation of the acquisition, would con-
trol 30 percent or more of the total amount of deposits of
relative to a core liability component, deposits, with a sig- insured depository institutions in any such State.
nificant difference. It is generally believed that deposits form
the least expensive financing mechanism for the banks bal- These regulations put logical limitations on consolidation and
ance sheet and the size of the concentration difference is of have significant implications for M&A in the industry with the
consequence. next result that bank M&A at or above the 10% deposit cap
limit absent further regulatory change will be extraordinarily
There remains significant regulatory hurdle regarding deposit challenging.
consolidation by banks under United States Code Title 12
Banks and Bank Holdings, Chapter 17 Bank Holding Companies, Given the significant concentration in the largest banks one of
Sec. 1842 that notes significant limitations on acquisition of the expected outcomes would be enhanced operating lever-
bank shares or assets. Specifically, it notes concentration lim- age with improvement in the efficiency ratio. This, however,
its such that on a deposits: The Board may not approve an has not been the case. To date, scale in concentration has
application pursuant to paragraph (1)(A) if the applicant been not proven to offer significant performance enhance-
(including all insured depository institutions which are affili- ment. This now requires a closer look at the expenses and the
business model to see the impediments.
69%

67%

65%
A closer look at expenses, productivity, and
63%
business model
61%
Over the past 5 years there has been a significant upward
59% shift in non-interest expense. Among the largest U.S. banking
57% companies we see that expenses have grown 9.3% CAGR over
55% the last five years ending in 2004.
2000 2001 2002 2003 2004
Average ER top 50 U.S. banks Average ER all U.S. banks
There was no significant efficiency gain among these same
Figure 8 Efficiency ratios 2000-2004 Top 50 U.S. banks as compared to U.S.
banking companies
institutions. While operational leverage, as measured by the
Source: FDIC, company annual reports, Capco analysis efficiency ratio, suggests industry improvement, overall

138 - The journal of financial transformation

 A bad situation getting worse the U.S. banking profitability crisis

100% 25%
CAGR 2000-2004 20%
90% 15%
Other expenses 10%
80% Other expenses
13.6% 5%
70% 0%
Technology/ -5%
60% communications Technology/ 5.8%
communications
Occupancy
50% Occupancy 8.8% % change banking employees % change banking output

40% 20%
15%
30% Compensation 10%
Compensation 7.2% 5%
20% 0%
-5%
10% -10%
-15%
0%
2000 2004
% change manufacturing employees % change manufacturing output

Figure 9 Expense analysis of top five U.S. banks 2000 vs 2004 expenses saw Figure 10 U.S. banking industry compared to manufacturing industry 1954 2004
9.3% CAGR over five years GDP output, employees % annual change
Source: FDIC, company accounts, Capco analysis Source: U.S. Department of Commerce Bureau of Economic Analysis, Capco analysis

results over time have not borne out adequate improvements Despite consolidation and technology evolution, branches are
in operating leverage to those rising costs. This is further as common now as they were 20 years ago with as many staff
demonstrated in analyzing financial services output and around as there were back in the early 1980s. While the com-
employment for the industry. On the surface this examination position of branch staff and their functional roles may have
suggests serious questions about the execution by these changed, it appears that the banks have been unable or
banks or the benefits of their scale. It is interesting evidence unwilling to reduce their reliance on branch staff in their deliv-
about whether scale is an adequate driver of enhanced per- ery model.
formance. Overall financial services headcount has been
largely stable for more than 50 years even as output has fluc- One hypothesis would suggest that branch banking activities
tuated widely. Unlike U.S. manufacturing output, where there would have changed considerably, with many processing func-
are significant correlations between output and employment, tions centralized or outsourced. This has not, however, been
banking lacks meaningful correlation as demonstrated in the borne out by the data in either staff per branch or population
output analysis in Figure 10. per branch, suggesting continuing deep-seated inefficiency in
the U.S. retail banking model (Figure 11).
Close examination of branch banking and headcount (relative
to U.S. population) demonstrates that trend. In 1984 the U.S. Examination of the overall banking cost base over the last
averaged 26 branches per 100,000 people. By 2004 the num- twenty years reveals that staff and property costs have
ber of branches had risen by two to 28 branches per remained largely steady (at between 41-49% and 12-16% of
100,000 in population. In 1984, there was approximately 25 overall costs, respectively), while other costs have fluctuated
staff per branch. That number has pretty much remained the between 35% and 46% of the overall costs. As shown earlier,
same by 2004, with no major fluctuations in between. banking operates a largely fixed cost base. Projecting forward
it appears that this cost base is likely to grow at a faster rate

139
 A bad situation getting worse the U.S. banking profitability crisis
0

02

04

06

08

10
20
20

20
20

20

20,000 250 added can transform the margins of the business.

18,000 Management focus Without question one of the key
16,000 200
14,000 issues facing the industry is and will remain the need for
150
12,000 management to attack these challenges and drive change.
10,000
8,000 100 Improving profitability
6,000 The U.S. banking industry is at a critical juncture, amid escalat-
4,000 50
2,000 ing costs, decreasing revenues, and tightening regulation. The
0
0
1984 1986 1988 1990 1992 1994 1996 1998 2000 2000 2004
increasing number of tools available to bank managers, includ-
ing IT leverage, M&A, re-engineering, and outsourcing must be
Branches per 100k pop (RHS) Employees per Branch (RHS) utilized more strategically over the coming decade. Practical
Employees per bank (RHS) Banks (LHS)
focus on a number of key operational management tech-
Figure 11 Number of U.S. banks, employees per bank and per branch, and branches niques will differentiate competitors and sustain profitability
per 100,000 population 1984-2004 and competitiveness. Particular attention needs to be placed
Source: FDIC Commercial & Savings Banks, U.S. Census Bureau, Capco analysis
on better leveraging of IT and a more thoughtful approach to
customers, their needs, and their behaviors. It is essential that
50%
4.7% 5.4%
8.6%
3.5% 5.4% threats to profitability be assessed and managed quantita-
40% tively as soon as possible.
4.5% 7.2% 4.1%
9.1% 6.1%

30%

20%
4.7%
2.6% 6.6% 5.2% 4.7%

10%

0%

Staff costs Property costs Other costs

Figure 12 U.S. Commercial Bank Expenses 1985-2004

Projections to 2010 and 5-year CAGRs
Source: FDIC, Capco Analysis

70% Revenue growth

1
5-year CAGR
60%

50%
A
40% Key companies
> 70% NI income
30% 2
< 30% NI income
3
20% B 4
E C 6 5
10% D
Average
0% F Net income growth
H G 5-year CAGR
-10%
-30% -10% 10% 30% 50% 70% 90% 110%

Figure 13 Comparing banks by sources of revenue and profitability

Fee-based banks underperformed 2000-2004
Source: annual reports, Capco analysis

140 - The journal of financial transformation

A bad situation getting worse the U.S. banking profitability crisis

than revenues over the coming years, as noted in Figure 12, demonstrated, revenue growth will soon be overtaken by
which shows the historical growth and projected growth of expense growth, and if this happens banks will be forced to
these costs out to 2010. address these issues.

Clearly these trends suggest challenging fundamental macro Additionally, the changing nature of the revenue mix on the
issues for the industry as projected expense growth will likely income statement, due to the potential shift in business
outstrip projected revenue growth by 2007. model, is also concerning and requires further examination.
Nevertheless, the transition from a more profitable and pre-
As we look through the prism of sustainable profitability the dictable business to one mixed with lower profitability and less
question of whether interest income orientation or a fee predictability increases the management and investment chal-
income orientation is more profitable offers further perspec- lenges moving forward.
tive. A comparison of banks with over 70% of their income
from non-interest sources and banks with over 70% of their A strategic response is necessary
income from interest-related sources provides interesting As long as banks cannot sustain profitability organically by
insight (Figure 13). better managing their expenses or earning adequate reve-
nues to offset higher expenses, mergers and acquisitions
The trend is clear. Compared to the average of the top fifty remain a viable solution. Significant opportunities remain for
banks, the majority of those institutions dependent on fee further consolidation, particularly given the significant macro
income underperformed, while the majority of those depen- structural and regulatory impacts borne of Basel II, Check 21,
dent on interest income outperformed the average. and the Patriot Act, as well as many of the issues referenced
in this paper. Nevertheless, the prism offered from a macro-
What does it all mean? economic perspective suggests the following template for
There is an alarming trend toward an inevitable declining prof- management and investors to consider.
itability in the financial services industry. As discussed above, Urgency The trends facing the banking industry require
the modest bank efficiency improvements over the last acknowledgement, significant attention, and response. The
decade, coupled with migration to fee income business mod- time to start acting is now.
els, and maturation of consumer securitization mask a deep Efficiency and scale There should clearly be significant
problem. These issues require significant attention from bank benefits from both scope and scale. These, however, need
management. to be put into action as scale absent efficiency is not prov-
ing adequate. Transformation of costs and requisite
Banks have not reaped adequate rewards through greater changes are key to the industrys economic vitality. The
productivity from the industrys consolidation over the last banks need to focus on matching the fixed and variable
decade with the appearance that the industry has made cost structures with the chosen businesses to sustain lon-
improvements around the edges without achieving fundamen- ger term profitability. Hard decisions will inevitably need
tal change. Further improvements in efficiency are essential. to be made on subsidizing one division or product line by
another.
Unfortunately, however, it is likely that such improvements will Differentiation In absence of cost and or scale/efficiency
involve both significant investment and simultaneous contrac- benefits it is essential that organizations attempt to realize
tion for the industry, which for managers of public companies incremental benefits valued by their clients through differ-
are challenging dynamics to execute against. Yet as we have entiation of products and services. The addition of value

141
142 - The journal of financial transformation
 Financial

Threshold
relationships among
inflation, financial
market development,
and growth1
Michelle L. Barnes
Senior Economist, Federal Reserve Bank of Boston

Nicolas Duquette
Senior Research Assistant,
Federal Reserve Bank of Boston2

Abstract
This paper tests for and estimates relationships among infla-
tion, financial market development (FMD), and growth. This
trivariate relationship changes across a statistically robust
inflation threshold of about 14%. Below 14%, the relationship
between growth and FMD is positive; above 14%, the relation-
ship between growth and inflation is negative. The interaction
between FMD and inflation has a significant impact, however:
below 14% there is a positive correlation between growth and
inflation, but marginal increases in inflation impair the rela-
tionship between growth and FMD; above 14% marginal
increases in inflation have little or no impact on this relation-
ship. This suggests that the role of financial markets as a
channel of economic growth is important and changes with
the level of inflation.

1 This is adapted from a 2000 University of Adelaide Working Paper # 00-4 of the their data, and Colin Cameron, Ananda Chanda, Mark Gersovitz, Tony Hughes,
same title. Oscar Jorda, Richard Pomfret, Ramkishen Rajan, and Christie Smith for their help- 143
2 The authors thank Bruce Hansen for providing his threshold panel testing and esti- ful comments. Views herein do not necessarily represent those of the Federal
mation code on his website, Thorsten Beck and Ross Levine for allowing the use of Reserve System or the Federal Reserve Bank of Boston.
 Threshold relationships among inflation, financial market
development, and growth

financial market activity5. cally significant single-threshold relationships among growth,

financial sector development, and inflation. These results are
In our research, a panel dataset is exploited to establish robust to model specification, control variable sets, and
whether there are statistically significant thresholds in the choice of proxy for financial market development. The esti-
single-equation, trivariate relationship among inflation, finan- mate of the threshold value of inflation is approximately 14%.
cial sector development, and growth. Following the above The confidence intervals about these threshold estimates are
bodies of literature, inflation is taken to be the threshold vari- generally tight6. The empirical findings strongly support the
able of interest. After testing for the presence of thresholds, general theoretical predictions of the existence of thresholds
a more precise threshold relationship is estimated. Different among growth, financial market development, and inflation,
models are specified in order to separately test for thresholds as in Choi, Smith, and Boyd (1996) and Huybens and Smith
in the relationship between growth and banking sector devel- (1999).
opment, growth and both banking sector development and
inflation, and growth and banking sector development, infla- The estimation results show that output growth and mea-
tion, and an interaction variable between banking sector sures of financial market development are positively corre-
development and inflation. This last specification allows for lated below the (14%) threshold level of inflation. These posi-
evaluation of whether the financial intermediation channel tive correlations become more significant with model gener-
matters for the relationship between growth and inflation, ality, i.e., as additional thresholds are specified in the relation-
and best represents the spirit of the Huybens and Smith ship between growth and inflation and growth and the inter-
(1999) model. action of financial market development and inflation. Above
the threshold level of inflation, however, the correlation
Hansen (1999) provides a method for testing the presence between growth and financial market development tends to
and number of thresholds, for estimating the value of the be indistinguishable from zero except for the least general
threshold levels, for bootstrapping the p-values for these model7. When provision is made for both the coefficient on
threshold tests, and for estimating the coefficients of the the measure of financial market development and the coef-
proposed threshold relationships using ordinary least squares ficient on inflation to depend on the threshold level of infla-
(OLS). Use of this methodology improves on the ad hoc, tion, the relationship between growth and inflation is signifi-
researcher-dependent methodology adopted so far in the cant and negative only above the threshold level of infla-
search for thresholds in the relationships between growth tion8.
and inflation, and financial market development and inflation.
The main advantages of Hansens approach over the usual Further generalizing the empirical model by allowing an inter-
dummy variable approach are that the data, and not the action between inflation and the financial market develop-
researcher, choose the threshold value and the number of ment measure to correlate with growth, as intimated in
thresholds, and that the statistical significance of the thresh- Huybens and Smith (1999), yields a coefficient on inflation
olds can be determined. Hansen (1999), however, has not that is large, positive, and significant below the threshold, but
worked out the asymptotics of this approach for either an above the threshold it is negative, smaller in absolute value,
unbalanced panel or a dynamic panel, so that not all of the and significant. Inclusion of this interaction channel also indi-
data points used in the previous literature can be used, and cates that the relationship between growth and financial
issues of causality can not be pursued. market development is affected by the level of inflation.9 The
interaction effects between inflation and measures of FMD
Our evidence upholds the hypothesis that there are statisti- suggest that the channels through which inflation and growth

3 Temple (2000) provides an excellent survey of the theoretical and empirical litera- 5 Frischtak (1992) offers a potential counterpoint by arguing that at high rates of
144 ture on the relationship between inflation and growth. inflation there are incentives to increase branch expansion in order to obtain the
4 In the linear context, many studies (e.g. Logue and Sweeney (1981), and Thornton large returns associated with low-interest bank deposits.
(1987) among others) argue that moderate inflation rates can boost growth.
Aghevli (1977) also shows that seniorage revenue can engender positive growth
effects from inflation.
Threshold relationships among inflation, financial market
development, and growth

Overview reaches a threshold level, where the threshold is determined

This paper links together three bodies of literature: the litera- in an ad hoc fashion. Hansen (1996) looks for thresholds in
ture on the relationship between growth and inflation; the nominal U.S. GDP, and further evidence of thresholds in
literature on the relationship between growth and financial growth is presented in Hansen (2000) in a (univariate) time-
market development; and the literature on the relationship series context4.
between financial market development and inflation. The
empirical literature has posited ad hoc thresholds in the rela- The empirical relationship between inflation and financial
tionship between inflation and growth and in the relationship market development has been studied by Boyd, Levine, and
between inflation and financial market development. It has Smith (2001). They show that nonlinear (and ad hoc threshold
also emphasized bivariate relationships in the estimation of or piecewise linear) relationships between inflation and finan-
econometric models, and has not considered a simultaneous, cial market development exist in a cross-section of data. At
trivariate relationship among these variables. The theoretical low to moderate long-run rates of inflation below 15%, they
literature has argued that there are thresholds in the rela- find a strong negative correlation between inflation and vari-
tionship among these three variables, and that the interac- ous indicators of banking sector and equity market develop-
tion between inflation and financial market development also ment, but these partial correlations become insignificant
affects growth. This paper systematically examines these above the stipulated threshold level of inflation (15%). In our
empirical and theoretical postulates using Hansens (1999) paper, an additional fourth model which enables testing for a
panel threshold methodology to test for and estimate thresh- threshold in the bivariate relationship between financial mar-
olds in three threshold growth models, where the relationship ket development and inflation is also studied to see if the
between growth, financial market development, and inflation data choose a 15% level of threshold inflation in this bivariate
becomes progressively more general. relationship.

The empirical literature has uncovered positive and signifi- Two theoretical papers explicitly model threshold relation-
cant linear relationships between growth and various indica- ships among inflation, financial sector development, and
tors of banking sector (and equity market) development in growth. In the model of Choi, Smith, and Boyd (2001) higher
cross-sections [King and Levine (1993a, 1993b), Levine and rates of inflation lead to higher credit rationing and decreased
Zervos (1998), and Atje and Jovanovic (1993)]. Levine, real activity. When inflation is low, credit rationing does not
Loayza, and Beck (2000) also find positive causation from occur, yielding threshold effects dependent on inflation.
financial market development (banking) to growth in a panel Huybens and Smith (1999) derive a model in which threshold
context. A negative and sometimes threshold long-run rela- relationships among inflation, financial market development,
tionship between inflation and growth has been found in and growth depend on the exogenous long-run rate of infla-
cross-sections and non-dynamic panels. This contrasts with tion. Under some parameterizations, inflation and financial
Barro (1995) who claims there is evidence of a negative rela- market development can interact, and this interaction effect
tionship at all rates of inflation. Levine and Renelt (1992) and will also impact growth. Once a threshold level of inflation is
Clark (1997) ask whether this negative relationship is inde- reached, lower levels of real and financial market activity are
pendent of the rate of inflation3. Bruno and Easterly (1998) obtained; below this threshold increases in inflation can
and Bullard and Keating (1995) show that this negative rela- reduce both real and financial market activity, but above the
tionship between inflation and growth emerges once inflation threshold further increases in inflation have no effect on

6 This tightness does depend on which model is estimated, the size of the grid over threshold. The significance of these correlations increases with model generality.
which the threshold is searched, and which control variable set is employed. Perhaps with more data, the positive correlations in the threshold relationship
7 For the (balanced panel) dataset employed in this paper, when a zero-threshold or would become stronger.
linear specification is estimated, as in the literature extant on the relationship 8 When the coefficient on inflation is restricted to be the same across the threshold
between growth and measures of FMD, the positive correlation between these two level of inflation, the coefficient is also negative and significant. This is consistent
variables is more tenuous than in the literature reviewed above. This must be due with results found elsewhere in the literature using linear specifications of the 145
to the fact that the methodology of Hansen (1999) requires a balanced panel, so relationship between growth and inflation.
only two-thirds of the countries included in Levine, Loayza, and Beck (2000) are 9 It is also consistent with the notion that the partial correlation between growth
usable. On the other hand, when thresholds are modeled, the estimated coeffi- and inflation is affected by marginal changes in measures of FMD.
cients suggest much stronger positive correlations with growth below the inflation
 Threshold relationships among inflation, financial market
development, and growth

growth, financial market development, and inflation. Finally, where is the indicator function which takes on a value of one
Model 3 is like Model 2, except that the coefficient on inflation when the expression is true and zero otherwise, and the coef-
is constrained to be the same above and below the threshold ficients take on the following values below and above the
of inflation. This least general model allows for a threshold threshold:
only in the relationship between growth and financial market
development, and forces the relationship between growth () = a if inflationnt , b if inflationnt >
and inflation to be the same above and below the threshold
value of inflation. () = a, inflationnt , b, inflationnt >

Model 1 can be expressed as: Growthnt = + controlnt + () = a, inflationnt , b, inflationnt >

() financent() + () inflationnt() + () [financent()
inflationnt()] + unt The indicator variable more or less splits the datasets into
two sets; one above the inflation threshold and one below,
Growthnt is real per capita growth in GDP for country n at and estimates a separate coefficient for each set of observa-
time t; controlnt refers to the set of control variables; finan- tions. Note that the threshold is chosen by the data, not by
cent is one of the two variables used to capture the notion of the authors. Hansens method simultaneously finds the infla-
financial market development; inflationnt is inflation; , , tion threshold () and the coefficients (a b a b a, b, , and
(), (), and () are regression coefficients; unt is the ) which minimize the sum of squared errors. Model 2
regression error term; and is the threshold level of the obtains when the coefficient () is set to zero, and Model 3
threshold variable (inflation). The explanatory variables are obtains when () is set to zero and () takes the same value
defined as: financent() = financent (inflationnt ) financent above and below the threshold , i.e. a = b. In Model 1, the
(inflationnt > ) interaction between inflation and financial market develop-
ment is permitted to affect growth, and just how it affects
inflationnt() = inflationnt (inflationnt ) inflationnt growth can change once the threshold level of inflation is
(inflationnt > ) reached, as suggested in Huybens and Smith (1999). They
predict that once inflation exceeds a critical level, the correla-
tion between financial sector development and inflation goes
Australia (AUS) Ghana (GHA) New Zealand (NZL)
Austria (AUT) Greece (GRC) Pakistan (PAK) from being negative to zero [ la Boyd, Levine, and Smith
Belgium (BEL) Guatemala (GTM) Paraguay (PRY)
(2001)]. So far, no empirical studies have looked at the rela-
Bolivia (BOL) Honduras (HND) Peru (PER)
Brazil (BRA) Indonesia (IND) Philippines (PHL) tionship between growth and this interaction channel, with or
Canada (CAN) Ireland (IRL) Portugal (PRT) without an inflation threshold. Model 1 bears the closest
Chile (CHL) Israel (ISR) Rwanda (RWA)
Columbia (COL) Italy (ITA) Senegal (SEN) resemblance to the theoretical model of Huybens and Smith
Costa Rica (CRI) Jamaica (JAM) South Africa (ZAF) (1999).
Germany (DEU) Japan (JPN) Spain (ESP)
Denmark (DNK) Kenya (KEN) Sri Lanka (LKA)
Dominican Republic (DOM) Mexico (MEX) Sweden (SWE) Huybens and Smith (1999) also predict that the negative cor-
Ecuador (ECU) Malaysia (MYS) Switzerland (CHE)
relation between growth and inflation can become stronger
El Salvador (SLV) Niger (NER) Thailand (THA)
Finland (FIN) Netherlands (NLD) Uruguay (URY) at higher levels of inflation. Thus, Model 2 can be interpreted
France (FRA) Norway (NOR) United States (USA)
quite directly in terms of their predictions. This model speci-
Great Britain (GBR)
fication is also in line with the empirical studies of Bullard and
Figure 1 Countries included in the dataset Keating (1995) and Bruno and Easterly (1998), except that in

10 The requirement of a balanced panel by Hansens (1999) methodology results in studies. Further, the specification employed here differs slightly from theirs. Boyd,
146 fewer countries being included in the study than were available in Boyd, Levine, Levine, and Smith (2001) did not explore thresholds at these low levels of inflation.
and Smith (2001). The fact that this study is exploiting disaggregated information 11 In comparison, Levine, Loayza, and Beck (2000) have 7 five-year sub-periods
in both the time and cross-sectional domains instead of just the cross-sectional extending from 1960 through 1995, with 74 countries in their unbalanced panel.
domain might also be causing the difference in the results between these two
Threshold relationships among inflation, financial market
development, and growth

are related matter. The previous literature has not studied the Our study also takes into account international differences in
relationship between growth and this interaction variable in GDP per capita, education level, government size, and the
either a linear or threshold framework. black market premium. Inflation is included in this set of con-
trol variables in many studies of the relationship between
Finally, the presence of a threshold in the regression of the growth and financial sector development, but in our study,
measure of FMD on inflation, as in Boyd, Levine, and Smith inflation plays a more central role. Many studies also include
(2001), is tested but the null hypothesis of no threshold typi- some sort of index of political stability, such as the number of
cally could only be rejected for this relationship for one of the revolutions and coups a country experiences, but it is not
measures of FMD at the 10% level of significance. For this included in Levine, Loayza, and Becks dataset, so we do not
case, the data-determined threshold level of inflation is include this variable in our set of control variables.
around 3%10.
Model specification
Data Our paper tests for the presence of thresholds and provides
Levine, Loyaza, and Becks (2000) dataset has 49 countries estimates of the threshold relationship among inflation,
over 6 five-year time intervals, from 1965 through 1995. Not financial sector development, and growth for four different
every country is observed in every time interval, and there- model specifications using the methodology of Hansen
fore not all can be used in this articles analysis. There are a (1999). Although the specifications of Models 1 through 3 are
total of 294 observations11. The list of countries included is in informed by the theoretical threshold growth models dis-
Figure 1. We chose to quantify banking sector development cussed above, the empirical models are not exact correlates
using two different variables, private credit and liquid liabili- in functional form of the theoretical models; they are best
ties. Private credit is defined as the value of credit extended thought of as representations of the theories predictions. For
by financial intermediaries to the private sector as a propor- parsimony of exposition, the most general model, Model 1, will
tion of GDP. It excludes credit issued to the public sector from be presented since Models 2 and 3 are special cases of Model
the public sector (e.g., investment of the Social Security sur- 1. Model 4 is discussed separately as it is not a threshold
plus in Treasury bonds). Levine, Loayza, and Beck (2000) growth model, but a threshold model of the relationship
argue that this is the best measure of banking sector devel- between financial market development and inflation.
opment because it distinguishes between credit issued to the
private sector from credit issued to governments, govern- The most general model, Model 1, allows for the coefficients
mental agencies, and public enterprises. on the independent variables of inflation, financial market
development, and the interaction between inflation and
Liquid liabilities is a measure of financial depth, or the size of financial sector development to change once the threshold
the intermediary sector, and is defined as currency plus level of inflation is reached, but restricts the coefficients on
demand and interest-bearing liabilities of banks and non-bank the control variables to be the same below and above the
financial intermediaries as a proportion of GDP. Liquid liabili- threshold level of inflation. Thus Model 1 simultaneously tests
ties has been used in many studies as a preferred measure of for and estimates thresholds in the relationship among
banking sector development, but Levine, Loayza, and Beck growth, financial market development, inflation, and the
(2000) argue that it does not capture the financial systems interaction between financial market development and infla-
role in reducing transaction costs and informational barriers, tion. Model 2 is the same as Model 1, except that the interac-
whereas private credit does. tion of financial market development and inflation has been
excluded. It allows for a threshold in the relationship among

147
 Threshold relationships among inflation, financial market
development, and growth

no-threshold model. The estimate of the threshold value of When we include the interaction between inflation and finan-
inflation is approximately 14%. (Threshold values are record- cial market development (Model 1), the coefficient on inflation
ed in Figure 2.) The confidence intervals about these thresh- alone becomes larger, positive, and statistically significant
old estimates are generally tight, especially for the Model 1, below the threshold, but above the threshold it remains nega-
which is closest in spirit to the theoretical model of Huybens tive, small in absolute value, and still statistically significant
and Smith (1999). This supports the theoretical predictions of when compared to Model 2, the model without the interaction
Choi, Smith, and Boyd (1996) and Huybens and Smith (1999). term. The coefficients on the measures of FMD remain posi-
When the coefficients on both financial market development tive too and become more significant in the presence of this
and inflation are allowed to depend on the threshold level of interaction term vis--vis Model 2. Furthermore, the coeffi-
inflation, the relationship between growth and inflation is cient on the interaction term is negative, large, and signifi-
significant and negative only above the threshold level of cant below the inflation threshold of 14%, and small, positive,
inflation. (The model estimation results are catalogued in and insignificant above this threshold. This implies that below
Figure 314.) This qualitatively supports the results of Bullard the threshold, small increases in inflation will weaken the
and Keating (1995) and Bruno and Easterly (1998). In quanti- positive correlation between growth and financial market
tative terms, however, the threshold of around 14% chosen by development. It also implies that increases in inflation will
the data is substantially different to the ad hoc threshold of most likely have no effect on the partial correlation between
40% chosen by Bruno and Easterly (1998). In addition, one of growth and financial market development above the thresh-
the innovations of our research is that it is possible to say old level of inflation15, 16. Below the 14% threshold level of
that this threshold is statistically significant. inflation, both the positive effect of inflation on growth and
the weakening impact of inflation on the relationship between
For the dataset employed in this paper, the positive correla- growth and financial market development emerge as a poten-
tion between growth and financial market development is tial tradeoff for consideration by policymakers. The interac-
more tenuous for non-threshold, or linear, specifications than tion effects between inflation and financial market develop-
in the literature reviewed above. This must be due to the fact ment suggest that the channels through which inflation and
that the methodology of Hansen (1999) requires congruent growth are related do matter.
data series for all countries, so one-third of the countries
included in the Levine, Loayza, and Beck (2000) data are Conclusion
unusable due to missing or limited data. On the other hand, There is robust evidence that the relationship among growth,
when thresholds are modeled, the estimated coefficients sug- inflation, and financial market development has an inflation
gest much stronger positive correlations with growth below threshold. Across three growth models, for both financial
the inflation threshold. The significance of these correlations market development measures, and two sets of control vari-
increases with the generality of the model. Perhaps with more ables, the null hypothesis of no threshold null is always
data, the positive correlations in the threshold relationship rejected against the alternative of a single threshold. This
would become stronger. When the coefficient on inflation is implies that regardless of single-equation model specifica-
restricted to be the same across the threshold level of infla- tion, there are thresholds in the trivariate relationship among
tion, the coefficient is negative and significant. This is consis- growth, financial market development, and inflation.
tent with results found elsewhere in the literature using linear
specifications of the relationship between growth and infla- The data imply that the threshold level of inflation is roughly
tion. 14%, and that the confidence intervals about these threshold
estimates are reasonably tight, especially for the empirical

12 Rousseau and Wachtel (2002) use a rolling regression model to chart the change since it is not clear what predictions theory would have for the relationship among
in model coefficients as data are added in order of rate of inflation, then manually growth, inflation, and financial market development across two threshold levels of
148 inspect the results for a shift as each datum is added. Their threshold estimate is inflation, these versions of the models will not be discussed further.
consistent with our paper; however, they do not model the financial markets as a 14 The White (1980) test of no heteroskedasticity (without cross-products) is rejected
channel of economic growth using an interaction variable, and their methodology for all three model specifications for both measures of FMD, so only NW-HAC
does not allow for statistical significance of an inflation threshold. p-values are presented in the figure. Once the threshold level of inflation has been
13 Since the evidence for double thresholds is not robust to model specification, and determined, it is legitimate to correct standard errors.
Threshold relationships among inflation, financial market
development, and growth

Private credit Liquid liabilities

our work a threshold relationship between growth and finan-
Model 1 Threshold 14.5% 14.5% cial market development is simultaneously specified, and the
C.I. 13.0% 13.8% threshold estimate is data-determined.
15.3% 14.6%
P-value 0.01 0.00
Model 2 Threshold 13.8% 13.8% Model 3 captures the prediction of Huybens and Smith (1999)
C.I. 12.8% 7.4% that the relationship between growth and financial sector
44.2% 44.8%
P-value 0.07 0.06
development can change once inflation reaches a threshold.
Model 3 Threshold 14.5% 13.8% At the time this article was first written, no previous empirical
C.I. 10.6% 10.8% studies had taken into account the possibility that the rela-
19.7% 19.9%
P-value 0.10 0.09
tionship between financial market development and growth
Model 4 Threshold 3.4% 4.9% may be affected by a threshold in inflation. Since then,
C.I. 3.2% 1.8% Rousseau and Wachtel (2002) also discovered a shift in the
4.9% 15.2%
P-value 0.08 0.26 relationship between growth and financial market develop-
ment at varying levels of inflation. They estimate that there
Figure 2 Threshold values of inflation, confidence intervals, and p-values for sta-
is an inflation threshold somewhere between 13 and 25 per-
tistical significance of a single threshold versus the null hypothesis of no inflation cent12.
threshold.

The last model, Model 4, seeks to verify whether or not the

Variable-coefficient Regime Model 1 Model 2 Model 3 Model 4
Private credit- Below 0.02 0.01 0.01
types of ad hoc thresholds between financial sector develop-
Standard error (0.0300) (0.1200) (0.1900) ment and inflation suggested in Boyd, Levine, and Smith
Private credit- Above -0.02 -0.01 -0.02
(2001) and Huybens and Smith (1999) are actually statisti-
Standard error (0.2200) (0.6000) (0.0500)
Inflation- Below 0.12 0.05 -0.02 3.78 cally significant, and whether the data would choose a
Standard error (0.0100) (0.1300) 0.0000 0.0000 threshold value of inflation similar to those suggested in
Inflation- Above -0.02 -0.02 same -0.11
Standard error 0.0000 0.0000 same 0.0000 Boyd, Levine, and Smith (2001). Model 4 is: financent = +
Interaction- Below -0.25 controlnt + () inflationnt() + unt, where () = 4a, infla-
Standard error (0.01)
Interaction- Above 0.06
tionnt , 4b, inflationnt >
Standard error (0.16)
R-squared 0.40 0.38 0.37 0.41 Since it is desirable to have at least a certain number of
Liquid liabilities- Below 0.02 0.01 0.01
observations lying in each regime, the set of over which we
Standard error (0.14) (0.23) (0.26)
Liquid liabilities- Above -0.02 0.00 -0.01 search for the optimal is restricted so that a certain per-
Standard error (0.29) (0.84) (0.30) centage of the observations lie in each regime. The modeling
Inflation- Below 0.17 0.04 -0.02 1.21
Standard error (0.00) (0.16) (0.00) (0.00) of the data must be non-dynamic, so issues of causality can
Inflation- Above -0.02 -0.02 same -0.06 not be addressed.
Standard error (0.00) (0.00) same (0.02)
Interaction- Below -0.36
Standard error (0.00) Results
Interaction- Above 0.05
The evidence upholds the hypothesis that there are statisti-
Standard error (0.25)
R-squared 0.40 0.38 0.37 0.32
cally significant single-threshold relationships among growth,
financial sector development, and inflation13. Across three

Figure 3 Coefficients, Newey-West (1987) HAC P-values for statistical signifi-

threshold models and for both measures of FMD, the data
cance, and adjusted R-squared. always favor a threshold model, rejecting the hypothesis of a

15 To determine whether or not Model 1 was in some sense picking up misspecifica- above the threshold were zero. These results support the notion that Model 1 is
tion error in Model 2, Model 2 was also estimated with an interaction term whose not picking up misspecification error in Model 2. 149
coefficient was not a function of the threshold level of inflation. Wald tests always 16 Models 3 and 1 are selected for private credit using Schwarz (1978) Bayesian
accepted the null hypothesis that the estimated coefficient on this linear interac- Information Criterion (BIC) and Akaikes (1973) Information Criterion (AIC) respec-
tion term was zero for Model 2. For Model 1, Wald tests also rejected the joint tively. AIC is relatively more favorable for large models than is BIC.
hypothesis that the estimated coefficients on the interaction terms below and
 Threshold relationships among inflation, financial market
development, and growth

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150
Threshold relationships among inflation, financial market
development, and growth

model which is closest in spirit to the theoretical model of Below the threshold, this negative impact of inflation on the
Huybens and Smith (1999). This supports the theoretical pre- relationship between growth and financial market develop-
dictions of Choi, Smith, and Boyd (1996) and Huybens and ment must be weighed against the direct positive relationship
Smith (1999). The threshold estimation results for these mod- between growth and inflation when making policy recommen-
els are distinct from the results of Bullard and Keating (1995) dations. Ideally, it would be possible to model the dynamics of
and Bruno and Easterly (1998) in that the threshold is not ad these contrasting effects, but this is not possible with Hansens
hoc, it is statistically significant, and is far less than the 40% (1999) methodology. Above the threshold level of inflation,
threshold level of inflation popularized in Bruno and Easterly further marginal increases in inflation have no impact on the
(1998). The evidence suggests that there is only a single relationship between growth and financial market develop-
threshold value of inflation below and above which the tri- ment. This is consistent both with Huybens and Smith (1999)
variate relationship among these variables changes. and the informal story that at higher rates of inflation, finan-
cial contracts become indexed to inflation so that the negative
This paper contributes three additional novel empirical impacts of inflation on the provision of financial contracts are
results. Firstly, when an interaction term between inflation eliminated.
and financial market development is allowed to affect growth
in a threshold model, the relationship between inflation and Lastly, including an interaction term leads to an even stron-
growth is strongly positive and statistically significant below ger positive partial correlation between growth and financial
the threshold level of inflation, and becomes negative and market development below the threshold and no relationship
significant above the 14% threshold level of inflation. It above the threshold, even though a linear or nothreshold
should be noted that in this specification, the positive coeffi- specification of the model implies that there is no significant
cient on inflation below the threshold is much larger and relationship between growth and financial market develop-
more significant than it is in specifications without the inter- ment for the balanced dataset employed. Across all models,
action term. This is in contrast to the results of most previous the positive relationship between growth and financial mar-
studies on the relationship between inflation and growth, but ket development breaks down above the threshold level of
it does lend support to the idea that the channels (i.e., finan- inflation, a threshold result which has not been considered by
cial sector) through which inflation and growth are related the empirical literature. This threshold relationship implies
matter. This finding thus supports the general theoretical that the positive benefits of financial market development on
predictions of Huybens and Smith (1998, 1999). growth occur at low to moderate levels of inflation.

Secondly, the financial development inflation interaction term

is significant in the single threshold specifications. Although
empirical researchers have studied the relationship between
inflation and financial market development in a bivariate
sense, they have not considered the impact of this interaction
on growth. Our results suggest that below the threshold level
of inflation, marginal increases in inflation impair the positive
partial correlation between growth and financial market
development, while above the threshold, marginal increases in
inflation either increase or have no effect on the partial cor-
relation between growth and financial market development.

151
152 - The journal of financial transformation
 Financial

Manufacturing growth

Peter Moles
Senior Lecturer in Finance, University of
Edinburgh Management School

Abstract
At a time of low interest rates and hence low future growth engineering techniques to manufacture growth securities that
and returns, investors who are looking for above-average have the desirable above-average growth attributes but with-
prospects have to seek out those investments which offer out the assessment problems of many existing high-growth
higher gains. However, in many cases, the securities that offer investments. Using the principles of financial engineering it is
high growth often involve hard to evaluate uncertainties on possible to create securities that provide the required level of
political, technological, economic, and social grounds. In expected reward without the uncertain bets on technological
mature economies, above-average prospects tend to be con- developments or emerging market economies. Financial inter-
centrated in particular industries, for instance, technological, mediaries are well placed to provide such synthetic growth
media, and telecoms. Investments in emerging markets, while securities since they can benefit from scale economies in the
they offer high prospective growth, can suffer from a variety manufacturing process.
of country specific problems. An alternative is to use financial

153
 Manufacturing growth

In an environment of low interest rates, there is a natural technology to solve financial problems and exploit financial
search for investment opportunities that offer above-average opportunities. Mason et al (1995) also make the point that
prospects. Investors seeking prospective high growth or financial engineering can be viewed as the means of imple-
return have been attracted to exotic securities and invest- menting financial innovation. Furthermore, in their view, the
ments, including emerging markets, commodities, and alter- power of financial engineering should not be defined by the
native investments, such as hedge funds. In a large number of complexity of its models or computers but by the expanded
cases there is a problem with these high return investments, economic or managerial flexibility it offers to its users.
namely a poor understanding of the risks involved. While it is
understood that high prospective returns only come from The popularity and growth of financial engineering as a way
assuming risk, many of the asset classes that offer the pros- of solving problems in finance can be seen in the ever-
pect of above-average returns involve complex, hard to define, expanding range of innovative securities and financing
nested, and interrelated risks. structures seen in the global capital markets. While financial
engineering is not a new phenomenon, structural changes in
For many investors the uncertainties involved in high return global financial markets are a major contributing factor to its
securities make them hard to evaluate bets on political, tech- rising popularity1. Other factors that have driven develop-
nological, social, and economic developments. For instance, ments include important advances in risk management tech-
emerging markets suffer not only from fair weather liquidity, niques, the drive to reduce issuing costs, increased opportu-
but also from country, political, and event risks, as well as nities for accounting, tax, and regulatory arbitrage, and the
contagion effects across the asset class. This makes them ability to mitigate pervasive incentive and agency issues. In
unattractive portfolio choices for those investors who are addition, pervasive market volatility, technological advances
seeking above-average growth by assuming a higher, but con- in data processing, and advances in financial theory have all
trolled level of, risk. This is where financial engineering prin- greatly contributed to widespread financial innovation.
ciples can help by manufacturing the required growth securi- Advances in our understanding of the principles of finance
ties from existing obligations. These synthetic growth securi- have significantly contributed to the current popularity of
ties involve well-understood risks and avoid many of the pit- financial engineering, as practitioners have implemented
falls of exotic investments. many of the insights provided by academic research.
Furthermore, the ability of market participants to observe the
Financial engineering success (or possible failure) of innovative securities and
Financial engineering can be defined in different ways. Some transactions has created a body of experienced practitioners
consider it to be simply a handy label for what corporate who understand not just the design, but also how to market
financiers do, while others view it as another term for compu- and trade the resultant securities2.
tational finance. Nevertheless, it is accepted that a key ele-
ment is the way financial engineering is linked to financial Financial engineering can be broadly categorized into three
innovation. In his review article on financial innovation, types of activity, namely creating innovative securities, inno-
Finnerty (1988) described financial engineering as the vative financial processes, and creative solutions to problems
design, development and implementation of innovative finan- in corporate finance. As a security creation process, it makes
cial instruments and processes, and the formulation of cre- use of fundamental financial instruments, borrowing and
ative solutions to problems in finance. The International lending, and derivatives to fine tune an existing financial
Association of Financial Engineers (2006) describes the pro- product in order to restructure it into one having more desir-
cess as the development and creative application of financial able risk-reward characteristics. This repackaging creates

1 Smithson (1998) makes the point that financial innovation was rediscovered in the 2 Financial engineers with a good grasp of the principles involved are easily able to
154 1970s. He cites the case of the Confederate States of America, which during the reverse engineer the structures of innovative securities and hence copy them,
American Civil War issued a dual-currency cotton indexed bond to show that finan- thus spurring rapid imitation and widespread adoption. See for example Banks
cial innovation is not a new phenomenon. The 1970s was also a period when many (2006).
of the fundamental insights that we now know as modern finance were first pub-
lished.
Manufacturing growth

value to the end user by more closely aligning the resultant The illustration will assume that the investment fund is being
securities with their investment needs. created now and will last for five years, which we take to be
the planned life of the fund after which all the value will be
Creating growth securities distributed to securities holders. The illustration will be used
to show how financial engineering, by structuring the liabili-
Element ties of the fund, can create securities with high promised
Index portfolio value 100 returns. As will be explained below, it is also necessary to price
Expected growth 7% p.a
Dividend yield 2% p.a the resultant securities using the contingent claim valuation
Portfolio volatility 25% approach developed for pricing derivatives and, again for
Life of fund 5 years
Beta (index portfolio = market) 1.0
simplicity of illustration, we will assume one-year steps in the
Risk-free interest rate 4% p.a model4.
Pricing step 1 year

Figure 1 Pricing variables for illustrative examples

By holding the index portfolio given in Figure 1, an investor can
anticipate a prospective average return of 7 percent per
To see how financial engineering can create growth securities annum for assuming this risk, so after five years the fund
in a low return environment, seemingly out of thin air, we will value is expected to grow to 140.3 (capital appreciation ratio
use a simple example to illustrate the process. This will ignore of 1.4 times). The simple model developed by Cox, Ross, and
some real world problems that impede innovation, such as Rubinstein (1979) allows us to model future uncertainty in
regulation, differences in tax treatment, and investor educa- asset prices. Using this model, as shown in Figure 2, at the end
tion3. The initial conditions for the underlying security that of the five years the value of the index portfolio can range
will be modified (in this case an index fund, say on the S&P between 349 and 28.7. This uncertainty is intrinsic to the index
500 or FTSE 100 index), its expected growth, and market con- fund and will affect the value and performance of the securi-
ditions are given in Figure 1. Note that, unlike many alternative ties the fund issues. By carefully selecting the liability struc-
investments, the index funds constituents are large, blue-chip ture of the fund securities with higher, or lower, prospective
stocks whose risk characteristics are well-known and, due to returns and risks can be created that match investors require-
the diversified nature of the portfolio, investors only bet is ments.
on how the market will perform over the five years.
How can growth-orientated investors obtain higher prospec-
tive returns? One approach is to remodel the fund into a high
0 1 2 3 4 5 beta portfolio5. Normally this involves finding suitable securi-
ties with high exposure to systematic risk. The problem with
349.0
271.8 this approach is that it means investing in speculative growth
211.7 211.7
areas, such as technology, media and telecoms, biotechnolo-
164.9 164.9
128.4 128.4 128.4 gy, or other nascent industries. Consequently, the resultant
100.0 100.0 100.0
77.9 77.9 77.9 portfolio is strongly exposed to industry effects and possibly
60.7 60.7 specific firms if the universe of such high growth stocks is
47.2 47.2
36.8 small. On the other hand, financial engineering techniques
28.7
can be brought to bear to generate growth securities, while
Figure 2 Possible future portfolio values at the end of each year using one-year
avoiding industry hot spots and stock-specific risk. The analy-
steps given volatility is 25 percent sis that follows will restrict itself to just a few simple steps to

3 The saga over the introduction of the SuperTrust by, Leland, O'Brien, Rubenstein 5 For example, a portfolio with a beta = 2.0 (twice as risky as the market) has an
Associates Inc. in the late 1980s is an example of how innovation can be stymied expected return of 10 percent per annum and, for the five years, a capital appreci- 155
by regulatory and other concerns. See Harvard Business School case study 9-294- ation ratio of 1.6 times.
050
4 In practice a more refined analysis would be used.
 Manufacturing growth

Figure 6 Effect of leverage on claims issued by the index fund with a debt obli-
gation of 60 at maturity
0 1 2 3 4 5

For growth hungry investors, the extra prospective return on 0.00

0.00
the leveraged units may not be enough and hence the amount 0.00 0.00
0.00 0.00
of debt in the structure may not be sufficient. In designing the
0.18 0.00 0.00
structure, more leverage can be added by increasing the 1.10 0.35 0.00
2.01 0.70 0.00
amount of borrowing, but this has to be matched by the 3.68 1.39
increase in performance risk for the debt security. Figure 6 6.68 2.76
12.01
shows the effect on the two securities if the amount of debt P P P
Vt-1 = [Vt u p+V t d (1p)](1+rf)1 21.35

to be repaid is increased to 60. In this example with additional

Figure 4 Valuation of default put in a contingent claim valuation framework
debt, the expected return on the leveraged units is very
slightly lower at 8.50 percent. This is because, given the struc-
ture, there is an optimum borrowing level that maximizes the ever rising prospective returns. Note too that the smaller the
possible returns to leveraged units under the market assump- fraction of the portfolio value represented by the growth
tions given in Figure 18. So adding debt does not automati- claims the more option-like they become and this can change
cally raise the prospective returns for holders of the leveraged the attractions of such securities.9
units. This is because additional borrowing raises the default
probability on the debt and hence the promised return that Step two create pure growth and pure income
such investors require. Debt markets tend to be sensitive to securities
the potential expected loss from debt instruments and may As the earlier discussion shows, there is a limit to the prospec-
demand a risk premium/price discount in excess of the expect- tive return that borrowing will achieve. However, debt derived
ed loss for assuming high levels of performance risk. So while leverage is not the only way growth can be manufactured. In
an element of debt can raise the return on the growth securi- the first step, the growth securities were simply leveraged
ties, ever increasing levels of leverage may not always lead to units in the index fund. Holders of such units receive not just
capital appreciation but also the dividends on the index over
the five years. Consequently, it raises the cost of acquiring
Value of claims
these growth units, since their value includes not just the ter-
issued by index fund Value of leveraged
units (ST 50) minal value of their entitlement in the index fund (ST B) but
If the assets of the index fund are
worth less than 50 at maturity, the
also the dividend stream over the five years.
leveraged unit holders get nothing
and the prior claim holders (zero-cou-
pon securities) get whatever is left Conceptually all equity securities are the present value of
50
Value of prior claim
their dividend stream. There are no legal impediments (or
(zero-coupon value loss) from unbundling these future cash flows. Hence it
securities)
is possible to create a pure growth security, which receives no
dividends over the five years and whose payoff depends
50 Value of fund at maturity uniquely on the index funds terminal value. The present
(5 years) value of the expected dividends will be simply the difference
between the pure growth security, which can be valued using
Figure 3 Effect of borrowing on returns to investors in the leveraged stock units
(growth units) contingent claim methods (and is worth 50.57) and the

6 There is no reinvestment risk from such a pure discount security, and when they 7 Again, an understanding of the principles of financial engineering and contingent
were first made popular they were issued as money multiplier securities. With an claim analysis will allow for an ex-ante estimation of this default risk. Using the
156 interest rate of 4 percent such a security will double in value every 18 years. contingent claim valuation approach, it is possible to estimate the probability of
Higher rates mean shorter doubling periods. With a yield of 8 percent the security default, which in this example is about 5 percent. So 95 percent of the time, inves-
will double in value in 9 years. In the context of creating (and selling) growth, such tors in the zero-coupon security will receive the promised payoff. For a discussion
zero-coupon securities could be considered a fixed return low-risk growth security. of this use of contingent claim valuation for default prediction see Merton (1974).
Manufacturing growth

illustrate the power of the principles involved. In theory there The valuation of the default put is shown in Figure 4. This
is no limit to what can be done; designers of such structured gives a value of 1.10. If the security was totally default-free, it
products are only limited by the demand for the resultant would earn the risk-free interest rate of 4 percent and hence
securities. have a present value of 41.10. The value of the risky zero-cou-
pon security is therefore 41.10 1.10 = 40.00, which gives a
Step one add debt prospective yield of 4.56 percent. The extra promised yield
A very simple piece of engineering involves borrowing; that is, over the risk free rate compensates the holders for the risk of
issuing a prior claim to finance part of the investment. Such a impairment. Investors would need to satisfy themselves that
debt security has the first claim on the assets of the fund the spread above the risk-free rate was worth the potential
while the residual claim has a payout of ST B, where ST is the loss7.
value of the index fund at maturity and B is the promised
repayment on the borrowing. The effect is to leverage up the From the principle of conservation of value, if the debt is
return on the index securities, which are now leveraged index worth 40, the remaining leveraged units must be worth 60. On
stock, index growth units, or whatever marketing term is used this basis the expected return has risen from the 7 percent for
to raise the interest of potential investors. It will also add to the unleveraged index fund to 8.52 percent for the leveraged
the leveraged securitys risk. The payout at maturity to the units (capital appreciation ratio of 1.50). Figure 5 shows the
two sorts of claims on the index fund from part financing with effect of this structure. Leveraged unit holders pay 60 to
debt is shown in Figure 3. acquire an economic exposure in the fund that is worth 88.65.
By getting fixed income investors to fund part of the invest-
We will assume that this prior claim is created via the issuance ment and to assume some performance risk, the leveraged
of a zero-coupon debt security with a payout of 50 at its five units obtain an increased prospective return of 1.52 percent.
year maturity. The zero-coupon is simply a modeling feature Conversely, the zero-coupon debt has a notional exposure to
but, in practice, may be attractive to investors seeking a the funds performance equivalent to 28.4 percent of the cur-
largely guaranteed expected return6. There is some perfor- rent value of the security and an impairment risk of about 5
mance risk for holders of the zero since there is the possibility percent.
that they do not get all their money back. As is evident in
Figure 2, there is some chance that the index fund will be Security Equivalent Default free Market
amount of debt value of
worth less than 50 after five years. In that case, holders of the index portfolio element security
security get whatever the value of the fund is at this point in Value of zero-coupon debt 11.35 28.65 40.00
time. This can be as little as 28.7 compared to a promised 50. Value of leveraged units 88.65 (28.65) 60.00
100.00 100.00
In effect, investors in the zero-coupon security have accepted
an element of exposure to the performance of the fund. In the Figure 5 Effect of leverage on claims issued by index fund with a debt obligation
language of corporate finance, in a situation where there is of 50 at maturity

some uncertainty about the potential repayment, debt holders

have written a default put on the underlying value of the port- Security Equivalent Default free Market
amount of debt value of
folio [Brealey, Myers & Allen (2006)]. Using the identity that index portfolio security

the value of risky bond is equal to the value of risk free bond Value of zero-coupon debt 17.78 28.65 46.43
Value of leveraged units 82.22 (28.65) 53.57
less the default option value, we can price the default option
100.00 100.00
and hence find the market value of the zero coupon security.

8 What is happening is that, given the expected growth rate in the portfolio, the use coupon debt, we have an expected payoff of 80.3 and a cost of 53.4, giving a
of debt is reducing the investment required in the growth units, but at the same return of 8.50 percent.
time the expected payoff (E(ST K) at maturity is also falling. Note that E(ST) is 9 As a rule-of -thumb if the growth securitys delta is less than 0.50, the security is 157
based on the prospective return on the underlying portfolio, namely 7 percent. out-of-the-money and is expected to be worthless at maturity. Hence such low-
The value of the index fund is expected to be 140.3 in five years. With a payout to delta securities are highly speculative; but at the same time, being highly lever-
zero-coupon security holders of 50, there will be 90.3 left to growth unit holders. aged, will be highly responsive to changes in the value of the underlying portfolio.
The prospective return = (90.3/60).20 1 x 100% = 8.52 percent. With 60 in zero-
 Manufacturing growth

the earlier example since they have a senior position to is 47.2. Under the assumptions used in this example, there is
income units and growth units. Another attractive feature of now only a small possibility that the zero-coupon holders will
the structure, from a selling perspective, is the way dividend not be repaid. If holders of the zero-coupon securities are
income is concentrated into the income units. These have a comfortable with its previous performance risk characteris-
prospective income yield of about 9 percent although this is tics, there is the capacity to add further debt. However, there
not without a capital loss. Holders will only receive 20 at matu- is a problem with this approach in that, in doing so, the market
rity, all being well, while purchasing a security costing 22.2812. value of existing debt, which has benefited both from the
In the above case, the debt-equity ratio is 0.67 and the struc- increase in asset cover and the reduction in maturity, would
tural leverage ratio is 1.65. be adversely affected. An alternative approach is to liquidate
part of the index portfolio and buy back and cancel existing
Step four dynamic adjustment growth and income units. With the debt currently worth 42.6,
The earlier discussion assumes a fixed capital structure where this means buying back 22.0 worth of the growth and income
the numbers of each security remain unchanged over the five- units to achieve the previous debt-equity ratio13. A frequently
year life of the fund. However, there is no inherent reason that used method of restructuring is to undertake an exchange
this should be the case. Assume that the market does well in offer (for instance, by setting up a new fund with a longer
the first year and for simplicity assume also that the value of maturity) and getting investors to convert their holdings into
the fund is 128.4 at the end of the year (this is the value of the the new fund.
upper node for year one shown in Figure 2). For simplicity, we
will keep the market conditions as given in Figure 1. Now the Note that if the market value of the portfolio had fallen,
expected value of the fund at the end of its life will be 168.3. restructuring in this case would involve buying back debt or
We need to reprice the elements of the fund (not shown) but issuing more growth and income units in order to reduce the
the new market value of the structure is given in Figure 8. amount of leverage in the structure. Hence, it is quite feasible
to have a situation where there is continual issuance and
The rise in the market has had the effect of reducing the
Security type Value
amount of leverage in the financial structure. Whereas the Growth security value 37.72
debt equity ratio was 0.67 it is now 0.50 and the structural Income security value
of which
leverage which was 1.65 is now 1.13. For growth unit holders,
Principal 12.85
the reduction in leverage means the expected return has fall- Dividends 9.43
22.28
en to 12.25 percent.
Zero-coupon security 40.00
Portfolio value 100.00
Financial engineers have a wide range of alternatives for
Figure 7 Value of the three security index fund structure at inception based on
restructuring the fund at this point. One possibility is to simply
market conditions from Figure 1
leave the structure unchanged. A second possibility is to raise
more debt to restore the initial leverage. Raising more debt is
a distinct possibility as long as the contractual arrangements redemption of the underlying units to the fund. This approach
allow for this. Given the favorable market scenario, the zero- allows both the desirable growth and risk characteristics to be
coupon debt has seen a significant reduction in performance maintained and, indirectly, provides a degree of liquidity for
risk. The lowest node of the tree in Figure 2 with four years the units.
left and the new market value for the index portfolio of 128.4

10 This was the approach taken by the innovative Americus Trust securities, which split-capital investment trusts.
divided the claims on the investment portfolio into Proscribed Right to Income and 11 In financial engineering terms, the income securitys principal is simply a bull
158 Maximum Equity (PRIME) and Special Claim on Residual Equity (SCORE) units. spread on the funds future value between the lower value of 50 (the amount due
PRIMEs had a maximum payout and received all the (concentrated) dividends from to debt holders) and the upper value of 70 (which is the debt value plus income
the trust, while the SCORE was a residual capital gains-only security which was unit principal value) to which has been added the dividend rights for the funds
entitled to all proceeds once the contractual payout had been made to the income.
PRIMEs. This structure has been imitated extensively, not least in the U.K. with
Manufacturing growth

growth unit with dividends (which was valued at 60). The in the fund can then decide on the mix of these to craft the
present value of the expected dividends is therefore 9.43. required growth/income/capital profile that best suits their
Stripping out the dividends in this way leaves a pure capital portfolio objectives. By weighing the portfolio heavily towards
appreciation security that still has the same expected payoff, the higher risk pure growth units, an investor would be seek-
so its prospective return is now 12.3 percent; that is, 5.3 per- ing principally capital appreciation. A predominance of zero-
cent above that of the unleveraged index fund and three coupon and income units, with possibly a small holding in the
times the risk-free rate (and a capital appreciation ratio of pure growth units, would provide current income and greater
1.79 over the five years). capital certainty. Hence by using structural leverage, financial
engineers can create securities that allow investors to fine
Designers of attractive liability structures and innovative tune their portfolio mix to match exactly their risk-reward
securities now have a range of choices once the intervening requirements.
cash flows are stripped from the growth units. One possibility
is that instead of offering a simple zero-coupon debt security Step three creating growth, providing income,
to add on the dividend income rights in order to make these and combining this with debt
income units. That is, this security is entitled to all dividend Structural leverage can be combined with debt to create secu-
income from the portfolio. Combining the rights with the divi- rities with higher prospective returns. Returning to the
dend stream and a maximum future payoff of 50, that is add- example, now we create a third class of security which is
ing the rights to the dividends to the zero-coupon securities, entitled to all the expected dividends over the life of the trust
would, in the example, cost 49.43 and would have a prospec- and receives a return on principal of 20 at maturity but which
tive yield of slightly above 4 percent (remember the current is subordinated to the (zero-coupon) debt in terms of repay-
yield on the index is only 2 percent)10. (Note, in this case, ment. This has the effect of increasing the leverage of the
Security type Value growth units. But this does not raise the default risk on the
Growth security 60.2 debt, since this dividend paying third security will be a type of
Income security value subordinated debt or equity instrument (typically a variety of
of which
preferred stock or preference share)11. The value of the three
Principal 15.8 securities is given in Figure 7. The amount represented by the
Dividends 9.8
25.6
growth security is now only 37.72 of the portfolio value and
Zero-coupon security 42.6 has a prospective return of 13.25 percent (and a capital appre-
Portfolio value 128.4
ciation ratio of 1.9 times). This is, of course, not achieved
Figure 8 Value of three security index fund structure after one year when the without taking on additional risk. If the portfolio value should
fall to 70 or below, holders of these securities will be wiped
additional leverage may be attractive in raising the capital out. However, for growth orientated investors who expect an
repayment to holders of these income units.) appreciation of the underlying portfolio, this is not necessarily
a hugely negative feature.
Another alternative is to create pure dividend annuity securi-
ties with no entitlement to any capital at the maturity of the From an engineering perspective, this triple slicing of the
trust. That is, the trust would now have three securities: a claims on the fund into capital, income, and debt has the
pure growth (capital appreciation) security, a pure zero-cou- attraction of not increasing the amount of debt finance. The
pon debt-like security, and a dividend-only security. Investors return demanded of debt holders remains unchanged from

12 Again, applying the principles of financial engineering, it is easy to manipulate the 13 To maintain the pre-buyback ratios, we need to retire 15.4 of the growth units and
offering price of the security at issuance so that it costs current income-seeking 6.6 of the income units. Note that there will be an interactive effect between the
investors par; that is 20 rather than 22.28. repurchase of the growth and income units and the value of the debt since reduc- 159
ing the asset cover raises the performance risk (default option) and hence reduces
the debt securitys market value.
 Manufacturing growth

risk is low can the firm safely borrow and be in a position to Conclusions
fully redeem the debt at maturity. This rule of thumb should Investing in growth can be in sectors that ex-ante are expect-
apply to manufactured growth securities. The underlying port- ed to offer higher than average returns. But these opportuni-
folio should consist of large, liquid blue chip securities, since ties come with risks which, for many existing securities,
the intention is to leverage the portfolio and hence its behav- involve investments that are often hard to evaluate. An alter-
ioral characteristics should be well known and understood. native approach is to manufacture growth securities that
Problems can arise when sector or industry specific portfolios meet investors requirements but whose underlying charac-
are leveraged, since investors are then assuming more com- teristics are well-understood. This approach uses principles
plex, and possibly hard to evaluate, risks. The amount of finan- from financial engineering to create structured products
cial risk being taken also needs to be carefully thought that deliver the required amount of expected growth. The
through via appropriate stress testing of outcomes. There are simple example used in this article showed how, by applying
hidden costs attached to excessive leverage when funds well-understood financial principles, a financial intermediary
become financially distressed and require restructuring or can create tailor-made growth investments using an underly-
liquidation. Either existing liabilities have to be reorganized or ing portfolio that has transparent risk characteristics. The
costly new financing has to be raised with dilutive effects on structuring of such growth units does not involve the use of
existing claimholders. Furthermore, both existing and new complex derivatives, although their pricing and structuring
investors cannot be sure whether the problem is due to bad does requires a clear understanding of contingent claim
luck or incompetent management. The complicated non-lin- valuation. In designing, structuring, and offering such securi-
earity of the liability structure in response to changes in ties, financial intermediaries have a number of competitive
underlying fundamentals can further muddy the waters. advantages that make them natural producers of such struc-
Excessive leverage also affects a funds human capital. High tured products.
quality managers might be reluctant for reputational and
career reasons to remain with or agree to manage such a References
Banks, E., 2006, Synthetic and Structured Assets, Winchester: John Wiley & Sons
fund. Finally, when leverage is high, some poor investment
Brealey, R.A., S.C. Myers & F. Allen, 2006, Corporate Finance, Boston MS: McGraw-
strategies might be adopted, raising the overall risk of the Hill Irwin
investment portfolio unnecessarily14. Cox, J., S. Ross and M. Rubinstein, 1979, Option pricing, a simplified approach,
Journal of Financial Economics, 7, October: 229-264
Finnerty, J. D., 1988, Financial engineering in corporate finance: an overview,
Financial Management, 17: 14-33
International Association of Financial Engineers, 2006, www.iafe.org (accessed
March 1)
Mason, S.P., R.C. Merton, A.F. Perold, and P. Tufano, 1995, Cases in Financial
Engineering: applied studies of financial innovation, Upper Saddle River, NJ:
Prentice Hall
Merton, R. C., 1974, Theory of rational option pricing, Bell Journal of Economics
and Management Science, 4, Spring: 141-183
Modigliani, F., and M. H. Miller, 1958, The cost of capital, corporate finance and the
theory of investment, American Economic Review, 48, June: 261-297
Smithson, C.W., 1998, Managing Financial Risk: a guide to derivative products, finan-
cial engineering, and value maximization, New York: Irwin Library of Investment &
Finance

160 - The journal of financial transformation

Manufacturing growth

Role of intermediaries what securities it issues, determines how a trust performs and
As demonstrated by Modigliani and Miller (1958) there is no the allocation of returns to the different providers of funds.
reason why individual investors cannot in principle construct The structure operates in two ways: firstly through the assets
home-made leveraged units as shown in the example above. held by the fund, which will impinge on the risk and return
Nevertheless intermediaries have a significant competitive characteristics of the liabilities issued by the fund; and sec-
advantage as providers of structured products. Using interme- ondly through how the right to capital and the income stream
diaries to create the growth units and other units via special- from the fund is divided between the different liabilities. The
ized funds, which do the borrowing, has significant attrac- funds structure will thus determine the risk-reward character-
tions: they can borrow on better terms than individuals and istics of the liabilities.
have limited liability status, which caps investors commitment
to their original investment in the event of bankruptcy. The use of debt leverage makes sense when there is a clien-
tele for high risk/reward securities. In situations where future
In addition, intermediaries benefit from economies of scale returns are expected to be low, there is a demand by investors
and scope, which means they have an important role in pro- for instruments that offer the prospect of above-average
viding structured products. They offer bundled services to returns. Splitting the funds returns between current income
investors: instant diversification, delegated and professional and capital appreciation also makes sense for tax and invest-
investment management, administrative services, such as col- ment purposes. On the other hand, the discussion has high-
lecting dividends and other payments due on holdings in the lighted how the different structures lead to potential problems
fund, valuation, and custodial services. They are able to for investor analysis and valuation. This is especially the case
spread the cost of the financial manufacturing systems (for in the more complex arrangements that financial engineers
instance, the use of specialist financial engineers, set up and can create. Complex liability structures have non-linear rela-
development costs) across a multitude of products. They can tionships with value shifts between the securities issued by
invest in sophisticated systems to monitor and manage the the fund that depend on the behavior of the underlying invest-
resultant risks. Finally, they are able, via marketing and sales ment portfolio. That is, there are complex interactions between
efforts, to target likely investors and aggregate demand from the investment portfolio value, its volatility, dividend yields,
investors. and interest rates and the funds financial structure which
lead to value shifts between different liability classes. These
Issues with the financial structure of funds are the consequences of the financial structure and the
The above analysis largely ignores some issues that can affect effects of the option-like characteristics embedded in the dif-
the attractiveness of growth securities and the structures ferent securities. There are also structuring risks. For instance,
used to create them. One area is regulatory approval and the risk that there may be unanticipated changes to the
oversight. In a risk-based regulatory environment, such funds investment portfolio.
might be subject to greater scrutiny than more conventional
funds. Another is the reputational risk for the sponsoring There is no reason why the structure of a fund issuing lever-
financial institution. Hence, designers of such funds need to aged securities should differ fundamentally from that of an
be aware of not just the financial principles involved but also industrial or commercial company. The corporate finance rule
the funds structure and how changes in market conditions of thumb requires that when the business risk of such firms is
might affect the value of the securities. high the firm should adopt a conservative financing policy.
That is, it should fund itself mainly through equity capital or at
A trusts asset-liability structure, that is how it invests and least minimize the extent of borrowing. Only if the business

14 This is a well-known problem in corporate finance called risk shifting and is most
likely to occur when the firm is experiencing problems. 161
162 - The journal of financial transformation
 Financial

Corporate hedging
and capital structure
decisions: towards an
integrated framework
Lutz Hahnenstein
for value creation1
IKB Deutsche Industriebank AG,
Kreditrisikocontrolling

Klaus Rder
Professor of Finance, Universitt Regensburg,
Lehrstuhl fr Betriebswirtschaftslehre, insbeson-
dere Finanzdienstleistungen

Abstract
We suggest a joint optimization model for a firms hedging and
leverage decisions that helps to establish an integrated frame-
work for value creation. Rather than artificially separating the
two interrelated parts of the firms financial policy, we treat
both corporate decision variables as endogenous. We argue
that exogenous differences between financial distress costs
across firms, and particularly across industries, simultane-
ously influence corporate risk management and capital struc-
ture decisions. Using anecdotal evidence, our focus is not on
so-called direct bankruptcy costs, but rather on the cross-
sectional variation in indirect bankruptcy costs, which may
result from a deterioration of relationships with customers,
suppliers, or other stakeholders prior to the legal act of bank-
ruptcy.

1 This article is based on the authors more technical paper Hedging, leverage, and Research (SGF), the 9th Annual Meeting of the German Finance Association (DGF),
shareholder value: a testable theory of corporate risk management under general the 2004 Basel Meeting of the European Financial Management Association 163
distributional conditions. We appreciate the valuable comments of Tim R. Adam, (EFMA), the 2005 WHU Campus for Finance Seminar and the 12th Global Finance
Axel F. A. Adam-Mller, Amrit Judge, Olaf Korn, Gunter Lffler, Josef Zechner and Conference in Dublin.
participants at the 5th Conference of the Swiss Society for Financial Market
 Corporate hedging and capital structure decisions: towards an
integrated framework for value creation

and Titman (1997)] and which seems to be about to undergo a industry. Figure 1 illustrates those potential differences in
renaissance in financial theory3 as well, the optimum debt financial distress cost functions that may be due to industry-
level is obtained by minimizing the total present value of bank- specific or product-type characteristics. Differences in direct
ruptcy costs and corporate taxes. However, of primary concern bankruptcy costs are likely to be small.
to us are not the so-called direct bankruptcy costs, such as
payments to trustees, lawyers, courts, auctioneers, referees, In order to empirically estimate the cross-sectional differenc-
appraisers, or accountants, which are commonly modelled as a es between firms financial distress cost functions, time series
percentage fraction of the remaining asset value. Instead, we of at least two proxy variables are needed: one to reflect the
assume that there are substantial financial distress costs at a changing degree of financial distress (measured, for example,
much earlier stage, specifically whenever the corporate stake- by the firms credit rating or, far better in terms of data avail-
holders notice that the firm is facing some difficulty in meeting ability, by its credit default swap spread5) and one for the
its obligations to creditors and, correspondingly, adapt their resulting distress costs (measured, for example, by accounting
behavior towards the company. According to Smith and Stulz earnings or, again far better in terms of data availability, by
(1985) and Stulz (1996), these costs, which are sometimes the firms stock price). We will ignore these regression issues
referred to as indirect bankruptcy costs, are assumed to for future practical application and empirical work and return
increase with the degree of corporate financial distress4. to the conceptual issue of capturing existing differences
These costs may, for example, arise from employees declining among the firms distress costs.
motivation or from sales being lost to competitors, because
customers become increasingly reluctant to buy products that In order to maintain the intuition of the Merton (1973, 1974)
require repairs or other services from a company that is on the option pricing framework, it seems reasonable to simplify the
verge of bankruptcy. Anecdotal evidence of such behavior is firms financial distress cost function by assuming a piecewise
provided, for example, by Rawls and Smithson (1990), who linear relationship between future firm value (V) and financial
report that when Wang Computers got into financial trouble, distress costs (DC). Then, with a constant-percentage financial
sales fell and who cite a Wang customer asking: How do we distress cost rate (m) for each firm, the claim by the beneficia-
know that in three years you wont be in Chapter 11? ries with respect to the firms precarious situation is given
simply by DC = m max (D V, 0). Here, D denotes the face
Shapiro and Titman (1985) give various other examples of value of debt that the firm issues, so that the term D V can
such indirect bankruptcy costs. They highlight the fact that be interpreted as the firms distance to default or its distance
some firms are, by the very nature of their business, more to bankruptcy that fluctuates over time. Hence, the more seri-
vulnerable to adverse changes in their perceived distance to ous the firms financial distress, the higher the associated
default than other firms. For example, they cite Lee Iacoccas costs. Furthermore, the higher the parameter m, the more
response to suggestions that Chrysler should declare bank- sensitive is the net value of the firm to adverse changes in its
ruptcy: Our situation was unique It wasnt like the cereal perceived probability of bankruptcy. In a sense, parameter m
business. If Kelloggs were known to be going out of business, could be described as a kind of bankruptcy beta, since its
nobody would say: Well, I wont buy their cornflakes today. empirical content as a sensitivity measure of the firms unsys-
What if I get stuck with a box of cereal and theres nobody tematic bankruptcy risk resembles the beta coefficient that is
around to service it? Hence, it is absolutely clear that finan- commonly applied to measure a firms systematic risk. In the
cial distress costs resulting from a deterioration of customer Iaccoca example cited above, a car manufacturer, such as
(or other stakeholder) relationships are not constant across Chrysler, would probably be characterized by a much higher
firms, but depend strongly on the particular business and bankruptcy beta m than a cereal producer like Kelloggs.

2 For example, Brealey, Myers and Allen (2005) state this hypothesis on their list of
164 - The journal of financial transformation
the ten most important unsolved problems in finance that seem ripe for produc-
tive research.
3 See, for example, the recent work of Molina (2005), who concludes that his esti-
mation of the ex-ante costs of financial distress can offset the current estimates of
debt tax shields.
Corporate hedging and capital structure decisions: towards an
integrated framework for value creation

From a managerial perspective, hedging market price risk Costs of Financial Distress
(Proxy Variables: Stock Price,
entails entering into selected derivative contracts, whose Kelloggs, ...
Accounting P&L, ...)
state-dependent payments are intended to manipulate certain Chrysler, Wang, ...

features of the probability distribution of the firms future

cash flows or accounting earnings. Among the risk factors
that typically cause this type of undesirable volatility are inter-
Degree of Financial Distress
est rates, foreign exchange rates, and the prices of commodi- (Proxy Variables: Credit
ties like crude oil, fuel, or steel, which may constitute the Rating Grade, Credit Default
Swap Spread, ...)
firms input factors or its products.

In general, corporate hedging can be defined as a reduction in

dependence between uncertain future corporate profits and
random market prices. Hence, speculative policies that
Figure 1 Differences in financial distress cost functions across firms
increase the firms exposure to price fluctuations, and that
might result from advantages in information about future
prices, are not considered here. debt capacity and the resulting additional interest tax shield.
While this motive has already found its way into the finance
In the academic literature on corporate hedging, several theo- textbooks2, a clear-cut analytical model of the interaction
ries offer competing answers to the questions of why and how between the firms hedging and capital structure decisions
firms should hedge [Graham and Rogers (2002), Brown and has been missing.
Toft (2002)]. Smith and Stulz (1985) deal with two value-
increasing effects of hedging, assuming a fixed capital struc- Financial distress costs and corporate taxes
ture. Firstly, they model the direct impact of hedging on corpo- constitute an optimal degree of leverage
rate tax liability as a result of a convex tax function. Secondly, From the famous Modigliani and Miller (1958) theorem it is
they demonstrate its influence on the costs of financial dis- well known that value creation through financial decision
tress and bankruptcy: By reducing the variability of the future making at the company level requires the presence of certain
value of the firm, hedging lowers the probability of incurring market frictions. In frictionless financial markets, not only a
bankruptcy costs. This decrease in expected bankruptcy costs firms capital structure decision, but also its hedging decision
benefits shareholders. Ignoring the issue of bankruptcy costs, can be regarded as irrelevant from the shareholders perspec-
MacMinn (1987) suggests the protection of depreciation charg- tive. If, for example, a company decides to buy an option for
es and tax credits as a rationale for corporate hedging. Froot, hedging purposes and pays exactly its fair market value, there
Scharfstein, and Stein (1993) propose that hedging can help to is no value creation for shareholders in the first place. This is
avoid the use of expensive external financing by coordinating where market frictions, such as bankruptcy costs, taxes, or
the firms investment and financing policy. transaction costs come into play. These market imperfections
can turn the initially zero net present value of the derivatives
More recently, another line of reasoning that explicitly takes contract into a positive value contribution.
the firms capital structure policy into account seems to be
gaining popularity. According to Ross (1996), Stulz (1996), and In the widely used trade-off model of a firms capital structure
Leland (1998), an important benefit of corporate hedging is [Kraus and Litzenberger (1973), Myers (1993)], which is still a
that it represents a means of taking advantage of increased very popular prototype for practical applications [Opler, Saron

4 See also Halls (2002) analysis of a banking firm: ...one would intuitively expect default swap spreads are now available for more than 1,500 companies. The
the cost of financial distress to curve upwards as the bank is forced into ever more relationship between credit default swap spreads, bond yields, and Moodys credit 165
draconian action to survive. rating announcements is analyzed, for example, by Hull, Predescu and White
5 With the development of liquid credit default swap markets the availability of high- (2004).
frequency time-series data has greatly improved. Bloomberg quotes for credit
 Corporate hedging and capital structure decisions: towards an
integrated framework for value creation

derived from an additional dollar borrowed. If the firms bank-

Present value of financial distress costs (PV(DC)

ruptcy risk can be reduced by a marginal increase in the hedge

Present value of corporate taxes (PV(CT)

ratio, then this increase renders less valuable the additional

financial distress costs that may arise in the future from an
PV(DC+CT) additional dollar borrowed today. Furthermore, the additional
future tax savings from an additional dollar borrowed become
more valuable now, because future taxes are only payable to
the government if bankruptcy does not occur. Thus, on the
PV(CT)
PV(DC) one hand, corporate hedging can make the tax shield from
additional debt safer, but on the other hand, can render less
L* Leverage
safe the claim by the beneficiaries of bankruptcy caused by
Figure 2 Financial distress costs (DC) and corporate taxes (CT) constitute an further borrowing. Hence, a marginal increase in the firms
optimal degree of leverage (L*)
hedge ratio can lead to both a shrinking present value of the
bankruptcy costs resulting from an additional dollar borrowed
that derive from the competing goals of shareholder value and at the same time to a growing present value of the tax
maximization and minimization of total risk (measured, for relief resulting from an additional dollar borrowed. Because
example, by the variance) will generally differ6. Hence, taking the reduction in bankruptcy risk triggered by corporate hedg-
into account that an increased volume of derivatives con- ing makes further debt financing more attractive, optimal
tracts typically leads to additional transaction costs, in the leverage will be adjusted upwards to the benefit of sharehold-
form of bid-ask-spreads, for example, the recommendation for ers.
management is to reduce risk to the degree which will enable
default to be ruled out with sufficient certainty.7 This second-order effect of corporate hedging on shareholder
value is illustrated in Figure 3. As already clear from Figure 2,
Corporate hedging benefits shareholders by the optimal size of the debt issue constitutes an optimal
raising optimal leverage degree of leverage L* that minimizes the sum of the present
Let us consider the situation in which the firms financial man- values of distress costs (DC) and corporate taxes (CT), if the
agement is confronted with a hedge ratio that is determined firm does not hedge at all (H = 0). The sum of deadweight
exogenously, so that only the face value of the debt issuance costs PV(DC+CT) that must ultimately be borne by the firms
is subject to optimization. Consider, for example, that it is the shareholders is illustrated in Figure 3 as a function of leverage
companys policy, for whatever reason, that exposures must (L) for three alternative hedge ratios (H) of 0%, 30%, and
always be fully hedged (H = 100%), hedged partly (H = 50%), 60%, respectively. As the arrow indicates, optimal leverage
or that the company has even decided not to use any deriva- (L*) increases with the selected hedge ratio. Hence, both types
tives at all (H = 0%). We wish to investigate briefly how a of undesired deadweight cost are not only diminished directly
change in the hedge ratio can create additional value for by corporate hedging, but they can be reduced even further,
shareholders by influencing the firms capital structure choice. as higher hedge ratios allow the firm to raise leverage without
increasing its bankruptcy risk.
A marginal increase in the hedge ratio affects the optimal
capital structure through both the market value of the Trading off the costs and benefits of corporate
increase in distress costs resulting from an additional dollar hedging: who hedges more?
borrowed and through the market value of the tax relief Finally, we consider the case in which the companys manage-

166 - The journal of financial transformation

Corporate hedging and capital structure decisions: towards an
integrated framework for value creation

Borrowing at the company level is motivated by income tax

Present value of financial distress costs and

considerations. Corporate debt is assumed to create a tax (H=0%)
(H=30%)
shield that serves as a counterweight to financial distress
(H=60%)
costs [Brealey, Myers and Allen (2005)]. A marginal increase

corporate taxes (PV(DC+CT))

PV(DC+CT)
in the debt issue reduces the present value of the govern-
ments tax claim. In bankruptcy, taxable income would be
negative and, if there was no associated tax credit, the tax
shield of debt would be lost (at least partly). The interpretation
of the distress costs (DC) and corporate tax (CT) functions
L*(H=0%)
illustrated in Figure 2, which constitute a unique optimal debt L*(H=30%) Leverage
level, is straightforward. A one dollar increase in the firms L*(H=60%)

debt level leads, on the one hand, to an increase in expected Figure 3 Combined present value of financial distress costs and corporate taxes
financial distress costs, but on the other hand, to a reduction as a function of leverage L for alternative hedge ratios H = 0%, 30%, and 60%

in expected corporate taxes. The optimal degree of leverage is

reached when the present value of expected tax relief of the firm (V) as its underlying [Majd and Myers (1987)]. In the same
last dollar promised to the creditors just offsets the present way, the financial distress costs (DC) can be seen as a put
value of the additional distress costs caused. option which is a contingent claim owned by the firms com-
petitors or other potential beneficiaries of its distressed situ-
Corporate hedging benefits shareholders by ation.
reducing financial distress costs and taxes
Let us now consider the case in which the firms risk manage- A familiar finding of option pricing theory is that the market
ment is confronted with a capital structure that is determined value of any option is, in principle, an increasing function of
exogenously, so that only the hedge ratio is subject to optimi- the risk inherent in its underlying [Merton (1973)]. As long as
zation. As explained by Brown and Toft (2002), such a situa- the variance of the firms asset value can be reduced by an
tion can be justified by thinking of the firms capital structure increasing hedge ratio, one would expect the present value of
choice as a more strategic long-run decision, while its hedging both external drains to shrink and, as a result, shareholder
decision is more flexible and focuses on the short-run. value to increase. However, as pointed out by Jagannathan
(1984) in an article that clarifies the role of Jensens Inequality
In this case, both the present values of financial distress costs in option pricing theory, this result would require strictly con-
and of corporate taxes are reduced by a marginal increase in vex payoff functions. Because the governments and the bank-
the hedge ratio, as long as the probability of bankruptcy can ruptcy beneficiaries contingent claims lose this feature when
be reduced further by corporate hedging. If, conversely, the the firms hedging activity exceeds a certain threshold level,
riskless payments from certain derivatives contracts already the present values of taxes and bankruptcy costs may remain
fully cover the firms credit obligation (D), then a marginal unchanged, although the variance of the firms asset value
increase in the hedge ratio has no further impact on share- simultaneously decreases further.
holder value.
Therefore, it cannot be concluded from an option-like convex-
To see how this works, it is helpful to think of the govern- ity of the deadweight costs (reflected either by costs of finan-
ments tax claim (CT) as a call option with a strike price that is cial distress or corporate taxes) alone, that only the full hedge
identical to the face value of debt (D) and with the value of the is optimal. With a fixed capital structure, the hedging policies

6 The fundamental difference between hedging strategies that focus on a reduction 7 The required confidence level may be derived from the firms target rating. This
of total risk (i.e., cash flow variance) and those that are designed to reduce bank- idea is implemented in the economic capital approaches that have become an 167
ruptcy risk is analyzed by Hahnenstein and Rder (2003). increasingly popular risk management concept during the past few years. See, for
example, Hall (2002) or Schroeck (2002).
 Corporate hedging and capital structure decisions: towards an
integrated framework for value creation

hedging are more likely either to hedge in full or in part. A tive manufacturing company should hedge more than the
second, not surprising finding is that those firms that are average cornflakes producer. As our hypothetical companys
exposed to more volatile operating cash flows derive greater bankruptcy beta (m) rises from 25% to 30%, its optimal
benefits from corporate hedging. The real reason behind this hedge ratio more than doubles from 17.2% to 35.2%, while
result is as follows. A greater level of price volatility in the the face value of its optimal level of outstanding debt is
firms operating income renders the deadweight options for reduced simultaneously by only less than 1%.
the beneficiaries of bankruptcy and of governments tax
claim more valuable. Because the firm chooses its capital Conclusion
structure such that there is always a positive probability of In this article, we have demonstrated how the popular trade-
bankruptcy, an increase in cash flow volatility leads to an off model of optimal leverage that minimizes the sum of cor-
increase in the marginal benefit that shareholders derive porate taxes and financial distress costs can be enriched with
from corporate hedging. This is the case because the reduc- the derivatives market. In this market, the firm can eliminate
tion in market value of both the external put and call options the market price risk associated with its operations by means
achieved through a derivates contract is ceteris paribus of hedging contracts. It was demonstrated that the optimal
higher. Our third, and most important, comparative static level of outstanding debt is raised by an increase in the hedge
result is that those firms whose indirect bankruptcy cost ratio, if the probability of the firm going bankrupt is reduced.
functions react more sensitively with an increasing degree of We have illustrated that, for a given capital structure, the
financial distress derive greater benefits from hedging. In market value of shareholder equity is an increasing function
terms of option pricing theory, firms that have higher bank- of the firms hedge ratio. This influence is, in terms of option
ruptcy betas are characterized by more convex distress cost pricing theory, due to the convexity of the deadweight claim
functions. Returning to the Chrysler vs. Kelloggs example payoff profiles. Interestingly, it cannot be concluded from the
discussed above, Figure 5 illustrates why the typical automo- convexity of deadweight costs, in conjunction with a fixed
capital structure, that the full hedge is the only optimal solu-
tion, because this convexity may disappear when bankruptcy
risk is reduced. However, it is evident that for an optimally
H=100%
leveraged firm the marginal benefit shareholders derive from
corporate hedging is always positive in the absence of trans-
action costs of hedging. Consequently, the firm insulates its
future payments completely from hedgeable risk in the simul-
Hedge Ratio

taneous optimum of its hedge ratio and capital structure. This

intermediate result sheds new light on minimizing the vari-
ance of future cash flows as an appropriate goal for corpo-
rate risk management, when transaction costs of hedging are
negligible.

H=0%
L*(H=0%) L*(H=100%) Leverage
Finally, and most importantly, however, when transaction
costs of corporate hedging are taken into account that can
Figure 4 Shareholder value as a function of the firms leverage (L) and hedge offset the benefits, it emerges that in a group of otherwise
ratio (H) in the absence of transaction costs of corporate hedging
identical optimally leveraged firms, those firms that face

8 The idea of hedging away all risk in the first step and then levering up to a higher 10 As in Graham and Rogers (2002), information about differences in firms hedge
debt level in order to minimize the firms tax liability can be attributed originally to ratios may be derived from mandatory accounting disclosures. A potential empiri-
168 MacMinn (1987). cal proxy variable for a firms hedge ratio is the net notional amount of its total
9 Stulz (1996) refers to the variance-minimization-paradigm as the prevailing aca- derivatives usage divided by its sales or total assets. Aggarwal and Simkins (2004)
demic theory of risk management and Froot, Scharfstein and Stein (1993) summa- provide a summary of US-GAAP disclosure requirements for derivative financial
rize that much of the previous work has the extreme implication that firms should instruments during the 1990s.
hedge fully completely insulating their market values from hedgeable risk.
Corporate hedging and capital structure decisions: towards an
integrated framework for value creation

ment selects both its leverage and hedge ratio simultaneously.

Stulz (1996) suggest that a companys decisions to hedge mCars > mCornflakes
H*Cars (L*) > H*Cornflakes (L*)
financial risks [...] should be made jointly with the corporate
capital structure decision. H=100%

We have stressed the fundamental difference between hedg-

ing strategies to reduce total risk, in terms of variance, and
H*Cars (L*)
= 35.2%
downside risk, in terms of the firms probability of default,

H*Cornflakes (L*)
when leverage is exogenous. However, these differences may

=17.2%
vanish in the simultaneous optimization of both corporate H=0%
L*(H=0%) L*(H=100%) L*(H=0%) L*(H=100%)
decision variables. To see how this works it is important to
L*(H*) L*(H*)
understand that shareholder value always increases with an
increase in the firms hedge ratio, when the firm is optimally
Figure 5 Impact of increasing sensitivity m in the firms financial distress cost
levered and when transaction costs deriving from corporate function on the joint optimum of its hedge ratio H* and leverage L*.
hedging can be ignored. Hence, it is an immediate conse-
quence that in the simultaneous optimum the firm fully factor. Therefore, in equilibrium, the allocation of risk across
hedges all its market price risk (H* = 100%).8 the economy through equity, bond, and derivatives markets
minimizes the total deadweight loss imposed by the legal,
This intermediate finding based on neglecting the potential regulatory framework. Interestingly, this line of reasoning
costs of corporate hedging is illustrated in Figure 4, which leads to an optimal hedging policy for the firm that coincides
depicts the contour curves of the shareholder value surface. with the variance-minimizing solution that emerges from con-
ventional wisdom9.
In particular, it becomes apparent that total shareholder
wealth always increases with the firms hedge ratio for an While our analysis has so far been restricted to the benefits of
optimized capital structure. Although shareholder value does corporate hedging and their interrelatedness, we now try to
not always increase with the firms hedge ratio (the iso-share- explain observable cross-sectional differences in corporate
holder-value-ellipses are vertical in the upper left corner of hedging behavior that result from trading off the benefits and
the base), it does so if further hedging reduces the bankruptcy costs of corporate hedging10. In order to establish an empiri-
risk incurred when leverage is optimal. cally testable theory of corporate hedging we introduce into
our framework transaction costs of hedging (TC) that are
Corporate hedging, which Stulz (1996) has characterized as a assumed to directly diminish shareholder wealth. These trans-
substitute for equity, is, in a sense, simply a means of applying action costs offset the benefits derived from reduced taxes,
regulatory arbitrage. The risk of future market price fluctua- lower distress costs, and higher leverage and can thereby
tions is transferred completely to the hedge counterparty, constitute a unique optimal hedge ratio. It can be shown that
who as the seller of protection effectively assumes the risk at the simultaneous optimum of both the firms hedging and
profile of an equity investor in the firm. Of course, this risk leverage variables, several comparative static results hold
transfer will only take place if the counterpartys marginal unambiguously for the chosen hedge ratio.
costs of financial distress and taxes, which depend on the cash
flows of all its other assets as well, are lower than those of the The first finding that emerges from the analysis is that those
firm, possibly because it needs the firms products as an input firms that face lower marginal transaction costs of corporate

169
 Corporate hedging and capital structure decisions: towards an
integrated framework for value creation

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170 - The journal of financial transformation

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Impact of e-finance on financial markets & institutions For monographs

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Leadership For contributions to collective works
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 Four Key
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1
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in a tougher market
how can a Private
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4
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