FINESS: In search of a sustainable European financial system

With the global financial crisis still putting pressure on European economies, high-level policy making bodies continue to grapple with demands for further regulatory reform. A number of important measures have already been implemented, but there is an ongoing debate about what action (if any) should be taken next, particularly with respect to the banking industry. Anyone participating in this debate would do well to consult the findings of FINESS, a two-year long research project that examined with a critical eye the underpinnings of the European financial system and yielded valuable insights into the nature of financial markets as well as respective policy recommendations.

Observing that the foreign asset portfolios of European banks are “less than optimally diversified”, the eight-member consortium put forward a number of concrete proposals aimed at boosting economic competitiveness and reducing the risk of contagion when individual parts of the system become distressed. The central policy challenge, FINESS argues, is to encourage diversification of international banking portfolios while preventing increased exposure to systemic risks, which could arise from banks becoming larger and systemically more important, or the joint exposure of many small and mid-sized banks to the same macroeconomic shocks.

One of the principal findings of FINESS is the vital importance of competition between banks. The researchers found that such competition is beneficial for the European economy in a number of ways. It not only helps existing companies acquire financing, it also supports ‘firm entry’, allowing entrepreneurs to get their companies up and running in the first place. Citing higher potential for cross-border lending, the consortium concluded that a) competition between banks should be enhanced and b) policy makers should take steps towards increasing the contestability and integration of bank lending markets in Europe.

FINESS produced several policy recommendations for those people dealing with banking sector regulation. Some of the suggestions are directed at preventing a repeat of the current crisis while others are aimed at promoting sustainable growth. Echoing the observations of many other analysts, the consortium identified a need for better reporting systems that would allow regulators to spot potential trouble coming from a long way off. In the hope of developing early warning capabilities, the researchers suggest that these reporting mechanisms should facilitate “systematic analysis of exposures of large and small financial institutions to macroeconomic risk factors”.

They also recommend that regulators consider restricting banks’ holdings of equity in non-financial firms. The reason for that, the researchers say, is that “banks do not appear to effectively monitor corporate management”. Indeed, the research identified a negative relationship between financial institution ownership of firms outside the financial sector and the market value of those firms.

A key message emerging from the FINESS project is the need to increase the diversification of banks´ international portfolios. However, as has already been mentioned, problems can arise if many banks pursue a similar diversification strategy. The FINESS consortium acknowledges that there has been a substantial increase in both cross-border assets and liabilities of commercial banks in recent years, especially during the past decade – see Figure 1. But this seems to have had little impact on asset diversification. Even though there has been a big spike in cross-border banking activity in recent years, the researchers determined that “the degree of diversification of banks’ foreign assets has not changed much”. They remind policy makers that regulation plays a crucial role in encouraging diversification and reducing the risk of contagion.

 

Figure 1 – Cross-border assets of banks relative to GDP (in %)


Source: Buch and Neugebauer (2009)1


While FINESS confirmed that competition between banks is beneficial for the performance of the real economy, it also showed that such competition has not developed favourably in Europe. The FINESS research reveals that a series of mergers and acquisitions in the sector has led to banking market concentration in most countries. This, the consortium points out, has increased the market power of banks and resulted in “reduced financing by banks of non-financial firms”. This, like many of the project’s findings, should provide financial regulators with useful evidence to inform their decision making.

 

1 See: http://www.finess-web.eu/publications/wp/FINESS_D_2_4_Buch_Neugebauer.pdf

FINESS - Financial systems, efficiency and stimulation of sustainable growth (duration: 15/2/2008 – 14/2/2010). FP7 Socio-economic Sciences and Humanities, Activity 1 “Growth, employment and competitiveness in a knowledge society", Research area 1.2 “Structural changes in the European knowledge economy and society". Collaborative project (small and medium scale focused research project).

See: http://www.finess-web.eu/

Contact: Dr. Tatjana Ribakoff, tribakoff@diw.de