SIZE AND EFFICIENCY IN THE EUROPEAN BANKING INDUSTRY

The book tries to offer a perspective on the size and efficiency dilemma in the European Banking industry from different angles. We include works which not only take into account the latest developments in the field, but also introduce the behavioural issue and the institutional role. There are several chapters dedicated to specific topics in Italy, Spain, Sweden, Turkey and the UK.
The book includes a selection of the papers presented at the 2006 annual meeting of the European Association of Teachers of Banking and Finance (Wolpertinger) that took place at the Institute for European Studies of the University of Valladolid. The meeting focused on Banking and Finance in Europe, with many good papers dealing with the size and/or efficiency topic. This issue is nowadays present in the financial markets, where there are discussions about the pros and cons of mergers between banks from different countries within the European Union. First, there was the debate about the size of the banks in each country of the EU, but once there are not many mergers or acquisitions of banks available within the same country, the question is about the merger and acquisition among banks from different countries (multinational banks versus national banks). Still the issue is whether such larger multinational banks are more efficient than rival national smaller banks. Then, the question that the researches try to answer is about the size and efficiency of the European banks which want to compete in a worldwide market. Niche players can be more efficient but they could lack the financial muscle to compete in a borderless market. The European Union needs efficient banks capable to compete worldwide and to provide financial resources for their citizens and firms; either these banks have to be larger multinational banks or smaller national banks is a question to be solved.
The 9 chapters of the book address the issue of size and efficiency in the European banking industry. These chapters can be grouped into three blocks. The first block includes chapter 1 and it focuses on the idea of size, efficiency and mergers in the banking industry. The second block deals with behavioural issues in the finance industry. It takes into account the limitations of the individuals? rationality in the decisions process. Within this block, chapter 2 deals with the topic of rationality or the lack of it, that could explain the merger waves in the banking industry, whereas chapter 3 introduces the idea of affective traits in the behaviour of bank CEOs. Finally, the third block deals with the issue of size and efficiency in Spain, UK, Sweden, Turkey and Italy. The focus on special topics by country permits us to understand how institutional differences could affect bank decisions. Chapters 4 and 5 explore the case of Spain, Chapter 6 the case of UK, chapter 7 the case of Sweden, chapter 8 the case of Turkey and chapter 9 the case of Italy.
The dilemma between the size and efficiency that a bank may face is not already solved. Thus, the first contribution to this book, chapter 1, by Santiago Carbó and Francisco Rodríguez from the University of Granada, deals with the idea that differences in efficiency are not conditioned by size, while they are largely influenced by environmental conditions across country. Each type of banks has specific aims and their performance in achieving these objectives must determine their efficiency, not only size. So, financial integration processes (such as the European single financial market) should be conducted on the basis of flexibility and institutional diversity, as opposed to the artificial homogenization of banks of all sizes. Social contribution and financial inclusion of population must also be considered regardless size, so policy for national champions is not justified from the efficiency point of view. There has been an intense debate on the different regulatory and strategic paths that should be followed in order to promote the financial integration process in Europe. One of the most controversial issues is the role of mergers, size and efficiency. The main criticism is that there is no guarantee that a higher number of cross-border mergers and acquisitions will lead to more competitive retail banking markets within a country. Mergers have been considered as the leading mechanism to achieve greater cross-border competition and integration because they allow us to achieve greater scale economies. Many US studies find that, on average, mergers seem neither to reduce nor raise unit cost overall. However, in the European Union, costs tend to fall after a merger. Some countries are promoting the ?national champions?, large institutions that are leaders within a country and that seek to become largely competitive in a broader geographical scope. They represent a policy that emphasizes bank size through mergers and acquisitions, a policy that does not have any justification from the efficiency point of view. Many micro institutions still have high cost-to-income ratios, but the dispersion in the efficiency outcomes of small European banks is quite high and depends on specialization and diversification levels. Above all, when analysing institutional diversity, the debate on efficiency should be extended beyond cost efficiency to social efficiency and welfare. The contribution of many small and medium institutions is very important in many European countries, where an important part of the population does not even have access to a current account.
In the second block of contributions we include chapters 2 and 3. They have in common the focus on human behaviour and the rationality hypothesis to explain what we observe in the banking industry. Thus, Valentín Azofra, Beatriz Fernández and Eleuterio Vallelado from the University of Valladolid introduce the inherent limits of an individual?s rationality to explain financial decisions. When humans do not behave rationally, there is a reappraisal of the dictates and, it specifically involves monitoring investor behaviour. This develops a new theory capable of reflecting the actual market behaviour and accounting for frequent anomalies. All this questions the efficiency hypotheses. The authors present evidence that individuals show procedural rationality, using techniques to simplify the assessment of the problems they face and, sometimes, forgoing an optimal solution. In particular, individuals tend to over- or underreact to new information on the market which could help to explain the mergers waves that we observe in the banking industry.
On the other hand, the contribution of Juan Manuel de la Fuente, Juan Bautista Delgado and Esther de Quevedo from the University of Burgos, chapter 3, deals with the influence of CEO affective traits in a bank?s decision about risk taking, such as the dilemma between size and efficiency. Research in banking has generated numerous explanations about the determinants of bank risk taking. However, this line of research has traditionally ignored the role of the managers? background characteristics and psychological traits in shaping their strategic choices. This chapter analyses the influence of the emotional traits of CEOs on bank risk taking. The hypotheses are tested on a sample of Spanish banks and savings banks. The results show that managers? negative affective traits are related to lower risk taking. Positive affective traits do not seem to influence on the level of risk.
Finally, the third block of contributions focus on country studies. Chapters 4 and 5 are about Spain. Laura Páramo and Roberto Rey from Caja de Burgos introduce the evolution of their institution in a highly competitive environment as the banking market in Spain can be considered. Caja de Burgos is a small, highly efficient savings bank. The recurrent efficiency on the Spanish deposit entities has been positive, especially in the case of the banks. They have based their better efficiency in the increase of their core business profitability and the increase of the profitability of their branches (Spanish banks have, on average, a higher number of branches per bank than their European competitors) and the lowest expenses per branch. When the environment is characterized by strong competition, smaller assets and liability margins and low interest rates, as it is the case of Spain in the last decade, efficiency is the main competitive variable of the financial institutions that does not grow by acquisitions. The recurrent efficiency ratio (Cost to Income ratio) measures the expenses in which a deposit institution must incur to get revenues from their main business. This ratio links the efficiency of the bank with: labour, growth in financial business and branch structure. Caja de Burgos has managed to combine the improvement on business profitability with a better branch profitability that compensates their higher general expenses per branch. Spanish banks have improved almost 15% their efficiency ratio during the period 2000-2004, with savings banks showing a more constant evolution than commercial banks.
A complementary contribution about the Spanish banking market is the work by Marcos Santamaria (University of Burgos) and Valentín Azofra (University of Valladolid). Thus, chapter 5 analyses the ownership and control structure of Spanish commercial banks. This is a relevant topic given the influence of institutional differences on firms? decisions. Bank ownership could interfere in the decision about size or efficiency. Spanish banks show a more concentrated ownership than other European banks: Thus, 97% of Spanish commercial banks have an ultimate controlling owner. Families are the main ultimate owner controlling 26% of the Spanish commercial banks. This ownership concentration in the Spanish banking sector reveals a potential governance problem about the expropriation of the minority shareholders and the depositors by the ultimate controlling owner. The incentive to expropriate worsens due to the great gap existing between cash flow and voting rights of the controlling shareholder (the ratio between both of them amounts to 62%). The banks? performances tend to be low if there is a high incentive to expropriate. Additionally, the authors´ contribution shows that the incentive to expropriate is high when the ultimate controlling owner: is the only significant shareholder; is a foreign shareholder; is from a civil law country; or exercise his/her control by using pyramidal structures.
The contribution of Shelagh Heffernan (Cass School of Business) and Xiaoqing (Maggie) Fu (University of Macau) looks into the relationship between market structure and performance in the British banking market. Their main objective is to investigate which structure-performance models apply to the UK retail banking market. The standard equations are extended to consider the influence, if any of the macro-economy, and managerial control variables. They include the estimation of cost X-efficiency and scale efficiency, and a test of the ?quiet life? hypothesis. They conclude that bank behaviour is best described by one of the two market-structure hypotheses, but within this group, there is only limited evidence that these banks enjoy a ?quiet life?. There is little support for the efficient structure hypotheses. They conclude that the retail banking sector should be closely monitored by the competition authorities.
The analysis of Sweden deals with the relations of competition and cooperation in such country between large and small banks. Magnus Willesson, from the University of Göteborg, brings out new illustrations of investments and cooperation in payment networks as regards two-sided networks. A case, describing small Swedish savings banks? use of a larger bank?s network, derives a perspective of investor and user problem of pricing. He illustrates that the sharing of fixed costs is a problem, especially in relations of two-sided markets, because on one hand it will lead to prices to the savings bank that are at premium compared to the marginal cost for covering fixed investment costs. On the other hand, if prices are set at the margin, the large bank customers will subsidise the small bank?s customers. A premium can be motivated only if the small bank can realise the benefit of the network service to increase benefit on their other services. The analysis of pricing in two-sided markets focuses on marginal benefit and prices. This chapter develops a real problem between savings banks and commercial banks in Sweden, where the small banks (savings) use the infrastructure of large banks (commercial). Willeson studies how fixed costs affect the relationship in a payment network between small and large banks by considering the benefit and pricing between an investor bank (large bank) and a user bank (small bank). The contract situation between network investor and network user influences the relationships between the two types of banks, which includes aspects of subsidisation between the customers of the banks. The application in this particular case requires additional knowledge about the incentives from the small bank and large bank to use a common payment network
Chapter 8 is the contribution of Saduman Okumus (Istanbul Commerce University) and Yener Altunbas (University of Wales). Their work investigates market discipline in Turkey banking sector by testing depositors´ discipline and banking firms operating in Turkey. Okumus and Altumbas conclude that the level of bank capital is a crucial indicator of depositor confidence, and, therefore, of market discipline. They argue that Turquish banks with sound capital adequacy ratio experience an inflow of deposits and a decrease in the interest rate. Besides, they observe that the amount of permanent assets raises the depositors? confidence, the same as permanent assets increase the chances of survival of the bank in a risky financial environment. In the same vein, they conclude that depositors impose market discipline by forcing banks to carry more liquid assets in their balance sheets that can be turned into cash quickly in case of a financial crises. Depositors identify the most profitable banks in the system of Turkey as those which are less risky, so they reward those banks with cheaper deposits. Finally, the authors provide evidence in favour of too big to fail argument in the sense that depositors are less capable to impose market discipline on large banks.
Finally, the contribution made by Elisabetta Montanaro and Mario Tonveronachi from the University of Siena deals with the issue of mergers as a way to solve banking crisis in Italy. The authors explain the Italian solution to restructure the banking industry. The Italian banking sector had excessive geographical concentration of lending, some bankruptcy fraud, poor lending practices, pervasive non competitive practices and mismanagement. Alarmed by the situation, the Italian Central Bank, as the supervisory authority, had some alternatives to deal with the distressed banking sector. The first alternative is the market solution, where banks are exposed to market discipline with no forbearance by supervisory authority. The second alternative is the Swedish solution, where the government becomes the owner of failing banks. The third alternative is the Italian solution, where the Central Bank, Bank of Italy, drives a consolidation process using its discretionary powers. The authors argue that the last alternative imposes a consolidation process that takes a long time and it is not driven by market forces. As a consequence, the new banking groups have experienced a delay in their catching up with the rest of banking groups in Europe in terms of efficiency. Besides, the new Italian banks that have appeared as a result of the consolidation process have not improved the competitiveness and the efficiency of the Italian financial sector. The authors conclude that often the acquirer bank was in worse position than the acquired. Besides they argue that the Bank of Italy consolidates banking industry discriminating depending on the size. Large banks were consolidated to avoid bankruptcy whereas small and medium banks were consolidated to create larger groups because the Bank of Italy understood that banks with a small size are not viable in the long run.
Then, this book tries to offer the reader a broader perspective on the size and efficiency issue in the European banking industry, from selected works presented at the 2006 Wolpertinger meeting. The book pretends to shed additional light to the not yet answered question of which is the optimal banking size for competing in a global planet. The book presents additional research on the influence of institutional framework on financial decisions as it is illustrated by the analysis of the cases of banks in Spain, UK, Sweden, Turkey and Italy.

ELEUTERIO VALLELADO and PHILIP MOLYNEUX

PREFACE .

CHAPTER 1
NEW APPROACHES TO SIZE AND EFFICIENCY IN BANKING;
by Santiago Carbó and Francisco Rodríguez

1.1. SIZE AND EFFICIENCY IN EUROPEAN BANKING: CONCENTRATION, PERFORMANCE AND SPECIALIZATION .
1.1.1. Strategies for bank growth: the role of mergers .
1.1.2. Financial integration and consolidation .
1.1.3. Efficiency and size: institutional diversity and social implications .
1.2. SIZE, EFFICIENCY AND NATIONAL CHAMPIONS .
1.2.1. National champions and bank costs: deconstructing the influences
1.2.2. National champions and efficiency: business environmental and internal productivity influences .
1.3. CONCLUSIONS .
REFERENCES .

CHAPTER 2
UNDER/OVERREACTION: AN INNATE BEHAVIOUR
OF THE FINANCIAL INVESTOR
by Valentín Azofra, Beatriz Fernández and Eleuterio Vallelado

2.1. INTRODUCTION .
2.2. UNDER/OVERREACTION IN THE MARKET AND INVESTOR RATIONALITY .
2.3. THE EXPERIMENT .
2.4. RESULTS .
2.5. CONCLUSIONS .
REFERENCES .

CHAPTER 3
MANAGERIAL DETERMINANTS OF BANK RISK TAKING.
THE INFLUENCE OF CEO AFFECTIVE TRAITS;
by Juan Manuel de la Fuente, Juan Bautista Delgado and Esther de Quevedo

3.1. INTRODUCTION .
3.2. HYPOTHESES: IMPACT OF CEO AFFECTIVE TRAITS ON RISK TAKING .
3.3. METHOD .
3.3.1. Independent variables .
3.3.2. Control variables .
3.3.3. Measures of bank risk .
3.4. RESULTS .
3.5. DISCUSSION .
REFERENCES .

CHAPTER 4
ANALYSIS OF BANKING EFFICIENCY
OF SPANISH FINANCIAL INSTITUTIONS
by Roberto Rey and Laura Páramo

4.1. INTRODUCTION .
4.2. MAIN FACTORS OF THE EVOLUTION OF THE EFFICIENCY .
4.3. PROGRESS ON THE EFFICIENCY RATIO IN BANKS AND SAVINGS BANKS .
4.4. CONCLUSIONS .

CHAPTER 5
THE ULTIMATE CONTROLLING OWNER OF SPANISH COMMERCIAL BANKS: A DESCRIPTIVE ANALYSIS (1996-2004)
by Valentín Azofra and Marcos Santamaría

5.1. INTRODUCTION .
5.2. THE PROBLEM OF CORPORATE GOVERNANCE AND THE ULTIMATE CONTROLLING OWNER .
5.3. WHAT?S DIFFERENT ABOUT BANKS? .
5.4. THE METHODOLOGY OF CONTROL CHAINS .
5.5. THE ULTIMATE CONTROLLING OWNER OF SPANISH COMMERCIAL BANKS .
5.6. CONCLUSIONS .
REFERENCES .

CHAPTER 6
BANK STRUCTURE AND PERFORMANCE IN UK
by Shelagh Heffernan and Xiaoqing (Maggie) Fu

6.1. INTRODUCTION .
6.2. THE ECONOMETRIC MODELS .
6.3. DESCRIPTION OF THE DATA SET .
6.4. EMPIRICAL RESULTS .
6.5. CONCLUSIONS .
REFERENCES .
APPENDIX A: COST X-EFFICIENCY AND SCALE EFFICIENCY .
APPENDIX B: ESTIMATION RESULTS .

CHAPTER 7
PRICING IN PAYMENT NETWORKS - A CASE STUDY OF SWEDISH SAVINGS BANKS AND THE SHARING OF FIXED COSTS
IN TWO-SIDED NETWORKS
by Magnus Willesson

7.1. INTRODUCTION .
7.2. THE CASE: SWEDISH SAVINGS BANKS? PAYMENT AGREEMENTS .
7.3. A THEORETICAL CONTEXT OF INTERCHANGE FEES IN TWO-SIDED NETWORKS .
7.3.1. Benefit and pricing in two-sided networks .
7.3.2. Network profit in a two-sided network .
7.4. A MODEL FOR ANALYSING FIXED COSTS BETWEEN AN INVESTOR BANK AND A USER BANK .
7.5. USING THE MODEL FOR ANALYSING CONSEQUENCES OF FIXED COSTS IN THE RELATION BETWEEN THE LARGE BANK AND THE SMALL BANK .
7.5.1. The large bank?s decisions .
7.5.2. The small bank?s decisions .
7.6. CONCLUSIONS .
REFERENCES .

CHAPTER 8
TESTING FOR MARKET DISCIPLINE
IN THE TURKISH BANKING INDUSTRY
by H. Saduman Okumus and Yener Altunbas

8.1. INTRODUCTION .
8.2. BACKGROUND OF THE ISSUE .
8.2.1. A Historical Approach to Turkish Financial Sector .
8.2.2. Basel-II and the Implementation of Basel-II for Turkish Banking .
8.2.3. The Deposit Insurance Scheme in Turkey .
8.2.4. Market discipline .
8.3. METHODOLOGY .
8.3.1. Explanatory Variables .
8.4. EMPIRICAL RESULTS .
8.5. CONCLUDING REMARKS .
REFERENCES .

CHAPTER 9
USING M&AS TO RESOLVE BANK CRISES.
THE CASE OF ITALY, 1992-2004
by Elisabetta Montanaro and Mario Tonveronachi

9.1. INTRODUCTION .
9.2. STRUCTURAL WEAKNESSES OF THE ITALIAN BANKING SECTOR AT THE END OF THE 1980S .
9.3. THE ITALIAN BANKING SECTOR IN THE 1990S .
9.4. THE BANK OF ITALY?S MANAGEMENT OF BANKING DISTRESS IN THE 1990S BY MEANS OF M&AS .
9.5. BANKING GROUPS AND CONSOLIDATION .
9.6. ALTERNATIVE SUPERVISORY STRATEGIES AND CONCLUSION .
REFERENCES .

FINAL REMARKS .

ABOUT THE AUTHORS .