What Impact Has the Introduction of the European Single Currency Had on Banks - Research Paper Example

Introduction The 15 member European Union (EU) underwent a substantial change in banking and financial structures which began in the decade of the 1990s with the initiation of single market banking in 1993 and significantly transformed the legislative and regulatory ambience for the banking and financial markets. Then on the 4th of January 1999, arguably the most significant step in the process was taken when 11 of the 15 members came under the purview of a single currency, the euro, and started financial operations under a single central bank, the European Central Bank (ECB) (Murphy, 2000). The process of conversion to the euro was complete by 2002, and all erstwhile European currencies were replaced by euro banknotes and coins. The present endeavour aims to asses the impacts the advent of the euro has had on the banking sector itself. The introduction of the euro against the backdrop of the single market system has led to the direct effects of substantially increased merger and acquisition (M&A) within the EU banking sector, raised transaction volumes in terms of currency, reductions in currency exchange and arbitrage, centralisation of monetary control in the hands of the ECB, interest rate convergence and substantial decrease in the banking regulations. These changes have in turn affected the banking patterns through acting upon the incentives and motivations for banking firms by altering the gains derivable from participating in the industry. In what follows, we turn to explore these direct changes and their effects on the gains by reviewing the evolution of the changes in the value addition to bank owners through M&A activities both within and outside domestic limits of the banking sector to the extent allowed by the scope of the present paper. 2. Structural changes in the banking sector Establishment of the single market program and anticipation of the advent of the single currency motivated consolidation efforts in banking firms earlier in the 1990s. The single market program by itself led to increased integration within the EU. 2.1 Increase in M&A activity There has been a significant fall in the number of the credit institutions in the euro area although evidence shows the number of branches to have remained the same thereby implying M&A activity as having played a far more significant role than branch restructuring in the process of consolidation (ECB, 2005). We find an increase in M&A transaction value from 8.3 per cent to 27.1 percent for the period 1992 to 1997-1998. For 1998, the financial sector recorded 500 per cent increase in value of mergers. With the advent of the euro in 1999, M&A activity surged up and attained its peak at 2000 and since then started to fall and reached to almost pre-euro 1998 levels (Yusov, 2004). 2.2 Reduction in net revenue gains The introduction of the euro has led to a substantial reduction in intra-European transfers of funds such as investment funds, pension funds and mutual funds. The exchange of travellers’ cheques, banknotes has also fallen. The transition into the single currency were associated with considerable costs due to the required changes that had to be brought about, such as adoption of new computer systems, renewed training of employees etc. All these amounted to significant revenue losses for the banks (Yusov, 2004). 2.3 Decrease in regulation One of the most important impacts of the advent of the euro has been that of the reduction in regulatory barriers on the banks. To facilitate smoother integrations, regulatory barriers were removed through the introduction of the Second Banking Directive (SBD) and the Financial Services Action Plan (FSAP) (Murphy, 2000). SBD refers to the dual provision of the single banking licenses, which provide branch creation and financial service provision options to credit institutions, and the supervisory home country control which accords higher authority to domestic bankers compared to local subsidiaries of non-domestic banking firms (Murphy, 2000). FSAP is composed of three main directives. First, it ensures an integrated single EU market for the wholesale financial services; the second and third directives are opening and securing retail markets and ensuring frontier level prudential rules and supervision (Yusov, 2004). These regulations have served in unification of the banking sector through integrating the market which has in turn united the investors on one hand, and increased the intensity of competition within the EU market on the other (Schmiedel, 2007). 2.4 Shift in monetary control A very important point to note is that the monetary control has been shifted to the ECB from the national central banks. The ECB which previously had only advisory control over the national central banks, as an integrated step of introducing the single currency has been accorded with supreme authority in that all tactical, liquidity and operational decisions associated with monetary policy are taken by it (Murphy, 2000). 2.5 Rise in cross border activities and unification That unification of banking markets has been greatly facilitated by the advent of the euro is evident in the raised euro area cross border lending. There has been an observed increase in liquidity across the EU and this is evident in the rise in cross border activity. The steep rise in cross border activity is evident in the diagram above. The surge in cross border claims within the euro area as a percentage of the total cross border claims by all reporting banks has been even more intense reflecting this fact strongly. This rise in deposits certainly indicates at the successful unification and integration of the banking markets. As larger banks are better suited to manage the higher degree of risk associated with cross border transactions and are better able to absorb higher cross border costs, cross border transactions generally occur between larger banks, while the smaller banks participate more in national transactions thereby benefiting from the significantly lower costs both in terms of operation and risk (Dermine, 1999). Yusov (2004) has found domestic transfers to range from .10 euro to 26 euro whereas in case of cross border transfers cost within the range of 31 to 400 euros generally. 2.6 Intra EU Convergences Although, initially cost of cross border payments did not exhibit converging trends, with the cost of transferring 100 euros moving up from 17.10 in 1999 to 17.37 2001, the volume of transfers exhibited rising trends. However, to initiate convergence the European Commission issued a directive to be effective from the 1st of July, 2003 which required the costs of domestic transactions to be equal to those associated with cross border transactions within the EU (ECB, 2005). A pertinent point to note is that as a result of the subsequent rise in inter-bank activity, there emerged a converging tendency. A study by Adam et al (2002) that tracked three month deposit rates over the period of 1995 to 2003 posited that these rates did indeed exhibit converging tendencies. So, we see that the integration of the banking sector has actually led to convergence in short term deposit rates in the wholesale banking sector. However it was found that convergence in the retail sector was significantly related to the convergence of macroeconomic monetary conditions such as price stability, liquidity, exchange rate, interest rates and the rate of inflation rather than to industry integration (Gross and Lannoo, 1999). 3. Impacts of these structural changes on the gains from M&A activities The discussion above has established the fact that the introduction of the euro has significantly changed the face of European banking and the period has been one characterised by integration and substantial consolidation through M&A activities. We shall now explore the impacts such changes has brought about on the profitability for banking firms. Although this does encompass a broad spectrum, we shall be addressing the issue of how gains for owners of the banks have been affected through these changes. In pursuit of this objective we shall be particularly reviewing how bidder’s gains from M&A activities have been affected due to the introduction of the euro. Albeit studies conducted by authors like Cybo-Ottone and Murgia (2000), Lepetit et al. (2004), Beitel et al. (2004) and many others investigate address the changes in bidder’s gains for EU banks, none of these suit our purpose due to the samples not covering the post-euro era, at least to the extent necessary to make the results convincingly true. However, the study conducted by Ekkayokkaya et al (2007), which examines the impact of the changing external environment, and, most importantly, the move towards, and introduction of the euro, on the announcement returns to shareholders of bidding banks covers the time period ranging from 1990 to 2004 and thus actually succeeds in exploring the effects of the introduction of the euro over the course of five years. This study examines the changes in announcement returns to shareholders of bidding banks over time, to infer on the extent of integration which the EU banking industry has gone through in the post euro period. The impacts of the move to a single currency on shareholder wealth are tested using a large sample of 963 (The sample size is the largest among the studies reviewed) bids by EU-based banks. The pre-euro era, the run-up to the euro era and the post-euro period are analysed as sub-periods to enable proper comparison. Due to the structural strength of this research work its findings are robust and the degree of trustworthiness is also very high. It is the results of this work we shall be reviewing. The investigation finds announcement period gains to bidding banks exhibit declining trends over time implying a drop in shareholder wealth with the development of EMU. Although for the pre-euro era bidders are found to be making significantly large gains, in the run-up-to and post-euro periods, the bids are found to be of non value adding types in that wealth of shareholders does not rise, whether the target be domestic or foreign, implying M&A within EU banking to be zero NPV transactions. This finding in turn implies enhancement of competitiveness for the market for corporate control with the announced movement towards, and implementation of, the euro. The reduction in cross-border business barriers, which was associated with the process also, had significant effects. It does therefore emerge that the introduction of the euro has definitely led to integration and increased competition in the banking sector (Ekkayokkaya et al, 2007). The possibility of bidder gain differentials arising out of the location of the targets within or outside the euro zone is also considered in the study. While it is found for those euro zone banks involved in bidding for euro zone targets, the bids were zero NPV transactions for both the period before the euro as well as that referred to as the “run-up to the euro” period, such bids generated significantly negative returns in the post-euro era. A similar result for non euro zone banks that bid for euro zone targets is found for the post-euro period. But results for banks bidding for non euro zone targets, irrespective of their own locations, result in losses for no sub-period. This finding actually supports the view that “decline in barriers to cross-border acquisitions and the elimination of currency risk within the euro zone increased competition among bidders, causing an increase in the bid premium.” (Ekkayokkaya et al, 2007). The hypothesis that the introducing the euro differentially affects mergers depending upon their whether their nature is focused or is motivated by diversification evident in the complementarity of the businesses of the merging firms is empirically found to be valid. The study finds deals with diversifying motives announced by EU banks gainful, and to have been independent to the introduction of the euro. The announcement of focused bids is adversely affected by the transformation to the single currency regime. They are found to be generating significantly negative values in the post euro era. Although this finding supports the notion of intensified competition among bidders aiming business expansions rather than diversification, that some barriers to cross-border transactions remain is supported by the findings for diversifying bid announcements, implying segmentation in this area of the financial services industry. Therefore, what emerges is that the changes in the nature of the European banking industry over the course of the last decade and a half, caused most significantly by the introduction of the single currency, has exhibited significant influences on the returns to M&A activity. 4. Conclusions The introduction of the euro therefore has apart from directly serving in integrating the banking market and influencing the competitiveness of the industry itself, been associated with a set of effects as which are essentially derivatives of the structural changes brought forth in the course of the process. The value of shareholders wealth accruing from M&A activity as been significantly affected by the introduction of a single currency in the pre-existing single market structure and has acted in tandem with the reduction of the regulatory barriers that were done aiming at enhanced integration and competition. However the competition increase has been pronouncedly evident in the market for corporate control. The associated reduction in the returns from banking acquisitions, particularly for focused bids and bids for banks within the euro zone has been an evident aftermath of the process of establishing the euro. To conclude then, the paper finds specific patterns in the broadly apparent M&A activities and has been able to establish the enhanced competition compared to previous levels. However for certain financial services, market segmentation remains, and the policy tools should be adopted to address these. References: Becher, D., 2000. The valuation effects of bank mergers. 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