APPENDIX B: NOTES ON THE COMMITTEE TRIP TO EUROPE

 

REGULATION OF FINANCIAL INSTITUTIONS IN THE UNITED KINGDOM

On 20 May 1997, the Chancellor of the Exchequer in the new Labour Government, Gordon Brown, made a statement to the House of Commons on reform of the Bank of England and of the structure of financial regulation. The Bank of England would relinquish responsibility for banking supervision while an expanded Securities and Investment Board (SIB) would assume responsibility for regulating everything from banking to pension sales. Mr. Howard Davies, the deputy governor of the Bank of England, would become head of the new SIB at the end of July 1997.

As the pressures for integration come from the EU, the FSA may be given even more powers. For example, there will be an enabling provision in the new act to permit Treasury to transfer listing functions from the stock exchange to the FSA (in order to actually make this transfer, a statutory instrument will be used which will require parliamentary approval.)

On 28 October 1997, the SIB formally changed its name to the Financial Services Authority. There are in place plans for early integration of the various financial sector regulatory organisations and a timetable for needed legislation, namely a new Bank of England bill and a financial regulatory reform bill.

When the new Bank of England legislation comes into force (expected by spring of 1998), appointments to the FSA Board will be the responsibility of the Treasury alone. It is envisaged that the Board will not exceed fifteen members. The main role of the Board will be to oversee the FSA’s exercise of its statutory powers, to deal with corporate governance issues, to exercise quality control over the organization and to handle major issues of policy and standard setting. FSA board members will have statutory immunity with respect to their performance as board members as long as they act in good faith.

Once the transition to the new regime has been completed, important information about the financial sector will be shared by the Bank of England, the FSA and the Treasury. The Bank’s Deputy Governor (financial stability) will be a member of the FSA Board and the FSA Chairman will sit on the Court of the Bank of England. In addition, there will be a Standing Committee of representatives of the Treasury, the Bank of England and the FSA which will meet monthly to discuss issues of significance to the financial sector. The FSA and the Bank of England will co-operate in their relations with international regulatory groups and committees.

The Treasury will continue to exercise major responsibility for regulatory policy through its powers to introduce new, and amend existing, legislation. With the legal framework affecting the financial services sector always being altered by what goes on in Brussels, Treasury will have a very active role. Treasury will, however, not want to be perceived to be interfering in the ongoing activities of the FSA; because, if something goes wrong, there may be questions raised about who is responsible.

Another important change in the new regime will be the role of the Bank as lender of last resort. In the past when there was a financial crisis, the Bank made an assessment of the situation because it was the lender of last resort. It will no longer have this role. In the future the FSA will assess the situation and make a recommendation to the government as to what should be done. Public funds can no longer be committed to a rescue operation without public debate. There are no "stand-by" funds.

The FSA legislation will contain specific objectives for the Board in five main areas: public confidence in financial markets, consumer protection, public education, criminal activities in the financial sector, and economic efficiency of the financial sector. It is expected that the Treasury Select Committee of Parliament will regularly hold hearings on FSA performance.

As the transition to the new regime progresses, the government will publish draft legislation and the FSA will outline its regulatory approach.

The FSA will be funded by the institutions regulated. "Institutions are being charged for the privilege of being regulated." The FSA is responsible to Parliament, not to the institutions. The institutions are not stakeholders, but they are worried about the costs of regulation. When the structure of the FSA was being discussed, the institutions wanted shareholder rights. Further, the House of Commons wanted a say in the makeup of the FSA board. The government said no to shareholder rights for the institutions and no to a role for Parliament in the FSA board.

With respect to the costs of regulation, the FSA is aware that London has thrived on the American costs of regulation. Specifically, the Euromarket grew in London because the tax regime and the regulatory regime were more favourable than in New York. Continental centres had a more nationalistic approach, while the UK tried to develop London as an international centre. Brussels is attempting to harmonise regulation across Europe, but this is a problem for London. For cities on the continent, competition is among European firms. For London, competition is with New York in the North American time zone and with Hong Kong and Tokyo in the Asian time zone. The FSA does not want to sacrifice financial innovation by imposing unnecessary costs on financial institutions. The FSA is required to do a cost-benefit analysis of proposed regulations and to consult with stakeholders about proposed regulations.

Regulations do not require the approval of Treasury. Treasury can intervene in cases of international obligations and in matters of competition policy (based on advice from the Office of Fair Trading). Regulations issued by the FSA cannot be anti-competitive.

The FSA will also have a public education role. A lot of consumer protection is needed because consumers are so woefully ill-informed. Of particular concern is that many individuals hold deposits in financial institutions that are not protected by public or private plans – yet that depositors think are protected. There is confusion about the role of financial institutions and about the types of deposits offered by these institutions.

Where the FSA is having problems is in its mandate to deal with financial crime. Other than money laundering, what are the specific areas that need attention? What does prevent prime mean? Will this lead to a proliferation in prosecution? There is still a lot of debate to be held on this task.

A. What The Committee Heard About The Proposed Restructuring

Following problems in the banking system (e.g. the failure of Barings) and in the marketing of private pensions, the United Kingdom decided the time had come for changes in the regulatory system overseeing the financial services sector. Those involved in designing change found no easily accessible model to copy. The American system was viewed as much too decentralised, impeding the effectiveness of regulation and imposing unnecessary costs on the sector and hence on the economy. The Norwegian system, while a model of an effective centralised system, was considered too small to be applicable to the British context. Canada’s OSFI presented a good model of unified banking and insurance regulation, but could provide no guidance on how to integrate securities regulation into a national regulatory scheme.

What policymakers in the UK noted was a general trend toward moving banking supervision away from the central bank; the majority of members of the Basle Committee on Banking Supervision now have central banks without banking supervision. Further, there is a general trend toward the consolidation of regulation (Australia, Japan, and South Korea being the most recent examples).

When reform was being discussed in the United Kingdom, it was not initially expected that the Bank of England would give up banking supervision. Two issues were raised which were among the factors leading the government to move banking supervision to the FSA. The first issue was political. If the Bank of England were given complete control of monetary policy, would it not be too powerful if it also had control of bank supervision? While there is clearly a link between monetary policy and banking supervision, the same organisation does not have to do both. In addition, it is possible that, if the same organisation does both, the conduct of monetary policy may be influenced by issues arising out of bank supervision. In Canada, Germany, and Belgium, the conduct of monetary policy has not been hampered by the central bank not having responsibility for banking supervision. Not everyone agreed that there is a conflict between monetary policy and financial regulation and these individuals argued further that, even if there is such an issue, it does not go away by splitting up the functions.

The second issue had to do with the extent of supervision that would be called for in a consolidated regulatory framework. The Bank of England did not want to extend its responsibility beyond the banking sector. Consequently, if policymakers chose (as they did) to go with a "mega" regulator, then the Bank recognised that it would have to give up banking supervision (which it did).

Another link between the central bank and banking supervision is the payments system. While the central bank oversees the payments system, this is not a key argument for having the central bank directly responsible for banking supervision. It is, however, a strong argument for having the central bank working closely with the financial services regulator in overseeing the financial sector.

In addition, while the central bank is also the lender of last resort, this does not mean it must regulate the banks. Whether or not there is a systemic threat (which is what you use the lender of last resort function for) should not be mixed with "supervisory embarrassment" (embarrassment of the regulator if a regulated institution runs into serious problems that should have been foreseen by the regulator). A regulator that is also the lender of last resort may be tempted to use its lender role to cover up its supervisory failures.

What is very important is that there be ongoing communication between the central bank and the regulator – that the central bank be aware of the status of "potential" borrowers from the lender of last resort. To ensure that there are open gateways between the FSA and the Bank of England, there is a memorandum of understanding on co-operation between the Treasury, the FSA and the Bank of England; there is cross-board membership between the latter two; standing committees of Bank and FSA officials have been set up; and contact on an informal basis is ongoing.

Based on this interpretation of international trends, a desire to improve the effectiveness of regulation, to increase the transparency of regulation, to clarify accountability, and to improve the efficiency of regulation, the British government chose to set up a "super regulator" to be responsible for overseeing almost the entire financial services sector – deposit takers, securities brokers and dealers, firms dealing in futures contracts, investment advisors, and insurance companies (as well as Lloyds of London). The most notable omissions were the regulation of occupational pension schemes and the professional organisations of lawyers and accountants.

Effectiveness will be achieved through intra-agency co-ordination of different areas of regulation. The regulation of financial conglomerates has presented particular problems for regulators because of the latter’s focus on traditional definitions of lines of business – banking, insurance, securities and so forth. The FSA proposes to build on existing arrangements to supervise these complex organisations – making use of a "lead supervisor" who would co-ordinate the work of regulators from each of the business groups within which the conglomerate operates. In addition, the FSA also proposes to work with groups in the private sector to set up pilot studies to test and fine tune alternative models and approaches to the supervision of complex groups. Firms should no longer have to go through a costly bureaucratic process every time they want to offer a new product or service. The super regulator should be able to "certify" the organisation’s financial soundness as a whole.

With a single regulator, the regulatory process should become more transparent. Consumers and financial services firms will have no question about whom they need to consult concerning financial sector issues. Access to the regulator should become clear and straightforward and multiproduct financial service firms will no longer have to deal with a number of regulatory agencies. One large financial institution had to register 30 of its operations with various self-regulatory organisations (SROs). This created management problems. This will no longer happen. The key criterion for success will be the cost-effectiveness of the FSA; there is currently a great deal of duplication. Firms would expect to see some alleviation of fees if they currently pay to more than one regulator.

The FSA should, for example, be able to deal with problems currently being experienced in the investment counselling business – an area in which monitoring has been uneven and for which questions of a level playing field have been raised. Currently to get into the investment counselling business you only have to get authorisation by somebody – the Institute of Accountants, the Law Society and so forth. The FSA will now be responsible for the whole field. It will be able to tighten up what is meant by authorization to get into the investment counselling business and will be able to regulate all those who actually give investment advice. Once standards and definitions are set, the FSA will probably delegate powers back to the professional associations – but the associations will need to demonstrate effective performance.

The FSA will have a board of directors that will include the FSA executive chairman, the three full-time executive managing directors, the Deputy Governor of the Bank of England (an ex officio member) and up to 10 non-executive members who are genuine outsiders. The latter will bring insight into the operations of the market. All will be appointed by the Chancellor of the Exchequer.

The board will be expected to operate like a typical corporate board with all the usual systems and checks and balances in place. It will be an oversight body, not an enforcement body, and will meet monthly.

In addition, the FSA recently appointed someone (formerly with Lloyds Bank) to head up a quality assurance function. His responsibility will be to ensure that procedures with respect to bank supervision are being followed; this is a process audit. (In the Barings case, while procedures were in place, many waivers were given. There was a clear failure of supervision.)

A larger regulatory agency should be able to develop a more efficient regulatory process. With more resources, greater division of labour and hence specialisation is possible. Resources can be moved as they are needed and new skills developed in-house in anticipation of, rather than in reaction to, need. With a multiplicity of agencies, each is individually too small to develop all the specialities needed, particularly when they are needed only infrequently. Further, temporary assignments across agencies can be costly.

With all the needed specialities in-house, the FSA should be able to more efficiently supervise large, complex institutions. The basic approach currently being used is that of the lead regulator. The FSA may well use a matrix approach, with the lead regulator responsible for prudential regulation and the institution’s overall strategy. For the 50 or 60 very complex institutions, the FSA has set up a special unit that will focus on the regulation of these organisations. In addition, it is exploring new ways of dealing with them by setting up pilot projects in co-operation with selected institutions (a half dozen are already complete).

Not everyone with whom the Committee met, however, viewed the establishment of a super regulator without reservations – despite their recognition of the arguments made in favour of the new structure. In spite of the governance procedures that have been set up, some question whether such a big, powerful agency will really be responsible to anyone. Because the heads of the FSA and of the Bank of England are not members of Parliament, the Chancellor answers questions concerning these agencies on the floor of Parliament. It is only in the House of Commons Treasury Committee that these agencies can be directly questioned. Further, there is some disquiet about the process leading to the creation of the FSA. Firms themselves were not as much a part of the consultative process as they would have liked.

There are two fundamental aspects to supervision: (1) individual banks and (2) the system as a whole. Can you separate the two? The evidence from outside Great Britain is that you can. There is clearly some tension among Treasury, the Bank of England and the FSA about the new regime; it will take some time to see how the roles of each develop. The real test will come if there is a crisis. Who will call the shots – the authority responsible for the individual institution, the FSA, or the one responsible for systemic stability, the Bank of England? The new arrangements will work quite well in routine ongoing situations, but the jury is out on crisis management.

Concerns were expressed that such a large agency might lose the flexibility that a smaller agency is able to exercise, that it would rely on a relatively inflexible rules-based approach to dealing with individual stakeholders. The institutions also want a degree of certainty so that they can plan their activities accordingly. Unfortunately, certainty often implies more detailed rules, while flexibility calls for more principles and less detail. Where to draw the line is not at all clear. What the regulated institutions are looking for is a consultation process with respect to regulations in which the regulator explains: (1) what submissions have been made by the regulated financial institutions to the regulator, and (2) when a decision is made, what the basis of the decision is. If a stakeholder’s views are rejected, an explanation should be provided.

One of London’s most important attributes is that it has allowed experimentation by financial institutions. It is important that the new super regulator not push synergy too far – that it not try to come up with a "one-size-fits-all" set of rules and regulations.

Regulators usually have a clear idea of what they want to achieve, but very little idea of how to draft a regulation to accomplish that goal. The business is evolving so rapidly. In the pre-FSA regime, there was good co-operation between the investment banking firms – those operating the most complex businesses – and the regulator, the Bank of England. The former worked well with the latter to develop regulations that accomplished the set goals and did so without imposing unnecessary costs on the regulated firms. Confidence in markets is good for the business of financial institution firms and consequently, the institutions are willing to work with the regulators. The investment bankers prefer that broad prudential regulation be emphasised and that details be left to individual negotiation. They expressed concern that this approach may be lost in a large, multi-industry regulator.

All discussion papers put out by the FSA must go through the board. Will they get practitioner input? In the pre-FSA regime, the self-regulatory organisations were all constituted with a self-regulatory philosophy that required considerable involvement of practitioners. The new organisation may be too large to operate in this way. Further, while almost everyone agreed that practitioner input is desirable, it appears that the FSA has a regulator’s view of the world – not a self-regulatory view. This could be a problem. How do you get institutions to get highly qualified people involved if the latter do not feel that their input will be taken seriously?

Some were, however, not as complimentary about the performance of some of the self-regulatory organisations, suggesting that a number focused on turf protection rather than on encouraging competition. They expressed the reservation that practitioners involved in the regulatory process tend to be captured by those being regulated. The Bank of England, they pointed out, undertook a very effective consultation process.

Given that the super agency is an amalgamation of a large number of smaller agencies, many of which did not share the same philosophy of regulation or objectives, will there be difficulties in establishing new objectives for the agency and to measure the effectiveness and the performance of the agency? Will the size of the agency generate yet more bureaucracy and more costs on the stakeholders?

The minister responsible for the FSA has stated that the agency will not go "over the top" with respect to fees. The FSA acknowledges that there will be one-time set-up costs and some duplication of efforts during the transition period, but promises lower costs of regulation down the road. There will be cost savings in the human resources function and in the IT area. Further, the FSA argues that it will keep the bureaucracy in check by: (1) devolving powers to professional organisations where feasible; (2) getting real expertise among the staff by paying market salaries; (3) ensuring practitioner involvement, and (4) pursuing specialisation in rules and arrangements. With respect to (4), the more general the rules and arrangements are, the more that staff time will be required to apply those rules and arrangements to each industry or product regulated. By pursuing specialization, clarity and transparency will be promoted. Finally, there will be public scrutiny of the FSA. The FSA will report regularly to the Treasury Select Committee of the Commons; it will report annually to the Chancellor; it will publish discussion papers on its processes and procedures.

Questions were also raised about the ability of the FSA to attract and keep able individuals. As part of the study of banking supervision following the Barings problems, a number of banking regulators discussed their operations. Among the metrics used for comparison among the regulatory agencies of different countries was the level of IT expenditures and the expenditures on staff, and on training in particular.

The Committee heard repeatedly about the steady flow of IT investments being made by financial institutions to deal with increasingly complex business arrangements. If the regulator cannot also make a level of IT investments that will permit it to deal with its increasingly complex tasks, then it is unlikely that regulation will very effective.

Staff of the regulator needs to understand the increasingly complex businesses in the financial services sector. Having someone with first hand experience is quite useful, but it is very difficult to attract such people given the existing pay scales. If a bank moves into a new area, it is important that the regulator have the skills to understand the area.

An analyst assigned by the regulatory agency to a specific institution will work with the internal auditor, with external auditors, and with those actually involved in risk assessment to see how things actually work in the organization. However, it may take up to half a year for an inexperienced analyst to develop the knowledge base necessary to carry out effective regulation of an organization. If the people who develop these skills are then bid away from the regulator by the regulated institutions, both the regulator and the regulated institution bear the costs. The former will have to attract and train a replacement, while the latter must deal with an individual who does not have a sound basis for making regulatory decisions directly affecting the firm.

One of the world’s largest financial institutions indicated that three different analysts – junior and inexperienced – had been working on its file in the span of one year. This is a problem for the financial institution both in its relationship with the regulator and with the competitor who hired the analyst who had worked on the former’s file. Further, when you employ people of the wrong calibre you get a rules-based approach – and often an adversarial system. This is counterproductive for all concerned.

One senior bank executive indicated an internal incentive problem within the regulatory agency. Ideally, the agency would like to start its junior analysts on less complex institutions and then, as they gain experience, move them on to more complex portfolios. What ambitious young regulator wants to work on a small "unexciting" assignment when there are all these world-class financial institutions to explore? This can create problems attracting people and keeping them, particularly when private sector compensation in the financial services sector is so attractive.

While there is high turnover of experienced staff, this is a problem, not a crisis. (This is not a new problem with the new structure, but an ongoing problem with public financial institution regulatory bodies.) While the FSA will not be subject to the public service pay scale, it will still not be able to pay top dollar. It will not be able to duplicate the long-term incentive schemes of the private sector (e.g., stock options). The goal of the FSA is to pay salaries that are between the market median and the upper quartile.

Questions were also raised about how consumer input would be incorporated into the new structure. In the pre-reform regime, the Personal Investment Authority (which dealt with the retail investment business) had a consumer panel that did economic research and had an independent voice. The FSA wants to use that model across the whole organization. It will give its consumer panel a bigger budget and consult the panel on drafts of policy papers.

The National Consumer Council is basically in agreement with this approach, but will probably call for a "large" budget to fund the panel. There is a question as to whether this panel should have a separate statutory existence (such as Gas Consumers Council), but controversy exists within the consumer movement about whether this is necessary. If the panel was given a statutory basis, the regulator might then treat it at arms-length. This may then not create the consumer input into policy that everyone seems to want. There is unlikely to be a statutory basis for the panel.

To further protect consumers, the various ombudsmen and compensation schemes that exist currently will be brought together in the FSA. The ombudsmen will in fact be adjudicators; they will have a statutory basis. What the FSA does not want to do however, is to "overprotect" the consumer so that the latter is continually being asked to approve actions taken by a financial institution what will affect him. The approach taken by the SFA is a useful example. The SFA has a huge rulebook governing consumer-financial-service-firm relations, but the customer can sign off from specified protections if he finds they generate burdensome correspondence. The firm must, however, have certain basic consumer protections in place that cannot be avoided.

Finally, a huge amount of financial service sector business is being done outside of the regulated environment. And, what is regulated and what is not varies by country. There is an unresolved issue with respect to giant, unregulated institutions such as GE Capital. What would happen if GE Capital got into trouble? Would it threaten system stability in a particular country? In a number of countries? Who would decide? It is, then, very difficult to globalize regulation.

According to the investment bankers, the biggest international problem is that as IT systems become more important in trading, it will become much more costly to regulated firms if each country demands different information. Another problem has to do with jurisdiction shopping by the big financial institutions. For control and management reasons, these firms operate from a small number of large bases. As these firms develop new products they will market these products (geographically) where it is most advantageous commercially. But if a firm has exposure to a number of countries, the liability is multinational. These firms would prefer to face a lead regulator rather than a number of competing, overlapping regulators.

Who should be the lead regulator? The Joint Forum of Banking, Securities and Insurance Supervisors, the Basle Committee on Banking Supervision (senior representatives of bank supervisory authorities and central banks from the G-10 countries plus Luxembourg), IOSCO (the International Organization of Securities Commissions) and Group of 30 (a Washington-based international group of bankers and former regulators) have addressed this question. According to those with whom the Committee met, U.S. regulators have been the most sceptical about the concept of a lead regulator. Many suggested that the concept would only be acceptable to the U.S. if the lead regulator were American. As an intermediate step, international standards as to how to treat the unregulated sector would be useful. With respect to information that the financial institution firms are asked to provide, IOSCO has been working with the International Accounting Standards Committee (IASC). If the IASC can develop standards that the international organisations of regulators are happy with, then national regulators will get them adopted in statute or regulation.

B. Basis Of Supervision

Following the Barings collapse in 1995, the Bank of England undertook a review of its Supervision and Surveillance Divisions. The report released in the latter half of 1996 recommended that the Bank’s basic method of supervision, based on a non-rules based judgmental approach should not change, but it called for the development of better tools for use by supervisors. It called, in particular, for the development of a more systematic model of risk assessment and a more effective use of prudential meetings with banks and of information gathering processes.

In fact, all of the organizations brought together have been moving toward risk-based supervision. The report also called for a clarification of the standards and processes of supervision with an explanation of their relationship to the overall objectives of supervision. This will enhance the transparency of the regulatory process and provide the basis for public education about the regulatory process. (The FSA is about to publish a document on the subject of models used to evaluate the risk associated with the activities of a financial institution.)

With respect to the relative roles of management and the regulator, it was made clear that it is not an objective of the regulator to prevent all failures. The regulator is concerned with the soundness of the system; senior management of the institution must be responsible for the institution. There is always a moral hazard problem when the regulatory structure is reformed and stakeholders then undertake more risk and do less monitoring, because they feel that the super regulator will be there to ensure that no problems arise. Management may feel that if the regulator does not see a problem, then it does not have to worry about internal processes. Consumers and businesses must be aware of what is going on in the financial services sector.

While there was a failure of public supervision as regards Barings (the SFA assumed that the Bank of England was the lead regulator while the Bank saw the SFA as the lead), monitoring processes within the Barings network also failed (Barings itself had no idea what was going on). Further, the Barings failure indicated a weakness in the repercussions on senior management from poor decision-making. It is important to define clearly the responsibilities of senior management. Sanctions will be put in the new regime; and it is absolutely crucial that they be extended to directors as well as management.

In March of 1997, the Bank of England released a consultative paper, A Risk Based Approach to Supervision (the RATE framework). RATE is an acronym for the three stages of the supervisory process: Risk Assessment, Tools of Supervision and Evaluation. Basically, this approach involves establishing a more systematic framework and spending more time visiting banks. The FSA will now be responsible for public consultation on this document. The goal of risk-based supervision is to adopt a comprehensive approach to risks associated with an institution – environmental risks, capital risks, etc. The FSA will use a similar approach in non-banking areas. The FSA will shortly be publishing a document on value-at-risk (VaR) models.

Staff of the Federal Reserve Board in the United States have developed a new approach to regulation of risk (which is for discussion purposes only at this time) by linking the regulatory capital required of a financial institution to the institution’s own estimate of the losses it expects to incur in its portfolio over some fixed period of time – together with a penalty imposed on the firm if it exceeds those estimates. In the European Community a similar approach is used. The capital adequacy directive in Europe allows people to use their own models to assess risk. The FSA will test these models for robustness, and if they prove acceptable, will use them to determine specific capital requirements.

The key to effective regulation is to focus on the actual risk involved in the portfolio. Financial institutions who met with the Committee were of the view that the regulator in the UK has focussed on this overall risk. American regulators, on the other hand, were more interested in classifying individual loans and trades by degree of risk. They do not focus on the overall risk involved in a financial institution’s portfolio. Consequently, the proposed Federal Reserve approach just described (called pre-commitment) which focuses on overall portfolio risk is more relevant in the U.S. context than in the UK.

The new capital adequacy framework of the European Community will not be applied to branches in the UK of banks incorporated elsewhere in the European Union, because these banks are primarily the responsibility of their home country supervisor (following the 2nd Banking Directive of the European Economic Area). The home regulator is responsible for prudential regulation; the host country, business conduct matters (such as privacy issues) and liquidity concerns.

There are two problems with this approach. First, there are still local market rules that the host country enforces. Second, there are things overseas banks do in London (because it is a major financial centre) that they do not do at home. There is therefore a lot more joint supervision than the 2nd Banking Directive would imply. FSA officials also indicated that there is a philosophical difference between the UK approach (more judgmental, less rules-based) and that on the continent (more rules-based). The UK has focused more on health in a dynamic context (institutions come and go but a sound system continues; the private sector eventually took care of the Barings affair), while the Europeans have focused more on health in a static context (system soundness is sustained by keeping all institutions sound).

With respect to banks that are incorporated outside the European Union, the FSA has developed a model to evaluate the supervisory regime in the country from which the overseas bank comes. The FSA will do supervision (collect information from these overseas banks) and surveillance (look at the regime in which the overseas bank operates).

In the case of the recent problems in the Asian economies, the system worked well. These were all treated as very risky situations and capital requirements were imposed accordingly. The regulator, the Bank of England during this period, had economists doing "surveillance" in these economies at the same time as it was supervising banks with exposure to the Asian economies. The Bank found this a very useful way to proceed.

That aside, however, is it possible to predict crises? The precision of the estimates generated by the UK system proved no better than anywhere else. Risk assessment systems are more honed to individual institutions, but it is critical to understand the broader context within which the institutions operate.

With respect to financial institutions that are truly global operations, there is the potential for conflicts among regulators. The FSA wants to see a framework of regulation using the lead regulator concept – where the lead regulator is from the home country of the global institution. The U.S. will not accept this approach. There are three issues involved. First, the U.S. generally insists that it be the lead regulator. Second, there is jurisdictional conflict among federal regulators within the United States. And third, there are jurisdictional disputes between federal and state regulators of financial institutions. The U.S. is now looking at the concept of an umbrella regulator to resolve the conflict. Another issue is that different countries have different levels of disclosure required for their financial institutions. The G-7 will be looking at this issue at its upcoming Birmingham meeting.

C. Issues Concerning Market Structure In The Financial Services Industry

What banking activities do you need for an efficient economy? You want an efficient, competitive structure that will gather savings from the public and funnel them to enterprises that can make good use of them while paying a competitive return to the savers. Certain core traditional services such as chequing, bill paying and savings deposits can be provided with or without big banks. A good retail franchise in banking is the most valuable asset you can have.

The United Kingdom has a unique structure to its financial services market. There is "in City" in London that is dominated by foreign banks operating as wholesale institutions. Outside the City, there is the retail banking sector serving the British consumers and small businesses; this sector is at least 80% British owned.

1. The Retail Banking Sector

FSA officials argued that Britain would really lose control of its financial system if non-British banks serving the retail British consumer did not operate as subsidiaries. This allows the British regulator to control the capital of the banks serving the consumer sector. When HSBC wanted to take over Midland, the regulator made permission contingent on HSBC becoming a British headquartered group.

Within the British retail banking sector, a process of consolidation is going on. Further, the big building societies are converting to banks and new institutions are entering the retail sector (Marks and Spencer, Sainsbury, Tesco). Strong competition exists.

What explains the entry of major retailers into the banking sector? These retailers are operating joint ventures with the big Scottish banks. The latter have no outlets in England, while the former have valuable brand names that can be applied to the banking sector to attract customers.

The 1987 Banking Act took down the barriers to this movement of retailers into banking. This was the necessary condition for retailer entry, but not the sufficient condition. Some argue that the sufficient condition was that banks are in such disrepute in the UK, that brand name retailers are preferable to existing banks in the eyes of consumers. Even though the new firms entering the market are not maintaining a full branch network, are not offering a full range of services and have no record in the financial services sector, they are viewed by consumers as safe and as a breath of fresh air. Where service is important, brand names are critical.

The United Kingdom has always been against structural prohibitions in the financial services sector. The policymakers and regulators are not concerned about who owns what, but they are very concerned about "connected" lending. Fences must be put up around the financial institution to ensure that prudential considerations are never brought into question because of a commercial-financial services link.

With respect to take-overs, the regulator in the UK has always taken a pragmatic view. Once an entity is taken over will the new institution be supervisable? Does the supervisor have confidence in management of the new institution?

With respect to dealing with large banks, the regulator has had no problems dealing with prudential issues, but competition issues are different. They are the responsibility of the competition authorities. The latter focus on competition in local areas, not from a country-wide point of view, and with respect to specific services, such as small business lending. At the end of the day a merger will not be challenged if there is adequate competition on both a product and a geographic basis. Representatives of consumers supported this view. They were not concerned with the size of institutions as long as consumers had good access to financial services in an open and fair market and if they had options for redress when they felt it was necessary.

With respect to competition, in the UK there are many potential providers. Further, in the future, physical presence will not matter because of alternative delivery modes – telephone and Internet being the most obvious examples.

The key issue in the future will become: who owns the customer? In PC banking, for example, is it the service provider or the bank that owns the customer?

From a public policy point of view a new issue is arising. Given modern technology and marketing trends, financial institutions are targeting the upscale. It is no longer profitable to service the individual who simply earns money and pays bills. How will this segment be served in the future?

2. The Wholesale Banking Sector

Will the UK banking system become "marginalized" because of the open door policy? Policymakers are not concerned with having British banks dominate the wholesale banking sector. In fact, in this sector, there are very few serious players that are UK owned. (A number of large British banks did try to become important internationally, but have recently pulled back because they could not compete successfully with the big American firms. By focusing on the retail sector, they have been able to increase shareholder value.) The wholesale bank world is dominated by six American investment banks. Their size is a result of having the American franchise with its access to huge pools of investment funds. In the United Kingdom, the open door policy has led to tremendous value-added for the economy. The UK has prospered. The evidence of this value-added is the growth of the City and, of incomes generated by the wholesale banks in the City. The UK has been willing to trade value-added for a national champion in the wholesale banking sector. Whether or not there is a level playing field in the City will be fought out in the marketplace.

Outside the United Kingdom, the EMU has added pace to events in Europe. Mergers are proceeding (Swiss Bank and Union Bank of Switzerland, ABN Amro and Bruxelles Lambert being the most notable developments.)

How important is it for banks to be large? Look at the global custody business. Just a few years ago, the "accepted" view was that each country had to have a major player in the custody market. Today there are only four major players: Citibank, Chase, State Street Bank and Trust, and the Bank of New York. The whole sovereignty-nationality issue was done away with. Is custody a forerunner of the banking industry in general?

The United Kingdom is fast becoming a country without a major investment bank. The UK treasury is however benefiting significantly from the rapidly expanding activities of foreign investment banks operating in London.

Other countries have taken different approaches. Australia has chosen to protect its banking sector and to prohibit its big four banks from merging. Various explanations were provided. Are Australians are unsure of what they want their banking sector to look like and are buying time? Or, is Australia is a parochial country?

The banking sector is changing so rapidly, however, that we are no longer looking at an entity called a bank. We are looking at numerous retail institutions providing, among other things, financial products and services. Branding is becoming increasingly important and only Citibank, among the giants, understands this. Most banks have been particularly bad at selling themselves on an international scale. Citibank, on the other hand, has cut down its costs and tries to use the same systems wherever it operates. If its brand is not successful (as happened in Italy) it moves quickly to withdraw.

A number of nonbank institutions have also adopted this strategy and are expanding the range of financial services they offer, with the consumer as their ultimate target. Merrill Lynch and Dean Witter are examples.

From a regulatory perspective, developments are coming so rapidly that it is difficult to know where to build fences to ensure systemic stability and to protect the consumer.

Does an institution have to be large to be successful? It is unclear. Size lets you take advantage of new technology, but a bank can always join a consortium.

Does Canada need a major player in the investment banking market? There was no definitive answer to this question either. Some of the people the Committee met with in Europe argued that it is not necessary, that the market will always provide the products and services that are needed and at a competitive price. Others argued that, when there are problems in a financial institution’s home country, the first thing the international financial institution does is pull back from foreign markets. Some argued before the Committee that this could pose a problem for domestic commercial businesses that have become dependent on foreign financial institutions for their capital. As competition across markets becomes increasingly global, they went on, Canadians will want to tap global financial markets. From the point of view of non-financial institutions, then, the Committee was told that it is important to have a major player in Canada to ensure a reliable source of capital on a large scale.

Some, who appeared before the Committee, made what they described as a "national pride" argument. They posed the question: do Canadians want to be considered important on a global scale? If the answer is yes, then they need a global player. There is also a spin-off from this argument. Having a global player will facilitate the distribution of Canadian debt. A big player can follow the small, growing firms as they expand abroad. A financial institution needs a big balance sheet to do this. For example, a junior mining company may not have the reputation to get foreign funding, they argue, but a "big" Canadian bank could help.

What is clear is that the economies of scale in the investment banking industry are increasing dramatically – because of technology and globalization. Salamon Brothers, for example, felt it was too small and merged with Smith Barney which then merged with Travelers. Because of these scale economies, some suggested that we see more institutions withdrawing from investment banking. There is a first division, a second division and a third division in this industry. There will be successful institutions in all divisions. What will be important is they choose what they want to do and then do it well. The second division players will provide capital on a regional basis (for example, North America or Europe); the third division players, on a local basis (in a specific country). Only the first division players will provide capital to world-scale industries.

With respect to the corporate organization of large financial institutions, banking industry officials argued that there are advantages to the holding company approach for both the institution and the regulator. There is a central unit that gathers data and monitors operations. This makes for better risk assessment by both the institution and the regulator.

 

REGULATION OF FINANCIAL INSTITUTIONS IN THE NETHERLANDS

A. Approach to Supervision and Regulation

The Dutch Central Bank (DNB) is responsible for the supervision of banks, while insurance and securities activities are supervised by separate organizations.

In addition to bank supervision, the DNB has also been responsible for the payments systems and monetary policy (the latter, however, will be assumed by the European central bank on 1 January 1999). The Netherlands does not currently have a specific legislative framework for the payments system (i.e., CPA Act), but this area is under review and the approach will be changing.

The supervision of prudential and systemic risks by one organization is considered essential, especially because the financial sector in the Netherlands is dominated by a few large players, so the two types of risks are closely linked.

The key duties of the banking supervisor are to protect consumers and creditors, and ensure the integrity and stability of the financial system. Consumers are also protected by a deposit guarantee system, which pays retail depositors up to 45 thousand guilders (approximately 33,000 $ C) if an institution fails. As this system is funded (by industry) on an ex post basis, it cannot be used to finance "going concern" solutions. The system is administered by the DNB; the pros and cons of this approach have not been subject to scrutiny as there is very little history of bank failures.

The regulator fulfils his duties by ensuring that internationally active banks adhere to Basle Committee guidelines, and that in general the banks are managing their risks appropriately. Since the Basle Committee recommendations are adopted by the EC, they de facto become the basis of regulation for most European countries.

The supervisory focus is on the organisational framework and internal controls, to ascertain that they are appropriate for the bank, given its size, corporate strategy, and other unique characteristics. An approach similar to the CAMEL system (as used in the United States to establish capital adequacy) is used to categorize banks as weak, strong or intermediate. This area is in the process of being redefined.

While the development of the FSA in the UK is being watched with interest, the DNB believes that close co-operation between regulators is an equally effective means of regulating diverse FIs. Two big challenges for regulators are (i) how can supervision be harmonised over a diverse range of products and (ii) how can the home supervisor effectively supervise an institution when the bulk of its assets are not domestic. Diverse conglomerates are regulated by ensuring that there is strong co-operation with other regulators. Domestically, a solo-plus model is used, where the insurance, banking and securities regulators each have responsibility for specific aspects of the institutions’ activities, and share responsibility for common areas. The DNB has an established protocol with the insurance regulator to ensure that regulation is well co-ordinated. Although there is a growing case to integrate all supervisory activities under one roof, this approach may be perceived as giving the DNB too much power, because they are also responsible for the payments system.

A key element of successful global regulation is harmonization of standards. Co-ordinating activities with international regulators is more difficult, but there are very strong relations with many jurisdictions (e.g. Belgium) and protocols are being developed. However, these arrangements are often less effective in the international context, due to sovereignty and information sharing concerns.

Unregulated entities do provide services not covered by the financial institutions statutes. However, there has been little pressure for regulating these activities, and there are not as many unregulated niche players as in some other jurisdictions (perhaps because regulated and unregulated entities can be part of the same corporate structure?).

The DNB is seen to be very independent of government. In the future, the independence of the DNB is expected to increase due to pressures from EC authorities (for example, the Minister’s directive power over the DNB will be limited). The DNB’s Board of Directors is appointed by government, but the President is appointed by the Board. The President of the DNB is never required to appear before the House of Parliament, because ultimately the Minister of Finance is considered responsible and accountable. In general, this permits the DNB to be apolitical. The Board of the DNB also appoints an Advisory Council, which consists of representatives of industry, labour organizations, and other representative groups.

B. Structural Policy

Responsibility for structural policy is shared by the Dutch Central Bank (DNB) and the Ministry of Finance.

For over 50 years, it was understood that Ministerial approval would be required before a bank could acquire another bank. This was formalized in a memorandum issued in 1980 which stipulated that banks could not own an insurance company, insurance companies could only own 15% of a bank, and banks and insurance companies could not acquire mortgage banks. In addition, mergers of banks of significant size would not be permitted. However, commercial co-operation between the sectors was permitted (for example, banks and insurance companies could share marketing channels). This policy reflected the view that a concentration of financial power would not be beneficial.

In the 1980s, however, when the mortgage banks experienced financial difficulties, banks and insurance companies were permitted to buy mortgage banks, and banks were permitted to own up to 15% of an insurance company.

Finally, in 1990, the government removed all remaining obstacles against bank mergers, as well as mergers between sectors of the industry. The current structural policy includes the following elements:

The evolution of the sector over the past thirty years was market driven, and does not reflect a strategic plan engineered by the DNB or Ministry of Finance. Notwithstanding, in the 1980s a number of trends were identified which influenced the change in policy direction:

Thus, while mergers were not overtly fostered, barriers were removed and weak institutions were asked to assess their ability to survive in an increasingly competitive market. In general, the government and DNB are comfortable with how things have evolved, and believe that their policies have allowed a strong and healthy sector to emerge, especially in contrast to countries like France, Belgium and Germany. Although the banks are currently domestically owned, foreign ownership is not a big concern. The quality of ownership is the key consideration in allowing an entity to own, but not vote, more than 5% of an FI.

Moreover, despite the apparent concentration in the domestic market, it is deemed to be very competitive. For example:

During the past year, a new independent body has been created to review the implications of proposed mergers for competition and concentration. Previously, that function had been carried on by the DNB as part of their overall evaluation of a merger. The criteria applied by this new body may be more stringent than those used previously, in part because consistency with the guidelines of the merger authority for the European Community will be important.

C. Evolution of the Financial Services Sector

Until World War II, financial services were provided by a number of small, privately owned banks. A period of consolidation started in the early 1960s:

Over the past eight years, five very large financial institutions that deliver all types of financial services have emerged:

The top 5 institutions have 85% of the retail deposit base, with the top 3 having about 75% of domestic deposits. Further concentration in the home market is being discouraged, and it is expected that in the future the Dutch banks will pursue further mergers in Belgium, France, the U.S.

When the various mergers of the 1990s were being reviewed, political considerations were not a big factor, largely because the political discussions took place earlier, when the underlying structural policy was reviewed and revised.

In general, the government believes that big financial conglomerates will ultimately benefit the economy as a whole, even if there are short-term job losses. There are other benefits too; for example, having a big international player gives the home country regulator a lot more clout in international fora. For institutions, being bigger means that funding costs decline, and they can participate in bigger deals while still conforming to lending limits.

D. Other Issues

 

REGULATION OF FINANCIAL INSTITUTIONS IN SWITZERLAND

The Swiss Banking Commission (SFBC) administers three separate pieces of legislation – federal law on 1) banks and savings banks, 2) investment funds, and 3) stock exchange and securities dealers. Each law generally covers the same topics as the Canadian equivalents, but is significantly more abbreviated, apparently in order to allow changes in application through interpretation.

Members of the seven person commission, which acts as a non-executive board of directors, are nominated by the government (the federal council; effectively Cabinet) for a four year term. Commissioners can be reappointed up to three times (until the age of 65). All commission members are "experts" not currently active in the industry, including retirees, professors, ex-bank counsel, and ex-bankers. The Commission meets for one day a month.

Beyond the responsibility for nominating commissioners, there is no government or Ministerial oversight of the banking commission or its officials – all dispute over actions and decisions are ultimately referable to the Supreme Court.

The Director of the SFBC (i.e. the equivalent of the Superintendent of Financial Institutions) is responsible for running the activities of the commission and for bringing forward recommendations for decision by the commission.

The SFBC does not perform on-site inspections. Banks in Switzerland are audited, for supervisory purposes, by external audit (i.e. accounting) firms. The audit firm is appointed by the bank, subject to the approval of the SFBC (approval can be revoked and a change of audit firm can be directed). The SFBC maintains a list of recognized audit firms (some 14, but in practice the large 6 accounting firms are performing the majority of the work) and have enforcement powers against both the bank and the audit firm. A second audit firm can be sent in if concerns or issues exist for which a second review would be appropriate. The extent of the audit is outlined in the banking law and generally goes beyond a traditional accounting audit. The SFBC receives audit reports annually and can direct that additional information be obtained and can order special purpose audits. Through this process, the SFBC is said to "supervise" the audit profession. Audit fees are paid directly by the banks; other supervisory costs are captured through annual fees. It is recognized that conflicts between the "private" and "public" roles of the audit firm can arise, but this is not considered a major issue at this time.

To meet its BIS responsibilities in the area of market risk, the SFBC is having to obtain some internal specialty support to verify value at risk models. Over time, the SFBC is planning to develop more internal expertise as a means of becoming less fully dependent on the external audit firms.

The reliance on outside audit firms allows the SFBC to operate with a small staff – some 60 persons. It is subject to all government pay and administrative restrictions.

Roughly the same process as in Canada of working with the Department of Finance on legislation and regulations appears to take place on Switzerland. However, much more elaboration of supervision takes place through guidelines and "ordinances" than through legislative means and the desire to keep laws simple and flexible contributes to this. Guidelines are largely developed in close consultation with the industry. Indeed, a number of self-regulatory guidelines of the Swiss Bankers Association have been designated as minimum supervisory standards by the SFBC. An iterative consultation process is used to ensure adequate regulatory input into the standards, the SFBC naturally retains the right to develop its own guidelines and standards. Recent industry-developed guidelines have covered topics such as: risk management in trading and derivatives activities, the management of country risk, a code of conduct for securities dealers and a code of conduct with regard to the exercise of due diligence (essentially the identification of the identity of bank clients).

A. Structure Of The Swiss Banking System

As of 31 December 1997, there were some 407 "banking" institutions operating in Switzerland.(3) This covers what are considered banks, trust and loan companies, credit unions, investment and finance companies, merchant banks and securities dealers in the Canadian context.

The three large national banks (UBS, Swiss Bank Corporation and Credit Suisse) are full service universal banks, and account for over 75% of the Swiss market. 24 Canton-owned and guaranteed banks (some 7 of which are large universal banks), lending institutions (including co-operatives) account for most of the remaining assets in the system. In addition, over 150 foreign banks (a combination of branches and subsidiaries) are present in Switzerland and carry out primarily portfolio management and securities activities.

Switzerland is considered a favourable banking climate due to its strong currency, low interest rates, stable political system and tradition of legal security. At the same time, Switzerland’s yet unsettled attitude towards membership in the EU may provide a counterweight to the positive factors that make it attractive.

The large national banks provide investment banking and private banking services as their core and most profitable activities. Retail banking services, although available from the large banks throughout Switzerland, are of lesser importance in business terms as these activities are largely unprofitable for the large banks. Most savings and loan activities (i.e. deposit taking and mortgage lending) are provided by the regional and cantonal banks. In practice, most Swiss citizens have an account with a national bank and with another institution (generally a cantonal bank).

In addition, the Post Office provides a range of banking services (including deposit-taking beginning later this year). The Post Office is not subject to Swiss banking law.

In the last decade, Switzerland, like many other countries, has seen a decline in the number of banking institutions operating in the country, accompanied by a decline in both the number of bank branches and the number of employees. A decline of some 200 institutions over the last 10 years is largely attributed to consolidation in the cantonal, regional and smaller banks as a result of competitive pressures, declines in real estate values, a recession and so on. The consolidation was not primarily related to problem company situations.

The last year saw the take-over of some foreign banks into Swiss banking groups and the closure of a number of branches by the larger banks. As is the case elsewhere, the trend has been towards an unbundling of financial services and the pricing of individual transactions according to risk. Significantly more pressure is being placed on shareholder value – traditionally 8% ROE was considered acceptable; 12-15% is now the target rate.

The merger of Credit Suisse and Winterthur Insurance in mid-1997 created the first Swiss bancassurance group. It is generally felt that this trend will continue due to the synergies between the provision of banking and life insurance services.

The banks employ in the range of 110,000 people (over 3% of the work force), and operate approximately 3,500 branches. Banking is a relatively high contributor of GNP in Switzerland – banking contributed an average of 7.8% to GDP over the period 1980-93, compared, for example, to 3.2% in the U.K. and 2.1% in the United States over the same period.

Deposit insurance in Switzerland is privately run by the banks in conjunction with the Swiss Bankers Association. Eligible deposits are covered with a cap of 30,000 Swiss francs(approximately 30,000 C$).

The general wisdom is that the Swiss retail banking sector is over-banked, given the high availability of banking services from entities other than the large banks.

Consumer protection issues in Switzerland tend to be different than in Canada. Both in law and in regulation, the accepted premise is that persons act responsibly and rationally (caveat emptor). In cases where market participants act in bad faith, to the detriment of clients, recourse is to the courts. Most financial advice is provided by the banks. However, there are other sources of advice; licensing is not required to act in an advisory capacity.

B. Competition Law

The new Federal Act on Cartels and Other Restraints of Competition was passed in July 1996. A major difference from previous law is that the new Competition Commission has enhanced decision-making power and is assisted by a Secretariat. The Commission is composed of three "chambers," one each to deal with competition issues for goods, services and matters of "infrastructure." The Commission acts in fact as a Board of Directors for the competition authority. The Secretariat has 34 employees and provides expert support and advice to the Commission.

In general, Swiss competition law applies to activities of public or private enterprises that are parties to agreements affecting competition, that have market power (and are abusing that position), or that are involved in transactions or arrangements that impact on concentration. The Commission has broad authority to stop, or unwind, agreements that impact negatively on competition, except where compelling public interests exist.

The previous Commission, operating under the former legislation, analyzed some 19 bank mergers, some 9 of which were overturned. These decisions have influenced the current approach to making merger decisions.

No public hearings are held. The Secretariat holds private hearings and, if desired, the Commission may also hold a private hearing. A decision is published and the interested parties are allowed access to files (except proprietary files). Only the parties directly involved in the outcome of a decision have standing to be heard – although others can seek to be heard and provide information, there is no official role for third party input. As a general matter, the Secretariat will seek input from a variety of parties.

The UBS/Swiss Bank Corporation merger application was presented on 2 January. The Commission had a month to decide whether the presented transaction would be subject to review. On 2 February, the Commission announced that it would do a review on the basis that the transaction may create or strengthen a dominant position. The Commission has four months, by law, in which to finalize its recommendation. This period cannot be extended.

In order to find the merger unlawful, or to impose conditions on it, the impact must be to create or strengthen a dominant position, either leading to the elimination of effective competition or not leading to an increase in competition in another market which outweighs the effect of the dominant position. In making its assessment, the Commission must also take into account market developments and the impact on international competition. The Commission has already decided that there are no international issues relevant to the bank merger – it will do its review based solely on domestic issues. (Aside: if a merger or amalgamation of banks is considered necessary to protect the interest of creditors (i.e. a problem company situation), the Swiss Banking Commission would do the review. The transaction is explicitly exempted from the purview of the Competition authorities).

If the decision is a "no," it can be appealed first to the Appeals Commission (essentially an administrative review to ensure the commission’s work was properly conducted; not a second-guessing the outcome). Further appeal can be made to the federal court (there is no Ministerial or other political involvement or recourse). If it is a "yes" with conditions, including those which may be onerous, it cannot be appealed. Under previous legislation, the Cartel Commission only had authority to recommend; the Minister of Economy would make the decision as to whether to accept the recommendation or to take a different decision.

A variety of factors will be taken into account in considering the merger. For example, there will be a review of market shares of various sub-market and geographic divisions. If there is >50% and <70% share, it may be assumed that there is scope to set prices. There will also be a review of the history of changes in product pricing to changes in interest rates. Finally, they will likely consider the scope for future entry of competitors into the market. Employment issues will not form part of the review. All work will be conducted internally.

The merger can be also reviewed under the auspices of the EU since both banks operate throughout. However, there are no links between the review processes and the Commission does not have the authority to share information. As noted earlier, the Commission will review the merger based only on domestic considerations. An EU review is not expected to raise problems with the proposed merger.

C. The Merger

UBS and Swiss Bank Corporation began talking in early 1997. Talks broke off and then started again in October 1997, six weeks prior to the announcement of the intention to merge. Globally, they see two trends among the large banks – those that want a significant global investment banking presence and those who are retreating. The merging banks want to be in the former camp.

The companies claim overall size is very important to future success in investment banking for a variety of reasons. For example, on the advisory side, only one firm involved in a transaction can earn a fee of any magnitude. That firm is inevitably a very large entity. On the distribution side, there is admittedly scope for a greater number of players. However, the larger firms inevitably get the deals. The goal is to capitalize on being a European investment banking leader to become a global investment banking presence. There is no jockeying for position on the retail side, although it may be possible to expand retail services in the EC countries. The merger will create synergies in things like the development of internet banking.

There was a concern as discussion between the companies were proceeding that a merger of equals might lead to interest by a 3rd party in taking a controlling position in one of the companies. This caused the banks to condense the time period between when negotiations started and were completed and announced. Substantial break-up fees were negotiated which would come into play if either party cancelled after the shareholder votes occurred.

There is only a modest amount of concern within the companies that the competition authorities will overturn the transaction because the domestic Swiss market is considered overbanked.

In consultation with the unions, the companies have worked out a plan for their employees. Severance will be based on years of service and age (as a benchmark, a long-term employee will get a year of severance). There will be payment for loss of pensions, and an early retirement option will be available at age 55 (generally 65 is the retirement age). Gross job losses in Switzerland will be some 7,000 (including those being lost because they do not have the correct job skills for the future); with a net loss of about 1500 positions after attrition and "packages" are taken.

Each bank has some 250-300 branches in the country. In a number of locales, only one branch is present, and it is profitable; naturally, these will be left in place. Where more than one exists, one will be closed and customer accounts will be transferred. All communities which now have more than one branch will end up with a branch. Overall, there will be about 300 branches left. The biggest growth in retail in Switzerland is in electronic banking – the role of the branch is diminishing significantly. Only a small increase in account closures has been observed since the merger plans were announced.

The new merged bank will have 10 board members (the combined total of the two existing banks is 35). Approximately one-half of the existing executive ranks will survive the merger.

The merged bank will target 15-17% returns from its domestic private banking operations. A target of 14% will come from offshore banking. Retail banking has not been profitable in Switzerland in the 1990s. Ongoing consolidation and higher rates charged to small and medium sized companies will be needed to improve this situation. (The number of banks has fallen from more than 600 at the start of the decade to about 400 today.) Shareholder value is maximized by emphasizing private banking. The lower the capital requirements associated with an activity, the higher the profit margin. High profit business can cover for lower profit businesses – however, you need to have a centralized and focussed sense of the extent of this cross-subsidization – otherwise, shareholder value will suffer. Attempts to figure out mathematically how risks are intertwined so that capital can be reallocated across business lines is very complex.

One of the merits of size is that the central bank will hold deposits in large financial institutions. A large, healthy financial institution can attract the business of large non-financial firms, and in addition, can act as a strong counterparty to transactions. Private banking facilities for offshore clients will only be attractive if the bank is large and well rated.

The banks were not driven by a sense of patriotism (i.e. wanted to emerge as a large Swiss presence). However, cultural similarities will make the merger easier. In any event, a European partner was key because electronic banking developments undertaken by a Swiss bank have synergies to other countries where English, French, German or Italian is spoken.

UBS currently invests about 700 million Swiss francs per year in hardware and software (including smart cards). Personnel costs take this number up to 2 billion Swiss francs. In Switzerland, consumer convenience comes through electronic banking, not physical branch services. Some 80% of the population have home computers and the future of retail banking is electronic. This is not a population that would, for example, want to source financial services through a grocery store or clothing chain.

Although the banks may see synergies with the life insurance industry, the P&C industry does not hold much appeal, largely because of the difference in traditional distribution channels.

The merged bank will be widely-held. The largest single shareholder would have roughly 4.5%. Swiss Bancorp’s current largest shareholder has 5% – this will fall to 2.5% after the merger.


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