CatchingUp: Financially Integrating Europe

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Catching-UpFinancially Integrating Europe

• Erik Berglof, SITE, Stockholm School of
  Economics CEPR and The Brookings Institution

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• Had I been present at the creation I would have
  given some useful hints for the better ordering
  of the universe
• Alphonso X, The Wise,1252-84, King of Leon and
  Castile

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Core and Periphery (infrastructure)
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Core and Periphery
Core and Periphery (market size)
GDP per capita per km
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The European ChallengeCatching-Up

• Financial integration with real integration
  (financial and real development)
• CEE catching up with Western Europe
• Europe catching up with the United States
• Enforcement of laws and regulation
• Periphery mostly FDI (few multinationals)
• Some countries less competitive, less reform

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Catching-Up will require more(Aghion, 2005)

• From imitation to innovation
• Different source of productivity growth
• Entrepreneurship, exit, and entry not existing
  firms
• Different quality of human capital
• Tertiary (graduate) education ltgt RD
• Different financial system
• Promote entry and exit finance innovation

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New engines of change needed

• Most trade gains from accession already realized
• FDI flows weakening as large privatizations are
  over, and service gap is closing
• Institutional change difficult to sustain as EU
  membership is achieved
• ...and EU center weakened

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Financial integration Basic premises

• Institutional development gt financial
  development and economic growth
• Finance not been the driver so far
• Financial development ltgt integration
• Finance critical for future growth
• Access to finance, not integration per se

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Financial Integration (and Development)

• Integration of EU 15
• Uneven (bonds vs. retail banking private equity
  vs. syndicated bank lending)
• Integration of CEEC
• Foreign ownership, but little functional
  integration poor access to investment finance
• Integration of hinterland
• Great Divide (underdevelopment fragility)

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Policy implications

• Enforcement of existing laws and regulation key
  to financial development and integration in CEE
• Not only government (EU and national)
• Private ordering (soft law), and private and
  public enforcement complement each other
• Success stories suggest change possible, but is
  their political will?
• EU pressure weakened, but club-in-club
  initiative may trigger EU-wide change

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Part I EU financial integration
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Financial integration at EU levelA lot has
happened

• Financial Services Action Plan (FSAP) to broaden
  and deepen capital markets
• Lisbon European Council set 2005 as the year when
  Action Plan fully implemented
• Introduction of euro
• Creation of single market (for services?)
• EU accession (Copenhagen Criteria)

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but integration remains uneven(Berglof et al.,
2005)

• Across sectors
• Bonds vs. retail banking (particularly to SMEs)
• Private equity vs. syndicated bank lending
• Across countries
• Italian banking (protectionism)
• Banca Antonveneta and Banca Nazionale de Lavoro
• CEEC Banking (access to finance)
• Strong control, but little functional integration

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Financial integration at EU level Remaining
challenges

• Multiplicity of regulatory and supervisory
  regimes
• Slows down functional integration
• Regulatory and non-regulatory barriers to entry
• Discriminatory vs. non-discriminatory barriers
• Slow progress in implementation of regulatory and
  supervisory framework
• Compared to speed of industry transformation
• Integration of new member states
• Broader, functional integration needed
  (enforcement)

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Implementation and enforcement

• EU (EMU) accession effect waning
• Implementation of FSAP lagging
• Lamfalussy Process not sufficient
• Options
• Single regulator and supervisor
• Lead regulators/supervisors
• Enhanced cooperation (avant-garde)

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Part II CEE financial integration
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Different starting points

• Soviet heritage
• Degree of central planning
• Experience of private enterprise
• Early reforms
• Macroeconomic overhang

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different policies

• Bad loan restructuring (Hungary vs. Poland)
• Hospital banks (Poland vs. Czech Republic)
• Bank privatization (Poland vs. Czech Republic)
• Entry policy (Poland vs. Czech Republic)
• Foreign entry (Hungary vs. Czech Republic)
• Firm privatization (Poland vs. Czech Republic)
• Stock markets (Hungary vs. Czech Republic)

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different trajectories
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but systemic convergence

• Strong domination for bank intermediation
• Investment financed through internal funds
• Most external funds from FDI
• Markets limited role in corporate finance
• Legal environment Laws and regulation on the
  books, but weak enforcement

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Emerging European Capitalism(Berglof and Bolton,
2002 Berglof and Pajuste, 2004)

• Private owners dominate, but state still
  important
• Ownership concentration high and increasing
• Increasing separation of ownership and control
• Corporate groupings and large foreign owners
• Firms still owner-managed, but changing
• Commercial banks dominant creditors

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Control Increasingly Concentrated
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Ownership and Control in Central and Eastern
Europe
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Western Europe and the US
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Financial integration

• Lagged real integration, uneven and partial
• Rapid integration of ownership
• But less functional integration
• Narrow banking portfolios
• Fee-based activities
• Working capital, but little investment finance

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Foreign bank penetration(Gianetti and Ongena,
2005)

• Broken up related (crony) lending
• Expanded credit volumes
• SME benefitted (much) less than large firms
• gt CEE financial development (integration)
  about broadening and deepening access to
  finance institutional environment

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Rapid implementation of Acquis (company law)
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Corporate governance disclosure (Berglof and
Pajuste, 2005)

• Regulation Annual reports - Websites
• The data
• All companies listed on the main (regulated)
  exchange in ten countries and covered by Amadeus
  financial companies excluded
• Sample of 370 companies (from 5 in the Slovak
  Republic to 153 companies in Poland)
• Website (370) annual reports (128)

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Website Disclosure
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Uneven Enforcement (Required and actual report
disclosure)
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Disclosure patterns

• Level of disclosure and enforcement varies
  substantially across firms and countries
• Disclosure depends on legal framework, but not on
  the firms financial performance
• But financial performance strongly correlated
  with availability of information (on website)
• Larger, less leveraged, higher market-to-book,
  and more concentrated ownership gt more available

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What is the CEE problem?

• Controlling shareholders have come to stay
• Main conflict controlling vs. minority
  shareholders
• Few alternative mechanisms, but
• Preventing fraud is paramount problem
• Enforcement overriding issues
• But is there the political will?

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Part III How to improve enforcement
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Enforcement, not laws-on-the-books, vary with
development
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What enforcement mechanisms?(Berglof and
Claessens, 2005)

• Private initiatives
• Unilateral (e.g., reputation)
• Bilateral (e.g., controlling shareholders)
• Multilateral (e.g., self-regulating arrangements
  soft law)
• Private law enforcement
• Litigation most important tool
• Public law/regulation enforcement
• Traditional view of enforcement
• Outside anchor (e.g., EU accession)

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Choice of enforcement mechanisms

• Overall institutional environment matters
• Relative importance of a particular mechanism
• Relative scope for policy impact
• Mix of technologies will be used
• Is there the political will?
• Outside anchor?

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Corporate governance and finance when enforcement
weak

• Large blockholders main response
• gt Conflicts controlling vs. minority
  shareholders
• gt Strong reliance on internal finance
• gt Bank finance dominate gt bank supervision
• gt Illiquid financial (and takeover) markets
• gt Other corporate governance mechanisms weak

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Limits to what firms (can) do (Doidge, Karloyi,
and Stulz, 2004)

• Almost all the variation in governance ratings
  across firms in emerging market economies
  explained by country characteristics
• in developed market economies 50 depends on
  firms
• Access to global markets improves governance
• decreases the importance of home-country laws

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Change in enforcement possible

• Variation across and within countries change
  over time gt large scope for improvements
• Disclosure Czech Republic vs. Poland
• Not all aspects of enforcement equally important
  or easy to reform
• Transparency Related transactions vs. director
  income
• Transparency vs. control arrangements
• Combine public and private enforcement and
  private ordering

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Part IV Club-in-Club to speed up pace of
reform(Baltic Financial Zone)
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Club-in-club(Berglof et al., 2004)

• Mere threat can trigger change
• Latent threat to form an EU inner core
• Maastricht EMU
• Amsterdam Reinforced Cooperation
• Nice Enhanced Cooperation regulation
• European Convention put it in the Constitution
• Less than unanimity for ratification of
  Constitution?
• Enhanced cooperation
• Controlled by the Commission
• Minimum 8 countries

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Baltic Sea Financial Integration

• Pan-Nordic financial industry strongly integrated
• A few banks dominate seven markets and have
  significant presence in two more
• OMX now control seven stock exchanges
• Face nine regulators, nine supervisors plus
  numerous national private initiatives
• Extensive regulatory/supervisory coordination

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Baltic Financial Zone A test case and trigger

• Financial integration proceeded very far
• Same issues as whole of EU
• Multiplicity of regulatory/supervisory regimes
• Old and new member states
• Less integrated members (Germany Poland)
• Closely integrated non-member (Norway)
• Hinterland (Russia)
• Club-in-club initiative gt EU-wide effects?
• a complement, not a substitute, to EU integration

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Policy implications

• Enforcement of existing laws and regulation are
  key to financial development and integration
• Success stories suggest change possible, but is
  their political will?
• Not only government
• Private ordering (soft law), and private and
  public enforcement complement each other
• Club-in-club initiative may trigger EU-wide
  change

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Core and Periphery (infrastructure)
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"If the Lord Almighty had consulted me before
embarking upon the Creation, I should have
recommended something simpler."

• Alphonso X, The Wise, 1252-84, King of Leon and
  Castile