european fin system

8/8/2019 European fin system

http://slidepdf.com/reader/full/european-fin-system 1/65



The Performance of the European Financial System*

Philipp Hartmann§, Annalisa Ferrando†, Friedrich Fritzer‡, Florian Heider†, Bernadette

Lauro† and Marco Lo Duca†

§ European Central Bank and CEPR

†European Central Bank ‡Österreichische Nationalbank

Revised and extended draft, August 2006

Abstract: The present article studies the quality with which financial systems perform their mainfunctions. The better financial systems perform these functions, the more they contribute toproductivity and economic growth. While the expanding theoretical and empirical economicliterature that emphasises this relationship has focused mostly on developing economies, thisarticle concentrates on industrialised economies with relatively developed financial systems. A

comprehensive framework for assessing financial system performance is established, which leadsto the identification of eight dimensions along which the performance of a financial system can becharacterised. For each of these dimensions the article presents a series of indicators (41 in total)that can be used to gauge the quality with which a financial system performs its main functions.In so doing, financial systems in euro area countries are compared to other major industrialisedcountries, both inside and outside of Europe. The framework and results are relevant for theongoing debate about structural reforms in European Union countries, in particular how financialsector reforms can contribute to policies stimulating growth and international competitiveness.

Key words: Financial systems, financial development, financial markets, financial intermediaries,economic indicatorsJEL classification: G1, G2, G3, K2, O16

* We are very grateful to Asli Demirgüc-Kunt and Franklin Allen for deep discussions aboutindicators of financial system performance and to Ross Levine for further discussions and help totrace down data. Fritzer conducted part of the project while visiting the ECB. Any viewsexpressed are only the ones of the authors and do not necessarily represent official views of theECB, the Austrian Nationalbank or the Eurosystem.

1



1. Introduction

The financial system is an important part of the economy. It ensures that savings are channelled to

the most productive investment opportunities and it allows for inter-temporal and cross-sectional

risk sharing (see for example Allen & Gale (2000)). In so doing, it helps households to smooth

consumption and firms to grasp investment opportunities when they arise. Hence, a well-

functioning financial system enhances welfare and is conducive to economic growth. A growing

body of literature supports these predictions with empirical evidence (see, e.g., Demirgüç-Kunt

and Levine (2004) or Levine (2005) for a recent survey of the literature). In particular, this

literature argues that improvements in the functioning of financial systems are an inherent part of

the development strategies of less developed, transition and emerging market countries. Much

less clear from this literature is, however, the role of financial sector reforms in industrial

countries with already relatively developed financial systems.

The functioning of financial systems has received special attention in European public policy in

recent years. A well-functioning financial system permits an economy to fully exploit its growth

potential, as it ensures that the best real investment opportunities receive the necessary funding.

Therefore, the European Union has made structural financial sector reforms one priority under the

Lisbon Agenda. In particular, in the EU Commission’s Financial Services Action Plan (1999-

2004), which is currently implemented in member countries, greater European financial

integration to complete the single market for financial services has been an important objective.

The Commission has also published a White Paper, explaining its financial sector policies for the

period 2005 to 2010. From the perspective of central banks, financial sectors also play crucial

roles in the implementation and transmission of monetary policy. This is a primary reason why

the ECB has a special interest in the functioning of the euro area financial system (see for

example Gaspar et al (2002)).1 Finally, the functioning of financial systems is relevant for

financial stability, which is of importance for both supervisory authorities and central banks.

In this context, this article presents an analysis of the performance of financial systems that isnovel in various respects. In particular, the approach adopted is broad in that it encompasses the

1 The interest of the ECB in financial sector issues is also reflected in the Monthly Bulletin articles “Recentdevelopments in financial structures of the euro area” (October 2003) and “Assessing the performance of financial systems” (October 2005), publication of the bi-annual ECB Financial Stability Review sinceDecember 2004 as well as the first report on “Indicators of financial integration in the euro area”(September 2005).

2



typical issues of financial structure and integration but goes much beyond those. The reason is

that some evidence seems to suggest that other dimensions of the performance of financial

systems, often summarised under the terms financial development or modernisation, may be even

more relevant for economic growth (see for example Levine and Zervos (1998), Edison et al

(2002) and Giannetti et al. (2002)). Our comprehensive approach starts from the well established

functions of a financial system and covers all of its dimensions that are likely to affect growth.

For each dimension a group of economic indicators can be derived that describe the quality with

which a given financial system fulfils its functions. This article presents a selection of indicators,

some of which are new while others are indicators that have been used in the finance and growth

literature before (see e.g. those described in the surveys by Demirgüç-Kunt and Levine (2001) or

Levine (2005)) and that we update where possible using previously unavailable data.2 In contrast

to most of the finance and growth literature, the focus here is on industrialised countries, covering

euro area countries and comparing them to major countries inside and outside of Europe. Bylooking at a large number of indicators, a more reliable assessment of the overall performance of

a financial system can be made.

The next section introduces the main functions of a financial system and reviews the economic

theory about how market imperfections and frictions can reduce its contribution to growth. In

order to see in more detail how market imperfections lead to an inefficient use of scarce

resources, we first present a simple reduced form model of corporate investment. We then

identify groups of characteristics/dimensions that lend themselves to an assessment of how well afinancial system performs its functions. In particular, we select eight dimensions along which we

structure our subsequent analysis, including financial innovation and market completeness,

transparency and information, corporate governance, legal system, regulation and supervision,

competition and openness. The third section presents the results for the indicators and discusses

their interpretation. Wherever possible, we display an indicator for each of the 12 euro area

countries and the euro area aggregate, for other European countries (Sweden, Switzerland and the

United Kingdom) and for major non-European countries (Japan and the United States). To

identify trends, we track indicators over time, subject to data availability. The comparison with

non-euro area countries allows identifying those trends that are specific to the euro area and those

that are not. The last section draws some conclusions.

2 We use data that is homogenous across countries so that one can make cross-country comparisons. Suchinternational data may not always coincide with particular national data that do not allow making thesecomparisons.

3



2. Theory and dimensions of financial system performance

A financial system influences the allocation of scarce resources across space and time. In order to

exploit the growth potential of an economy, resources need to be reallocated towards the bestinvestment opportunities. When frictions hinder the flow of resources to the best possible uses,

economic growth suffers. A financial system addresses these market imperfections since, it

• produces information about investments and possibilities to allocate capital,

• monitors investments and ensures that investors and savers are paid back according to the

contracts they hold,

• allows the trading, diversification and management of risk,

• mobilises and pools savings,

• eases the exchange of goods and services. 3

In order to see in more detail how market imperfections lead to an inefficient use of scarce

resources, we first present a simple reduced form model of corporate investment.4 The model

illustrates our discussion of how a financial system functions to overcome these frictions and thus

affects growth.

3

We follow the classification of Levine (2005) here.4 While the model illustrates a number of particularly important elements in the working of financialsystems, it does not capture all their functions in an exhaustive way. For example, it does not formalisehousehold saving decisions. There is a literature that suggests that physical capital accumulation per se doesnot account for all that much of long-run economic growth (Jorgenson, 1995 and 2005). The model alsodoes not explicitly treat the allocation of risk. The literature argues that the effect of risk on savings isambiguous. This is due to the interplay of the well known income and substitution effects (see, e.g., Levhariand Srinivasan, 1969). Instead, the model treats saving and risk in reduced form via the supply curve of capital. See also Levine and Zervos (1998) who find that stock market volatility is not robustly linked withgrowth and that private savings rates are not closely associated with indicators of financial development.

4



2.1 The model5

The simple model first illustrates the benchmark case that occurs when capital markets are

perfect, and there is no wedge between the internal and external cost of capital. In a second stepwe discuss deviations from the perfect market benchmark leading to inefficient investment

decisions.

There are two dates. At time zero, the firm is endowed with a stock of internal funds F . It then

invests an amount I that yields a future gross return of f(I) at date one. The production function

f(.) is an increasing, concave function. After normalising the risk-free interest rate to one, the

profit from investing is then f(I)-I . The first best level of investment I * maximises profits. It

occurs when the marginal productivity equals the marginal cost of capital, which is equal to one

since this is the rate that funds can earn if they are not invested:

1)(' = I f . (1)

The firm can raise an amount X of external capital at date 0, but it must repay an amount p(X)X to

outside investors at date one, where p(X) is price of external financing of size X . The firm’s

budget constraint is

F X I +≤ (2)

The firm’s investment problem then is

X X p X I I f X I

)()(max,

−+− (3)

subject to the budget constraint (2).

Perfect market benchmark

Economic theory states that a perfect market is characterised by a frictionless flow of capital

ensuring that all valuable investment opportunities are exploited optimally. Even though some

agents transfer their capital, and thus give up control, to others who may have different

information or different interests when investing, it is possible to specify at no cost contracts that

cover all possible future contingencies. Similarly, households can achieve optimal consumption

smoothing and risk sharing over their lifecycle. In a perfect market where capital flows without

5 The model is based on Kaplan and Zingales (1997) and Stein (2001).

5



frictions, the organisation of economic activity, i.e. firms, institutions and the location of

economic agents, is irrelevant (see for example Coase (1937) or Modigliani Miller (1958)). It

does not matter whether savers and investors are the same person or not. A perfect market

achieves the same allocation of capital and level of investment as if each owner of an investment

opportunity, e.g. a firm or a household, was already endowed with sufficient resources to investup to the optimal point where the marginal benefit equals the opportunity cost so that there is no

need to contact capital markets.

In the model, the perfect markets benchmark is achieved when p(X)=1, i.e. when the supply of

capital is perfectly elastic and the cost of capital is equal to the marginal cost of internal funds.

Then the investment problem (3) yields the first best level of investment in (1). Frictionless

external financing closes any gap between the first best level of investment I * and the amount of

internal funds F .

Capital market imperfections

It is clear that in reality firms and households need to contract in financial markets that are not

perfect and frictionless. First, economic agents neither share nor have access to the same

information. Investors, for example, provide the investment capital but delegate the investment

decision to a manager, since he often has better information about the use of capital. When an

investor no longer has control over his funds, he demands a premium that increases the cost of

capital, since he needs to be compensated for not knowing exactly how his funds are being used

by the manager. The increase in the cost of capital makes investing more expensive and leads to

underinvestment relative to the perfect market benchmark (see for example Stiglitz and Weiss

(1981) and Myers and Majluf (1984)).

In the model, we can illustrate this capital market imperfection by setting the price of external

capital larger than the cost of internal financing, p>1. When the budget constraint (2) is binding,

the first order condition for the investment problem (3) becomes:6

X p p I f ')(' += (4)

The firm invests until the marginal benefit equals the marginal cost of external financing. If the

cost of external financing p(X) increases, the firm invests less:

6 If the investment is of such a small scale that it can be financed internally and the budget constraint doesnot bind, then imperfections in external capital markets clearly do not matter.

6



where γ is a parameter that describes the divergence between management’s and owners’

objectives. When γ >1 (γ <1) there is going to be over (under)-investment. The classic argument

for γ <1 is the “moral hazard” problem in which managers exert too little costly effort, either

because of insufficient incentives or because they are too risk averse. The standard argument for

γ >1 is that managers may enjoy “private benefits of control” that are proportional to the level of investment, such as the use of a corporate jet for example.

Several arrangements in a financial system address the control problem. Banks for example serve

as “delegated monitors”, i.e. a bank acts on behalf of many depositors, thus avoiding a wasteful

duplication of monitoring expenses (see Diamond (1984)). Stock markets allow investors to exert

pressure by selling their shares. The buying or selling of shares influences a company’s stock

price with possible consequences for management, e.g. its dismissal after a poor stock price

performance. More directly, stock markets exercise control through voting at shareholdermeetings or, in extreme cases, through takeovers.

A third type of friction in financial markets is that capital is dispersed among many different

people who have different time and risk preferences (see for example Allen and Gale (1997)).

The perfect market benchmark assumes that capital is fully liquid, meaning that financial assets

can be traded and converted into real assets without frictions. In reality, physical assets used in

production and human capital are highly illiquid, e.g. it is neither easy to buy or sell production

plants, nor to borrow against future expected income.

To finance production, capital must be committed in many cases for a long period of time, but a

saver does not typically like relinquishing control over his assets for long periods. A saver’s

investment horizon is often shorter than the investment horizon of industrial production.

Households are subject to liquidity risks, i.e. they may need quick access to their capital in order

to cover unforeseen contingencies. Banks and stock markets mitigate the adverse effects of such

liquidity risks. A bank transforms short-term liquid deposits into long-term illiquid loans (see

Diamond and Dybvig (1983)). A bank therefore makes it possible for households to react to

liquidity shocks and to withdraw deposits without interrupting industrial production. Stock

markets similarly reduce liquidity risks by allowing stock holders to trade their shares, while

firms still have access to long-term capital.

8



Fourth, in the perfect market benchmark, the location of capital and economic activity does not

matter since financial contracts can be written to cover all possible future contingencies. But in

reality economic capital is dispersed across many investors. Without access to multiple investors,

many production processes would be constrained to sub-optimal scales. A key function of a

financial system is therefore the pooling and the mobilisation of scarce and dispersed capital.Having standardised financial contracts, such as bonds or shares, lowers the transaction costs of

trading in public markets. Without such standard contracts, firms would have to enter into a large

number of bilateral agreements, specifying a large number of contingencies, instead of being able

to tap into a large pool of readily available capital. A pooling of resources also occurs through

financial intermediaries, where a large number of depositors entrust their funds to a “middleman”

who is then able to invest on a large scale on their behalf.

Finally, and closely related to the previous point about the location of economic activity, afinancial system facilitates the exchange of goods and services. In order to exploit the full growth

potential of an economy, specialised investments need to be made and households need to be able

to finance the consumption of goods. Greater specialisation allows higher returns to be earned,

because it makes better use of the information and skills that are specific to a production process.

But greater specialisation also requires more coordination and transactions than an autarkic

environment. At the same time, the financing of consumption over time also requires financial

arrangements. Households for example need to be able to save or to borrow against their future

stream of income.

In the perfect market benchmark, goods and services flow without frictions across production

processes and to consumers. Information asymmetries and transaction costs, however, cause

frictions to build up in this exchange. A financial system overcomes these barriers by providing

suitable specialised instruments such as derivatives, which can fix prices in advance (e.g. forward

contracts). Credit cards, consumer credit and mortgage refinancing are channels through which a

financial system facilitates the consumption of goods and services by the household sector.

These last three frictions, risk diversification, mobilising savings and easier exchange of goods,

are somewhat outside the scope of our simple model. Nevertheless, the shape of the supply curve

of external capital p(X) does reflect these frictions to some extent. For example, less diversified

households demand a higher price for parting with their savings for long periods of time. The

same holds when firms have to pay large transaction and contracting costs to attract scarce capital

9



that is scattered among many different investors. Larger frictions result in a more inelastic supply

of capital, i.e. p’(X) increases, which in turn pushes up the marginal cost of capital in (4).

To sum up, a financial system performs several functions to ease the flow of resources fromowners of capital, e.g. households which possess savings, to ensure efficient investment, and

hence growth, in an economy when there are a number of market imperfections.

2.2 Dimensions of financial system performance

Having reviewed the main elements of economic theory explaining how a financial system helps

to overcome the frictions that can hinder the efficient flow of savings into investment, one can goahead and identify groups of characteristics/dimensions that lend themselves to an assessment of

a financial system’s performance of its functions. Table 1 summarizes the eight dimensions along

which we structure our subsequent analysis. For each dimension, we present a number of

indicators that measure a particular aspect of the functioning of financial systems. We draw on

the existing empirical evidence on the link between finance and growth, but present also a

number of new indicators, and we pay special attention to dimensions and indicators that are

particularly relevant for industrialised countries. Where possible, the analysis shows the evolution

of an indicator over time, distinguishing euro area countries and the euro area aggregate from

non-euro area European countries and other major countries.

10



Table 1: Dimensions of financial system performance covered by the indicators

1. Size of capital marketsand financial structure

Financial systems with larger overall capital markets willprovide easier financing for real investment. This relates to both

larger securities markets and to more bank credit. Systems thatrely primarily on one but not the other may be less efficient.Also the liquidity of the different markets is relevant for thisdimension.

2. Financial innovation andmarket completeness

Many financial innovations reduce capital market imperfectionsand make markets more complete. This opens up newpossibilities to allocate capital across space, time and riskpreferences. New financial instruments and practices forexample allow firms to manage certain risks by shifting them toinvestors who have a better ability to bear them.

3. Transparency andinformation

Financial systems help produce and spread information aboutinvestment opportunities, market conditions and the behaviour of agents. The better they function, the lower should e.g. beasymmetric information between firms and outsiders and themore information should be incorporated into stock prices.

4. Corporate governance There are conflicts between insiders who control a firm andoutside investors who provide financing. Better governance willensure that investors receive the full return on their investmentand that there will be little deadweight costs due to opportunisticbehaviour by firm insiders, with beneficial effects on the cost of capital.

5. Legal system A key aspect of a financial system is how well it enforcescontracts. As it allocates capital across time and space, contracts– either explicit or implicit – are needed to connect providers andusers of funds. The legal system and how it is applied by legal

institutions determine the “distance” over which capital can bereallocated.6. Financial regulation,

supervision and stabilityGovernment intervention in financial systems tends to bestronger than in other economic sectors. Well designedregulation and supervision should correct for marketimperfections and enhance stability, whereas imperfect policiesmay have adverse effects on the performance of the financialsector.

7. Competition, opennessand financial integration

More openness of a financial system and more competitionamong banks and other financial intermediaries lower capitalmarket imperfections. Pressure from competition, for example,should ensure that financial institutions operate efficiently, earnfewer rents from market power and provide new instruments tocustomers.

8. Economic freedom,political and socio-economic factors

Economic freedom means the absence of constraints to economicactivities, e.g. corruption, administrative burdens or notefficiency-related political interventions. Given the greatimportance of information, contract enforcement and ease of exchange in financial transactions, there is also a significant rolefor social capital in the form of cooperativeness, ethics and trust.

11



3. Indicators of financial system performance

3.1. Size of capital markets and financial structure

Financial structure traditionally refers to the relative size of different capital markets, e.g.

securities markets. There has been an extensive debate on whether bank-based or market-based

financial systems perform better. On the one hand, banks can exploit scale economies in

acquiring information, exercise control through monitoring, and form long-run relationships with

firms that reduce information asymmetries. On the other hand, banks may exploit their dominant

position vis-à-vis a borrower, they may have a bias towards prudence, and they maximise their

own interests and do not necessarily act in the interest of firm owners. More recently, the debate

has however shifted away from pitting markets against banks. Rather, it is recognised that both

perform valuable functions in a financial system. For example, Allen and Gale (1997) argue thatbanks foster inter-temporal risk sharing, whereas markets foster cross-sectional risk sharing.

Some functions may even require complementarities between bank- and market-based financing

(see for example Levine (2002)).

Therefore chart 1 displays a broad indicator of overall capital market size, measuring total

financing in the economy. It aggregates bank credit to the private sector, stock market

capitalisation and the outstanding amount of domestic debt securities issued by the private sector

as a share of GDP. Several contributions to the literature have shown that private credit or stockmarket capitalisation can be important indicators of financial development (see for example King

and Levine (1993), Levine and Zervos (1998) and Rajan and Zingales (1998)). Since we are

dealing with industrial countries, however, we prefer to complement them with corporate bond

markets, which are usually only an important form of finance in already quite developed financial

systems.

Chart 1: Size of capital markets

The size of capital markets has increased since the 1990s for all countries except Japan. The

Netherlands, Greece, Portugal and to some extent Spain have seen the size of their markets more

than double over the last fourteen years. Austria, Greece and Italy have the smallest markets,

while the financial centres of Luxembourg, Switzerland and the United Kingdom have the largest

12



ones. The average size of financial markets in the euro area is roughly comparable to the size of

financial markets in Japan and it is much smaller than the United Kingdom and the United States.

A complementary measure to the overall size of capital markets is the volume of securities traded

in a market: a high volume of trading indicates a liquid market that channels large amount of

funds across investors and firms fast. High turnover is often seen as an indicator of low capital

market frictions (see Levine and Zervos (1998)). Greater liquidity usually improves price

discovery and lowers transaction costs. Chart 2 for example shows the stock market turnover, i.e.

the value of the trades of domestic shares on domestic exchanges divided by the value of listed

domestic shares.

Chart 2: Turnover ratio

Chart 2 shows that trading activity varies considerably across the euro area. France, Belgium, the

Netherlands and Portugal now trade their domestic shares via the Euronext stock exchange that

has less turnover than the Italian, German and Spanish stock market. The turnover has increased

on the most active stock exchanges, e.g. Germany and Italy, but has decreased in less liquid

markets such as Austria or Greece. No European stock market matches the turnover ratios found

on the UK and especially on the US stock market.

Taken together, charts 1 and 2 show that the size of a financial market does not necessary

correspond to its liquidity or how active trading in that market is. For example, Austria’s capital

markets are comparable in size to those in Italy, but the Austrian stock market is much less liquid

than the Italian one. Also, the capital markets in the US and the UK are of comparable size, but

trading on the US stock market is twice as active as in the UK.

The next sub-sections go beyond the traditional size measures of financial markets and consider

indicators that relate more directly to the different functions of a financial system.

3.2. Financial innovation and market completeness

Financial innovation opens up new possibilities for economic agents to allocate capital across

space, time and risk. This makes markets more complete. For example, new financial instruments

13



allow firms to manage risks by shifting them to economic agents which have a better ability to

bear them. Financial innovation allows households to refinance their mortgages and banks to

resell risks using mortgage-backed securities. Prices of new financial instruments contain

additional information. Thus, financial innovation facilitates the supply of capital and reduces

information asymmetries (see for example DeMarzo (2005)).

We propose to measure financial innovation by examining the extent to which modern financial

instruments such as asset- or mortgage backed securities, interest rate derivatives or venture

capital contracts are used. Chart 3 proposes a measure of securitisation, i.e. the transformation of

illiquid assets such as receivables or mortgages into liquid ones. The chart shows the proceeds

from the issuance of asset- and mortgage backed securities (ABS and MBS) as a fraction of

domestic GDP by country of securitised assets. For example, in 2004, assets worth a little over

7% of GDP were securitised in Germany.

Chart 3: Securitisation

The chart indicates that the level and the growth of securitisation are uneven across the euro area.

While a lot of Spanish, German, Dutch and UK assets are securitized, there is hardly any such

activity occurring in Austria, Belgium, Finland, Greece and Sweden.

Chart 4 shows the turnover of interest rate derivatives.7 More active trading of interest rate

derivatives allocates capital across time and risk because investors can lock in future interest rates

using forwards and futures, hedge using options and exchange fixed and flexible interest rate

agreements using swaps.

Chart 4: Turnover of interest rate derivatives

The most active markets for interest rate derivatives are the financial centres of Luxembourg andthe United Kingdom. The market is much less active in most other countries, although Austria,

Belgium, France and Ireland have seen strong growth of interest rate derivative trading over the

7 It would be even more informative to compare the amount of outstanding interest rate derivatives acrosscountries, as this would illustrate inter alia the extent of actual hedging activities. Unfortunately, such dataare not available in the format used in the chart. Moreover, ideally also more recent innovations such ascredit derivatives or structured finance products should be covered. But again no detailed country-by-country information is available for them.

14



last decade. The market has recently shrunk in Germany, Spain and the Netherlands. On average,

interest rate derivatives are much more actively traded in the euro area than in the United States.

A caveat when interpreting chart 4 is that the location of trading may not be fully informative

about the location of counterparties or underlying assets. An investor in country A may enter into

a contractual agreement with an investor in country B, while the contract itself is traded in

country C and the underlying asset is located in yet another country. This illustrates that financial

systems can benefit from the existence of standardised financial instruments whose trading

activity transcends national borders. Chart 5 presents an example of such a standardised financial

instrument by showing the size of UCITS (Undertakings for the Collective Investment of

Transferable Securities) funds. These funds can be marketed within all EU countries irrespective

of their domiciliation.

Chart 5: European UCITS fund assets (for US and Japan mutual fund assets)

The chart shows tremendous growth of UCITS funds that are domiciled in Ireland and

Luxemburg. The euro area average amount of assets of this type of fund is about a third smaller

than the amount of mutual fund assets in the US. Easy access to mutual fund investments is an

important element in households’ portfolio management and therefore optimal consumption

behaviour.

Financial frictions are particularly relevant for the investment decision of small and young firms

(see for example equation (5)). These firms have no access to public capital markets and may

have difficulties obtaining private bank financing since they often have little collateral, no track

record and are usually high risk enterprises. A recent market form of financing these firms is

private equity or venture capital. Here, investors provide funds in return for an equity stake in the

firm or a debt claim that can be converted into equity at a later stage, and hope to recoup their

initial investment in an initial public offering. The advantage of this mode of financing is that in a

public offering the prospects of a high potential growth may overcome the constraints of havinglimited collateral, a high business risk and strong information asymmetries. At the same time,

venture capital firms provide business advice and monitor firms in a way that is similar to banks.

Chart 6 shows the amount of venture capital financing that is spent at an early investment stage of

a project, while chart 7 shows the amount that is spent on expansions or replacements of existing

projects (both by country of management).

15



Charts 6: Venture capital financing (early investment stage) by country of management

Charts 7: Venture capital financing (expansion and replacement stages) by country of

management

The charts show that while venture capital is increasing the euro area, especially in Finland,

Sweden and Spain, it amounts only to a fifth of venture capital financing in the US and a half of

such financing in the UK. Among all the European countries, also the Netherlands have a more

active VC market, whereas this form of financing runs particularly low in Greece and perhaps

Austria and Italy.

Chart 8 shows the amount of venture capital financing (early investment and expansion) bycountry of destination. The advantage of this indicator is that by focusing on the destination it is

more precise in measuring the amount of financing received by a specific country, the

disadvantage is that data for the United States are not comparable to Europe as they exclude

management buyouts. The results are roughly comparable to those in charts 6 and 7.

Charts 8: Venture capital financing by country of destination

3.3 Transparency and information

Transparency and information refer to measures that capture the degree to which a financial

system produces and spreads information about investment opportunities, market conditions and

the behaviour of economic agents. For example, the quality of accounting standards captures the

degree of asymmetric information between investors and managers. Better information on and

more transparent reporting of company performance alleviate the control problem between

outside investors and firm insiders, e.g. through more accurate stock prices, allowing outsiders to

exert pressure by selling their shares, or through an improved market for corporate control.

A measure of transparency and information that has been used in the finance and growth literature

comes from the disclosure of firms’ accounting information. Rajan and Zingales (1998) for

16



example use the CIFAR (Centre for International Financial Analysis and Research) index that is

based on the inclusion or omission of 90 items in firms’ annual reports. Chart 9 reports this index.

Chart 9: Accounting transparency (CIFAR index)

The quality of accounting information reported generally increases over time. For the latest data

available, the highest disclosure is found in Sweden, Finland, Ireland and the US. The smallest

number of accounting items is reported by firms in Portugal and Greece. 8

A potential shortcoming of such measures of disclosure though is that they do not capture

whether the information is actually used in capital markets. To address some of the issues, anumber of other measures of how a financial system deals with information frictions are

presented here. Chart 10 presents the extent of analyst coverage over time, while Chart 11 shows

the dispersion of analysts’ forecasts. Analysts study companies and make earnings forecasts.

They therefore represent an important outside assessment of a company’s condition. The more

companies are covered by analysts, the more information is available in a financial system.

Chart 10: Analyst coverage

In most countries, analyst coverage is either high or has increased significantly since 1990, except

in Germany where the extent of coverage has shrunk. Spanish, Greek and Irish companies are the

least covered companies in the euro area.

Related to the extent of analyst coverage is the dispersion of analysts’ forecasts. If a firm

discloses relevant and credible information, or if this information is readily available in a market,

then analysts’ earnings forecasts should converge. A financial system that aggregates and spreads

8 The latest data point available for the CIFAR index is 1995. Given changes in accounting rules in variouscountries over time, it might therefore not reflect the most recent levels of firm transparency.

17



information more efficiently may therefore be associated not only with more analyst coverage,

but also with a lower dispersion of analysts’ forecasts.9

Chart 11: Dispersion of analysts’ forecasts

Chart 11 shows that analysts disagree most in Germany, Italy, Portugal, Sweden and Japan. The

extent of coverage in the euro area is comparable to that in the United States. The dispersion of

earnings forecasts, however, is more than twice as high.

The dissemination of information by stock markets is an important function of a financial system.

In order to determine how well a stock market incorporates useful information into stock pricesand how efficient it therefore is in guiding capital to the best investment opportunities, we

decompose stock price volatility into market volatility and firm-specific volatility. If firms’ stock

prices are mainly driven by market factors, i.e. if there is a high synchronicity among stocks, then

this is evidence that the stock market does not efficiently transmit firm-specific information. In

that case, the explanatory power (measured by the R2 statistics) of a regression of a firm’s stock

price on market factors should be high, i.e. most of firms’ stock price variation is explained

without firm-specific information (see for example Durnev et al (2003)).

To measure the information content of stock prices using the R 2 statistic, we consider the

following model:

ijt t t t jt ijt EM US EU STMKT r ε β β β β α +++++= 4321 (6)

where r ijt is the return on stock i in country j at time t , STMKT jt is the return on the stock market

index in country j at time t , and EU t , USt and EM t are the returns on the euro area, the US and on

an emerging market stock market indices at time t .

9 Analysts will also tend to agree less in periods of financial turmoil, e.g. Finland and Sweden in the early1990s. This shows that economic and financial conditions may feed back into the indicators. Robustnesschecks however show that the average dispersion over the last five years is uncorrelated with the averagestock market volatility over the same period but that it is negatively correlated with average GDP growth.

18



In this specification, stock prices are driven by two sets of explanatory variables. First, there are

the market factors (ST MKT, EU, US, EM ) that are common to all stocks in a market. They

capture market-wide information, i.e. the systemic information that enters into prices. Second,

there is the error term ε that captures the non-systemic or idiosyncratic element that drives stock

prices. It is assumed to pick up firm-specific news or events since they would not affect the

systemic factors. After computing R2 for a set of stocks in a given market, the average R2 is

computed for the market.

If the information disclosed by firms is relevant and credible, and if the stock market is efficient

in aggregating and spreading information, e.g. a great deal of informed trading takes place, then

the regression should not perform well in the sense that the R2 of the regression should be low. A

low R2 therefore indicates that the stock market is able to convey information about valuable

investment opportunities of firms (or the lack thereof). Conversely, if the R2 is high, the

explanatory power of systemic factors is high. In this case, stock prices move for reasons other

than firm-specific information, meaning that the stock market does not convey useful information

about individual firms’ investment opportunities.

The results reported in Chart 12 are based on a sample from 1990 to 2004 of 4,051 companies

listed in 17 countries.10

Chart 12: Pricing of firm-specific information in the stock market (R2 statistics)

Greece, Italy and Sweden have the highest R2, i.e. in these countries stock markets incorporate the

least amount of firm-specific information. The stock markets of Austria, Finland, Ireland and

Portugal have in the last few years incorporated a lot of firm-specific information into prices.

Since 2000, the euro area has incorporated on average more firm-specific information into stock

prices than the United Kingdom or the United States.

3.4. Corporate governance

10 The average country R2s from 2000 to 2004 are uncorrelated with average (i) industry composition andsector concentration of firms, (ii) stock market volatility and (iii) GDP growth over the same period.

19



Corporate governance addresses the potential conflict between investors and managers, and

among investors, e.g. large versus small shareholders. Better governance ensures that their

interests are more aligned, that investors obtain a better return and that there will be a smaller loss

of efficiency due to opportunistic behaviour by managers.11

One example of good governance is strong shareholder protection. If for example investors are

allowed to vote in shareholder meetings even without being physically present, they can more

easily dismiss management. By threatening management with dismissal, shareholders will be

more likely to receive promised repayments, which in turn lowers the rate of return they demand

on their investments and the cost of capital.

Chart 13 presents a measure of how well the law protects minority shareholders in companies’

annual meetings (see La Porta et al (1997, 1998, 2000)). By this measure, shareholder rights have

improved in many European countries over the last years. In 2005 they were only slightly lower

in the euro area than in the US or the UK. Only the data for Belgium indicate very low

shareholder protection.

Chart 13: Shareholder rights

A recent alternative measure of shareholder protection quantifies their rights against expropriation

by corporate insiders through self-dealing (see Djankov et al. (2006)). Various forms of such self-

dealing include executive perquisites to excessive compensation, transfer pricing, self-serving

financial transactions such as directed equity issuance or personal loans to insiders, and outright

theft of corporate assets. These shareholder rights have improved in most European countries

(except Greece and Portugal) but are still not quite as strong as in the United Kingdom and the

United States.

Chart 14: Enforcement of shareholder rights against self-dealing (anti self-dealing index)

11 While the benefits of better governance for long-term growth are well understood, it may take time forthese benefits to materialise. Adopting better governance may have some adverse consequences in the shortrun, as new laws and administrative measures may be burdensome at first. An open issue is to which extentstrong creditor rights could lead to more firm failures and to the unnecessary destruction of going-concernvalue.

20



Chart 14 shows that the enforcement of shareholder rights against self-dealing by corporate

insiders is particularly easy in the UK, the US but also in Ireland (and to a lesser extent in

Belgium and Portugal). They are much weaker in Austria, Greece, Luxemburg and the

Netherlands. The euro area average score on this index of shareholder protection is about a half of

the score for the US and about a third of the score for the UK.

A related but more difficult measure of corporate governance is the protection of creditors’ rights.

Different kinds of creditors have different interest, e.g. senior versus junior creditors. Also, a

defaulting firm may either be reorganised or liquidated which makes it difficult to establish when

exactly creditors are well protected. We follow the methodology of La Porta et al (1997, 1998,

2000) and present, and update, in chart 15 a measure that i) focuses on senior creditors and ii)does not take a stand on whether reorganisation or liquidity is more efficient.

Chart 15: Creditor rights

Creditor rights are weakest in Finland, Greece, Ireland, Portugal, Sweden, Switzerland and also

the US. The UK has by far the strongest protection of creditors. The rights of Japanese creditors

appear to have decreased recently.

The classic image of the modern corporation run by professional managers and dispersed small

outside shareholders has been questioned by La Porta et al. (1998, 1999). They show that except

in the US, firms tend not to be widely held and most corporations have outside shareholders with

significant stakes. Chart 16 presents the shareholding of the largest and the ten largest

shareholders for the ten largest publicly traded firms in our set of euro area and benchmark

countries.

Chart 16: Ownership concentration (size of shareholdings)

21



We see that firms in the euro area have on average a largest shareholder who holds a stake that is

more than three times as large as his counter part in the US, and that is more than five times as in

the UK. The largest shareholder is most dominant in Italy and Portugal.12 The ten largest

shareholders together hold 43% of the largest euro area companies, and they hold around 27% in

the US and the UK.

As an alternative measure of ownership concentration, Chart 17 shows the Herfindahl index of

the shareholdings of the largest twenty shareholders. Most euro area countries have comparable

shareholder concentration at a level that is more than five times as large as in the US, and

especially the UK. Ireland and the Netherlands, and to a lesser extent, Sweden and Switzerland

have somewhat lower concentration.

Chart 17: Ownership concentration (Herfindahl index)

The academic literature has identified cost and benefits for a firm of having large outside

shareholders. On the one hand, having a large outside shareholder facilitates take-overs and

monitoring both of which exerts positive pressure on management. On the other hand, large

outside shareholders may derive private benefits of control and therefore not act in the interest of

minority shareholders (Shleifer and Vishny (1986)). La Porta et (1999, 2000) argue that the cost

of having concentrated ownership outweighs its benefits. Countries with a better protection of

minority shareholders tend to have more dispersed ownership. The same holds in our sample of

industrialised countries (compare Charts 13 and 14 with Charts 16 and 17). Better legal protection

means that shareholders can give up control, reduce their equity stake and diversify more, which

in turn leads to more liquid stock markets.

The identity and type of dominant outside shareholders is also relevant for corporate governance.

Research has shown that i) having a large outside shareholder is detrimental if that shareholder isa family or another entrenched individual or entity (see Morck et al (2005) for a survey of this

rapidly growing literature together with implications for growth), and that ii) institutional

investors actively intervene to improve the corporate governance of firms whose shares they hold

12 Luxemburg is an outlier since the high concentration there is due to the RTL group that is wholly ownedby Bertelsmann, a German media company.

22



(Hartzell and Starks (2003)). Chart 18 shows the proportion of large outside shareholders that are

institutions.

Chart 18: Proportion of institutions among largest shareholder

While 9 out of the 10 largest US or UK firm do have an institution (defined here as an entity in

the business of investment management) as the largest shareholder, the same is true on average in

the euro area for not even 2 out of the 10 largest firms.

3.5. Legal system

In the perfect market benchmark, there are no frictions because contracts covering all possible

future contingencies can be written and, equally importantly, can be enforced. When a financial

system allocates capital across time and space, contracts are needed to connect providers and

users of capital. A financial investor relinquishes control of his funds now in return for a

promised claim to future cash flows. In order for the promise not to be an empty one, contracts

are written and a well-functioning financial system must have an implicit or explicit mechanism

to enforce them. The legal system, among other things, explicitly enforces financial contracts and

thus contributes to the performance of financial systems.

It is extremely difficult to assess the many facets of a legal system in relation to the financial

system and many different measures of legal effectiveness are conceivable. Chart 19 presents one

possible measure that covers adherence to the rule of law: the “Law and Order” index. It has been

used successfully in the legal and financial literature (see La Porta et al (1998), Erv et al (1996) or

the United Nations “Human Development Report”). The index intends to capture the strength and

impartiality of a legal system as well as popular observance of the law.

Chart 19: Law and Order index

23



Due to the limited scope of the index, its results must be interpreted very carefully. It does not for

example consider a legal system’s procedures and arrangements or its ability to foresee conflicts.

According to the Law and Order index, all the countries considered here score relatively highly

(except for Greece recently), as one would expect for most industrial countries. On average, the

level of the Law and Order index for the euro area is comparable to that for the United States or

Japan.

Chart 20 through 22 report indicators that measures in more detail how well a legal system solves

financial conflicts and enforces laws that protect investors. Recent research shows that not only

the existence of such laws but also their enforcement reduces frictions impeding the flow of

capital (see for example Bhattacharya and Daouk (2002), Djankov et al (2003) and La Porta et al

(2006)). The indicator in Chart 20 asks how many days it takes on average in a country to recoup

a bounced cheque through the courts. A speedy resolution of financial conflict in courts reduces

administrative costs and enhances the trust in financial contracts, thereby improving the

functioning of a financial system.

Chart 20: Duration of enforcement

While the courts in most euro area countries allow a quick recovery of bounced cheques, it takes

considerably longer to do so in Austria, Portugal and especially Italy.13 It takes the least amount

of time to resolve this particular type of financial conflict in the Netherlands and in Japan. The

average time for the recovery of bounced cheques in the euro area is comparable to that in the

United Kingdom and the United States.

Chart 21 shows the degree to which managers believe the legal system will uphold contracts and

property rights in a business dispute. Should those rights be ill protected then there will be serious

frictions to the allocation of capital from investors to firms and their managers.

Chart 21: Enforcement of property rights

13 The 2004 data are not exactly comparable with the 2003 data (see the notes of the chart for more details).

24



On average, managers from euro area countries believe that the property rights are worse

protected than managers in the US or the UK. Within the euro area, Spain, France, Greece, Italy

and Portugal appear to have weaker protection of property rights.

Table 2 compares the existence and the enforcement of insider trading laws across countries.

Bhattacharya and Daouk (2002) show that the start of enforcement of insider trading laws, as

indicated by the first prosecution under it, is associated with a drop in the cost of equity for firms.

All the countries in our sample do have insider trading laws, with the US being the first country to

adopt them. There are some differences in when these laws were enforced. The earliest

enforcements took place in the US, followed by France and the UK. Spain, Portugal and

Luxemburg were the last countries in the sample to enforce such laws.

Table 2: Laws on insider trading

3.6. Regulation and supervision of the financial sector and financial stability

It is widely recognised that the financial sector is “special” compared with many other sectors of

the economy. First, it faces a greater risk of instability, both at the level of individual financial

intermediaries and markets and at the level of the overall financial system. In particular, systemic

financial crises can have large adverse effects on growth. Second, many households using retail

financial services may lack financial knowledge and the ability to collect information about the

nature and risks of various financial contracts and about the viability of financial intermediaries to

whom they entrust their savings. For these reasons, financial sectors tend to be subjected to more

regulation and supervision than most other sectors (see Dewatripont and Tirole (1994) or

Goodhart et al. (1998)). This regulation and supervision aims to stabilise financial intermediaries

and financial systems as well as to protect consumers. In pursuing financial stability and

consumer protection, efficiency can however sometimes suffer, for example when regulationsinadvertently deter efforts to innovate, lead to adverse risk-shifting incentives or impose

excessive administrative costs on financial intermediaries (see Shleifer and Vishny (1998)). We

follow and update the analysis of Barth et al (2004) who examine bank regulation and supervision

in a large number of countries.

25



Chart 22 shows an index of how much power the bank supervision authority has in a given

country, i.e. whether the supervisor can intervene in, restructure or declare the insolvency of

banks. Banks are costly and difficult to monitor so that a power supervisor can step in and fill this

gap. But a powerful supervisor can also use its power to serve his own or vested interest, e.g. to

favour certain political constituents. The most powerful supervision authorities are found in

Luxemburg, Switzerland and the US, the weakest ones in France, Italy and perhaps the

Netherlands.

Chart 22: Bank supervisor power

Chart 23 presents a measure of whether the supervisor can engage in forbearance when banks

violate regulations or act imprudently and chart 24 measures the degree to which the supervisory

authority is independent from political pressure and protected from lawsuits by supervised banks.

While too much forbearance is regarded as detrimental, since it creates moral hazard on the part

of banks, supervisory independence should be beneficial for the efficiency of the banking system.

Chart 23: Supervisory forbearance discretion

Chart 24: Bank supervisor independence

The figure shows that there are significant differences across countries, with some benefiting

from a lot of discretion (e.g. Germany, Sweden, the UK and perhaps Belgium) and others not

(including Finland, Spain, Japan and the US). On average there appears to be more discretion for

supervisory forbearance in Europe than in the US. This is to a large extent a consequence of the

US Federal Deposit Insurance Improvement Act introduced in the 1990s, which limits the risk of

moral hazard by prompt corrective action provisions. On the other hand, the supervisors are more

independent in the euro area than in the US (with the exception of Sweden).

Deposit insurance scheme are an attempt to prevent bank runs by depositors. But such schemes

come at a cost of increasing the moral hazard of banks. Knowing that government will guarantee

the claims of their depositors, banks may take excessive risks and therefore destabilise the

financial system. Chart 25 presents an index used by Demirgüc-Kunt and Detragiache (2002) to

26



show that more extensive deposit insurance, e.g. schemes that cover wholesale deposits and are

fully funded, increases the likelihood of a costly financial crisis.

Chart 25: Moral hazard index of deposit insurance

Chart 25 shows again significant differences across countries. High bars, indicating a significant

risk of moral hazard, are found for Finland, Germany, Italy and the US. In contrast, the risk of

bank moral hazard due to deposit insurance seems to be low in Switzerland.

Similarly, restrictions on bank activities could, on the one hand, make banks more transparent,

and thus easier to monitor, and limit their degree of market power. On the other hand, restrictionscould prevent banks from exploiting economies of scale and limit their franchise value, thereby

reducing their incentives for sound and prudent behaviour. Chart 26 shows whether banks are

allowed to undertake fee-based activities, e.g. the underwriting and selling of securities and

insurance, in addition to deposit-taking and lending.

Chart 26: Bank activity restrictions

Most European banks were previously unrestricted in their activities, but are now not allowed to

undertake the full range of activities in the insurance business (except in France and Ireland). In

contrast, US and Japanese banks were strongly regulated, but recently saw a loosening of the

restrictions across both securities and insurance businesses.

Supervisors can also encourage private monitoring by capital markets to complement their own

effort. Recent regulatory efforts place indeed increasing importance on accurately assessing risks

and on the role of market discipline.14 Chart 27 therefore presents a measure that relies on

potential complementarities between regulation and private market monitoring. It aggregates

formal regulations that ease the private monitoring of banks, in particular by wholesale investors,

14 See, for example, the provisions in pillar 3 of the new framework of the Basel Committee on BankingSupervision (“Basel II: International Convergence of Capital Measurement and Capital Standards: aRevised Framework”, June 2004).

27



e.g. accounting and audit requirements. Stronger incentives for private bank monitoring in turn

have been shown to lower net interest margins and to reduce the proportion of non-performing

loans.

Chart 27: Bank regulations supporting market discipline

Taken together, the indicators of banking regulation in Charts 22 to 27 present a picture of

supervision in the euro area that is comparable to supervision in the US and UK. At the same

time, there is a considerable degree of heterogeneity across measures and countries in the euro

area.

While most analysis of regulation and supervision of intermediaries in financial markets focuses

on banks, insurance companies are heavily regulated as well.15 Chart 28 quantifies the power of

the regulator in the insurance sector. For example, can the regulator require insurers to comply

with prescribed solvency regimes (e.g. capital requirement), carry out on-site inspections, enforce

corrective measures and impose sanctions?

Chart 28 Insurance supervisor power

Chart 29 captures regulatory transparency. This measure includes both the extent to which the

regulator’s authority and objective are clearly defined and its actions carried out in a transparent

fashion, as well as the degree to which insurance companies are forced to disclose relevant

information on a timely basis in order to give stakeholders a clear view of the risks to which they

are exposed.

Chart 29: Transparency of insurance sector regulation

15 To our knowledge there has been no published academic research on supervision in insurance. Thereason appears to be a lack of data.

28



Overall, there seems to be very little difference among the countries for which we have data in

how the insurance sector is regulated (except for the Netherlands with respect to transparency).

3.7. Competition, openness and financial integration

More competition among suppliers of capital in a financial system reduces frictions. It eliminates

inefficient suppliers, frees up resources that are captured through market power and ensures value

maximisation as a means of survival. Less restrictions, openness and integration in turn support

competition by easing the exchange of goods and services and allowing easier entry of

competitors.16

However, with respect to banking, the overall effect of competition on growth is theoretically

ambiguous. More competition could force banks to lower lending rates and increase the provision

of credit. But it could also decrease incentives to acquire information about borrowers and to

monitor them, leading to poorer loan quality and a higher cost of capital. In practice, however, the

benefits of banking competition appear to outweigh its costs (Claessens and Laeven (2005)).

It is very difficult to assess the competitiveness of a market. One standard but imperfect measure

of competition is market concentration. The more concentrated a product-differentiated market,

such as a loan market, is the greater may be monopoly profits and the higher loan rates. Charts 30

shows the Herfindahl index based on banks’ assets.

Chart 30: Bank concentration

A number of European countries have reached a high level of bank concentration, notably

Austria, Belgium, Finland, the Netherlands, Switzerland and the UK. This contrasts with the

situations in Germany, France, Italy, Luxembourg and Spain as well as with those in Japan and

16See, for instance, London Economics (2002), “Quantification of the macroeconomic impact of integrationof EU financial markets”, a study commissioned by the European Commission on the economic benefits of financial integration, which is available on the Commission’s website. Moreover, Giannetti et al (2002)argue that integration and openness supports further domestic financial development through externalcompetitive pressures.

29



the US where domestic consolidation was more limited so far or did not have the same

concentrating effect.17 Apart from challenges concentration poses for competition, there may also

be an enhanced risk of political involvement in the banking sector.

One possible way to counter domestic bank concentration is via foreign bank entry. As a general

rule, however, foreign bank penetration tends to be quite low among industrial countries. Chart 31

depicts the asset market shares of foreign bank branches and subsidiaries and confirms that except

for Luxembourg and recently Finland (driven by changes in the company structure of Nordea),

foreign penetration is very limited in all sample countries.

Chart 31: Foreign bank penetration

Chart 32 through 36 present alternative measures of competition in banking using balance sheet

and income statement information. Competitive forces should erode profits and foster efficiency.

But even under those forces, banks may continue to make considerable profits since there are

economies of scale and fixed costs involved in lending and deposit taking (see for example

Diamond (1984)).

Chart 32: Net interest income over assets

Chart 33: Net interest margins (for commercial banks)

Charts 32 and 33 show that US and Spanish banks have the highest interest income and interest

margins, while banks in Luxemburg have the lowest. Overall, banks in the euro area have

somewhat less interest income and interest margin than banks in the US but are comparable to

banks iin the UK. A different picture emerges by looking also at non-interest income in Chart 34.

First, there appears to be a trend away form interest to non-interest incomes, i.e. less lending andmore trading and fee based activities such as underwriting or origination of securities. Second,

US and UK banks obtain much more income from these activities than banks in the euro area.

And third, this trend towards non-interest income is stronger in the US than in Europe (see also

17 In Germany concentration would be somewhat higher, if savings and co-operative bank networks wereregarded as a single entity.

30



Decressin et al (2004)). An inability to develop significant non-interest business could be a sign

of weakness, as it is likely that the banking sector will be moving even further away from

traditional forms of intermediation in the future.

Chart 34: Net non-interest income over assets

But although euro area banks obtain less income than banks in the US, they also have lower

operating expenses (Chart 35). Overall then banks cost to income ratios are quite similar across

countries and over time at a level of just above or below 60% (see Chart 36). Some exceptions are

Finland and Sweden in the early 1990s and Japan since 2000. Banking in Luxemburg appears tobe more efficient than elsewhere.

Chart 35: Operating expenses over assets

Chart 36: Cost to income ratio

Despite the similarity in cost-income ratios, banks’ return on assets vary significantly across

countries and over time (see Chart 37). The returns are lowest in Germany (except for Japan

where returns are negative since 1995), likely related to the inability of German banks to move

successfully away from traditional interest-rate based to more innovative fee-based business (see

Decressin et al. (2004)), and highest in the US and Finland (since 2000).

Chart 37: Return on assets

A more structural though controversial approach to measuring competition in banking is to

examine how banks’ revenues vary with changes in factor input prices (see Rosse and Panzar

(1977) and, more recently, Claessens and Laeven (2004)). Under competition, increases in input

prices lead to both higher marginal costs and higher revenues, while the latter decreases in a

monopoly. With this insight and making a number of simplifying assumptions, one can measure

competition with the following reduced form revenue equation:

31



it it it it it CONTROLSOTHER LABOUR INTEXP REV ε β β β α +++++= lnlnlnln 321 (8)

where REV is interest income over total assets, INTEXP is interest expenses over deposits and

money market funding, LABOUR is personnel expenses over assets, OTHER is other operatingand administrative expenses over assets, CONTROLS are book equity over assets, loans over

assets, assets, operating income minus net interest income over assets and time dummies; i

indexes banks and t indexes time. Using the estimated coefficients from regression (8), we cancompute the so-called “H-Statistic”, 321 β β β ++= H . When H=1 the market is assumed to be

competitive since the elasticity of revenue with respect to costs is one. As markets become less

competitive, this elasticity decreases since there are less competitive forces that pressure banks

into adjusting revenues to costs.

Chart 38: Bank competition (H-Statistic)

According to the H-statistic, the Dutch, and Luxembourg (but also Greek) banking sector are the

most competitive, while Japanese banking is the least competitive. According to this measure,

euro area banking is on average more competitive than US or UK banking. Some of these results

seem rather counter-intuitive and may suggest that the restrictive assumption of the H-statistic do

not hold in a number of countries.

Finally, we present a measure of state ownership of banks (Chart 35). Higher government

ownership of banks limits competition and entry, and it is associated with lower financial

development and lower economic growth (La Porta et al (2002)). Research shows that

government owned and controlled banks may pursue political objectives (e.g. lending to

politically connected firms and entrepreneurs) at the expense of profit maximisation (see for

example Dinc (2005) or Sapienza (2004)).

Chart 39: State ownership of banks

32



Significant state ownership of banks is still present in some countries of the euro area, especially

in Germany but also in Portugal and Greece.18 There is no state ownership of banks in the UK, the

US or Spain.

3.8. Economic freedom, and political and socio-economic factors

The functions of a financial system centre on the provision of information, the enforcement of

contracts and the facilitation of transactions. These functions are affected by political and socio-

economic factors in addition to the more tangible forces presented so far. This last section

mentions some issues that are harder to measure but nevertheless are important for a broad

discussion of the performance of financial systems.

Not only the legal system but also the general institutional environment partly determines the

functioning of a financial system (see Williamson (2000) for a conceptual framework).

Governance structures that mitigate the control problem between financial investors and

managers are, for example, embedded in traditions, social norms, religion and politics. A

manager’s sense of duty towards outside investors will ease the conflict of interest between him

and his investors even when there are few formal governance arrangements. The idea is that

explicit contracts can neither anticipate nor include all possible contingencies, nor can they be

perfectly enforced under all circumstances. All economic exchange depends to some extent on

trust and fairness, and on what is perceived as “fair”, which are all shaped by socio-economic and

ethical factors. This is particularly pronounced in the financial sector, where contracts have a

strong inter-temporal component and providers of funds have to rely on users of funds being able

and willing to return the money in the future. It has been shown that social capital, measured

either using surveys on how people trust each other or using a metric of civic engagement such as

voter turnout at local elections, matters in a financial system (see for example Guiso et al (2004)).

Similarly, politics shape the laws governing creditor and shareholder protection and partly

determine the protection of private property rights vis-à-vis the rights of the State.

18 In Portugal, one large bank accounts for most of the state ownership in banking, whereas in Germany it ismainly due to the large network of savings banks.

33



Economic freedom captures the notion that fewer administrative burdens on economic activity,

e.g. less red tape, means less frictions in the flow of capital. The indicator of economic freedom

shown in Chart 40 measures “the absence of government coercion or constraint on the production,

distribution, or consumption of goods and services beyond the extent necessary for citizens to

protect and maintain liberty itself.” (Miles et al (2006)).

Chart 40: Economic freedom

The indicator of economic freedom does not show large differences across countries. However, it

is noteworthy that economic freedom has increased in all countries since 1995 except Italy, Japan

and to some extent Greece, which also has the lowest economic freedom. The UK in contrast has

the highest economic freedom according to this indicator.

Related to government involvement in a countries economy is the starker issue of corruption in

government. Chart 41 presents a measure that has been used successfully in the finance and

growth literature (for example by La Porta et al (1997, 1998) and Djankov et al (2004)).

Chart 41: Control of corruption

While the euro area level of control of corruption is comparable to the one in the UK and the US,

there are some differences within Europe. Finland, Swede, Switzerland and Luxemburg achieve

the best scores while Italy and Greece have the lowest scores in the sample of countries.

4. Tentative conclusions

This work presents a framework for assessing the performance of financial systems in developed

countries. The approach taken is a functional one, i.e. a financial system is viewed as performing

a number of functions to overcome market imperfections. The article shows how the functional

framework translates into a number of groups of financial system characteristics that can be used

to structure the assessment of performance. The quality with which a financial system performs

34



its functions can then be evaluated with a set of economic indicators under each group. The

framework and the choice of indicators are particularly geared towards the most important

dimensions for industrialised countries with relatively developed financial systems.

The article applies a selection of these indicators to euro area countries and to a reference group

of non euro area countries. Some are updates of indicators used previously in the finance and

growth literature and others are new. A number of preliminary conclusions emerge from them.

First, there is in general a fair amount of heterogeneity in financial system performance across

euro area countries. Second, a country’s performance, as measured by the indicators displayed,

can vary a lot across functions and dimensions. Some countries that score high in one dimension

of a financial system may not necessarily do so in another.

Whereas the financial systems of many European countries have improved over time, there is still

further room for financial development or modernisation. Our indicators suggest that Greece,

Italy and Portugal appear to have more room for further improvements of their financial systems,

while Finland, the Netherlands and Sweden are front-runners in terms of financial development.

The large financial systems of France and Germany offer a somewhat mixed picture. The UK,

and to a lesser extent the US, somewhat stand out as performing better across a large number of

indicators than euro area countries. The large differences in performance identified so far seem to

suggest that there is further room for structural reforms of financial sectors in the euro area. Thesereforms have a high potential to foster productivity and economic growth in Europe.

35



References

Allen F. and D. Gale, 1997, “Financial Market, Intermediaries and Intertemporal Smoothing”, Journal of Political Economy, 105, 523-546.

Allen and Gale (2000), Comparing Financial Systems (Cambridge, MA: MIT Press).

Barth, Caprio and Levine (2004), Bank regulation and supervision: What works best?, Journal of

Financial Intermediation

Bhattacharya, U., and H. Daouk, 2002, “The World Price of Insider Trading”, Journal of

Finance, 57, 75-108.

Claessens and Laeven (2004), What drives bank competition: Some international evidence, Journal of Money Credit and Banking, Vol. 36.

Claessens and Laeven (2005), Financial sector competition, financial dependence and growth, Journal of the European Economic Association, 3 (1)

Coase (1937), The nature of the firm, Economica.

Decressin, Brunner, Daniel and Kudela (2004), Germany’s three pillar banking system: cross-

country perspectives in Europe, IMF Occasional Paper No 233

DeMarzo, 2005, The Pooling and Tranching of Securities: A Model of Informed Intermediation, Review of Financial Studies, 18, 1-35.

Dewatripont, M., and J. Tirole, 1993, The prudential regulation of banks, (Cambridge, MA: MITPress).

Diamond (1984), Financial intermediation and delegated monitoring, Review of Economic

Studies, 51, 393-414.

Diamond and Dybvig (1983), Bank runs, deposit insurance and liquidity, Journal of Political

Economy, 91, 401-419.

Demirgüc-Kunt and Detragiache (2002), Does deposit insurance increase banking systemstability? An empirical investigation, Journal of Monetary Economics.

36



Demirgüc-Kunt and Levine (eds., 2001), Financial Structure and Economic Growth (Cambridge,MA: MIT Press).

Dinc, S., 2005, “Politicians and Banks: Political Influences on Government-Owned Banks inEmerging Countries”, Journal of Financial Economics, 77, 453-479.

Djankov, La Porta, López-de-Silanes and Shleifer (2002), “The Regulation of Labor”, Quarterly

Journal of Economics.

Djankov, La Porta, López-de-Silanes and Shleifer (2003), Courts: The Lex Mundi Project, Quarterly Journal of Economics, 65, pp. 453-517.

Djankov, S., C. McLiesh, and A. Shleifer, 2006a, “Private Credit in 129 Countries”, Journal of

Financial Economics, forthcoming.

Djankov, S., R. La Porta, F. Lopez-de-Silanes, and A. Shleifer, 2006b, “The Law and Economicsof Self-dealing”, working paper.

Durnev, Morck and Yeung (2003), “Value enhancing capital budgeting and firm-specific stockreturns variation”, Journal of Finance, 59 (1), pp. 65-106.

Edison, Levine, Ricci and Slok (2002), International financial integration and economic growth,

Journal of International Money and Finance.

Erv, Harvey and Viskanta (1996), Political risk, economic risk and financial risk, Financial

Analysts Journal, vol. 52 (6)

Gaspar, Hartmann and Sleijpen, eds (2002), The Transformation of the European Financial

System (Frankfurt: European Central Bank).

Giannetti, Guiso, Japelli, Padula and Pagano (2002), Financial integration, corporate finance and

economic growth, European Economy Economic Papers, No. 179.

Goodhart, Hartmann, Llewellyn, Rojas-Suarez and Weisbrod (1998), Financial Regulation: Why,

How and Where Now? (London: Routledge).

Guiso, Sapienza and Zingales (2004), The role of social capital in financial development, American Economic Review, 94 (3), pp. 526-56.

37



La Porta, López-de-Silanes, Shleifer and Vishny (2000), Investor protection and corporategovernance, Journal of Financial Economics, vol. 58 (1-2), pp. 3-27

La Porta, López-de-Silanes, Shleifer and Vishny (2002), Government ownership of banks, Journal of Finance.

La Porta, R., F. Lopez-De-Silanes, and A. Shleifer, 2006, “What Works in Securities Laws?”, Journal of Finance, 61, 1-32.

Miles, O'Grady and Holmes (2006), The 2006 Index of Economic Freedom, The Heritage

Foundation, (www.heritage.org/research/features/index)

Modigliani and Miller (1958), The cost of capital, corporation finance and the theory of investment, American Economic Review.

Morck, Wolfenzon and Yeung (2005), Corporate governance, economic entrenchment andgrowth, Journal of Economic Literature.

Myers, S., and N. Majluf, 1984, “Corporate Financing and Investment Decisions when Firmshave Information that Investors Do Not Have”, Journal of Financial Economics, 13, 187-221.

Rajan and Zingales (1998), Financial dependence and growth, American Economic Review,88 (3), pp. 559-86.

Rosse and Panzar (1977), Chamerlin vs Robinson: an Empirical Test for Monopoly Rents, Bell Laboratories Economics Discussion Paper , No 90.

Sapienza, P., 2004, “The Effects of Government Ownership on Bank Lending”, Journal of

Financial Economics, 72, 357-384.

Shleifer and Vishny (1986), Large shareholder and corporate control, Journal of Political

Economy.

Shleifer and Vishny (1998), The grabbing hand: government pathologies and their cures,

(Cambridge, MA: Harvard University Press).

Stein (2001), Agency, information and corporate investment, Handbook of Finance.

Stiglitz, J.E., and A. Weiss, 1981, “Credit Rationing in Markets with Imperfect Information”, American Economic Review, 71, 393-410.

Williamson (2000), The New Institutional Economics: Taking Stock, Looking Ahead, American

Economic Review, vol. 38, no 3, pp. 595-613.

39

http://mba.tuck.dartmouth.edu/pages/faculty/rafael.laporta/publications/LaPorta%20PDF%20Papers-ALL/Govt%20Ownershi-Banks-All/Govt%20Ownership%20Banks.xls



http://www.heritage.org/research/features/index

http://www.heritage.org/research/features/index






Chart 1: Size of capital markets(percentages of GDP)

0%

50%

100%

150%

200%

250%

300%

350%

400%

450%

500%

AT BE DE ES FI FR GR IE IT LU NL PT EA CH SE UK JP US

1990-1994 1995-1999 2000-2005

Data sources: BIS, Eurostat, IMF International Financial Statistics, World Federation of Exchanges and ECBcalculations.Notes: Sum of (i) stock market capitalisation, (ii) bank credit to the private sector and (iii) domestic debt securitiesissued by the private sector divided by GDP. Data for Luxembourg exclude debt securities. Euro area (EA) figures areaverages of EA country data weighted by GDP.

Chart 2: Turnover ratio(percentages of market capitalisation)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

A T

B E

D E

E S F

I F R

G R I E I T L

U N L

P T

E u r o n e x t

C H

S E

U K J P U

S

1990-1994 1995-1999 2000-2005

Data sources: World Federation of Exchanges, Datastream and ECB calculations.Notes: turnover is defined as trading volumes divided by market capitalisation. Data for BE, FR and NL are from 1991until 2000; for PT from 1993 until 2001. Data for Euronext start in 2001, for ES in 2002, for IE in 1996 and for CH in

1991. Turnover for US is the Nasdaq turnover.

40



Chart 3: Securitisation(percentages of GDP, by country of collateral)

0%

5%

10%

15%

20%

25%

AT BE DE ES FI FR GR IE IT LU NL PT EA CH SE UK

2000 2002 2005

Data sources: European Securitisation Forum, Eurostat and ECB calculations.Notes: Issuance placed in the Euromarket or in European domestic markets. Data include asset-backed securities,mortgage-backed securities and Pfandbriefe. No data for US, JP and FI (in 2005). Euro area (EA) figures are averagesof EA country data weighted by GDP.

Chart 4: Turnover of interest rate derivatives(percentages of GDP)

0%

5%

10%

15%

20%

25%

30%

AT BE DE E S FI FR GR IE IT LU NL PT EA CH SE UK JP US

1995 1998 2001 2004

Data sources: BIS, IMF and ECB calculations.Notes: Daily average turnover in the month of April of OTC single currency interest rate derivatives (net of local inter-dealer double-counting). Euro area (EA) figures are averages of EA country data weighted by GDP.

41



Chart 5: European UCITS fund assets (for US and Japan: mutual fund assets)(percentages of GDP by domicile nation of a fund)

0%

50%

100%

150%

200%

250%

300%

AT BE DE E S FI FR GR IE IT LU NL PT EA CH SE UK JP US

2000 2002 2005

LU

2000: 3600%

2002: 3190%

2005: 4730%

Data sources: EFAMA, Eurostat and ECB calculations.

Notes: Data are net assets of nationally domiciled UCITS (Undertaking for Collective Investment in Transferable

Securities). That means that the funds that are domiciled abroad and promoted by national sponsors are not counted in

the sponsor’s country but in the country where they are domiciled. Fund of funds are included in figures for IT, FR

and LU. Euro area (EA) figures are averages of EA country data weighted by GDP.

Chart 6: Venture capital financing (early investment stage) by country of management (percentages of GDP, by country of management)

0.00%

0.05%

0.10%

0.15%


1995-1999 2000-2004

Data sources: European Private Equity and Venture Capital Association, PricewaterhouseCoopers and Eurostat.

Notes: Venture capital investment is defined as private equity raised for investment in companies; management

buyouts, management buyins and venture purchases of quoted shares are excluded. Early investment stage means seed

and start-up financing. Data report venture capital funds raised from companies in each country. No data for LU andJP. CH data start in 1999. US data end in 2002. Euro area (EA) figures are averages of EA country data weighted by

GDP.

42



Chart 11: Dispersion of analysts’ forecasts(percentages of forecasted earnings per share)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

AT BE DE ES FI FR GR IE IT NL PT EA CH SE UK JP US

1990-1994 1995-1999 2000-2004

Data sources: Thomson Financial’s First Call database and ECB calculations.

Notes: Average standard deviation of the earnings per share (EPS) forecasts for a given year divided by the level of the

EPS forecasts for that year. The average standard deviation of the EPS is an average of firm level standard deviation of

EPS forecasts weighted by the market capitalisation of firms and the level EPS forecast is an average of the firm level

EPS forecast weighted by the market capitalisation of firms. Data for LU are not available, while for the NL and PTthe data end in 2001. Euro area (EA) figures are averages of euro area country data weighted by the stock market

capitalisation covered by analysts in each country.

Chart 12: Pricing of firm-specific information (R2

statistics)

0

0.1

0.2

0.3

0.4


1990-1994 1995-1999 2000-2004

Data sources: Datastream and ECB calculations.

Notes: Country average R2 statistics for the regressions described in section 3.3. Low bars indicate that stock prices

reflect more firm specific information. Euro area (EA) figures are averages of EA country R2 statistics weighted by

stock market capitalisation.

45



Chart 13: Shareholder rights

0

1

2

3

4

5

6


1998 2005

Data sources: R. La Porta, F. Lopez-de-Silanes, A. Schleifer and R. W. Vishny (1998), “Law and Finance”, Journal of Political Economy, OECD Corporate Governance and Company Law Database and ECB calculations.Notes: The index ranges from 0 to 6, the lower the score the weaker are shareholder rights. The index is computed asthe sum of the following variables: (1) proxy by mail allowed; (2) shares not blocked before meeting; (3) cumulativevoting or proportional representation; (4) oppressed minorities mechanism; (5) pre-emptive rights; and (6) percentageof share capital to call an extraordinary shareholder meeting. Variables from (1) to (5) equal 1 if allowed and 0otherwise, while (6) equals 1 when the minimum required percentage is less than 20%, and 0 otherwise. For US for2005 the update is not available. Data for 1998 have been appended. Euro area (EA) figures are averages of EAcountry data weighted by stock market capitalisation.

46



Chart 14: Enforcement of shareholder rights against self-dealing (anti self-dealing index)

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0


Data sources: Djankov et al., 2006b and ECB calculations.

Notes: The index ranges from 0 to 1. Higher bars indicate better shareholder protection. The index incorporates ex-

ante and ex-post private control of self-dealing transactions. Ex-ante control includes the following issues for a

transaction between a corporate insider and an outside buyer: 1) Must disinterested shareholders approve the

transaction? 2) Must the buyer disclose the nature of the transaction and a possible ownership of the buyer by the

corporate insider?, 3) Must the corporate insider disclose the transaction and its nature? and 4) Is an independent

review, e.g. by a financial expert, required?. Ex post control considers the following points: 1) Are transactions

disclosed in periodic filings such as annual reports?, 2) Can a 10% shareholder sue the corporate insider for damagessuffered as a result of the transaction?, 3) How easy is it to rescind the transaction, 4) How easy is it to hold the

corporate insider liable for civil damages?, 5) How easy is it to hold approving corporate bodies liable for civil

damages?, 6) How easy is it to access evidence about the transaction? Euro area (EA) figures are averages of EA

country data weighted by stock market capitalisation. Data are from May 2003.

47



Chart 15: Creditor rights

0

1

2

3

4

AT BE DE ES FI FR GR IE IT NL PT EA SE CH UK JP US

1998 2002

Data sources: Djankov et al. (2006a) and ECB calculations.Notes: The index ranges from 0 to 4. The higher the score the higher the protection. A score of one is assigned wheneach of the following rights of secured lenders are defined in laws and regulations: First, there are restrictions, such ascreditor consent or minimum dividends, for a debtor to file for reorganisation. Second, secured creditors are able toseize their collateral after the reorganisation petition is approved, i.e. there is no "automatic stay" or "asset freeze."Third, secured creditors are paid first out of the proceeds of liquidating a bankrupt firm, as opposed to other creditorssuch as government or workers. Finally, if management does not retain administration of its property pending theresolution of the reorganisation. Euro area (EA) figures are averages of EA country data weighted by GDP.

Chart 16: Ownership concentration (size of shareholdings)(fraction of shares held by the largest and by the first 10 shareholders)

0%

10%

20%

30%

40%

50%

60%

70%

AT BE DE ES IE FI FR GR IT LU NL PT EA CH SE UK JP US

Top 1shareholder Top 10 shareholders

Data sources: ECB calculations using Reuters Kobra database (2005).

Notes: Calculated on the basis of data available for the largest shareholders in 10 top quoted companies in terms of

market capitalisation in each country. The comparison highlights the concentration of share capital in the hands of the

first compared to the largest 10 shareholders. Euro area (EA) figures are averages of EA country data weighted bymarket capitalisation.

48



Chart 17: Ownership concentration (Herfindahl index)(Herfindahl index for the largest 20 shareholders)

0%

5%

10%

15%

20%

25%

30%


Data sources: ECB calculations using Reuters Kobra database (2005).Notes: Calculation of the Herfindahl index for the 20 largest shareholders in 10 top quoted companies in terms of market capitalisation in each country. Euro area (EA) figures are averages of EA country data weighted by marketcapitalisation.

Chart 18: Proportion of institutions among largest shareholder(proportion of companies whose largest shareholder is an institution and proportion of institutions among ten largestshareholders)

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0


top 1 shareholder top 10 shareholders

Data sources: ECB calculations using Reuters Kobra database (2005).Notes: Calculated on the basis of data available for the largest shareholders of the 10 top quoted companies in terms of market capitalisation in each country. Institutional holdings are defined as holdings by buy-side institutions (theinvesting institutions such as mutual funds, pension funds, and insurance firms). An institution is an entity in thebusiness of investment management (e.g., they employ investment professionals, have assets under management etc).Investments may be managed on behalf of third parties or proprietary. Euro area (EA) figures are averages of EA

country data weighted by market capitalisation.

49



Chart 19: Law and Order index

0

1

2

3

4

5

6


1990-1994 1995-1999 2000-2005

Data sources: International Country Risk Guide and ECB calculations.Notes: The index ranges from 0 to 6, with lower scores indicating lower rates of law and order. The law sub-component is an assessment of the strength and impartiality of the legal system, while the order sub-component is anassessment of popular observance of the law. The index is the outcome of a subjective PRS staff analysis based onquestions such as: Are judges/magistrates appointed by qualification or by political affiliation/interest? How well paidare police and law enforcement officers relative to other professionals? Have higher courts ruled against governmentor against highly placed politicians/members of social/business elites? Euro area (EA) figures are averages of EAcountry data weighted by GDP.

Chart 20: Duration of enforcement(number of calendar days)

0

200

400

600

800

1000

1200

1400


2002 2004

Data sources: Djankov et al. (2003), World Bank and ECB calculations.Notes: Total number of calendar days needed to recoup a bounced cheque, i.e. the time between the moment of issuance of judgement and the moment the creditor obtains payment of a cheque. This is the sum of: (1) duration untilcompletion of service of process; (2) duration of trial; and (3) duration of enforcement. 2004 data are not exactlycomparable with 2002 data. The 2002 (2004) survey refers to a cheque worth the equivalent in local currency of 5%(200%) of GNP per capita of the respondent country. The 2004 survey also considers administrative procedures for thecollection of overdue debt. Euro area (EA) figures are averages of EA country data weighted by GDP.

50



Chart 22: Bank supervisor power

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14


1999 2002 2005

Data sources: Information provided by supervisory authorities to the World Bank for 1999 and 2002, to the authors for2005 and ECB calculations.Notes: The index is on a scale from 0 to 14 with higher numbers indicating more supervisory power. The followingquestions are quantified according to the answers yes=1 and no=0 and then summed up to yield the index: 1) Cansupervisors meet external auditors to discuss the report without bank approval?; 2) Are auditors legally required toreport misconduct by managers/directors to supervisory agency?; 3) Can legal action against external auditors be takenby supervisor for negligence?; 4) Can supervisors force banks to change the internal organizational structure?; 5) Areoff-balance sheet items disclosed to supervisors?; 6) Can the supervisory agency order directors/management toconstitute provisions to cover actual/potential losses?; 7) Can the supervisory agency supersede bank shareholderrights and declare bank insolvent?; 9) Does banking law allow the supervisory agency to suspend some or allownership rights of a problem bank?Yes=1 and no=0 for the each of the following: Can the supervisory agency suspend director's decision to distribute: a)dividends? b) Bonuses? c) Management fees?; Regarding bank restructuring & reorganization, can supervisory agencyor any other govt. agency do the following: a) supersede shareholder rights b) remove and replace management c)remove and replace directors. No 2005 updates for FR,IT,NL,PT. Euro area (EA) figures are averages of EA countrydata weighted by total assets of the banking sector. Due to data availability 2005 information had to be weighted with2004 assets.

52



Chart 23: Supervisory forbearance discretion

0

1

2

3

4


1999 2002 2005

Data sources: Information provided by supervisory authorities to the World Bank for 1999 and 2002, to the authors for

2005 and ECB calculations.

Notes: The index ranges from 0 to 4. The higher the index the higher the discretion. The index is the sum of the values

given for the answers of the following questions. Does the law establish pre-determined levels of solvency

deterioration which forces automatic actions such as intervention? No =1. Can a supervisory agency or any other

government agency forbear certain prudential regulations? Yes=1. Must infraction of any prudential regulation found

by a supervisor be reported? No=1. Any mandatory actions in these cases? No = 1. No 2005 updates are available forFR, IT, NL and PT. For BE and FR 2001 data are not available. Euro area (EA) figures are averages of EA country

data weighted by total assets of the banking sector. Due to data availability 2005 information had to be weighted with

2004 assets.

53



Chart 24: Supervisor independence

0

1

2

3

4


1999 2002 2005

Data sources: Information provided by supervisory authorities to the World Bank for 1999 and 2002, to the authors for2005 and ECB calculations.Notes: the index ranges from 0 to 4. The higher the index the higher the independence. Values for independence vs. thepolitical sphere are assigned according to the interpretation to the answers to the following questions (as 1=low,2=medium, 3=high independence); 1) To whom are supervisors accountable?; 2) How is head of supervisoryagency/other directors appointed?; 3) How is head of supervisory agency/other directors removed?; The index is the

average of the answers to the questions above plus an assessment on the independence of supervisors vs. banks, i.e. theprotection against lawsuits from banks (yes=1). No 2005 updates for FR, IE, IT, NL, PT. Euro area (EA) figures areaverages of EA country data weighted by total assets of the banking sector. Due to data availability 2005 informationhad to be weighted with 2004 assets.

54



Chart 25: Moral hazard index of deposit insurance

0

1

2

3

4

5

6

7

8

AT BE DE ES FI FR GR IE IT LU NL PT EA CH SE UK US JP

Data sources: Demirguc-Kunt and Detragiache (2002) and ECB calculations.Notes: The index ranges from 0 to 8. The higher the index the higher the risk of moral hazard. Index values are thesums of the values assigned to the following questions: 1) coinsurance required; 2) whether foreign currency depositsare covered; 3) whether interbank deposits are covered; 4) whether deposit insurance is funded or not; 5) source of funding (the scores are: 2 if government, 1 if government and banks, 0 if banks only); 6) type of management of deposit insurance (the scores are: 3 if private, 1 if official, 2 if joint); 7) type of membership (the scores are: 1 if compulsory, 0 if voluntary). The values assigned to points 1), 2), 3) and 4) are 1 if yes and 0 if no. No data areavailable for ES and LU. Data refer mainly to the period 1999-2000. Euro area (EA) figures are averages of EAcountry data weighted by total deposits.

Chart 26: Bank activity restrictions

0

1

2

3

4


1999 2002

Data sources: Information provided by supervisory authorities to the World Bank for 1999 and 2002, to the authors for2005 and ECB calculations.Notes: The index ranges from 0 to 4 and it is the sum of the scores in two categories, insurance and securities. The rangein each category is as follows: 0 = unrestricted, the full range of activities can be conducted or/but some or all must beconducted in subsidiaries; 1 = restricted, less than full range of activities can be conducted in the bank or subsidiaries; 2= prohibited, the activity cannot be conducted in either the bank or subsidiaries. Euro area (EA) figures are averages of

EA country data weighted by total assets of the banking sector.

55



Chart 27: Bank regulations supporting market discipline

0

1

2

3

4

5

6

7

8


1999 2002 2005

Data sources: Information provided by supervisory authorities to the World Bank for 1999 and 2002, to the authors for2005 and ECB calculations.Notes: The index ranges from 0 to 8 and the higher the score the better market discipline is supported by regulations. Theindex combines information on the following categories: (1) external certified auditor required (yes=1, no=0); (2) Noexplicit deposit insurance scheme (yes=1, no=0); (3) comprehensiveness of bank accounting (sum of the values (yes=1,no=0) assigned to: (a) income statement containing accrued but unpaid interest/principal while loan is non-performing;(b) consolidated accounts covering bank and any non-bank financial subsidiaries required; and (c) directors legally liable

for erroneous/misleading information; (4) off-balance-sheet items disclosed to public (yes=1, no=0); (5) banks discloserisk management procedures to the public (yes=1, no=0); and (6) subordinated debt allowable (required) as part of capital (yes=1, no=0). No 2005 updates for FR, IT, NL, PT, CH. Euro area (EA) figures are averages of EA country dataweighted by total assets of the banking sector. Due to data availability 2005 information had to be weighted with 2004assets.

56



Chart 28: Insurance supervisory power

0

1

2

3

4

5

6

7

8

9

10

JP UK AT DE FR NL LU SE

Data sources: IMF FSAP and ECB calculations.Notes: the index ranges from 0 to 10. The higher the index the higher the supervisory power. The index is based on thecompliance with applicable core principles of the International Association of Insurance Supervisors (IAIS). Valuesassigned to the IAIS core principles are 1 if compliant and 0 otherwise. Compliance with the following core principlesis considered: ICP 11 deals with market analysis (authority monitors and analyses all factors that may have an impacton insurers and insurance markets and takes action as appropriate); ICP 13 deals with on-site inspection (authority

carries out on-site inspections to examine the business of an insurer and its compliance with legislation andsupervisory requirements); ICP 14 deals with preventive and corrective measures (authority takes preventive andcorrective measures that are timely, suitable and necessary); ICP 15 deals with enforcement or sanctions (authorityenforces corrective action and, where needed, imposes sanctions based on clear and objective criteria that are publiclydisclosed); ICP 20 deals with liabilities (e.g. requirements for establishing adequate technical provisions and power of authority to increase provisions if necessary); ICP 21 deals with investments (requirements of standards for investmentactivities and enforcement of these by authority); ICP 22 deals with derivatives and similar commitments (authorityrequires insurers to comply with standards on the use of derivatives); ICP 23 deals with capital adequacy and solvency(authority requires insurers to comply with the prescribed solvency regime. This regime includes capital adequacyrequirements and requires suitable forms of capital that enable the insurer to absorb significant unforeseen losses); ICP24 deals with intermediaries (authority sets requirements for the conduct of intermediaries); ICP 27 deals with fraud(authority requires that insurers and intermediaries take the necessary measures to prevent, detect and remedyinsurance fraud).

57



Chart 29: Transparency of insurance sector regulation

0

1

2

3

4

5

6

7

JP UK AT DE FR NL LU SE

Data sources: IMF FSAP and ECB calculations.Notes: the index ranges from 0 to 7. The higher the index the higher the transparency. The index is based on thecompliance with applicable core principles of the International Association of Insurance Supervisors (IAIS). Valuesassigned to the IAIS core principles are 1 if compliant and 0 otherwise. The following principles are considered; ICP 2deals with supervisory objectives (principal objectives should be clearly defined); ICP 4 deals with supervisoryprocess (authority should conduct its functions transparent and accountable; ICP 5 deals with supervisory cooperationand information sharing (supervisory authority cooperates with other relevant supervisors); ICP 6 deals with licensing

(an insurer must be licensed before it can operate; licensing must be clear, objective and public); ICP 11 deals withmarket analysis (authority monitors and analyses all factors that impact on insurers and insurance markets and takesaction as appropriate); ICP 25 deals with consumer protection (authority sets minimum requirements for insurers indealing with consumers in its jurisdiction, e.g. provision of timely, complete and relevant information); ICP 26 dealswith information disclosure and transparency towards the market (authority requires insurers to disclose informationon a timely basis in order to give stakeholders a clear view of their business activities and financial position and tofacilitate the understanding of the risks to which they are exposed).

58



Chart 30: Bank concentration(Herfindahl index computed on total assets)

0

1000

2000

3000

4000

5000

6000


1998 2004

Data sources: Bankscope and ECB calculations.

Notes: The Herfindahl index has been computed by summing the squares of the market share of each bank in terms of

total assets. The index has been rescaled in order to range from 0 to 10000, with higher scores indicating more

concentrated markets. Euro area (EA) figures are averages of EA country data weighted by total assets of the banking

sector.

Chart 31: Foreign bank penetration(Assets of foreign owned banks over total domestic assets, in %)

0%

10%

20%

30%40%

50%

60%

70%

80%

90%

100%


1999 2004

Data sources: Worldbank for 1999 and ECB for 2004.

Notes: For 1999 data are missing for BE, FR, IE, NL and UK. For LU, CH, JP and US data are available only until

2002 from the Worldbank. Euro area (EA) figures are averages of EA country data weighted by total assets of the

banking sector.

59



Chart 32: Net interest income over total assets

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%


1990-1994 1995-1999 2000-2003

Data sources: OECD and ECB calculations.

Note: Euro area (EA) figures are averages of EA country data weighted by total assets of the banking sector.

Chart 33: Net interest margins(for commercial banks)

0.00

0.01

0.02

0.03

0.04

0.05


1996-1999 2000-2003

Data sources: World Bank database on financial structure and ECB calculations.

Notes: Net interest margin is defined as difference between interest income and interest expense divided by interest

bearing assets. Country figures are unweighted country averages. Euro area (EA) figures are averages of EA country

data weighted by total assets of the banking sector.

60



Chart 34: Net non-interest income over assets

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

AT B E DE ES FI FR GR IE IT LU NL PT EA CH S E UK JP US

1990-1994 1995-1999 2000-2003

Data sources: OECD and ECB calculations.Note: Euro area (EA) figures are averages of EA country data weighted by total assets of the banking sector.

Chart 35: Operating expense over assets

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%


1 99 0-1 99 4 1 99 5-1 99 9 2 00 0-2 00 3

Data sources: OECD and ECB calculations.Note: Operating expenses are the sum of (i) staff costs, (ii) property costs and (iii) other operating expenses. Euro area(EA) figures are averages of EA country data weighted by total assets of the banking sector.

61



Chart 36: Cost to income ratio

0%

20%

40%

60%

80%

100%

120%

140%

AT BE DE ES FI FR GR IE IT LU NL PT EA CH S E UK JP US

1 99 0-1 99 4 1 99 5- 19 99 2 00 0-2 00 3

Data sources: OECD and ECB calculations.Note: Cost to income ratio is defined as operating expenses (sum of (i) staff costs, (ii) property costs and (iii) otheroperating expenses) divided by the sum of non net interest income and net interest income. Euro area (EA) figures areaverages of EA country data weighted by total assets of the banking sector.

Chart 37: Return on assets(net income after taxes over year end total assets)

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

AT B E D E ES FI FR GR IE IT LU NL PT EA CH S E U K JP US

1990-1994 1995-1999 2000-2003

Data sources: OECD and ECB calculations.Notes: Euro area (EA) figures are averages of EA country data weighted by total assets of the banking sector.

62



Chart 38: Bank competition (H-statistic)

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

AT BE DE ES FI FR GR IE IT LU NL PT E A CH S E UK JP US

All Banks Commercial Banks

Data sources: Bankscope and ECB calculations.

Note: the H statistic measures the elasticity of firms output to input prices. Under competition the H statistic is one,

under monopoly is equal or lower than 0. See section 3.7 for explanation on its computation. Euro Area (EA) figures

has been estimated by considering EA as a single country (i.e. using all banks from EA)

Chart 39: State ownership of banks

(percentages of total banking assets)

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

AT B E DE ES FI FR GR IE IT LU NL PT E A CH SE UK JP US

1999 2002

Data sources: World Bank survey conducted with national supervisory authorities and ECB calculations.

Notes: There are no data for IE. For BE, FR and SE data are missing for 2001. Euro area (EA) figures are averages of

EA country data weighted by total assets of the banking sector.

63

european fin system

Documents