09/2006/#17

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the journal of financial transformation

Growth

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Recipient of the APEX Awards for Publication Excellence 2002-2006

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Growth
Editor
Shahin Shojai, Director of Strategic Research, Capco

Advisory Editors
Dai Bedford, Partner, Capco
Predrag Dizdarevic, Partner, Capco
Bill Irving, President, Capco
Pedro Matthynssens, Partner, Capco

Editorial Board
Franklin Allen, Nippon Life Professor of Finance, The Wharton School,
University of Pennsylvania
Joe Anastasio, Partner, Capco
Philippe dArvisenet, Group Chief Economist, BNP Paribas
Rudi Bogni, former Chief Executive Officer, UBS Private Banking
Bruno Bonati, Strategic Consultant, Bruno Bonati Consulting
David Clark, NED on the board of financial institutions and a former senior
advisor to the FSA
Gry Daeninck, former CEO, Robeco
Stephen C. Daffron, COO, Renaissance Technology Partners
Douglas W. Diamond, Merton H. Miller Distinguished Service Professor of Finance,
Graduate School of Business, University of Chicago
Elroy Dimson, BGI Professor of Investment Management, London Business School
Nicholas Economides, Professor of Economics, Leonard N. Stern School of
Business, New York University
Michael Enthoven, Chief Executive Officer, NIB Capital Bank N.V.
Jos Luis Escriv, Group Chief Economist, Grupo BBVA
George Feiger, Executive Vice President and Head of Wealth Management,
Zions Bancorporation
Gregorio de Felice, Group Chief Economist, Banca Intesa
Hans Geiger, Professor of Banking, Swiss Banking Institute, University of Zurich
Wilfried Hauck, Chief Executive Officer, Allianz Dresdner Asset Management
International GmbH
Thomas Kloet, Senior Executive Vice-President & Chief Operating Officer,
Fimat USA, Inc.
Herwig Langohr, Professor of Finance and Banking, INSEAD
Mitchel Lenson, former Global Head of Operations & Technology, Deutsche Bank Group
David Lester, Chief Information Officer, The London Stock Exchange
Donald A. Marchand, Professor of Strategy and Information Management,
IMD and Chairman and President of enterpriseIQ
Colin Mayer, Peter Moores Professor of Management Studies, Sad Business School,
Oxford University
Robert J. McGrail, Chairman of the Board, Omgeo
Andrew McLaughlin, Group Chief Economist, The Royal Bank of Scotland
John Owen, COO, Wholesale Banking, ING
Derek Sach, Managing Director, Specialized Lending Services, The Royal Bank
of Scotland
Jos Schmitt, Partner, Capco
John Taysom, Founder & Joint CEO, The Reuters Greenhouse Fund
Graham Vickery, Head of Information Economy Unit, OECD
Norbert Walter, Group Chief Economist, Deutsche Bank Group
Table of contents
Nobel Laureate View
8 How to deal with a Europe in crisis: some responses to
questions, for a different Europe.
Professor Maurice Allais, Professor Emeritus of Economic Analysis, Ecole
Nationale Suprieure des Mines de Paris, and Winner of The Bank of
Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1988
12 War and business enterprises
Angelo Gnaedinger, Director-General, International Committee of the Red
Cross (ICRC), recipient of the Nobel Peace Prize in 1917, 1944, and 1963
Institutional
16 Opinion: Access to financial services: a review of the issues
and public policy objectives
Stijn Claessens, Senior Adviser, Financial Sector Vice-Presidency (FSE), The
World Bank
20 Opinion: The governance of the securities clearing and
settlement industry
Daniela Russo, Deputy Director General, Directorate General Payment
Systems and Market Infrastructure, European Central Bank
Chryssa Papathanassiou, Senior Expert, Directorate General Payment
Systems and Market Infrastructure, European Central Bank
24 Opinion: The day of the MiFID: applying to all, different
implications for each
Ian Jack, Business Development Manager, COLT Financial Services Practice
Mark OConor, Partner, Technology, Media and Communications group, DLA
Piper Rudnick Gray Cary
28 Opinion: Does capital mobility promote economic growth?
The link to education
Hartmut Egger, Senior Assistant, University of Zurich, CESifo, and GEP
Peter Egger, Professor, University of Munich, CESifo, and GEP
Volker Grossmann, Associate Professor, University of Fribourg, CESifo, and
Institute for the Study of Labor (IZA)
32 Opinion: Growth and its measurement
Bala R. Subramanian, Chairman, President, and CEO, Synergism, Inc.
36 Opinion: The welfare implications of product patent: a simple
model
Arijit Mukherjee, Associate Professor, School of Economics, University of
Nottingham and The Leverhulme Centre for Research in Globalisation and
Economic Policy
Achintya Ray, Assistant Professor, Economics & Finance, Tennessee State
University
39 Knowledge management, innovation, and productivity in
French manufacturing
Elizabeth Kremp, Chef du bureau des etudes structurelles, Sessi
Jacques Mairesse, Professor CREST-ENSAE and Maastricht University
49 Obstacles in offshoring and outsourcing investment banks
research
Michael H. Grote, Klein&Coll.-Professor for Mergers and Acquisitions of SME,
Finance Department, Johann Wolfgang Goethe University
Florian A. Tube, Research Associate, Innovation Studies Centre, Tanaka
Business School, Imperial College
61 European banking consolidation: effects on competition,
profitability, and efficiency
David-Jan Jansen, Economist, Economics and Research Division, De
Nederlandsche Bank
Jakob de Haan, Professor of Political Economy and Director of Graduate
Studies, Faculty of Economics, University of Groningen
73 The merchant-bank struggle for control of payment systems
Adam J. Levitin is an attorney in New York City
85 The credit rating agencies and their credit ratings
Herwig M. Langohr, Professor of Finance and Banking, INSEAD
Financial
98 Opinion: Creating real business intelligence: seven key
principles for MIS professionals
Laurence Trigwell, Senior Director of Financial Services, Cognos
Corporation
103 Opinion: Using business intelligence to develop standard
measures of operational risk
Jill Eicher, Managing Director, Adaptive Alpha LLC
David Ruder, Managing Director, Adaptive Alpha LLC
106 Opinion: Surviving the future: how operations and IT
transformation can be at the core of a winning strategy
Crispian Lord, Managing Principal, Capco
112 Opinion: Leveraging hosted middleware services to deploy
valuable new services quickly and easily
Gailanne Barth, Global Practice Leader, Easylink Services Corporation
Henry Bayard, VP Strategic Initiatives, Easylink Services Corporation
115 Opinion: Why gut feeling is just not enough for building a
successful bank?
Francesco Burelli - Principal Consultant, Capco
Kim Warren - Teaching Fellow, Strategic and International Management,
London Business School
123 Is competition in the financial sector a good thing?
Falko Fecht, Economist, Deutsche Bundesbank
Antoine Martin, Senior Economist, Federal Reserve Bank of New York
131 A bad situation getting worse the U.S. banking
profitability crisis
Adam Dener, Partner, Capco
Andrew Pirnie, Head of Research, Capco
Diane McDevitt, Managing Principal, Capco
141 Threshold relationships among inflation, financial market
development, and growth
Michelle L. Barnes, Senior Economist, Federal Reserve Bank of Boston
Nicolas Duquette, Senior Research Assistant, Federal Reserve Bank of
Boston
151 Manufacturing growth
Peter Moles, Senior Lecturer in Finance, University of Edinburgh
Management School
161 Corporate hedging and capital structure decisions:
towards an integrated framework for value creation
Lutz Hahnenstein, IKB Deutsche Industriebank AG,
Kreditrisikocontrolling
Klaus Rder, Professor of Finance, Universitt Regensburg, Lehrstuhl fr
Betriebswirtschaftslehre, insbesondere Finanzdienstleistungen
Planning for growth

For most of their productive lives human beings strive for bigger, better, faster, larger, and more especially in the
Western world. We are programmed to think in terms of growth, it is in our DNA. A Journal focused on growth will,
therefore, appeal to our readership at large, especially now that economic growth rates, with all of their embellish-
ments and accoutrements, seem to be back to stay in Europe and the Americas, as well as in Japan.

Before you start reading this 17th issue of our award-winning Journal of Financial Transformation, I want to share
three recent news snippets with you:
BNP Paribas aims for growth in Europe: preparing an ambitious expansion into Germany, Spain and the UK in

attempt to take on some of its established rivals on their home turf. (Financial Times July 26, 2006)
Hedge funds attracted a net $42.1 billion from April through June 2006, the most in one quarter since at least

2003, according to a new report from HedgeFund Research, Inc. (HedgeFundFocus.com July 24, 2006)
Hewlett-Packard to buy takeover target Mercury in USD 4.5 bln cash deal, its biggest since its ill-starred USD 21

bln acquisition of Compaq (eFinancialnews.com July 26, 2006)

As a trained economist and an entrepreneur, I share two different views on how to realize economic growth. The
age-old issue around growth is the intuitive dichotomy between government-led planning for growth versus the
individual (enterprise) initiative for newer, higher, and better.

Macroeconomic policies (classical, Keynesian demand-side fiscal or monetary policies, coupled with supply-side leg-
islation aimed at improving economic infrastructure, such as leaner labor laws or business licensing) have proved
their effectiveness. Favorable economic policies have helped the United States to outperform the countries of the
European Union in economic terms for most of the six decades since World War II. This superior growth has been
based on less rigid fiscal and above all monetary, and credit policies, coupled with favorable economic infrastruc-
ture measures. Many economists would also argue that the enormous productivity growth in the U.S. (spurred by the
ever growing numbers of immigrants and ensuing economic demand) has helped to boost the performance of the
United States economy [Finance and Development, IMF Breaking Down Barriers to Growth March 2006].

However, wearing my entrepreneurial hat, I also strongly believe in the power of the individuals or companies making
growth decisions. The news snippets I presented earlier prove just that: expanding a business into new territories,
setting up new investment vehicles to attract huge inflows of capital, or buying your way into a new line of business
are deliberate plans for growth, inspired by an idea, a vision, or a need for DNA-based more. All three are perfect
examples of the power of the individual (enterprise), not directly linked to any macroeconomic policy or measure.

The best way to achieve economic growth is as always probably a hybrid of these two competing views. Planning
for growth, however, is what mankind will continue to do for the foreseeable future. This Journal examines the insti-
tutional and regulatory framework for growth, and the impact this has on the financial services industry. It also looks
at ways and means to facilitate growth, from IT and operations to corporate hedging and capital structure decisions.
I hope the many essays on development, expansion, and enlargement in this Journal will help you advance your
insight into growth.

Yours,

Rob Heyvaert,
Founder, Chairman and CEO, Capco
It is now time to focus on growth

The last six years or so have become synonymous with efforts by financial institutions to reduce costs and improve
the efficiency of their operations. Having slashed costs to acceptable levels, financial institutions are now turning
their attention to increasing revenues and growing the business, something most of their management are better
suited to; after all, the cost-cutting exercises of most financial institutions in response to the collapse of the equity
markets do not provide best-practice case studies of how such activities should be undertaken. By contrast, increas-
ing revenues is something that comes naturally to most financial executives, and if the recent record-breaking
figures are anything to go by, they seem to have become even better at it.

However, the articles in this issue highlight two important issues that might have been overlooked in all the attention
received by the industrys record-breaking figures. Firstly, it seems that some, and by no means all, financial institu-
tions are recognizing that their huge investments in operations and technology can actually be used to help grow
the business, and that may be they can even be turned into successful businesses in their own right. Of course, mak-
ing a cost center into a profitable organization is no easy task, but there is a growing number of precedents to prove
that it can certainly be done. The other important issue is that the U.S. banking industry is in fact in the early stages
of a sustainable profitability compression, and that despite the huge strides taken in improving the efficiency of the
industry more needs to be done in order to avoid what seems to be an industry-wide problem.

This issue of the Journal is focused on an area that most financial executives are interested in, namely growth. The
articles in this issue of the journal aim to help financial executives better prepare for growth and avoid the potential
profitability compression that is being predicted. We are grateful to all the authors who contributed to this issue.

We are also very pleased to inform you that, as with previous issues, we have two wonderful contributions for our
Nobel Laureate View section. We are very grateful to Professor Maurice Allais who shares with us his views about
the problems facing the European Union and provides prescriptive solutions as to how these issues could be best
managed. Professor Maurice Allais is one of the greatest living economists. His contributions to the theory of mar-
kets and efficient utilization of resources are the foundation upon which many other laureates have based their work.
Prof. Allais is also one of the very few laureates who many believe deserves a second Nobel Prize for his contribution
to another discipline, namely physics.

For the non-economist Nobel Laureate View, we have an excellent contribution from the Director-General of undoubt-
edly the most famous humanitarian organization of them all, the International Committee of the Red Cross (ICRC),
recipient of the Nobel Peace Prize in 1917, 1944, and 1963. We are very grateful to Angelo Gnaedinger for kindly
taking the time to share with us his views about how the world of business could become a better partner for
humanitarian organizations like the ICRC, and improve the way we help those in need.

We genuinely hope that you enjoy reading this fascinating issue of the Journal and that you continue to support this
publication by submitting your ideas to us.

On behalf of the board of editors

 The Nobel Laureate view
How to deal with a Europe in crisis:
some responses to questions, for
a different Europe
Professor Maurice Allais
Professor Emeritus of Economic Analysis, Ecole Nationale Suprieure des Mines de Paris, and
Winner of The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1988
We are very grateful to both Prof. Maurice Allais and publish-
ers Clment Juglar for giving us permission to reprint
excerpts from Prof. Allais book (LEurope en crise, que faire?:
Rponses quelques questions, pour une autre europe), pub-
lished in 2005 in Paris, for the Nobel Laureate section of this
issue. We are also very grateful to Martyn Shone for kindly
translating the text into English.
Q: Is the euro essential to the development of Europe?
I have always been of the opinion that a single currency
should and could only be the final part to the creation of an
economic union. Therefore, from my point of view the intro-
duction of the euro has been premature.
However, now that the euro has been adopted by the 12 E.U.
member states1 under a set of proven regulations2 I can see
the advantages, as long as the regulations are maintained.
The European Central Bank (ECB) should achieve an average
annual growth of 2% and there should be a control on capital
movements between foreign countries.
Today, there are a large number of critics that feel this policy
is responsible for the difficulties encountered and strongly
advocate a solution to revive the economy through inflation.
This is a big mistake. The difficulties we come across do not
come from the European Central Banks monetary policies but
from free trade policies set in Brussels. The best proof of this
is that in 2004 the average unemployment rate in both the
Euro-zone and the thirteen other E.U. countries was exactly
the same at 8.8%3.
As I have been saying for the past 50 years, inflation is not a
condition of growth. In fact, inflation will only jeopardize
growth4. It is true that the stability of the euro tends to make
it stronger against other currencies, leading to a reduction in
1 Members: Germany, Austria, Belgium, Spain, Finland, France, Greece, Ireland, Italy,
10 Luxembourg, Netherlands, and Portugal.
2 Apart from Spain, Portugal, and Greece, Gross Domestic Product (GDP) per person
is the same for all countries within the Euro-zone.
exports and an increase in imports, but this effect only exists
if there is no tariff limit or protection from the Euro-zone and
thus could be phased out following fundamental changes by
the International Monetary System5.
Q: Technically, modernization is perhaps inevitable, but
what measures should we take to overcome its negative
effects?
Pseudo solutions
There is a massive problem with unemployment today and
there is still no proven diagnosis, resulting in many pseudo
solutions being put forward.
We have been told it is simple. If you want to stamp out
unemployment, you have to reduce wages, but nobody
tells us by how much, or mentions how feasible this could
be without affecting social peace. It is appalling to see
large organizations, such as the OECD, WTO, IMF, or the
World Bank, advocate such a solution.
We have been told that the reduction of working hours
will reduce unemployment, but apart from the fact that
workers are not perfectly substitutable for one another,
such a solution ignores the fact that many urgent needs
are not met. Therefore, these issues cannot be resolved
by workers working less. Furthermore, looking at the pop-
ulation pyramid and demographic forecasts, surely a
reduction of working hours and a lowering of the retire-
ment age will seriously jeopardize the future.
Some believe you can overcome the problem of unem-
ployment through inflation. However, trying to struggle
against the effects of global free trade using monetary
expansion and inflation is misguided, and shows a lack of
awareness of the true causes of the problems. This situa-
tion is, in its nature, nothing like the Great Depression of
3 Bulletin from the Bank of France, April 2005
4 Refer to Allais, 1974, LInflation Francaise et la Croissance, Mythologies et Realite
5 Refer to Allais, 1999, La Crise Mondiale dAujordhui. Pour de Profondes Reformes
des Institutions Financieres et Monetaires
 the 1930s.
Consider something that may appear to be a paradox: the
blind pursuit of an allegedly liberal policy that provides
widespread global free trade and establishes pseudo solu-
tions both leads our country towards the creation of inter-
ventionist measures of a collectivist type and tries to
cover up the disruptions fueled by global free trade.
The established truth
France today is in self-destruct mode.
How do you explain such a situation? Essentially, the extreme
deterioration of France since 1974 can be explained by the
continuing repetition of the established truth, with those
unspoken taboos, the mistaken prejudices, accepted without
being approved, of which the perverse effects are multiplied
and reinforced throughout the years.
This control results in a non-stop attack of opinions by some
financial media, by powerful lobbyists. It is practically forbid-
den to suggest that the secret globalization of trade is a cause
of unemployment. Nobody wants to and nobody can look at
the obvious: if all the policies of the last 30 years have failed
then they have constantly refused to look at the root cause of
the problem, the globalization of free trade.
This evolution is down to the growing power of American
multinationals, resulting in multinationals all over the world.
Each of these multinationals has hundreds of subsidiaries.
They have enormous financial resources and are able to slip
through all the control barriers. They carry extortionate
political power. Only they benefit from unreserved liberaliza-
tion of trade.
In fact, this evolution has come about at the same time as an
unhealthy development of capitalism.
This pseudo liberalism and the increase in deregulation
has ever so slightly resulted in a global laissez- faire
havoc. But, remember the trade economy is only a tool
and should not be disassociated from its institutional and
political context. There would not be an effective market
economy if it did not take place within an appropriate
institutional and political context. A free market society
does not and could not exist in a state of anarchy.
Globalization of the economy is certainly very profitable for a
few groups of privileged people. However, the interests of
these groups may no be shared by the rest of the population.
Rapid and anarchic globalization will only lead to instability,
unemployment, injustice, chaos and all sorts of misery, and
will only be a disadvantage for everyone.
The reason we are in this situation today is because the prin-
ciples above have been ignored. However, if the principles
were implemented it would encourage a society of progress,
efficiency, and humanity.
A mandatory condition: restoration of
community first position
Undeniably, global free market policies put in place in Brussels
are the major cause, and by far the most important are mass
under-employment and growth reduction. To solve this, the
European project should be based on the restoration of com-
munity first position and the control of capital flows: the true
condition of expansion, labor and prosperity. This principle is
universally valid for all countries.
A sensible objective would be to allocate a minimum per-
centage, by product or product type, of E.U. consumption
11
 to be satisfied by E.U. production. A target average of
80% of E.U. consumption from local production seems
reasonable. Looking at todays situation, we have a funda-
mentally liberal approach that permits an efficiently run
economic community safe from any external problems,
with everyone offering extended and beneficial links with
non-E.U. trading partners6.
In fact, total market freedom is neither possible nor desir-
able, except within regional frameworks, constituting
countries with common economic and political associa-
tion, with comparable economic development and social
situations, and where a sufficiently large market can
ensure sufficient competition to generate efficiency and
benefits.
Every regional organization should be able to implement a
system that can protect itself from external sources, to avoid
excessive distortions of competition and perverse effects of
external events, and to stop unwelcome specializations that
would unnecessarily generate instability and unemployment.
These specializations are the exact opposite of a situation
where there is maximum efficiency on a global scale associ-
ated with an international distribution of wealth.
The conditions for restoring community first
position
In fact a community first position should be at the heart of
any policy if it is to restore growth and employment. It assumes
a very strong political will within the current climate. It would
not be put in place unless it was unanimously agreed to by all Common Market from external competition within a frame-
25 European Union members. This would also require a modi-
fication to the WTO. If these two conditions were not met then
the 12 Euro-zone partners would need to reestablish their own
community first position and leave the WTO.
If a solution presented itself that would require France to leave
the European Union, it is quite possible they would be followed
by the majority of the members from the Euro-zone, espe-
cially the six founders of European Union.
12 - The journal of financial transformation
The immediate restoration of the community first position and
all it implies is absolutely necessary for the survival of the E.U.
In fact it would be very difficult from a legal or institutional
perspective to restore a community first position. However, if
that did occur, it would result in a group of members withdraw-
ing from the E.U.
However, I am convinced that if the people from the extreme
right and extreme left united to restore the community first
position, the French President would listen to their case.
The rivalry between politicians and political parties for the
2007 election is insignificant compared to the rebuilding of
growth and employment. This can only be achieved through
the restoration of the community first position.
Only one compelling strategy emerges: victims of globaliza-
tion unite!
Unity is power and overcomes all obstacles.
French politics
France cannot continue to participate in a policy of global free
trade, supported by Brussels, because it will result in an
unbearable situation.
Today, the only condition France will contribute to the con-
struction of Europe is the restoration of the community first
position, that is to say a reasonable level of protection for the
work of a Charter of Confederation.
What must happen will happen? Todays shameful crisis,
characterized by unbearable unemployment and the day
to day destruction of French society, is the consequence
of dogmatic politics ever since the Great Rupture of 1974,
which has led us to disaster. It would be criminal to contin-
ue to pursue these.
This current situation cannot last. It should not last. It will not
6 A choice between tariff protection and quota protection, refer to Allais, 1999. La
Mondialisation, la Destruction des Emplois et de la Croissance, pp. 589-603
last.
The big question today is not only about mass unemployment;
it is also about the destruction of our industries, of economic
growth, and the difficulties they present.
It is certain that France has no future of its own unless it is
part of Europe, but this does not mean its power should be
reduced to a level where it is controlled by the apparatchik in
Brussels, nor should it be dictated by a large zone of global
free trade open for business. Nor should it be dictated by the
U.S. who themselves are dominated by powerful American
multinationals.
Under no circumstances should France be involved in the
reconstruction of Europe if its interests are dissolved within a
group where its fundamental interests are unrecognized,
resulting in self-destruction or loss of soul. In fact, France has
no interest in continuing to participate within an organization
that would only result in an unbearable situation.
The only condition under which we would participate in the
reconstruction of Europe is if we could explicitly reestablish
the community first position, that is to say a reasonable pro-
tection from outside economic forces.
Although, by a different token, the forces of social disintegra-
tion are without doubt stronger today than they were leading
up to the French Revolution, and nobody knows what could
happen if there was a breakdown of public order. Like then,
the unconscious nature of certain feudals (old fashioned
types), who thought they were safe and who unduly benefited
from the privileged situation, is very apparent today.
Perversions of socialism have led to the breakdown of societ-
ies in the East. The laissez-faire perversion of this so-called
liberalism in the past 30 years has led us to the breakdown of
French society.
Confusion of liberalism versus laissez-faire
Liberalism would not lower itself to be an economic laissez-
faire: above everything it is a political doctrine, destined to
provide conditions for us all to live together as a collective
group of citizens; economic liberalism is only a tool for this
political doctrine to be effectively applied in the economic
domain.
Todays confusion about laissez-faire liberalism is one of the
biggest errors of our time. A liberal and humanist society
should not be identified with terms such as lax, laissez-faire,
perverted, manipulated, or blind.
In reality, the global economy, which is presented to us as a
panacea, knows only one thing, money. It has only one faith,
money. Without all ethical criteria, it can only destroy itself.
A crisis of intelligence
The opening of global business to the European Community in
a fundamentally unstable global framework, perverted by a
floating exchange rate system and where the exchanges are
totally distorted by a broad range of salaries, is the main
cause of such a deep crisis which is slowly moving us towards
the abyss.
The facts are startling. The economic analysis confirms and
explains it. The facts, as well as the theory, both confirm that
if a generalized policy of global free trade is continually
adopted, it will only fail and result in disaster. Todays crisis is
essentially a crisis of intelligence. It is not good enough to just
look at resolving the effects. We must look at the causes.
In overcoming this, one principle should be followed that tran-
scends all others: the economy should be a service to man and
not vice versa.
13
 The Nobel Laureate view
War and business enterprises
Angelo Gnaedinger
Director-General, International Committee of the Red Cross (ICRC), recipient of the Nobel Peace
Prize in 1917, 1944, and 1963
parties to a conflict must at all times distinguish between civil-
ians and combatants so as to spare the civilian population and
civilian property. Attacks may be made solely against military
objectives. This rule protects business installations, which are
considered civilian objects, and their personnel, who unless
they are part of the armed forces of a state are civilians.
Accordingly, they may neither be targeted nor take a direct
part in hostilities. If they do take part in fighting or otherwise
actively serve or support warring parties, they become a
legitimate military target and may be attacked.
These rules are particularly relevant to private military and
security firms, which are the firms most likely to be engulfed
in armed conflict or to take part in actual fighting. The per-
sonnel of these firms, like the members of regular armed
forces, must also obey other fundamental rules. For example,
it is forbidden to kill or wound an adversary who surrenders
or who can no longer take part in the fighting (because he,
and increasingly she, is wounded or sick). The right to choose
methods and means of warfare is not unlimited in particu-
lar, those that are likely to cause superfluous injury or unnec-
essary suffering are prohibited. Captured combatants and
civilians who find themselves under the authority of the
adverse party must be protected against all acts of violence
or reprisal. They are entitled to exchange news with their
families and receive aid. They must enjoy basic judicial guar-
antees.
Although as a matter of law the staff of private military and
security firms may be held personally responsible for viola-
tions of IHL, in practice it could be difficult to find a national
criminal court able and politically willing to exercise extrater-
ritorial jurisdiction over their alleged crimes. States too may
be held responsible for violations of IHL committed by private
military and security companies which they have empowered
to exercise elements of governmental authority, or which are
de facto acting on their instructions or under their direct con-
trol. Even if private contractors are not acting as state agents,
states still have a duty to ensure respect for IHL and exercise
due diligence by doing what is necessary to prevent and pun-
14 - The journal of financial transformation
ish violations committed by individuals or entities operating
on or from their territory.
Business enterprises are increasingly concerned about
enhancing their good name through active programs of cor-
porate responsibility. An ever larger part of business value is
determined by brand reputation. Large companies understand
that they should offer benefits not only to their shareholders
but also to society at large. A careful and sensitive analysis of
the impact they may have while operating in conflict areas or
weak governance zones is a step towards achieving their aim
of being perceived as a force for good and boosting their
brand. Corporate codes of conduct, industry-wide codes of
conduct, and multi-stakeholder initiatives are some of the
tools used by business enterprises to ensure that their opera-
tions are socially responsible. The Equator Principles a set
of guiding principles developed by and for the financial indus-
try provide a benchmark for assessing and managing envi-
ronmental and social risks in project financing.
The ICRC has a mandate from the international community of
states to ensure that IHL is applied fully and to provide protec-
tion and assistance for persons adversely affected by armed
conflict. To fulfill this mandate the ICRC must find ways to
reach those in need of help. To obtain access to conflict areas,
it must talk to all those wielding power: not only political
authorities, government armed forces, and rebel forces, but
others too, including civil society leaders, religious leaders
and business leaders. For decades the ICRC has developed
close relations with civilian and military authorities, interna-
tional organizations, non-governmental organizations, and
academic circles but has had few systematic contacts with the
business community, except when buying goods and services
from private suppliers. To remedy this, it is now developing a
dialogue with a number of companies operating in situations
of conflict or weak governance, which is aimed mainly at mak-
ing companies aware of their rights and obligations under IHL.
As part of its strategy of dialogue the ICRC is participating as
an observer in the initiative known as the Voluntary Principles
Warfare has undergone profound changes since Henry
Dunant, a businessman from Geneva, founded the Red Cross
in 1863. At that time wars were conducted mainly by States
and their armies. Today, however, there are others, such as
private business enterprises, playing an increasingly signifi-
cant role in conflict situations.
There are various ways in which business enterprises can be
involved in or have an impact on armed conflict. For the pur-
pose of this article we will explore two of them. Firstly, as
states have relinquished their monopoly on the legitimate
use of violence, private military and security firms have
increasingly taken on functions that used to be the exclusive
resort of state bodies. Over the past three years, the public
has been discovering the scope of involvement of such firms
in some of todays conflicts. In Iraq, for example, private con-
tractors have been not only running large chunks of the
logistical chain on behalf of the multinational forces but also
providing protection for military compounds, public buildings,
and government officials, in addition to manning checkpoints,
operating weapons systems, interrogating prisoners, gather-
ing intelligence, etc. The private military and security sector
has grown tremendously since the end of the Cold War. The
size of the global market for the firms in this sector was esti-
mated at around U.S.$100 billion in 2001 and has continued
to expand, boosted by the conflicts in Afghanistan and Iraq.
Clients include states, armed groups, business enterprises,
the U.N., and NGOs even the ICRC has occasionally resorted
to private security firms to protect its premises. Some of the
firms are publicly traded on major stock exchanges and mar-
ket themselves as flexible tools to accomplish the security
goals of their clients around the world.
Secondly, business enterprises not involved in the security
field but operating in difficult conflict environments also exert
an influence on conflicts. The wealth they create or extract
may attract interest from warring parties and turn a business
operation into a military objective. Companies may have to
enter into security arrangements with one or several of the
parties to a conflict, which may directly affect its dynamics;
alternatively, companies may have to hire private security,
introducing a new armed entity into an already fragile and
volatile environment. Companies may pay taxes, in one form
or another, that fill the coffers of one or several warring par-
ties. Companies may be tempted to use their political or eco-
nomic clout to steer a conflict in one direction or another. The
job creation and local development brought about by compa-
nies may be used as a pretext by some belligerents to move
people and alter the racial, ethnic, or religious balance of a
given region. As all these examples show, there are numerous
ways in which business enterprises, willingly or not, have an
effect on the dynamics of a conflict.
International humanitarian law (IHL) is a set of rules which
seek, for humanitarian reasons, to limit the effects of armed
conflict. It protects persons not, or no longer, taking part in
hostilities and restricts the means and methods of warfare.
IHL is also known as the law of war or the law of armed con-
flict. It does not regulate whether a state may actually use
force this is governed by an important, but distinct, part of
international law set out in the United Nations Charter. Some
of the rules of IHL are similar to those of human rights law, but
these two bodies of law have developed separately and are
contained in different treaties. Human rights law unlike IHL
applies in peacetime, and many of its provisions may be
suspended during armed conflict. IHL applies only during
armed conflict and cannot be suspended.
IHL distinguishes between international and non-international
armed conflicts. International armed conflicts, which are sub-
ject to a wide range of rules, are those in which at least two
states are involved. Non-international armed conflicts, which
are subject to a more limited range of rules, are those restrict-
ed to the territory of a single state, involving either regular
armed forces fighting groups of armed dissidents or armed
groups fighting each other.
IHL is rooted in the rules of ancient civilizations and religions
warfare has always been subject to certain principles and
customs. One of the fundamental rules of modern IHL is that
15
 on Security and Human Rights, which is being led by the
International Business Leaders Forum. The Voluntary
Principles are intended to guide extractive companies in man-
aging the security of their operations in a way that ensures
respect for the human rights of host populations. The ICRC is
also participating in an inter-governmental initiative led by
Switzerland that promotes respect for IHL and human rights
law among private military and security firms operating in
conflict situations. The ICRC website (www.icrc.org) now offers
a special section on this topic.

Talking to business should come naturally to the ICRC. After

all, Henry Dunant himself was a businessman. He was on a
business trip when he happened to be present at the end of
the battle of Solferino. Horrified by the sight of thousands of
soldiers left to suffer for want of medical care, Henry Dunant
appealed to the local people to help him tend the wounded.
Upon his return to Geneva he created the Red Cross and then
undertook to persuade the European states to adopt the
original Geneva Convention providing protection for wounded
military personnel. Henry Dunant was initially considered a
hopeless romantic, but by 1901 he had received the first Nobel
Peace Prize (which he shared with Frderic Passy). Dunants
whole life was guided by a passionate devotion to the human-
itarian cause. Even his Peace Prize money he bequeathed to
charitable causes rather than spend it himself, despite being
penniless. The ICRC his creation was subsequently award-
ed the Nobel Prize on three different occasions: in 1917, then
in 1944 as a tribute to its humanitarian activities during the
two World Wars, and again in 1963 on the occasion of its 100th
anniversary.

16 - The journal of financial transformation

 Institutional

Access to financial services: a review of the issues and public policy objectives

The governance of the securities clearing and settlement industry

The day of the MiFID: applying to all, different implications for each

Does capital mobility promote economic growth? The link to education

Growth and its measurement

The welfare implications of product patent: a simple model

Knowledge management, innovation, and productivity in French manufacturing

Obstacles in offshoring and outsourcing investment banks research

European banking consolidation: effects on competition, profitability, and efficiency

The merchant-bank struggle for control of payment systems

The credit rating agencies and their credit ratings

 Access to financial services:
a review of the issues and public
policy objectives1
Stijn Claessens
Senior Adviser, Financial Sector Vice-Presidency (FSE), The World Bank
important impact on the poor, we now need to try to under-
stand what access to finance means, what the current usage
of access to financial services is and what this shows about
access, what the impediments are to access and how these
might be changed, and what role governments might play in
improving this.
Differentiation between access and usage
To better understand issues surrounding the poors access to
financial services, it is important to keep in mind how access
and usage can differ. Access refers to the availability of the
supply of financial services at a reasonable cost, where quality
and reasonable have to be defined in some objective standard
and costs have to reflect all financial and non-financial costs.
Access thus only refers to the presence of financial services,
but may say little about the degree to which they are con-
sumed. Usage refers to the actual consumption of financial
services. In a standard demand-supply framework, access
refers to the presence of supply (at a reasonable cost) and
usage is the intersection of the supply and demand schedules.
There is currently very limited data on usage of financial ser-
vices by different income groups10, making it more difficult to
establish the determinants or impediments to access to
finance. Even basic questions like is lack of access a result of
low supply or is there a supply but low usage (implied
demand)? can not be answered. As noted in many places dur-
ing the 2005 U.N. International Year of Microcredit (IYOM),
appropriate data first need to be compiled. Nevertheless,
based on the data available to date and anecdotal evidence, as
well as economic reasoning, some lessons can be drawn on
what policies can facilitate access. These lessons can be cat-
egorized along the lines of reducing barriers to the efficient
supply of financial services and a more efficient role of gov-
1 Based on the paper by the author, Access to financial services: a review of the
issues and public policy objectives, World Bank.
2 World Bank. 2001. Finance for Growth, Policy Choices in a Volatile World, Oxford
University Press and Washington, D.C.
3 Beck, T., A. Demirguc-Kunt and M. S. Martinez Peria, 2005, Reaching out: Access
to and use of banking services across countries, World Bank mimeo
18 4 Littlefield, E., J. Morduch, and S. Hashemi, 2003, Is microfinance an effective
strategy to reach the millennium development goals? CGAP Focus Note 24,
January, Washington, D.C.
5 Morduch, J., 2003, Microinsurance: The next revolution? New York University.
mimeo
ernment.
Reducing barriers to enhance supply and improve
access
Explaining lack of supply falls into two areas: financial institu-
tions specific constraints rather than arising from the envi-
ronment within which these institutions operate and the
overall institutional environment deficiencies. This distinction
consequently breaks solutions down into institutional solu-
tions and country actions.
Constraints specific to financial institutions mostly
relate to the non-profitability of small scale transactions. For
financial service providers whether banks or micro-finance
institutions the fixed costs involved in financial intermedia-
tion make providing services for small clients, by small institu-
tions, and in small markets, hard. High transactions costs for
small volumes the fact that the underserved are new, not
experienced in business, etc. and the high costs for expand-
ing reach (i.e., to establish rural branches) often make it
unprofitable to cater to the poor segments and for small
amounts. Taking into consideration economies of scale, better
cost management can lower unit costs and lead to higher
outreach and more attractive prospects from the institutions
perspective. Still, catering to low-income households with
specific products will remain for many financial institutions a
too high-risk, high-cost proposition.
Similar constraints arise at the country level where many
financial systems are often very small, hindering effective
financial service provision11. If the scale for effective financial
services provision does not exist in all countries, at least not
using traditional financial service providers, what can be
done? Evidence suggests that internationalization of financial
Morduch, J., and B. Hayley, 2002, Analysis of the effects of microfinance on pov-
erty reduction, NYU Wagner Working Paper No. 1014
6 Honohan, Patrick. 2004, Financial sector policy and the poor: Selected findings
and issues, Working Paper No. 43. Washington, D.C.: The World Bank
7 Beck, T., A. Demirg_-Kunt and R. Levine, SMEs, growth, and poverty: Cross-
country evidence, Journal of Economic Growth, forthcoming. Also World Bank
Policy Research Working Paper 3178
8 Rajan, R., and L. Zingales, 2003, Saving capitalism from the capitalists, Crown
Business Division of Random House
Finance is an important component of development, including
for the poor. Indeed, much recent empirical evidence has
shown that a more developed financial system can help
reduce poverty and lower income inequality. In addition to
facilitating overall economic growth, finance can help individu-
als smooth their income, insure against risks, and broaden
investment opportunities. Yet, access to finance is limited in
many developing countries to few individuals and firms. Policy
questions thus arise concerning what determines access to
financial services, what barriers may hinder access, whether
more general availability of financial services should be a
public sector goal, and, if so, what the best means of achieving
this are.
Finance and growth
Finance affects poverty and income distribution through sev-
eral channels. The first being the effects of finance on eco-
nomic growth, which raises overall income levels and helps
reduce poverty. Empirical studies have demonstrated that a
doubling of private sector credit to GDP is associated with a
two percentage point increase in the rate of GDP growth2.
This additional growth in turns translates into lower poverty.
Finance also helps reduce poverty through additional chan-
nels, specifically by reducing income concentration and
enhancing income equality, leading to a further reduction in
poverty3.
Indeed, it has become the common view that finance can
strongly affect the attainability of the Millennium Development
Goals (MDGs). Finance refers here to direct access of poor
people to financial services as well as to more generally inclu-
sive financial systems. And the MDGs include not only poverty
headcount but also those that chiefly require upgrading of
public services in health and education, etc. Clearly, greater
direct access can enhance income as it provides greater
opportunity to invest and smooth shocks. It also helps people
achieve other development goals, such as education, as these
9 Halac, M., and S. L. Schmukler, 2004, Distributional effects of crises: The financial
channel, World Bank, Working Paper 3173
10 For a complete discussion of what limited data are available in certain areas,
please see Honohan, P., 2005, Measuring microfinance access: Building on exist-
ing cross-country data thinking, World Bank working paper 3606
also require poor households to be able to afford these ser-
vices, which in turn is facilitated by their access to finance4.
Indeed, studies find specific impact of access to microfinance
on reductions in child labor, increases in education, and better
insurance against shocks5. It is not just direct access to
finance or the specific forms of access that matter. In fact,
recent studies debate the direct link between microfinance
penetration and poverty eradication6 and point to the more
general need for efficient inclusive financial systems.
The ability of countries, firms, and individuals to make use of
(new) growth opportunities can be another positive contribu-
tion to economic development and poverty reduction of
increased financial development. Finance matters to firm
growth, particularly of SMEs. While empirical evidence shows
that SMEs do not cause growth, nor do they alleviate poverty,
evidence shows that the overall business environment accel-
erates economic growth, more so for small firms, and particu-
larly for the entry of new firms. A business environment which
includes sound property rights, proper contract enforcement,
and ease of firm entry and exit is essential. But it is the addi-
tional requirement of a well-developed financial system that
allows firms to operate on a larger scale, encourages more
efficient asset allocation, and thus helps to level the playing
field among firms and countries7. Because of unequal access,
finance has been a barrier to entry (loans allocated by con-
nection and non-market criteria)8.
There is also increasing evidence that the inequality of access
to finance can be a problem not only in normal times but also
in times of crisis. Research demonstrates that the cost of
financial crises have been allocated unevenly, with the brunt
being borne by the poor. Evidence has shown that financial
transfers during crises are large and can increase income
inequality. They also tend to be very regressive9.
Because there is clearly a case that finance can have an
11 Hanson, J., P. Honohan and G. Majnoni, 2003, Globalization and national financial
systems, Oxford University Press and World Bank, Oxford and Washington, D.C. 19
 services can help overcome some of these scale problems.
Foreign banks not only improve financial system efficiency
and stability, with large long-run benefits, but they can also
enhance access. Analysis of borrowers perceptions across 36
countries finds that financing obstacles are lower in countries
with high levels of foreign bank penetration. This work reports
strong evidence that even small enterprises benefit and there
is no evidence to suggest that they are harmed by foreign
banks. The channels appear to both improve competition and
direct provision of financial services by foreign banks. A Latin
America specific study finds that foreign banks with small
local presence do not appear to lend much to small business-
es, but large foreign banks lending often surpasses large
domestic banks.
Country-level constraints tend to be both macro- and
micro-economic in nature. The overall macroeconomic envi-
ronment is often a barrier, especially for lending, as prospects
for profitable business and consequently viable lending
are limited when there is macro instability. Even when a firms
business is viable, uncertain repayment capacity given volatile
income and expenditure and high exposure to systemic risks
often make it hard for financial institutions to lend. Often this
weak macroeconomic environment will be exacerbated by
weaknesses in the enabling and regulatory environment, such
as poor quality of the legal system, limited availability of reli-
able information, poor payment systems, and weak distribu-
tion and other infrastructures. Limited competition can make
financial institutions uninterested in providing basic financial
services. Absence of credit information, lack of collateral, and
difficulties in contract design and enforcement can make prof-
itable lending hard. Empirical analysis supports the impor-
tance of these barriers.
Analysis of households access has been limited to date, but it
has been found that access to micro-finance credit for the
poor/near-poor across the country is less when GDP per capi-
ta is higher and greater where there is better institutional
quality and the market size is larger. Also where the quality of
the main banking system is poor higher spreads and high
20 - The journal of financial transformation
profitability micro-finance institutions may be discouraged,
suggesting that more competition in the banking system can
foster micro-finance institutions. Access to savings can also
be a function of distribution networks (postal, saving, and
other proximity banks), suggesting that the barriers to estab-
lishing branches and ATMs should be kept as low as possible.
In Brazil, some role has been found for wider branch networks,
both of public and private banks, and a good mix of domestic
and foreign banks distribution, in determining access.
Analysis of small firm access to financial services, less limited
to date, has found that the quality of the legal system and
property rights and their enforcement, and the availability of
information are especially important. Small firms and firms in
countries with poor institutions use less external finance,
especially less bank finance. Protection of property rights
increase external financing of small firms more significantly
than they do for large firms, mainly due to the existence of
more banks and greater availability of equity finance.
Substitutes are imperfect. For example, small firms do not use
disproportionately more leasing or trade finance than larger
firms, meaning the former suffer from a lack of access as the
alternative forms of finance are either more costly or not
available.
Policies like interest rate ceilings, usury laws, and credit subsi-
dies or targeted lending, can all contribute to a distorted
enabling environment for financial intermediation. Heavy
regulation in the forms of high minimum capital adequacy
requirements, exorbitant compliance costs, and rigidity in
chartering can endanger the institutional environment.
Regulations, such as interest rate ceilings, usury laws, restric-
tions on lending, priority lending and credit subsidies policies,
and other government interference distorts risk-return sig-
nals, and can thereby hinder access. Rigidity in chartering,
(high) minimum capital adequacy requirements, limited
degrees in funding structures, too heavy regulations and
supervision, too strict accounting requirements, and high
compliance costs can hinder financial institutions from oper-
ating efficiently. Costumer identification (Know Your
Customer), AML/CFT, and other rules can be costly in terms of
access to financial services, as was found in South Africa.
Nevertheless, trade-offs arise as regulations serve other pub-
lic policy purposes.
Governments attempts to increase access
Governments can, and often have, tried to improve access.
Governments might try to encourage the use of a public infra-
structure to potentially deliver private financial products.
Specific interventions, such as the use of existing distribution
channels (postal offices in India), can help increase outreach.
While this is certainly an innovation that can affect access, it,
like many innovative technologies, does not necessarily affect
underlying regulatory or systemic distortions in the system.
Increasing competition has been proved to be beneficial and
has the added benefit of improving the environment at the
same time as it is bringing in new technology and know-how.
Because there may be a supply of financial services without a
demand (access but no usage), limited use of financial servic-
es do not necessarily reflect a systemic market failure at the
country level. This is one reason why trying to broaden finan-
cial access may not necessarily be a public policy goal. While
governments can foster a better environment through anti-
predatory lending laws rather than usury laws and promote
customer education, a proactive role of the government may
not be efficient. Given political economy factors, government
targeted efforts to broadening access may not relax credit
and savings constraints, when there is a selection bias, i.e.,
those households or firms with good prospects apply for
credit in any case. Subsidies can not only distort markets, but
evidence is mounting that they are captured by the relatively
well off, which often already have access. Priority lending
requirements are not the solution either, as they can also
divert resources away from the lowest segments, often
towards the less needed. Furthermore, there may not be any
additionality, as clients that have access already move to new
providers that are being subsidized. A balance of limited direct
government stimulation and an emphasis on proper regula-
tion should be a goal.
Conclusion
Over the last decade, finance has been recognized as an
important driver of economic growth. More recently, access to
financial services has been recognized as an important aspect
of development and more emphasis is being given to extend-
ing financial services to low-income households. Although still
early in the analysis, there is some evidence that access is
improving. The need for more empirical data is needed in
order to better track and benchmark access progress. On the
household side, there are some data on the use of micro-
finance that suggest that there has been an expansion of
access for households. Data here have to be interpreted care-
fully as increases may represent a better coverage over time,
rather than an expansion.
With better data one can learn more about the benefits of
access, the reasons why households and firms may (or may
not) demand financial services, why financial service provid-
ers may (or may not) provide financial services, and, of course,
the costs to society of providing greater access. In this con-
text, there is an interesting opportunity for the international
community to lead the way in better measuring access so that
one can better understand it. Through better understanding,
one can develop more efficient models and offer better policy
advice with the goal of increasing access to finance and thus
improving development.
21
 The governance of the securities
clearing and settlement industry
Daniela Russo
Deputy Director General, Directorate General Payment Systems and Market Infrastructure,
European Central Bank
Chryssa Papathanassiou
Senior Expert, Directorate General Payment Systems and Market Infrastructure, European
Central Bank
this open access principle would not be in line with E.U. poli-
cies. Secondly, many want to ascertain the extent to which
governance is a tool for ensuring appropriate management of
service providers that provide a wide range of services under-
pinned by very divergent risk profiles under the same legal
entity. Examples of such entities are international central
securities depositories (ICSD) that offer security depository
services as well as banking services assuming credit risk, CSDs
that also perform central counterparty services, and stock
exchanges that also act as central securities depositories.
Two broad issues are important for the governance of these
entities. The first relates to conflicts of interest typically aris-
ing in the securities settlement infrastructure and the mecha-
nisms for their resolution. The governance arrangements for
a clearing or settlement system must address not only the
conflicts of interest that are common to the corporate gover-
nance of all corporate entities, but also the public interest and
the corresponding interests of regulatory authorities. In the
context of the ongoing reorganization of the clearing and
settlement infrastructure within Europe, governance arrange-
ments must also address a number of conflicts of interest
unique to operators of clearing and settlement systems.
Firstly, especially with reference to CCPs and CSDs offering
banking services in addition to core settlement services, it is
important that corporate governance mechanisms contribute
to full independence of decisions concerning risk manage-
ment. In particular, corporate governance mechanisms can
contribute to a clear separation of risk management decisions
from other day-to-day decisions relating to the business of the
system operator. Secondly, the vertical and horizontal integra-
tion among trading, clearing, and settlement systems into a
single entity or financial group calls for an investigation into
potential conflicts of interest between the different entities
within the financial group and mechanisms for their resolu-
1 IOSCO Technical Committee, 2001, Issues Paper on Exchange Demutualization,
22 June; Lee, R., 2002, The future of securities exchanges, Brookings-Wharton
Papers on Financial Services, 1-33; Steil, B., 2002, Changes in the ownership and
governance of securities exchanges: Causes and consequences, Brookings-
Wharton Papers on Financial Services, 61-91; Blume, M., 2002, The structure of
the US equity markets, Brookings-Wharton Papers on Financial Services, 35-59;
tion. Thirdly, the horizontal integration at the level of exchang-
es, central counterparties, and central securities depositories,
by increasing the number of markets served by each inte-
grated settlement system, introduces or increases the need to
also take into account the interests of non-resident customers
and shareholders. Lastly, the emergence of business models
that consolidate activities across competitive markets creates
the need to investigate whether and to what extent gover-
nance mechanisms can contribute to preventing or mitigating
the potential for the abuse of monopoly positions in the provi-
sion of some services.
The second set of issues relates to the actions that authorities
can take to ensure that adequate corporate governance
mechanisms are adopted by securities clearing and/or settle-
ment systems. The interest of payment and settlement system
regulators and overseers internationally in issues concerning
governance is relatively recent. The first international over-
sight standard on governance was only formulated in 2001 in
the Core Principles for Systemically Important Payment
Systems of the Committee on Payment and Settlement
Systems (CPSS) relating to institutions active in the operation
of large-value payment systems. This standard was followed
up by the adoption of an international standard on gover-
nance for securities settlement systems (SSSs) by CPSS-
IOSCO. In particular, the recommendation on governance for
SSSs and CCPs calls for governance arrangements for central
securities depositories and central counterparties to fulfill
public interest requirements and to promote the objectives of
owners and customers.
The importance of appropriate SSS corporate governance
arrangements for innovation and competition has also been
stressed in the first Giovannini Report, a report of a group of
experts appointed by the European Commission to address
Russo, D., T. Hart, M. C. Malaguti and C. Papathanassiou, 2004, Governance of
securities clearing and settlement systems, ECB Occasional Paper No. 21, October
2 In this article, the term corporate governance refers to the internal corporate
structures and mechanisms by which decisions are taken in relation to the opera-
tions of a clearing or settlement system.
Over the past few years, numerous securities exchanges have
altered their ownership structures by transforming them-
selves from mutualized, member-owned companies into for-
profit, shareholder-owned ones. Within Europe, the adoption
of the Euro, the legal and regulatory changes adopted pursu-
ant to the European Commissions Financial Services Action
Plan, and the resulting market integration have also led to alli-
ances and mergers among exchanges and other institutions
involved in the post-trade processing of securities transac-
tions to flourish. These recent trends in market integration
and consolidation have facilitated an increase in cross-border
trading and have brought significant increases in market effi-
ciency: markets are more liquid and provide a wider range of
products at lower costs than in the past. The growth in col-
lateralized transactions (including repurchase agreements
and securities lending), many of which involve counterparties
located in different jurisdictions, has also fueled growth in
cross-border transactions.
Yet, market integration and consolidation create conditions in
which financial turmoil can spread with greater speed and
virulence. This process of demutualization and consolidation
has prompted a significant volume of work on the governance
of the new for-profit exchanges and on the mechanisms by
which a for-profit exchange should fulfill its self-regulatory
functions1. However, little work has been done on the gover-
nance2 of central securities depositories (CSD) and central
counterparties (CCP) that are often associated with exchang-
es. The current situation is very diverse in Europe where these
entities may be a bank, a commercial entity, a public limited
company, or a non-distinct legal entity, such a division of the
exchange. Some are user-owned, some for profit, and others
are group-owned. Relying merely on the governance required,
or not, by the existing legal or other rules made for each com-
pany type for entities performing the same type of activity in
every country and offering services cross-border creates an
uneven playing field and does not do justice to the importance
of the CSD and CCP function.
CSDs are entities that hold securities in book-entry form. In
this respect, immobilized or dematerialized securities are
deposited in CSDs, which are the ultimate holders of assets
worth several trillion Euros and provide their availability to
market participants. CCPs have a different function. They
assume credit risk by interposing in trades and becoming the
buyer to every seller and the seller to every buyer. The recent
cases of Enron and Parmalat underlined the importance of
governance for any entity and proved that weak governance
of non-financial entities may give rise to financial turmoil. For
CSDs and CCPs, governance arrangements are important
because of the impact on the decision-making process of
those entities, which affects the market at large. Governance
arrangements may be considered a level of self-regulation
and help self-discipline, in particular when taking decisions
that affect market participants at large, including competitors,
with regards to risk management (eligibility criteria, and other
risk control measures) and commercial development (access,
pricing, and fees).
Since 2001, there has been a robust E.U.-wide dialogue on
adequate governance arrangements for CSDs and CCPs for
two reasons. Firstly, many want to establish the extent to
which vertical integration of stock exchanges with deposito-
ries and clearing houses that all belong to a vertical silo may
impede horizontal integration of those service providers
across national borders. Within Europe, the aspiration is to
ensure open access to those services regardless of the nation-
ality of the participant, as the Directive on Markets in Financial
Instruments of 2004 has already required for CCPs (2004/39/
EC). That is why structures that have the potential to hinder
23
 issues concerning securities transfers, and in a report of the
European Parliament. Furthermore, the Group of Thirty
(G30), a private sector body, has also developed recommen-
dations on SSS governance and regulation. Lastly, the recent
Communication from the Commission to the Council and the
European Parliament on Clearing and Settlement in the
European Union dated 28 April 2004 [COM (2004) 312 final]
envisages the adoption of a framework Directive addressing
inter alia appropriate governance arrangements for securi-
ties settlement systems and central counterparties. The
European Commission also takes the view that governance
arrangements applicable to intermediaries should be consis-
tent with those envisaged for securities clearing and settle-
ment systems. All of the international standards adopted to
date reflect the fact that corporate governance mechanisms
for securities settlement systems must be complemented by
adequate transparency, requirements for effective gover-
nance irrespective of the ownership structure (whether
mutual or demutualized), appropriate oversight, and regula-
tion. Standards and reports regarding the governance of
European securities clearing and settlement systems also
generally address competition concerns and the need for
greater efficiency in securities clearing and settlement within
Europe. The reports also note that the increased consolida-
tion and cross-border operation of securities settlement sys-
tems may require greater cooperation and practical protocols
among relevant authorities.
In the context of securities clearing and settlement systems,
the nature of governance arrangements acquires a dimension
that goes beyond their traditional function in corporate law.
They constitute a tool for regulators and central banks to
achieve their respective policy goals relating to market integ-
rity and systemic stability. From that perspective there are
points that matter for the governance of the clearing and
settlement industry:
Whatever the model of corporate governance used in a juris-
diction, securities clearing and settlement systems should
adopt and ensure effective implementation of the highest
24 - The journal of financial transformation
corporate governance standards or best practices adopted by
or recommended for companies in the jurisdiction in which
they operate, as such standards or practices evolve over time.
Generally, this would imply that securities clearing and settle-
ment systems at a minimum should adopt and implement the
best practices recommended for listed companies.
Additionally, a securities clearing or settlement system
should adopt corporate governance mechanisms adequate to
address the interests of customers and the public in the
operation of the system. Such mechanisms may include tradi-
tional mechanisms of corporate governance in the jurisdic-
tion, such as the appointment of independent board mem-
bers and the use of specialized board committees, or they
might have been developed specifically in the context of
securities settlement systems, such as the use of board advi-
sory committees or public consultation documents. Such
mechanisms should be organized so that the criteria followed
to select members of the board or participants in specialized
committees are established ex-ante. Board members should
also take into account the interests of customers and the
public in board decisions, in particular those relating to sys-
tem access criteria, fair pricing, the adequacy of service lev-
els, the integrity of the risk management system, the need for
innovation and efficiency, and the achievement of the policy
objectives of competent authorities.
Securities clearing and settlement systems should make
adequate disclosures regarding their corporate governance
arrangements so that customers and the public can ascertain
the manner in which conflicts of interest among owners, the
board, customers, and the public are prevented, resolved, or
mitigated. Securities clearing or settlement systems operated
by an entity held within a financial group should disclose the
governance arrangements in place at the level of the system
operator as well as any relationships within the financial
group that bear on the financial condition of the system
operator or on its ability to fulfill its functions in the markets
which it serves. Disclosure should also include detailed infor-
mation on the composition, rules, and procedures of advisory
bodies and their impact on management decisions.
Furthermore, public authorities should consider the implica-
tions of the formation of these financial groups within the
clearing and settlement infrastructure and the adequacy of
their governance arrangements.

Corporate governance arrangements of securities clearing

and settlement systems should be subject to adequate regula-
tion and oversight. In this respect, the company statutes, the
by-laws, the professional qualifications and ethical integrity of
members of the boards of directors of system operators,
shareholdings and changes in shareholdings, the rules of the
system, the general system of internal controls, and the risk
management program of the system should be subject to
review or oversight by a competent authority. Regulators,
central banks, and competition authorities should also insti-
tute policies that operate in concert to ensure that services
are provided to customers at fair prices under fair and equi-
table conditions of access; that the risk management pro-
grams of system operators are effective; that risk manage-
ment decisions are not affected by considerations extraneous
to the risk management function; and that, to the maximum
extent possible, functional service providers compete in
equivalent conditions of competition. Achievement of these
policy objectives will require that regulators, central banks,
and competition authorities cooperate at a high level, either
formally or informally.

The above conclusions are an attempt to clarify the general

requirements of international standards by making them
more concrete for regulators and overseers to assess and for
the securities clearing and settlement industry to follow.

25
 The day of the MiFID: applying to
all, different implications for each
Ian Jack
Business Development Manager, COLT Financial Services Practice
Mark OConor
Partner, Technology, Media and Communications group, DLA Piper Rudnick Gray Cary
emptive approach to building a compliant infrastructure. In
some cases, compliance will be achieved by simply throwing
money at the problem perhaps not the most efficient use of
their resources. Our view is that many firms are underestimat-
ing the amount of additional infrastructure required to
achieve compliance with the directive as it stands today.
Also, given the scale of recent initiatives, including Sarbannes
Oxley and Basel II, some organizations may choose to kill a
number of regulatory birds with one stone and roll their
responses to these into a single reworked system this may
create some efficiencies, but also introduces significant com-
plexity and should clearly be handled very carefully.
Tier 2/3: smaller investment banks and exchang-
es
Some of these organizations have invested heavily in technol-
ogy and are closer to larger institutions in terms of their pre-
paredness. However, the majority lack the resources of their
larger competitors and MiFID may be part of a long to do list
or, as the deadline for implementation may feel a long way off,
it may be filed in the important but not urgent category.
However, these organizations are subject to the same require-
ments as the biggest investment banks and must make the
same investments in systems and processes.
Analysts are predicting the costs of MiFID compliance to be
10 million (approximately U.S.$19 million) for upgraded IT
systems and 12m (approximately U.S.$23 million) for new
processes costing the industry around 1bn (approximately
U.S.$1.9 billion)3. Some careful thought, therefore, needs to be
given to whether or not continued participation in the securi-
ties market is justified in light of the costs and disruption
involved. If trading in the securities market is a core business
then, clearly, there is no choice but to proceed with the com-
pliance program.
26 - The journal of financial transformation
However, it is important to realize that non-compliance with
the requirements of MiFID would be severe. In our view, it is
these smaller organizations, which have underestimated the
resources required for MiFID compliance, that are the ones
most at risk and only urgent action will prevent potential
catastrophe.
Other organizations for which securities trading is only a small
proportion of their business may opt to get out of this market
altogether, prompting a wave of consolidation. It is inevitable
that some organizations will choose to exit the market and it is
ironic that one of the unintended side effects of a Directive
expressly aimed at increasing competition may be to actually
decrease choice for the consumer. Interestingly, similar effects
may also result from the Single Euro Payments Area (SEPA)
initiative, which is part of the same European Financial
Services Action Plan: harmonized European payments charges
may well force some mid-tier regional banks to move out of the
clearing and settlement space, and outsource this activity to
the larger players, ultimately reducing the competition.
The buy-side
A survey of buy-side organizations4 conducted by block trad-
ing specialists, Liquidnet, in November of 2005 found there
was little consensus around the benefits of MiFID with almost
half the respondents (43.8 percent) saying their firm did not
plan to spend any money to meet its requirements. However,
MiFID requires a buy-side firm to create a policy for best exe-
cution which must then be provided to and provable to
their clients. As Clare Vincent-Silk, the Chair of the MiFID Joint
Working Group Buy-Side focus group, points out5, There will
be a greater need for pre-trade and post-trade transaction
cost analysis tools that allow you to analyze the liquidity, price
and likely market impact of trading this particular order on a
trading venue. Therefore, you are looking at the purchase of
additional systems for the buy-side to show that you are giv-
ing your clients best dealing performance.
1 http://www.fsa.gov.uk/pubs/international/planning_mifid.pdf
2 Ibid
MiFID is being cited as the largest shakeup of the financial
markets since the Big Bang, representing a significant over-
haul of 1993s Investment Services Directive (ISD). It aims to
create a single market in financial services across Europe by
increasing the number of services that can be passported
and provided in markets around the Community. According to
the FSAs Planning for MiFID1 document, it will affect all ple markets they will already be compliant with many of the
those currently covered by the ISD, including investment
banks, portfolio managers, stockbrokers and broker dealers,
corporate finance firms, many futures and options firms, and
some commodities firms. Crucially, the FSA also plans to
review its Handbook to accommodate the requirements of
MiFID and warns that, Even if your firms investment business
is partly or wholly outside the scope of MiFID, this does not
mean that you will be unaffected by our approach to its
implementation.
So, in practical terms, what does this mean for you? In truth,
it is somewhat too early to provide concrete advice on this
subject as the final rules for implementing MiFID will not be
published until January 2007 (although, given that the dates
for compliance have been already pushed back to 1 November,
2007, it would come as no surprise if this deadline slips even
further). However, the broad scope of the legislation is clear
and, given the sweeping changes that it ushers in, now is the
time to start planning for it.
In our view, different types of firms are in different states of
preparedness and, given that at best firms are still in the
early planning stages, perhaps it makes sense to segment the
MiFID community into four distinct groups: Tier 1: large invest-
ment banks & exchanges; Tier 2/3: smaller investment banks
and exchanges, and inter-dealer brokers; the buy-side; and,
finally, other companies currently falling outside the scope of
the ISD but who are affected by MiFID. We will then treat each
group individually.
1. Tier 1: large investment banks & exchanges
It is clear that these larger institutions have already begun
investigating MiFID and we have anecdotal evidence to sug-
gest that some of them are confident that compliance repre-
sents only a minor hurdle. There is some logic to this belief as
through building the systems and processes to trade in multi-
measures of the Directive. However, the devil is in the detail
and there may be less harmonization than they expect.
There is also a potential danger if this confidence slips over
into complacency. MiFID introduces a number of new require-
ments, chief among which is the proof for best execution
taking all reasonable steps to obtain the best possible result
for its clients including considerations such as price, cost,
speed and the likelihood of execution and settlement when
executing orders.2
Importantly, this data must be kept for five years and available
in near real-time and may have to have evidential weight,
such that firms must be able to demonstrate that the integrity
of the data has not been violated. The recreation of each
trade (both voice and data transactions) has immense implica-
tions on data storage. Banks, being banks, have largely kept
their cards close to their chests when discussing anything
other than the clarification of the directives terms; however,
if there is a case for an industry-wide community-based solu-
tion to this problem, it has yet to present itself.
It is our view that very few if any of even the largest insti-
tutions have in place the systems, such as high speed net-
working and storage capabilities, and processes to support
these data storage requirements. There is little doubt that a
majority will be compliant by the due date, but if Basel II com-
pliance is any guide, the number of firms taking last-minute,
reactive measures as the deadlines approach will more than
offset the number of large sell-side firms that take a pre-
3 http://www.silicon.com/financialservices/0,3800010322,39153793,00.htm
4 Liquidnet Europe survey gathers buy-side opinion on MiFID and PS 05/9 27
5 The Banker, 2005, Cash & securities services: Buy-side ignores MiFID at its peril, 1
November
 Outsourcing
One final word of caution: the sheer costs involved in ensuring
compliance with MiFID and other financial regulatory require-
ments may well encourage many firms to consider leveraging
the capabilities of third party IT or service providers. While
any new contracts will clearly need to be drawn up in the con-
text of the new regulation, the FSA Planning for MiFID guid-
ance states that firms will need to ensure that all existing
outsourced arrangements meet the relevant requirements as
finally agreed If this is to be taken literally, it could mean
that affected firms with extant outsourcing contracts will
need to implement a screed of contract changes to meet the
new requirements when they are finally published! If so,
does the outsourcer have to foot the bill, or does that current
contract mandate that the service provider meets all legal and
regulatory requirements, now known or in the future imple-
mented?
It remains to be seen what the relevant technical implement-
ing measures (Level 2 legislation) will entail, but one thing is
immediately clear: organizations currently planning to out-
source must ensure that their contractual arrangements deal
expressly with this issue in order to avoid a costly change to
services and systems in order to achieve compliance at a later
date.
28 - The journal of financial transformation
Conclusion
MiFID will have a huge impact on those organizations working
within securities markets. The major players will most likely be
compliant in time, although poor planning will ensure that
they pay over the odds for the privilege. Smaller investment
firms and exchanges have the most to lose by not planning for
its implementation and they should act before it is too late.
Similarly, those firms that are concerned that they may fall
within the scope of the Directive should ensure that they are
fully up-to-date with the latest guidance and prepared to act
in their own defense if necessary. On a more positive note, the
requirements for the publication of financial data may create
opportunities for those able to move fast enough to exploit
them.
Overall, while the day of the MiFID may be sooner than you
think, beginning to plan for its implementation now will ensure
that you are not exposed when it arrives.
6 MiFID: The Continental Shift in Markets, Securities Industry News, 3 April 2006
The MiFID regulation is also likely to result in buy-side firms
taking a more active role in procurement of networking ser-
vices, and continue the phasing out of conventional soft dol-
laring. The buy-side will have to be more transparent than it is
used to being and will need to meet the same audit require-
ments and is therefore subject to the same infrastructure
requirements as its sell-side counterparts. The only differ-
ence here is that, as the survey showed, there is a much lower
appreciation in the buy-side that action is required. Again, the
sooner that the problem is investigated, the sooner a relevant
solution can be found.
Other affected companies
Given the broad scope of the Directive and the lack of clear
guidance as to the type of companies to which it may apply,
it is difficult to provide firm advice concerning companies
not currently covered by the ISD. All one can really recom-
mend is to keep a watching brief, bookmark sites like the FSA
that carry information on the Directive and read your trade
publications so that you have the earliest intelligence on its
ramifications.
If it is becoming clear that your type of organization will fall
under the scope of the Directive and that this will be to your
detriment, then this early intelligence will enable you to have
the best possible chance of framing a response. In this case,
our recommendation would be to make your representations
to your trade body and work with them and other companies
in the same position to determine a coordinated position on
the Directive.
A quick note about systematic internalizers (SIs)
A systematic internalizer is defined by MiFID as an invest-
ment firm which, on an organized, frequent, and systematic
basis, deals on its own account by executing client orders off
book, (i.e., outside a regulated market or multilateral trading
facility). Generally speaking, these SIs tend to be sell-side
investment banks, so treating these organizations as a sub-
set of the two categories described above seems appropri-
ate.
The new transparency regime relating to the real-time publi-
cation of trades falls heavily upon SIs, as they have to publish
prices for shares they internalize in a public setting at a rea-
sonable commercial price. Trades in over-the-counter stocks
must be published to any end-investor within three minutes
and transactions in all instruments must be reported to a
competent authority typically the national regulator by
close of play the following day. Furthermore, all off-book activ-
ity must be provided not only to the primary exchange, but
also to a wide variety of different MTFs and third parties.
Simply posting the information on a company website is
unlikely to meet these requirements and doing so will put
strains on systems and processes similar to those described
above. A more general problem may be that many SIs are not
aware that they qualify in this category. A large number of
firms are waiting for Level 3 (ratification by the E.U.) before
taking any action a dangerously short-sighted approach.
There is also evidence that some SIs are considering develop-
ing (or acquiring) their own trading platforms in a bid to
become an MTF or alternative execution venue and thereby
benefit from different rules under the Directive. However,
according to Barry Marshall, co-chair of FIX Protocol Ltd.
(FPL), Few firms will want to [become] a multilateral trading
facility because even though there are fewer requirements
for disclosing prices, the costs are higher and revenues are
potentially lower.6 If this is a path that an SI wishes to follow,
they must understand that exchanges require large and
sophisticated infrastructures to reach their customers, which
will have to be provisioned in order to support the banks.
Another opportunity is to transform the requirement to pub-
lish data from a cost center to a profit center. Given the sheer
volume of data that is now required to be published, some
organizations may opt to add value to that data and become
financial data publishers. While exchanges might be consid-
ered an obvious example of an organization that may go down
this route, data vendors and MTFs may also choose to enter
the fray. Again, the rewards of doing so must be carefully bal-
anced against the risks.
29
 Does capital mobility promote
economic growth?
The link to education
Hartmut Egger
Senior Assistant, University of Zurich, CESifo, and GEP
Peter Egger
Professor, University of Munich, CESifo, and GEP
Volker Grossmann
Associate Professor, University of Fribourg, CESifo, and Institute for the Study of Labor (IZA)
sical growth model any increase in investment at some period
(whether foreign or domestic) should raise subsequent
growth via a larger capital stock, but whether they help
improve productivity and/or the growth potential via spillover
effects, such as from adoption of new technology or increased
management know-how associated with FDI.
Empirical results on technology spillovers from financial inte-
gration are mixed. For the period 1980-2000, Edison et al.
(2002) do not find a robust positive effect from various mea-
sures of the degree of international financial integration on per
capita income growth2. Borensztein et al. (1998) examine the
impact of FDI from industrial to developing countries on
growth in host countries in a panel estimation (with two time
periods, 1970-79 and 1980-89) and find that the contribution of
FDI to growth is greater than that of domestic investment3.
This is indirect evidence for a technological spillover.
Interestingly, the paper suggests a positive interaction between
FDI and human capital for growth and argues that technology
spillovers occur only if human capital in a host country exceeds
some minimal level. This lends support to the idea that human
capital in the host country is needed to render it capable of
absorbing knowledge embodied in FDI inflows. Moreover,
human capital seems to be important for attracting foreign
investment in the first place, as argued by Lucas (1990).
Focusing on FDI effects at the firm level within specific devel-
oping countries, the evidence on knowledge transfers is, at
best, weak. For example, in a widely-recognized study, which
employs plant-level data from Venezuela, Aitken and Harrison
(1999) find that the net effect of FDI inflows on productivity
is small, being negative for domestically owned plants. As
30 - The journal of financial transformation
summarized by Rodrik (1999), todays policy literature is
filled with extravagant claims about positive spillovers from
FDI but the evidence is sobering. Alfaro et al. (2004) argue in
a cross-country study that the growth effect of FDI interacts
with the degree of development of local financial markets.
Their evidence suggests that domestic firms are unable to
reap the benefits of knowledge spillovers triggered by FDI
without being able to finance outlays for organizational
changes required to raise productivity. Hu and Jefferson
(2006) find that Chinese firms own research and develop-
ment (R&D) complements the technology transfer from both
domestic and foreign firms, but foreign direct investment
does not facilitate foreign technology spillovers.
There is convincing evidence, however, that FDI flows between
developed countries can exert positive spillovers. For instance,
Bernstein and Mohen (1998) show that a higher stock of R&D
capital by Japanese firms in the U.S. raises productivity in
Japan and lowers unskilled labor intensities there. However,
there seems to be no significant spillover effect to the benefit
of U.S. firms holding R&D capital in Japan. Also addressing
spillovers from FDI inflows to the U.S., Roy and van den Berg
(2006) provide time-series evidence on a bi-directional rela-
tionship between U.S. growth and FDI inflows. In another
recent study, Branstetter (2006) attempts to identify techno-
logical spillovers from FDI more directly. He exploits data on
citations of patents held by U.S. firms which are made by
Japanese firms when applying for a patent in the U.S. By
regressing the (log of) number of patent citations of Japanese
firms on their FDI stock in the U.S., he finds considerable
evidence that Japanese firms which hold FDI capital in the
U.S. indeed cite U.S. patents more frequently.
1 Note that a small capital stock ceteris paribus should imply a high marginal prod-
uct of capital, such that all other things being equal capital should flow to poor
countries.
We provide a brief account of the ongoing debate on the
relationship between international capital flows and eco-
nomic growth. In particular, we argue that the current debate
may be enriched by looking more closely at the relationship
between these key variables and educational choice and pub-
lic education policy.
The sharp reduction of barriers to cross-border investments
during the last few decades has led to a breathtaking increase
in international capital flows. For instance, this development
becomes evident in the sheer number of bilateral investment
treaties, more than 2000 by 2005 [UNCTAD (2006)], that are
designed to protect foreign investors against expropriation.
Valued at current prices, foreign direct investment (FDI)
inflows at the global level have risen from U.S.$59 billion in
1982 to U.S.$1,271 billion in 2000, although declining thereaf-
ter to U.S.$648 billion in 2004 [UNCTAD (2001, 2005)]. This
corresponds to an increase in the FDI stock from U.S.$ 628
billion to U.S.$8,902 billion between 1982 and 2004 [UNCTAD
(2005)].
International capital market integration raises at least three
important questions: Firstly, who are the recipient countries
of international capital? Secondly, what determines whether
or not a country attracts foreign capital? And finally, what are
the effects of international capital flows on the macroeco-
nomic performance of both host and source countries?
Related to the first question, Nobel laureate Robert E. Lucas
famously asked, less than two decades ago, Why doesnt
capital flow from rich to poor countries? [Lucas (1990)].
Since then, however, capital inflows to developing countries
2 Focusing on FDI plus portfolio investment inflows over GDP as measure of financial
integration, Schularick and Steger (2006) reproduce this result for a similar time
period. Interestingly, however, they find a positive impact for the globalization era
before World War I.
have surged (including FDI, on which we should mostly focus
here) and they mainly came from developed countries. It is
true that the U.S. is still at least, until recently it was the
largest recipient of FDI (followed by the U.K.), with an inflow
of over U.S.$95 billion in 2004 (about 15 percent of world FDI
inflows), now hosting about one sixth of the worlds FDI
inward stock [UNCTAD (2005)]. But in 2004 developing coun-
tries received the considerable amount of U.S.$233 billion (36
percent of world FDI inflows). Between 1981-85, the annual
average inflows into these countries was only U.S.$13 billion.
For example, FDI inflows into China and Hong Kong combined
amounted to almost U.S.$95 billion in 2004 [UNCTAD
(2005)], which is roughly similar to the U.S. figure. And by
2005/06 China is said to have taken the leading position of
being the largest recipient of FDI from the world economy.
On the second issue, the determinants of the direction of
international capital flows, one may again refer to the analy-
sis of Lucas (1990). Given that capital flows into a country
when its marginal product of capital (or the return to capital,
respectively) is relatively high, Lucas has pointed out that
due to typically low levels of human capital and low produc-
tivity in poor countries, capital returns may be low in spite of
the low capital stock1. Moreover, the costs of financing capital
inputs in a host country also depend on possible business
risks and legal barriers to investment (i.e., on various eco-
nomic and political institutions).
Regarding the third question, an important ongoing debate is
the impact of FDI flows on an economys rate of GDP growth.
The question is not as much about whether FDI inflows posi-
tively affect growth, since according to the standard neoclas-
3 Including also outward investment of developing countries, Khawar (2005) finds a
similar result in a cross-section analysis for the period 1970-91. 31
 References
Aitken, B. J., and A. Harrison, 1999, Do domestic firms benefit from direct foreign
investment, American Economic Review, 89, 605-618
Alfaro, L., A. Chanda, S. Kalemli-Ozcan, and S. Sayek, 2004, FDI and economic
growth: The role of local financial markets, Journal of International Economics,
64, 89-112
Bernstein, J. I. and P. Mohen, 1998, International R&D spillovers between U.S. and
Japanese R&D intensive sectors, Journal of International Economics, 44, 315-338
Borensztein, E., J. De Gregorio, and J.W. Lee, 1998, How does foreign direct invest-
ment affect economic growth, Journal of International Economics, 45, 115-135
Branstetter, L., 2006, Is foreign direct investment a channel of knowledge spill-
overs? Evidence from Japans FDI in the United States, Journal of International
Economics, 68, 325-344
Edison, H., R. Levine, L. Ricci and T. Slok, 2002, International financial integration
and economic growth, Journal of International Money and Finance, 21, 749-776
Egger, H., P. Egger, J. Falkinger, and V. Grossmann, 2005, International capital
market integration, educational choice and economic growth, CESifo Working
Paper No. 1630
Gradstein, M., and M. Justman, 1995, Competitive investment in higher education:
The need for policy coordination, Economics Letters, 47, 393-400
Hu, A. G. Z. and G. H. Jefferson, 2006, R&D and technology transfer: Firm-level
evidence from Chinese industry, Review of Economics and Statistics, forthcoming
Khawar, M., 2005, Foreign direct investment and economic growth: A cross coun-
try analysis, Global Economy Journal, 5, Article 8
Lucas, R. E., 1990, Why doesnt capital flow from rich to poor countries, American
Economic Review, 80, 92-96
Rodrik, D., 1999, The new global economy and developing countries: Making open-
ness work, Overseas Development Council (Baltimore, MD) policy essay No. 24
Roy, A. G., and H. F. Van den Berg, 2006, Foreign direct investment and economic
growth: A time-series approach, Global Economy Journal, 6, Article 7
Schularick, M., and T. M. Steger, 2006, Does financial integration spur economic
growth? New evidence from the first era of financial globalization, CESifo Working
Paper No. 1691
UNCTAD (2001), World Investment Report 2001, United Nations, New York
UNCTAD (2005), World Investment Report 2005, United Nations, New York
UNCTAD (2006), Treaty Database 2005, United Nations, New York
Viaene, J-M, and I. Zilcha, 2002, Public education under capital mobility, Journal
of Economic Dynamics and Control, 26, 2005-2036

32 - The journal of financial transformation

Abstracting from the issue of spillover effects, recent studies
on capital market integration have emphasized a further
channel through which FDI flows may affect economic
growth: human capital formation. The key assumption, which
gives rise to a link between capital flows and education and
therefore to human-capital driven growth, is the empirically
well-supported capital-skill complementarity. To fix ideas,
consider a three factor model of a perfectly competitive
economy, where skilled labor (S), unskilled labor (L), and
physical capital (K) enter an aggregate production function.
That is, output Y is produced according to Y = AF (K,S,L),
where A is a total factor productivity parameter which cap-
tures the state of technology and F is a linearly homoge-
neous, increasing, and concave production function. Capital-
skill complementarity may be defined to exist if the following
two conditions are met: firstly, the marginal product of capi-
tal, AFK, is increasing in skilled labor S (but not in L) and,
secondly, the relative marginal product of skilled to unskilled
labor, FS/FL, is increasing in K.
Building upon the assumption of capital-skill complementari-
ty, Gradstein and Justman (1995) and Viaene and Zilcha
(2002) investigate the incentives to increase public expendi-
tures if a better skill supply leads to a capital inflow with
positive effects on national income. In such a setting, loca-
tional competition for mobile capital gives rise to an over-
provision of public education expenditures, calling for policy
coordination. Egger et al. (2005) complement this literature
by elaborating on the individual incentives to participate in
non-compulsory, though publicly financed, higher education.
In their analysis, they distinguish between the share of edu-
cated workers, determined by private incentives, and the
quality of human capital, which depends on public education
policy. The model predicts that capital market integration
induces positive net capital inflows if human capital S is suf-
ficiently abundant, if productivity A is sufficiently high, or if
(institutional) impediments to investment are low. That is, the
direction of capital flows depends on the economys initial
conditions (relative to the rest of the world) at the time capi-
tal markets open up. Due to capital-skill complementarity, as
just defined, for given public education expenditures, an
increase in net capital inflow raises the incentives to acquire
education by raising the relative marginal product of skilled
labor, FS/FL. To the extent that a higher share of skilled labor
promotes the growth rate of total factor productivity, A, this
provides novel insights in how capital market integration can
impact the growth rate of GDP per capita. Moreover, public
education expenditures raise the share of skilled labor in an
integrated economy primarily through attracting foreign
capital investment. Finally, treating education expenditure as
endogenous, the analysis suggests that, under optimal
adjustment of public education policy, educational attain-
ment typically rises after capital market integration unless
unfavorable initial conditions induce large capital outflows
after integration. These predictions are then tested by using
data for the period 1960-2000 from 87 countries, focusing on
FDI as a measure of international capital flows. Net capital
flows are instrumented by a measure of international invest-
ment barriers, provided by the Business Environment Risk
Intelligence. The empirical analysis largely confirms the main
hypotheses derived by Egger et al. (2005): firstly, net capital
inflows whether or not they are treated as endogenous
significantly affect participation in higher schooling (using
various measures thereof). Secondly, changes in investment
barriers and public education spending are important deter-
minants of net capital flows and through this channel affect
the participation in higher education. Thirdly, capital flows
significantly affect economic growth through their effect on
higher education.
These promising results should motivate further research on
the links between FDI and growth to education. While the lit-
erature has mainly focused on technological spillovers from
gross FDI inflows so far, the impact of financial integration on
education incentives and human capital-based growth
depends on the size of net capital inflows and how govern-
ments use education policy in order to attract foreign capital.
These insights may be used in future studies to reconcile the
conflicting evidence on the relationship between capital
mobility and growth.
33
 Growth and its measurement
Bala R. Subramanian
Chairman, President, and CEO, Synergism, Inc.
outcome of human survival. What about providing warnings
and adjustments before catastrophic and irreversible out-
comes? In a sense, migration methodologies, such as the one
proposed here, will become automatic and evident long before
language induced reactions that may fail to avert the forces of
destructions. The speed or the rate of transformation would
be the only self-adjusting mechanism to accommodate the
capabilities of the participants. Using this lone characteristic
of change it ought to be possible to manage any transforma-
tion.
Poverty in a human society is the result of limiting human
capabilities to the view of biological universes. When non-bio
universes are included poverty will not only disappear but
along with it human philosophies that constrain human poten-
tial to a non-existent strife of human conditions.
Making the transactional tools available when and where
needed by the humanity is the function of the intellectual
institutions of any society. Having created the banking and the
financial institutions of modern economies, the next step is to
empower these institutions with the ability to offer services
that are relevant and enhance their creativity to absorb the
many shocks likely to result from many divergent views.
Linking and holding these processes tight to the known phe-
nomena of bio-universes will only result in greater poverty
among the many and a concentration of wealth in the unnec-
essary and outdated philosophies of the past.
Business cycles are the outcome of the structural zigzags of
relationships. Using a time-technology framework it will not
only be possible to understand this phenomenon but also to
take actions when warranted to streamline growth of societal
well-being. Societal well-being consists of harmonious rela-
tionships among many variables, biological as well as other
forms of energies. To restrict our horizons to the languages
designed to deal with only the biosphere is likely to prolong
the human strife and the gloom and doom associated with
that view. With time-technology information will be available
as and when needed without it becoming a political tool avail-
34 - The journal of financial transformation
able to the highest bidder. Anyone that deciphers the DNA of
time would be awestruck by its intelligent design, marvel at its
consistency, and the ability to function in any and all environ-
ments.
It is natural to wonder who or how will this time-technology be
built? The answer is as obvious as the question itself.
Eventually our data mining tools will decipher these patterns
from the vast amounts of data that are constantly collected
and stored in data warehouses. Let us hope that these pat-
terns will not be misrepresented, distorted, or misinterpreted
by our biologic. Barring that eventuality, time-technology is
the next step beyond the information age. Financial service
enterprises that choose to use mathematical techniques to
decipher these patterns at societal, community, business, and
enterprise levels to ensure societal well-being and harmony
sooner than the others will profit greatly and survive any con-
solidation movements. MIS and CIO functions will have to
widen their horizons beyond the customer data to look for
these patterns. It is likely that even large regional trading
blocks of many nations will not be able to ensure adequate
growth of their economies because the forces that propel
change are the result of human relationships. A new industry
capable of mapping many ideas, thoughts, and motivations of
human psyche may have to emerge as the feeder industry to
enable this vast transformation from material wealth assets to
human relationship assets that take into account the meaning
of life as perceived by various generations of humanity. Many
scientists from all walks of human endeavors may have to col-
laborate to peer beyond the biospheric atmosphere of the
civilizations up to the 21st century to bring about this vast leap
forward. Educational institutions may have to delve deep into
their intellectual pockets to create new academic disciplines
that move away from behavior modification education to a
behavior identification, explanation, and learning environ-
ment to facilitate innovation. Governments and religious insti-
tutions may have to abandon mere enforcement of laws and
traditions to, instead, favor inquiry and adjustment as change
and transformation dictate for universal well-being. National
and sectarian perspectives may have to yield to pragmatic
It is interesting to see change being perceived as either growth
or decline from different points of views. It is interesting also,
given the nature of this universe, where there are only trans-
formations since energy is neither created nor destroyed and
the sum is a constant how human languages and vocabular-
ies have evolved to describe only the immediate and the tran-
sient to have them appear as permanent and absolute. Of
course, these myopic vocabularies enable us to stay focused
on what needs to be dealt with here and now and hence admi-
rable and convenient. However, from many strategic points of
views the transformational aspect is more relevant to ensure
efficacy of designs, plans, and programs. This paper will
address the opportunities available to manage transforma-
tions in a way that will be conducive to both the businesses
that are supposedly only concerned with the immediate and
the humanity at large that strives at least, intellectually to
ensure its eternal survivability. Is it politics, then, that strives to
strike a middle ground in this battle? In any sense, truth which
is perhaps a perception of known facts gets determined by a
judicial process that strives to balance fairness against mercy
at a given point, that is also transitory, in these dynamic rela-
tionships. So, why does any one pay attention to only growth
and its measurement while leaving out the dynamic aspects of
relationships? The only answer I could come up with is, per-
haps, because it customary to do so.
By bringing into this discussion the customary and the tradi-
tional framework, I have established the on-going nature of
relationships, be they long or short, and the component of
wisdom in the aforementioned judgmental processes.
Management of growth or any other similarly observed phe-
nomenon is a continuum in the many and variegated relation-
ships spectrum. How does one measure and keep track of
relationships that barely budge in ions of existence alongside
those that change in micro- or milliseconds and bring wisdom
to the individual responses at a point of decision making? The
answer, perhaps, lies in the creation and use of a new method-
ology I have chosen to call time-technology.
While we are accustomed to thinking of time as a phenome-
non of nature, especially the solar system-based nature; the
word time is much more complex and meant to include non-
biological nature as well. Time, viewed in this manner, is a
derivative of a relationship. Any change in that relationship is
measured as a phenomenon of time. Intellectually, words and
phrases in any language are disjointed concepts leaving cir-
cumstances to determine their meaning, relevance, and the
perception of facts, as truths, by the participants of that lan-
guage. Time-technology framework provides a mechanism
that is independent of spoken, written, or any other form of
languages; thus providing a new medium of communication.
Use of time-technology would be essential to measure growth,
or lack thereof, especially in the wealth management industry,
since wealth is an intellectual concept and its use in a modern
society is not just limited to providing an income or growth to
its holders. Growth occurs in the absence consumption, or
more likely smaller rates of consumption than the increments
in inputs. In either case, the underlying relationships are per-
ceived to be constant and are not validated in reality.
Economic bubbles are the outcome of such misperceived con-
stancy of relationships.
Having outlined in the discussion above the topography of
human perceptions and the communication limitations of the
language mechanisms we could delve into the solutions that
can protect and enhance measurement of values, be they
cultural, financial, and social or of any other statistical or non-
statistical groupings. The significant advantage, by the depar-
ture from the language mechanisms to the time mechanism,
is the elimination of the need for a hierarchical view of rela-
tionships that constrain and obscure other significant and
dynamic factors that underlie any relationship. Another
advantage might be the elimination of the need to trade off or
prioritize options and have them available for comparison
throughout any relationship.
These two advantages alone could and should justify its cre-
ation and adoption and pave the way for human existence
without the need of politics. The physics of the dynamical
forces in all relationships would alone determine the final
35
 to help make correct decisions in real time and ought not to
produce any unintended repercussions to any members of the
community and society as a whole. The fact gathering and the
educational processes ought to be neutral to any philosophies
and the resulting actions clearly sustainable at all strategic
levels. The end goal of education ought to make each and
every societal member a statesman; not just the likes of Jack
Kennedy alone3. Just as the process of making the air and
water and having it available to all is a secret and mystery of
nature, the data source and its integration in the societal pro-
cesses ought to remain a mystery but nevertheless available
for users. Our present day IT combined with these concepts of
time-technologies could bring about the utopia dreamed in
the literature. All we need now is the will to use the informa-
tion as a solution to every individual so that the institutions
can fulfill their missions and societies can function without
systemic failures. Since statesman citizens have to remain so
throughout their lifetime and beyond, software agents repre-
senting them will have to be educated and kept abreast of the
ever changing circumstances; hence, the need for artificial
intelligence in every walk of life and everyday use. If we want
peace and no strife to obtain it, there is no other cheaper and
efficient way than developing a time-technology framework.
Our investment in the space technologies has produced great
dividends. In a similar vein, investment in time-technologies
will help us navigate through difficult periods of human devel-
opment. Use of AI agents will eliminate the need for behav-
ioral modifications of humans and instead provide the leisure
and luxury which, at least in the present day perspective, is
not affordable by all members of any community even after
declaring a war on poverty many decades ago by the most
powerful. Will leisure and luxury alone result in a more con-
templative and peaceful behavior on everyones part? We do
not know and probably can not predict; but at least we could
feel better that knowledge and wisdom are applied in every-
day decision making using objective technologies and no lon-
ger remain as concepts in the ivory towers of academia, and
economic growth is not measured in meaningless statistics, or
that wealth is not attributed to hollow economies.
36 - The journal of financial transformation
Economic growth has to be defined in terms of core activities
that are essential for human well-being and then categorized
to help evaluate those that are temporary, such as the ones
attributable to wars, famines, and disasters of one kind or
another, much like the one time events in corporate annual
reports. Lumping them all together not only misrepresents
the truth but also leads to incorrect policy making in the name
of job creation.
With such undistorted measurement of growth we will be able
to allocate the resources to help improve societal welfare in a
manner that is both efficient and effective from a strategic
point of view. If our philosophers and theologians are yet to
conclude the meaning and purpose of life, the only framework
that would make sense is to be able to map all of the thoughts
and actions of every individual without violating their priva-
cies against the backdrop of not only a few specimens but the
entire communities.
One of the uncertainties is the human perception. We need to
resolve this through the exploration of the inner spaces, much
like the outer space of the earth, of mind, body, and the spirit
before any progress or growth could even be conceived. The
notion of individual wealth could only exist after we are able
to conceive of human values independent of biologic forms to
compare and improve its deficiencies, real or imagined.
1 CBC Community based consulting is a conceptual framework proposed by this
author to help utilize the local resources of the communities before reaching out-
wards in increasing geographical or virtual circumference in case of emergencies
or need of cooperative efforts from a point of need.
and wiser human attributes. Products and services created to
these newer markets might sustain the economies be they
urban or rural, domestic or foreign and perhaps in the fore-
seeable future eliminate poverty in the bio-universe. Universal
wisdom may have to precede universal affluence. To bring
about this universal wisdom it will be necessary to link human-
ity with its past and future alongside its literature, laws, tradi-
tions, convictions, beliefs, and faith in a transcape that is
visual and accessible to everyone all the time.
Education and cooperative work among all the cultures with
universal respect to every individual would have to be the
foundation of this transcape. The maturing generations of the
affluent east and the west provide the unique opportunity for
the next 50 years to start on this wiser path to human well-
being. If the younger generations could be led by the wise
counsels of the transformed aged, then, the increasing life
expectancy of the affluent societies will turnout to be not a
burden on the exchequer but a resource to devise a system
that could make the transformation permanent.
Few examples of bubbles in the measurement of growth are
in the linear relationship of eating habits and health. As the
societal members indulge in higher caloric food, let us say
due to heavy advertising by a company that is part of the
restaurant industry, and there is a demand for fitness prod-
ucts by a percentage of the population that succumbs to its
enticement, and there is an increase in the demand for medi-
cal services by another percentage of the population that
falls victim to the product promotion, there is a cause and
effect. In a free enterprise system, product innovations and
product promotions are expected and even encouraged. So,
there is a new equilibrium in the markets and there is growth
in multiple sectors of the economy. Is there a higher human
well-being or is this a bubble? If there is a crime and it
becomes a wave and the institutions that deal with it all
respond to solve those problems, there is growth in related
sectors. Do these activities foster human well-being? If yes,
how is that computed? What is the final benefit to the sum
total of the economy? The above examples should make it
2 Leaming, B., 2006, Jack Kennedy: the education of a statesman, W.W. Norton
apparent for the need of a permanent backdrop against
which growth measurements are understood and interpreted.
When nations declare wars on one another or undertake civil
reforms of one kind or another we need to measure their
costs against an enduring background of human well-being.
Otherwise, human efforts at progress might turnout to be
more illusionary than real. The value of the national curren-
cies in the international currency markets might be based on
the short-term demand and supply for those currencies but
to gain true importance as a currency of substance for its
universal respect, a gold standard if you will, their economies
might have to show sustained growth without bubbles of any
kind at all levels of societal memberships. Investment in the
building of this infrastructure to measure the well-being may
have to precede the aspirations for the universal wisdom that
was mentioned earlier. Universal affluence might follow uni-
versal wisdom. If our national governments were to function
and fulfill their intended roles, our information systems of
today will have to include every individual and that individu-
als life and its interaction with the rest of the universes dur-
ing that life-time. Our information technology (IT) needs to
create these linkages in a timely manner to provide depth to
the census data. Decision making based on events and hap-
penings need to be refined to a point where data is not
deceiving or misleading but provides the correct sense from
every perspective. Data and computing, in this scheme of
design, become a utility that needs to be available to all com-
munities just like water and air is essential for human exis-
tence. Knowledge economies can become sentinel and pro-
vide warnings long before catastrophes emerge and destroy
its well-being. Community Based Consulting (CBC) that link
innovations to people, their needs, and their societal process
times are likely to produce the sustainable well-being of the
entire community and help all of the ecosystems of the uni-
verses1.
Linking of data to people, in a utility model might cause pri-
vacy concerns. Such concerns ought to be addressed by an
intermediary layer of a middleware that will hide the actual
identity of individuals. The purpose of using the actual data is
37
 The welfare implications of
product patent: a simple model
Arijit Mukherjee
Associate Professor, School of Economics, University of Nottingham and The Leverhulme Centre
for Research in Globalisation and Economic Policy
Achintya Ray
Assistant Professor, Economics & Finance, Tennessee State University
economy (which is the sum of industry profit and consumer
surplus) is Wpr = 2D + CSd, where CSd is the consumer surplus
for the duopoly market with F1 and F2. Note that F2 does not
invent a non-overlapping technology and instead both F1 and
F2 use the same technology to produce the product.
Under the product patent system, F2 cannot enter the market
and F1 gets the monopoly profit, M. Let us assume that M>2D,
i.e., the industry profit reduces as the number of firms in the
product market increase5. Hence, it is trivial that F1 will not
license its technology to F2, since licensing will create compe-
tition and will lower the industry profit. Therefore, under
product patent, profit of F2 is 0 and welfare of the economy
is Wpd = M + CSm, where CSm is the consumer surplus for the
monopoly market structure with F1 as the only producer.
Since monopoly creates higher deadweight loss than duopoly,
we have Wpr > Wpd, which demonstrates that the concern
about the welfare reducing effect of product patents, as com-
pared to process patents, may not be entirely baseless.
Let us now assume that, under product patent, industrial
regulations compel F1 to license its technology to F2 against a
lump-sum fee. Therefore, under this compulsory licensing
scheme, there will be duopoly in the product market, and prof-
its of F1 and F2 will be respectively D+L and D-L, where L is the
licensing fee charged by F1. F1 will charge L=D and the profits
of F1 and F2 will be 2D and 0 respectively6. Therefore, under
product patent with compulsory licensing, welfare is given by
Wpd,cl = 2D + CSd, which is equal to Wpr. Therefore, the pres-
ence of compulsory licensing eliminates the welfare reducing
effect of product patents, as compared to process patents.
So far we have not considered F1s incentive for R&D. Given
that R is the cost of doing R&D, we find that the net profit of
1 We refer to Mazzoleni and Nelson (1998) for an overview of the benefits and costs
of patent protection.
2 We do our analysis with the reduced form profit functions, and therefore, our anal-
ysis is not dependent on a particular demand structure. Further, our results hold
38 for both Cournot and Bertrand competition in the product market. If the competi-
tion is characterized by Bertrand competition, we assume that the products of the
firms are symmetrically differentiated.
3 If D<K, imitation is unprofitable to F2. Hence, to make the threat of imitation credi-
ble, we should consider D>K.
F1 under a product patent without licensing, under a product
patent with licensing, and under a process patent are respec-
tively M-R, 2D-R, and D+K-R. Hence, F1s incentive for R&D is
highest under product patent without licensing and lowest
under process patent. The incentive for R&D under product
patent with licensing is lower than the incentive for R&D under
product patent without licensing but higher than the process
patent, since D>K and M>2D>D+K.
Therefore, if the cost of R&D is very small, i.e., R<D+K, it is
clear that F1 will always innovate the product, and welfare is
the same under process patent and product patent with
licensing. If the cost of R&D is moderate, i.e., D+K<R<2D, F1 will
not strive to invent the product under process patent, but will
try to invent it under product patent irrespective of licensing
regulations. Hence, in this situation, it is optimal for the gov-
ernment to impose product patent but with compulsory
licensing. If the cost of R&D is very high, i.e., 2D<R<M, F1
invents the product only under product patent without licens-
ing, and it is optimal for the government to impose product
patent without compulsory licensing.
Hence, it is clear from the above analysis that product patent
is necessary if innovation does not happen under process pat-
ent. However, the welfare of an economy under product patent
with compulsory licensing could be the same as it would be
under process patent when the innovation could have occurred
under process patent. Even if an economy needs to switch
from the process patent regime to the product patent regime
when innovation occurs under process patent, the presence of
compulsory licensing can make the same welfare under these
patent systems, thus eliminating the welfare reducing effect
of product patent.
4 We assume that the lack of enforcement does not make it possible for F1 to com-
mit that it will not enter the market after licensing. Under the process patent
regime, F1 may produce this product with a slightly different product and may
enter the market even if it agrees to not enter the market while licensing the tech-
nology. F2 would anticipate this possibility, and would not be interested to pay
more than K for the licensed technology. Because, otherwise, F2 would prefer imi-
tation than licensing. Furthermore, we assume for simplicity that the licenser has
full bargaining power and, therefore, gets K as the licensing fee.
One important discussion in the contemporary world is the
standardization of the patent system. More specifically, it has
been suggested that all countries should adopt product pat-
ents instead of process patents. Under the process patent
regime, a particular way of making a product is patented. In
other words, a single product may be made using different
proprietary technologies under the process patent. In the
product patent regime, a particular product is patented no
matter how it is produced.
Supporters of product patent argue that this regime actually
provides more comprehensive protection to the inventor since
the product itself is protected. Supporters of process patent
argue that this regime promotes competition and may also
inspire innovation of new technologies that are more efficient.
Since there is a considerable threat of imitation in the process
patent regime, patent protection may be less effective. As a
result, the WTO has called for a product patent regime rather
than a process regime under TRIPS. Many countries, who up
to recently were following process patent systems, have been
forced to change their laws and start pursuing product patent
regimes. For example, India moved from a process patent sys-
tem to a product patent system in 2005.
While the R&D increasing effect of product patent is easy to
understand [Maskus (1990) and Subramanian (1990)], the
developing countries are skeptical about its welfare implica-
tions. For example, Marjit and Beladi (1998) showed that the
imposition of product patent in the developing countries may
reduce welfare of these countries by discouraging the innova-
tors from the developed countries to sell their products in the
developing countries with small markets. If the developing
country market is sufficiently small compared to the rest of
the world and the markets are integrated to the extent that
they prevent the innovator from the developed country to
charge different prices in different countries, the innovator
5 Later, we will discuss the implications of M<2D.
6 It may be reasonable to assume that, under compulsory licensing, F1 will not be
able to extract entire profit of F2, since it can produce the product only if it licens-
es its technology to F2. However, we assume that the purpose of this licensing
scheme is not to give higher bargaining power to F2, rather the purpose is to cre-
may not have the incentive to sell their product in the devel-
oping country if the developing country practices product
patent. But, process patent in the developing country could
create the threat of competition from a developing country
firm and the product could be sold in the developing country.
Hence, product patent in the developing country could pre-
vent the product from being sold in that country, thus reduc-
ing its welfare compared to process patent.
While the switch from process patent to product patent is
important, the existing literature has not paid much attention
to it. Instead, it has mainly looked at the effects of strengthen-
ing the process patent regime1. In this paper, we use a simple
model of product and process patents to show that product
patents help to increase welfare in presence of compulsory
licensing. There is no need to be overly concerned about the
welfare reducing effect of a product patent regime.
The model and the results
Consider a market with two firms: Firm 1 (F1) and Firm 2 (F2).
Assume that F1 can invent a new product, whereas F2 cannot
invent this product by itself. However, if the patent system
permits (i.e., under the process patent regime), F2 can pro-
duce the product of F1 by adopting a non-infringing technol-
ogy that does not overlap with F1s production techniques. But
to do so, F2 will have to make a fixed investment of K. If there
is a product patent, F2 cannot imitate the product of F1.
Let us first consider the process patent regime. Assume that,
under imitation, F1 earns a profit D, and the profit of F2 net of
imitation cost is (D-K)2. Assuming that D>K,3 F1 will license its
technology to F2 against a lump-sum payment of K. F1 realizes
that it needs to compete with F2, since F2 will imitate and
enter the market. Therefore, F1 finds it optimal to allow F2 to
use the technology against a fee K4. Therefore, the profits of
F1 and F2 are respectively D+K and D-K, and welfare of this
ate competition in the product market. Additionally, the government always has
the option to tax F2 and redistribute the tax revenue to F1, thus generating net 39
profit of F1 and F2 as 2D and 0 respectively. As a simplification, we assume that F1
can charge D as the licensing fee, which generates the same net payoffs for these
firms.
 It is worth mentioning that, so far, we have assumed M>2D.
However, if the products of these firms are sufficiently hori-
zontally differentiated, we can have M<2D. Hence, in this situ-
ation, F1 will have a natural incentive for licensing its technol-
ogy to F2 even under product patent, since licensing will
increase the industry profits. Therefore, in this situation, com-
pulsory licensing may not be required to maintain competition
in the product market.
References
Marjit S, and H. Beladi, 1998, Product versus process patents: A theoretical
approach, Journal of Policy Modeling, 20, 193 99
Maskus, K., 1990, Normative concerns in the international protection of intellectual
property rights, The World Economy, 13, 387 410
Mazzoleni, R. and R. Nelson, 1998, The benefits and costs of strong patent protec-
tion. A contribution to the current debate, Research Policy, 27, 273 84
Mukherjee, A. and A. Ray, 2006, Patents, imitation and welfare, Economics of
Innovation and New Technology, Forthcoming
Subramanian, A., 1990, TRIPS and the paradigm of GATT: a tropical temperate
view, The World Economy, 15: 509 22

Conclusion
While many countries need to change their patent system
from process patent to product patent, there is not much for-
mal analysis about the regulations that should be contem-
plated while making the switch. We use a simple model to
show that the countries may not need to be worried about the
adverse welfare impact of product patent, as suggested by the
earlier work. If there is compulsory licensing, it can help to
eliminate the welfare reducing effect of product patents, as
compared to process patents. This is the key contribution of
our paper.

We have abstracted several important factors in our analysis,

such as entry and exit of firms in the market, uncertainty in
R&D, and the dynamic aspects of production and R&D, which
may have important implications for the number of innova-
tions, cooperative R&D, and collusion in the product market7.
These issues and other related matters deserve careful atten-
tion for improving our understanding of the impact of product
patents on market outcomes and welfare.

Our paper may be used as a guideline while doing empirical

studies about the welfare implications of patent related policy
changes. As we have indicated, compulsory licensing may or
may not be required but that decision will depend on the
industrial structure.

7 In a duopoly market with R&D competition, Mukherjee and Ray (2006) show the
40 - The journal of financial transformation effects of product and process patents on R&D and welfare, with and without
licensing and collusion in the product market.

Elizabeth Kremp
Chef du bureau des etudes structurelles, Sessi
Jacques Mairesse
Professor CREST-ENSAE and Maastricht University
Abstract
In modern knowledge driven economies, firms are increas-
ingly aware that individual and collective knowledge is a major
factor of economic performance. The larger the firms the
more likely they are to set up Knowledge Management (KM)
policies, such as promoting a culture of information and
knowledge sharing, motivating employees and executives to
remain with the firm, forging alliances and partnerships for
knowledge acquisition, and implementing written knowledge
management rules. Based on the French 2000 Community
Innovation Survey (CIS3), which has surveyed the use of these
four KM policies for a representative sample of manufacturing
firms, our microeconometric analysis tends indeed to confirm
that knowledge management contributes significantly to firm
innovative performance and to its productivity. The estimated
impacts of adoption of these four practices are not complete-
Institutional
Knowledge
management,
innovation, and
productivity in French
manufacturing1
ly accounted for by firm size, industry, research & develop-
ment (R&D) efforts, and other factors, but persist to a sizeable
extent after controlling for them. These practices also appear
to be strongly complementary, since firms tend to adopt them
jointly and their impacts on firm performance tend to be
cumulative. What seems to matter for innovative performance
is knowledge management intensity as simply measured by
the number of different KM practices implemented by the
firm. For labor productivity, however, the estimated individual
impact of an incentive policy to retain employees and execu-
tives is clearly largest, that of promoting a culture of knowl-
edge sharing is about twice smaller, while the impacts of the
other two policies are not statistically significant.
1 We are grateful to Dominique Foray and Fred Gault for encouragement to perform
this study and to Rachel Griffith, Bronwyn Hall and Kathryn Shaw for comments. 41
This is a shorter version of Kremp-Mairesse (2004).
 Knowledge management, innovation, and productivity in French
manufacturing
In the knowledge driven economy, firms are becoming more
and more aware of the fact that knowledge is a resource
requiring explicit and specific management policies and prac-
tices to be acquired, processed, and exploited efficiently.
Among other objectives, the role of knowledge management
(KM) policies and practices is to foster all types of firm innova-
tion, whether process or product oriented or mainly organiza-
tional, and to improve firm productivity and competitive
advantage2.
In this study, we try to assess the effective impact of such KM
policies on firm innovative and productive performance. To do
so, we take advantage of the introduction of four new ques-
tions on four relatively well-defined KM policies, in the French
Community Innovation Survey covering the years 1998-2000
(CIS3) for manufacturing firms.3,4 These questions concern
the existence in the firm of a written policy (W) of KM, of a
culture (C) of knowledge sharing, of a policy of retention (R) of
employees and executives, and of alliances (A) and partner-
ships for knowledge acquisition. In the first section of the
study, we provide evidence on the diffusion of the four KM
policies and on their complementarity, in the sense that firms
tend to adopt them jointly. In the second, we estimate their
specific impacts on four indicators of firm innovation and on
labor productivity, controlling for a number of factors, and
show they are complementary also in the sense that their
impacts tend to be cumulative. We briefly conclude in the last
section. The exact wording of the four new questions on the
four KM policies in CIS3 (and that of three other related ques-
tions on the implementation of new managerial methods and
the use of Internet and ICT resources) is documented in the
Appendix.5
Diffusion and complementarity of knowledge
management practices
Several reasons explain the increasing concern of firms for
knowledge management. Firms have to deal with a more com-
plex world because of rapidly changing technologies.
Information and communication technologies (ICT) are ubiqui-
2 We use the words KM policies and practices (or even methods or strategies) inter-
changeably.
3 The CIS3 survey for French manufacturing firms has been performed by SESSI
42 (Service des Etudes et Statistiques Industrielles). For a summary presentation of
its overall results, see Lhomme (2002). We are grateful to SESSI for providing us
with access to the French CIS3 firm data.
4 The introduction of the four KM questions in the French CIS3 was part of a pilot
project initiated by OECD and Statistics Canada to document firm KM behavior. For
100
80
60
40 28 27
23
20 17
0
C: Knowledge R: Incentive policy A: Alliances for W: Written KM
sharing culture to retain knowledge policy
employees acquisition
20 to 49 employees 250 to 499 employees 2,000 employees or more
50 to 99 employees 500 to 999 employees Total
100 to 249 employees 1,000 to 1,999 employees
Figure 1 Diffusion of knowledge management practices by firm size
tous, creating new needs and requiring appropriate organiza-
tional structures, facilitating the automation of some tasks and
the outsourcing of others, supporting technological watch and
improving access to external knowledge. Firms have to react
faster to keep their competitive edge and to be able to build on
all or part of their past experiences. They are more and more
aware of the fact that their competencies largely rely on indi-
viduals and on tacit knowledge special to the company. They
are worried about the loss of skills caused by the mobility of
their personnel and are striving to motivate their employees
and executives to remain within the company, improving their
career and remuneration prospects, setting up training cours-
es and encouraging professionalism. Firms are also aware that
they cannot maintain and develop their knowledge by relying
only on internal forces. They have to form alliances and part-
nerships with other firms, competitors as well as suppliers and
clients, to acquire new knowledge and expertise.
Over the past years, French manufacturing firms have adopted
different KM practices. In 2000, nearly one out of two had
implemented at least one of the four KM policies (Figure 1).
Roughly one out of four of them had a culture of promoting
knowledge sharing (C), had an incentive policy to keep employ-
ees and executives in the firm (R), or forged alliances or part-
nerships for knowledge acquisition (A), and one out of six put
into practice a written knowledge management policy (W).
a presentation of this project and its main results, see Foray and Gault (2004).
5 The descriptive statistics given in the first section are weighted to be representa-
tive of French Manufacturing as a whole (for firms with 20 employees or more).
The econometric estimates given in the second section are not weighted, but we
have introduced size and industry indicators in all our estimated models. We have
checked that the weighted econometric estimates were not meaningfully different
from the unweighted ones.
 Knowledge management, innovation, and productivity in French
manufacturing
50
40
30
20
10
0
C: Knowledge R: Incentive policy A: Alliances for
sharing culture to retain knowledge policy
employees acquisition
Low technology Medium-High Total
Medium-Low High
Figure 2 Diffusion of knowledge management practices by technology intensive
industries
As could be expected, the diffusion of KM policies is much
more widespread in large than in small firms. Setting up a
special organization is less critical, and more costly, in small-
er firms where information circulates more easily and infor-
mal procedures can be efficient. In the larger firms, on the
other hand, identifying the experts (the knowledge holders)
within the company is essential vis--vis other employees and
working with outside experts is an important asset. In 2000,
almost four out of five of French manufacturing firms with
2,000 employees or more declared they had a knowledge
sharing culture (C) or alliances for knowledge acquisition (A),
while only one out of five of those with 20 to 49 employees
said so. Likewise, adopting a written knowledge management
policy (W) is much more frequent in the large firms. By con-
trast to large firms, small firms are likely to be more depen-
dent on the expertise and know how of a few number of their
employees, and much more concerned if they leave. That is
possibly why the adoption of a policy to retain employees in
the firm (R), even if much less common in the smaller firms
than in the larger ones, is somewhat more frequent relative
to the adoption of the three other policies.
KM policies are also particularly widespread in the high and
medium-high tech industries, such as the pharmaceutical
industry, aeronautic and space construction, or electronic
component manufacturing (Figure 26). In these industries,
40% to 45% of the firms have implemented policies to foster
knowledge sharing (C), to retain employees (R), or to estab-
lish partnerships to acquire knowledge (A), and about 25%
6 Definition: The classification of industries by technological intensity is mainly
based on the average ratio of R&D to output of the industry at the CITI rev2 level
[OECD (1997)]. Scope: Manufacturing firms with 20 employees or more (excluding
the food industry), weighted results. Source: SESSI, CIS3 Survey.
have adopted a knowledge written policy (W). The diffusion of
KM policies is about half as prevalent in the low-tech indus-
tries, such as clothing and leather, publishing, printing and
reproduction, or home equipment.
W: Written KM
From 1998 to 2000, one manufacturing firm out of five had
implemented new methods of management in the broad
sense, that is, with respect to other corporate functions,
rather than just KM. A good example is the development of
project-based management practices that altered existing
work relations within companies, and led to the progress of
corporate cross-departmental culture. Unsurprisingly, KM is
more widespread in firms that have adopted such new man-
agement methods (Figure 3). Among these firms three out of
four have also implemented at least one of the four KM prac-
tices, while among firms that have not adopted new manage-
ment methods, this is the case of less than two out of five.
Knowledge management is also prevalent among firms
investing in R&D, innovating, and patenting. In 2000, 30% of
French manufacturing firms had invested in R&D, and 20%
had patents on products protecting part of their output, while
about 35% had generated innovations on products or pro-
cesses. The diffusion among these firms of all four KM prac-
tices is at least twice that of those firms that were not innova-
tive or had low R&D focus, and at least 60% higher than
non-patenting firms (Figure 3).
As part of their strategy to foster innovation, firms make spe-
cific efforts to gain better information on technologies, prod-
ucts, and materials, as well as about their customers, suppli-
ers, and competitors. They find such information from a wide
range of sources: from universities and public or private
research laboratories, in technical and economic databases, in
professional journals and conferences, trade fairs, and exhibi-
tions. Indeed, 40% of innovating firms state that they use the
Internet to acquire information for their innovating activities,
35% take advantage of ICT resources to share such informa-
tion between employees, and 25% do both. Among this last
group, about 60% have a knowledge sharing culture (C) and
43
 Knowledge management, innovation, and productivity in French
manufacturing

Among % of firms % of firms having KM intensity

Knowledge Incentive policy Alliances for Written At least one
sharing culture to retain knowledge KM policy of the four
employees acquisition policies
All firms 28 27 23 17 45 0.9

R&D-doing firms 30% 45 42 39 28 71 1.6
Non-R&D-doing firms 70% 20 20 15 12 34 0. 7

Innovating firms 34% 41 42 38 26 68 1.5

Non-innovating firms 66% 19 19 14 12 34 0.7

Firms with patents 20% 40 39 35 26 62 1.4

Firms with no patents 80% 25 24 20 15 41 0.8

Firms having adopted
new management methods 21% 51 47 42 29 76 1.7
Firms not having adopted
new management methods 79% 21 21 17 14 37 0.7
Innovating firms which are:
--using the Internet and ICT for
acquiring and sharing information 28% 62 56 51 39 82 2.1
--not using the Internet and ICT for
acquiring and sharing information 68% 37 36 34 21 63 1.3
Among all firms, 28% of them have implemented a knowledge sharing culture, 45% have adopted at least one of the four KM policies. Among all firms, 30% of them do R&D.
Among the R&D-doing firms, 45% of them have implemented a knowledge sharing culture.
Definitions:
The innovating firms are firms earning a turnover from new or significantly changed products on the market from 1998 to 2000 (in %).
The firms with patents are firms having patented products in 2000 (in %).
Scope: Manufacturing firms with 20 employees or more (excluding the food industry), weighted results.
Source: SESSI, CIS3 Survey.

Figure 3 Diffusion of knowledge management practices

40% a written knowledge management policy (W), twice as
many as for all manufacturing firms.
Looking at the occurrence of joint adoption shows that firms
view them as complementary and suggests that the basic
reasons for their adoption are similar. Firms that implement
one KM policy are much more likely to adopt a second one
than firms which have not implemented the first one. Three
out of five firms, among the 28% which have a knowledge
sharing culture (C), also implement an incentive policy to
keep employees (R); one out of two also develop partnerships
to acquire knowledge (A), and about one out of two also have
a written knowledge management policy (W). On the other
hand, among the 72% of firms declaring that they did not
have a culture of knowledge sharing, only one out of eight set
up partnerships for knowledge acquisition (A) or implement
an incentive policy for employees retention (R).
The complementarity of KM practices is reflected in the high
correlations, ranging from 0.30 to 0.50, between the corre-
sponding binary indicators of adoption. It is also confirmed by
the fact that such correlations remain high, in the range of
0.15 to 0.40, when we try to control for various factors of
adoption (Figure 4). The easiest way to take into account this
complementarity is to define a KM intensity indicator (KMI) as
being simply the number of adopted practices.7 It increases
strongly with size as well as with the industry technology
intensiveness. It is about 2.7 in firms with 2,000 employees or

7 It can be shown that KMI roughly corresponds to the first component in a principal
44 - The journal of financial transformation
factor analysis (or multiple correspondence analysis) of the correlation matrix (or
the contingency table) of the four KM policies binary indicators.
Knowledge management, innovation, and productivity in French
manufacturing

Raw correlations
(before any controls) Knowledge sharing Incentive policy to Alliances for Written KM policy KM intensity
culture retain employees knowledge acquisition
Knowledge sharing culture 1 0.47 0.40 0.48 0.81
Incentive policy to retain employees 0.47 1 0.40 0.28 0.74
Alliances for knowledge acquisition 0.40 0.40 1 0.27 0.71
Written KM policy 0.48 0.28 0.27 1 0.68
KM intensity 0.81 0.74 0.71 0.68 1
Partial correlations
(after controlling for size, industry, and other relevant factors)
Knowledge sharing culture 1 0.36 0.28 0.39 0.76
Incentive policy to retain employees 0.36 1 0.29 0.16 0.68
Alliances for knowledge acquisition 0.28 0.29 1 0.16 0.64
Written KM policy 0.39 0.16 0.16 1 0.62
KM intensity 0.76 0.68 0.64 0.62 1
The (raw) correlation between the binary indicator of firm adoption of a culture of knowledge sharing (C) and incentive policy to retain employees (R) is of 0.47, while the partial
correlation is of 0.36, after (linearly) controlling for size, industry, and other factors (included as controls in the firm performance equations).
Scope: Manufacturing firms with 20 employees or more (excluding the food industry), weighted results.
Source: SESSI, CIS3 Survey.

Figure 4 Correlations between knowledge management practices

more as against 0.7 in firms with 20 to 49 employees.
Likewise, it averages about 1.6 in high-tech industries and
about 0.7 in low-tech intensity industries.
Knowledge management, innovation, and
productivity
The diffusion of KM practices is far from being complete
among innovating firms or firms with patents, although much
more advanced than among non-innovating and non-patent-
ing firms. It thus makes sense to estimate the specific impact
of adoption of KM practices on firm innovative performance,
controlling for other factors and firm characteristics. To
assess firm innovative performance, we use four variables
from CIS3. The first two are the propensity to innovate and
the (product) innovation intensity, that is the binary indicator
of whether the firm has introduced during the period 1998-
2000 any new or significantly improved products, and if yes
the share of turnover from these new or significantly
improved products in the overall turnover of the firm in 2000.
The other two variables, defined in an analogous way, are the
propensity to patent and the patent intensity. The average
propensities to innovate and to patent are respectively about
35% and 20%, while the average innovation intensity is about
15% for the innovating firms and the average patent intensity
about 30% for the firms with patents.
The fact that the innovation and patent intensity variables
can only be known for the innovating and patenting firms is a
likely source of selectivity, which would result in biased esti-
mates if we were to estimate the intensity relations sepa-
rately from the propensity relations. Thus, we consider jointly
the propensity and intensity relations within the framework
of a generalized Tobit model, which allows for correcting of
possible selectivity biases8. As control variables, we use the
firm size, industry indicators, R&D intensity for R&D-doing
firms, and three other binary indicators for belonging to a
group, using new management methods, and not doing R&D.
We also introduce a control for the acquisition and sharing of
information using the Internet and other ICT tools. In view of
the strong complementarity of KM practices, we consider
four specifications. In the simplest specification (Model 1), we
use our KM intensity variable (KMI) as the only KM explana-
tory variable in the propensity and intensity equations,
assuming that the individual impacts of the four KM practices
are both (roughly) equal and linearly cumulative in the two
equations. In the next specifications, we introduce, instead of

8 Since the observed innovation and patent intensity variables are share variables, the 0 to 1 interval). We estimate this Tobit model by the method of maximum likeli-
we use in fact as the dependent variable in the outcome equation their logit trans- hood, making sure that we reach the absolute maximum (using TSP international 45
formation [i.e., z = log(y/(1-y))], so that the distribution of the logit-shares are version 4.5).
(approximately) consistent with the assumed normal distribution (and limited to
 Knowledge management, innovation, and productivity in French
manufacturing

Impacts in % Propensity to innovate Innovation intensity Propensity to patent Patent intensity Labor productivity
Number of firms 3,474 1,635 3,474 1,125 3,419
Mean of left hand variable 47.1 15.8 32.4 30.5 5.64

Model 1 regression with

the KM intensity variable
KM intensity 4.0a 1.6a 1.6a 3.1b 3.0a
Log likelihood -4226.49 -4089.63 -1650.55
Root MSE 1 19.18 1 67.73 39.36
Rho 0.73 0.94

Model 2 regression with
4 KM intensity binary indicators
KM intensity=1 6.3a 3.5b 1.3 5.8 7.1a
KM intensity=2 10.0a 3.8a 2.7 5.4 5.6a
KM intensity=3 11.6a 4.4a 4.1c 7.6 9.0a
KM intensity=4 15.7a 7.5a 7.1a 14.9b 13.3a
Log likelihood -4224.00 -4088.84 -1647.80
Root MSE 1 19.18 1 67.77 39.35
Rho 0.73 0.94

Model 3 regression with

the 4 KM practices indicators
(C): Knowledge sharing culture 2.8c -1.6 0.5 -1.2 5.0a
(R): Incentive policy to retain employees 6.4a 3.2a 3.3b 7.7b 10.3a
(A): Alliances for knowledge acquisition 4.9a 1.8c 0.5 1.0 -1.8
(W): Written KM policy 1.6 1.7c 2.3 5.0 -3.5c
Log likelihood -4222.26 -4088.34 -1632.72
Root MSE 1 19.13 1 67.62 39.17
Rho 0.73 0.94

Model 4 regression with

fully interacted KM practices indicators
Log likelihood -4208.16 -4080.53 -1623.96
Root MSE 1 19.02 1 67.11 39.14
Rho 0.73 0.94
a, b, c significance at the 1%, 5%, and 10% levels
Scope: manufacturing companies with 20 employees or more (excluding the food industry), not weighted.
Source: SESSI, CIS3 Survey.

Figure 5 Estimated impacts of knowledge management on firm innovation and productivity, controlling for other relevant factors

KMI, four binary indicators in the propensity and intensity
equations. In Model 2, these indicators respectively corre-
spond to the use of only one, two, three, or all four KM prac-
tices, still implying that the impacts of the four practices are
equal but allowing them to be more or less cumulative. In
Model 3, they simply correspond to the separate use of each
of the four KM practices, allowing the impacts of the four
practices to be different as well as cumulative. In the most
general specification, Model 4, we introduce, in addition to
the KM indicators, all their possible interactions, that is elev-
en other binary indicators. Clearly Model 1 is nested in the
other three models, while Models 2 and 3 are also nested in
Model 4, permitting us to test whether the four KM policies
appear interchangeable and more or less cumulative, in
terms of their impacts on firm innovative performance.
The estimated impacts of the KM indicators on the innovation
and patent propensities and intensities are all statistically

46 - The journal of financial transformation

Knowledge management, innovation, and productivity in French
manufacturing
Innovation Patent Productivity
propensity propensity seem cumulative. They are, however, not so huge that one
and intensity and intensity
Model 1 against Model 2
Chi2(n) 2.49 (6) 0.79 (6) 2.8 (3)
P-value in % 87% 99% 43%
Model 1 against Model 3
Chi2(n) 4.23 (6) 1.29 (6) 17.8 (3)
P-value in % 65% 97% 0%
Model 1 against Model 4
Chi2(n) 18.33 (28) 9.1 (28) 26.6 (14)
P-value in % 92% 100% 2%
Model 2 against Model 4
Chi2(n) 15.84 (22) 8.3 (22) 23.8 (11)
P-value in % 82% 100% 1%
Model 3 against Model 4
Chi2(n) 14.1 (22) 7.8 (22) 8.8 (11)
P-value in % 90% 100% 64%
Chi2(n) test statistics are directly computed on the base of the maximum
log-likelihood values given in Figure 5. The number of degrees of freedom n is the
difference in the number of KM parameters between the encompassing model
and the model tested.
Scope: Manufacturing companies with 20 employees or more (excluding the food
industry), not weighted.
Source: SESSI, CIS3 Survey.
Figure 6 Tests of the regression model with KM intensity against models with
four KM intensity binary indicators, and the four KM practices binary indicators
alone or fully interacted
very significant for Model 1; most of them are also very sig-
nificant, for Models 2 and 3, while only a few are for Model 4
(Figure 5).9 The Chi2 tests of specification show clearly that
the more parsimonious Model 1, with the KM intensity specification, which can be viewed as a simple extended pro-
variable, cannot be statistically rejected against the other
three models, even with a very low level of significance
(Figure 6). Model 1 can thus be viewed as the preferred
model.
Firms do tend to innovate and patent more extensively, if
they have adopted KM policies, regardless of their size and
industry, of their R&D efforts, whether they belong to a
group, and have implemented new management methods. All
else equal, when KM intensity increases by one, the propen-
sity to innovate increases by 4% at the sample mean and
innovation intensity increases by 1.6% for the innovating
firms. Similarly the propensity to patent increases by 1.6%
and patenting intensity increases by 3.1% for the patenting
9 We do not report the estimated impacts for model 4, since they are not significant,
with very few exceptions, for the eleven indicators of KM interactions (and practi-
cally not different for the four non-interacted KM indicators from the estimated
impacts in Model 3). We thus do not find evidence of complementarity (or substi-
tutability) between the four KM policies, in the specific sense that if a firm has
firms10. These estimated impacts are quite substantial and
would have to conclude that they are necessarily wrong. It is
true that all the usual reasons of econometric misspecifica-
tion potentially apply: omitted control variables, unobserved
firm characteristics, and endogeneity of right hand variables.
These problems may be particularly serious with cross-sec-
tional data. There is not much that we can do to address them
very effectively, short of being able to gather more and bet-
ter data. On the other hand, an extreme degree of disbelief is
not warranted. Even if the adoption of KM has become fash-
ionable among firms, one will expect that on average firms
will not go through the various costs of implementing KM
policies unless they have some real impacts on their perfor-
mance. Anyhow, whether one views our findings with exces-
sive skepticism or is willing to give them some causal mean-
ing, in both cases they remain statistically informative. At the
minimum, they reflect significant positive correlations, condi-
tional on a fair number of relevant factors.
We also investigate whether KM practices have a specific
impact, both statistically and economically significant, on
labor productivity, using basically the same models as for
innovation and patenting with two differences. Firstly, instead
of a generalized Tobit, we can rely on a log-linear regression
duction function of current use in studies of R&D productivity.
Secondly, we introduce physical capital per employee as an
additional control variable, since this is the major variable
accounting for productivity differences among firms.
The estimates and specification tests of the four models, cor-
responding to the different ways of entering knowledge man-
agement in the productivity equation, tell us a somewhat
different story than for innovative performance (Figures 5 to
7). Model 3, in which the four KM policy indicators are includ-
ed separately, performs slightly better than the others: it is
statistically different from Model 1 using our simple measure
of KM intensity, but it is not statistically different from the
less parsimonious Model 4 with fully interacted KM policy
already adopted one such policy the impact on its performance of adopting anoth-
er one would be higher (or weaker). 47
10 The orders of magnitude of the control variables estimates (reported in Figure 7
for Model 1) are also statistically significant and fairly reasonable, although the
specific impact of R&D intensity may seem on the low side.
 Knowledge management, innovation, and productivity in French
manufacturing

Impacts in % Propensity to innovate Innovation intensity Propensity to patent Patent intensity Labor productivity
KM intensity 4.0a 1.6a 1.6a 3.1b 3.0a
(0.5) (0.4) (0.5) (1.3) (0.6)
R&D intensity 1.7a 1.2a 2.8a 5.3a 1.6b
(0.6) (0.4) (0.6) (1.4) (0.6)
Non-R&D-doing indicator -43.4a -19.8a -30.3a -48.3a -13.9a
(3.1) (2.3) (3.0) (7.3) (3.2)
Group indicator 3.3b 2.1 5.2a 13.0b 3.8a
(1.6) (1.3) (1.8) (5.0) (1.7)
New management methods indicator 6.5a 3.9a 2.6c 9.3b -3.2c
(1.5) (1.0) (1.5) (3.6) (1.6)
Internet and ICT for information acquisition
and sharing indicator -- 1.5 -- -0.8 --
(0.9) (2.9)
Physical capital intensity -- -- -- -- 15.4a
(0.7)
Log likelihood -4226.49 -4089.63 -1650.55
Root MSE 1 19.18 1 67.73 39.36
Rho 0.73 0.94
Number of firms 3,474 1,635 3,474 1,125 3,419
Mean of left hand variable 47.1 15.8 32.4 30.5 564.0
a, b, c significance at the 1%, 5%, and 10% levels
Scope: Manufacturing firms with 20 employees or more (excluding the food industry), not weighted.
Source: SESSI, CIS3 Survey.

Figure 7 Estimated impacts of knowledge management intensity, R&D intensity, and other control variables on firm innovation and productivity

Less desirable and somewhat puzzling is the observation that

our specific KM practices are not only cumulative, but also
apparently interchangeable in the case of innovative perfor-
mance. The model with KM intensity, simply defined as the
number, varying from zero to four, of KM practices imple-
mented by firms, performs statistically as well as the one with
the four individual KM indicators. An explanation may be
found in the collinearity of these indicators reflecting the
complementarity of KM practices, but also in the intrinsic
crudeness and subjective nature of such binary survey indi-
cators, which is a likely source of measurement errors. Also
rather puzzling is the finding that the estimated impacts of
implementing new management methods in the broad sense
are about as large as the impacts of KM practices on firm
innovative performance, while they are if anything negative
on firm productivity, unlike the positive significant impacts of
employees retention and knowledge sharing culture policies
(R and C).

11 The estimated elasticities of the physical capital intensity and of R&D intensity are
48 - The journal of financial transformation
consistent with what could be expected from previous productivity studies (report-
ed in Table 5 for Model 1). Contrary to what we find for innovation and patenting,
the estimated impact of the implementation of new management methods on pro-
ductivity is barely statistically significant and if anything negative.
Knowledge management, innovation, and productivity in French
manufacturing

indicators (while Model 2 differs statistically from Model 4,
n o
from Model 1). It is clear that the four KM policies do not
appear exchangeable anymore and remain only partly cumu-
lative. All else being equal, labor productivity is higher, and
very significantly so, by about 10% for firms implementing a
policy to retain executives and employees (R) than for firms
which do not, and by about 5% for firms promoting a culture
of knowledge sharing (C) than for firms which do not. At the
opposite, all else equal, labor productivity is not statistically
different between firms declaring that they have or have not
a policy to establish alliances to acquire knowledge (A), and a
written knowledge policy (W)11.
Conclusion
In this exploratory study of the diffusion and impact on firm
performance of KM policies, we have found some not very
t surprising results, some more surprising ones, some of them
satisfactory, while others are puzzling.
Among the expected results, the diffusion of KM policies is
much more advanced in the larger firms and in the technol-
ogy intensive industries. As expected also these practices
appear highly complementary, firms tending to adopt them
jointly. Among the less obvious but satisfactory findings, the
impacts of KM practices on firm performance are in general
statistically and economically significant and more or less
cumulative, even controlling for firm size, industry, and other
important factors, such as R&D intensity and physical capital
intensity. These estimated impacts are on the high side, but
still in the range of values that one is a priori ready to accept
as plausible.

Appendix:

A) Definition of the four Knowledge Management (KM) indicators and of two
other directly related indicators on adoption of new management methods
and on the use of Internet and ICT for information acquisition and sharing.
The four KM binary are based on four questions introduced in the Third
Community Innovation Survey (CIS3) for Manufacturing firms, conducted by
SESSI (Service des Etudes et Statistiques Industrielles). It is a mandatory sur-
vey for some 5500 manufacturing firms with 20 employees or more, which
have been chosen randomly using the legal business register and a stratified
sampling design (exhaustive for firms with 500 employees or more, and with
a decreasing sampling rate from 1/2 to 1/8 for firms from 100 to 499, 50 to 99
and 20 to 49 employees). The overall rate of response was of 86%.
The four questions directly referring to firm KM policies have been chosen as
particularly meaningful among the 23 questions considered in the KM pilot
survey by Statistics Canada [Earl and Gault (2003)]. They are the following:
By the end of 2000, did your firm have a written knowledge management
policy? (W)
Did it have a culture to promote knowledge sharing? (C)
Did it put into practice an incentive policy to retain employees and execu-
tives in firm? (R)
Did it forge partnerships or alliances for knowledge acquisition? (A)
The survey also includes other questions related to the KM policies, only asked
to the innovating firms. They concern the adoption of new management prac-
tices in general and the use of Internet and ICT resources to acquire and share
information for innovation purposes. Since the answers to these last two ques-
tions are strongly correlated, we pooled them as only one binary indicator.
B) Definitions of other variables
The propensity to innovate variable is measured by the proportion of firms
earning a turnover from new or significantly changed products on the market
from 1998 to 2000 (in %).
The propensity to patent variable is measured by the proportion of firms hav-
ing patented products in 2000 (in %).
The innovation intensity variable is measured by the logit function of the share
(or logit-share), in the firms total turnover in 2000, of the turnover from new
or significantly changed products introduced on the market from 1998 to
2000 (in %).
The patent intensity variable is measured by the by the logit function of the
share (or logit-share), in the firms total turnover in 2000, of the patented
products sales (in %).
The labor productivity variable is measured by the logarithm of the firms
value added to the total number of employees in 2000 (in K per person).
The physical capital intensity variable is measured by the logarithm of the
firms gross book value to the total number employees in 2000 (in K per
person).
The R&D intensity variable is measured by the logarithm of the share of the
firms R&D expenditures in the firms total turnover in 2000.
The knowledge management intensity variable is measured by the number
(from 0 to four) of knowledge management practices implemented by firms.
The group, new management methods, Internet and ICT for external data shar-
ing use, and non-R&D-doing variables are binary 0-1 indicators (respectively
equal to 1 if the firms belong to a group, have adopted new management
methods, Internet and ICT for external data sharing use, or are not doing R&D).
The 14 industry and 7 size binary indicators are defined on the basis of the
classification of industries and of the groupings by total number of employees.

49
 References
Commissariat gnral du Plan, 2002 : La France dans lconomie du savoir : pour
une dynamique collective, La Documentation franaise, Novembre.
Earl, L., and F. Gault, 2004, Knowledge management: size matters, in Measuring
Knowledge Management in the Business Sector; First Steps, Foray and Gault eds,
OECD
Foray, D., 2003: The Economics of Knowledge, MIT Press, Cambridge,
Massachusetts
Foray D., and F. Gault, 2004, Measuring Knowledge Management in the Business
Sector; First Steps, OECD
Galia, F., and D. Legros, 2005, Knowledge management and human resource prac-
tices in an innovation perspective: evidence from France, Journal of Knowledge
Management, Vol.III, No. 2, 54-73
Kremp, E. and J. Mairesse, 2004, Knowledge management, innovation and produc-
tivity: a firm-level exploration based on French manufacturing CIS3 Data, in
Measuring Knowledge Management in the Business Sector; First Steps, Foray and
Gault eds, OECD
Lhomme, Y., 2002, Technological innovation in industry, The Newsletter of
Industrial Statistics, SESSI, no. 168 December
Mairesse, J., and M. Sassenou, 1991, R-D and productivity: a survey of econometric
studies at the firm level, Science-Technology Industry Review, Paris, OECD, n 8,
1991, 9-43

50 - The journal of financial transformation

 Institutional

Obstacles in
offshoring and
outsourcing
investment banks
Michael H. Grote
research
Klein&Coll.-Professor for Mergers and
Acquisitions of SME, Finance Department,
Johann Wolfgang Goethe University

Florian A. Tube
Research Associate, Innovation Studies Centre,
Tanaka Business School, Imperial College

Abstract
Outsourcing is high on the agenda of firms seeking to cut
costs. Based on an enhanced value-chain concept we develop
a model that determines the conditions under which outsourc-
ing and offshoring are not expedient. Equity and country
research in investment banks and their outsourcing potential
are used as case studies. We draw mainly on qualitative evi-
dence from interviews with investment bank analysts as well
as data on locations of research units of foreign investment
banks in India. The option of outsourcing certain stages of
business processes and offshoring parts of the value chain
within firms to low-wage locations depends crucially on how
processes are embedded in relation to other departments
within and to corresponding actors outside the firm. Our
analysis shows that there is little, if any, scope for outsourcing
but some potential for low-level research activities to be off-
shored to low-cost regions.

51
 Obstacles in offshoring and outsourcing investment banks research
The concept of value chains provides a simultaneous and dis-
aggregated analysis of process and actors, allowing for the
appraisal of competitive advantages of firms (looking for pro-
cesses that could be outsourced) and comparative advantages
of countries or regions [looking for places to which they could
be offshored see Kogut (1985)]. The concept of value chains
is mostly used for the analysis of production systems, while
services are regarded merely as facilitating links between
production stages [Dicken (1998)]. We build upon an approach
suggested by Grote et al. (2002) that allows for analyzing
those junctures (breaking points) where production stages
can be separated, either spatially (offshoring) or organization-
ally (outsourcing). While traditional value chain analyses con-
centrate on vertical relationships, this enhanced approach
integrates also horizontal links to firms, customers, or other
sources of information and knowledge. Grote et al. (2002)
utilize a combination of vertical analysis with horizontal con-
nections in order to locate the different stages of financial
production. Thus, each stage is regarded as a node which is
in itself a network connected to other nodes concerned with
related activities [Appelbaum et al. (1994)].
The ability to slice up the value chain and to outsource certain
stages or phases of business processes and to offshore parts
of the value chain within their firms to low-wage locations
depends crucially on how the processes are embedded in
relation to a) other departments of the bank and b) to corre-
sponding actors outside the bank. The need for the exchange
of information and knowledge between research departments
and actors outside, as well as inside their banks in other
departments, such as along the value chain, determines the
possibility of reorganizing and relocating activities. We argue
that different kinds of proximity are necessary for the com-
munication of complex information or knowledge spatial,
organizational, cultural, and professional proximity.
Information (and codified knowledge) is easily transferable
between actors via ICT, while tacit knowledge is not. Tacit
knowledge is strongly linked to subject and context, and thus
difficult to pass on [Nonaka and Takeuchi (1995)]. There is,
52 - The journal of financial transformation
however, no clear-cut distinction between tacit knowledge and
information: the degree of tacitness [Nelson and Winter
(1982)] is determined by time, complexity, and depth of expla-
nation needed. Whether a specific type of knowledge could in
principle be codified and transferred via ICT is not considered
here; when the costs of codifying become prohibitively high,
the use of ICT becomes de facto impossible. ICT allows for
more and more knowledge to become codified and thus trans-
ferable in space. However, to interpret this codified knowledge,
most often a specific code which has to be learned by actors
beforehand is needed with that learning process itself being
based on tacit knowledge [Nelson and Winter (1982), Cowan
and Foray (1997)].
Knowledge with a high degree of tacitness is still passed on
only between co-present actors, or those who know and trust
each other. Therefore, face-to-face contact is an efficient
communication technology, where verbal, physical, contex-
tual, intentional, and non-intentional levels of communication
are addressed at the same time [Storper and Venables
(2004)]. The higher the need for spontaneous meetings and/
or regular informal contacts, the more important spatial prox-
imity becomes. In addition, face-to-face contacts display sev-
eral other advantages, such as the possibility of judging other
persons and being judged by others, thereby facilitating the
building up of trust and the detection of lies, and better moti-
vation in co-presence [Storper and Venables (2004)].
Especially when new and ambiguous information has to be
interpreted, processed, and communicated extremely fast, a
constant co-presence between the actors i.e., not more than
a couple of meters distance remains necessary.
Other proximities play a role in the spatial organization of
financial research as well. Since nation-states create those
institutions which actively define and maintain distinct indus-
trial practices, [Gertler (1993)] it is a kind of cultural or
national proximity that is needed to understand certain busi-
ness practices, local regulations (or local interpretations of
international regulations), and not least the language of the
actors. The less transparent an object or transaction, the
higher is the relevance of cultural proximity. Face-to-face con-
1 The financial sector is heavily regulated and the decision to outsource and off-
shore activities is often subject to approval of regulatory bodies in charge of the
stability of the financial system. However, regulators do not consider research
activities to be critical to the survival of financial institutions and will not be con-
sidered here.
Obstacles in offshoring and outsourcing investment banks research

Introduction
Value chain
Outsourcing and offshoring are high on the strategy agenda
of banks seeking to cut costs. For the first time even complex
Phase Phase Phase
tasks at the core of financial services firms, such as equity and
country research, are considered to be outsourced or off- Bank Type of Bank Type of Bank
department proximity department proximity department
shored [Irving et al. (2003)]. Will there be a World Financial
Research Centre in Mumbai (formerly called Bombay), rising Type of Type of Type of
proximity proximity proximity
at the cost of other financial centers around the globe?
Investment banks seem reluctant to rely fully on outsourced
Corresponding Corresponding Corresponding
and/or offshored analysis only. This indicates some hidden actor actor actor

obstacles for such restructuring that we carve out in this

paper. Based on an enhanced value-chain concept we develop
a model that determines the modularity of business process-
es, and apply it to two activities in investment banks institu-
tional equity and country research as illustrative case stud-
ies. The options of outsourcing certain stages of business
processes and offshoring parts of the value chain within firms
to low-wage locations depend crucially on how processes are
embedded in relation to other departments within and to
corresponding actors outside the firm.
Research is an important cost factor in the financial industry:
the total equity research budget for seven large investment
banks amounted to U.S.$2.7 billion in 2001. Compensation of
equity analysts is among the highest in investment banking
with salaries accounting for up to three quarters of the total
costs of research [CGE&Y (2004)]. Salaries for analysts with a
comparable background for example, in India typically
reach only 30-40% of a U.S.-based analyst. In the so-called
Spitzer-Settlements in 2003, ten of the largest investment
banks have been forced to contract with at least three inde-
pendent research firms and make that research available to
their customers. The agreement is in effect for five years and
bears costs of more than U.S.$400 million [SEC (2005)]. Each
stock that is covered by the banks own research has to be
covered by an additional independent analysis, which is linked
on the banks website. Investment banks have been pushed by
regulators to duplicate their in-house research with outside
research providers, paving the way to completely outsource
these activities. At the same time, in-house research gets
Figure 1 Proximities in value chains
more costly for the securities business units because it must
not be cross-subsidized by other investment banking units any
longer arguably a push towards offshoring. In this context,
sourcing strategy, comprising contract and location decisions,
has attracted the attention of top executives within invest-
ment banks. Yet, one can witness that most investment banks
retain their in-house equity research units, and mostly in
Western financial centers. It is a puzzle why outsourcing and
offshoring of equity research activities of investment banks
happens only on very rare occasions.
Outsourcing is understood here as a process in which certain
service providers external to the firm take over business pro-
cesses formerly conducted within the firm. A relocation of
these processes is thus not required for outsourcing.
Conversely, offshoring means the relocation of activities from
one site to another, which is often in low-cost regions, within
the same firm or at least the same corporate group. Offshoring
can occur in combination with outsourcing, but not necessar-
ily so. It is argued here that the amount and sort of informa-
tion and communication exchanged in business processes is
crucial for the possibilities of outsourcing and offshoring
research activities1.
Value chains and proximities
An analysis of the spatial consequences of reorganization
decisions has to take into account firm and department levels.

53
 Obstacles in offshoring and outsourcing investment banks research
through twelve in-depth interviews with analysts from eight
banks that lasted from one to two and a half hours between
winter 2003 and winter 2004 in Frankfurt. In addition, it is
supplemented by findings of interviews carried out during
certain former research projects of the authors on the spatial
organization of the financial industry (references omitted for
anonymity reasons). All interviews were semi-structured and
open ended; notes were taken during the process. The inter-
viewees are research analysts and senior analysts in invest-
ment banks based in Frankfurt and London. We asked the
interview partners to reflect on other industry practices and
former work experiences, which yielded no different results.
Indeed, the answers we got in the interviews showed a very
consistent picture with only little variance. Industry standards
were referred to quite often and actually shape analysts work
to a large extent. Nevertheless, this part of the survey is not
intended to furnish a quantitative analysis of the spatial
restructuring of financial research activities, but to reveal the
underlying rationales, possibilities, and targets for outsourcing
and offshoring different research activities in banks.
Research in investment banks is a heterogeneous field and
quite different from research and development in other indus-
tries in that it is much more short-term in nature. In our
analysis we concentrate, for illustrative purposes, on two
examples of research analysts that are the most and least
embedded respectively: institutional equity analysts and
country analysts. By asking analysts in open interviews about
their daily work, their data gathering, their contacts and fre-
quency thereof, a picture of their embeddedness in local and
organizational structures emerges. Institutional equity ana-
lysts output consists of three main areas. Firstly, they write
research reports on specific firms and update them every
time a major event is happening, either economy-wide, indus-
try-wide, or firm specific. Secondly, they visit large investors
to present their results. Thirdly, they give short-term advice to
the traders of the bank, both for the banks own account (pro-
prietary trading) or for those of the clients (sales trading).
Each of these areas mutually benefits from each other; there
are economies of scope in production which are critical for
54 - The journal of financial transformation
understanding analysts embeddedness in the firm.
Institutional equity analysts work within the wholesale broker-
age departments. Institutional equity analysts typically cover
not more than five big companies in depth and up to about the
same number of smaller ones, mostly in related industries.
The value of a company depends on its future earnings pos-
sibilities; therefore, a large part of what analysts do is project
the future. All available data about the company are taken into
account: company sources, analyst meetings, road shows,
talks with investors, specialized data providers, newspaper
articles, etc. [Wrigley et al. (2003)]. Almost as important are
the consequences for the company ensuing from any other,
also seemingly unrelated, events. Analysts interpret a wide
range of signals, including price movements of the companys
or other stocks, market rumors, and the mood, etc. There is a
lot of number-crunching involved, but this is used merely as a
tool. Data gathering and entering the data into the firm-spe-
cific (and sometimes analyst-specific) format and programs is
a job frequently done by the analysts themselves and by assis-
tants. To carry out these tasks, organizational and sometimes
only professional proximities would be enough. However, it
was repeatedly stressed in the interviews that understanding
what is going on and what will be going on in the company
and in the industry is most important [see Agnes (2000) for
analogous results for swap traders]. Contrary to the general
impression, the most significant inputs used by analysts are
not codified knowledge and information but qualitative, soft
information and knowledge about future developments. To
exchange the latter, recurrent face-to-face contacts are need-
ed with all kinds of actors, albeit at different frequencies.
In order to get as much information as possible from the cur-
rent market situation institutional equity analysts are com-
monly located right within the trading room of banks and
communicate with all sorts of traders intensively. Since com-
pliance regulations do not allow even traders of their own
bank from seeing the written recommendations before they
are officially published, the analysts desk is situated on a dais
about one and a half meters high above the traders level with
Obstacles in offshoring and outsourcing investment banks research
tacts and cultural proximity can be partially compensated
through vertical integration or organizational proximity
[Lundvall (1988)]. Organizational proximity exists between
actors working in the same company regardless of their geo-
graphical location and thus gains a new relevance with the
implementation of ICT [Yeung (2005)]. It refers to firm-specif-
ic information and the way one deals with it: corporate iden-
tity, corporate philosophy, organizational rules, and codes play
a significant role [Blanc and Sierra (1999)]. In a similar man-
ner, proximity between actors in the same type of job can
bridge spatial and cultural distance to a certain extent. Actors
in close professional proximity possess an understanding of
each others methods, practices, and aims, share similar inter-
ests, and professional language. Both organizational and pro-
fessional proximity facilitate the building up of trust and fur-
nish a common background for the actors and hence a context
for interaction, thereby simplifying knowledge exchange. They
are based on shared conventions, thereby providing a com-
mon framework of action [...] with other actors engaged in
that activity [Storper (1997)]. Professional proximity favors
also outsourcing, since the common framework is the same
across firm boundaries. In contrast, the requirement of spatial
and cultural proximity acts predominantly to keep activities
within a certain territory. However, parallel to organizational
proximity, ethnic networks also create a common background
and thus help in extending communication from a local,
regional, or national dimension to a transnational one, as
exemplified in the case of the Indian software industry and its
connections with Silicon Valley [Saxenian et al. (2002), Taeube
(2005)].
To illustrate the different concepts of proximity introduced in
this paper imagine five young British analysts sitting together
at a desk in a major investment bank in London. Their
exchange of information and knowledge is based on all four
proximities: they are spatially very close together, share the
same cultural background, work for the same firm, possessing
organizational proximity, and do the same jobs and are there-
fore also professionally close to each other. Now think of one
of the analysts being moved to the Edinburgh office of the
same bank. She is losing the spatial proximity even though she
maintains cultural, organizational, and professional proximity
with her colleagues. The second analyst decides to become a
freelancer. He stays in London, visits the old colleagues fre-
quently and delivers research reports on the very same com-
panies that he has analyzed before i.e., his work has been
outsourced but not offshored. He now shares only part-time
spatial proximity, as well as cultural and professional, with his
former desk mates, but has lost organizational proximity. The
third analyst is fired. Part of her work is offshored (but not
outsourced) and now done by a newly hired Indian colleague
in the Bangalore office of the same bank. She will not have
cultural proximity (i.e., to understand and interpret messages
from Chief Financial Officers of Indian and U.K. companies
respectively, different cultural backgrounds have to be taken
into account) but shares organizational and professional prox-
imity with the analysts in the London office. Lastly, also the
fourth analyst is fired. His work is now done by an analyst in
an Indian consultancy company in Bombay, which is special-
izing in collecting and streamlining financial information
about firms. The work has been outsourced and offshored; the
Indian analyst only has professional proximity to the analysts
in London. These hypothetical reorganizations appear in
order of their feasibility, with the last one, outsourcing and
offshoring, being quite infeasible.
In general, outsourcing becomes an option only when organi-
zational proximity is not necessary. Moreover, the content of
the processes to be outsourced ought not to be of strategic or
otherwise critical value to the outsourcing company [Cronin et
al. (2004)]. Offshoring of complex tasks is possible for parts
of the value chain that do not require cultural proximity and
face-to-face contacts and where professional and organiza-
tional proximity ensures sufficient common background for
communicating. In what follows we analyze why most of the
hypothetical outsourcing and offshoring actions in our story
do not actually materialize in investment banks.
Embeddedness of research analysts
Empirical evidence pertaining to analysts were compiled
55
 Obstacles in offshoring and outsourcing investment banks research
board members of the firms they cover. Our results show a
strong need for cultural proximity between analyst and man-
agement of the covered firms. This is consistent with the find-
ings by Bae et al. (2005), who observe that geographically
proximate analysts give more accurate forecasts; a finding
which is even true on a regional level [Malloy (2005)].
Country analysts are to be found on the opposite side of the
scale of embeddedness. They assess country risks and pros-
pects for further regional development. Findings are some-
times published in public country reports distributed by banks.
Their main output, however, consists of updating the proprie-
tary information and risk management systems of banks. Here
they are used as inputs in a variety of decisions: in assessing
the credit risk of countries and thus the loan terms for lenders
in that country, in generating a benchmark world-portfolio of
equity investments, or in advising clients before large real or
financial investments. These evaluations are updated frequent-
ly on the margin but have an average time horizon of half a
year to even a few years. Typically, a certain number of coun-
tries in one region are covered simultaneously, depending on
their importance to the bank. For example, there might be two
or three country analysts for South America in a bank and five
for the U.S. and Canada alone. Clients of country analysts are
almost exclusively other departments of the same bank. Being
far from sales, earnings potential for the banks is much lower
and thus country analysts are paid considerably less than their
equity peers which reduces the pressure for outsourcing and
offshoring in the first place. The potential for offshoring, how-
ever, is higher as face-to-face contacts almost never occur.
Sometimes, a department has a specific question regarding a
particular development, but in general this is solved via tele-
phone. Information is gathered from a variety of sources,
mostly Internet, newspapers, and research reports from spe-
cialized vendors. New developments are discussed with col-
leagues via telephone, email, and face-to-face when they are
close by. In large banks, the analysts covering a specific area,
like South America, are scattered across different financial
centers. Analysts visit the countries they cover to confer with
government officials about once a year. In general, much of the
56 - The journal of financial transformation
informational input is based on codified knowledge and infor-
mation, thus at first glance the jobs might be outsourced as
well almost identical reports can be bought from commercial
vendors.
Here again economies of joint production come into play.
Since the main task of country analysts is to feed the propri-
etary risk management systems of banks, organizational
proximity plays an important role. Therefore, outsourcing is
not likely at all; crucial inputs for the risk position of banks are
provided in-house. The offshoring and/or outsourcing poten-
tial of the different types of analysts depend on their embed-
dedness in local or organizational structures. The two types of
analysts described above are two extreme cases of embed-
dedness, with many other kinds of economic and financial
research in between possessing characteristics of both sorts.
Institutional equity analysts need cultural proximity to the
firms they cover and maintain sporadic face-to-face contact
with the firms as well as investors. This requirement confines
them to the same nation or at least region as the firms they
cover, such as the E.U. The smaller the firms get, the more
important is cultural proximity [Bae et al. (2005)]. Since a lot
of tacit knowledge is frequently exchanged with traders and
salespersons, outsourcing as well as offshoring away from
these departments seems highly unlikely. Banks trying to
reduce costs in their investment banking departments, there-
fore, try not to outsource or offshore the expensive equity
analysts themselves, but to relieve them from a lot of non-
essential work. Organizational and professional proximity
allow for offshoring tasks that are more than just data pro-
cessing: Internet searches, processing of data from publica-
tions of firms into proprietary databases, standardized calcu-
lations, and preliminary firm valuations can be offshored,
since very little face-to-face contact is necessary.
Country economists do not have to be close to the countries
they cover and face-to-face contacts hardly play a role in their
daily business. Incoming and outgoing information is mostly
processed electronically. Since they feed mostly proprietary
Obstacles in offshoring and outsourcing investment banks research
access restricted only to analysts. The interchange and testing
of ideas with other equity analysts of their own bank is consid-
ered as absolutely necessary; analysts sit cheek by jowl on the
dais in the trading room. Thus, analysts get to know what is
going on in the trading room without any trader being able to
see what they are writing. In turbulent markets say, the
share price of a firm increases strongly against the market
traders and analysts gather spontaneously in order to try to
understand the situation and come up with a trading strategy.
In these situations many ambiguous signals from various
sources have to be interpreted quickly (typically in less than
an hour) and spatial proximity with other analysts and traders
is considered inalienable. Since meetings are scheduled at few
minutes notice, a location in close spatial proximity is essen-
tial. Interestingly, contact with economists of their own bank
who make long-term, macroeconomic projections about
business cycles and growth, both country- and industry-wise,
that analysts use as inputs in their studies is mostly via
email and reading and writing reports.
Also of interest is the demand side, viz. investors or potential
investors. Analysts frequently speak to the salespersons of
the bank. Ultimate clients are big, mostly institutional inves-
tors, like pension funds or insurance companies, investing
large sums of money. Analysts get in touch with them often
together with salespersons who maintain relationships with
the clients. An analysts main task is to generate trading
ideas for their clients, on which they could (or should) trade.
These trading ideas have a time horizon that could last from
one day to a few months. In general, analysts are paid to know
more than the market does or at least, before the market
does. When new studies come out, instead of just mailing
them to investors and informing them of trends, most often
they are presented face-to-face to investors (sometimes in
one-to-one meetings) to brief them about the companies and
potential developments relative to the market. This involves
traveling to meet clients who might be located in Europe, the
U.S., or Asia as often as three to four times a year. Asked for
the reason, one interviewee answered, They wont take you
seriously otherwise. Theyre getting loads of studies everyday
via email. You have to show a commitment. This confirms the
findings of Storper and Venables (2004), who conclude: []
for complex context-dependent information, the medium is
the message. But here information is flowing in both direc-
tions: when talking with investors, analysts learn about the
market, i.e., the future demand for and/or supply of shares.
The close connection to salespeople and clients is crucial for
the profit-generation of analysts. Clients do not pay the banks
a set fee for the analysis but route trading volume to that bank
in exchange (these are the so-called soft dollars, a practice now
under interrogation by several regulatory authorities [Financial
Services Authority (2003)]. Analysts are paid according to the
amount of trading volume they generate and their position in
ranking lists, which are compiled by industry observers.
Suppose an institutional investor asked her salesperson for
in-depth information by the equity analyst on a potential port-
folio firm. If the analyst is able to convince the investor of the
trading ideas generated during the production of the research
report, the bank profits through revenues from trading com-
missions. On the other hand, if this analyst was external and
the client is interested in getting in contact with the analyst
directly, future business with this client might be foregone.
Decoupling of the research analyst from the sales-trader, i.e.,
outsourcing, would mean loss of profits for investment banks.
Equity analysts have regular and frequent contacts with firms
they are covering [Palmer and Sparks (2004)]. They use their
homepages, have telephone contacts with the investor rela-
tions department, attend analyst meetings, and sometimes
visit the sites physically. A close understanding of local regula-
tions and the interpretation of accounting regulations is
viewed as essential. Personal contacts with the heads of inves-
tor relations and the chief financial officers (CFOs) are com-
mon and regularly renewed at investor conferences. That
allows analysts to solve problems with the data and to confirm
rumors via telephone more easily. Two analysts stressed that
when talking to CFOs, it is crucial how they express something
and what the CFOs do not say. All interview partners empha-
sized the high relevance of close and personal contacts to
57
 Obstacles in offshoring and outsourcing investment banks research
which 131 of those 133 deals take place; we exclude the remain-
ing two transactions. The number of IT companies per larger
metropolitan area is taken from the National Association of
Software and Service Companies, NASSCOM, for September
2003. In order to avoid problems of multicollinearity, the num-
ber of IT firms per million inhabitants in the metropolitan
areas have been calculated (ITCAP). Data about the local
financial sector (BANK) as of 30th September 2003 is taken
from the Reserve Bank of India; the enrollment in higher edu-
cation per 1000 capita (EDUCAP) at the state level in 2001 is
provided by the Indian Ministry of Education; and population
data is taken from the Census of India 2001. The dummy for
the Financial Centre (FIN) is 1 for Mumbai and 0 for all other
metropolitan areas.
Foreign direct investments by banks are concentrated in very
few cities only (the top three are Mumbai with 49 transac-
tions, Bangalore with 24, and Delhi with 21), as could be
expected from the literature. The main hypothesis inferred
from the interviews and reasoning above states that the local
concentration of IT firms should strongly influence the local-
ization of banks investments in India. Due to strong agglom-
eration forces in the financial sector, however, investments are
also expected to take place in locations with an already strong
presence of other banks. We control for the number of com-
mercial banks in the state and also include a dummy for
Mumbai as the predominant financial centre in India to take
care of the other financial activities (i.e., stock exchange trad-
ing and investment banking) that are predominantly located in
Mumbai [Derudder et al. (2003), Poon (2003)]. The size of the
local economy is controlled for (approximated by the popula-
tion of the larger metropolitan areas) as well as the regional
educational level (measured by enrollment in higher educa-
tion per capita at the state level). Since we regress on count
data the number of FDI transactions in a city being the
dependent variable we estimate the parameters of the
model using quasi maximum likelihood of a negative binomial
specification. Quasi-maximum likelihood estimators are robust
in incorrectly specified distributions. We use generalized lin-
ear models estimates for covariances to account for overdis-
58 - The journal of financial transformation
persion in the data (many urban areas do not receive any M&A
transactions). Thus, our estimation model adopts the follow-
ing form: TRANS = 1ITCAP + 2FIN + 3BANK + 4log(POP) +
5EDUCAP + . The results are displayed in Figure 2.
The results for ITCAP, the number of IT firms per million
inhabitants in the metropolitan areas, are highly significant.
Even when we control for the financial center (Mumbai)
which is also highly significant the presence of other banks,
the size of the population, and the general educational level,
ITCAP is robust in the positive coefficient and highly signifi-
cant (models 2-5). The number of banks in the state turns out
to be negatively significant, but with a small coefficient. We
conducted a variety of robustness checks for the size of the
local banking sector without any qualitative change in the
results: neither the number or the share of employees in the
financial sector of the respective states, the size of the finan-
cial sector relative to the state GDP, and the state relative to
the national GDP in banking explain the attractiveness of met-
ropolitan areas very well, nor does it change the coefficient
and the significance of ITCAP-variable qualitatively. Whereas
banks tend to invest in the predominant financial center, other
smaller financial centers do not influence the number of
investments in a statistically significant way. Conversely, the
locations of foreign banks investments in India are strongly
influenced by the local density of IT firms in the metropolitan
area.
On top of the Brownfield investments made by foreign banks,
more recently there is also some (anecdotal) evidence of
investment banks relocating their research activities [Atal and
Niranjan (2004), Kulkarni (2004)]. We have collected data
from newspaper articles and the Internet on Greenfield invest-
ments. The dataset focuses exclusively on the setting up of
research activities of financial firms without the acquisition of
an Indian company. We find that most of the Greenfield invest-
ments take place in the existing IT centers Bangalore,
Hyderabad, and Chennai (Madras) as well as the financial
capital Mumbai and the national capital region Delhi. These
data show a pattern quite similar to the distribution of
Obstacles in offshoring and outsourcing investment banks research
information systems, offshoring seems to be the best option to
cut costs. However, there is not much evidence on such a move
besides sporadic newspaper reports of single banks and con-
sulting firms that open economic research departments in
India. One reason for this missing offshoring activity might be
the small size of these departments (even the largest interna-
tional banks employ not more than about 30 country analysts)
and the fact that they are paid considerably less than their
investment banking peers. Summing up the findings so far,
offshoring of wholesale equity research is not a straightfor-
ward undertaking due to the strong embeddedness, both local
(within the bank) and regional (with the analyzed firms).
Country analysts could be moved more easily but they are not
a big cost factor anyway, so the pressure to offshore is not
high. Hence, the main strategy of banks could be to offshore
junior analysts work, like gathering and preparing data, per-
forming standardized calculations, and putting together pre-
sentations.
International corroboration: case study India
India is the predominant location for the offshoring and/or
outsourcing activities of U.S. and U.K. banks. In general,
investment banks that set up research units in India do so
mainly for three reasons: to enter the Indian market, to relo-
Independent variables (1) (2) (3) (4) (5)
ITCAP 0.22a 0.15a 0.28a 0.27a 0.28a
(5.10) (4.88) (3.93) (4.24) (3.41)
FIN 2.53b 3.24b 5.56a 4.19a
(2.39) (2.36) (2.80) (2.78)
BANK -0.02b -0.04b -0.03c
(-2.37) (-2.27) (-1.85)
log(POP) 0.08 0.17
(1.23) (1.49)
EDUCAP -0.25
(-1.19)
No. of observations 35 35 35 35 34
Akaike info criterion 3.49 3.24 2.98 2.98 2.68
Schwarz criterion 3.53 3.33 3.12 3.16 2.91
z-statistics in parentheses; a, b, c indicate significance at the 1, 5, 10% level respec-
tively
Figure 2 Regression findings (dependent variable: TRANS)
cate their existing research departments completely, or, as our
interviews suggest, to shift only junior analysts tasks.
Investment banks research, whether junior or not, is a com-
plex task that requires capabilities and training which is not
available ubiquitously, contrary to, say, call center activities.
So just moving to the cheapest locations in the countryside is
not an alternative: banks shift their research activities to
places where there is already a pool of adequately trained
staff i.e., to clusters, to exploit external knowledge [Cohen
and Levinthal (1990)]. Hence, one would expect localization of
higher value-added activities to take place in those existing
clusters exhibiting features, such as labor markets, with expe-
rience specific to the banks requirements. For junior analyst
tasks, however, Indian IT clusters, in addition to the financial
center, seem to be prepared quite well: financial services
already make up the largest part of the business of Indian
software companies and still increasing in market share
[Nasscom (2003)]. However, investment banks which try to
enter the fast growing Indian domestic capital market will
move towards the predominant Indian financial center, Mumbai
[Shah (2004)]. Since research units there will prepare whole-
sale analysis for the domestic market anyway there might be
attempts to use the existing manpower and facilities to con-
duct research on foreign firms too.
We use a stepwise regression analysis to explore the factors
that might attract Brownfield FDI (i.e., inward M&A transac-
tions) into India by financial institutions. There is only anec-
dotal evidence for Greenfield investments of banks, but there
are data available on M&A transactions of foreign financial
institutions in India. Both are analyzed in order to verify the
findings of our interviews with analysts. The dependent vari-
able is the number of transactions (TRANS) that take place in
larger metropolitan areas in India with more than 1 million
inhabitants between 1992 and 2004. Financial institutions
pursued 133 inward M&A transactions in India with a known
target location (data from Thomson Financial), the majority of
deals occurred after 1997. We use data provided by The World
Gazetteer for the number of inhabitants (POP) in each larger
metropolitan area in 2004. There are 35 of these areas in
59
 Obstacles in offshoring and outsourcing investment banks research

companies create the dynamics, Oxford University Press, Oxford

Palmer, M., and L. Sparks, 2004, Investment bank analysts and retail research,
more recently.
Environment and Planning A, 36, 1521-1528
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60 - The journal of financial transformation

Obstacles in offshoring and outsourcing investment banks research
Brownfield investments and thus substantiate the findings
from the regression analysis above. Our results are consistent
with banks that a) want to enter the Indian market and b)
settle in IT-centers in India to source junior analysts tasks.
Conclusion
One of the most critical decisions for managers is to evaluate
how, and where, goods and services are procured; recently
this became true also for investment bank managers, particu-
larly after regulators demanded fresh answers to flawed
research reports that have been published in recent years.
Outsourcing and offshoring of research departments is an
issue discussed at the boards of many investment banks. This
study contributes by providing empirical guidance for manag-
ers in investment banks that institutional research is almost
impossible to outsource and difficult to offshore. Our analysis
of research departments in Western financial centers revealed
a degree of embeddedness of the highly debated wholesale
equity research analysts that makes even offshoring unlikely.
The results provide specific managerial directions. Despite the
ubiquity of information and communication technologies,
knowledge is still passed on best via face-to-face contacts.
Continuous direct interactions with traders, other analysts,
and sales people are regarded as absolutely necessary by
institutional equity analysts for developing their trading ideas.
In other words, there are limits to modularity [Ernst (2004)].
Other analysts covered here are country analysts are
embedded only to a rather low extent and could therefore be
transferred to a low-wage country like India without greater
loss of information and knowledge. Due to the organizational
proximity needed to feed the internal risk-management sys-
tems, offshoring is much more feasible than outsourcing.
These analysts are fewer in number and significantly less
expensive than their equity peers, so the pressure to find a
new sourcing strategy for their work is considerably lower. For
equity analysts, the obstacles to outsourcing and offshoring
stem from the economies of scope of their different tasks.
Long-term reports and short-term advice are heavily interre-
lated. Clients regard original research as the main asset they
are paying for and demand face-to-face contacts with ana-
lysts, as well as with sales persons. Most feasible, therefore, is
the relocation of technical analyses and data gathering assis-
tant work to India to save some costs this might even take
place in combination with outsourcing as has been witnessed
61
 Institutional

European banking
consolidation:
effects on
competition,
David-Jan Jansen
profitability, and
efficiency
Economist, Economics and Research Division,
De Nederlandsche Bank

Jakob de Haan
Professor of Political Economy and Director of
Graduate Studies, Faculty of Economics,
University of Groningen1

Abstract
The consolidation trend in the European banking sector has
raised concerns about competition in this sector. This article
analyses the relationship between concentration, competitive-
ness, efficiency, and profitability of national banking markets
of European countries. We use panel regressions in which
estimates from previous studies on competition and efficiency
in national banking sectors are related to concentration and
profitability indicators for these sectors. Our results do not
suggest the existence of any connection at the country-level
between concentration and competition. There is also no
robust relationship between concentration and profitability.

1 Jakob de Haan worked on this paper while he was visiting scholar at De

Nederlandsche Bank. The authors would like to thank Linda Toolsema, Peter van 63
Els, Jaap Bos and Maarten van Rooij for valuable comments. Views expressed are
those of the individual authors and do not necessarily reflect official positions of
De Nederlandsche Bank.
 European banking consolidation: effects on competition, profitability,
and efficiency

the 1997-1998 period, for example, five times as many merg-
ers and acquisitions occurred in the U.S. as in the Euro-area.
The general trend seems to be that the number of acquisi-
tions in Europe is declining while the total value is on the
increase. Consequently, the average value per acquisition has
risen. That is not surprising since it is likely that, initially,
small banks were the main targets for acquisition.
Consolidation in the Euro-area grew strongly in 1997/98 as
illustrated by the sharp rise in the value of the transactions.
Using data provided by the European Central Bank (ECB),
Figure 2 shows that bank acquisition activities in Europe tra-
ditionally have a national focus3. The number of mergers
exclusively involving domestic parties is given in parentheses.
Spain is one of the few countries where international mergers
and acquisitions figure strongly. In 1999, for example, only 5
of the 17 mergers involved two Spanish parties. Dutch banks
also appear to have a relatively strong international orienta-
tion. The 2005 developments in the Italian banking market,
where Dutch bank ABN AMRO and Spanish BBVA tried to
acquire Italian banks strengthens this impression4.
An important characteristic of a national banking market is
its degree of concentration, which can be measured in vari-
ous ways [Bikker and Haaf (2002b)]. Generally the ratio
between the assets of the five largest banks and total bank
assets (C5 ratio) is used5. Instead of all assets, also specific
assets (like loans) or liabilities (like deposits) can be used for
calculating the C5 ratio. The advantage of the C5 ratio is that
it is relatively easy to calculate, but the disadvantage is that
not all information about the market is used. As an alterna-
tive we, therefore, also use the Herfindahl Index (HI), which is
calculated as the sum of the squares of the market shares of
all banks in the sector [Bikker and Haaf (2002b)].
Figure 3 shows the C5 ratio and the HI for 15 E.U. countries
for selected years. Both indicators show similar develop-
ments. In eight countries the C5 ratio clearly increased
between 1985 and 1999. Between 1995 and 1999 the C5 ratio
only declined in two countries, Portugal and Ireland. Likewise,
the Herfindahl Index declined in these two countries and in
Greece between 1995 and 1999, whereas it increased in other
countries, except for Sweden where the index remained sta-
ble. Figure 3 also illustrates existing differences in the bank-
ing sectors in the various European countries. In 1999
Germany, Luxembourg, and the U.K. had C5 ratios of less
than 30 percent, while Sweden, say, had a ratio of almost 90
percent. So, despite the European integration process there
are still large differences between national banking sectors

Number Value
Country 1991-92 1993-94 1995-96 1997-98b 1991-92 1993-94 1995-96 1997-98b
United States 1,354 1,477 1,803 1,052 56.8 55.3 114.9 362.4
Euro-areaa 495 350 241 203 17.5 14.6 19.1 100.4
France 133 71 50 36 2.4 0.5 6.5 4.0
Germany 71 83 36 45 3.5 1.9 1.0 23.2
Italy 122 105 93 55 5.3 6.1 5.3 30.1
Netherlands 20 13 8 9 0.1 0.1 2.2 0.4
United Kingdom 71 40 25 17 7.5 3.3 22.6 11.0
Switzerland 47 59 28 22 0.4 3.9 1.0 24.3
a excluding Austria, Ireland, Luxembourg, and Portugal
b as at 30 October 1998
Source: Bank for International Settlements (1999)

Figure 1 Bank mergers and acquisitions: number and value (U.S.$ billions)

2 A highly concentrated banking sector may also entail benefits. Using data on 70
64 countries from 1980 to 1997, Beck et al. (2003) find, for instance, that systemic
banking crises are less likely in economies with more concentrated banking sys-
tems, fewer regulatory restrictions on bank competition and activities, and nation-
al institutions that encourage competition.
European banking consolidation: effects on competition, profitability,
and efficiency
Country 1995 1996 1997 1998 1999 2000
Austria 14 (14) 24 (24) 29 (27) 37 (37) 24 (20) 8 (5)
Belgium 6 (6) 9 (8) 9 (7) 7 (6) 11 (6) 3 (0)
Denmark 2 (2) 2 (2) 2 (1) 1 (1) 2 (0) 2 (1)
Finland 9 (7) 6 (6) 5 (5) 7 (5) 2 (2) 5 (3)
France 61 (60) 61 (61) 47 (46) 53 (52) 55 (51) 25 (21)
Germany 122 (100) 134 (117) 118 (109) 202 (189) 269 (240) 101 (91)
Greece 0 (0) 1 (0) 3 (3) 9 (7) 8 (3) 1 (0)
Ireland 3 (1) 4 (1) 3 (0) 3 (2) 2 (1) 0 (0)
Italy 73 (68) 59 (56) 45 (45) 55 (52) 66 (64) 30 (30)
Luxembourg 3 (3) 2 (1) 3 (3) 12 (9) 10 (6) 8 (6)
Netherlands 7 (2) 11 (2) 8 (5) 3 (0) 3 (1) 5 (2)
Portugal 6 (5) 6 (5) 2 (1) 5 (1) 2 (0) 9 (6)
Spain 13 (4) 11 (4) 19 (1) 15 (5) 17 (5) 29 (3)
Sweden 1 (1) 2 (2) 5 (2) 1 (1) 7 (1) 2 (0)
U.K. 6 (2) 11 (4) 21 (15) 24 (16) 19 (14) 6 (4)
Source: ECB (2000)
Figure 2 Mergers and acquisitions of credit institutions: total and domestic (in
parentheses)
Since the early 1990s, the merger and acquisition activities of
European banks have increased [Walkner and Raes (2005)].
By increasing the scale of operations banks may generate
efficiency gains and improve profitability. There are good rea-
sons to expect the process of consolidation to continue in the
near future. The number of banks per capita in Europe is still
relatively large compared to the United States and there are
still important differences between national banking markets
in Europe, suggesting the existence of possible gains from
consolidation [Altunba and Marqus Ibez (2004)].
Academics and policy makers have expressed some concern
about the increase in market shares of the larger European
banks, as high levels of concentration could have a negative
impact on competitive conditions, which, in turn, may lead to
excessive bank profits. Indeed, Bikker and Groeneveld (2000)
conclude that the increase in the degree of concentration in
the European banking sector is negatively related to competi-
tion2.
This article studies the effects of consolidation (defined as
3 The ECB does not apply a uniform definition of the term credit institution and
collects the data based on national standards. This explains the inconsistency
between Figures 1 and 2.
4 The lack of progress in cross-border integration can be attributed to various fac-
tors, including national differences in market practices, regulation, and taxation.
C5 ratio Herfindahl Index
Country 1985 1995 1999 1985 1995 1999
Austria 35.9 39.2 50.4 - 0.04 0.10
Belgium 48 51.2 77.4 - 0.06 0.16
Denmark 61 72 77 - 0.12 0.14
Finland 38 70.6 74.3 - 0.18 0.20
France 46 41.3 42.7 - 0.04 0.05
Germany - 16.7 19 - - 0.01
Greece 80.6 75.7 76.6 0.25 0.18 0.15
Ireland 47.5 44.4 40.8 - 0.07 0.05
Italy - 32.4 48.3 0.02 - 0.06
Luxembourg 26.8 21.2 26.1 - - 0.02
Netherlands 72.9 76.1 82.3 0.13 0.16 0.17
Portugal 61 74 72.6 0.11 0.14 0.12
Spain 35.1 47.3 51.9 0.04 0.05 0.07
U.K. - 28.3 29.1 0.02 0.02 0.03
Sweden 80.8 86.5 88.2 0.20 0.20 0.20
Source: ECB (2000)
Figure 3 C5 ratio and Herfindahl Index (based on total assets) for credit institu-
tions in the EU15
increased concentration) in the national banking sectors of
various European countries on competition, profitability, and
efficiency. We use country level data taken from various pre-
vious studies on competition in and efficiency of national
banking markets. Our results are as follows: we find no evi-
dence that competition indicators are linked to profitability
measures. A similar conclusion holds for concentration and
competition. Moreover, we do not find a robust relationship
between concentration and profitability. We report only
mixed evidence for a positive connection between efficiency
indicators and profitability.
Trends in the European banking sector
What are some of the characteristic developments in the
European banking sector since the beginning of the 1990s?
Firstly, we provide evidence on trends in M&As. Figure 1 pro-
vides data on the numbers and value of acquisitions for vari-
ous European countries and compares them to figures for the
United States. Both the number and value of mergers and
acquisitions in the United States are higher than in Europe. In
A fairly comprehensive list of existing obstacles and their impact on the main ave-
nues for cross-border banking integration is provided by Walkner and Raes (2005). 65
5 Sometimes the C3 ratio is used; see, for example, Goldberg and Rai (1996).
 European banking consolidation: effects on competition, profitability,
and efficiency
Recently, a number of studies have been published in which
the banking sectors in the various European countries are
compared to each other in terms of efficiency. While various
efficiency studies had been carried out before they generally
related to a single country. Bikker (2001), Wagenvoort and
Schure (1999), and Altunba et al. (2001) estimate cost func-
tions in order to measure the so-called X-inefficiencies6.
Bikker (2001) analyzes 3085 banks in 9 European countries in
the period 1989-97. The study by Wagenvoort and Schure
(1999) relates to 1974 European banks in the E.U. countries
for the period 1993-1997, while the study by Altunba et al.
(2001) analyzes 15 European banking markets between 1989
and 1997. All three studies conclude that there are major dif-
ferences in efficiency, but their findings differ widely as to
which country has the most efficient banking sector. Bikker
(2001) concludes that banks in Luxembourg, Belgium, and
Switzerland exceeded the average European level of effi-
ciency. According to Wagenvoort and Schure (1999), banks in
Belgium, the Netherlands, Austria, and the U.K. are the most
efficient. In contrast, Altunba et al. (2001) reach the conclu-
sion that the most efficient banking sectors are those in
Denmark, Germany, Italy, and Austria. These major differ-
ences between studies on the efficiency of the banking sec-
tors suggest caution when examining the connection between
efficiency and concentration.
66 - The journal of financial transformation
+ +
SCP: Concentration Non-competitive behavior Profitability
+
EFF: Efficiency Profitability
+
Concentration
Figure 4 SCP versus efficiency hypothesis
Methodology and data
We investigate the connections between concentration, com-
petition, profitability, and efficiency at the macro-level by
using panel regressions. We use estimates from previous stud-
ies on competition and efficiency in national banking sectors
and study to what extent these are related to concentration
and profitability indicators for these sectors. Our methodolo-
gy resembles that of Bikker and Groeneveld (2000). These
authors examine the relationship between indicators of com-
petition and concentration in the national banking sectors in
Europe. However, they only employ one indicator for competi-
tion and use only one indicator for concentration (C5 assets).
As discussed previously, there are other estimates of the
degree of competition in the European banking markets and it
is also possible to use other indicators of concentration (like
the Herfindahl index). By using a wider range of indicators we
can check to what extent the conclusion of Bikker and
Groeneveld (2000) is robust. Furthermore, there are other
interesting relationships that can be examined than just the
relationship between concentration and competition.
We test 5 connections implied by the SCP paradigm and the
efficiency hypothesis. The SCP paradigm implies 3 hypotheses:
H1: A higher degree of concentration leads to less competi-
tive behavior.
H2: A higher degree of concentration leads to greater profit-
ability.
H3: Less competitive behavior will lead to greater profitabil-
ity.
The efficiency hypothesis implies the following 2 hypotheses:
European banking consolidation: effects on competition, profitability,
and efficiency
[Gual (2004)].
Research on E.U. banking
In this section, we discuss recent studies on concentration,
competition, efficiency, and profitability within the European
banking sector. In a nutshell, we discuss the following: the use
of the Panzar-Rosse methodology to measure competition,
studies of the structure-conduct-performance (SCP) para-
digm and the efficiency-hypothesis, and finally, research on
banking efficiency.
The method developed by Panzar and Rosse (1977) constructs
a measure of competition. This measure is called the
H-statistic, which is defined as the sum of the factor price
elasticities of interest revenue with respect to borrowed capi-
tal, labor, and physical capital. The value of H can be inter-
preted as follows. In case of a monopoly, H is lower than or
equal to zero. This also applies to an oligopolistic market with
cartels or complete imitation of each others behavior. A value
of H between zero and one indicates monopolistic competi-
tion. A value equivalent to one points to perfect competition
[De Bandt and Davis (2000), Claessens and Laeven (2004)].
Using this methodology, De Bandt and Davis (2000) study the
market structure in Germany, France, and Italy at the start of
EMU. For the first two countries, they find that monopolistic
competition characterizes the market for large banks while
the market for small banks looks like a monopoly. In Italy, the
market form in both sectors is monopolistic competition. On
the basis of these results, these authors conclude that at the
start of EMU perfect competition was virtually nonexistent.
According to Bikker and Groeneveld (2000) and Bikker and
Haaf (2002a), monopolistic competition is the dominant mar-
ket form in the European banking sector. Interestingly, these
authors find a negative connection between a concentration
index and their estimated H statistic. Both studies, therefore,
conclude that further consolidation could reduce competition
in Europe.
The structure-conduct-performance (SCP) paradigm postu-
lates a connection between market structure, behavior, and
6 Wagenvoort and Schure also measure scale inefficiency.
profitability. According to Goldberg and Rai (1996), this para-
digm provides an explanation for the positive connection
between concentration and profitability often found in the
American banking sector. The reasoning is as follows: in mar-
kets with a high degree of concentration, firms have more
market power, which allows them to set prices above mar-
ginal costs and achieve higher profits. Another explanation
for the connection between concentration and profitability is
the efficiency hypothesis. The efficiency hypothesis states
that more efficient enterprises will be capable of expanding
their market share and will have higher profitability. The pos-
ited connections are clarified in Figure 4.
Both the SCP and the efficiency hypothesis have been exten-
sively tested for the United States. Fewer studies are avail-
able for Europe. Molyneux and Forbes (1995) estimate a
model for banking profits in which the degree of concentra-
tion, market share, and a number of control variables are the
explanatory variables. They find a positive significant con-
nection between concentration and profitability, while mar-
ket share appears to have no influence. On the basis of these
findings, the authors reject the efficiency hypothesis in favor
of the SCP hypothesis. Goldberg and Rai (1996) make some
justified criticisms of this method. It is confusing to use the
market share variable as an efficiency indicator, given that
this variable may also refer to market power. It is better to
directly include efficiency variables into the model. Goldberg
and Rai (1996) do this for a set of large banks from various
European countries and find no connection between profit-
ability and concentration but report support for the effi-
ciency hypothesis. Bikker and Haaf (2002a) also explore the
SCP-hypothesis, investigating the relationship between mar-
ket structure and conduct. To this end they relate the H sta-
tistic, estimated following the Panzar-Rosse method, to the
degree of concentration in the market. These authors find a
negative connection between the two variables, leading
them to conclude that increasing concentration in Europe
would harm competition. Bikker and Groeneveld (2000)
reach the same conclusion on the basis of a similar analysis.
67
 European banking consolidation: effects on competition, profitability,
and efficiency
rithm of) the number of banks as a control variable, as sug-
gested by Bikker and Haaf (2002a).
As concentration indicators, we use the C5 ratio and the
Herfindahl Index. For profitability, we use both the return on
assets and the return on equity. Like Bikker and Haaf (2002a)
and Bikker and Groeneveld (2000), we apply the H statistic
from the Panzar and Rosse method as a competition indica-
tor. As explained above, the estimates of efficiency in the
banking sectors in the various European countries differ
widely. As indicators for the efficiency of the banking sector
in the various countries we therefore use the estimates of
Wagenvoort and Schure (1999) as well as those of Altunba
et al. (2001). Since Bikkers study (2001) included only seven
E.U. Member States, his efficiency figures were not used.
We use a number of data sources. The ECB (2000) provides
various data on the degree of concentration in the European
banking sector. We use C5 ratios and Herfindahl indices cal-
culated on the basis of total assets, deposits, and loans of the
banking sector. These indicators are available for 1980, 1985,
1990, and 1995-99. The H statistics were taken from the stud-
ies by Bikker and Groeneveld (2000) and Bikker and Haaf
(2002a) and are available for 1989, 1991, 1996, and 1997.
Profitability figures are based on publications by the
Organisation for Economic Cooperation and Development
H2
Efficiency Concentration Competitiveness Profitability
H5 H1 H3
H4
Figure 5 Five testable hypotheses
7 Demirg-Kunt and Huizinga (1999) use similar variables in their analysis of bank
68 profitability in 80 countries. They find that a higher ratio between banks and GDP
and a lower level of concentration reduce profitability. We find that bank assets
relative to GDP are not related to profitability. Therefore, we report our results
(1987, 1995, and 1999). We use both the return on assets and
the return on equity, available for 1980, 1985, and 1988-97.
Data on the efficiency of banks are obtained from Wagenvoort
and Schure (1999) and are available for the period 1993-1997.
In addition, we use the efficiency estimates from Altunba et
al. (2001), which are available for the period 1989-97. The
control variables are obtained from the OECD and the IMF
International Financial Statistics.
Results
Does more concentration imply less competition? (H1)
A higher degree of concentration could lead to anti-competi-
tive behavior. To investigate this connection, we estimate
fixed effect panels for 1989, 1996, and 1997 with the H statis-
tic as dependent variable8. Figure 6 shows our results. We
have used various proxies for concentration: the C5 ratios
(column 1) and the Herfindahl Index (column 2). These con-
centration indicators can be calculated on the basis of assets
(columns a), deposits (columnss b), or loans (columns c).
Corvoisier and Gropp (2002) argue that conditions may be
different in deposit and loan markets and we therefore use
various proxies for concentration. In most cases we do not
find a significant relationship between concentration and
competition. This result differs from the findings by Bikker
and Groeneveld (2000). Column 3 shows that if we solely use
the Bikker and Groeneveld figures for competition (which are
available for 1989 and 1996) we find a significant negative
excluding this variable. Results including bank assets are available upon request
from corresponding author.
European banking consolidation: effects on competition, profitability,
and efficiency

H4: Greater efficiency in the banking sector leads to higher

profitability.
H5: Greater efficiency will eventually result in a higher con-
centration in the banking sector.
We investigate the connection between indicators of concen-
tration, profitability, competition, and efficiency. To make as
much use as possible of the available data, we estimate panel
regressions. We only test for a connection between these
variables, which is not quite the same as a causal explanation.
However, absence of a connection would be in conflict with
the hypotheses. We test every relationship shown in Figure 5.
For example, H1 is tested by running panel OLS regressions
with a proxy for competition as the dependent variable and a
proxy for the degree of concentration as the explanatory
variable. We try to make our sample as large as possible. In all
regressions we have the 15 E.U. countries. The number of
years we can use ranges between 2 (when we use the H sta-
tistic) and 9 (when we study efficiency and profitability). In all
cases, we estimate fixed effects panels.
In addition to the variables shown in Figure 5, we use a set of
control variables. When profitability is the dependent variable
we use the interest rate (the money market rate), inflation
(the change in the consumer price index), GDP growth, and
(the natural logarithm of) the number of banks7. When com-
petition is the dependent variable we use the (natural loga-

(1a) (2a) (3a) (4a)

Years: 1989,96,97 1989,96,97 1989,96 1989,96
C5 ratio assets 0.02 (0.07) - -0.53 (-2.24)b -
Herfindahl Index assets - 0.88 (0.94) - -0.42 (-1.42)
Log # banks -0.15 (-0.60) 0.33 (0.89) -0.51 (-2.32)b -0.24 (-1.99)c
F statistic 100.70a 81.11a 219.83a 1054.53a
Adj. R2 0.67 0.65 0.89 0.98
# observations 42 36 27 21

(1b) (2b) (3b) (4b)

C5 ratio deposits -0.36 (-0.91) - -0.78 (-2.65)b -
Herfindahl Index deposits - 0.50 (0.51) - -0.36 (-1.10)
Log # banks -0.22 (-0.84) 0.27 (0.72) -0.56 (-2.66)b -0.23 (-1.80)c
F statistic 104.83a 77.93a 251.01a 948.54a
Adj. R2 0.68 0.64 0.90 0.98
# observations 42 36 27 21

(1c) (2c) (3c) (4c)

C5 ratio loans 0.01 (0.03) - -0.63 (-1.94)c -
Herfindahl Index loans - 1.36 (1.39) - -0.45 (-1.36)
Log # banks -0.16 (-0.62) 0.37 (1.01) -0.49 (-2.14)b -0.25 (-2.01)b
F statistic 100.68a 86.38a 200.19a 1032.84a
Adj. R2 0.67 0.67 0.88 0.98
# observations 42 36 27 21
Notes: t-statistics in parentheses, a/b/c significant at 1/5/10% level

Figure 6 Concentration and competition: panel regressions, 1989, 1996, and 1997 (dependent variable: H statistic)

8 As we have no data on concentration for 1989, we used the figures of 1990

instead. The same conclusion is reached when the data for the H statistic for 1991 69
and the concentration data for 1990 is combined with figures for 1996 and 1997.
 European banking consolidation: effects on competition, profitability,
and efficiency

(1a) (2a) (3a) (4a)

Dependent variable: ROE ROA
C5 ratio assets -0.27 (-1.81)c - -0.02 (-1.31) -
Herfindahl Index assets - -0.81 (-1.05) - -0.01 (-0.22)
Interest rate -0.79 (-1.94)c -0.58 (-0.95) -0.02 (-0.60) 0.01 (0.34)
Inflation 0.38 (0.83) 0.11 (0.20) 0.01 (0.17) -0.03 (-0.83)
GDP growth 0.83 (1.62) 0.90 (0.86) 0.06 (1.31) 0.06 (1.03)
Log # banks 0.07 (0.78) -0.01 (-0.11) 0.00 (0.60) 0.00 (0.40)
F statistic 13.24a 10.91a 10.84a 15.03a
Adj. R2 0.35 0.36 0.29 0.48
# observations 65 47 64 46

(1b) (2b) (3b) (4b)

C5 ratio deposits -0.73 (-3.58)a - -0.05 (-2.60)b -
Herfindahl Index deposits - -1.32(-2.46)b - -0.05 (-1.60)
Interest rate -0.69 (-1.72)c -0.46 (-0.85) -0.04 (-1.13) 0.01 (0.27)
Inflation 0.05 (0.12) 0.03 (0.06) 0.01 (0.29) -0.03 (-0.80)
GDP growth 0.88 (1.71)c 0.70 (0.73) 0.08 (1.85)c 0.05 (0.88)
Log # banks 0.05 (0.59) 0.05 (0.42) 0.01 (1.19) 0.01 (0.79)
F statistic 17.80a 13.97a 13.11a 17.06a
Adj. R2 0.46 0.45 0.36 0.53
# observations 63 47 62 46

(1c) (2c) (3c) (4c)

C5 ratio loans -0.51 (-2.33)b - -0.05 (-2.66)a -
Herfindahl Index loans - -2.22 (-2.90)a - -0.10 (-2.06)b
Interest rate -0.96 (-2.05)b -0.62 (-1.16) -0.08 (-1.86)c -0.00 (-0.04)
Inflation 0.33 (0.68) -0.00 (-0.01) 0.03 (0.72) -0.03 (-0.76)
GDP growth 0.94 (1.71)c 0.30 (0.32) 0.09 (2.01)c 0.03 (0.57)
Log # banks 0.13 (1.41) 0.01 (0.04) 0.02 (1.99)c 0.00 (0.60)
F statistic 14.05a 15.40a 13.25a 18.41a
Adj. R2 0.42 0.49 0.36 0.55
# observations 63 47 62 46
Notes: t-statistics in parentheses, a/b/c significant at 1/5/10% level

Figure 7 Concentration and profitability: panel regressions, 1980/85/90/95-97

observations from the 1980s and those from the 1990s are
too different to be included in one sample, we have reesti-
mated the relationship between concentration and profitabil-
ity using only observations for the period 1995-1997. It turns
out that in this period there is no connection between con-
centration and profitability. As a matter of fact, all indepen-
dent variables lose their explanatory powers for this sample
period (Figure 8).
Are competition and profitability correlated? (H3)
The final building block of the SCP paradigm is the relation-
ship between market conduct and profitability. Figure 9 pres-
ents the results of regressions of the H statistic and the
control variables on profitability (return on equity or return
on assets). We have used three different samples. In the first
we use all available estimates for the H-statistic (column a).
As these estimates are from two different studies, we have
also used the H estimates from our two sources separately. In
column (b) we employ the data of Bikker and Groeneveld
(2000), while in column (c) the estimates of Bikker and Haaf
(2002a) are used. Figure 9 shows that there is no connection

70 - The journal of financial transformation

European banking consolidation: effects on competition, profitability,
and efficiency

(1a) (2a) (3a) (4a)

Dependent variable: ROE ROA

C5 ratio assets 0.19 (0.45) - 0.01 (0.56) -
Herfindahl Index assets - 0.42 (0.34) - 0.03 (0.39)
Interest rate -0.42 (-0.49) -0.50 (-0.52) -0.01 (-0.14) -0.01 (-0.23)
Inflation 0.87 (0.63) 1.40 (0.87) 0.03 (0.48) 0.07 (0.83)
GDP growth 0.55 (0.79) 1.12 (0.95) 0.03 (0.82) 0.08 (1.32)
Log # banks -0.05 (-0.16) 0.04 (0.11) -0.00 (-0.05) 0.01 (0.0)
F statistic 19.20a 13.71a 25.94a 21.21a
Adj. R2 0.59 0.51 0.68 0.65
# observations 42 37 42 37

C5 ratio deposits 0.26 (0.46) - 0.01 (0.46) -

Herfindahl Index deposits - -0.37 (-0.24) - -0.01 (-0.08)
Interest rate -0.42 (-0.50) -0.50(-0.52) -0.01 (-0.16) -0.01 (-0.24)
Inflation 0.93 (0.69) 1.58 (0.95) 0.04 (0.56) 0.08 (0.88)
GDP growth 0.50 (0.70) 0.97 (0.83) 0.03 (0.74) 0.08 (1.22)
Log # banks -0.04 (-0.12) -0.00 (-0.01) -0.00 (-0.02) 0.00 (0.20)
F statistic 19.21a 13.65a 25.81a 21.01a
Adj. R2 0.59 0.50 0.68 0.65
# observations 42 37 42 37

C5 ratio loans 0.11 (0.36) - 0.00 (0.14) -

Herfindahl Index loans - -1.81 (-1.77) - -0.09 (1.59)
Interest rate -0.46 (-0.55) -0.64 (-0.73) -0.01 (-0.21) -0.02 (-0.39)
Inflation 0.98 (0.73) 1.74 (1.17) 0.04 (0.62) 0.09 (1.11)
GDP growth 0.50 (0.70) 0.56 (0.52) 0.03 (0.77) 0.05 (0.93)
Log # banks -0.07 (-0.20) -0.02 (-0.06) -0.00 (-0.08) 0.00 (0.15)
F statistic 19.12a 16.73a 25.55a 24.57a
Adj. R2 0.59 0.58 0.67 0.69
# observations 42 37 42 37
Notes: t-statistics in parentheses, a/b/c significant at 1/5/10% level

Figure 8 Concentration and profitability: panel regressions, 1995-97

connection between competition and concentration. However,
this only applies to the C5 indicator for assets (column 3a)
and deposits (column 3b). If we use the Herfindahl index,
there is again no significant connection between competition
and concentration (column 4). Our conclusion is that the con-
nection found by Bikker and Groeneveld is not robust: more
observations and/or another indicator for concentration lead
to a completely different result. So, all in all, we find little sup-
port for hypothesis H1.
Is concentration positively related to profitability? (H2)
Figure 7 gives an overview of the results obtained by regress-
ing profit on concentration. We use two indicators for profit:
return on equity (columns 1 and 2) and return on assets (col-
umns 3 and 4). Concentration is again proxied by the C5 ratio
(columns 1 and 3) and the Herfindahl Index (columns 2 and 4)
using assets (column a), deposits (column b), or loans (column
c). Our results provide only partial support for the second
hypothesis. In 7 out of 12 cases the coefficient is negative
rather than positive. We also find evidence that there is a
negative relationship between interest rates and profitability.
This effect is the strongest if we relate C5 ratios and the
return on equity. There is also evidence for a positive rela-
tionship between GDP growth and profitability. This effect is
also strongest for the C5 ratios. As it can be argued that

71
 European banking consolidation: effects on competition, profitability,
and efficiency

Dependent variable: ROE

between X-inefficiency and profit in the data of Altunba et
(1a) (1b) (1c) al. Given the large differences in the estimates of X-efficiency,
Years 1989,91,96,97 1989,96 1991,97
it is not surprising that the results of the regressions are
H 0.08 (0.63) 0.32 (1.33) -0.40 (-0.25)
Interest rate -1.45 (-2.34)b -2.07 (-1.48) -2.79 (-2.10)b widely divergent. We conclude that there is no robust rela-
Inflation 2.26 (2.52)b 0.45 (0.41) 5.8 (2.97)b tionship between inefficiency and profitability.
GDP growth 0.43 (0.78) 1.86 (1.04) 1.04 (1.06)
Log # Banks -0.05 (-0.31) 0.59 (2.07)c 0.00 (0.00)
Adj. R2 0.25 0.05 0.08 Are efficiency and concentration related? (H5)
Observations 52 26 26
The connection between efficiency and concentration was
Dependent variable: ROA examined by regressing the C5 ratio (columns 1 and 3 of
(2a) (2b) (2c)
Years 1989,91,96,97 1989,96 1991,97
Figure 11) or the Herfindahl Index (columns 2 and 4) on the
H 0.00 (0.65) 0.02 (1.37) -0.05 (-0.77) inefficiency measures of Wagenvoort and Schure (columns 1
Interest rate -0.05 (-1.42) -0.04 (-0.45) -0.13 (-2.35)c
Inflation 0.12 (2.38)b 0.00 (0.01) 0.32 (3.98)a
and 2) and those of Altunba et al. (columns 3 and 4). The
GDP growth 0.05 (1.51) 0.08 (0.63) 0.08 (1.98)c concentration measures refer to assets (column a), deposits
Log # Banks -0.01 (-1.14) 0.01 (0.66) -0.01 (-0.63)
(column b), or loans (column c). We observe no significant
Adj. R2 0.43 0.04 0.76
Observations 51 25 26 connection between efficiency and concentration. Our
Notes: t-statistics in parentheses, a/b/c significant at 1/5/10% level results, therefore, provide no support for the second link in
the efficiency hypothesis.
Figure 9 Competition and profitability: panel regressions, 1989, 1991, 1996, and
1997

(1a) (2a)
Dependent variable: ROE ROA
Years: 1993-97 1993-97
Wagenvoort-Schure:
Scale-inefficiency 0.54 (0.75) 0.04 (0.98)
X-inefficiency -0.56 (-3.39)a -0.02 (-2.53)b
Interest rate -0.23 (-0.39) -0.03 (-1.02)
Inflation 0.34 (0.30) 0.07 (1.15)
GDP growth 0.47 (0.95) 0.05 (1.80)c
Log # banks 0.04 (0.15) 0.01 (0.89)
F statistic 25.47b 27.73a
Adj. R2 0.62 0.65
# observations 67 66

(1b) (2b)
Years: 1989-97 1989-97
Altunba et al.:
X-inefficiency 0.23 (1.09) 0.01 (1.16)
Interest rate -1.13 (-3.16)a -0.06 (-2.71)a
Inflation 1.83 (3.23)a 0.13 (3.68)a
GDP growth 0.63 (1.52) 0.06 (2.45)b
Log # banks 0.21 (1.87) 0.00 (0.59)
Adj. R2 0.44 0.47
# observations 115 111
Notes: t-statistics in parentheses, a/b/c significant at 1/5/10% level
Is efficiency related to profits? (H4)

Figure 10 Efficiency and profitability: panel regressions, 1993-97 and 1989-97

72 - The journal of financial transformation

European banking consolidation: effects on competition, profitability,
and efficiency

Wagenvoort-Schure Altunba et al
(1a) (2a) (3a) (4a)
1995-97 1990, 1995-97
Dependent variable: C5 ratio assets Herfindahl Index assets C5 ratio assets Herfindahl Index assets
Scale inefficiency -0.59 (-1.04) -0.32 (-0.93)
X-inefficiency -0.05 (-0.60) 0.01 (0.2) 0.21 (1.15) -0.03 (-0.39)
Log # banks -0.04 (-0.25) -0.05 (-0.76) -0.20 (-1.44) -0.17 (-2.42)b
F statistic 2704.60a 1043.82a 845.59a 693.47a
Adj. R2 0.99 0.98 0.94 0.94
# observations 45 40 57 48

(1b) (2b) (3b) (4b)

Dependent variable: C5 ratio deposits Herfindahl Index deposits C5 ratio deposits Herfindahl Index deposits
Scale inefficiency -0.37 (-0.78) -0.03 (-0.11)
X-inefficiency -0.02 (-0.28) -0.01 (-0.12) 0.16 (1.18) -0.03 (-0.42)
Log # banks -0.06 (-0.51) -0.04 (-0.75) -0.23 (-2.15)b -0.16 (-2.37)b
F statistic 3953.83a 1698.66a 1729.16a 1037.49a
Adj. R2 0.99 0.99 0.97 0.96
# observations 45 40 57 48

(1c) (2c) (3c) (4c)

Dependent variable: C5 ratio loans Herfindahl Index loans C5 ratio loans Herfindahl Index loans
Scale inefficiency -0.34 (-0.45) -0.19 (-0.48)
X-inefficiency -0.04 (-0.34) 0.02 (0.49) 0.14 (0.90) -0.08 (-1.23)
Log # banks 0.05 (0.23) 0.01 (0.17) -0.11 (-0.92) -0.13 (-1.96)c
F statistic 1449.41a 741.70a 120.50a 693.21a
Adj. R2 0.98 0.97 0.95 0.94
# observations 45 40 57 48
Notes: t-statistics in parentheses, a/b/c significant at 1/5/10% level

Figure 11 Concentration and efficiency: panel regressions, 1995-95 and 1990, 1995-97

between competition and profits. In none of the regressions
do we find a relationship between competition and profits.
The coefficients do have the right sign, but are never signifi-
cantly different from zero. We do find, once again, a negative
connection between interest rates and profits. In addition,
there is also evidence that inflation and bank profitability are
positively related.
Is efficiency related to profits? (H4)
The efficiency hypothesis assumes a positive connection
between efficiency and profits. Since Wagenvoort and Schure
(1999) and Altunba et al. (2001) calculate the degree of inef-
ficiency the hypothesis implies negative coefficients in the
regression. The estimated equations have profitability as the
dependent variable (ROE in column 1 and ROA in column 2 of
Figure 10) and the inefficiency measures and control vari-
ables as the independent variables. In column (a) the indica-
tors of Wagenvoort and Schure are used, while in column (b)
the indicator of Altunba et al. are employed. The results are
mixed. On the basis of Wagenvoort and Schures data, the
expected negative connection between X-inefficiency and
profit does indeed show up. However, it emerges that no con-
nection exists between their measure for scale inefficiency
and profit. We also fail to find a significant relationship

73
 European banking consolidation: effects on competition, profitability,
and efficiency

Conclusion defensible, but it should be remembered that certain informa-

There was a sharp increase in the merger and acquisition tion will be lost in this way. The second simplification is that
activities of European banks during the 1990s. It is likely that cross-border activities between banking sectors are left out
this process of consolidation will continue in the coming of consideration. Since earlier studies concluded that there
years. This raises questions on possible detrimental effects of was no European market in place for most banking services,
a higher degree of concentration in European banking mar- this assumption can also be defended.
kets. Earlier research pointed to the existence of monopolistic
competition in the European banking markets [De Bandt and
Davis (2000)] and the possibility of a negative relationship
between the degree of concentration and profitability [Bikker
and Groeneveld (2000)]. However, our country-level analysis
suggests that caution is in order. For the largest possible
sample, we do indeed find some evidence for a positive rela-
tionship between concentration and profitability [cf.
Demirg-Kunt and Huizinga (1999)]. However, this finding is
not robust as it is not confirmed if data for a more recent
sample are used. Furthermore, our results suggest that there
is no connection between concentration on the one hand and
market competition on the other. We also find no evidence
that competitive conditions are related to profitability. We
only report mixed evidence for the hypothesis that efficiency
improves profits. Our data does not show a connection
between efficiency and concentration, while the relationship
between efficiency and profits strongly depends on the cho-
sen efficiency indicator.

Finally, two caveats are in order as to the nature of the analy-

sis. One problem is the limited availability of data for the E.U.
countries. Data on profitability are relatively easy to obtain,
but there is a lack of good data on concentration, H values,
and efficiency indicators. This restricts the number of years
that can be examined and makes it difficult to determine the
extent to which the results are generally applicable. Another
problem lies in the question of what exactly is meant by the
European banking market. The above analysis assumes that,
in the period under review, the banking markets in the fifteen
E.U. countries were homogenous and distinctly separate from
each other [Neuberger (1998)]. The first simplification is that,
say, the difference between the corporate and consumer
markets is not taken into account. Such an assumption is

74 - The journal of financial transformation

 Institutional

The merchant-bank
struggle for control of
payment systems

Adam J. Levitin
is an attorney in New York City

Abstract
Merchants and banks are currently engaged in a wide-ranging
struggle for control over payment systems. The conflict is
playing itself out in business practices, in banking regulation,
in corporate governance, in corporate restructuring, and in
the biggest antitrust litigation since AT&T. Yet, it is possible
that the extraordinary energy being spent in this fight is for
naught, as the growth of national bank brands, technological
developments, and innovative business models are likely to
result in a radical reshaping of the payments world. This arti-
cle reviews the factors behind the struggle between mer-
chants and banks and the strategies adopted by each, and
questions what impact changes in the payment card indus-
trys structure and the emergence of new payments technolo-
gies and business models will have on the merchant-bank
contest.

75
 The merchant-bank struggle for control of payment systems

ciation keeps part of this and remits some in turn to the issu- Market share
ing bank. The purpose of these fees is to cover the costs, 70%
60%
particularly chargeback (returns) and fraud risks. The inter-
50%
change rate is set by the network. 40%
30%

The fee level within this network is based on the interchange 20%
10%
rate; the merchant discount rate will always be the inter-
0%
change rate plus a percentage for the acquirer bank.

ct 6

ct 8
00

04
02
90

98
94

96
92

di 00

di 0
)

)
ed

ed
re 20
20

20
20
19
Interchange rates vary not on networks costs but on the

19

19

19
19

re 2
(p

(p
merchants risk profile and the level of rewards points
Personal checks Credit cards Other payment
systems
Cash Debit cards (all types)

Checks Credit cards Online (PIN) Cash
& offline debit cards
(signature)
debit cards
Cost per transaction $0.36 $0.72 $0.34 $0.12
Cost per $100 sales $0.80 $1.80 $0.80 $0.90
Source: Humphrey et al., (2003)
Figure 1 Retailer payment costs in U.S. in 2000
attached to the payment card. Thus, interchange rates are
lower for low-margin industries like groceries, but extremely
high for adult Internet sites.
The bank card associations employ a number of contractual
merchant restraints to increase card usage at the expense of
other payment systems and to allow them to charge higher
interchange rates. Firstly, merchants are forbidden from
imposing a surcharge for the use of credit or debit cards,
even though card transactions cost merchants more than
other payment systems. Secondly, merchants are required to
take all credit cards bearing the card associations brand.
Different types of cards of the same brand have different
costs to merchants premium rewards cards cost merchants
more in interchange fees than non-rewards cards. Indeed,
some card issuers account for the cost of rewards programs
in their financials as reductions in their interchange income.
Thirdly, merchants are forbidden from imposing a minimum
charge amount, although this rule is widely flouted. Fourthly,
merchants are required to accept cards at all their locations,
Figure 2 U.S. payment systems market share by dollar volume
Source: Nilson report
regardless of different business models (Internet store, main-
line retail, discount outlet). Finally, the card associations for-
bid some forms of factoring, so merchants are not always
able to take advantage of a factors superior credit-worthi-
ness and willingness to assume payment risk to obtain a
lower discount rate. Visa has additional rules that require
merchants to use its proprietary payments clearance system
and to purchase its payment guarantee services.
The net effect of these rules is to force merchants to charge
the same price regardless of a consumers payment method.
Accordingly, consumers do not take price into account in
their decision as to which payment system to use. Instead,
they decide based solely on factors such as convenience,
bundled rewards, image, and float. These factors tend to favor
bank card transactions over other payment systems. Higher
purchase volume increases the banks income on the front-
end in terms of interchange income and on the back-end in
terms of more interest, late fees, and penalties. Interchange
accounts for only 15% of MasterCard and Visa issuers reve-
nues,7 but are the engine that pulls consumers toward more
card transactions, thus increasing interest and late fees,
which account for 70% and 15% of revenues, respectively.
Thus, interchange is estimated to account for one-third of
card issuer revenues in the U.S.8

1 Levitin, A., 2005, The Antitrust Super Bowl: Americas Payment Systems,
76 No-Surcharge Rules, and the Hidden Costs of Credit, Berkeley Business Law
Journal 3:1 265, 272-73
2 Humphrey, D., M. Willesson, T. Lindblomand, and G. Bergendahl, 2003, What does
it cost to make a payment? Review of Network Economics, 2:2, 159-174
3 Association of Finance Professionals, 2005, Retail industry forum survey:
Consumer payment choices and bank relationships, key results, May
4 Merchants payments coalition, 2006, Merchants welcome congressional hearings
on secret fees charged by credit card companies, Press Release, Feb. 14
5 Haddad, A., 2006, The interchange industry is bigger than . . ., Aneaces Blog,
May 12
6 CardTrak, 2004, Card Networks Q3, Dec
The merchant-bank struggle for control of payment systems
At the core of the merchant-bank dispute is the fact that dif-
ferent payment systems have different acceptance costs for
merchants. Precise quantification of these costs is difficult
and varies by merchant, but credit cards are by far the most
expensive payment system for merchants, followed closely by
signature-based (offline) debit cards. Next come PIN-based
(on-line) debit cards, then checks, and finally cash [Levitin
(2005)]1. A credit card transaction costs a typical retailer
about six times what a cash transaction does and twice as
much as a PIN-based debit card2.
Normally, when goods or services have different costs to
merchants, the cost differences are reflected in the price
charged to consumers. Payment systems are different.
Merchants are unable to pass along the relative costs of dif-
ferent payment systems to consumers because the rules of
the major payment card networks MasterCard, Visa,
American Express, and Discover functionally require mer-
chants to charge consumers the same price, regardless of the
payment system [Levitin (2005)]. Therefore, merchants must
either absorb the cost of higher priced payment systems or
raise the cost of all goods and services to the level necessary
to cover the cost of the higher priced payment systems, but
at the expense of sales volume. This problem has been exac-
erbated in recent years as the cost of accepting payment
cards has increased, as has the number of payment card
transactions and the percentage of transactions made on
payment cards. The average cost of accepting payment cards
has increased since 2003 by at least ten percent for almost
two-thirds of retailers, and by at least twenty-five percent for
over a quarter of retailers3.
The rising cost, number, and percentage of payment card
transactions have combined to squeeze many merchants
profit margins without providing any corresponding increase
in the benefits of card acceptance. In fact, for many mer-
chants, payment card acceptance has become the fastest
growing cost of doing business. While the cost of payment
acceptance is only a few cents or dollars per transaction,
these costs accumulate quickly. As much as U.S.$40 billion
per year is involved in the U.S. alone,4 which makes the inter-
change component of the payments industry larger than the
music industry, the microprocessor industry, the electronic
game industry, Hollywood box office sales, and worldwide
venture capital investments5.
Structure and costs of bank payment card
networks
Most credit and debit cards in the United States are run on
bank-controlled networks, such as MasterCard, Visa, American
Express, and Discover. In 2004, Visa had a 53.6% market
share of the U.S. payment card purchase volume, followed by
MasterCard with 29.2%, American Express with 12.9%, and
Discover with 4.3%6. Visa and, until recently, MasterCard are
joint ventures owned by their member banks, while American
Express and Discover are owned by individual banks.
MasterCard and Visa have a 95% overlap in bank member-
ship. These networks consist of the banks that issue the cards
and have the consumer relationship and banks that acquire
the card transactions from merchants. Often the acquirer
bank will outsource the actual processing operations.
Intermediating between the issuer and the acquirer is the
network association, which performs authorization, clearing,
and settlement (ACS) services. In the case of American
Express and Discover, the issuer, acquirer, and network asso-
ciation have traditionally been the same entity.
There are several components to the cost of a bank card
transaction. When a consumer makes a purchase with a card,
the merchants account at the acquiring bank is credited with
the purchase amount less a percentage, known as the mer-
chant discount fee, typically in the nature of 100-200 basis
points, but sometimes as much as 1200 basis points for mer-
chants who present a particularly high risk either because of
low transaction volume, limited credit history, or the nature
of their business. Of the merchant discount fee, part is
retained by the acquirer bank, and part is remitted to the
network association. The remittance to the network associa-
tion is called the interchange fee, although this term is often
applied to the merchant discount rate too. The network asso-
7 Whats at stake in the interchange wars, The Green Sheet, Nov. 28, 2005
8 Patti Murphy, 2004, ATM cards + bill pay = winning play, The Green Sheet, Issue 77
04:04:02, 14, 16, April 26
 The merchant-bank struggle for control of payment systems
bank-controlled payment card systems are still in their infan-
cy and face many obstacles, including the possibility that ACH
networks will impose interchange fees of their own. In the
long-run, merchant-based systems offer the most viable non-
bank strategy. At present, though, non-bank payment sys-
tems have neither gained sufficient merchant nor consumer
acceptance to be viable alternatives to bank payment cards.
Neither opt-out nor imitation strategies are particularly
effective, because consumers want to use bank payment
cards because of convenience and float. While multi-mer-
chant non-bank payment systems hold promise for the
future, they do not answer merchants problems of increased
payment costs at present.
Opt-in strategies
Other merchants have taken if you cant beat em, join em A merchants size is the key factor in determining its pay-
approach. Some merchants co-brand with an individual bank
that is a member of a card association, such as the American
Airlines Visa or Wal-Mart Discover card. These merchants
then split a percentage of the issuers income from the co-
branded cards. Co-branding benefits the card issuer by
increasing purchase volume on the card, typically because of
a bundled rewards program involving the co-branding mer-
chants products. The difficulty with co-branding is that con-
sumers tend to carry a limited number of credit cards, so co-
branded cards compete with each other for consumer loyalty.
Other merchants go beyond co-branding, and become banks
themselves by creating an affiliated industrial loan company
(ILC). ILCs are obscure banking entities that may issue credit
cards, take deposits, and make loans, as well as transact busi-
ness for their own account. With limited exceptions, ILCs may
not offer checking accounts. ILCs are not subject to the heavy
regulation of full-service commercial banks. They are subject
to the safety and soundness regulations of the Federal
Deposit Insurance Corporation and state banking regulators,
but are not under the purview of the Federal Reserve system
or the Office of the Comptroller of the Currency.
78 - The journal of financial transformation
ILCs have recently received attention because Wal-Mart,
Americas largest retailer, has filed an application to open an
ILC in order to reduce its costs of processing payments, and
the Home Depot, Americas second largest retailer, is seeking
regulatory approval for its acquisition of an existing ILC. With
an ILC, Wal-Mart and Home Depot could process payments
in-house. Moreover, they could then join MasterCard and Visa
and issue their own Wal-Mart and Home Depot card
MasterCard and Visa cards, rather than co-brand.
Finally, as the ultimate opt-in strategy, the biggest retailers
can contemplate buying existing credit card networks. Wal-
Mart, for example, has been mentioned as a possible buyer of
the Discover network, which was formerly owned by Sears.
The opt-in strategies are workable, but not for all merchants.
ments strategy options. Co-branding is only an option for
larger merchants, and only the largest merchants have
undertaken acquisition of ILCs or can consider buying an
existing network. Similarly, although the possibility of opt-in,
imitate, and opt-out strategies gives merchants leverage in
negotiating better interchange rates with banks, the extent of
this leverage is determined by the size of the merchant. Wal-
Mart, for example, is large enough that banks care about
retaining its business. It has managed to squeeze interchange
rates from the banks lower, much like it squeezes all other
suppliers. A single local retailers individual payments strate-
gy, by contrast, is inconsequential. In some industries, mer-
chants have tried to overcome the size problem by banding
together to negotiate industry-wide interchange rates. This
leaves few business strategy options for smaller merchants
that are not in well-organized or franchised industries. The
smaller, independent merchants have, therefore, turned to
litigation and lobbying for regulatory intervention.
Merchant antitrust litigation
The credit card industry has been besieged by antitrust litiga-
tion for several years. The Department of Justice success-
fully sued to end MasterCard and Visas exclusivity rules10,
9 Bezard, G., 2004, Are merchant-controlled debit networks the next big thing?
FinanceTech, Aug. 17
The merchant-bank struggle for control of payment systems
The payments industrys fee structure is designed to avoid
commoditization because profit margins tend to be lower in
commoditized industries, since competition is solely on price.
Card companies attempt to avoid commoditization by divert-
ing competition from the obvious price points cost at point-
of-sale and, for credit cards, interest rate to bundled
rewards, which are less prone to commoditization [Levitin
(2005)]. No-surcharge rules mask the point-of-sale cost of
payment systems to consumers. Interest rates too are
masked to consumers through teaser introductory offers,
often of 0%, and inscrutable card holder agreements with
universal cross-default clauses make it impossible for a con-
sumer to understand the true interest rate on a card.
From a merchants perspective, payment services should be
commoditized. Payments are the ultimate transaction cost.
Merchants do not see the bundled rewards or credit card
interest rates and no-surcharge rules only mask point-of-sale
price to consumers, not merchants. The non-price differences
to a merchant between card brands and card types are insig-
nificant. Therefore, merchants expect competition to be on
the basis of efficiency and price. Yet, it is precisely the ability
to treat payment cards as commodities that the card net-
works rules curtail. cards are nothing more than old-fashioned store credit,
Merchant strategies to minimize payment costs
For a merchant who wishes to accept payment cards, the card
networks rules are an all-or-nothing proposition. Most mer-
chants feel like they have little choice but to accept cards
because consumers like the convenience, bundled rewards,
and float, all without a perceived cost. Therefore, many mer-
chants simply absorb the cost of accepting payment cards or
pass it on to their consumers, at the cost of lower sales vol-
umes. Many merchants attempt to minimize their payments
costs through various business strategies, litigation, and lobby-
ing for regulatory intervention. The payment cost reduction
business strategies can be categorized as opt-out, imitate, and
opt-in.
Opt-out strategies
Some merchants simply refuse to accept payment cards. This
is not a viable option for most merchants, particularly those
with e-commerce operations or large ticket items. Moreover,
card usage increases the frequency and volume of transac-
tions, which merchants do not want to surrender. Ultimately,
merchants who want to stop accepting payments cards find
themselves in a prisoners dilemma they do not want to
stop accepting cards unless their competitors do, lest they be
at a disadvantage. Other merchants accept payments cards
but attempt to steer customers toward other payment meth-
ods by offering discounts or asking customers for a specific
payment type. Card network no-surcharge rules (and state
law in several states) prevent merchants from imposing a
surcharge on credit or debit cards, but do not prevent them
from doing the economic equivalent of offering a cash dis-
count. Cash discounts are rarely used by merchants because
they are not particularly effective in affecting consumer
behavior, unlike a surcharge for credit use [Levitin (2005)].
Imitation strategies
A variant of the opt-out approach is for merchants to imitate
bank payment card systems. Thus, some merchants, like JC
Penney and Macys, offer a private label credit card. Such
accessed through a card, although sometimes a financial
institution like GE Consumer Finance is involved. Private label
credit cards are of limited appeal, however, because they only
provide a line of credit for one merchant, and consumers
loathe carrying too many cards with them. Other merchants
offer pre-paid cards, which involve an extension of credit not
by the merchant, but by the consumer.
Some merchants, including Wal-Mart, are working to develop
a broader merchant-based payment card network, modeled
on the system in Germany, where half of debit card transac-
tions are processed on a no-interchange merchant-owned
debit card system that piggybacks on interchange-free
Automated Clearing House (ACH) technology9. A company
called Debitman is attempting to develop a similar shared
network, retailed-issued PIN debit system in the U.S. Non-
10 United States v. Visa U.S.A., Inc., 344 F.3d 229 (2d Cir. 2003), cert. denied, 543 U.S.
811 (2004). 79
 The merchant-bank struggle for control of payment systems
MasterCard has gone further and has undertaken an IPO
whose unusual deal structure is driven by antitrust concerns,
as the banks attempt to limit their liability by limiting their
control over the network. The MasterCard IPO will result in a
corporation with three classes of stock: publicly-held Class A
shares with a 49% economic interest and an 83% voting
interest; bank-held non-voting class B shares with a 41% eco-
nomic interest; and bank-held Class M shares that have veto
power over major transactions. A new charitable foundation
will receive stock with 21 year alienation restrictions that
constitutes a 10% economic interest and 17% voting interest.
The new board will consist of eight independent, publicly
elected directors, the CEO, and three bank-elected directors.
Additionally, European issues will be controlled by a special
board elected by MasterCards European bank members that
can be overridden only by a 75% majority vote of the regular
board.
The MasterCard IPO is a hedging strategy. The banks will
retain an ownership interest in MasterCard that allows them
to receive a large share of its profits and veto power over
major transactions. They have also insured against major
institutional change through the charitable foundations
stock alienation restrictions. The lockup restricts new share-
holders powers and limits the likelihood of major changes at
MasterCard by putting a large chunk of the stock in the hands
of a long-term shareholder. Finally, no party is allowed to
acquire more than 15% of the public corporation. Thus, the
banks have kept functional control over the association, but
brought in outside investors to share the risk. Meanwhile, the
banks have retained their stake in Visa, the larger, more prof-
itable card association, with superior market position for
debit cards, although there is speculation that a Visa IPO
could follow if MasterCards is successful19.
Will these plans work? Yes and no. The restructuring of Visas
board and MasterCards ownership will blunt the merchants
11 Visa U.S.A., Inc. v. First Data Corp., 2005 U.S. Dist. LEXIS 34281 (N.D. Cal. Aug, 16,
2005).
12 PSW, Inc., 2004, PSW, Inc. files antitrust lawsuit against MasterCard and Visa,
Press Release, Aug. 16
13 Payment card interchange fee & merchant discount, Antitrust Litigation, 398 F.
80 Supp. 2d 1356 (J.P.M.L. 2005)
14 International Cards & Payments Council, 2006, US cards industry lawsuits cause
international concern, Press Release, Jan. 23
15 Breitkopf, D., and H. M. Jalili, 2006, Visa advances, but . . . A lawsuit looms; small
issuers gain a seat, American Banker, May 1
attack on the collusive setting of the interchange rates in
terms of prospective, injunctive relief. From a legal standpoint
it should have no effect on a determination of liability for past
behavior, damages for which could be ruinous. Yet, the
restructurings might even blunt liability for past behavior
because MasterCard and Visa will appear to have defanged
themselves.
Neither associations plan addresses the antitrust suit com-
plaints about merchant restraints that insulate the inter-
change rate, no matter how it is set, from the pressures of the
free market. MasterCard and Visa have focused on the graver
threat, but not the more likely threat. A successful attack on
the collusive setting of the interchange rate would be the
death knell for the card associations, because it would take
away the networks ability to set their services prices. For
that very reason, a court would think twice about ruling
against MasterCard and Visa. It is only with great caution that
a court would grant a decisive ruling against such a corner-
stone of the American economy.
In the case of merchant restraints, though, a court would feel
no such trepidation. MasterCard and Visa can survive without
the merchant restraints, as shown by MasterCards unilateral
rescission of its no-surcharge rule in Europe and the continu-
ing (although lower) profitability of MasterCard and Visa in
Australia after the Reserve Bank of Australia banned several
merchant restraints. Accordingly, the suits aimed at mer-
chant restraints have a better chance of succeeding than
those that focus on the collusive setting of interchange rates.
The card associations restructurings provide no protection
against merchant restraint suits.
Merchant-initiated antitrust litigation is ultimately a business
strategy to reduce payment acceptance costs. Merchants
goal is not the elimination of the payment cards industry, just
a lowering of payment costs. Litigation is a leverage point
that opens the door to negotiated settlements. If MasterCard
16 MasterCard 10-Q, Mar, 31, 2006
Manfred, L. 2005, The Kansas City FED conference: Another skirmish in the inter-
change controversy, First Annapolis Navigator, May
Dagan, R, 2006, Chevrot ha-bituach yishaveiku kartisei ashrai (Insurance compa-
nies will market credit cards), Haaretz, May 11 (Israel)
17 Breitkopf, D., and I. Lindenmayer, 2006, Visa reorganization vote near; where
does Bank of America sit? American Banker, Apr. 27
18 Nilson Report, 2005, Visas 1,700 principal members vote proportional to their
Visa USA sales volume, 845, Nov
The merchant-bank struggle for control of payment systems
and American Express and Discover have since sued for dam-
ages from the rules. First Data Corporation has challenged
Visas requirement that all Visa transactions be authorized,
cleared, and settled on Visas proprietary system11. PSW Inc.,
an aggregator for Internet merchants, has sued MasterCard
and Visa over the setting of chargeback fees12. And mer-
chants have brought a variety of antitrust litigation, most
notably a suit brought by Wal-Mart, Sears, and other retailers
alleging that MasterCards and Visas Honor All Cards rule, as
applied to debit cards, was illegal. The rule required mer-
chants that wished to accept MasterCard and Visa credit
cards to also accept MasterCard and Visa offline (signature)
debit cards, which are more expensive than online (PIN) debit
cards. MasterCard and Visa settled for a total over U.S.$3 bil-
lion, plus a partial rescission of the rule, the largest antitrust
settlement in history.
Numerous antitrust suits have been filed relating to inter-
change rates13. These antitrust suits have several basic
charges. Firstly, they contend that the member banks of
MasterCard and Visa are engaged in collusive price fixing in
the setting of interchange rates. Secondly, they allege unfair
business practices in the form of the various merchant
restraints. Thirdly, they allege the bundling and tying of dif-
ferent products (premium and regular credit cards; payment
clearing and payment guarantee services). And, finally, they
allege attempted monopolization because the merchant
restraints increase the card associations market share at the
expense of other payment systems. MasterCard and Visa are
the suits main targets, although American Express is a defen-
dant in a few.
The merchant litigation and regulatory threats to the pay-
ment card associations and member banks are serious. They
are the biggest and most important antitrust litigation since
the governments cases against AT&T, IBM, and Microsoft. As
much as U.S.$100 billion in damages and the very survival of
MasterCard and Visa is on the line14. An adverse judgment
could bankrupt the card associations, and injunctive relief
could prevent their future operations.
19 Kelleher, J. B., 2005, Visa can sit out MasterCards IPO for a while, Reuters, Dec. 9
The member banks are on the line too. The merchant suits
name the leading member banks as defendants, alleging a
conspiracy by the banks to fix prices through the card asso-
ciations. Nor will the card associations corporate form neces-
sarily provide the banks with protection. Visas by-laws allow
it to assess its members for its litigation losses15. MasterCard
surrendered its assessment rights as part of its IPO, but the
merchant litigation has claimed that this was a fraudulent
conveyance in light of MasterCards potential insolvency.
Watching the struggle play out from afar are the various
American bank and competition regulators. Internationally, a
movement is afoot for intense regulatory scrutiny of credit
card networks. Australia led the way in 2003 with a sweeping
series of ongoing reforms. These reforms banned many of
the card networks merchant restraints, and interchange fees
fell by nearly half. Regulatory authorities in Argentina,
Brazil, the E.U., Columbia, Hungary, Israel, Mexico, New
Zealand, Norway, Poland, Portugal, South Africa, Spain,
Sweden, Switzerland, and the U.K. are reviewing interchange
fees and related practices with an eye toward possible regu-
lation16. In the United States, there is no government agency
with authority to regulate interchange rates or card associa-
tion rules, although the Department of Justice could bring
litigation. Even if merchant-initiated litigation fails, regula-
tory changes or government-initiated litigation could accom-
plish similar ends.
Bank reactions
The bank card associations and their member banks have
reacted to the litigation threat in different ways. Visa U.S.A.
has reorganized its corporate governance structure to deflect
collusive price fixing charges. Its new board has increased the
number of independent directors, who will have sole authority
to set interchange rates17. Rule-making, which would cover
merchant restraints, however, continues to be the purview of
the full board, where the banks retain a significant presence,
and other issues are reserved solely for the bank directors18.
Visas reorganization appears to be aimed solely at blunting
claims of interbank collusion in interchange rate setting.
81
 The merchant-bank struggle for control of payment systems
share in terms of credit card outstandings, far ahead of
American Express, at 9.8%, and Discover, at 6%23. It would
also deprive MasterCard and Visa of seven and twenty per-
cent of their business, respectively [Bauerlein (2006)]24.
There has also been speculation of a merger between Bank of
American and Morgan Stanley. Such a merger would not only
give Bank of America the major investment banking presence
it lacks, but also control of Discover.
JPMorgan Chase has put itself in a similar position to Bank of
America. It has leading presences on the issuer and acquirer
sides. JPMorgan Chase is the second largest issuer in the
country and holds a majority interest in the nations largest
acquirer, Chase Paymentech Solutions, a joint venture with
FDC. Besides its minority interest in Chase Paymentech
Solutions, FDC maintains other significant acquirer and pro-
cessing operations. FDC owns the STAR debit card network,
and although it does not have a credit card issuer presence,
it is rumored to be another possible purchaser of Discover.
FDC has also been developing a variety of non-card based
payment systems, including a partnership with Wal-Mart for a
real-time check verification system. Finally, if FDC wins its
litigation challenge to Visas requirement that all transactions
be authorized, cleared, and processed through its proprietary
system, FDC could easily increase its lower cost on-us trans-
action capability and set itself up as a rival ACS system.
If major players like Bank of America, JPMorgan, and FDC
jump ship, the question will become what the other large
banks will do. Will Citibank, Washington Mutual, Wells Fargo,
HSBC, Wachovia, and Capital One remain in MasterCard and
Visa, or will they too seek to set up as independent networks?
There will certainly be a temptation for the big boys to set up
as independents, if only for prestige and control. Capital
Ones 2005 purchase of Hibernia, a sizeable retail bank, and
its reported interest in purchasing another retail bank indi-
cate that it too may be setting itself up to have the merchant
and consumer relationships necessary to become an inde-
pendent network.
82 - The journal of financial transformation
On the other hand, there is tremendous brand value to
MasterCard and Visa, and, at least in the case of Bank of
America, the profits from creating an independent network
are relatively small [Bauerlein (2006)]. The answer may
depend, in part, on the manner in which the antitrust litiga-
tion proceeds. If the big banks desert MasterCard and Visa, it
will increase the relative power of the smaller banks, as well
as the relative power of any big bank that remains in these
networks. Already, Bank of America has lost its Visa board
seat in Visas board reshuffling, while small issuers have
gained a seat, and the MasterCard IPO is an opportunity for
banks to increase their relative control beyond their current
sales volume-related control share. On the other hand, small
banks will more likely become acquisition targets of big banks
with independent networks that seek to expand their net-
works reach. Although new, independent card networks
could impose the same merchant restraints as the existing
networks, their existence would reduce the market power of
MasterCard and Visa, which would in turn help the associa-
tions in the antitrust litigation.
Can the bank card associations offer more than financial
services?
The energy spent on the struggle over payment costs may
not matter because the scope of the bank-merchant relation-
ship could change to allow new pricing parameters and a
mutually beneficial relationship. The expansion of electronic
payments has created the potential for banks to provide
more than financial services. With the growth of electronic
payments, banks are poised to provide information services
to merchants as well.
Consumer data has tremendous value for merchants.
Properly analyzed, it can be a highly effective marketing tool.
Paper payments do not readily lend themselves to data min-
ing, but electronic, card-based payments do. To capitalize on
payments data, however, banks and merchants must adopt
cooperative strategies. The banks are in the best position to
capture and mine the data, but the data is primarily valuable
to the merchants. This situation creates an opportunity for
20 Nilson Report, 2005, Issue 827, Feb
21 Nilson Report, 2005, Issue 831, Apr
22 United States v. Visa U.S.A., Inc., 344 F.3d 229 (2d Cir. 2003), cert. denied, Visa
U.S.A., Inc. v. United States, 543 U.S. 811 (2004), Mastercard Intl, Inc. v. United
States, 543 U.S. 81 (2004).
23 Nilson Report, 2006, Issue 850, Feb
The merchant-bank struggle for control of payment systems
and Visa can defeat the life-or-death interchange rate setting
attacks, they will have room to settle the merchant restraint
suits because the restraints are not vital to the viability of the
card associations, just their level of profitability and market
share. A settlement might be expensive, but it is also an
opportunity for the banks to co-opt merchants into the card
associations. Visa has already made a move in that direction
by appointing a board member of one of the merchants that
has initiated litigation as an independent director.
MasterCards IPO could also open the door for merchant
involvement in the card associations. There is nothing that
prevents Wal-Mart, Microsoft, Google, or Verizon from pur-
chasing a large stake in MasterCard as part of the IPO, as
could individual banks looking to increase their influence in
the association.
Does any of this matter?
Do the big banks need the card associations?
The struggle between merchants and banks over payments
costs has spilled over into business practices, litigation, cor-
porate governance, and corporate restructuring. Does any of
it really matters in the long run? Other developments in the
banking industry, the changing business landscape, and the
emergence of new payment technologies and business mod-
els might well make the energy spent on the interchange
struggle all for naught.
Changes in the card industry mean that the interests of indi-
vidual banks, particularly large banks, are no longer aligned
with the card networks. The Gramm-Leach-Bliley Act of 1999
allowed for greater affiliation between different types of
financial institutions and facilitated the establishment of
banks with national reach and brand recognition. The large
banks are eager to exploit their new brand value and are reluc-
tant to put the card associations brands ahead of their own.
There has also been tremendous consolidation in both the
issuer and acquirer markets, which has not only contributed
to brand building but also positioned some banks to be able
to break off from MasterCard and Visa and set up indepen-
24 Bauerlein, V., 2006, Bank of America might create credit-card processing net-
work, Wall Street Journal, Apr. 26, B2;
Mildenberg, D., 2006, Bank of America ponders card to rival giants, Charlotte
Business Journal, April 14
dent payment networks. Currently five banks Bank of
America, JPMorgan Chase, Citigroup, Washington Mutual,
and Capital One account for 65% percentage of card issu-
ance, and the top ten issuers account for 85%, as compared
to 36% for the top five banks and 54% for the top ten banks
in 199520. A similar story has emerged on the acquirer side.
First Data Corporation is involved with over half of the
nations card transactions, both directly and through joint
ventures and alliances, while Bank of America accounts for
another seventeen percent of the acquirer market21.
The development of national bank brands and the consolida-
tion in issuer and acquirer markets has set the stage for
larger banks to desert MasterCard and Visa and set up their
own, independent, on us payment networks. The ground-
work for bank desertions has also been laid by antitrust litiga-
tion by the Department of Justice that forced MasterCard
and Visa to rescind their exclusivity rules22. These rules pre-
vented issuers of MasterCard and Visa cards from issuing
American Express or Discover cards. The end of exclusivity
means banks are not tied to dealing with one card network,
thus reducing bank loyalty to particular networks.
MasterCards IPO will further reduce bank incentives to sub-
ordinate their brand to the card associations. Accordingly, if
the card associations litigation outlook is unpromising, banks
will desert them for greener pastures.
Already Bank of America, FDC, and JPMorgan Chase have
positioned themselves to become independent networks on
the model of American Express and Discover. In 2004, Bank
of America purchased National Processing Inc., the nations
second largest acquirer. It followed up this acquisition by
purchasing MBNA, the third largest credit card issuer. These
acquisitions, which followed Bank of Americas 2003 pur-
chase of Fleet Bank, another large issuer, have resulted in
Bank of America becoming the largest card issuer and the
second largest acquirer in the country, which gives it the
access to both consumers and merchants necessary to create
an independent network. If Bank of America were to split off
from MasterCard and Visa, it would have a 20.2% market
83
 The merchant-bank struggle for control of payment systems
arrangements, though, PayPal commits to purchase the
receivables as an output contract.
Transactions on PayPal can be made in a number of forms,
including payment cards. The consumer never sees that
PayPal is involved, unless payment is made with a PayPal
account, and the merchant never sees the consumers pay-
ment information. PayPals intermediary status creates a
level of financial privacy and security that makes it an attrac-
tive system for many consumers, although there are issues
regarding what law governs consumers rights in PayPal
transactions. Merchants are willing to use the service because
PayPals fees are lower than that they would pay in a tradi-
tional acquirer relationship.
By allowing PayPal to stand between them and payment card
networks, merchants are also able to hedge the costs of high
and low cost payment systems and of premium and regular
payment cards. Rather than paying higher rates for transac-
tions on American Express cards than on MasterCards or on
Signature Rewards Visa cards than on regular Visa cards,
merchants pay PayPal the same rate for all cards. In this man-
ner, PayPal allows merchants to circumvent the impact of the
card associations requirements that the merchants accept
all cards if they accept any and that they accept them at all
locations.
The first key to PayPals business model is that it presents a
lower credit risk than the merchants its services. PayPal has an
extensive credit history, some of the lowest fraud rates in the
industry, and an enormous sales volume. PayPals low credit
risk allows its acquirer, Wells Fargo, to offer it an extremely
favorable discount rate. The second key to PayPals business
model is its funding mix. PayPal lets consumers use a wide
array of payment methods, some of which have very low cost
to PayPal and some of which have high cost. PayPal, however,
charges merchants the same fee regardless of the means of
transaction. PayPals funding mix allows it to accept lower
profit margins on credit card transactions because of the
higher profits it makes on ACH and bank account transactions.
84 - The journal of financial transformation
How PayPals move into brick-and-mortar processing will
work is an open question. PayPal offers an option for mer-
chants to receive non-Internet payments via a virtual termi-
nal, for which it charges a small monthly fee. It may well be
that PayPal remains best suited for e-commerce solutions for
small businesses rather than for the general marketplace. To
the extent that PayPal attempts to expand its brick-and-
mortar presence or the banks eye the e-commerce market,
PayPal will come into more direct competition with banks.
Even if PayPal is unable to expand effectively beyond e-com-
merce payments, it has snatched away a developing sector of
the payments economy from the banks by offering merchants
a payments solution at a lower cost than the traditional
acquirer relationships. The merchant-bank struggle over con-
trol is ultimately about cost, and PayPal demonstrates that
there is room for a restructuring of payments costs through
innovative business models like credit risk arbitrage through
factoring.
Innovation and acquisition of innovation by the
card networks
Of course, the card networks themselves develop new tech-
nology in-house and buy-out competitors and promising
start-ups. The card networks have significant financial ability
to purchase potential rivals and thus control the development
of technology. If litigation costs drain the card networks
resources, it will be harder for them to compete on the tech-
nology front.
A major advantage the bank networks have against new
would-be rivals is the high costs of creating a dual-sided net-
work. It is not enough to sign up merchants or consumers. The
participation of both is needed to make a successful network,
and merchants are reluctant to sink costs into participating in
a new network if consumers are not demanding to use it and
vice-versa. If technology makes the interchange/clearing
house function of the card networks less vital or if it allows for
cheaper formation of dual-sided consumer and merchant net-
works (as the Internet already promises to do), then the card
The merchant-bank struggle for control of payment systems
banks to expand their supporting roles for merchants. Banks
could provide not only payment services, but also information
services via targeted advertisements on billing statements,
direct mail campaigns, or targeted rewards offers. When
banks and merchants partner to analyze consumer data, as
they already do in co-branding and private label credit card
arrangements, they can produce highly effective marketing
campaigns that increase advertising value. The question is
whether banks can successfully expand this type of partner-
ship to general purpose credit cards. Visa looks to be moving
in this direction through the Visa Incentive Network, a pro-
gram that allows more tailored discounts and promotions to
cardholders based on cardholder behavior.
To be sure, there are numerous business and regulatory chal-
lenges, particularly data privacy concerns, that banks will
have to address if they are to move into the information ser-
vices area. Nonetheless, the inclusion of new, bundled finan-
cial and information services would reshuffle pricing in the
merchant-bank relationship. Increasing the size of the pie to
be divided among merchants and banks could defuse the
merchant-bank struggle, at least temporarily.
Will technological developments mean merchants have
more options?
Perhaps most crucially, technological developments are likely
to recast the merchant-bank dynamic. Speculation on the
state of payment technology in five years, much less a
decade, is little more than augury, but it is hardly farfetched
to envision ACH networks being seamlessly integrated with
PDAs, i-Pods, and cellular phones. The number of ACH trans-
actions has been rapidly growing and wireless technology
allows access to most consumer transactions.
Going hand-in-hand with the development of new payments
technology is the development of new payments competitors
from the non-bank sector. Aggregating services like
Peppercoin allow merchants to reduce the flat-fee portion of
interchange rates by aggregating several payments from a
single consumer into one larger one. Such services make
small ticket merchants more amenable to card transactions.
Internet-based payment systems like AliBaba, 2Checkout,
and e-Bay-owned PayPal provide payment services for mer-
chants without merchant banking accounts, and Google is
developing a payment system. Even within the banking
world, companies like FDC are developing technologies for
real-time debit and check or ACH transactions that do not
depend on the existence of the card networks. Microsoft
could easily join the fray, while telecommunication and cable
networks are in some ways well-situated for entering the
payments world, as they already have portal access to mer-
chants and consumers and national data transfer and pro-
cessing networks.
The case of PayPal
The example of PayPal illustrates how non-bank parties are
using technology to step into the merchant-bank struggle
and offer improved packages of services for both consumers
and merchants at a lower cost than the traditional merchant-
bank-consumer relationship. PayPal is not a bank. It began as
an online payment service that allowed consumers to make
transactions using PayPal accounts. That is, the merchant
was accepting PayPals credit risk, not the consumers, and
merchants did not need to be equipped to accept payment
cards to accept PayPal payments. Since then, PayPal has
expanded to offer a full array of merchant payment services
in all locales.
PayPal offers merchants a variety of services from lines of
credit (through GE Money Bank) to accounting. At its core,
though, it is a credit arbitrage operation. PayPal arbitrages its
own credit risk to offer high credit risk merchants lower dis-
count rates than they could otherwise obtain.
The model of a PayPal transaction is that when a consumer
makes a purchase from a PayPal serviced merchant, the con-
sumer actually pays PayPal, who then relays the payment on
the merchant for a fee. PayPal is not an acquirer. Rather, it
operates like a factor, purchasing receivables and collecting
them itself, through acquirer banks. Unlike many factoring
85
 The merchant-bank struggle for control of payment systems

networks will lose much of their advantage. Instead, they will lot like landline telephone companies that have clung on to a
be forced to compete with a broader field of payment options core business, but are becoming obsolescent in the face cel-
and accept smaller profit margins. lular and VoIP technology.

This is not to say that the card networks will not still have Conclusion
huge advantages. They have existing business relationships Antitrust suits present a significant short-term threat to
with merchants and consumers, and the trade cachet of their MasterCard and Visa and are spurring the reshaping of the
names is of tremendous value in getting the market to accept U.S. payments industry. In the longer term, however, the anti-
a new payments technology. Still, technological develop- trust threat may not particularly matter, as the growth of
ments might ultimately present perhaps the greatest threat national bank brands has created the possibility of large
to banks control over payment networks. banks splitting off and forming their own independent pay-
ment networks, while developments in payments technology
Innovation has long been a problem for payment card compa- and Internet commerce have created a competitive threat to
nies. There have been relatively little changes in cards over MasterCard and Visa. The ultimate outcomes of these devel-
the past quarter century. Some improved security features opments are uncertain, but one thing is not: the payments
have appeared, and PIN-based debit cards have emerged, to industry will look very different in a decade.
be sure. The essential concept and technology has remained
the same, however, since 1979, when electronic dial-up termi-
nals and magnetic striped cards that made payment cards an
electronic payment system and offered noticeably decreased
transaction time25. The card companies have been trying to
change this of late, with the introduction of contactless cards
that decrease transaction time and increase spending. It is
unlikely that contactless cards will be sufficient, though, for
merchants to feel that they are getting enough new value out
of card acceptance to justify increased card acceptance costs.
Unless MasterCard and Visa can offer merchants increased
payments value, either through technology or through bun-
dled information services, their businesses will start to look a

25 Aneace Haddad, 1979: Year of the Last Major Payment Card Innovation? ANEACES
86 - The journal of financial transformation
BLOG (Mar. 30, 2006).
 Institutional

The credit rating

agencies and their
credit ratings

Herwig M. Langohr
Professor of Finance and Banking, INSEAD1

Abstract
This paper is based on an address given to the Bond Market
Association in Paris in February 2006, an outsiders perspec-
tive on the credit rating agencies (CRAs) and their credit rat-
ings. It examines the CRAs valued-added, some of the chal-
lenges they face today, and the experience of other codes of
conduct. I focus on what I believe is the striking value-added
of the agencies to three of their direct constituencies: the
issuers (the purchasing clients), the investors (the main users
of credit ratings), and the shareholders.

1 The author thanks Rupert Atkinson, Managing Director at Morgan Stanley, and I acknowledge the following sources of data used in this paper and the figures:
Patricia Langohr, Professor of Industrial Organization at ESSEC, for many valuable Thomson Datastream, Financial Times financial statements, Moodys, S&P 87
comments on previous drafts of this paper, and Arindam Chatterjee (Insead MBA CreditPro.
2005) for the competent numerical solutions and computations of France
Telecoms default probabilities and related metrics. All errors are mine.
 The credit rating agencies and their credit ratings

per cent in July 2002.
Something else that was critical to creditors happened con-
currently. The value cushion of France Telecoms assets was
deflating. The ratio of France Telecoms market value of assets
to the book value of its debt the value cushion per Euro of
debt, or cushion ratio became very dynamic. This ratio had
reached a comfortable peak of 4.2 by 31 March 2000. But
then, in just four months, it dropped dramatically to 2.1 by 31
July. It is worth noting that this happened two years before
Moodys two-notch in June 2002, which, according to Michel
Bon, supposedly triggered FTs crisis. The ratio continued its
downdrift uninterruptedly from there. It hit the sensitive floor
of 1.0 by 31 March 2002 and made a hard landing of 0.5 on 30
September. Fortunately, it quickly bounced back to start a
subsequent slow and gradual recovery.
Figure 2 illustrates that the ratings first anticipated and then
tracked the path of that critical ratio. Once the ratio had
reached its trough, the ratings stabilized, for 21 months skirt-
ing alongside the below investment grade level. Until the
trough, the CRAs exercised a moderating influence on man-
agement, first anticipating, then feeding back to management
that it was entering a dangerous path. But then, at a critical
juncture, the CRAs direction shifted from moderating man-
Annual volatility
140%
120%
100%
80%
60%
40%
20%
0%
8
agement to moderating the markets. Interestingly, the rating
never went through the investment grade floor, even though
several measures suggested it should.
One such set of measures are default probabilities based on
market prices or mechanical credit scores. They are market
credit spreads (Figure 3), structural Merton type models
(Figure 4), or Altman Z-scores types of models. These all
hinted that from June 2002 through March 2003 France
Telecoms near default probability was around 50 90 percent
(depending on the metric used).
Another market measure is France Telecoms net market
worth, the implied market value of its assets minus its default
point. The former became negative during the third quarter of
2002, as Figure 5 shows. The light blue area beneath the zero
line is France Telecoms debt due within a year, and the short-
fall in net worth is the negative dip in 2002.
Figure 6 shows a last indicator of the path, and the extremes
of market reaction to France Telecoms fortunes: the market
value of the put option on France Telecoms assets that the
companys creditors implicitly shorted. This put option was
almost worthless until April 2002. Then, six months later,
when the time-discounted value of France Telecoms debt was
about 112 billion, it shot up to about 51billion, reducing the
overall value of France Telecoms debt by about 54 percent.
The debasement of the debt rapidly and almost completely
disappeared within six months.
In order to make the different market measures of default
probability as comparable as possible to France Telecoms
long-term issuers rating, consider the following. Invert the
traditional ordinal scale and map it on the cardinal scale of
the average expected default frequency that corresponds to

98

99

00

01

02

03

04
r0

the ordinal ratings. Figure 7 plots the result from 1997

r9

r0
r0

g
g
c

c
c

au

ap
ap

ap
de
ap
de

au

de
de
au

Volatility of Equity (Annualized) through 2004. The fundamental credit rating cycle shows
Asset Volatility (From C program)
similar contours to the previously shown market implied
Figure 1 France Telecoms Black-Scholes asset and equity return volatility (1997-
default probabilities. But there is one distinctive difference. It
2004) is considerably attenuated, in three ways. Firstly, it starts

2 France Inc. is fuming at top rating agencies, Wall Street Journal, 20 November
88 - The journal of financial transformation
2002.
 The credit rating agencies and their credit ratings

Fundamental credit ratings: weather or

Aaa
Aa1
weathermen?
Aa2 In the CRA industry, France is infamous as the country where
Aa3
issuers complain more than anywhere else that CRAs create
A1
A2
bad weather, rather than being the weathermen who report it.
A3 In the Wall Street Journal Europe, Alcatel SA CEO Serge
Baa1
Tchuruk likened the agencies to pyromaniac firemen, while
Baa2
Baa3
Vivendi Universal SA CEO Jean-Ren Fourtou called them
executioners, and France Telecom SAs former CEO, Michel
Bon, said an unjustified downgrade by Moodys helped initi-
5

4
/0

/0

/0
/9

/9

/9

/0

/0
/0

09
02
07

06
09
06

03
12

12

ate a debt crisis that cost him his job2.

Figure 2 France Telecom: Moodys long issuer rating (1995-2004)
However, the fact of the matter is that the 19952004 rating
cycle of France Telecom illustrates exactly the opposite of
Redemption yield what Michel Bon claims. This cycle is a case of rating actions
12%
and inactions demonstrating great moderation, and of ratings
10%
8% setting themselves apart from credit spreads and changes in
6% them. It shows credit ratings conveying a forward-looking
4% perspective and degree of anticipation akin to the traditional
2%
perspective of bank credit committees. These committees had
0%
to gauge the consequences of the lending bank being exposed
9

4
/0

/0

/0

/0

/0

/0

/0

/0

/0
/9

/9

/0

/0

/0
/0

/0

/0

09
05
01

09

09
05

05
09

01

01

09
09
05

05
05

01
01

to the borrower over the whole lifetime of the loan. For medi-
FT 1993-2006 6.25%
Equivalent Benchmark Yield um- to long-term lending, the perspective taken was unavoid-
Credit Spread ably a long-term one.

Figure 3 France Telecom 1993-2006 6.25% and its credit spread (1999-2004) The bond trader tends to focus on the arrival of new informa-
tion. Anticipating this correctly is critical for dealing purposes,
regardless of how transient the information will be once it
EDF arrives. While forward-looking in his pricing decisions in the
0,9
0,8
bond market, the traders perspective is essentially short-
0,7 term.
0,6
0,5
0,4 Like many of its competitors, France Telecom was in turmoil. It
0,3
0,2 over-levered itself to finance acquisitions, and continued to
0,1
0
borrow heavily from June 2000, after the market value of the
assets in which it had invested started going down a few
8

98

99

00

01

02

03

04
r0
r9

r0
r0

g
g
c

c
c

au

ap
ap

ap
de
ap
de

au

de
de
au

Ratings (MKMV:Cardinal) months earlier, accelerating the downturn in its equity. Figure
Default Probability (C) [Assumed Normal] (Equation 13) 1 shows France Telecoms asset and equity volatility. Both
moved in tandem until June 2000, when equity volatility
Figure 4 France Telecom: Black-Scholes default probabilities (1999-2004) started diverging upwards from asset volatility, to about 120

89
 The credit rating agencies and their credit ratings

behavior the reasons for which might, in fact, have been

250000
excellent. It was then up to France Telecom management to
200000

150000
integrate its awareness of risk-shifting activities in optimal
100000 decision-making.
50000

0 Briefly, ratings provide management and boards feedback

-50000 about the long-term implications of the risk stance they main-
-100000 tain or alter. This long-term perspective, relative to the short-
8

98

99

00

01

02

03

04
r0
r9

r0
r0

term perspective of bond spreads, shows up in the compari-

g

g
g
c

c
c

au

ap
ap

ap
de
ap
de

au

de
de
au

Implied Market Value of Asset (BS) son between the average annual volatility of ratings versus
Default Point (C) (Moodys Definition)
Market Net Worth bond yield implied ratings. Figure 8 tabulates comparative
Figure 5 France Telecoms default points and market net worth (1997-2004)
average annual volatility statistics for 19992002.

This long-term perspective on a borrowers downside risk is

Euro Millions nothing new. Years ago, before disintermediation, commercial
150000
banks used it. They incurred the costs of highly labor-intensive
100000 credit diligence, charging the borrower for it a little bit in
50000 commission, a little bit in spread. Nowadays, commercial
0 banks for a variety of reasons have withdrawn from long-

-50000
term lending to corporations. The bond market does that now.
The CRAs have stepped into the credit diligence vacuum that
-100000
the commercial banks left, conducting in their place the costly
8

98

99

00

01

02

03

04
r0
r9

r0
r0

g
g
c

c
c

au

ap
ap

ap
de
ap
de

au

de
de
au

PV(X)
credit risk diligence on these bonds, and they charge the bor-
Market Value of Liabilities (Implied) (A) rowers for it in the same way that the commercial banks did
Put Price
on a commission basis.
Figure 6 France Telecoms debt implied short put market value (1997-2004)

Nowadays CRAs position an issuer on the long-term default

risk spectrum. Figure 9 shows the fine rating class distribu-
EDF Moodys ratings tions of issuers in the four major regions of the world on 30
0,20%
0,18% Baa3
0,16%
Baa2
0,14% Moodys Bond yield-
0,12% Baa1 ratings implied ratings

0,10% A3 Rating changes 25% 91%

0,08% A2
Large rating changes (more than 2 notches) 7% 43%
0,06% A1
Rating reversals 1% 76%
0,04% Aa3 Memo item: average number of rating 1.2 4.5
0,02% Aa2/Aa1/Aaa changes over 12 months for each issuer
0,00% that experiences a rate change
8

98

99

00

01

02

03

04

Source: R. McDaniels, President of Moodys, Annual Meeting of the IOSCO Panel

r0
r9

r0
r0

g
g
c

c
c

au

ap
ap

ap
de
ap
de

au

de
de
au

on the Regulation of Rating Agencies, Seoul, 17 October 2003

Figure 7 France Telecom: Moodys ordinal and cardinal rating histories (1997-
2004)

90 - The journal of financial transformation

 The credit rating agencies and their credit ratings
16%
14%
12%
10%
8%
6%
4%
2%
0%
Emerging Markets (total rated: 659) Europe (total rated: 1010)
Figure 9 Four regions S&P related corporate issuer by rating class as of June 30, 2005
going up sooner but climbs more gradually. Secondly, it
reaches a plateau of relatively high default probability but it
never goes through the roof. Thirdly, it declines gradually, not
abruptly. In other words, rating cycles are a moderating fac-
tor, almost like central bank interest rate movements.
Fundamental credit ratings, in other words, aim to be weather-
men, not weather makers. They tend to keep management on
a leash when it risks running ahead of what is sustainable.
They also tend to tame markets when they overshoot during
periods of irrational depression.
The CRAs value-added
The value-added of CRAs to the issuers
How valuable is all of that to issuers who pay the ratings bill?
Corporate treasurers are sometimes quick to complain that
companies only incur these costs because they are forced to,
and that credit ratings are worthless to the company. Is this
really so?
Let us consider what the France Telecom case illustrates, as it
is an excellent example. In the face of market implied ratings
that rated France Telecom as junk, the CRAs fundamental
perspective allowed them to maintain France Telecoms invest-
ment grade status. This moderating stance was a comfort to
North America (total rated: 3198) Asia (total rated: 715)
France Telecoms new management team when it was working
hard to see the bond markets opening again for France
Telecom in the fall of 2002. Ratings thus assess the issuer
from a fundamental measuring perspective, rather than from
a cyclical taste-for-risk one. They endeavor to anticipate an
issuers relative long-term resilience and staying power, rather
than express a view on the attractiveness of its bond prices.
Conversely, when the CRAs started to anticipate structural
weakening in France Telecoms creditworthiness, because of a
complex interaction of different forces, they did not hesitate
to downgrade gradually, thereby acknowledging that France
Telecom was migrating from being a low-risk issuer to becom-
ing a high-risk one. It was not the notching down of the rat-
ings that changed France Telecoms risk profile; it was France
Telecoms environment and expansion strategy, and the way
they were financed. The rating changes were sending a series
of valuable warning signals to France Telecoms CEO and
board of directors. These were not signals about the appro-
priateness of France Telecoms business conduct, nor about
the pricing of its bonds. They were signals about the long-
term implications of its approach to its business development
and financing. That the ratings went down did not imply that
France Telecoms business conduct somehow became bad. It
only meant that France Telecom was involved in risk-shifting
91
A3 aa1 a2 3
B Ba aa Ba1 a2 3
B B Ba B1 B2 3 C
B a-
Ca

The credit rating agencies and their credit ratings

80 observe. So we are obliged to focus on Moodys.

Default
70
rate %
60 For the period 200004, Moodys reported average ROA of
50
over 45 percent per year and average growth in EPS of

?
40
around 25% percent per year. Through 2005 it repurchased
30
20
stock worth about U.S.$1.5 billion and reached stock market
10 capitalization of around U.S.$18 billion, more than quadrupling
0 its U.S.$4 billion IPO value. Moodys is a real free cash-flow
1 year generating engine, and financial analysts describe it as one of
Rating scale 5 years
the best performing stocks in the business services/publishing
10 years
sector.
Figure 10 One-, five- and ten-year average issuer weighted-cumulative default
rates by rating category (1983-2004)
It is unclear to what extent Moodys performance is typical of
ordinal rating scales in cardinal expected default frequencies, a CRA. Figure 11 shows the stock price evolution of Fimalac,
which is similarly exponential for the same reasons. Is the McGraw-Hill, and Moodys, and some indexes from October
highly non-linear path the most useful one for bond investors? 2000 through December 2005. Is Moodys credit rating busi-
It is a useful question, and the CRAs should give it serious ness really outperforming Fitch (a business line of Fimalac)
80

70

thought before dismissing it. and S&P (a business line of McGraw-Hill)? Or are Fimalac and
60

50
McGraw-Hill internally reinvesting the free cashflows that
The value-added of CRAs to shareholders their equally well-performing credit rating business gener-

?
40

It is impossible to dismiss the value that CRAs add to their

30
ate?
shareholders as a relevant topic for discussion about the role
20

of CRAs. In corporate finance we teach that it is hard to gener- Looking at Moodys stock market history raises some interest-
10

ate sustainably valuable free cash flows that translate as

Aaa
Aa1
Aa2 Aa3
A1
A2
A3 10 Years
ing questions. Are Moodys extraordinary shareholder results
Baa1
Baa2

shareholders value-added without competitive products and just a temporary consequence of the demand for ratings
Baa3
Ba1
Ba2 1 Year
Ba3
B1
B2
B3
Caa-

services that satisfied clients are willing to purchase at a good expanding at a speed that supply cannot match? Is this mar-
price. Growth in revenues and in shareholder value could thus velous performance a competitive result of significant and
be key indicators of CRAs value-added. And that growth has sustainable comparative advantage? Does it represent a rent
been terrific and highly profitable, as publicly available data accruing to a few oligopolistic players protected behind barri-
suggest. ers to entry? Are these barriers natural or are they artificial,
the consequence of regulations that protect incumbent
Aggregated credit rating revenues of Fitch, Moodys, and S&P CRAs?
grew at a compounded annual growth rate of 14.9% during
19992004, reaching U.S.$3.9billion. What about free cash- Is it all due to the Nationally Recognized Statistical Rating
flow generation, profitability, and shareholder value creation? Organization (NRSRO) factor? Some of it, maybe, but gener-
Since 20 September 2000, Moodys has been listed on the ally NRSRO is a relatively irrelevant explanation for CRA
NYSE. It is the only pure credit rating company the stock mar- industry concentration, which existed before NRSRO was
ket plays. The results of Fitchs and S&Ps credit rating busi- introduced in 1975 and exists today in the E.U., in which
ness are confounded with those of other lines of business of NRSRO does not apply. Rather, this concentration is largely
Fimalac and McGraw-Hill, respectively, and thus harder to due to natural barriers to entry: reputation, first mover advan-

3 Partnoy, F., 2006, Take away the credit rating agencies licences, Financial Times,
92 - The journal of financial transformation
13 March.
 The credit rating agencies and their credit ratings

June 2005. By helping a company to identify its place in these
distributions, in a sense CRAs provided access to global capi-
tal markets. CRAs could be regarded as gatekeepers of the
capital markets arena. Obtaining a credit rating for a corpora-
tion has become a normal, unavoidable necessity, although it
has also been suggested that the excess of information about
creditworthiness now means that little attention is paid to the
rating itself and that, for corporates at least, the fine rating
does not much matter. To borrow an analogy, a rating is like a
nose. As long as you have one, nobody notices it whatever it
looks like. But beware of not having one.
The value-added of CRAs to investors
Ratings temporarily anchor the default risk of an issuer or
issue in an ordinal space. They measure long-term default risk,
rather than instantaneous taste for risk. What value do these
data points on default risk have for corporate bond portfolio
holders? The question addresses bondholders (as distinct
from short-term bond investors) and portfolio investors (as
distinct from event, name, or spread traders). Short-term
investors and traders bet on singular events that unwind over
a relatively short time span. They very willingly take diversifi-
able risks on the basis of their beliefs. For these market par-
ticipants, fundamental credit ratings cannot be all that impor-
tant because these ratings say relatively little about near-
term singular events. One has to bear in mind that one needs
70
60
50
40
30
20
10
0 spectrum, were better understood.
2
to apply large sample statistical inference techniques to evalu-
ate the accuracy of ratings, and that the power of ratings to
discriminate between defaults and non-defaults increases
with sample size and with time. These elementary rules of
inference are completely missed by Frank Partnoy when he
claims that rapid ratings have far outperformed Moodys and
S&P in assessing credit risks. It predicted financial distress at
Enron and Parmalat well before [these agencies] downgraded
their debt3.
But for the segment of bond portfolio holders, the default
distributions that CRAs produce, according to several differ-
ent views, are an invaluable input for portfolio construction.
Figure 10 shows one-, five- and ten-year average issuer-
weighted cumulative default rates for 17 fine rating categories
for the period 19832004. This mimics the typical default
experience for a systematic investor over an extended period
of time in any one of the 17 rated corporate bond categories
on offer in the market. These data are invaluable inputs for
long-term bond portfolio management, inasmuch as the fore-
casting ability of the historical frequency distributions associ-
ated with the rating categories is reasonably powerful.
Bond investors may find that the granularity on the left side
of the scale is too fine and that it is too abrasive on the right.
The scale offers fine nuance in default probability as the rating
goes down from Aaa to A3. But beyond that, default frequency
nearly doubles with each downward notch. One must ask
whether there is not excessive investing in more risk measure-
ment information to obtain further refinements at the left end
of the scale and thus very low marginal return and wheth-
er or not there would be scope for potential high marginal
return on investment if the right, or really risky side of the

5
0

5
/0

/0

/0

/0

/0

/0

/0

/0
/0

/0

/0

/0
/0

/0

/0
/0

08
04

12

08

08
04

04
12

12

04

08
08
04

12
12
12

Moodys (MCO) price-close McGraw-Hill indexed to Fimalac indexed to MCO The scales might be more useful to bond investors after
MCO
broadening the bands on the left-hand side and narrowing the
S&P indexed to MCO SP500 DVSF FIN indexed
to MCO bands on the right-hand side. The distribution would then
Figure 11 Stock price evolution of Fimalac, McGraw Hill, Moodys and some Indexes probably look more like a straight upward sloping line, as
Source: Thomson Datastream and Compustat Figure 10 indicates (with a question mark). One could also map

93
 The credit rating agencies and their credit ratings
alternative forms of competition, or a state monopoly? Do
CRAs, as a consequence, generally exercise undue rent gener-
ating pricing power? Are there no threats of new entrants to
discipline the behavior of incumbents?
It is not essential for the public good for incumbents to be
prevented from maximizing profits subject to demand charac-
teristics and the nature of competition. But it is essential that
no artificial barriers should encumber or prevent rivals from
entering, and that the large profit potential should be suffi-
ciently transparent to attract new rivals (as they are at
Moodys). Under these circumstances, CRA industry concen-
tration does not need to be societally suboptimal. And rivals
do enter, nibbling at the market share of incumbents. When
one compares the revenue growth of both Fitch and Moodys,
it becomes evident quite quickly that they have outpaced the
S&P during the last five years. Consider the recent formation
of the International Ratings Group (IRG), creating a global
network of independent rating agencies operating under one
brand throughout emerging markets, and the recent decision
of Dominion Bond Rating Service (DBRS) to launch sovereign
ratings operations, expecting to establish coverage in 15 coun-
tries by 2008.
The key is that regulators do not prevent entry or slow down
the entry process, as some U.S. regulations do. Indeed, there
are rent-generating artificial barriers to entry in the U.S. that
should be abolished. The E.U. deserves praise for refraining
from intrusive and obstructive regulation. It has relied instead
on the principle that the International Organization of
Securities Commissions (IOSCO) adopted in December 2004
with respect to the reinforcement of the Fundamentals of a
Code of Conduct for Credit Rating Agencies4. At the heart of
the code is a disclosure mechanism to monitor compliance:
comply or explain. Rating agencies must disclose how they
implement the various provisions of the code fundamentals.
CRAs are profitable for their shareholders. To some extent
this profitability results from artificial barriers to entry in the
U.S. But it is mainly the consequence of significant natural
94 - The journal of financial transformation
barriers to entry sunk costs, network externalities, and repu-
tation. Fortunately, the profit potential is sufficiently large to
entice entrepreneurs who already have a toehold in the mar-
ket to aspire to occupying larger parts of the space.
Current challenges faced by CRAs
Like most companies, CRAs continuously face challenges. I
will comment on just a few of them. The CRAs legitimacy and
acceptability have been questioned. Are codes of conduct the
answer? Innovations in financial engineering and in the tech-
nological infrastructure of information economics are chal-
lenging the traditional methods of CRAs. In the face of that,
how could CRAs strengthen their uniqueness as an infomedi-
ary? Is growth a curse for CRAs?
Legitimacy and acceptability
Credit ratings are part of the soft infrastructure of capital
markets. When they reduce information asymmetry, and are
independent and objective, they strengthen it. When these
qualities are lacking, they damage it. In addition, there are
many regulatory uses of the CRAs product that inevitably
affect the demand for credit ratings, possibly but not defi-
nitely making that demand stronger than it might otherwise
have been. But beyond any doubt, credit ratings generate
public interest externalities. CRAs play a public interest role.
How can this be managed from a societal perspective? Do
these externalities create a structural misalignment with
CRAs business conduct, from the perspective of maximizing
shareholder value? There are few industries that do not pres-
ent some public interest externalities, and in the financial
sector, there is not a single subsector that does not: banks,
insurance companies, stock exchanges, equity analysis, audit-
ing, etc.
The question is not whether CRAs should be regulated to
ensure they conduct their business in a way that will strength-
en their contribution to the infrastructure of capital markets,
but how to regulate them. The E.U. has decided to stay away
from the issue of licensing, and from intrusive prescriptions
4 The technical committee of the international organization of securities commis-
sioners, 2004, Code of conduct fundamentals for credit rating agencies, IOSCO,
December, 11 pages, to be found at www.iosco.org (IOSCOPD180)
The credit rating agencies and their credit ratings

tages, networking externalities, and sunk costs in the busi-

1. Rating actions should reduce information assymetry
ness.
2. Rating actions should be independent and objective
3. CRAs should pursue transparency and disclosure
4. CRAs should keep confidential all non-public information

Source: IOSCO Statement of Principles Regarding the Activities of Credit Rating

Agencies, a statement of the technical committee of IOSCO, September 25, 2003

Figure 12 Principles for the activities of credit rating agencies

Reputation
The value of a rating to the markets depends on its statistical
ability to gauge the likelihood of default. That ability and the
reputation for it result from the CRAs continuous lifting of
their learning curve on how-to-do ratings. This, in turn, repeat-
edly reasserts incumbents first mover advantages.

Networking
Market participants use the ratings of a particular CRA
because other market participants do. Issuers want a lot of
bond investors to notice their rating. Bond portfolio managers
look for complete coverage of investment opportunities.
Portfolio sponsors want to be in good company when setting
portfolio constraints. Ratings are thus full of network exter-
nalities.

Sunk costs
Sunk costs are unrecoverable and they dominate the rating
production function. Ratings are made from the labor time
spent in producing them, for which there is no secondary
market (who can sell used time?). These costs are, therefore,
sunk, and there are large amounts of them. Moodys 2004
accounts show that operating, general, and administrative
expenses represented 94.9 percent of expenses, of which
compensation amounted to about 71 percent. Capex used just
12.6 percent of total sources of cash in the period 19982004.

The nature of the credit rating business, therefore, leads to

industry concentration characterized by oligopolistic competi-
tion, as is the case of most industries with high natural barri-
ers to entry. Is this in any sense bad, or indeed worse than

95
 The credit rating agencies and their credit ratings
tective regulation. But CRAs themselves are first and fore-
most responsible for the conduct of their business on a play-
ing field that regulators need to keep or make as level as fea-
sibly possible. Transparency should, of course, be the over-
arching principle.
Information economics and financial engineering
Innovations in financial engineering and in the technological
1.11 The CRA and its employees should comply with all applicable laws and
regulations governing its activities in each jurisdiction in which it oper-
ates.
1.12 The CRA and its employees should deal fairly and honestly with issuers,
investors, other market participants, and the public.
1.13 The CRAs analysts should be held to high standards of integrity, and the
CRA should not employ individuals with demonstrably compromised
integrity.
Figure 13 Integrity of the rating process
infrastructure of information economics are challenging the
traditional methods of CRAs. In the face of that, how can CRAs
strengthen their uniqueness as infomediaries?
Nowadays, as the France Telecom case showed, there are sev-
eral mathematical financial models that, fed with the proper
data, extract issuer default probabilities from market prices.
These probabilities are highly sensitive to changing market
conditions, as I indicated earlier. Agencies are now under pres-
sure to show the same responsiveness in their credit rating
actions by changing their ratings at the same speed and to the
same extent as default probabilities extracted from market
prices change.
This pressure started in 1984 when Oldrich Vasicek recom-
mended parting ways with some of the traditional credit
analysis. Conventional analysis involves detailed examination
of the companys operations, projection of cash flows and
assessments of the future earning power of the firm. Such
analysis is not necessary. This is not because future prospects
96 - The journal of financial transformation
of the firm are not of primary importance they most defi-
nitely are. It is because an assessment, based on all currently
available information of the companys future, has already
been made by the aggregate of market participants, and
reflected in the firms current market valueWe do not
assume that this assessment is accurate in the sense that its
implicit forecasts or future prospects will be realized. We only
assume that any one person or institution is unlikely to arrive
at a superior valuation. The most junior claim on the firms
assets is equity. If the future earnings of the corporation start
looking better or worse than before, the stock price will be the
first to reflect the changing prospects. Our challenge is to
properly interpret the changing share prices.5
In other words, do away with fundamental credit analysis,
observe stock prices, and extract all information that is
embedded in them, including an issuers probability of default.
With all due respect to the mathematical creativity and rigor
of Vasiceks many highly valuable contributions to our under-
standing of credit valuation, and the probabilities of loss of an
issuer or a whole portfolio of them, his recommendation is
based on three fundamental flaws in thinking. Firstly, Vasicek
confounds the measurement of risk with the appetite for risk.
Stock prices do not only reflect expectations of free cash-flow,
but also the market price for risk at which they are being dis-
counted. Prices are different beasts from analysis. They play
as much in the field of appetite for risk as in the field of risk
measurement. Credit analysis plays only in the field of risk
measurement. Secondly, the purpose of credit analysis is not
to achieve superior valuation. It is to produce relevant insight
in the lasting downside characteristics of free cash-flow distri-
butions. Thirdly, changes in information do indeed tend to lead
to changes in prices. But there is the other side of the coin as
well, which is that prices occasionally change independently
of changes in information.
CRAs should have the self-confidence to dismiss any chal-
lenges that come from that corner. They should stick to their
guns of fundamental credit analysis, undisturbed by market
5 Vasicek, O.A., 1984, Credit valuation, March 22, KMV, San Francisco, 1-2
The credit rating agencies and their credit ratings
about how to reach a credit rating, leaving the market open to
entry subject to registration and relying instead on self-
reinforcing transparency about respecting the IOSCO code
about the conduct of a ratings business. This is a wise deci-
sion, subject to three important caveats. Firstly, to appreciate
the impact of such codes of conduct, one has to distinguish
between two phases: the construction and initial implementa-
tion of the code, and life afterwards. Stakeholder efforts to
construct the code in a consensual way are genuinely energiz-
ing. They create a period of intense re-awareness in the
industry. They make stakeholders take stock of what the
industry is all about and develop a better understanding of the
minimum degree of coordination in the conduct of the busi-
ness that is required to best serve issuers and investors. In
other words, they help stakeholders reach a level of agree-
ment about industry standards without colluding over pricing.
In this regard, preparation work under the guidance of IOSCO
has been highly expert and insightful. And emphasizing the
fundamentals of the industry at the beginning of the consulta-
tion process, as summed up in Figure 12, has certainly been
extremely useful.
Senior management of CRAs, fully aware of these principles,
seized the opportunity offered by the code to implement or
accelerate changes within their own organizations that they
intended to make anyway. By facilitating internal change in
this way, codes of conduct are part of the change equation
towards the better.
But what about life afterwards? There is a real danger that
codes and regulations could undermine the responsibilities of
boards and senior management who, now that they have lists
of things to do, can simply check them off without worrying
about the principles involved. If something does not appear on
the code list, you do not have to think about it. So there is an
issue. Is life after the code really more principled and respon-
sible, or less?
There is a second caveat. The markets want agencies to be
different from each other. There is no value-added in cloning.
Just as financial diversification improves the risk-return effi-
ciency of financial portfolios, so method and opinion diversifi-
cation across CRAs improves the mapping efficiency of the
long-term default risk spectrum available in the bond markets.
The markets also want agencies to innovate, improve their
methods, and ameliorate their techniques. There is a danger
that excessively prescriptive codes of conduct could reduce
this ability to differentiate and innovate.
The last caveat is that some provisions in these codes are
overbearing, and undermine the basic sense of self-responsi-
bility at the top of hierarchies. For example, articles 1.11 to 1.13
of the IOSCO code on The integrity of the rating process,
shown in Figure 13, are elementary and obvious. They state
that CRAs and their employees are not above the law and that
CRAs should not recruit criminals. No code should need to
state this. Putting articles like these in a code, superseding
general law, only creates an undeserved and counterproduc-
tive atmosphere of general suspicion of unethical conduct by
CRAs. Regulators who approve such codes must remain mind-
ful of a codes subsidiarity.
Self-reinforcing consensual codes of conduct based on the
principle comply or explain are superior to intrusive and pro-
97
 The credit rating agencies and their credit ratings
exuberance or depression and by the perpetually-moving
pendulum of market liquidity.
By analogy, CRAs should follow the lead of Nobel Prize win-
ner Harry Markowitz who discovered the famous separation
theorem in portfolio theory, which states that your appetite
for risk should not influence the composition of your portfo-
lio of risky assets, but only the fraction of your wealth that
you put in that portfolio. The composition of the portfolio is
purely analytical, unrelated to your appetite or taste for risk.
Similarly, CRAs should continue to decide their rating
actions, unrelated to the appetite for risk in capital markets
or among analysts.
Growth
Lastly, CRAs have been growing extremely rapidly. Could this
be a curse? And if so, why?
Credit rating is a labor-intensive activity. There are relatively
limited economies of scale in the production of ratings. As a
CRA needs to produce more ratings, it needs to recruit more
people and provide them with the tools to work. How does a
CRA respond to the conflicting needs to expand rapidly the
number of analysts they put to work on the one hand, and to
preserve a relatively homogeneous and consistent credit
analytical culture across regions, offices, sectors, products,
etc., on the other? Inevitably, the ratio of highly-seasoned
analysts to junior ones has to decrease, making it extremely
difficult to absorb incoming talent while preserving the tried
and tested fundamental credit rating culture. This presents a
knotty problem for the management of a credit rating
agency, for which, unfortunately, I can offer no cheap or easy
solution.
To conclude, CRAs add value to issuers because they help
them to be noticed and to identify their own risk profile. To
98 - The journal of financial transformation
investors, the independence and expertise of CRAs reduce
otherwise dangerous information asymmetries. To share-
holders in their firms, CRAs offer an attractive business
model. Among the many challenges CRAs face, they must
assume their public role through impeccable business con-
duct. This business is unique, and should remain so, and its
unique culture should be transmitted to ever larger numbers
of new hires.
Appendix I
Congress Committee opens up the credit rating
industry.
Herwig M. Langohr, Professor of Finance and Banking, INSEAD
Patricia T. Langohr, Professor of Industrial Organization, ESSEC
The U.S. House Committee of Financial Services recently adopted Mr. Oxleys
version of HR2990: the Credit Rating Agency Duopoly Relief Act of 2006. This
act forces a regime change in the way credit rating agencies (CRAs) compete in
the U.S. Why? What should we expect from it?
Catastrophic default disasters struck South-East Asia in 1997, the U.S. in 2001-
2002, and Europe in 2002-2003. The CRAs only spotted these at the last min-
ute, and the world berated them for failing to give issuers sufficient lead time
to protect themselves from credit losses. But CRAs do not have crystal balls in
which they can see what issuer shall default when. Nevertheless, legislators
seized the opportunity to rein in the CRAs. Since 2002, thousands of pages of
hearings, interviews, testimonies, and studies have appeared in a seeming
attempt to exorcise the evil influence of CRAs as the masters of capital. The
committee adoption is the first concrete result at Congress level of this effort.
HR2990 is a mixed bag. It reinvents the wheel by codifying the current prac-
tices of CRAs, such as disseminating rating criteria and performance, and
establishing policies for dealing with conflicts of interest and non-public infor-
mation, already well-documented on the CRAs own websites. It includes dan-
gerous features, such as granting the SEC intrusive regulatory authority over
CRAs and prohibiting aggressive competitive practices among CRAs. But most
importantly, it contains one unusually significant breakthrough: it abolishes a
major catch-22 in SEC dealings with CRAs. The current criterion of the SEC to
grant Nationally Recognized Statistical Rating Organization (NRSRO) status to
a CRA to license its ratings for regulatory uses is a classic catch-22. As
Chairman Shelby of the U.S. Senate put it poignantly on March 7, to receive the
license, a firm must be nationally recognized, but it cannot become nationally
recognized without first having the license.
Used only once in 1975, this regulation was originally harmless. Fitch, Moodys,
and Standard & Poors were the first to be licensed, a much-deserved stamp of
approval for 75 years of successfully assessing borrowers credit-worthiness.
 Financial

Creating real business intelligence: seven key principles for MIS professionals

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Surviving the future: how operations and IT transformation can be at the core of a winning strategy

Leveraging hosted middleware services to deploy valuable new services quickly and easily

Why gut feeling is just not enough for building a successful bank?

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Threshold relationships among inflation, financial market development, and growth

Manufacturing growth

Corporate hedging and capital structure decisions: towards an integrated framework for value creation
 Creating real business
intelligence: seven key principles
for MIS professionals
Laurence Trigwell
Senior Director of Financial Services, Cognos Corporation
which use different schemas and data definitions, inherently
presents inconsistencies, gaps, and discrepancies when it con-
solidates data from those varying sources. Inevitably, analyses
and strategic discussions devolve into questions about the
provenance of the underlying data.
One of the fundamental issues with these data aggregations
is that the individual participants providing the separate data
components the department heads, customer, channel and
product line managers, controllers, and directors have an
incomplete view of the entire data picture. To borrow from the
clichd fable, they only see their portion of the elephant.
Conversely, the senior-level consumers of this information,
such as company officers and senior executives, are left to
reconcile conflicting and disparate views without any insights
as to the nature of the underlying data. The information lacks
consistency, and this is unfortunate because truly strategic
decisions cross boundaries. A simple query, such as who are
the most profitable customers, leads to more meaningful que-
ries such as:
What makes them profitable?
What channels do our profitable customers use most?
What is the ideal product and channel mix to optimize
profitability?
Can we service marginally profitable customers differently
and more appropriately to increase profitability?
Are we attracting customers that our competitors are
happy not to service because of the complexity of their
transactional demands and the impact on the back-office?
Are we providing services to customers that are not val-
ued?
What is the true cost for our most popular products?
MIS leading the BI charge
Of course, owing to the divergent goals of transaction perfor-
mance and complex reporting and analysis, banks must imple-
100 - The journal of financial transformation
ment enterprise information architectures that employ differ-
ent data structures, schemas, and environments. It is impos-
sible to deploy a single database for a financial services
organization, for example. The result would be an unwieldy
compromise. However, without proper alignment and consis-
tency of data from many different sources, business intelli-
gence efforts cannot succeed, and that is an area where MIS
professionals must provide leadership. Based on engage-
ments with financial services firms around the world, here are
some best-practice recommendations for MIS professionals
seeking to facilitate and strengthen enterprise BI initiatives:
First recommendation carefully define BI
expectations
It is essential to think about what the end-game of information
delivery will be who will consume the information and how
are they expected to act on it. This will help you align your BI
design with business needs.
Banks need to think about the balance between knowing what
is transpiring in their institutions and acting on that informa-
tion. What people in the enterprise will have access to the BI
system? What are their roles and responsibilities? Will they be
accountable for the data presented by the BI system? What do
senior managers and executives expect to see on their BI
screens?
It is perfectly reasonable for senior managers to demand con-
sistent visibility across the organization, but they gain even
greater confidence when appropriate information is also avail-
able to those in the trenches who run the business and inter-
act with customers.
Consider how widely you want to deploy your BI system. Highly
centralized management teams, of course, do not need to
worry about broad deployments. But as your BI system pushes
lower into the organization you will need to carefully balance
For MIS professionals, an enterprise-wide business intelli-
gence initiative is an opportunity to play a strategic role. By
helping to set expectations, working closely with business
units, providing technology leadership, devising new initia-
tives, and furnishing insights into underlying data, MIS can
help financial institutions achieve new levels of competitive-
ness and efficiency.
Business intelligence: a centerpiece of optimized
financial services performance
In the past 15 years, business intelligence has emerged as an
enduring component of the forward-thinking CFOs agenda
for numerous good reasons. Implemented properly, business
intelligence provides unique and timely insights that can
directly affect strategic corporate decisions in all areas of a
banking organization: finance, sales, product, marketing, IT,
human resources, back office, support services, and many oth-
ers. Additionally, tighter regulation demands greater levels of
visibility and control for senior management and external
stakeholders.
In fact, IDC Financial Insights (IDC FI) has ranked performance
management, including business intelligence, as the No. 1 or
No. 2 issue for global retail bankers [Bradway (2005a)]. This
assertion was reinforced in two more in-depth 2005 IDC FI
studies of more than 30 global banks [Bradway (2005a, b)].
That research uncovered several factors and pressing issues
that underscored the need for business intelligence, including
complex ranges of business units, operations in multiple geog-
raphies, multiple customer segments and distribution chan-
nels, development of increasingly sophisticated products, and
cost structures. Collectively, these create complex matrices
where traditional organizational structures, systems, and pro-
cesses struggle to provide a consistent view of performance.
For example, identifying which client generates the most
transaction income from products in two business units might
involve a manual assessment of information from separate
systems, authorized access to the information, the extraction
of that information, manual aggregation, presentation of the
combined information, validation from interested parties, and
a statement of the assumptions made before the information
can be used. Such an unwieldy, time-consuming, and error-
prone process limits analysis to infrequent use for highly
strategic issues or senior-management requests.
BI provides a structured approach for collecting, analyzing,
and acting upon business information all supported by a
foundation of sophisticated software that can aggregate, cal-
culate, distribute, and securely display analyses from a variety
of perspectives. While each implementation varies, many BI
deployments feature a range of functions, including score-
carding, geographical mapping, information visualization,
data mining, business planning, and end-user querying and
reporting. Successful BI applications often feature visual
interfaces that encapsulate and greatly simplify vast quanti-
ties of information. Users can drill down to succeeding levels
of detail and discover new insights and interrelationships
among what previously seemed to be disparate data points.
Business intelligence provides the enterprise with the frame-
work for maximizing the institutions existing investment in
highly tailored operational and transactional systems and
satisfy the demand for consistent information regardless of
ones role in the organizational matrix.
It all starts with the data
Of course, any seasoned MIS professional knows that sustain-
able BI systems solutions that can deliver ongoing value to
the enterprise are predicated on the timeliness and accura-
cy of the data feeds that populate those visual interfaces. And,
for most companies, that is the rub. MIS typically has informa-
tion stored in many different systems, databases, files, data
warehouses, and other locations. A jury-rigged, massively
manual process that aggregates data from different sources,
101
 Link that to an incentive program and you can start to identify
and change process and behavior as part of the information
you are giving people. Link that to marketing investments and
you can correlate marketing dollars with customer return
(retention, profitability, cross-sell). It becomes much more than
a simple report about account activity and evolves into a
mechanism to drive client servicing strategy, account manage-
ment behavior, and maximizing the impact of marketing.
Fifth recommendation consider related tech-
nologies
In virtually all BI implementations there are related enterprise
technologies and systems that can dramatically enhance BI
value. For example, activity-based costing, data warehousing,
or enterprise risk management are some of the systems that
manage and generate high-value data. Look beyond the classic
application silos that are typically purchased and deployed
tactically to get information that has strategic value. Too often,
companies think about operational/transaction silos first and
the reporting and analysis needs later. MIS has to be a leader
in changing that sequence. For example, one European invest-
ment bank had all the systems it needed to service and execute
the demands of its customers. The systems had been carefully
selected specifically for this purpose and highly skilled practi-
tioners and technologists invested significant intellectual capi-
tal optimizing the services offered. However, understanding
the fully costed profitability of that customer required complex
cost allocation for a range of services, such as direct transac-
tions costs and third-party fees, funding, commission, client
T&E, research costs, IT, and back-office.
Sixth recommendation measure what matters
Make sure your BI initiative is designed to measure the met-
rics that matter most up and down the organization. For
instance, scorecarding the use of simple stoplight charts is
a popular and proven BI strategy. But does your BI solution
scorecard the right things? Have you identified the right key
performance indicators (KPIs), the ones that drive divisional
and enterprise performance across geographies, business
units, channels, and products? And have you properly mapped
102 - The journal of financial transformation
in the right data feeds to accurately populate those calcula-
tions? Equally important: capturing the organizational knowl-
edge about how one performance indicator drives another.
Seventh recommendation
think about new initiatives and plans
Beyond a roadmap for consistently delivering accurate and
timely information about what happened to the right people,
institutions also need alignment with their future initiatives
and plans. The first step: getting a matrix-wide view of the
performance indicators (and their interrelationships) impact-
ing the business.
When you consolidate those KPIs, think about how you can
apply that data to new initiatives that tie into financial goals
or forecasts. Now, take it to the next level by anticipating and
controlling what will happen. This means disciplines, such as
business planning, financial planning, budget creation, and
forecasting, which collectively raise the strategic profile of
business intelligence. That might mean more effective use of
budgets for existing initiatives or larger plans that extend to
acquiring a wealth management business in a new region. For
example, if the bank is about to acquire a wealth management
business in Eastern Europe, how will the bank unlock the value
of that investment by appropriately driving more revenues
from those customers or increasing customer retention?
Inevitably that is going to require an aggregated business plan
that links strategic objectives with performance measures.
Whether it is a new initiative or deriving greater value from
existing assets, taking an understanding of what drives
improved performance in a particular geography, customer
segment, or product and incorporating that into the appropri-
ate investments, plans, forecasts, and budgets is proven to
deliver improved ROI. This allows finance to manage the gap
between the planning process and actuals without wrestling
control away from the business manager.
Conclusion
For MIS professionals, business intelligence represents an
conflicting expectations and requirements. That means not
only delivering information to less-senior staff members, but
also understanding how capable those lower-level managers
are at consuming this information and making decisions. Are
they empowered to act on what they see? If not, is there a use-
ful purpose in presenting that information? Clarity here will
pay dividends. For example, one European bank is distributing
daily customer reports to its relationship managers that reflect
the performance measurement criteria and expected behav-
iors. This does not include analysis capability. Conversely, the
larger corporate banking account teams receive analysis tools
to identify profitable product/service mixes.
Second recommendation take stock of your
current corporate MIS landscape
Before embarking on any BI initiative, first assess your cur-
rent data processing environment and your enterprises data
capabilities. Do you have the information you need to popu-
late a BI system with useful information; information that
people will want to see and that has a high likelihood of yield-
ing valuable, strategic or operational insights? What aggrega-
tion mechanisms, a crucial enabler of BI, are in place to pull
all of the vital data together and index it in a uniform format?
Do you have the infrastructure in place today to deploy BI to
the right people?
Does the organization have the definition of the right metrics?
Is revenue the right measure? For example, an investment
banks use of production credits ensures a consistently
defined and calculated value measure to support a single view
of the customer or channel across multiple products. This is a
critical area for obvious reasons and one that often comes
under scrutiny from colleagues. Increasingly we are seeing
the CFO and CIO play critical roles. These key players must
demonstrate transparency and have sufficient muscle to
stand by the results.
Third recommendation beware of success
In many instances, phased deployments can be a sensible
approach; there is no need to have it all in place on day one.
What would a sensible first-phase delivery look like? Try to
reach a critical mass of useful value to generate initial
momentum. However, be careful of success! Although you
may have carefully assessed the organizations stated appe-
tite for information, often there is a latent, pent-up demand
that surfaces quickly once a successful BI system begins to
have impact. Once decision makers see the kinds of informa-
tion BI can produce in one area, they usually can immediately
think of dozens of other strategic uses for the system. That
can quickly fuel a rapid expansion that you need to be ready
for.
Fourth recommendation work with business-
unit owners
Owning and managing the data that populates BI systems is
only effective if MIS understands what data is valuable to
users and why. The key strategy here is to forge strong part-
nerships with the business units to understand the strategic
(not technical) issues, and the business and performance chal-
lenges so that you can make meaningful contributions that
effect the most positive changes. It could be as simple as
understanding the inputs into product margins or customer
profitability. It might involve gaining a truer understanding of
back-office efficiency and third-party servicing costs. It can
involve gaining a deeper understanding of market-share goals.
This partnership ideally involves a series of mutually agreed
upon milestones that create demonstrable proof points, ongo-
ing validation of the deployment project, and lower risk. A
journey that involves multiple small steps has a much better
chance of success than a three-year, all-or-nothing project
cycle that carries too great a risk of ending with a thud.
Start with simple milestones that deliver basic value. For
example, a business banking account manager might receive
simple customer information account status, credit utiliza-
tion, or product and services offered. Next, you might want to
provide service metrics to business banking managers which
account managers have the best rankings, customer retention/
profitability, crosssell/up-sell performance, or productivity.
103
 ideal intersection of technology and business strategy that
can drive new levels of performance for financial institutions.
By injecting itself into a central role, MIS can be both a tactical
facilitator (through its ownership of data and technology) and
leader of a strategic process that can yield significant com-
petitive advantage to the institution.

References
Bradway, B., 2005a, Performance management drives improvement at U.S. Banks,
Financial Insights, an IDC Company, December
Bradway, B., 2005b, Performance management drives improvement at European
banks, Financial Insights, an IDC Company June

104 - The journal of financial transformation

Using business intelligence to
develop standard measures of
operational risk
Jill Eicher
Managing Director, Adaptive Alpha LLC
David Ruder
Managing Director, Adaptive Alpha LLC
Operational risk is now a key concern of constituencies within
the asset management industry. One driver of that concern is
the realization that as investment strategies of hedge funds
and traditional asset managers become increasingly complex,
the underlying operational infrastructures supporting those
strategies may be inadequate or underresourced, thus increas-
ing the risk associated with the asset manager. More concern-
ing for many, however, is that constituencies in the asset
management industry, including asset managers themselves,
are generally in the dark about the strengths and weaknesses
of operational infrastructures.
Currently, asset managers are evaluated by investment per-
formance and risk via standard measures, such as Sharpe
ratios and VaR, but there are no comparable standard mea-
sures for operational performance and risk. As a result, the
majority of the quantitative evaluations of asset managers are
focused on investments, while operational evaluation is large-
ly anecdotal. It is a well respected axiom that you cannot man-
age what you cannot measure, and the lack of standard
operational measures has led many industry constituencies to
reach the erroneous conclusion that operational risk cannot
be measured or managed.
Fortunately, with advancements in the understanding of busi-
ness processes and business intelligence technology, the
development of operational standards is now possible. There
is a vast supply of operational data that can be used to quan-
titatively evaluate operational risk and performance in a stan-
dard way across the industry. To start developing industry
standards, however, the industry must embrace a new
approach to operational risk.
The case for operational risk standards
It has become conventional wisdom that asset managers can
enhance performance and better manage and mitigate risk by
strengthening the operational infrastructures of their firms.
As the investment industry becomes more competitive, the
effectiveness of an asset managers infrastructure becomes a
strategic differentiator not only for the managers themselves,
but also for their clients and counterparties. At some point in
the near future, institutional clients will require asset manag-
ers to demonstrate the effectiveness of their infrastructure in
order to be hired to perform complicated derivative transac-
tions or pursue a multi-strategy approach. Likewise, counter-
party risk will be evaluated not only in terms of a counter-
partys financial balance sheet, but also by their ability to
execute, clear, and settle transactions.
With standard measures of operational risk and performance,
objective operational evaluations of managers and counter-
parties are possible. There are other benefits as well. One is
that managers can make better business decisions about their
infrastructures and improve the management of their opera-
tions. Another benefit is that direct comparisons can be made
between managers on the basis of performance and risk.
Ultimately, though, the most compelling benefit is that man-
agers and counterparties with the soundest operational infra-
structures will be able to warrant premium pricing for their
services.
Limitations of current approaches to operational
risk
There are currently two widely adopted approaches to under-
standing operational risk: standard due diligence of asset
managers, via interviews and surveys, and the Basel II focus
on capital-at-risk. Each serves a purpose, but neither was con-
ceived to lend themselves to the development of industry
standard measures.
105
 Due diligence
The primary focus of due diligence practices today is on the
investment strategy and performance of an asset manager,
not the operational infrastructure. In fact, most due diligence
processes involve only a cursory examination of an asset man-
agers infrastructure through interviews and/or written sur-
veys. This examination generally is performed when a man-
ager is hired and then on a periodic basis. Due diligence is
often outsourced to intermediaries, such as investment con-
sultants or funds of funds with limited operational knowledge.
Thus, from an informational standpoint, the due diligence
process as it exists today has severe limitations to achieving a
quantitative estimation of operational risk. To begin with,
scant verifiable data is collected that pertains to operational
performance and risk. What can largely be learned from sub-
jective interviews and written questionnaires are whether
elements of an operational infrastructure (such as a portfolio
accounting system, trading system, or risk management sys-
tem) are in place and whether operations personnel are on
staff. Additionally, conventional due diligence provides a snap-
shot at one point in time and precludes ongoing monitoring of
the stability of the asset managers infrastructure.
Another limitation of the due diligence process is that there is
no way of verifying the adequacy of the asset managers infra-
structure in terms of its support of the managers investment
strategy. Because of the standard ways for measuring perfor-
mance, a managers investment returns can readily be ascer-
tained at any moment in time; however, there are no mecha-
nisms in place for a corresponding evaluation of operational
effectiveness. An asset manager can believe that everything
is running well from an operational standpoint and communi-
cate this during a due diligence process, but the actual levels
of operational performance and risk will only be known to an
investor should an operational failure occur and result in a
loss to the investment portfolio, which is when it would be too
late.
At best, a thorough due diligence assessment can reveal high-
level deficiencies in an operational infrastructure at one
106 - The journal of financial transformation
moment in time. This process, however, is compromised by its
labor intensive and subjective nature, as well as an inability to
provide continuous monitoring. Ultimately, the most efficient
and objective way to understand operational performance and
risk is through the continuous, automated measurement and
evaluation of operational business processes.
The Basel II approach
Under the Basel II initiative, significant efforts have been
made to appreciate the impact of operational failures on capi-
tal, and these efforts have advanced the industrys under-
standing of operational risk. Through the development of loss
event databases, banks have adopted practices crafted to
effect a continuous monitoring of operational risk as it relates
to capital loss. This approach has made it possible to assess
how often certain types of operational failures have occurred,
and the negative impacts or losses that stemmed from them.
The lessons learned from these databases, however, are lim-
ited to their impact on capital loss and stop short of providing
firm-wide perspective and insight related to risk either inter-
nally (to managers) or externally (to investors). Basel II compli-
ant firms are able to categorize losses by type, frequency, and
impact, and new sophisticated models (incorporating tech-
niques such as binomial distributions, probabilities, and
Operational VaR) enable them to project what types of losses
might occur in the future.
The strengths of the Basel II approaches relate to efforts to
create a continuous monitoring of operational failures and
their impact on capital. The weaknesses relate to the data that
is generated by these approaches, which falls short of inform-
ing managers and investors of the soundness of operational
infrastructures.
Loss databases and capital-at-risk modeling emphasize under-
standing the potential exposures of operational failures rather
than the prevention of failures. As a result, they can be useful
neither as proactive management tools nor as industry stan-
dard measures. At the heart of these approaches are assump-
tions or subjective assessments that preclude standardization tion and analysis of business process data from a myriad of
and therefore, comparison. The calculation of potential loss systems. Business process data that it is drawn from the sys-
events provides no insights into the actual level of operational tems of the firm lends itself to objective analysis over time on
performance or risk of asset manager infrastructures. From a continuous basis. Most importantly, with the objective mea-
the perspective of an investor or asset manager, understand- sures that emerge from business process analyses, industry
ing what could be lost is not as imperative as preventing the standard measures can be introduced and the operational risk
opportunity for loss. and performance levels of asset management firms can be
compared.
Using business intelligence to create a common
denominator
Ultimately, the greatest weakness of the current approaches
to operational risk is the lack of a common denominator upon
which constituencies in the industry can agree. This deficiency
precludes objectivity, verification, and most importantly,
industry standards. Without common denominators, there is
inconsistency and confusion as managers and investors dis-
cuss operational risk.

The solution to this problem lies within the understanding and

monitoring of business processes. All asset managers use
business processes to run their businesses, whether it is for
generating a research idea, executing a trade, or settling a
transaction. Tracking and monitoring the consistency and
performance of these business processes can generate pow-
erful insights into the operational performance and risk of
asset managers. For instance, if a manager has a 90% success
rate in settling credit default swaps transactions one month,
but that rate falls to 75% the next, one can surmise that there
might be a problem in the settlement business process. If
these transactions are left as open positions and not resolved,
then operational risks have increased. Conversely if the credit
default swap settlement rate increases to 99%, one could feel
confident that the business processes supporting credit
default swaps are sound.

Measuring and monitoring business processes is not only

achievable, but has been a key competitive driver for manu-
facturing and outsourced service providers in a variety of
industries. There is a large and growing market for business
intelligence applications, and technologies exist for the extrac-

107
 Surviving the future: how
operations and IT transformation
can be at the core of a winning
strategy
Crispian Lord
Managing Principal, Capco
20 3
96

20 9

02
98

20 1

04
97

00

0
9

20

20
19
19
19

differentiation. Competitive costs and quality service will con-
tinue to be factors that are important, but are more likely to
be prerequisites to merely stay in the game. A clearer strat-
egy that focuses on areas of real differentiation be they by
market, product, or customer segment are more likely to be
winning overall strategies.
er than on the customer, as well as a reliance on people
with product, firm, and infrastructure knowledge to com-
plete any transaction.
Unstructured and complex interactions with sourcing
partners poorly executed outsourcing and service level
agreements and a lack of definition of interaction points.

Clearly the overall strategy is imperative, but within opera-
tions and IT, the engine room of the bank, there lays the
potential to truly out compete the competition. Banks today
are a product of the last 30 years of operations and IT trends,
and suffer from a number of challenges:
Legacy infrastructure the spaghetti of applications
supporting specific products and functions with various
point-to-point and network connections.
Poor overall MIS limited visibility of end-to-end product
profitability and multi-dimensional drill down on cost driv-
ers.
Business unit silos and reliance on specialist knowl-
edge continuing business and product-based focus rath-
15.000
10.000
5.000
0 deliver additional client requirements, such as one off work-
These factors make institutions inherently slow to respond to
change either from competitors, new entrants, regulations, or
macro trends. An example in the U.K. was the introduction of
the offset mortgage more than six years ago. The response to
the introduction of this product was slow and one of the
larger banks took the step of acquiring the institution that
introduced it. Other banks have either introduced a competi-
tor product, but rely upon poor quality workarounds which are
obvious to the customer, or have been unable to launch any-
thing at all.
Furthermore, the engine room is focused on cost reduction
and has sought to achieve this by taking each new product
and seeking scale benefits through automation and standard-
izing processes. If we look at this product silo mentality in
detail we find that it is often not successful at reducing costs,
as these cost mitigation exercises are gradually eroded by
changes from the front office. This phenomenon is shown in
Figure 2, which illustrates the effect of front office pressure to
arounds or special servicing requirements for certain clients.

European institutions average cost/income ratios

US Institutions average cost/income ratios
Europe
USA
Figure 1 Historical graph of cost/income ratios and number of banking institutions
Source: FDIC (Commercial banks only), OECD, Capco analysis
The net result is an upturn in the unit costs to accommodate
these additional client service requirements.
As well as the additional client fulfillment costs there is a gen-
eral layer of waste within the organization that arises from
exception processing, duplication of activities, and inefficien-

108 - The journal of financial transformation

Why is your bank at risk?
In most markets, banks have faced some form of competition
from local competitors and whilst some executives continue to
characterize their market as difficult and competitive they
are not faced with the type of competition that impacts many
other industries. The barriers to entry of the banking market,
in the form of regulation and the need to establish credibility
and trust, as well as the distribution network requirements,
have limited the success of new entrants. Evidence here
comes from the limited success of many of the e-banks and
the lack of penetration of the supermarket banks in the U.K. In
reality the competition that the industry has faced has been
limited and has tended to come from within its own market.
Where banks have been taken over it has been because they
have been inefficient and the result has been a focus on con-
solidation and efficiency, especially given the limited top line
growth potential in the major players developed markets.
The focus on consolidation and efficiency has resulted, over
the past decade, in the decrease in the number of institutions
in the European banking market, by an average annual rate of
5%. In the U.S. and other markets we see similar trends. So
whilst some banks have succumbed to this relatively benign
level of competition, the death rate is likely to increase for
three reasons:
Efficiency trends There is a widening gap between the
cost/income ratios of the top quartile banks (44.9%) and
the average bank (58.7%). As consolidation increases this
gap is likely to get larger and will be the focus of the larg-
er scale players. Furthermore, with Wal-Mart intent on
entering the industry we could see a new player that
might target a ratio in the low 20 percentiles?
Regulatory change The protection that local regulators
used to provide domestic banks is breaking down through
globalization and supra-regional initiatives. The most obvi-
ous evidence of this is in the European Union where the
E.U. Commission is becoming almost apoplectic with the
industrys progress towards breaking down the national
borders. The forcing through of the ABN AMRO bid for
Antoveneta may have turned the tide in this area and
I would expect to see further initiatives from the
Commission around topics, such as SEPA, and a general
acceleration of progress as the Lisbon agenda deadline
approaches in 2010.
Cross-border competition The regulatory changes men-
tioned above facilitate increased cross-border competition
and the scale players will increasingly be looking further a
field to diversify revenue streams and to improve efficien-
cies through scale. Additional drivers, such as the fact that
some of the large U.S. banks are reaching the regulatory
limit of holding 10% of the total U.S. bank deposits,
increase the likelihood of cross-border M&A activity as
these banks seek growth outside their local market.
As a result of these trends I would expect to see the death rate
of banks double and then triple over the next 5 and 10 years,
respectively, and that this trend will probably be on a logarith-
mic basis as the impact will create its own momentum. So,
how can you ensure that your bank is one of those that will
survive and how can operations and IT facilitate this strategy?
The survival strategy
The overall strategy of the bank is crucial in terms of focusing
in on how it can successfully compete in this future environ-
ment. How will it differentiate its offerings in products that are
difficult to differentiate? The latest view appears to be that we
can all differentiate on service hardly most banks core com-
petency but if everyone targets this area then there is no
109
 Unit
cost
Economies driven by scale can
be offset by the increased cost
of satisfying unique client
demands that cannot be
fulfilled through existing pro-
cesses
Costs attributable to lack
of automation and inefficiency
processing exceptions
Figure 2: Illustrative view of the challenge faced by Ops & IT when trying to reduce
product processing costs and understood is one way of facilitating this process.
Once control and scope is established, the alignment phase
focuses on the evaluation of the areas for potential value
release through the establishment of a baseline fact base
which will be critical in defining the business case for the next
phase. It will also provide the baseline from which quantified
benefits can be demonstrated as the operating model chang-
es. Clearly identifying and quantifying these benefits is critical
if the change program is to receive senior sponsorship and
funding.
Value release
The value release phase is focused on consolidating control by
delivering savings. It is important to demonstrate quick wins
or success nuggets to prevent opponents seeking to destroy
the operating model concept through typical anti-centraliza-
tion rhetoric. Ideally these savings would utilize some of the
transformation thinking around engineering, but the length of
time required to embed the deep change will typically mean
that synergy capture will focus on areas such as offshoring,
system consolidation, and de-duplication of some functions.
The initiatives that begin to deliver later in this phase and
facilitate the transform phase include reengineering the archi-
tecture using workflow, both light and heavy versions, as well
as service orientated architecture concepts and distribution
technologies which are key enablers to creating a manufactur-
110 - The journal of financial transformation
ing model with location independent supply chains. In one
institution 40% of the cost base was taken out during this
stage whilst at the same time the underlying technology infra-
structure was retained through the establishment of a layered
architecture.
Elements of alignment continue to be critical as the program
Additional client
fulfillment costs begins to develop the operating model. It is critical that the
Economy of interaction points with the front office are established and
scale
Cost of
operate effectively. The front office needs to be involved in the
planning, initiative selection, change roll out, and funding
Scale
decisions. The development of a client layer that can focus on
business unit needs and ensure that they are fully involved
Transform
The transform phase will begin in earnest as the value release
phase begins to deliver the synergies. This phase is focused on
the deep transformation of the operations to one that is agile.
We believe that there are three themes around which an orga-
nization can focus when facing the challenge of this phase:
Engineering operations Bringing the philosophy of
leading service and manufacturing companies into opera-
tions. This focuses on the reevaluation of operations
through the use of engineering concepts as demonstrated
in other leading organizations. Initiatives in this area will
begin to evaluate the unbundling of value chains and the
creation of horizontal scale at a functional level. In addi-
tion, a focus on the operating model should seek to
ensure that the transition to a client and commercial ori-
entation is firmly embedded within the culture.
Dynamic sourcing Building an effective dynamic and
responsive global operations sourcing strategy. This is a
fundamental shift towards supply chain management and
requires these types of skills to facilitate the establish-
ment of continuous monitoring and benchmarking of ser-
vice cost, quality, and control. The organization develops
the ability to work closely with partners that can deliver
elements of the value chain at a lower cost and higher
quality because of their focus on this service.
cies. The overall result is an engine room composed of a large
number of these types of single product focused sets of pro-
cesses that are tightly linked and create an architecture where
it is difficult to reduce cost. Most importantly, and this is the
key point, the organization lacks the agility to respond to big-
ger picture change, such as new products or market entry
opportunities, as well as the need to quickly absorb acquisi-
tions whilst retaining customers.
So what would agility mean to a bank and how would it deliver
competitive advantage? If the banks board had the ability to
look at the portfolio of products, markets, and business lines
it owns and then assesses profitability trends it would look at
the opportunities and threats and decide to exit or enter dif-
ferent aspects of its portfolio. Imagine a situation where it
could quickly divest a product and launch a different one in
weeks, visualize a bank that could bolt on an acquisition in 6
months rather than 3 years, or enter a new market in a couple
of months.
What would this look like in terms of operations and IT?
Essentially, the concept of transformation is the creation of
an agile operations and IT organization, which involves a fun-
damental shift to something that is closer to a modern manu-
facturing concern. Ops & IT becomes an entity that funda-
mentally understands its customer (the front office), antici-
Focus
Transform
Value release
ion
s synergies from the different sets of Ops and IT within the
rat
Alignment g ope
in
orm
nsf
Tra
Time
Figure 3: The three phases of the transformation journey
pates the customers strategies and demands, and has scale-
able and flexible processes, as well as the adaptability needed
to deliver change in a time period that delivers competitive
advantage to the bank. A transformed organization would be
able to operate like a Toyota with multiple manufacturing
hubs spread across the globe that can deal with change
because the process components are so well understood and
can be deployed across multiple products. Supply and demand
are understood and controlled through detailed MIS so that
spikes in demand can be load balanced across different teams
and even locations. The supply chain is run like a manufactur-
ing supply chain with the connection between internal and
external suppliers practically seamless and the MIS provides
the ability to continuously benchmark and switch between
them.
Making transformation happen
Is this the sort of thing that can be delivered tomorrow?
Perhaps not, but this is a strategic vision of the end state and
the journey to get there is as important as the vision. A useful
way to look at this journey is through three phases:
Alignment
The alignment phase is about bringing together a sufficient
proportion of Ops and IT around a shared services model and
under the same governance.
Critical to large scale transformation is obtaining sufficiently
senior level sponsorship, almost certainly meaning board
level. This provides the top cover required to establish suf-
ficient scope for the program, as this needs to be sufficiently
large so that real scale can be achieved when identifying
group. The extent of Ops and IT included from the various
product lines and business units (i.e., how close to the cus-
tomer is considered operations) is a matter for each indi-
vidual institution and will inevitably also depend on the
strategy of the firm (i.e., there may be plans for certain areas
to be divested).
111
 cess may not even have or need a quality control point as a result.

At the core of the cultural challenge is the need to focus operations staff on bad
news meetings rather than good news meetings. Operations should be about
focusing in on waste, the failure points, and quality control problems to continu-
ously improve. This starts to move operations more towards the manufacturing
environments of companies like Toyota and the goal of professionalizing the
workforce.

Results
LTSB have not used armies of consultants or hired great swathes of manufactur-
ing experts to undertake the Lean program. Indeed, there are a large number of
people who claim to be experts in this field, but these are typically just six sigma
experts and are often from finance or financial services companies, and not from
real manufacturing backgrounds. LTSB have utilized the experts that they have
recruited by asking them to work closely with the workforce to get them to look
at their jobs differently. The results have been impressive:
Quality A Lean process places the customer at the centre and seeks to
ensure that the end output is a positive customer experience. This is resulting
in increased customer satisfaction amongst clients and much improved pro-
cess sigma scores.
Effectiveness Typically LTSB is generating double digit (15 30%) cost
savings over a 12-month period in each of the areas where Lean has been
deployed.
Adaptability This would appear to be reduced as the Lean process seeks to
create standard repeatable processes. However, LTSB have found that the
workforce have much more control and understanding of their processes as a
result of Lean and when new products or processes are required they are
looked at through Lean eyes, i.e., they are rapidly industrialized and estab-
lished.

Whats next?
Lean continues to be rolled out across the LTSB group and there are a number of
areas that are yet to be targeted. In the longer term the team at LTSB believes
that the next step will be improving the componentization of processes and
releasing the value that can be achieved from this level of process break down. In
addition, they are seeing signs that suppliers are improving their business and
technology process offerings. Although the environment for rolling out fully
dynamic sourcing is not there at this point, they believe that this concept will
offer substantial opportunities for operations in the future and are already pilot-
ing some of these ideas.

112 - The journal of financial transformation

 People Tooling, developing, and motivating people to
design, deliver, and share best practices for operations. Lloyds TSB
A fundamental shift needs to take place from an organiza-
tion that has process and product specialists to one where
engineering evaluation, design, and change are core skills.
In addition, the importance of having people that can
operate in a commercial way and treat the front office as
valued clients also requires skills that are not typically
available within operations. Initial competency mapping
and gap analysis versus future requirements are often a
first step in this area.
Conclusion
The trend in the bank death rate is likely to increase over the
next 10 years and merely tinkering with the strategy and
implementing a cost efficiency exercise is unlikely to prevent
a bank from becoming one of these statistics. Operations and
IT can be at the core of the survival strategy by delivering the
kind of agility, flexibility, and adaptability a bank requires to
obtain a competitive advantage. It is only through transforma-
tion that this can be delivered as the end state is a fundamen-
tal shift in mindset, structure, and capability.
Appendix I Case Study: Lean manufacturing at
Why lean manufacturing?
Lloyds TSB (LTSB) has been successfully utilizing lean manufacturing concepts
over the last few years and its use is spreading across the group. The adoption of
Lean was driven from within the organization through the trialing of the tools
during the consolidation and centralization of the branch network back offices.
As the benefits of the approach became clear and created incontrovertible
examples of improved effectiveness, LTSB operations began to recruit a small
group of experts to work with project teams and operations staff to tackle some
of the issues it saw within the bank:
The need to professionalize operations Typically an organization will pick
specialists to undertake certain functions, such as marketers for the market-
ing department, accountants for the finance department, etc. In the banking
industry the operations area has typically used bankers and asked them to
run and operate the processes. Although these people have typically done a
good job, they are not professional operations staff who would approach this
role in the same way as a manufacturing engineer or an operations specialist
would.
The need to increase effectiveness Lean manufacturing is in some
respects the wrong word as it has connotations of efficiency and cost savings,
which are the usual focus of operations programs and create distrust
amongst staff. Instead, LTSB has focused on the effectiveness improvements
that Lean can bring to a set of processes. The various tools of Lean are used
to identify process standardization opportunities and better ways of creating
the output so that the end result is an improvement in relative cost due to an
increase in output.
The need to create more shelf space and offer better customer service
Competing in the current environment means differentiating by delivering
better products and, perhaps more importantly, offering the best customer
service. Lean provides this by rationalizing the operations required for exist-
ing products and workarounds, as well as reducing the likelihood of poor
end-customer experiences through improved processes with embedded qual-
ity controls.
Making it happen
LTSB operations team believes it was critical to create a shared sense of owner-
ship between the operations teams and the business. On more recent projects,
Lean has become embedded and driven by the business, and the selection of a
senior high flyer to lead the initiative has sent a clear message about the organi-
zations commitment to the program.
As with many of these types of initiatives, the key has been in changing the cul-
ture of the organization. Process owners like to think that their process is very
different and difficult. Challenging this with the tools that Lean provides is the
first step towards the end goal of standardized repeatable processes. It also chal-
lenges the quality control approach that is typified by a banks processes, for
example, the quality control aspect may happen towards the end of the process
at the customer touch point or not at all. Lean seeks to embed the quality con-
trols within the process, as well as identifying the cause of problems to ensure
that defective outputs are minimized towards zero defects and any that arise are
rapidly corrected long before the end of the process. Indeed, the end of the pro-
113
 Leveraging hosted middleware ser-
vices to deploy valuable new ser-
vices quickly and easily
Gailanne Barth
Global Practice Leader, Easylink Services Corporation
Henry Bayard
VP Strategic Initiatives, Easylink Services Corporation
but it should be.
Hosted middleware can help
However, this situation is beginning to change. One of the
technological approaches being used to drive growth in addi-
tion to cost savings is hosted middleware services. We are all
familiar with middleware. In simple terms, middleware denotes
a range of interoperability technologies (software, servers,
APIs, etc.) that support application development and delivery
enabling integration among disparate systems/infrastruc-
tures. Today, financial institutions are moving to distributed
Unix-based or Linux-based environments deploying grid com-
puting and Service Oriented Architecture (SOA); expanding
their ability to scale applications. Complementing this infra-
structure is middleware which allows the interoperability of
information and customer. Middleware is fast becoming part
of the DNA of financial institutions and they are using it in a
myriad of ways, such as, as a key architectural component to
integrate complex IT infrastructures and as a tool to acceler-
ate delivery of new products and services to leapfrog com-
petitors. Middleware is the glue between diverse applications,
i.e., databases and web servers. Middleware takes many forms
that of enterprise solutions, and as application service pro-
viders (ASPs), which give global reach to information and
customers.
Hosted middleware services take this functionality a step fur-
ther by delivering these capabilities on high-capacity, secure,
highly configurable infrastructure deployed in a hosted envi-
ronment. The benefits to financial institutions are that it has a
very fast time-to-market with little or no upfront capital
investment, a usage based pricing model, and deployment and
maintenance responsibilities are shifted to the service pro-
vider. As such, hosted middleware services take the risk out of
expensive data integration and new product development
114
projects, i.e., no stranded capital if the project does not work,
quick time-to-market, and added flexibility. Financial institu-
tion product managers looking to create new value for cus-
tomers can focus more on the information asset to be lever-
aged and how to best package it for customers than the cur-
rently daunting tasks of navigating internal IT governance of
project resources needed to build the systems to deliver it.
Not to be underestimated is the advantages hosted middle-
ware provide product managers in developing and deploying
point solutions for segments of customers focused, high-
value projects that all too often fall by the wayside because IT
resources are substantially consumed by larger, longer-cycle,
farther reaching projects. Most of the recent projects we have
seen with our large financial industry clients have been of this
type something people have wanted to do for a long time,
but traditional resourcing and deployment models could not
deliver. Additionally, hosted middleware solutions provide
transparency, especially during the implementation phase of a
service. End-users enjoy a hassle-free implementation, afford-
ing financial institutions a customer-friendly new service.
Transparency also reaches into information flow and business
processes; providing value add in an ever increasing regula-
tory environment.
Figure 1 Fueling growth bridging content and customers
Engineering growth by bridging content and
customers
Enterprise-based middleware and hosted middleware solu-
tions are allowing financial institutions to be nimble, avoiding
complex, protracted integration projects, managing costs, and
accelerating time to market. For example, in the face of heavy
competition, financial institutions are rolling out new types of
financial products and services (like derivatives, hedge funds,
etc.) implemented on a fast track with minimal infrastructure,
Financial Institutions have an unutilized strategic asset in the
information that lies dormant, or worse yet, trapped inside
complex IT infrastructures. At the same time, their customers
are becoming increasingly accustomed to having ready access
to information and being notified/informed of information and
developments in other areas of their business and personal
lives. Financial Institutions are starting to find that they can
harness information technology to tap this unutilized asset to
introduce new, innovative products, better satisfy customers,
and fuel business growth.
Consider for a moment the strides taken by the travel industry
over the course of the past several years in providing much
more convenient and useful access to information, such as
multi-carrier flight schedules, single session booking for air
travel, hotel, car, and even special event booking, online
check-in, SMS notification of flight delays, and even e-mail
itinerary distribution to the person picking you up at the air-
port. Until a few years ago much of this information was simi-
larly locked away in disparate legacy infrastructures, with
Infrastructure

Hosted
Background middleware
services
Infrastructure
Financial institutions have employed multiple business models
Information silos

to achieve growth by merger-acquisition, outsourcing/

Multiple
insourcing, white-labeling, etc. each of which has contribut- Infrastructure products/services
Enterprise
ed to the creation of a complex IT infrastructure. More often middleware

than not, this infrastructure is wrapped around siloed busi-

ness services that access disparate technology platforms and Infrastructure
Hosted middleware services attributes
legacy systems. Keeping these systems running and making Middleware attributes
Interoperability
Pre-existing
Pay per transaction
Flexibility
them more cost efficient has been the technology focus of Time to market
Transparency

many financial institutions, more so than improved serving of
customers with better access to their financial information.
Not surprisingly, technology has not been a major driver of
market share or revenue growth, or minimally, it has not
achieved its potential in these areas for most companies in the
industry.
Perhaps one of the biggest missed opportunities stems from
the creation of fragmented segments of users accessing/
sending information but unable to extract value from this
information. A dichotomy has emerged. On the one hand, we
have financial institutions with embedded infrastructure and
islands of information. On the other hand, there are custom-
ers with varying demands for information that adds value to
their world.
Cost effective
pieces of it only available to highly trained professionals
within the travel industry, using green-screen terminals con-
nected to mainframes.
Today, driven partially by the strides made by industries such
as travel, customers want information quickly, proactively
delivered, and in a manner and format that fits the way they
do business today. One of the best places financial institutions
can look to for growth is through the vast information assets
they control, but have historically not harnessed to their full
potential to both win new customers and drive new revenue
streams from existing customers. Information technology has
not primarily been thought of as an engine of revenue growth,

115
 few interchangeable parts, and less variables. For such varied
and demanding rollouts, middleware, either enterprise or
hosted, is becoming a preferred form of information technol-
ogy, ultimately delivering products, services, and information
to customers in the way their businesses want and need it.
Enterprise middleware has many practical applications. One
typical scenario is transforming data from a web server to
input directly into multiple back office legacy systems. A spe-
cific example of a hosted middleware application in use today
in international trade finance uses middleware to transform a
purchase order or letter of credit from an EDI-formatted mes-
sage into a SWIFT-formatted one. Similarly, a securities trade
confirmation can be captured as an image and converted into
an XML format for delivery into a back office system.
Middleware is increasingly providing flexible solutions to lega-
cy environments. In such environments, middleware is facili-
tating information flows for application integration required
for straight through processing (STP). It can extract informa-
tion from documents and forms, convert it into a usable for-
mat, and securely deliver the information as a new service to
customers globally capturing new customers and maintain-
ing existing customers while creating a new revenue stream
for the institution.
The added functionality of a hosted middleware service is tak-
ing STP one step further. For example, an international money
center bank was able to acquire new revenue by securely dis-
tributing statements to clients all over the world it had to
ensure that only the intended recipient could view the infor-
mation while preventing manipulation of the original elec-
tronic content. Under the banks old business processes, per-
sonnel had to manually rekey data to create the statements,
manually convert them to another file format, and then manu-
ally encrypt and distribute the files. This was a very expensive
system which would have required substantial investment to
upgrade. The process was slow, error-prone, painfully outdat-
ed, and not compliant.
116
The solution: the bank implemented a hosted middleware
solution, which automated the entire process improving the
institutions existing service. The global service automatically
accepts an XML-based data feed directly from the banks back-
office applications, parses the data on a per-recipient basis,
converts the data and creates two files with custom branding,
logos, and security statements (a PDF to serve as an elec-
tronic original, and an Excel file allowing the clients to copy or
manipulate the data into their own personal accounting appli-
cations), password-protects and encrypts the files, securely
delivers the files based on the information in the original XML
feed, and provides the bank with a handy tool to track and
report on message disposition.
As a result of the deployment of this application, the institu-
tion was able to increase market share. The combination of
information and content, made available and delivered to cli-
ents using hosted middleware, enabled the creation of a new
and improved statement, one that got to customers faster and
provided them with the capability to import statement infor-
mation into their own financial applications. The bank was
able to extend the new service offering from its E.U. commu-
nity to a new customer base in the Pacific Rim. As an added
benefit related to business process improvement (BPI), the
institution was able to address issues relative to security and
compliance, such as audit trails, archiving, and securing the
customer information.
Conclusion
In todays highly competitive environment, financial institu-
tions will be hard-pressed to fund capital investments, system
upgrades, new projects, state-of-the art infrastructures, and
ultimately new products and services. They will, however, be
expected to grow their businesses in the double digits! To suc-
ceed, business owners need to capitalize on stores of informa-
tion that have long sat dormant, inaccessible. By bridging
information housed in disparate infrastructures and delivering
it to customers on demand in the format the customer wants
it, financial institutions will be able to acquire new customers
and retain existing customers thereby achieving double digit
Why gut feeling is just not enough
for building a successful bank?
Francesco Burelli
Principal Consultant, Capco
Kim Warren
Teaching Fellow, Strategic and International Management, London Business School
Like firms in other industries, every financial services organi-
zation is characterized by a specific culture and ways of man-
aging its own business from the highly competitive and
confrontational culture of Citibank to the more risk adverse
one at HSBCs. Despite the differences in culture, manage-
ment styles, and preferred controls, all banks operate in
number-driven industries in which the core business consists
of managing risk.
After the dot-com crash and the subsequent market down-
turn, banks employed many staff with consulting backgrounds,
who typically had a highly analytical, fact-based, quantitative
approach to problem solving. We should, therefore, have
expected to see banks shifting gears and becoming more suc-
cessful in their strategies and decision making and conse-
quently achieving superior financial performance. Yet it
seems that these changes in the skills base of the banks have
not made any significant impact on the performance of indi-
vidual banks1.
Capco has researched the financial results of the top 100 U.S.
and European banks over the past 5 years and identified two
key trends between two groups of financial services institu-
tions. They found that banks which stick to the traditional
retail business of lending and deposit taking are largely
immune to the vagaries of the financial markets. The same
does not hold true for the investment banks that derive a
much higher proportion of their income from fees. Regardless
of stock market turbulence, banks have shown relatively con-
sistent profitability over the last few years, although one
might question how long efficiency drives and opening of new
revenue streams can sustain this momentum in the longer
term. A key assumption of the Capco research is that neither
changes in the skills base of the banks nor the performance of
financial markets has any significant impact on individual
bank performance.
So far there is little evidence that decisions are being taken
1 Dener, A., A. Pirnie, D. McDevitt, 2006, A bad situation getting worse The U.S.
banking profitability crisis, Working paper, the Capco Institute
differently from how they were in the past; organizational
inertia and the effort needed to evaluate, learn, and adopt
anything different from the-way-things-have-always-been-
done-round here still drive the way decisions are taken in
many instances. The problems of unreformed decision-mak-
ing, together with the cumulative effects of decisions taken in
the past, continue to create problems with organizations
achievement of seemingly realistic aspirations.
There are a number of well known cases of planning gone
wrong. Egg PLC could perhaps be forgiven for not anticipating
exactly the huge response to its initial launch in 1998, but
much of its initial subsequent response made matters worse
before moving customers from call centers to the Internet and
ending up being an Internet bank out of the initial telephone
banking aspirations. Then came the disappointing results of
its expansion into France, when again the early miscalculation
paled into insignificance when compared with its refusal to
respond when real-time data showed the scale of error.
HypoVereinsbanks trailing and inflating portfolio of bad debt
that led to its acquisition by Unicredit is another example of
decision making that did not deliver the expected perfor-
mance. Even CapitalOne, whose strategic development has
generally been admirable, tripped over when its formula did
not work as expected in parts of its European expansion in the
early 2000s.
Another initiative that did not live up to expectations was the
Barclays B2 proposition, launched in late nineties. This direct
retail investment proposition was set up under separate
branding and with significant above the line marketing spend.
The business never really took off for a number of reasons.
Firstly, at the time the market for this type of direct, execu-
tion-only style, of selling for investments did not really exist.
Secondly, the main product was a guaranteed-style invest-
ment that relied heavily on hedging of positions to avoid
capital loss. It was, therefore, too complex and did not provide
great value. The B2 brand eventually moved into more main-
117
 financial services industry is no exception. If we set aside for
now those emerging markets where undeveloped opportuni-
ties are significant and where growth arises from simply serv-
ing an unmet need, companies in developed economies face
an industry that has largely reached maturity. Without disrup-
tive innovation, opportunities for noticeable bottom line
growth are limited, so there is little option but to take business
from tough competitors by winning ever more savvy custom-
ers. With investors expecting, say, 10% growth in returns on
investments, shared between dividends and capitalization
growth, and a limited pool for potential growth that is far
short of two digits, financial services companies face the chal-
lenge of finding the demanded earnings growth. Cost-saving
only goes so far few companies in other markets have
shrunk their way to industry leadership, so developing growth
strategies have to be found in markets where the differential
between firms is marginal and products are replicated ever
more quickly. Growth brings further challenges to manage-
ments decision-making capability. Meeting sales and profit-
ability budgets in a bank branch under business as usual
conditions is tough enough, but leading from the front to meet
the growth expected from shareholders is even more difficult
because many more variables come into play. Only the few
largest banks have the luxury of being able to leverage large
pools of resources, brand strength, and global reach in order
to keep increasing their bottom line while sticking to their
ways of doing business.
Share price performance of banks and hence their capital-
ization appears to be unrelated to their underlying business
models. A concern we have from the Capco analysis of U.S.
and European Banks is that investors are enchanted by head-
line grabbing performance figures rather than long-term
financial stability. This may be understandable from an inves-
tor perspective, as shares can always be sold if results stop
coming in. The impact on CEOs is much less satisfactory, as it
forces a focus on surpassing the last record profits announce-
ment, rather than solving fundamental business problems or
building solid platforms for the future. The larger the bank the
more this pressure arises. However, mid-sized banks are not
118 - The journal of financial transformation
exempt from such pressures. In fact, for them the line between
pleasing shareholders and becoming a potential take-over
target is thinner than for the larger banks.
When working out a path to substantial, profitable growth, the
number of variables that need to be taken into account is high,
such as pricing, price sensitivity, product offering, operational
resources, competitors pricing decisions, staff turnover, and
capital requirements. Furthermore, these are not isolated fac-
tors, but are linked in a complex web of direct and indirect
dependencies. Even companies that are highly analytical in
their approach sometimes misunderstand how these linkages
work through the whole system, and consequently fail to meet
their aspirations. Analytics are quoted to have been instru-
mental to Capital One to exceed 20% earnings per share
every year since it became public2. Despite this, their recent
efforts to expand within continental Europe have not proved
as successful as expected and the Italian operations, which
started in 2001 with an initial pilot together with Clarima, fol-
lowed by the set up of independent operations in 2003, were
closed in 2005. Strategy had to change after the anticipated
overnight growth of revolving credit on credit cards did not
materialize. Other banks have also invested heavily in analyt-
ics, from Wachovia in the U.S. to Barclaycard in the U.K., which,
spent five years executing its plan to apply analytics to the
marketing of credit cards and other financial products.
There is nothing inherently wrong with those analytical
approaches to profiling customers. It is just that quite differ-
ent methods are needed to steer a strategic business unit or
a whole organization to a successful growth path. Those mul-
tiple interdependencies amongst the many factors involved
create chains of causalities that are not linear but circular,
with feedback loops that reinforce the outcome of the interde-
pendency in a cumulative manner. The outcome of such feed-
back loops could be both good or bad. For example, the
strength of a brand that outperforms competitors by employ-
ing exceptional staff makes the organization attractive to the
best potential employees. The stronger the brand, the more
attractive it is to top quality candidates, so the tougher the
stream style investments and was even pushed through the
branch network in an attempt to build sales which effec-
tively destroyed the value of the direct business model.
Eventually the business was closed down.
Now banks are once again looking for growth, after spending
the first few years of the new century focusing on reducing
costs, streamlining processes, and overhauling their opera-
tions. Unfortunately, the effects of poor decision makings of
the past are becoming manifested in widespread failure to
restart profitable growth, making some organizations easy
take-over targets. Unicredits acquisition of the ailing HBV has
received a lot of attention from the press and was one the larg-
est cross-border deals in continental Europe. Bank of Americas
take over of MBNA at the end of 2005 will enable the two
organizations to leverage each others assets for cross-selling
purposes. These are just two of the major deals that have
occurred recently and the rate of M&A activity taking place
across the sector is now substantial. Fortis Banks takeover of
Von Essen Bank, ABN Amro and Antonveneta, BNP Paribas and
BNL in Rome, Woori bank and Yegaram bank are a few exam-
ples of the deals that have been hitting the industry news-
rooms in the last weeks. The U.K.s Lloyds-TSB is another bank
that is now being mentioned as a viable target. It is remarkable
thing, when one considers that not that long ago the bank was
very much admired for its exemplary cost-efficiency.
In our experience and on the basis of what we have observed
frequently at levels immediately below the board, decisions
are often taken for the sake of short-term results without
considerations given to their longer term effects. Todays
admirable cost-efficiency is tomorrows incapacity to develop
or even to sustain todays business. Moreover, many deci-
sions reflect arbitrary assumptions, qualitative analysis, and
gut-feel far short of what we would consider to be a best
practice management style.
Why do they do it?
This saga of strategic and decision-making errors cannot
entirely be blamed on management. Financial control tools,
2 Thomas H. D., 2006, Competing on Analytics, Harvard Business Review
such as value-based management, are persuasive and
methodical, but do not offer any real grasp of the balance
between short-term performance and long-term robustness.
Balanced score-cards make some attempt to look at non-
financial factors that may impact on future performance, but
generally lack any means to assess, systematically and quan-
tifiably, any link between decisions taken now and their medi-
um to long-term consequences.
Without any decent tools to help their decision-making, what
do managers do? Doing nothing is often not an option [though
frequently it would be better than what is done], so they do
the best they can, based on what experience tells them about
how the world works. Unfortunately, unless they happen to
have discovered a business model that is successful, and sta-
ble in the face of external changes, that experience is unlikely
to be appropriate. First Direct landed on a successful formula
over a decade ago, and has continued to thrive albeit at
modest scale ever since, and is now seen as an example of
best practice within its industry and the HSBC group. Egg too
found a strong sustainable model within a few years of its
frenetic launch, although not before burning large quantities
of its parent groups cash. Fineco Online Bank developed its
niche business mirroring the models of U.S. and U.K. banks
during the dot.com boom and is now a successful part of the
bigger Capitalia group, after undergoing a period of difficulty
subsequent to the dot.com crash.
For most other financial institutions, though, strategy contin-
ues to be a worrisome tip-toe from one mine-field to the next.
It is surprising, then, to find little interest in more professional,
analytical approaches to strategic management and decision-
making. This is especially puzzling, given that the products
these institutions trade are so deeply quantitative in nature
making profit out of risk is hardly an activity for which check-
lists and two-by-two grids would be the tools of choice!
The quest for growth makes good decisions more
critical, but also more difficult!
Competition is tough in just about every business and the
119
 every customer you ever won minus those you ever lost, it
cannot be explained by any current feature of the business,
neither your pricing, your marketing, nor the appeal of your
products or services. Factors such as these affect how rapidly
you win or lose customers [plus how much they buy]. This
accumulation phenomenon is captured by what is known as
the bathtub metaphor, because customers flow in and out of
your business like water into or out of a bathtub. This princi-
ple is illustrated in Figure 1, taken from a real case concerning
a company selling investment products to wealthy individuals
through brokers.
Each months movement in the stock of brokers is exactly
equal to the number gained and lost in that month, and the
number at the end of 2004 [~85] reflects the number it
started with two years previously, plus/minus all those gains
and losses since. Needless to say, this particular business was
in some trouble, and the project focused on how to reverse
this situation. Interestingly, this company believed that it had
over 200 brokers, because that was the number of accounts
on its database, whereas in fact, brokers who had not traded
for 6 months were effectively lost.
So fundamental is this basic principle that if your plans do not
explicitly recognize these mechanisms for staff, products,
and other resources as well as customers there is little
chance they will turn out as you hope.
What does getting it right look like
We can illustrate the power of the approach with two exam-
ples one concerning new product development in credit
cards, and the other an opportunity to initiate a competitor
destruction strategy.
The first case concerns a project to evaluate in advance the
launch of an introductory interest free card, where the eco-
nomic performance, in terms of cash flow and profitability, of
the card has to be balanced against the attractiveness of its
promotional features in order to ensure rapid uptake. The
expected performance is heavily influenced by the promo-
120 - The journal of financial transformation
tion attached to the card. The more appealing the promo-
tion, the quicker the product uptake. The longer the interest
free period, the higher the funding costs that the issuer will
have to sustain as a consequence of the promotion. The
market reaction to the launch of interest free period credit
cards can vary depending on the other products offered by
other issuers. Small differences in the percentage split of
card usage behavioral profiles can make a significant differ-
ence for the issuer in terms of the cost of the product during
its promotional period. Similarly, variations of the interest
free period offering (interest free period number of months)
and the nominal APR applied to the revolving balances (com-
pared to the market APR) after the initial interest free period
makes a significant difference to the overall product adop-
tion, numbers of cardholders who will move off to other
similar offers (called Gamers or Rate Tarts), and revolvers
applying for the card with the addition of word of mouth
feedback from current cardholders. The word of mouth
effect was crucial to attract other potential cardholders in
order to leverage the launch of a product that was nearly
new to the market and planned to be very appealing to card-
holders with significant revolving balances. During the proj-
ect it was found that the word of mouth positive and nega-
tive effect ratio differed widely amongst the various card-
holders behavioral profiles. Intuitively, it was expected that
as the value proposition to a cardholder became more inter-
Brokers won Active brokers Brokers lost
per month per month
150
100
50
0
20 20
10 10
0 0
Figure 1 Winning and losing customers
3 Warren, K., 2002, Competitive Strategy Dynamics, Wiley
selection can be and the quality of those employed increases
further. On the other hand, unexpected success in sales can
bring in business way beyond the capacity of the business to
cope, leading to bad service that destroys the very success
that started happening.
Tools are required that are fit-for-purpose
Whilst these kinds of feedbacks are common sense and easy
to grasp, they are often ignored when management comes to
forecast business performance, when the tendency is to
revert to assumptions based on historical, linear analysis. It is
certainly rare that any attempt is made to actually quantify
such effects and set the scale and timing of decisions accord-
ingly. Some such effort is essential, not only because of the
interdependencies involved, but also because the delays
between action and response can be considerable. To make
the point simply, if you need people with 5 years experience,
and neither you nor your competitors hired those people 5
years ago, you can wish for them all you like, but they just
would not exist. Resource-building delays are the second
important characteristic of strategic decision-making that is
usually ignored or underestimated, and not factored into the
evaluation of business development.
Before going further, we need to be clear what the perfor-
mance result we are trying to estimate is exactly, so that we
can make the decisions most likely to bring it about. Neither
some absolute profit figure, nor some linear growth rate in
profit is realistic. Any real-world initiative whether to exploit
a potential opportunity or to resolve a problem will exhibit
continually changing results, as resources and expenditures
are added or reduced, and as cash in-flows develop. What we
really need are answers to the following three questions:
Why profits are at the present level is not answered by
other information about our current situation the busi-
ness is on a trajectory through time which reflects histori-
cal events and decisions.
Where is it headed if we do nothing also needs to be clear,
as any impact of our revised plans or decisions will be
moderated by forces that are pushing performance in that
direction.
How those revised plans and decisions will alter that
future for the better is, of course, the overriding question
to be answered and answered with evidence-based con-
fidence, not merely wishful thinking.
The good news is that tools are available that can both make
explicit this performance-over-time and deal with the tricky
issues of feedback and delay. Those tools are not too complex
or arcane either; they are certainly within the grasp of reason-
ably skilled business analysts. They work on some basic
underlying principles:
Performance depends on resources customers drive
sales, staff drive costs, for example.
Resources accumulate over time the number of cus-
tomers today is the sum of all those you ever won, minus
all those you ever lost and the same principle is true for
staff, processing capacity, product range, and so on.
How quickly resources build up, or are lost, depends on
what is currently in place customer losses each month
reflect the processing capacity and number of staff avail-
able to serve their needs
Put these principles together, and you can create a complete-
ly transparent, fact-based, and quantified picture of your busi-
ness. Its use for planning business development or tackling
major challenges is known as Strategy Dynamics3, and it can
be done at a simple, high level on paper or a whiteboard. As
the detail increases, more powerful methods are needed, and
although the analysis can be done with spreadsheets, you
would not want to, as much better tools are available. These
make explicit the feedback and delays that result from the
principles above, and although their use is entirely common in
other complex situations, such basic simulation methods
rarely make it into a board level toolbox.
At the heart of this approach, and the simulation tools that
make it usable, lies a critical feature of the second principle
above, for example, that resources accumulate over time.
Because, for example, your customer-base is the sum of
121
 unlikely to join up mid-range customer losses in, say, manufac-
turing industry in Southern Italy with media-sector losses in
Belgium and realize that this is a deliberate plan against their
corporate banking unit.
This approach can be used in both B2B and B2C cases, though
the tactics and mechanisms vary considerably. In one case, a
company offering an investment product for high-net-worth
individuals through brokers found itself competing with sev-
eral established competitors. Rather than simply send its sales
force after the best brokers in every locality, the company
identified that one particular competitor had a broadly-
spread, but substantial set of broker relationships throughout
the country, but did not have an especially attractive product.
It was a relatively easy matter to estimate the mid-ranking
brokers in this competitors account base. From this knowl-
edge, a sales force deployment plan was hatched that picked
off just a few brokers each quarter, in each territory. This was
backed up by consumer promotions, targeted using census-
based profiling on just those streets in those localities where
the key consumers were most concentrated. This increased
hugely the likelihood that, when such an individual was seek-
ing this kind of investment product, they would be most likely
to contact a broker who had been targeted by the companys
sales rep. Piece by piece, broker by broker, the competitor
found its business base picked apart until finally there was
nothing valuable left. Of course, it took a couple of years, but
the prize was well worth the patience.
sible without some basic ongoing intelligence and continuing
fact-based decisions on how to respond as events unfolded.
Conclusion
The recent performance of most financial service companies
suggests that there is substantial room for improvement in
the strategies and decisions they make in their efforts to
develop. Making the right decisions to make it possible to ful-
fill those aspirations is not easy, because of the complexities
that arise from accumulation effects, interdependencies, and
feedback in the business systems we run.
This is especially challenging when seeking growth, as many
more factors must be understood and manipulated than when
running business-as-usual. Fact-based, numerical decision-
making is essential for tackling these complexities, and can
give real competitive advantage when it is thoroughly and
professionally applied, using tools that are fit-for-purpose.
Success stories demonstrate that the rigor of the Strategy
Dynamics approach can make sense of complex situations
with high levels of uncertainty, and build estimates of future
performance that have much higher levels of confidence than
can be achieved by traditional methods.

Then came the consequential damage. The competitors best

sales people were demoralized, with many joining the attacker,
who then, of course moved on to target the next line of busi-
ness and the next rival in its progress to leadership in the
sector. Throughout this episode, management were able to
monitor the plans progress with week-by-week information on
business gains and losses. Not even the sales force them-
selves knew of the plan. They simply thought they were being
given good prospects to pursue which of course they were.
Management, though, knew exactly the rate at which the plan
was coming to fruition, none of which would have been pos-

122 - The journal of financial transformation

esting, the more pronounced the word of mouth leverage
across all behavioral segments would have been. Our analy-
sis outlined that only the gamers were particularly active in
spreading the word concerning the interest free offer, conse-
quently attracting other unprofitable customers interested
in using the card to get free funding at the expense of the
issuer. By analyzing the product launch challenge and model-
ing the economic effect of various scenarios on the basis of
the cardholder response, it was possible to test the results of
various product configurations on the overall economic per-
formance projected over a number of months from product
launch. The effectiveness of this approach to product design
on the performance of the card was highly positive, with the
actual performance during the initial months after product
launch being close to those that were simulated. It was also
possible to anticipate the impact of reactive initiatives by
competitors that changed the initial assumptions underlying
the product development model.
Beating competitors is widely thought to be a good thing to
do, but few organizations display the focus or determination
to do it properly. Mostly, firms seek to offer a better value
proposition to customers, in the hope that this will win per-
centage points of market share. This is way short of what can
be done why? Firstly, it spreads efforts too thinly, when
higher impact can result from focusing on where gains are
easiest. It is also costly to try and win on all fronts at the same
time. Secondly, if your market is growing slowly, stretching
targets might imply taking substantial share from everyone,
and few will sit back and let this happen. Thirdly, competitors
can differ widely in both the profile of their business and their
ability to compete, so some are easier to beat than others.
Lastly, many markets include competitors who make life more
difficult for everyone, customers included offering foolish
prices they cannot sustain, promising services they cannot
fulfill, and so on. You would be better off if they were not there
and you do not have to do anything that falls foul of compe-
tition rules to make this happen.
You need two pieces of information: firstly, an estimate of the
quality distribution of your rivals customer-base. This simply
shows the cumulative profit you think they make from each
customer in their business, from best to worst. Secondly, a
segmentation of their business into customer groups by
industry and/or territory, for example.
Few companies seem to have such intelligence. You may need
to do a bit of work, or spend a bit of money, and just ask your-
self this: what is the size of the prize you can take by decimat-
ing chosen competitors in your space? It does not need to be
100% accurate, just near enough to choose your priorities.
So you now have some rough information on where each
competitor makes money. Which are you going to attack,
where, and how? Taking on the strongest could be a bloody
battle, and hurt you more than them. Often, the best choice
is a competitor who is about the same size as you, but clearly
weaker in some important parts of their business. Taking
significant revenue from them makes a worthwhile contribu-
tion to your own aims, and may so weaken them that they
collapse entirely.
Choosing where to target their business is where the cus-
tomer quality curve and segmentation come into use. Often,
companies aim for the big targets competitors key custom-
ers who contribute most to their profits. There are two prob-
lems with this: firstly, they will probably notice, and secondly,
they will likely defend them to the death, or worse, retaliate in
kind. It is often better to pick your competitors mid-range
customers. It is usually best if your victim does not realize you
are after them, so aiming across a large number of not-so-
large customers allows you to pick targets in a seemingly
random manner that will not be noticed.
You can make the attack still harder to detect by using your
segmentation of the competitors business. Most organiza-
tions divide up business development efforts in some way,
whether by industry-served or by region, for example. You can
use this knowledge to randomize further the customers you
target. Unless your rival is highly sophisticated, they are most
123
124 - The journal of financial transformation
 Financial

Is competition in the
financial sector a good
thing?1

Falko Fecht
Economist, Deutsche Bundesbank

Antoine Martin
Senior Economist,
Federal Reserve Bank of New York

Abstract
We argue that increased competition in the financial sector
may not be beneficial, at least in some cases. Increased com-
petition has the benefit of reducing inefficiencies associated
with monopoly rents. However, increased competition
between banks and the financial markets also limits the
amount of risk-sharing that banks can provide. If competition
between banks is not very strong, then increased competition
with the financial markets may well be beneficial. Indeed, in
this case the benefit of reducing the inefficiencies associated
with monopoly rents is likely to be greater than the costs of
reduced risk-sharing. In contrast, if competition between
banks is already strong, then increased competition with the
market could be negative. In this case, competition with the
market primarily reduces the amount of risk sharing banks
can provide.

1 The views expressed here are those of the authors and not necessarily those of
the Deutsche Bundesbank, the Federal Reserve Bank of New York, or the Federal 125
Reserve System.
 Is competition in the financial sector a good thing?
particular, if the benefit arising from a reduction in monopoly
rents more than compensates for the decrease in the amount
of risk-sharing banks can provide. The optimal level of compe-
tition with the financial markets equalizes the marginal bene-
fit and cost of such competition.
In contrast, increasing competition with financial markets is
not likely to be beneficial if competition between banks is
already very strong. When competition between banks is
strong, the monopoly rents are already very low. Thus, the
cost of decreased risk-sharing is likely to be greater than the
benefit of increasing competition.
A stylized environment
To provide some rigor to our argument, we describe a stylized
environment2. Consider an economy that lasts three periods,
0, 1, and 2. There are several regions or neighborhoods, each
containing a bank and a large number of households.
Households are endowed with some resources at date 0.
These resources can be deposited in a bank, invested into a
short-term asset, say a T-bill, or invested into a long-term
project. The long-term project reaches maturity at date 2 and
has a higher return than T-bills if it reaches maturity. However,
if the project must be liquidated early (at date 1), then its
return is lower than that of the T-bills.
Households do not know at which date they will want to con-
sume. They want to consume either at date 1 or date 2 but not
both. However, households know the probability with which
they want to consume at date 1. They find out at date 1 the
exact date at which they would like to consume.
Deposit Equity + bonds Fund shares Branches CR5
(% of GDP, (% of GDP, (% of GDP, (per million (1999)
2002) 2002) 2002) inhabitants,
2001)
USA 34 48 18 272.9 26.2
Germany 53 31 17 640.5 18.8
Figure 1 Comparison of the German and the U.S. financial system
126
We can derive the consumption of households if financial mar-
ket access is unrestricted. Impatient households, who care for
consumption at date 1, consume an amount equivalent to the
return of their endowment invested in T-bills. Patient house-
holds, who care for consumption at date 2, consume an
amount equivalent to the return of their endowment invested
in a long-term project. This result is a consequence of arbi-
trage.
Arbitrage imposes that the price of a claim on a long-term
project is the same as the price of a T-bill, at date 1. To gain
some intuition, assume that the price of a claim on a long-
term project is in fact greater than the price of a T-bill. If that
were true, all households would have an incentive to invest all
their endowment in long-term projects. Impatient households
could sell their projects for more T-bills than they would be
holding, had they invested in T-bills at date 0. Patient house-
holds could hold on to their projects until they want to con-
sume. But if all household invest in long-term projects, there
will be nobody to trade with at date 1. This contradiction shows
that the price of long-term projects cannot be greater than
the price of T-bills at date 1.
Could the price of long-term projects be smaller than the price
of T-bills at date 1? If this were true, all households would have
an incentive to invest in T-bills only. Patient households could
sell their T-bills for more long-term projects than they would
be holding, had they invested in long-term projects at date 0.
Impatient agents can simply sell their T-bills to consume.
However, if all households had invested in T-bills, then there
would be no long-term projects to be traded at date 1. This
shows that the price of long-term projects cannot be smaller
than the price of T-bills at date 1. The prices must thus be the
same.
In summary, when households have unrestricted access to
financial markets, they invest their endowment in a mix of
T-bills and long-term projects. At date 1, impatient household
sell their long-term projects to patient households for T-bills.
Is competition in the financial sector a good thing?
This paper argues that the effect of increased competition in
the financial sector may not be beneficial, at least in some
cases. Our theory suggests that the benefits of increased
competition between banks and financial markets depend on
the competition that may already exist between banks. If
banks are already very competitive, increasing competition
from financial markets can have a negative effect.
Our study is motivated by the differences that exist between
the financial systems of different countries. For example,
households in the United States typically hold relatively large
parts of their portfolio in market related investments. These
are typically in the forms of stocks and corporate bonds, but
shares of money market funds and investment funds also play
an important role within the portfolios of private households.
Bank deposits are relatively less important. The small share of
bank deposit may reflect, in part, a lack of competition
between banks for households funds.
In contrast, Germany has a dense network of competing bank
branches. Competition indicators, such as a low Herfindahl
index and the concentration ratio of the 5 largest banks (CR5),
suggest a high degree of competition among banks for house-
holds savings. This may also account for the fact that German
households still hold a large part of their portfolios as bank
deposits. Only a relatively low fraction is invested in non-
intermediated assets and shares of market-related financial
intermediaries, such as investment and money market funds.
Figure 1 provides some numbers illustrative of these observa-
tions.
2 The formal model can be found in Fecht and Martin (2005)
In summary, while the market-oriented financial system of the
U.S. is characterized by a high degree of competition between
banks and markets, the German bank-dominated financial
system is best described as having intense competition among
banks.
In our model, banks provide risk-sharing. They offer liquid
deposit contracts to agents who are not sure at what time
they will want to consume. In other words, banks can provide
some insurance to depositors against the risk of having to
consume early, before high yielding projects have matured
[Diamond and Dybvig (1983)].
In contrast, financial markets are unable to provide insurance.
Contracts cannot depend on depositors desire to consume
early or late because this trait is not observable. Moreover, if
depositors have unrestricted access to financial markets, the
banks can no longer offer a deposit contract that provides
insurance [Jacklin (1987), Diamond (1997)].
Financial markets allow depositors to renege on an implicit
commitment they make when they accept a deposit contract
from a bank. Indeed, banks provide risk-sharing by offering
depositors who withdraw early more than they would get on a
financial market. Consequently, they must offer less to depos-
itors who withdraw late. Financial markets provide patient
depositors with an outside option and thus undermine the
efficient contract offered by banks.
Increased competition between banks and financial markets
can have negative welfare consequences. This is because risk-
sharing opportunities disappear as access to market improves.
The deposit contract offered by the banks provides less insur-
ance. However, increased competition has the benefit of
reducing monopoly rents. In turn, the welfare losses associat-
ed with these rents are reduced. Our paper studies the trade-
off between these two effects of increased competition.
Increased competition by financial markets is likely to be ben-
eficial if competition between banks is not very strong. In
127
 Is competition in the financial sector a good thing?
ciently. As a consequence, monopoly profits are associated
with an inefficiency.
With all the elements of our environment in place, we can
study the interaction of a monopolistic bank with a financial
market.
A monopolistic banking system
Households have unrestricted access to the bank that oper-
ates in their region. However, households must pay a cost to
deposit their resources in banks that operate in other regions.
This cost may reflect the effort necessary to gather informa-
tion about banks situated outside of the households region. In
this section, the cost is assumed to be so high that no house-
hold would consider paying it. In other words, each bank is a
local monopoly constrained only by the households ability to
invest in the financial market.
We let denote the cost that households must pay to become
sophisticated and thus have access to the financial market. If
this cost is high, few households will choose to become sophis-
ticated and the local banks monopoly position is little con-
strained. In contrast, if is low, many households will choose
to have access to the financial market and the local bank will
be more constrained.
The welfare implications of improved access to a financial
market are summarized in Figure 2. The horizontal axis
denotes the cost, , that households must pay to become
sophisticated and have access to the financial market. The
vertical axis denotes the expected utility, or the welfare,
received by households in this economy.
If the cost of becoming a sophisticated investor is very high
(higher than ) then becoming a sophisticated investor is
prohibitively costly. The only relevant outside option for
households in that case is to invest in T-bills. Knowing that, the
bank can offer a deposit contract that pays out very little.
Because the banks profits are high, the inefficiencies associ-
ated with monopoly rents are high. Slight changes in the costs
128 - The journal of financial transformation
of becoming a sophisticated investor do not affect welfare in
that case.
In the interval between
and , the cost of becoming a
sophisticated investor is sufficiently low that this is now
the relevant outside option for households. Thus, with a lower
cost the banks monopoly position is constrained further.
The regional bank must increase the amount paid out by its
deposit contract to reduce the incentives of households to
become sophisticated. The profits of the regional bank
decrease as the amount paid out by the deposit contract
increases. Therefore the inefficiencies associated with monop-
oly rents also decrease. In summary, improved financial mar-
ket access improves welfare because it limits inefficiencies
due to monopoly rents if the cost belongs to the interval
between
and .
Finally, consider the interval between 0 and . The inefficien-
cies associated with monopoly rents continue to decline as
the deposit contract pays out more. However, in this region
increased financial market access also reduces the amount of
risk-sharing that can be provided by the deposit contract.
For such low values of , all households have an incentive to
deposit their resources in the bank. Patient depositors can
pretend that they are impatient, withdraw their deposit at
date 1, and invest in the financial market. To reduce the incen-
tive to do so, the regional bank must decrease what it pays out
at date 1 and increase what it pays out at date 2. In other
words, it has to reduce the liquidity insurance or the amount
of risk-sharing provided by the deposit contract. Hence, some
costs are associated with an improved financial market access
in this interval.
At the point denoted by *, the marginal welfare benefit from
reducing the inefficiencies due to monopoly rents is equal to
the marginal welfare costs from the reduction in risk-sharing.
This is the value of the cost that maximizes overall welfare in
this case.
Is competition in the financial sector a good thing?
EU
Figure 2 Welfare in a monopolistic banking system
The role of banks
We assume that our households are sufficiently risk-averse.
Specifically, we assume that at date 0, before they know
their type, households would be willing to give up a little bit
of consumption if they are patient, in which case they benefit
from the higher returns of the project, for a little bit more
consumption if they are impatient, in which case they only
realize the lower return on T-bills. In other words, households
would like some insurance against the risk of being impatient
and consuming only the equivalent of the return on T-bills.
Banks deposit contracts are able to provide risk-sharing, if
households do not have access to financial markets. The
deposit contract allows all households to withdraw at date 1.
Only impatient households will want to withdraw early if the
deposit contract promises a higher return at date 2 than at
date 1. Diamond and Dybvig (1983) first studied this role of
banks.
We can show that financial markets are unable to provide
this kind of insurance because a households type is unob-
servable. Worse, household access to financial markets
undermines banks ability to offer a deposit contract that
provides risk-sharing. Indeed, patient households that have
access to financial markets can pretend to be impatient in
order to receive the high return promised by the bank at
date 1. These households can then trade what they have
received on the market for long-term projects. In other
words, patient households are not willing to accept the low
return offered by banks at date 2 if they can avoid it. This
insight is due to Jacklin (1987). Diamond (1997) also studies
this problem.
In our story, households access to financial markets is related
to their ability to monitor long-term projects. Sophisticated
households are able to select good long-term projects and
monitor them effectively. This allows them to realize a high
return. In contrast, naive households are likely to select poor
projects and may be unable to monitor them properly. The
expected return that naive households receive from a long-
term project is so low that these households prefer to invest
in T-bills or deposit their resources in a bank.
Households can pay a cost to become sophisticated. This
cost reflects the effort needed to acquire the knowledge
necessary to screen and monitor projects. We assume that
the banks ability to select and monitor projects is equivalent
to that of sophisticated households.
Monopoly rents
Each region has one bank. Many bank managers compete for
the license to run a bank. They compete by promising to pay a
share of the banks profits to its owners. We assume that
households own banks and that each household has a diversi-
fied portfolio. Competition spurs bank managers to promise
the maximum pledgeable share of profits.
Bank managers are unable to promise the entire realizable
profits because of informational frictions. One story might be
that higher bank profits lower the pressure on the bank man-
ager to spend his/her full effort on managing the bank effi-
EU
1 > 2
1
2
Figure 3 Welfare in a competitive banking system
129
 Is competition in the financial sector a good thing?
that can be achieved with a high value of in a bank-based
system depends on the intensity of bank competition. As
shown in Figure 4, a bank-based system can achieve higher
welfare than a market-based system if the intensity of compe-
tition between banks is sufficiently high ( smaller than ).
In our simple environment, the highest achievable level of
welfare can only be reached in a fully competitive bank-based
system. This corresponds to the case where interbank compe-
tition is at its highest level ( = 1) and the competition with the
market is not too high ( greater than
). In other words, it is
a system in which banks do not have any regional market
power and households do not have an efficient market access.
In that case banks do not realize monopoly rents that cause
inefficiencies nor does the threat of financial market invest-
ments constrain the amount of risk-sharing offered by the
optimal deposit contract.
Conclusion
In summary, in a monopolistic banking system an optimal
degree of financial market access exists that trades-off the
benefits of risk-sharing with the costs of monopoly rents. In a
competitive banking system, improved financial market access
can only reduce risk-sharing because monopoly rents are
already small. Reducing the costs of financial market access
cannot be beneficial in this case.
If competition among banks is sufficiently intense, monopoly
rents are so small that the cost associated with reducing risk-
sharing is greater than the benefit of a further reduction in
the monopoly rents. In that case, a financial system with com-
petition among banks but no competition between banks and
markets is more efficient than a system with competition
between banks and markets but not sufficient competition
within the banking sector.
Our analysis suggests that improved access to financial mar-
kets is likely to be beneficial in market-based systems if the
risk-sharing provided by banks deposit contract is not reduced
too much. In contrast, in bank-based systems there appear to
130 - The journal of financial transformation
EU
=1
1
Figure 4 Comparing the efficiency
be few benefits from increased market access.
Consequently, the developments in households portfolios in
Germany and the U.S., as depicted in Figures 5 and 6, might
have very different welfare implications. While the greater
bank dominance in Germany is reflected in the structurally
larger fraction of cash and deposit holdings of households, in
both countries this position experienced a remarkable decline
in the recent decade. At the same time direct capital market
investments and particularly more market oriented intermedi-
aries gained substantially in importance.
If these changes reflect an intensified competition between
banks and other market related investments our analysis sug-
gests that this might have been welfare improving in the U.S.
Here this development might have contributed to a reduction
in banks market power leading to greater efficiency in the
banking sector. In contrast, in Germany where banks have had
historically low market power in the retail business anyway,
the increased competition by more market related invest-
ments might have only reduced the risk-sharing provided by
banks deposit contracts.
References
Diamond, D., 1997, Liquidity, banks, and markets, Journal of Political Economy, 105,
928-956
Diamond, D., and P. Dybvig, 1983, Bank runs, deposit insurance, and liquidity,
Journal of Political Economy 91, 401-419
Fecht, F., and A. Martin, 2005, Bank, markets, and efficiency, Staff report 210,
Federal Reserve Bank of New York
Jacklin, C. J., 1987, Demand deposits, trading restrictions, and risk sharing. In
Prescott, E.C. and N. Wallace, Contractual arrangements for intertemporal trade,
26-47, Minneapolis, University of Minnesota Press
 Is competition in the financial sector a good thing?

100% The horizontal and vertical axes have the same interpretation
as in Figure 2. With competition between banks, access to the
80%
financial market is no longer necessary to reduce monopoly
60%
rents of the local bank. Such rents are constrained if the cost
40% is sufficiently low to make the option of going to a non-
20%
regional bank enticing. In this case an increasing competition
between banks and financial markets does not have any ben-
0%
eficial effects a reduction in never improves welfare. But
91

97
94

01
98
95
92

02
99

improved financial market access (a reduction in ) may still

96
19

93

03
00
20
19
19

19

20
19
19

19

19

20
19

20

Mutual fund shares Shares reduce the amount of risk sharing that banks are able to offer.
Credit market instruments Cash and deposit By the same reasoning as above, banks must decrease the
Other equity
amount they pay out at date 1 and increase the amount they
pay out at date 2 if competition with the financial market is
Figure 5 Households portfolio in Germany
more intense. The reduction in risk-sharing lowers welfare.
A competitive banking system This can be seen in Figure 3 in the region where is lower
100% than
.

80%

If the cost of going to a bank from a different region decreas-

60%
es from 1 to 2, as in Figure 3, welfare increase as monopoly
40%
rents are squeezed out by the increased competition.
20%

0%
Comparing bank-based and market-based
systems
90

96
93

03
00
97
94
91

01
98
95
92

02
99
19

19

20

We can think of the financial structures described above as

19

19

20
19
19

19

20

20
19

19

19

Mutual fund shares Shares
Credit market instruments Cash and deposit
Other equity
Figure 6 Households portfolio in the U.S.
The welfare implications of improved financial market access
are quite different in a competitive banking system. In this
section, we assume that the cost for households to deposit
their funds in the bank of another region is not too high.
Competition between banks increases as the cost, denoted by
, decreases. Of course, the financial market continues to
compete with all the banks in the system.
The welfare implications of improved access to a financial
market and increased competition are depicted in Figure 3.
polar cases of market-based versus bank-based systems. In
one section we assumed that there is no competition
between banks and only the financial market provides an
outside option to local households. In the following section
we assumed that there is intense competition between banks
as well as, possibly, competition with the financial market. In
this section we compare the welfare implications of the two
systems.
In Figure 4, we have merged Figures 2 and Figure 3 together
for ease of comparison. The optimal degree of financial mar-
ket access for a system with insufficient competition among
banks is given by *. This point corresponds to the highest
level of welfare achievable in a market-based system. In a
system with competitive banks welfare is maximized when the
cost of financial market access is higher than . The welfare

131
132 - The journal of financial transformation

Adam Dener
Partner, Capco
Andrew Pirnie
Head of Research, Capco
Diane McDevitt
Managing Principal, Capco
Abstract
Dener (2004) suggested that the U.S. banking industry was in
the early stages of increasing and sustaining profitability
compression. The issues facing banking are numerous, com-
plex, and onerous, spanning commercial, competitive, and
regulatory challenges which have resulted in average returns
on equity (ROE) for the banking industry when compared to
other industries. This paper will extend on the findings of
Dener (2004) and illustrate that the negative momentum in
sustaining profitability is continuing. It will also highlight
Financial
A bad situation
getting worse
the U.S. banking
profitability crisis
some of the underlying causes for this negative trend. Our
findings suggest that improvements in productivity are insuf-
ficient to offset the constrained revenue dynamics of banking
and that revenues generated from the migration towards
increasing fee income as a percentage of total income cou-
pled with inadequate operational leverage and compensation
dynamics provide limited relief to the pressure on profitabili-
ty that we see today.
133
 A bad situation getting worse the U.S. banking profitability crisis
Dener (2004)1 suggested that the U.S. banking industry was
at the early stages of a prolonged period of profitability com-
pression. This paper aims to extend on Dener (2004) and
provide detailed analysis of the financial results and trends in
the U.S. banking marketplace. Together with industry-wide
analysis, and qualitative research into key trends and drivers
that are impacting the U.S. banking industry, this paper looks
at the evolution of the change in how banks generate reve-
nues and the nature of the underlying expenses associated
with them over the last twenty years and undertakes a closer
examination of expenses, productivity, and profitability of the
business models deployed to determine their effectiveness. In
addition, this paper will asses the effectiveness of the merger
and acquisition strategies deployed over the past ten years, as
measured by the efficiency ratio, and takes a closer look at the
concentration of asset and deposit market shares.
The results of the analyses are insightful. Firstly, we find that
banking profitability is caught between a high, largely inflexi-
ble, fixed cost base unable to cope with slower growth in rev-
enues and faster growth in expenses. Projected revenue and
cost growth figures suggest that expenses will outstrip reve-
nues between now and 2007, which will be the first time this
has happened for almost thirty years, and that bank revenues
will continue to shift from interest generated sources to fee-
based ones. Secondly, we see that projected average profit-
ability growth is declining and 2007 will likely mark the start
of a profit compression that could leave some banks seriously
exposed to underlying market conditions. Finally, business
models and strategies are important considerations as banks
that are predominantly reliant on corporate and institutional
fee-based businesses continue to consistently underperform
their interest income oriented peers.
This is an alarming trend toward the declining profitability of
the financial services industry. The modest improvements
made in bank efficiency over the last couple of years have
masked a deeper problem in profitability. The banking giants
have not obtained adequate rewards through greater produc-
tivity from industry consolidation nor have they been effec-
134 - The journal of financial transformation
tive in managing the profitability of the chosen business
models. The industry has only made improvements around
the edges without achieving fundamental change.
These issues require focused attention from bank manage-
ment to stimulate growth and profitability. Urgent action is
required because of the expense trend. Clearly, management
needs to manage the efficiencies that should be generated
from scale. If banks prove incapable of managing cost, driving
revenues, and sustaining profitability organically, mergers and
acquisitions remain a viable alternative. However, manage-
ment will need to drive harder for performance resulting from
these mergers. If underperformance vis--vis other industries
investment opportunities continues and is due to lack of depth
of management expertise, investors might consider alterna-
tive investments or action to effect the fundamental change
needed to drive towards comparable investment performance
and profitability. Investors will demand change.
Crisis, what crisis?
The banking industry has recorded significant headline grab-
bing gross profits in recent years. While the news suggests
that the industry is experiencing positive momentum, closer
examination reveals that there is a dangerous shift away from
sustainable profitability. Real banking revenues have been flat
and are experiencing limited growth (Figure 1).
500 5.00%
400 4.00%
300 3.00%
200 2.00%
100 1.00%
0 0.00%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Commercial Banks
Savings Institutions
Revenue/GDP
Figure 1 U.S. Financial services revenues U.S.$ bln 1994-2004 as % of GDP
Source: FDIC, IMF, Capco analysis
1 Dener, A. L., 2004, The emerging crisis in U.S. banking profitability, working
paper, Capco Institute
 A bad situation getting worse the U.S. banking profitability crisis
There has been a fundamental shift in revenue generation
from interest income sources towards nontraditional busi-
nesses that generate fee income, such as trading services and
other transaction and fee-based products that provide non-
interest income. As illustrated in Figure 2, commercial banks
now generate approximately 40% of their revenues from non-
interest sources; up from 25% in the mid-1980s.
On the surface, this diversification trend would appear benefi-
cial, with several important trends having contributed to this
evolution. Firstly, business model integration of traditional
banking and investment banking products has increased the
overall fee income opportunity for a number of the larger
banking institutions. Secondly, the rise of securitization, par-
ticularly of consumer credit pools, has reduced interest
income statement centricity for many institutions. And, finally,
the migration from interest income to non-interest income
represents a shift from a longer term income source (interest
income is recognized over the life of a loan obligation) towards
a shorter term one (non-interest income is often recognized
upon a transaction or event).
Many might argue that this shift is healthy, as interest income
is cyclical. A mechanism used to maintain revenues during
difficult times in the credit cycle is to lower credit standards.
100%
80%
60%
40%
20%
0%
1984 1987 1990 1993 1996 1999
Interest income
Non interest income
Figure 2 U.S. commercial banks interest vs non-interest income 1984-2004
Source: FDIC, Capco analysis
Nevertheless, it is important to note that non-interest income
is also cyclical and has business cycle dynamics that may be
similar or different from those of the credit cycle.
An implication of these changes is the need to generate
increasing amounts of non-interest-based revenues to offset
the reductions in gross margins. This move towards a shorter
term view has implications for medium-term profitability, as
the core interest income revenue streams dissipate with the
shift. Furthermore, there are other implications of the revenue
shift that are of importance as well, such as increased costs.
The underlying scalability of the new revenue sources and the
operational infrastructure requirements of the underlying
businesses are important components in assessing the overall
profit viability of the shift in the industrys income statement
as a whole. The industry is now facing a challenge of matching
fixed and variable cost structures of the supporting business-
es in line with the variability of the revenue streams.
A shift in making a buck
Looking back over the past 20 years and the evolution of how
revenues have been generated and the nature of the expenses
involved in that revenue generation process offers us a strik-
ing perspective, as Figure 3 demonstrates. Several issues are
noteworthy about the data. Firstly, interest income is down by
approximately fifty percent. Secondly, provision for loan loss-
es is down three fold. Thirdly, the mix between interest and
non-interest income has shifted considerably. Finally, taxes
and extraordinary items have approximately doubled.
Banks have experienced a dramatic reduction, of over 50%, in
interest income between 1984 and 2004. This shift and the
greater dependency on non-interest revenue streams mark a
fundamental shift in the way banks earn their money. Interest
income is derived from what could be called traditional bank-
2002 2004
ing products mortgages, personal lending, bank account
balances and so on. These lending and deposit taking func-
tions are represented on the balance sheet as assets and lia-
bilities, so a large bank by assets could reasonably derive a
significant portion of its income from such products.
135
 A bad situation getting worse the U.S. banking profitability crisis
es

e
he

m
ss

co
ot
lo

in
&
n
oa

et
xe

N
rl

Ta

$8 present day revenue is only 0.3%, or 30 basis points, ahead of

$7
1.71 2.38 expense growth.
1984
$6
5.24
Projecting these trends forward, between 2006 and 2007
$5 0.77
1.62
long-term expense growth will likely outstrip revenue growth.
$4
This last happened in 1987 which was also the only year in
$3
0.89 the last twenty years when the combined commercial and
$2
0.29 savings banking industry reported a loss. The 1987 loss was
1
$1
driven primarily by heavy losses by savings banks, although
$0
commercial banks also reported their worst results since the
($2.86) $0.05 ($1.32) ($0.46) ($0.53) ($0.64) $0.14 Change mid-1960s.
$8

$7 This view of the past and the glimpse into the future helps us
2004
$6 focus today on the performance of the chosen business mod-
$5 els to better understand its inherent ability to sustain longer
1.76 1.06
$4
term profitability.
0.31
$3 1.09
2.38
0.25
Is scale helping?
$2
0.43
1 Another important trend for the industry is consolidation. The
$1
overall number of banks has declined in recent years due to
$0
mergers and acquisitions within the U.S. industry, running at
4%. Clearly M&A has been a preferred strategic tool over the
past decade and a half as banks have executed numerous
horizontal mergers and product acquisition transactions.
Whether or not the outcomes have been effective is open to
debate. Nevertheless, close examination of the relationship
Figure 3 U.S. commercial banks how to make a $1 in 1984 & 2004
Note: Taxes & other other is extraordinary items and securities gains & losses between the number of banks and efficiency ratio suggests a
Source: FDIC, Capco analysis linear relationship.

which have invested in higher paid staff and fewer offices,
against the traditional retail banks, which are reliant on a
higher fixed cost base of branches and large, stable work-
force.
Elements of these issues are apparent in a comparison of
revenues, expenses, and profit growth over the last 20 years.
Figure 4, which provides the five year Compound Annual
Growth Rates (CAGRs) for each, illustrates that while in the
mid 1990s strong profit growth was supported by revenue
growth which was 2% per annum above expenses growth,
In addition to the absolute numbers of banks, manifestations
of consolidation are also reflected in reviewing elements of
the industrys concentration in balance sheet accounts. A
review of deposits indicates that the top 10 banking compa-
nies now control 35% of all industry deposits, up from 20%
ten years ago.
In terms of asset concentration, the top 10 banks now hold
over 51.5% of all bank assets, up from 18.5% ten years ago.
Clearly this is a concerning relationship. The largest banking
companies have been able to concentrate their assets faster,

136
 A bad situation getting worse the U.S. banking profitability crisis

600 $ Billions 4.2%

of revenue risk or higher credit provisions in the event of poor
lending decision making in economic downturns.
500 5.1%

400 8.7%
4.7%
Banks have traditionally depended on a broad branch infra-
300 4.8%
structure and stable headcount to support this business mix,
6.8%
7.8% both of which are largely reflected in the income statement as
6.8% 9.5%
200
4.7% fixed costs. In essence, interest income requires infrastructure
6.4% 11.8%
100 7.9% which equates to a certain level of fixed costs.
28.4%
-2.1%
0
Non-interest income (largely fee-based) tends not to be as
-100
broadly reflected in the balance sheet and depending on the
type of business activity requires a lower fixed asset base.
Revenues Expenses Profits
80% 20,000
18,000
Figure 4 U.S. commercial bank revenues, expenses, and profits 1984-2004, pro- 75% -4.0% 16,000
jections to 2010 and 5-year CAGRs 14,000
70% -4.7%
Source: FDIC, Capco analysis -1.8%
12,000
-3.6%
65% -2.4% 10,000

Fluctuating interest rates have a significant impact on the -2.6% 8,000

60%
-1.2% 6,000
business, with rate trends reducing credit availability, interest -0.4%
4,000
55%
income, and potentially deposit taking during different cycles. 2,000

The converse in different parts of the economic cycle is also 50% 0

true. While rates shift product margins are largely unaffected,

as most changes are passed on to customers and investors in Efficiency Ratio Institutions
800
Figure 6 U.S. banks efficiency ratio 1984-2004 and 5 year CAGRs
700
Source: FDIC, Capco analysis
600

500

400
Additionally, fee-based incomes are not as balance sheet
300 intensive, which means that banks are not required to hold as
200 much regulatory capital, which in turn allows the industry to
100 more flexibly finance these businesses. The cost of generating
0
this income, however, is more dependent upon human capital.
In this way, fee-based banks have a greater degree of financial
Mergers New charters leverage than interest income-based banks with arguably
more flexibility in their cost base.
Figure 5 U.S. banks merger and de novo banks 1990 -2005
Source: FDIC, Capco analysis
On the surface, non-interest (fee-based) income, which is not
dependent on balance sheet size, is arguably less dependent
the form of higher (or lower) charges and return rates on on the extensive infrastructure which serves to support the
credit, securities, and deposits. In this sense, interest income asset-based business model. This perspective is supported by
is a secure revenue stream with the largest risks being those the relative performance strength of the investment banks,

137
 A bad situation getting worse the U.S. banking profitability crisis

40%
ates of the applicant) controls, or upon consummation of the
35% CAGR 1994-2004
Top 5 14.0% acquisition for which such application is filed would control,
30% Next 5 7.9% Next 5
Top 10 12.1% more than 10 percent of the total amount of deposits of
Industry 5.6%
25% Citigroup insured depository institutions in the United States while on a
20% JPMorgan statewide basis immediately before the consummation of the
15% Next 5
Wachovia
acquisition for which such application is filed, the applicant
10%
Citicorp Wells Fargo (including any insured depository institution affiliate of the
Banc One
Chemical Bank applicant) controls any insured depository institution or any
5% Nationsbank Bank of America
Bankamerica branch of an insured depository institution in the home State
0%
1994 2004 of any bank to be acquired or in any host State in which any
Figure 7 Market share of top ten U.S. banks as % of total U.S. banking deposits
such bank maintains a branch; and (ii) the applicant (including
1994 & 2004 all insured depository institutions which are affiliates of the
Source: FDIC at June each year, Capco analysis
applicant), upon consummation of the acquisition, would con-
trol 30 percent or more of the total amount of deposits of
relative to a core liability component, deposits, with a sig- insured depository institutions in any such State.
nificant difference. It is generally believed that deposits form
the least expensive financing mechanism for the banks bal- These regulations put logical limitations on consolidation and
ance sheet and the size of the concentration difference is of have significant implications for M&A in the industry with the
consequence. next result that bank M&A at or above the 10% deposit cap
limit absent further regulatory change will be extraordinarily
There remains significant regulatory hurdle regarding deposit challenging.
consolidation by banks under United States Code Title 12
Banks and Bank Holdings, Chapter 17 Bank Holding Companies, Given the significant concentration in the largest banks one of
Sec. 1842 that notes significant limitations on acquisition of the expected outcomes would be enhanced operating lever-
bank shares or assets. Specifically, it notes concentration lim- age with improvement in the efficiency ratio. This, however,
its such that on a deposits: The Board may not approve an has not been the case. To date, scale in concentration has
application pursuant to paragraph (1)(A) if the applicant been not proven to offer significant performance enhance-
(including all insured depository institutions which are affili- ment. This now requires a closer look at the expenses and the
business model to see the impediments.
69%

67%

65%
A closer look at expenses, productivity, and
63%
business model
61%
Over the past 5 years there has been a significant upward
59% shift in non-interest expense. Among the largest U.S. banking
57% companies we see that expenses have grown 9.3% CAGR over
55% the last five years ending in 2004.
2000 2001 2002 2003 2004
Average ER top 50 U.S. banks Average ER all U.S. banks
There was no significant efficiency gain among these same
Figure 8 Efficiency ratios 2000-2004 Top 50 U.S. banks as compared to U.S.
banking companies
institutions. While operational leverage, as measured by the
Source: FDIC, company annual reports, Capco analysis efficiency ratio, suggests industry improvement, overall

138 - The journal of financial transformation

 A bad situation getting worse the U.S. banking profitability crisis
100%
CAGR 2000-2004
90% 15%
Other expenses
80% Other expenses
13.6%
70% 0%
Technology/ -5%
60% communications Technology/ 5.8%
communications
Occupancy
50% Occupancy 8.8%
40%
30% Compensation
Compensation 7.2%
20%
10%
0%
2000 2004
Figure 9 Expense analysis of top five U.S. banks 2000 vs 2004 expenses saw
9.3% CAGR over five years GDP output, employees % annual change
Source: FDIC, company accounts, Capco analysis
results over time have not borne out adequate improvements
in operating leverage to those rising costs. This is further
demonstrated in analyzing financial services output and
employment for the industry. On the surface this examination
suggests serious questions about the execution by these
banks or the benefits of their scale. It is interesting evidence
about whether scale is an adequate driver of enhanced per-
formance. Overall financial services headcount has been
largely stable for more than 50 years even as output has fluc-
tuated widely. Unlike U.S. manufacturing output, where there
are significant correlations between output and employment,
banking lacks meaningful correlation as demonstrated in the
output analysis in Figure 10.
Close examination of branch banking and headcount (relative
to U.S. population) demonstrates that trend. In 1984 the U.S.
averaged 26 branches per 100,000 people. By 2004 the num-
ber of branches had risen by two to 28 branches per
100,000 in population. In 1984, there was approximately 25
staff per branch. That number has pretty much remained the
same by 2004, with no major fluctuations in between.
25%
20%
10%
5%
% change banking employees % change banking output
20%
15%
10%
5%
0%
-5%
-10%
-15%
% change manufacturing employees % change manufacturing output
Figure 10 U.S. banking industry compared to manufacturing industry 1954 2004
Source: U.S. Department of Commerce Bureau of Economic Analysis, Capco analysis
Despite consolidation and technology evolution, branches are
as common now as they were 20 years ago with as many staff
around as there were back in the early 1980s. While the com-
position of branch staff and their functional roles may have
changed, it appears that the banks have been unable or
unwilling to reduce their reliance on branch staff in their deliv-
ery model.
One hypothesis would suggest that branch banking activities
would have changed considerably, with many processing func-
tions centralized or outsourced. This has not, however, been
borne out by the data in either staff per branch or population
per branch, suggesting continuing deep-seated inefficiency in
the U.S. retail banking model (Figure 11).
Examination of the overall banking cost base over the last
twenty years reveals that staff and property costs have
remained largely steady (at between 41-49% and 12-16% of
overall costs, respectively), while other costs have fluctuated
between 35% and 46% of the overall costs. As shown earlier,
banking operates a largely fixed cost base. Projecting forward
it appears that this cost base is likely to grow at a faster rate
139
 A bad situation getting worse the U.S. banking profitability crisis
0

02

04

06

08

10
20
20

20
20

20

20,000 250 added can transform the margins of the business.

18,000 Management focus Without question one of the key
16,000 200
14,000 issues facing the industry is and will remain the need for
150
12,000 management to attack these challenges and drive change.
10,000
8,000 100 Improving profitability
6,000 The U.S. banking industry is at a critical juncture, amid escalat-
4,000 50
2,000 ing costs, decreasing revenues, and tightening regulation. The
0
0
1984 1986 1988 1990 1992 1994 1996 1998 2000 2000 2004
increasing number of tools available to bank managers, includ-
ing IT leverage, M&A, re-engineering, and outsourcing must be
Branches per 100k pop (RHS) Employees per Branch (RHS) utilized more strategically over the coming decade. Practical
Employees per bank (RHS) Banks (LHS)
focus on a number of key operational management tech-
Figure 11 Number of U.S. banks, employees per bank and per branch, and branches niques will differentiate competitors and sustain profitability
per 100,000 population 1984-2004 and competitiveness. Particular attention needs to be placed
Source: FDIC Commercial & Savings Banks, U.S. Census Bureau, Capco analysis
on better leveraging of IT and a more thoughtful approach to
customers, their needs, and their behaviors. It is essential that
50%
4.7% 5.4%
8.6%
3.5% 5.4% threats to profitability be assessed and managed quantita-
40% tively as soon as possible.
4.5% 7.2% 4.1%
9.1% 6.1%

30%

20%
4.7%
2.6% 6.6% 5.2% 4.7%

10%

0%

Staff costs Property costs Other costs

Figure 12 U.S. Commercial Bank Expenses 1985-2004

Projections to 2010 and 5-year CAGRs
Source: FDIC, Capco Analysis

70% Revenue growth

1
5-year CAGR
60%

50%
A
40% Key companies
> 70% NI income
30% 2
< 30% NI income
3
20% B 4
E C 6 5
10% D
Average
0% F Net income growth
H G 5-year CAGR
-10%
-30% -10% 10% 30% 50% 70% 90% 110%

Figure 13 Comparing banks by sources of revenue and profitability

Fee-based banks underperformed 2000-2004
Source: annual reports, Capco analysis

140 - The journal of financial transformation

A bad situation getting worse the U.S. banking profitability crisis
than revenues over the coming years, as noted in Figure 12,
which shows the historical growth and projected growth of
these costs out to 2010.
Clearly these trends suggest challenging fundamental macro
issues for the industry as projected expense growth will likely
outstrip projected revenue growth by 2007.
As we look through the prism of sustainable profitability the
question of whether interest income orientation or a fee
income orientation is more profitable offers further perspec-
tive. A comparison of banks with over 70% of their income
from non-interest sources and banks with over 70% of their
income from interest-related sources provides interesting
insight (Figure 13).
The trend is clear. Compared to the average of the top fifty
banks, the majority of those institutions dependent on fee
income underperformed, while the majority of those depen-
dent on interest income outperformed the average.
What does it all mean?
There is an alarming trend toward an inevitable declining prof-
itability in the financial services industry. As discussed above,
the modest bank efficiency improvements over the last
decade, coupled with migration to fee income business mod-
els, and maturation of consumer securitization mask a deep
problem. These issues require significant attention from bank
management.
Banks have not reaped adequate rewards through greater
productivity from the industrys consolidation over the last
decade with the appearance that the industry has made
improvements around the edges without achieving fundamen-
tal change. Further improvements in efficiency are essential.
Unfortunately, however, it is likely that such improvements will
involve both significant investment and simultaneous contrac-
tion for the industry, which for managers of public companies
are challenging dynamics to execute against. Yet as we have
demonstrated, revenue growth will soon be overtaken by
expense growth, and if this happens banks will be forced to
address these issues.
Additionally, the changing nature of the revenue mix on the
income statement, due to the potential shift in business
model, is also concerning and requires further examination.
Nevertheless, the transition from a more profitable and pre-
dictable business to one mixed with lower profitability and less
predictability increases the management and investment chal-
lenges moving forward.
A strategic response is necessary
As long as banks cannot sustain profitability organically by
better managing their expenses or earning adequate reve-
nues to offset higher expenses, mergers and acquisitions
remain a viable solution. Significant opportunities remain for
further consolidation, particularly given the significant macro
structural and regulatory impacts borne of Basel II, Check 21,
and the Patriot Act, as well as many of the issues referenced
in this paper. Nevertheless, the prism offered from a macro-
economic perspective suggests the following template for
management and investors to consider.
Urgency The trends facing the banking industry require
acknowledgement, significant attention, and response. The
time to start acting is now.
Efficiency and scale There should clearly be significant
benefits from both scope and scale. These, however, need
to be put into action as scale absent efficiency is not prov-
ing adequate. Transformation of costs and requisite
changes are key to the industrys economic vitality. The
banks need to focus on matching the fixed and variable
cost structures with the chosen businesses to sustain lon-
ger term profitability. Hard decisions will inevitably need
to be made on subsidizing one division or product line by
another.
Differentiation In absence of cost and or scale/efficiency
benefits it is essential that organizations attempt to realize
incremental benefits valued by their clients through differ-
entiation of products and services. The addition of value
141
142 - The journal of financial transformation
 Financial

Threshold
relationships among
inflation, financial
market development,
and growth1
Michelle L. Barnes
Senior Economist, Federal Reserve Bank of Boston

Nicolas Duquette
Senior Research Assistant,
Federal Reserve Bank of Boston2

Abstract
This paper tests for and estimates relationships among infla-
tion, financial market development (FMD), and growth. This
trivariate relationship changes across a statistically robust
inflation threshold of about 14%. Below 14%, the relationship
between growth and FMD is positive; above 14%, the relation-
ship between growth and inflation is negative. The interaction
between FMD and inflation has a significant impact, however:
below 14% there is a positive correlation between growth and
inflation, but marginal increases in inflation impair the rela-
tionship between growth and FMD; above 14% marginal
increases in inflation have little or no impact on this relation-
ship. This suggests that the role of financial markets as a
channel of economic growth is important and changes with
the level of inflation.

1 This is adapted from a 2000 University of Adelaide Working Paper # 00-4 of the their data, and Colin Cameron, Ananda Chanda, Mark Gersovitz, Tony Hughes,
same title. Oscar Jorda, Richard Pomfret, Ramkishen Rajan, and Christie Smith for their help- 143
2 The authors thank Bruce Hansen for providing his threshold panel testing and esti- ful comments. Views herein do not necessarily represent those of the Federal
mation code on his website, Thorsten Beck and Ross Levine for allowing the use of Reserve System or the Federal Reserve Bank of Boston.
 Threshold relationships among inflation, financial market
development, and growth
financial market activity5.
In our research, a panel dataset is exploited to establish
whether there are statistically significant thresholds in the
single-equation, trivariate relationship among inflation, finan-
cial sector development, and growth. Following the above
bodies of literature, inflation is taken to be the threshold vari-
able of interest. After testing for the presence of thresholds,
a more precise threshold relationship is estimated. Different
models are specified in order to separately test for thresholds
in the relationship between growth and banking sector devel-
opment, growth and both banking sector development and
inflation, and growth and banking sector development, infla-
tion, and an interaction variable between banking sector
development and inflation. This last specification allows for
evaluation of whether the financial intermediation channel
matters for the relationship between growth and inflation,
and best represents the spirit of the Huybens and Smith
(1999) model.
Hansen (1999) provides a method for testing the presence
and number of thresholds, for estimating the value of the
threshold levels, for bootstrapping the p-values for these
threshold tests, and for estimating the coefficients of the
proposed threshold relationships using ordinary least squares
(OLS). Use of this methodology improves on the ad hoc,
researcher-dependent methodology adopted so far in the
search for thresholds in the relationships between growth
and inflation, and financial market development and inflation.
The main advantages of Hansens approach over the usual
dummy variable approach are that the data, and not the
researcher, choose the threshold value and the number of
thresholds, and that the statistical significance of the thresh-
olds can be determined. Hansen (1999), however, has not
worked out the asymptotics of this approach for either an
unbalanced panel or a dynamic panel, so that not all of the
data points used in the previous literature can be used, and
issues of causality can not be pursued.
Our evidence upholds the hypothesis that there are statisti-
3 Temple (2000) provides an excellent survey of the theoretical and empirical litera-
144 ture on the relationship between inflation and growth.
4 In the linear context, many studies (e.g. Logue and Sweeney (1981), and Thornton
(1987) among others) argue that moderate inflation rates can boost growth.
Aghevli (1977) also shows that seniorage revenue can engender positive growth
effects from inflation.
cally significant single-threshold relationships among growth,
financial sector development, and inflation. These results are
robust to model specification, control variable sets, and
choice of proxy for financial market development. The esti-
mate of the threshold value of inflation is approximately 14%.
The confidence intervals about these threshold estimates are
generally tight6. The empirical findings strongly support the
general theoretical predictions of the existence of thresholds
among growth, financial market development, and inflation,
as in Choi, Smith, and Boyd (1996) and Huybens and Smith
(1999).
The estimation results show that output growth and mea-
sures of financial market development are positively corre-
lated below the (14%) threshold level of inflation. These posi-
tive correlations become more significant with model gener-
ality, i.e., as additional thresholds are specified in the relation-
ship between growth and inflation and growth and the inter-
action of financial market development and inflation. Above
the threshold level of inflation, however, the correlation
between growth and financial market development tends to
be indistinguishable from zero except for the least general
model7. When provision is made for both the coefficient on
the measure of financial market development and the coef-
ficient on inflation to depend on the threshold level of infla-
tion, the relationship between growth and inflation is signifi-
cant and negative only above the threshold level of infla-
tion8.
Further generalizing the empirical model by allowing an inter-
action between inflation and the financial market develop-
ment measure to correlate with growth, as intimated in
Huybens and Smith (1999), yields a coefficient on inflation
that is large, positive, and significant below the threshold, but
above the threshold it is negative, smaller in absolute value,
and significant. Inclusion of this interaction channel also indi-
cates that the relationship between growth and financial
market development is affected by the level of inflation.9 The
interaction effects between inflation and measures of FMD
suggest that the channels through which inflation and growth
5 Frischtak (1992) offers a potential counterpoint by arguing that at high rates of
inflation there are incentives to increase branch expansion in order to obtain the
large returns associated with low-interest bank deposits.
Threshold relationships among inflation, financial market
development, and growth
Overview
This paper links together three bodies of literature: the litera-
ture on the relationship between growth and inflation; the
literature on the relationship between growth and financial
market development; and the literature on the relationship
between financial market development and inflation. The
empirical literature has posited ad hoc thresholds in the rela-
tionship between inflation and growth and in the relationship
between inflation and financial market development. It has
also emphasized bivariate relationships in the estimation of
econometric models, and has not considered a simultaneous,
trivariate relationship among these variables. The theoretical
literature has argued that there are thresholds in the rela-
tionship among these three variables, and that the interac-
tion between inflation and financial market development also
affects growth. This paper systematically examines these
empirical and theoretical postulates using Hansens (1999)
panel threshold methodology to test for and estimate thresh-
olds in three threshold growth models, where the relationship
between growth, financial market development, and inflation
becomes progressively more general.
The empirical literature has uncovered positive and signifi-
cant linear relationships between growth and various indica-
tors of banking sector (and equity market) development in
cross-sections [King and Levine (1993a, 1993b), Levine and
Zervos (1998), and Atje and Jovanovic (1993)]. Levine,
Loayza, and Beck (2000) also find positive causation from
financial market development (banking) to growth in a panel
context. A negative and sometimes threshold long-run rela-
tionship between inflation and growth has been found in
cross-sections and non-dynamic panels. This contrasts with
Barro (1995) who claims there is evidence of a negative rela-
tionship at all rates of inflation. Levine and Renelt (1992) and
Clark (1997) ask whether this negative relationship is inde-
pendent of the rate of inflation3. Bruno and Easterly (1998)
and Bullard and Keating (1995) show that this negative rela-
tionship between inflation and growth emerges once inflation
6 This tightness does depend on which model is estimated, the size of the grid over
which the threshold is searched, and which control variable set is employed.
7 For the (balanced panel) dataset employed in this paper, when a zero-threshold or
linear specification is estimated, as in the literature extant on the relationship
between growth and measures of FMD, the positive correlation between these two
variables is more tenuous than in the literature reviewed above. This must be due
to the fact that the methodology of Hansen (1999) requires a balanced panel, so
only two-thirds of the countries included in Levine, Loayza, and Beck (2000) are
usable. On the other hand, when thresholds are modeled, the estimated coeffi-
cients suggest much stronger positive correlations with growth below the inflation
reaches a threshold level, where the threshold is determined
in an ad hoc fashion. Hansen (1996) looks for thresholds in
nominal U.S. GDP, and further evidence of thresholds in
growth is presented in Hansen (2000) in a (univariate) time-
series context4.
The empirical relationship between inflation and financial
market development has been studied by Boyd, Levine, and
Smith (2001). They show that nonlinear (and ad hoc threshold
or piecewise linear) relationships between inflation and finan-
cial market development exist in a cross-section of data. At
low to moderate long-run rates of inflation below 15%, they
find a strong negative correlation between inflation and vari-
ous indicators of banking sector and equity market develop-
ment, but these partial correlations become insignificant
above the stipulated threshold level of inflation (15%). In our
paper, an additional fourth model which enables testing for a
threshold in the bivariate relationship between financial mar-
ket development and inflation is also studied to see if the
data choose a 15% level of threshold inflation in this bivariate
relationship.
Two theoretical papers explicitly model threshold relation-
ships among inflation, financial sector development, and
growth. In the model of Choi, Smith, and Boyd (2001) higher
rates of inflation lead to higher credit rationing and decreased
real activity. When inflation is low, credit rationing does not
occur, yielding threshold effects dependent on inflation.
Huybens and Smith (1999) derive a model in which threshold
relationships among inflation, financial market development,
and growth depend on the exogenous long-run rate of infla-
tion. Under some parameterizations, inflation and financial
market development can interact, and this interaction effect
will also impact growth. Once a threshold level of inflation is
reached, lower levels of real and financial market activity are
obtained; below this threshold increases in inflation can
reduce both real and financial market activity, but above the
threshold further increases in inflation have no effect on
threshold. The significance of these correlations increases with model generality.
Perhaps with more data, the positive correlations in the threshold relationship
would become stronger.
8 When the coefficient on inflation is restricted to be the same across the threshold
level of inflation, the coefficient is also negative and significant. This is consistent
with results found elsewhere in the literature using linear specifications of the 145
relationship between growth and inflation.
9 It is also consistent with the notion that the partial correlation between growth
and inflation is affected by marginal changes in measures of FMD.
 Threshold relationships among inflation, financial market
development, and growth
growth, financial market development, and inflation. Finally,
Model 3 is like Model 2, except that the coefficient on inflation
is constrained to be the same above and below the threshold
of inflation. This least general model allows for a threshold
only in the relationship between growth and financial market
development, and forces the relationship between growth
and inflation to be the same above and below the threshold
value of inflation.
Model 1 can be expressed as: Growthnt = + controlnt +
() financent() + () inflationnt() + () [financent()
inflationnt()] + unt
Growthnt is real per capita growth in GDP for country n at
time t; controlnt refers to the set of control variables; finan-
cent is one of the two variables used to capture the notion of
financial market development; inflationnt is inflation; , ,
(), (), and () are regression coefficients; unt is the
regression error term; and is the threshold level of the
threshold variable (inflation). The explanatory variables are
defined as: financent() = financent (inflationnt ) financent
(inflationnt > )
inflationnt() = inflationnt (inflationnt ) inflationnt
(inflationnt > )
Australia (AUS) Ghana (GHA) New Zealand (NZL)
Austria (AUT) Greece (GRC) Pakistan (PAK)
Belgium (BEL) Guatemala (GTM) Paraguay (PRY)
Bolivia (BOL) Honduras (HND) Peru (PER)
Brazil (BRA) Indonesia (IND) Philippines (PHL)
Canada (CAN) Ireland (IRL) Portugal (PRT)
Chile (CHL) Israel (ISR) Rwanda (RWA)
Columbia (COL) Italy (ITA) Senegal (SEN)
Costa Rica (CRI) Jamaica (JAM) South Africa (ZAF)
Germany (DEU) Japan (JPN) Spain (ESP)
Denmark (DNK) Kenya (KEN) Sri Lanka (LKA)
Dominican Republic (DOM) Mexico (MEX) Sweden (SWE)
Ecuador (ECU) Malaysia (MYS) Switzerland (CHE)
El Salvador (SLV) Niger (NER) Thailand (THA)
Finland (FIN) Netherlands (NLD) Uruguay (URY)
France (FRA) Norway (NOR) United States (USA)
Great Britain (GBR)
Figure 1 Countries included in the dataset
10 The requirement of a balanced panel by Hansens (1999) methodology results in
146 fewer countries being included in the study than were available in Boyd, Levine,
and Smith (2001). The fact that this study is exploiting disaggregated information
in both the time and cross-sectional domains instead of just the cross-sectional
domain might also be causing the difference in the results between these two
where is the indicator function which takes on a value of one
when the expression is true and zero otherwise, and the coef-
ficients take on the following values below and above the
threshold:
() = a if inflationnt , b if inflationnt >
() = a, inflationnt , b, inflationnt >
() = a, inflationnt , b, inflationnt >
The indicator variable more or less splits the datasets into
two sets; one above the inflation threshold and one below,
and estimates a separate coefficient for each set of observa-
tions. Note that the threshold is chosen by the data, not by
the authors. Hansens method simultaneously finds the infla-
tion threshold () and the coefficients (a b a b a, b, , and
) which minimize the sum of squared errors. Model 2
obtains when the coefficient () is set to zero, and Model 3
obtains when () is set to zero and () takes the same value
above and below the threshold , i.e. a = b. In Model 1, the
interaction between inflation and financial market develop-
ment is permitted to affect growth, and just how it affects
growth can change once the threshold level of inflation is
reached, as suggested in Huybens and Smith (1999). They
predict that once inflation exceeds a critical level, the correla-
tion between financial sector development and inflation goes
from being negative to zero [ la Boyd, Levine, and Smith
(2001)]. So far, no empirical studies have looked at the rela-
tionship between growth and this interaction channel, with or
without an inflation threshold. Model 1 bears the closest
resemblance to the theoretical model of Huybens and Smith
(1999).
Huybens and Smith (1999) also predict that the negative cor-
relation between growth and inflation can become stronger
at higher levels of inflation. Thus, Model 2 can be interpreted
quite directly in terms of their predictions. This model speci-
fication is also in line with the empirical studies of Bullard and
Keating (1995) and Bruno and Easterly (1998), except that in
studies. Further, the specification employed here differs slightly from theirs. Boyd,
Levine, and Smith (2001) did not explore thresholds at these low levels of inflation.
11 In comparison, Levine, Loayza, and Beck (2000) have 7 five-year sub-periods
extending from 1960 through 1995, with 74 countries in their unbalanced panel.
Threshold relationships among inflation, financial market
development, and growth
are related matter. The previous literature has not studied the
relationship between growth and this interaction variable in
either a linear or threshold framework.
Finally, the presence of a threshold in the regression of the
measure of FMD on inflation, as in Boyd, Levine, and Smith
(2001), is tested but the null hypothesis of no threshold typi-
cally could only be rejected for this relationship for one of the
measures of FMD at the 10% level of significance. For this
case, the data-determined threshold level of inflation is
around 3%10.
Data
Levine, Loyaza, and Becks (2000) dataset has 49 countries
over 6 five-year time intervals, from 1965 through 1995. Not
every country is observed in every time interval, and there-
fore not all can be used in this articles analysis. There are a
total of 294 observations11. The list of countries included is in
Figure 1. We chose to quantify banking sector development
using two different variables, private credit and liquid liabili-
ties. Private credit is defined as the value of credit extended
by financial intermediaries to the private sector as a propor-
tion of GDP. It excludes credit issued to the public sector from
the public sector (e.g., investment of the Social Security sur-
plus in Treasury bonds). Levine, Loayza, and Beck (2000)
argue that this is the best measure of banking sector devel-
opment because it distinguishes between credit issued to the
private sector from credit issued to governments, govern-
mental agencies, and public enterprises.
Liquid liabilities is a measure of financial depth, or the size of
the intermediary sector, and is defined as currency plus
demand and interest-bearing liabilities of banks and non-bank
financial intermediaries as a proportion of GDP. Liquid liabili-
ties has been used in many studies as a preferred measure of
banking sector development, but Levine, Loayza, and Beck
(2000) argue that it does not capture the financial systems
role in reducing transaction costs and informational barriers,
whereas private credit does.
Our study also takes into account international differences in
GDP per capita, education level, government size, and the
black market premium. Inflation is included in this set of con-
trol variables in many studies of the relationship between
growth and financial sector development, but in our study,
inflation plays a more central role. Many studies also include
some sort of index of political stability, such as the number of
revolutions and coups a country experiences, but it is not
included in Levine, Loayza, and Becks dataset, so we do not
include this variable in our set of control variables.
Model specification
Our paper tests for the presence of thresholds and provides
estimates of the threshold relationship among inflation,
financial sector development, and growth for four different
model specifications using the methodology of Hansen
(1999). Although the specifications of Models 1 through 3 are
informed by the theoretical threshold growth models dis-
cussed above, the empirical models are not exact correlates
in functional form of the theoretical models; they are best
thought of as representations of the theories predictions. For
parsimony of exposition, the most general model, Model 1, will
be presented since Models 2 and 3 are special cases of Model
1. Model 4 is discussed separately as it is not a threshold
growth model, but a threshold model of the relationship
between financial market development and inflation.
The most general model, Model 1, allows for the coefficients
on the independent variables of inflation, financial market
development, and the interaction between inflation and
financial sector development to change once the threshold
level of inflation is reached, but restricts the coefficients on
the control variables to be the same below and above the
threshold level of inflation. Thus Model 1 simultaneously tests
for and estimates thresholds in the relationship among
growth, financial market development, inflation, and the
interaction between financial market development and infla-
tion. Model 2 is the same as Model 1, except that the interac-
tion of financial market development and inflation has been
excluded. It allows for a threshold in the relationship among
147
 Threshold relationships among inflation, financial market
development, and growth
no-threshold model. The estimate of the threshold value of
inflation is approximately 14%. (Threshold values are record-
ed in Figure 2.) The confidence intervals about these thresh-
old estimates are generally tight, especially for the Model 1,
which is closest in spirit to the theoretical model of Huybens
and Smith (1999). This supports the theoretical predictions of
Choi, Smith, and Boyd (1996) and Huybens and Smith (1999).
When the coefficients on both financial market development
and inflation are allowed to depend on the threshold level of
inflation, the relationship between growth and inflation is
significant and negative only above the threshold level of
inflation. (The model estimation results are catalogued in
Figure 314.) This qualitatively supports the results of Bullard
and Keating (1995) and Bruno and Easterly (1998). In quanti-
tative terms, however, the threshold of around 14% chosen by
the data is substantially different to the ad hoc threshold of
40% chosen by Bruno and Easterly (1998). In addition, one of
the innovations of our research is that it is possible to say
that this threshold is statistically significant.
For the dataset employed in this paper, the positive correla-
tion between growth and financial market development is
more tenuous for non-threshold, or linear, specifications than
in the literature reviewed above. This must be due to the fact
that the methodology of Hansen (1999) requires congruent
data series for all countries, so one-third of the countries
included in the Levine, Loayza, and Beck (2000) data are
unusable due to missing or limited data. On the other hand,
when thresholds are modeled, the estimated coefficients sug-
gest much stronger positive correlations with growth below
the inflation threshold. The significance of these correlations
increases with the generality of the model. Perhaps with more
data, the positive correlations in the threshold relationship
would become stronger. When the coefficient on inflation is
restricted to be the same across the threshold level of infla-
tion, the coefficient is negative and significant. This is consis-
tent with results found elsewhere in the literature using linear
specifications of the relationship between growth and infla-
tion.
12 Rousseau and Wachtel (2002) use a rolling regression model to chart the change
in model coefficients as data are added in order of rate of inflation, then manually
148 inspect the results for a shift as each datum is added. Their threshold estimate is
consistent with our paper; however, they do not model the financial markets as a
channel of economic growth using an interaction variable, and their methodology
does not allow for statistical significance of an inflation threshold.
13 Since the evidence for double thresholds is not robust to model specification, and
When we include the interaction between inflation and finan-
cial market development (Model 1), the coefficient on inflation
alone becomes larger, positive, and statistically significant
below the threshold, but above the threshold it remains nega-
tive, small in absolute value, and still statistically significant
when compared to Model 2, the model without the interaction
term. The coefficients on the measures of FMD remain posi-
tive too and become more significant in the presence of this
interaction term vis--vis Model 2. Furthermore, the coeffi-
cient on the interaction term is negative, large, and signifi-
cant below the inflation threshold of 14%, and small, positive,
and insignificant above this threshold. This implies that below
the threshold, small increases in inflation will weaken the
positive correlation between growth and financial market
development. It also implies that increases in inflation will
most likely have no effect on the partial correlation between
growth and financial market development above the thresh-
old level of inflation15, 16. Below the 14% threshold level of
inflation, both the positive effect of inflation on growth and
the weakening impact of inflation on the relationship between
growth and financial market development emerge as a poten-
tial tradeoff for consideration by policymakers. The interac-
tion effects between inflation and financial market develop-
ment suggest that the channels through which inflation and
growth are related do matter.
Conclusion
There is robust evidence that the relationship among growth,
inflation, and financial market development has an inflation
threshold. Across three growth models, for both financial
market development measures, and two sets of control vari-
ables, the null hypothesis of no threshold null is always
rejected against the alternative of a single threshold. This
implies that regardless of single-equation model specifica-
tion, there are thresholds in the trivariate relationship among
growth, financial market development, and inflation.
The data imply that the threshold level of inflation is roughly
14%, and that the confidence intervals about these threshold
estimates are reasonably tight, especially for the empirical
since it is not clear what predictions theory would have for the relationship among
growth, inflation, and financial market development across two threshold levels of
inflation, these versions of the models will not be discussed further.
14 The White (1980) test of no heteroskedasticity (without cross-products) is rejected
for all three model specifications for both measures of FMD, so only NW-HAC
p-values are presented in the figure. Once the threshold level of inflation has been
determined, it is legitimate to correct standard errors.
Threshold relationships among inflation, financial market
development, and growth

Private credit Liquid liabilities

Model 1 Threshold 14.5% 14.5%
C.I. 13.0% 13.8%
15.3% 14.6%
P-value 0.01 0.00
Model 2 Threshold 13.8% 13.8%
C.I. 12.8% 7.4%
44.2% 44.8%
P-value 0.07 0.06
Model 3 Threshold 14.5% 13.8%
C.I. 10.6% 10.8%
19.7% 19.9%
P-value 0.10 0.09
Model 4 Threshold 3.4% 4.9%
C.I. 3.2% 1.8%
4.9% 15.2%
P-value 0.08 0.26
Figure 2 Threshold values of inflation, confidence intervals, and p-values for sta-
tistical significance of a single threshold versus the null hypothesis of no inflation
threshold.
our work a threshold relationship between growth and finan-
cial market development is simultaneously specified, and the
threshold estimate is data-determined.
Model 3 captures the prediction of Huybens and Smith (1999)
that the relationship between growth and financial sector
development can change once inflation reaches a threshold.
At the time this article was first written, no previous empirical
studies had taken into account the possibility that the rela-
tionship between financial market development and growth
may be affected by a threshold in inflation. Since then,
Rousseau and Wachtel (2002) also discovered a shift in the
relationship between growth and financial market develop-
ment at varying levels of inflation. They estimate that there
is an inflation threshold somewhere between 13 and 25 per-
cent12.

The last model, Model 4, seeks to verify whether or not the

Variable-coefficient Regime Model 1 Model 2 Model 3 Model 4
Private credit- Below 0.02 0.01 0.01
types of ad hoc thresholds between financial sector develop-
Standard error (0.0300) (0.1200) (0.1900) ment and inflation suggested in Boyd, Levine, and Smith
Private credit- Above -0.02 -0.01 -0.02
(2001) and Huybens and Smith (1999) are actually statisti-
Standard error (0.2200) (0.6000) (0.0500)
Inflation- Below 0.12 0.05 -0.02 3.78 cally significant, and whether the data would choose a
Standard error (0.0100) (0.1300) 0.0000 0.0000 threshold value of inflation similar to those suggested in
Inflation- Above -0.02 -0.02 same -0.11
Standard error 0.0000 0.0000 same 0.0000 Boyd, Levine, and Smith (2001). Model 4 is: financent = +
Interaction- Below -0.25 controlnt + () inflationnt() + unt, where () = 4a, infla-
Standard error (0.01)
Interaction- Above 0.06
tionnt , 4b, inflationnt >
Standard error (0.16)
R-squared 0.40 0.38 0.37 0.41 Since it is desirable to have at least a certain number of
Liquid liabilities- Below 0.02 0.01 0.01
observations lying in each regime, the set of over which we
Standard error (0.14) (0.23) (0.26)
Liquid liabilities- Above -0.02 0.00 -0.01 search for the optimal is restricted so that a certain per-
Standard error (0.29) (0.84) (0.30) centage of the observations lie in each regime. The modeling
Inflation- Below 0.17 0.04 -0.02 1.21
Standard error (0.00) (0.16) (0.00) (0.00) of the data must be non-dynamic, so issues of causality can
Inflation- Above -0.02 -0.02 same -0.06 not be addressed.
Standard error (0.00) (0.00) same (0.02)
Interaction- Below -0.36
Standard error (0.00) Results
Interaction- Above 0.05
The evidence upholds the hypothesis that there are statisti-
Standard error (0.25)
R-squared 0.40 0.38 0.37 0.32
cally significant single-threshold relationships among growth,
financial sector development, and inflation13. Across three

Figure 3 Coefficients, Newey-West (1987) HAC P-values for statistical signifi-

threshold models and for both measures of FMD, the data
cance, and adjusted R-squared. always favor a threshold model, rejecting the hypothesis of a

15 To determine whether or not Model 1 was in some sense picking up misspecifica-
tion error in Model 2, Model 2 was also estimated with an interaction term whose
coefficient was not a function of the threshold level of inflation. Wald tests always
accepted the null hypothesis that the estimated coefficient on this linear interac-
tion term was zero for Model 2. For Model 1, Wald tests also rejected the joint
hypothesis that the estimated coefficients on the interaction terms below and
above the threshold were zero. These results support the notion that Model 1 is
not picking up misspecification error in Model 2. 149
16 Models 3 and 1 are selected for private credit using Schwarz (1978) Bayesian
Information Criterion (BIC) and Akaikes (1973) Information Criterion (AIC) respec-
tively. AIC is relatively more favorable for large models than is BIC.
 Threshold relationships among inflation, financial market
development, and growth

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150
Threshold relationships among inflation, financial market
development, and growth
model which is closest in spirit to the theoretical model of
Huybens and Smith (1999). This supports the theoretical pre-
dictions of Choi, Smith, and Boyd (1996) and Huybens and
Smith (1999). The threshold estimation results for these mod-
els are distinct from the results of Bullard and Keating (1995)
and Bruno and Easterly (1998) in that the threshold is not ad
hoc, it is statistically significant, and is far less than the 40%
threshold level of inflation popularized in Bruno and Easterly
(1998). The evidence suggests that there is only a single
threshold value of inflation below and above which the tri-
variate relationship among these variables changes.
This paper contributes three additional novel empirical
results. Firstly, when an interaction term between inflation
and financial market development is allowed to affect growth
in a threshold model, the relationship between inflation and
growth is strongly positive and statistically significant below
the threshold level of inflation, and becomes negative and
significant above the 14% threshold level of inflation. It
should be noted that in this specification, the positive coeffi-
cient on inflation below the threshold is much larger and
more significant than it is in specifications without the inter-
action term. This is in contrast to the results of most previous
studies on the relationship between inflation and growth, but
it does lend support to the idea that the channels (i.e., finan-
cial sector) through which inflation and growth are related
matter. This finding thus supports the general theoretical
predictions of Huybens and Smith (1998, 1999).
Secondly, the financial development inflation interaction term
is significant in the single threshold specifications. Although
empirical researchers have studied the relationship between
inflation and financial market development in a bivariate
sense, they have not considered the impact of this interaction
on growth. Our results suggest that below the threshold level
of inflation, marginal increases in inflation impair the positive
partial correlation between growth and financial market
development, while above the threshold, marginal increases in
inflation either increase or have no effect on the partial cor-
relation between growth and financial market development.
Below the threshold, this negative impact of inflation on the
relationship between growth and financial market develop-
ment must be weighed against the direct positive relationship
between growth and inflation when making policy recommen-
dations. Ideally, it would be possible to model the dynamics of
these contrasting effects, but this is not possible with Hansens
(1999) methodology. Above the threshold level of inflation,
further marginal increases in inflation have no impact on the
relationship between growth and financial market develop-
ment. This is consistent both with Huybens and Smith (1999)
and the informal story that at higher rates of inflation, finan-
cial contracts become indexed to inflation so that the negative
impacts of inflation on the provision of financial contracts are
eliminated.
Lastly, including an interaction term leads to an even stron-
ger positive partial correlation between growth and financial
market development below the threshold and no relationship
above the threshold, even though a linear or nothreshold
specification of the model implies that there is no significant
relationship between growth and financial market develop-
ment for the balanced dataset employed. Across all models,
the positive relationship between growth and financial mar-
ket development breaks down above the threshold level of
inflation, a threshold result which has not been considered by
the empirical literature. This threshold relationship implies
that the positive benefits of financial market development on
growth occur at low to moderate levels of inflation.
151
152 - The journal of financial transformation

Peter Moles
Senior Lecturer in Finance, University of
Edinburgh Management School
Abstract
At a time of low interest rates and hence low future growth
and returns, investors who are looking for above-average
prospects have to seek out those investments which offer
higher gains. However, in many cases, the securities that offer
high growth often involve hard to evaluate uncertainties on
political, technological, economic, and social grounds. In
mature economies, above-average prospects tend to be con-
centrated in particular industries, for instance, technological,
media, and telecoms. Investments in emerging markets, while
they offer high prospective growth, can suffer from a variety
of country specific problems. An alternative is to use financial
Financial
Manufacturing growth
engineering techniques to manufacture growth securities that
have the desirable above-average growth attributes but with-
out the assessment problems of many existing high-growth
investments. Using the principles of financial engineering it is
possible to create securities that provide the required level of
expected reward without the uncertain bets on technological
developments or emerging market economies. Financial inter-
mediaries are well placed to provide such synthetic growth
securities since they can benefit from scale economies in the
manufacturing process.
153
 Manufacturing growth
In an environment of low interest rates, there is a natural
search for investment opportunities that offer above-average
prospects. Investors seeking prospective high growth or
return have been attracted to exotic securities and invest-
ments, including emerging markets, commodities, and alter-
native investments, such as hedge funds. In a large number of
cases there is a problem with these high return investments,
namely a poor understanding of the risks involved. While it is
understood that high prospective returns only come from
assuming risk, many of the asset classes that offer the pros-
pect of above-average returns involve complex, hard to define,
nested, and interrelated risks.
For many investors the uncertainties involved in high return
securities make them hard to evaluate bets on political, tech-
nological, social, and economic developments. For instance,
emerging markets suffer not only from fair weather liquidity,
but also from country, political, and event risks, as well as
contagion effects across the asset class. This makes them
unattractive portfolio choices for those investors who are
seeking above-average growth by assuming a higher, but con-
trolled level of, risk. This is where financial engineering prin-
ciples can help by manufacturing the required growth securi-
ties from existing obligations. These synthetic growth securi-
ties involve well-understood risks and avoid many of the pit-
falls of exotic investments.
Financial engineering
Financial engineering can be defined in different ways. Some
consider it to be simply a handy label for what corporate
financiers do, while others view it as another term for compu-
tational finance. Nevertheless, it is accepted that a key ele-
ment is the way financial engineering is linked to financial
innovation. In his review article on financial innovation,
Finnerty (1988) described financial engineering as the
design, development and implementation of innovative finan-
cial instruments and processes, and the formulation of cre-
ative solutions to problems in finance. The International
Association of Financial Engineers (2006) describes the pro-
cess as the development and creative application of financial
1 Smithson (1998) makes the point that financial innovation was rediscovered in the
154 1970s. He cites the case of the Confederate States of America, which during the
American Civil War issued a dual-currency cotton indexed bond to show that finan-
cial innovation is not a new phenomenon. The 1970s was also a period when many
of the fundamental insights that we now know as modern finance were first pub-
lished.
technology to solve financial problems and exploit financial
opportunities. Mason et al (1995) also make the point that
financial engineering can be viewed as the means of imple-
menting financial innovation. Furthermore, in their view, the
power of financial engineering should not be defined by the
complexity of its models or computers but by the expanded
economic or managerial flexibility it offers to its users.
The popularity and growth of financial engineering as a way
of solving problems in finance can be seen in the ever-
expanding range of innovative securities and financing
structures seen in the global capital markets. While financial
engineering is not a new phenomenon, structural changes in
global financial markets are a major contributing factor to its
rising popularity1. Other factors that have driven develop-
ments include important advances in risk management tech-
niques, the drive to reduce issuing costs, increased opportu-
nities for accounting, tax, and regulatory arbitrage, and the
ability to mitigate pervasive incentive and agency issues. In
addition, pervasive market volatility, technological advances
in data processing, and advances in financial theory have all
greatly contributed to widespread financial innovation.
Advances in our understanding of the principles of finance
have significantly contributed to the current popularity of
financial engineering, as practitioners have implemented
many of the insights provided by academic research.
Furthermore, the ability of market participants to observe the
success (or possible failure) of innovative securities and
transactions has created a body of experienced practitioners
who understand not just the design, but also how to market
and trade the resultant securities2.
Financial engineering can be broadly categorized into three
types of activity, namely creating innovative securities, inno-
vative financial processes, and creative solutions to problems
in corporate finance. As a security creation process, it makes
use of fundamental financial instruments, borrowing and
lending, and derivatives to fine tune an existing financial
product in order to restructure it into one having more desir-
able risk-reward characteristics. This repackaging creates
2 Financial engineers with a good grasp of the principles involved are easily able to
reverse engineer the structures of innovative securities and hence copy them,
thus spurring rapid imitation and widespread adoption. See for example Banks
(2006).
Manufacturing growth
value to the end user by more closely aligning the resultant
securities with their investment needs.
Creating growth securities
Element ties of the fund, can create securities with high promised
Index portfolio value 100
Expected growth 7% p.a
Dividend yield 2% p.a
Portfolio volatility 25%
Life of fund 5 years
Beta (index portfolio = market) 1.0
Risk-free interest rate 4% p.a
Pricing step 1 year
Figure 1 Pricing variables for illustrative examples
To see how financial engineering can create growth securities
in a low return environment, seemingly out of thin air, we will
use a simple example to illustrate the process. This will ignore
some real world problems that impede innovation, such as
regulation, differences in tax treatment, and investor educa-
tion3. The initial conditions for the underlying security that
will be modified (in this case an index fund, say on the S&P
500 or FTSE 100 index), its expected growth, and market con-
ditions are given in Figure 1. Note that, unlike many alternative
investments, the index funds constituents are large, blue-chip
stocks whose risk characteristics are well-known and, due to
the diversified nature of the portfolio, investors only bet is
on how the market will perform over the five years.
0 1 2 3 4 5
349.0
271.8
211.7 211.7
164.9 164.9
128.4 128.4 128.4 gy, or other nascent industries. Consequently, the resultant
100.0 100.0 100.0
77.9 77.9 77.9 portfolio is strongly exposed to industry effects and possibly
60.7 60.7
47.2 47.2
36.8
28.7
Figure 2 Possible future portfolio values at the end of each year using one-year
steps given volatility is 25 percent
3 The saga over the introduction of the SuperTrust by, Leland, O'Brien, Rubenstein
Associates Inc. in the late 1980s is an example of how innovation can be stymied
by regulatory and other concerns. See Harvard Business School case study 9-294-
050
4 In practice a more refined analysis would be used.
The illustration will assume that the investment fund is being
created now and will last for five years, which we take to be
the planned life of the fund after which all the value will be
distributed to securities holders. The illustration will be used
to show how financial engineering, by structuring the liabili-
returns. As will be explained below, it is also necessary to price
the resultant securities using the contingent claim valuation
approach developed for pricing derivatives and, again for
simplicity of illustration, we will assume one-year steps in the
model4.
By holding the index portfolio given in Figure 1, an investor can
anticipate a prospective average return of 7 percent per
annum for assuming this risk, so after five years the fund
value is expected to grow to 140.3 (capital appreciation ratio
of 1.4 times). The simple model developed by Cox, Ross, and
Rubinstein (1979) allows us to model future uncertainty in
asset prices. Using this model, as shown in Figure 2, at the end
of the five years the value of the index portfolio can range
between 349 and 28.7. This uncertainty is intrinsic to the index
fund and will affect the value and performance of the securi-
ties the fund issues. By carefully selecting the liability struc-
ture of the fund securities with higher, or lower, prospective
returns and risks can be created that match investors require-
ments.
How can growth-orientated investors obtain higher prospec-
tive returns? One approach is to remodel the fund into a high
beta portfolio5. Normally this involves finding suitable securi-
ties with high exposure to systematic risk. The problem with
this approach is that it means investing in speculative growth
areas, such as technology, media and telecoms, biotechnolo-
specific firms if the universe of such high growth stocks is
small. On the other hand, financial engineering techniques
can be brought to bear to generate growth securities, while
avoiding industry hot spots and stock-specific risk. The analy-
sis that follows will restrict itself to just a few simple steps to
5 For example, a portfolio with a beta = 2.0 (twice as risky as the market) has an
expected return of 10 percent per annum and, for the five years, a capital appreci- 155
ation ratio of 1.6 times.
 Manufacturing growth

Figure 6 Effect of leverage on claims issued by the index fund with a debt obli-
gation of 60 at maturity
0 1 2 3 4 5

For growth hungry investors, the extra prospective return on 0.00

0.00
the leveraged units may not be enough and hence the amount 0.00 0.00
0.00 0.00
of debt in the structure may not be sufficient. In designing the
0.18 0.00 0.00
structure, more leverage can be added by increasing the 1.10 0.35 0.00
2.01 0.70 0.00
amount of borrowing, but this has to be matched by the 3.68 1.39
increase in performance risk for the debt security. Figure 6 6.68 2.76
12.01
shows the effect on the two securities if the amount of debt P P P
Vt-1 = [Vt u p+V t d (1p)](1+rf)1 21.35

to be repaid is increased to 60. In this example with additional

debt, the expected return on the leveraged units is very
slightly lower at 8.50 percent. This is because, given the struc-
ture, there is an optimum borrowing level that maximizes the
possible returns to leveraged units under the market assump-
tions given in Figure 18. So adding debt does not automati-
cally raise the prospective returns for holders of the leveraged
units. This is because additional borrowing raises the default
probability on the debt and hence the promised return that
such investors require. Debt markets tend to be sensitive to
the potential expected loss from debt instruments and may
demand a risk premium/price discount in excess of the expect-
ed loss for assuming high levels of performance risk. So while
an element of debt can raise the return on the growth securi-
ties, ever increasing levels of leverage may not always lead to
Value of claims
issued by index fund
If the assets of the index fund are
worth less than 50 at maturity, the
leveraged unit holders get nothing
and the prior claim holders (zero-cou-
pon securities) get whatever is left
50
50 Value of fund at maturity
(5 years)
Figure 3 Effect of borrowing on returns to investors in the leveraged stock units
(growth units)
Figure 4 Valuation of default put in a contingent claim valuation framework
ever rising prospective returns. Note too that the smaller the
fraction of the portfolio value represented by the growth
claims the more option-like they become and this can change
the attractions of such securities.9
Step two create pure growth and pure income
securities
As the earlier discussion shows, there is a limit to the prospec-
tive return that borrowing will achieve. However, debt derived
leverage is not the only way growth can be manufactured. In
the first step, the growth securities were simply leveraged
units in the index fund. Holders of such units receive not just
capital appreciation but also the dividends on the index over
the five years. Consequently, it raises the cost of acquiring
these growth units, since their value includes not just the ter-
Value of leveraged
units (ST 50) minal value of their entitlement in the index fund (ST B) but
also the dividend stream over the five years.
Conceptually all equity securities are the present value of
Value of prior claim
their dividend stream. There are no legal impediments (or
(zero-coupon value loss) from unbundling these future cash flows. Hence it
securities)
is possible to create a pure growth security, which receives no
dividends over the five years and whose payoff depends
uniquely on the index funds terminal value. The present
value of the expected dividends will be simply the difference
between the pure growth security, which can be valued using
contingent claim methods (and is worth 50.57) and the

6 There is no reinvestment risk from such a pure discount security, and when they
were first made popular they were issued as money multiplier securities. With an
156 interest rate of 4 percent such a security will double in value every 18 years.
Higher rates mean shorter doubling periods. With a yield of 8 percent the security
will double in value in 9 years. In the context of creating (and selling) growth, such
zero-coupon securities could be considered a fixed return low-risk growth security.
7 Again, an understanding of the principles of financial engineering and contingent
claim analysis will allow for an ex-ante estimation of this default risk. Using the
contingent claim valuation approach, it is possible to estimate the probability of
default, which in this example is about 5 percent. So 95 percent of the time, inves-
tors in the zero-coupon security will receive the promised payoff. For a discussion
of this use of contingent claim valuation for default prediction see Merton (1974).
Manufacturing growth
illustrate the power of the principles involved. In theory there
is no limit to what can be done; designers of such structured
products are only limited by the demand for the resultant
securities.
Step one add debt
A very simple piece of engineering involves borrowing; that is,
issuing a prior claim to finance part of the investment. Such a
debt security has the first claim on the assets of the fund
while the residual claim has a payout of ST B, where ST is the
value of the index fund at maturity and B is the promised
repayment on the borrowing. The effect is to leverage up the
return on the index securities, which are now leveraged index
stock, index growth units, or whatever marketing term is used
to raise the interest of potential investors. It will also add to
the leveraged securitys risk. The payout at maturity to the
two sorts of claims on the index fund from part financing with
debt is shown in Figure 3.
We will assume that this prior claim is created via the issuance
of a zero-coupon debt security with a payout of 50 at its five
year maturity. The zero-coupon is simply a modeling feature
but, in practice, may be attractive to investors seeking a
largely guaranteed expected return6. There is some perfor-
mance risk for holders of the zero since there is the possibility
that they do not get all their money back. As is evident in
Figure 2, there is some chance that the index fund will be
worth less than 50 after five years. In that case, holders of the
security get whatever the value of the fund is at this point in
time. This can be as little as 28.7 compared to a promised 50.
In effect, investors in the zero-coupon security have accepted
an element of exposure to the performance of the fund. In the
language of corporate finance, in a situation where there is
some uncertainty about the potential repayment, debt holders
have written a default put on the underlying value of the port-
folio [Brealey, Myers & Allen (2006)]. Using the identity that
the value of risky bond is equal to the value of risk free bond
less the default option value, we can price the default option
and hence find the market value of the zero coupon security.
8 What is happening is that, given the expected growth rate in the portfolio, the use
of debt is reducing the investment required in the growth units, but at the same
time the expected payoff (E(ST K) at maturity is also falling. Note that E(ST) is
based on the prospective return on the underlying portfolio, namely 7 percent.
The value of the index fund is expected to be 140.3 in five years. With a payout to
zero-coupon security holders of 50, there will be 90.3 left to growth unit holders.
The prospective return = (90.3/60).20 1 x 100% = 8.52 percent. With 60 in zero-
The valuation of the default put is shown in Figure 4. This
gives a value of 1.10. If the security was totally default-free, it
would earn the risk-free interest rate of 4 percent and hence
have a present value of 41.10. The value of the risky zero-cou-
pon security is therefore 41.10 1.10 = 40.00, which gives a
prospective yield of 4.56 percent. The extra promised yield
over the risk free rate compensates the holders for the risk of
impairment. Investors would need to satisfy themselves that
the spread above the risk-free rate was worth the potential
loss7.
From the principle of conservation of value, if the debt is
worth 40, the remaining leveraged units must be worth 60. On
this basis the expected return has risen from the 7 percent for
the unleveraged index fund to 8.52 percent for the leveraged
units (capital appreciation ratio of 1.50). Figure 5 shows the
effect of this structure. Leveraged unit holders pay 60 to
acquire an economic exposure in the fund that is worth 88.65.
By getting fixed income investors to fund part of the invest-
ment and to assume some performance risk, the leveraged
units obtain an increased prospective return of 1.52 percent.
Conversely, the zero-coupon debt has a notional exposure to
the funds performance equivalent to 28.4 percent of the cur-
rent value of the security and an impairment risk of about 5
percent.
Security Equivalent Default free Market
amount of debt value of
index portfolio element security
Value of zero-coupon debt 11.35 28.65 40.00
Value of leveraged units 88.65 (28.65) 60.00
100.00 100.00
Figure 5 Effect of leverage on claims issued by index fund with a debt obligation
of 50 at maturity
Security Equivalent Default free Market
amount of debt value of
index portfolio security
Value of zero-coupon debt 17.78 28.65 46.43
Value of leveraged units 82.22 (28.65) 53.57
100.00 100.00
coupon debt, we have an expected payoff of 80.3 and a cost of 53.4, giving a
return of 8.50 percent.
9 As a rule-of -thumb if the growth securitys delta is less than 0.50, the security is 157
out-of-the-money and is expected to be worthless at maturity. Hence such low-
delta securities are highly speculative; but at the same time, being highly lever-
aged, will be highly responsive to changes in the value of the underlying portfolio.
 Manufacturing growth
the earlier example since they have a senior position to
income units and growth units. Another attractive feature of
the structure, from a selling perspective, is the way dividend
income is concentrated into the income units. These have a
prospective income yield of about 9 percent although this is
not without a capital loss. Holders will only receive 20 at matu-
rity, all being well, while purchasing a security costing 22.2812.
In the above case, the debt-equity ratio is 0.67 and the struc-
tural leverage ratio is 1.65.
Step four dynamic adjustment
The earlier discussion assumes a fixed capital structure where
the numbers of each security remain unchanged over the five-
year life of the fund. However, there is no inherent reason that
this should be the case. Assume that the market does well in
the first year and for simplicity assume also that the value of
the fund is 128.4 at the end of the year (this is the value of the
upper node for year one shown in Figure 2). For simplicity, we
will keep the market conditions as given in Figure 1. Now the
expected value of the fund at the end of its life will be 168.3.
We need to reprice the elements of the fund (not shown) but
the new market value of the structure is given in Figure 8.
The rise in the market has had the effect of reducing the
amount of leverage in the financial structure. Whereas the
debt equity ratio was 0.67 it is now 0.50 and the structural
leverage which was 1.65 is now 1.13. For growth unit holders,
the reduction in leverage means the expected return has fall-
en to 12.25 percent.
Financial engineers have a wide range of alternatives for
restructuring the fund at this point. One possibility is to simply
leave the structure unchanged. A second possibility is to raise
more debt to restore the initial leverage. Raising more debt is
a distinct possibility as long as the contractual arrangements
allow for this. Given the favorable market scenario, the zero-
coupon debt has seen a significant reduction in performance
risk. The lowest node of the tree in Figure 2 with four years
left and the new market value for the index portfolio of 128.4
10 This was the approach taken by the innovative Americus Trust securities, which
divided the claims on the investment portfolio into Proscribed Right to Income and
158 Maximum Equity (PRIME) and Special Claim on Residual Equity (SCORE) units.
PRIMEs had a maximum payout and received all the (concentrated) dividends from
the trust, while the SCORE was a residual capital gains-only security which was
entitled to all proceeds once the contractual payout had been made to the
PRIMEs. This structure has been imitated extensively, not least in the U.K. with
is 47.2. Under the assumptions used in this example, there is
now only a small possibility that the zero-coupon holders will
not be repaid. If holders of the zero-coupon securities are
comfortable with its previous performance risk characteris-
tics, there is the capacity to add further debt. However, there
is a problem with this approach in that, in doing so, the market
value of existing debt, which has benefited both from the
increase in asset cover and the reduction in maturity, would
be adversely affected. An alternative approach is to liquidate
part of the index portfolio and buy back and cancel existing
growth and income units. With the debt currently worth 42.6,
this means buying back 22.0 worth of the growth and income
units to achieve the previous debt-equity ratio13. A frequently
used method of restructuring is to undertake an exchange
offer (for instance, by setting up a new fund with a longer
maturity) and getting investors to convert their holdings into
the new fund.
Note that if the market value of the portfolio had fallen,
restructuring in this case would involve buying back debt or
issuing more growth and income units in order to reduce the
amount of leverage in the structure. Hence, it is quite feasible
to have a situation where there is continual issuance and
Security type Value
Growth security value 37.72
Income security value
of which
Principal 12.85
Dividends 9.43
22.28
Zero-coupon security 40.00
Portfolio value 100.00
Figure 7 Value of the three security index fund structure at inception based on
market conditions from Figure 1
redemption of the underlying units to the fund. This approach
allows both the desirable growth and risk characteristics to be
maintained and, indirectly, provides a degree of liquidity for
the units.
split-capital investment trusts.
11 In financial engineering terms, the income securitys principal is simply a bull
spread on the funds future value between the lower value of 50 (the amount due
to debt holders) and the upper value of 70 (which is the debt value plus income
unit principal value) to which has been added the dividend rights for the funds
income.
Manufacturing growth
growth unit with dividends (which was valued at 60). The
present value of the expected dividends is therefore 9.43.
Stripping out the dividends in this way leaves a pure capital
appreciation security that still has the same expected payoff,
so its prospective return is now 12.3 percent; that is, 5.3 per-
cent above that of the unleveraged index fund and three
times the risk-free rate (and a capital appreciation ratio of
1.79 over the five years).
Designers of attractive liability structures and innovative
securities now have a range of choices once the intervening
cash flows are stripped from the growth units. One possibility
is that instead of offering a simple zero-coupon debt security
to add on the dividend income rights in order to make these
income units. That is, this security is entitled to all dividend
income from the portfolio. Combining the rights with the divi-
dend stream and a maximum future payoff of 50, that is add-
ing the rights to the dividends to the zero-coupon securities,
would, in the example, cost 49.43 and would have a prospec-
tive yield of slightly above 4 percent (remember the current
yield on the index is only 2 percent)10. (Note, in this case,
Security type Value
Growth security 60.2
Income security value subordinated debt or equity instrument (typically a variety of
of which
Principal 15.8 securities is given in Figure 7. The amount represented by the
Dividends 9.8
25.6
Zero-coupon security 42.6
Portfolio value 128.4
Figure 8 Value of three security index fund structure after one year when the
additional leverage may be attractive in raising the capital
repayment to holders of these income units.)
Another alternative is to create pure dividend annuity securi-
ties with no entitlement to any capital at the maturity of the
trust. That is, the trust would now have three securities: a
pure growth (capital appreciation) security, a pure zero-cou-
pon debt-like security, and a dividend-only security. Investors
12 Again, applying the principles of financial engineering, it is easy to manipulate the
offering price of the security at issuance so that it costs current income-seeking
investors par; that is 20 rather than 22.28.
in the fund can then decide on the mix of these to craft the
required growth/income/capital profile that best suits their
portfolio objectives. By weighing the portfolio heavily towards
the higher risk pure growth units, an investor would be seek-
ing principally capital appreciation. A predominance of zero-
coupon and income units, with possibly a small holding in the
pure growth units, would provide current income and greater
capital certainty. Hence by using structural leverage, financial
engineers can create securities that allow investors to fine
tune their portfolio mix to match exactly their risk-reward
requirements.
Step three creating growth, providing income,
and combining this with debt
Structural leverage can be combined with debt to create secu-
rities with higher prospective returns. Returning to the
example, now we create a third class of security which is
entitled to all the expected dividends over the life of the trust
and receives a return on principal of 20 at maturity but which
is subordinated to the (zero-coupon) debt in terms of repay-
ment. This has the effect of increasing the leverage of the
growth units. But this does not raise the default risk on the
debt, since this dividend paying third security will be a type of
preferred stock or preference share)11. The value of the three
growth security is now only 37.72 of the portfolio value and
has a prospective return of 13.25 percent (and a capital appre-
ciation ratio of 1.9 times). This is, of course, not achieved
without taking on additional risk. If the portfolio value should
fall to 70 or below, holders of these securities will be wiped
out. However, for growth orientated investors who expect an
appreciation of the underlying portfolio, this is not necessarily
a hugely negative feature.
From an engineering perspective, this triple slicing of the
claims on the fund into capital, income, and debt has the
attraction of not increasing the amount of debt finance. The
return demanded of debt holders remains unchanged from
13 To maintain the pre-buyback ratios, we need to retire 15.4 of the growth units and
6.6 of the income units. Note that there will be an interactive effect between the
repurchase of the growth and income units and the value of the debt since reduc- 159
ing the asset cover raises the performance risk (default option) and hence reduces
the debt securitys market value.
 Manufacturing growth
risk is low can the firm safely borrow and be in a position to
fully redeem the debt at maturity. This rule of thumb should
apply to manufactured growth securities. The underlying port-
folio should consist of large, liquid blue chip securities, since
the intention is to leverage the portfolio and hence its behav-
ioral characteristics should be well known and understood.
Problems can arise when sector or industry specific portfolios
are leveraged, since investors are then assuming more com-
plex, and possibly hard to evaluate, risks. The amount of finan-
cial risk being taken also needs to be carefully thought
through via appropriate stress testing of outcomes. There are
hidden costs attached to excessive leverage when funds
become financially distressed and require restructuring or
liquidation. Either existing liabilities have to be reorganized or
costly new financing has to be raised with dilutive effects on
existing claimholders. Furthermore, both existing and new
investors cannot be sure whether the problem is due to bad
luck or incompetent management. The complicated non-lin-
earity of the liability structure in response to changes in
underlying fundamentals can further muddy the waters.
Excessive leverage also affects a funds human capital. High
quality managers might be reluctant for reputational and
career reasons to remain with or agree to manage such a
fund. Finally, when leverage is high, some poor investment
strategies might be adopted, raising the overall risk of the
investment portfolio unnecessarily14.
160 - The journal of financial transformation
Conclusions
Investing in growth can be in sectors that ex-ante are expect-
ed to offer higher than average returns. But these opportuni-
ties come with risks which, for many existing securities,
involve investments that are often hard to evaluate. An alter-
native approach is to manufacture growth securities that
meet investors requirements but whose underlying charac-
teristics are well-understood. This approach uses principles
from financial engineering to create structured products
that deliver the required amount of expected growth. The
simple example used in this article showed how, by applying
well-understood financial principles, a financial intermediary
can create tailor-made growth investments using an underly-
ing portfolio that has transparent risk characteristics. The
structuring of such growth units does not involve the use of
complex derivatives, although their pricing and structuring
does requires a clear understanding of contingent claim
valuation. In designing, structuring, and offering such securi-
ties, financial intermediaries have a number of competitive
advantages that make them natural producers of such struc-
tured products.
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theory of investment, American Economic Review, 48, June: 261-297
Smithson, C.W., 1998, Managing Financial Risk: a guide to derivative products, finan-
cial engineering, and value maximization, New York: Irwin Library of Investment &
Finance
Manufacturing growth
Role of intermediaries
As demonstrated by Modigliani and Miller (1958) there is no
reason why individual investors cannot in principle construct
home-made leveraged units as shown in the example above.
Nevertheless intermediaries have a significant competitive
advantage as providers of structured products. Using interme-
diaries to create the growth units and other units via special-
ized funds, which do the borrowing, has significant attrac-
tions: they can borrow on better terms than individuals and
have limited liability status, which caps investors commitment
to their original investment in the event of bankruptcy.
In addition, intermediaries benefit from economies of scale
and scope, which means they have an important role in pro-
viding structured products. They offer bundled services to
investors: instant diversification, delegated and professional
investment management, administrative services, such as col-
lecting dividends and other payments due on holdings in the
fund, valuation, and custodial services. They are able to
spread the cost of the financial manufacturing systems (for
instance, the use of specialist financial engineers, set up and
development costs) across a multitude of products. They can
invest in sophisticated systems to monitor and manage the
resultant risks. Finally, they are able, via marketing and sales
efforts, to target likely investors and aggregate demand from
investors.
Issues with the financial structure of funds
The above analysis largely ignores some issues that can affect
the attractiveness of growth securities and the structures
used to create them. One area is regulatory approval and
oversight. In a risk-based regulatory environment, such funds
might be subject to greater scrutiny than more conventional
funds. Another is the reputational risk for the sponsoring
financial institution. Hence, designers of such funds need to
be aware of not just the financial principles involved but also
the funds structure and how changes in market conditions
might affect the value of the securities.
A trusts asset-liability structure, that is how it invests and
14 This is a well-known problem in corporate finance called risk shifting and is most
likely to occur when the firm is experiencing problems.
what securities it issues, determines how a trust performs and
the allocation of returns to the different providers of funds.
The structure operates in two ways: firstly through the assets
held by the fund, which will impinge on the risk and return
characteristics of the liabilities issued by the fund; and sec-
ondly through how the right to capital and the income stream
from the fund is divided between the different liabilities. The
funds structure will thus determine the risk-reward character-
istics of the liabilities.
The use of debt leverage makes sense when there is a clien-
tele for high risk/reward securities. In situations where future
returns are expected to be low, there is a demand by investors
for instruments that offer the prospect of above-average
returns. Splitting the funds returns between current income
and capital appreciation also makes sense for tax and invest-
ment purposes. On the other hand, the discussion has high-
lighted how the different structures lead to potential problems
for investor analysis and valuation. This is especially the case
in the more complex arrangements that financial engineers
can create. Complex liability structures have non-linear rela-
tionships with value shifts between the securities issued by
the fund that depend on the behavior of the underlying invest-
ment portfolio. That is, there are complex interactions between
the investment portfolio value, its volatility, dividend yields,
and interest rates and the funds financial structure which
lead to value shifts between different liability classes. These
are the consequences of the financial structure and the
effects of the option-like characteristics embedded in the dif-
ferent securities. There are also structuring risks. For instance,
the risk that there may be unanticipated changes to the
investment portfolio.
There is no reason why the structure of a fund issuing lever-
aged securities should differ fundamentally from that of an
industrial or commercial company. The corporate finance rule
of thumb requires that when the business risk of such firms is
high the firm should adopt a conservative financing policy.
That is, it should fund itself mainly through equity capital or at
least minimize the extent of borrowing. Only if the business
161
162 - The journal of financial transformation

Lutz Hahnenstein
IKB Deutsche Industriebank AG,
Kreditrisikocontrolling
Klaus Rder
Professor of Finance, Universitt Regensburg,
Lehrstuhl fr Betriebswirtschaftslehre, insbeson-
dere Finanzdienstleistungen
1 This article is based on the authors more technical paper Hedging, leverage, and
shareholder value: a testable theory of corporate risk management under general
distributional conditions. We appreciate the valuable comments of Tim R. Adam,
Axel F. A. Adam-Mller, Amrit Judge, Olaf Korn, Gunter Lffler, Josef Zechner and
participants at the 5th Conference of the Swiss Society for Financial Market
Financial
Corporate hedging
and capital structure
decisions: towards an
integrated framework
for value creation1
Abstract
We suggest a joint optimization model for a firms hedging and
leverage decisions that helps to establish an integrated frame-
work for value creation. Rather than artificially separating the
two interrelated parts of the firms financial policy, we treat
both corporate decision variables as endogenous. We argue
that exogenous differences between financial distress costs
across firms, and particularly across industries, simultane-
ously influence corporate risk management and capital struc-
ture decisions. Using anecdotal evidence, our focus is not on
so-called direct bankruptcy costs, but rather on the cross-
sectional variation in indirect bankruptcy costs, which may
result from a deterioration of relationships with customers,
suppliers, or other stakeholders prior to the legal act of bank-
ruptcy.
Research (SGF), the 9th Annual Meeting of the German Finance Association (DGF),
the 2004 Basel Meeting of the European Financial Management Association 163
(EFMA), the 2005 WHU Campus for Finance Seminar and the 12th Global Finance
Conference in Dublin.
 Corporate hedging and capital structure decisions: towards an
integrated framework for value creation
and Titman (1997)] and which seems to be about to undergo a
renaissance in financial theory3 as well, the optimum debt
level is obtained by minimizing the total present value of bank-
ruptcy costs and corporate taxes. However, of primary concern
to us are not the so-called direct bankruptcy costs, such as
payments to trustees, lawyers, courts, auctioneers, referees,
appraisers, or accountants, which are commonly modelled as a
percentage fraction of the remaining asset value. Instead, we
assume that there are substantial financial distress costs at a
much earlier stage, specifically whenever the corporate stake-
holders notice that the firm is facing some difficulty in meeting
its obligations to creditors and, correspondingly, adapt their
behavior towards the company. According to Smith and Stulz
(1985) and Stulz (1996), these costs, which are sometimes
referred to as indirect bankruptcy costs, are assumed to
increase with the degree of corporate financial distress4.
These costs may, for example, arise from employees declining
motivation or from sales being lost to competitors, because
customers become increasingly reluctant to buy products that
require repairs or other services from a company that is on the
verge of bankruptcy. Anecdotal evidence of such behavior is
provided, for example, by Rawls and Smithson (1990), who
report that when Wang Computers got into financial trouble,
sales fell and who cite a Wang customer asking: How do we
know that in three years you wont be in Chapter 11?
Shapiro and Titman (1985) give various other examples of
such indirect bankruptcy costs. They highlight the fact that
some firms are, by the very nature of their business, more
vulnerable to adverse changes in their perceived distance to
default than other firms. For example, they cite Lee Iacoccas
response to suggestions that Chrysler should declare bank-
ruptcy: Our situation was unique It wasnt like the cereal
business. If Kelloggs were known to be going out of business,
nobody would say: Well, I wont buy their cornflakes today.
What if I get stuck with a box of cereal and theres nobody
around to service it? Hence, it is absolutely clear that finan-
cial distress costs resulting from a deterioration of customer
(or other stakeholder) relationships are not constant across
firms, but depend strongly on the particular business and
164 - The journal of financial transformation
industry. Figure 1 illustrates those potential differences in
financial distress cost functions that may be due to industry-
specific or product-type characteristics. Differences in direct
bankruptcy costs are likely to be small.
In order to empirically estimate the cross-sectional differenc-
es between firms financial distress cost functions, time series
of at least two proxy variables are needed: one to reflect the
changing degree of financial distress (measured, for example,
by the firms credit rating or, far better in terms of data avail-
ability, by its credit default swap spread5) and one for the
resulting distress costs (measured, for example, by accounting
earnings or, again far better in terms of data availability, by
the firms stock price). We will ignore these regression issues
for future practical application and empirical work and return
to the conceptual issue of capturing existing differences
among the firms distress costs.
In order to maintain the intuition of the Merton (1973, 1974)
option pricing framework, it seems reasonable to simplify the
firms financial distress cost function by assuming a piecewise
linear relationship between future firm value (V) and financial
distress costs (DC). Then, with a constant-percentage financial
distress cost rate (m) for each firm, the claim by the beneficia-
ries with respect to the firms precarious situation is given
simply by DC = m max (D V, 0). Here, D denotes the face
value of debt that the firm issues, so that the term D V can
be interpreted as the firms distance to default or its distance
to bankruptcy that fluctuates over time. Hence, the more seri-
ous the firms financial distress, the higher the associated
costs. Furthermore, the higher the parameter m, the more
sensitive is the net value of the firm to adverse changes in its
perceived probability of bankruptcy. In a sense, parameter m
could be described as a kind of bankruptcy beta, since its
empirical content as a sensitivity measure of the firms unsys-
tematic bankruptcy risk resembles the beta coefficient that is
commonly applied to measure a firms systematic risk. In the
Iaccoca example cited above, a car manufacturer, such as
Chrysler, would probably be characterized by a much higher
bankruptcy beta m than a cereal producer like Kelloggs.
2 For example, Brealey, Myers and Allen (2005) state this hypothesis on their list of
the ten most important unsolved problems in finance that seem ripe for produc-
tive research.
3 See, for example, the recent work of Molina (2005), who concludes that his esti-
mation of the ex-ante costs of financial distress can offset the current estimates of
debt tax shields.
Corporate hedging and capital structure decisions: towards an
integrated framework for value creation
From a managerial perspective, hedging market price risk
entails entering into selected derivative contracts, whose
state-dependent payments are intended to manipulate certain
features of the probability distribution of the firms future
cash flows or accounting earnings. Among the risk factors
that typically cause this type of undesirable volatility are inter-
est rates, foreign exchange rates, and the prices of commodi-
ties like crude oil, fuel, or steel, which may constitute the
firms input factors or its products.
In general, corporate hedging can be defined as a reduction in
dependence between uncertain future corporate profits and
random market prices. Hence, speculative policies that
increase the firms exposure to price fluctuations, and that
might result from advantages in information about future
prices, are not considered here.
In the academic literature on corporate hedging, several theo-
ries offer competing answers to the questions of why and how
firms should hedge [Graham and Rogers (2002), Brown and
Toft (2002)]. Smith and Stulz (1985) deal with two value-
increasing effects of hedging, assuming a fixed capital struc-
ture. Firstly, they model the direct impact of hedging on corpo-
rate tax liability as a result of a convex tax function. Secondly,
they demonstrate its influence on the costs of financial dis-
tress and bankruptcy: By reducing the variability of the future
value of the firm, hedging lowers the probability of incurring
bankruptcy costs. This decrease in expected bankruptcy costs
benefits shareholders. Ignoring the issue of bankruptcy costs,
MacMinn (1987) suggests the protection of depreciation charg-
es and tax credits as a rationale for corporate hedging. Froot,
Scharfstein, and Stein (1993) propose that hedging can help to
avoid the use of expensive external financing by coordinating
the firms investment and financing policy.
More recently, another line of reasoning that explicitly takes
the firms capital structure policy into account seems to be
gaining popularity. According to Ross (1996), Stulz (1996), and
Leland (1998), an important benefit of corporate hedging is
that it represents a means of taking advantage of increased
4 See also Halls (2002) analysis of a banking firm: ...one would intuitively expect
the cost of financial distress to curve upwards as the bank is forced into ever more
draconian action to survive.
5 With the development of liquid credit default swap markets the availability of high-
frequency time-series data has greatly improved. Bloomberg quotes for credit
Costs of Financial Distress
(Proxy Variables: Stock Price,
Kelloggs, ...
Accounting P&L, ...)
Chrysler, Wang, ...
Degree of Financial Distress
(Proxy Variables: Credit
Rating Grade, Credit Default
Swap Spread, ...)
Figure 1 Differences in financial distress cost functions across firms
debt capacity and the resulting additional interest tax shield.
While this motive has already found its way into the finance
textbooks2, a clear-cut analytical model of the interaction
between the firms hedging and capital structure decisions
has been missing.
Financial distress costs and corporate taxes
constitute an optimal degree of leverage
From the famous Modigliani and Miller (1958) theorem it is
well known that value creation through financial decision
making at the company level requires the presence of certain
market frictions. In frictionless financial markets, not only a
firms capital structure decision, but also its hedging decision
can be regarded as irrelevant from the shareholders perspec-
tive. If, for example, a company decides to buy an option for
hedging purposes and pays exactly its fair market value, there
is no value creation for shareholders in the first place. This is
where market frictions, such as bankruptcy costs, taxes, or
transaction costs come into play. These market imperfections
can turn the initially zero net present value of the derivatives
contract into a positive value contribution.
In the widely used trade-off model of a firms capital structure
[Kraus and Litzenberger (1973), Myers (1993)], which is still a
very popular prototype for practical applications [Opler, Saron
default swap spreads are now available for more than 1,500 companies. The
relationship between credit default swap spreads, bond yields, and Moodys credit 165
rating announcements is analyzed, for example, by Hull, Predescu and White
(2004).
 Corporate hedging and capital structure decisions: towards an
integrated framework for value creation

derived from an additional dollar borrowed. If the firms bank-

Present value of financial distress costs (PV(DC)

ruptcy risk can be reduced by a marginal increase in the hedge

Present value of corporate taxes (PV(CT)

ratio, then this increase renders less valuable the additional

financial distress costs that may arise in the future from an
PV(DC+CT) additional dollar borrowed today. Furthermore, the additional
future tax savings from an additional dollar borrowed become
more valuable now, because future taxes are only payable to
the government if bankruptcy does not occur. Thus, on the
PV(CT)
PV(DC) one hand, corporate hedging can make the tax shield from
additional debt safer, but on the other hand, can render less
L* Leverage
safe the claim by the beneficiaries of bankruptcy caused by
Figure 2 Financial distress costs (DC) and corporate taxes (CT) constitute an further borrowing. Hence, a marginal increase in the firms
optimal degree of leverage (L*)
hedge ratio can lead to both a shrinking present value of the
bankruptcy costs resulting from an additional dollar borrowed
that derive from the competing goals of shareholder value and at the same time to a growing present value of the tax
maximization and minimization of total risk (measured, for relief resulting from an additional dollar borrowed. Because
example, by the variance) will generally differ6. Hence, taking the reduction in bankruptcy risk triggered by corporate hedg-
into account that an increased volume of derivatives con- ing makes further debt financing more attractive, optimal
tracts typically leads to additional transaction costs, in the leverage will be adjusted upwards to the benefit of sharehold-
form of bid-ask-spreads, for example, the recommendation for ers.
management is to reduce risk to the degree which will enable
default to be ruled out with sufficient certainty.7 This second-order effect of corporate hedging on shareholder
value is illustrated in Figure 3. As already clear from Figure 2,
Corporate hedging benefits shareholders by the optimal size of the debt issue constitutes an optimal
raising optimal leverage degree of leverage L* that minimizes the sum of the present
Let us consider the situation in which the firms financial man- values of distress costs (DC) and corporate taxes (CT), if the
agement is confronted with a hedge ratio that is determined firm does not hedge at all (H = 0). The sum of deadweight
exogenously, so that only the face value of the debt issuance costs PV(DC+CT) that must ultimately be borne by the firms
is subject to optimization. Consider, for example, that it is the shareholders is illustrated in Figure 3 as a function of leverage
companys policy, for whatever reason, that exposures must (L) for three alternative hedge ratios (H) of 0%, 30%, and
always be fully hedged (H = 100%), hedged partly (H = 50%), 60%, respectively. As the arrow indicates, optimal leverage
or that the company has even decided not to use any deriva- (L*) increases with the selected hedge ratio. Hence, both types
tives at all (H = 0%). We wish to investigate briefly how a of undesired deadweight cost are not only diminished directly
change in the hedge ratio can create additional value for by corporate hedging, but they can be reduced even further,
shareholders by influencing the firms capital structure choice. as higher hedge ratios allow the firm to raise leverage without
increasing its bankruptcy risk.
A marginal increase in the hedge ratio affects the optimal
capital structure through both the market value of the Trading off the costs and benefits of corporate
increase in distress costs resulting from an additional dollar hedging: who hedges more?
borrowed and through the market value of the tax relief Finally, we consider the case in which the companys manage-

166 - The journal of financial transformation

Corporate hedging and capital structure decisions: towards an
integrated framework for value creation
Borrowing at the company level is motivated by income tax
considerations. Corporate debt is assumed to create a tax
shield that serves as a counterweight to financial distress
costs [Brealey, Myers and Allen (2005)]. A marginal increase
in the debt issue reduces the present value of the govern-
ments tax claim. In bankruptcy, taxable income would be
negative and, if there was no associated tax credit, the tax
shield of debt would be lost (at least partly). The interpretation
of the distress costs (DC) and corporate tax (CT) functions
illustrated in Figure 2, which constitute a unique optimal debt
level, is straightforward. A one dollar increase in the firms
debt level leads, on the one hand, to an increase in expected
financial distress costs, but on the other hand, to a reduction
in expected corporate taxes. The optimal degree of leverage is
reached when the present value of expected tax relief of the
last dollar promised to the creditors just offsets the present
value of the additional distress costs caused.
Corporate hedging benefits shareholders by
reducing financial distress costs and taxes
Let us now consider the case in which the firms risk manage-
ment is confronted with a capital structure that is determined
exogenously, so that only the hedge ratio is subject to optimi-
zation. As explained by Brown and Toft (2002), such a situa-
tion can be justified by thinking of the firms capital structure
choice as a more strategic long-run decision, while its hedging
decision is more flexible and focuses on the short-run.
In this case, both the present values of financial distress costs
and of corporate taxes are reduced by a marginal increase in
the hedge ratio, as long as the probability of bankruptcy can
be reduced further by corporate hedging. If, conversely, the
riskless payments from certain derivatives contracts already
fully cover the firms credit obligation (D), then a marginal
increase in the hedge ratio has no further impact on share-
holder value.
To see how this works, it is helpful to think of the govern-
ments tax claim (CT) as a call option with a strike price that is
identical to the face value of debt (D) and with the value of the
6 The fundamental difference between hedging strategies that focus on a reduction
of total risk (i.e., cash flow variance) and those that are designed to reduce bank-
ruptcy risk is analyzed by Hahnenstein and Rder (2003).
Present value of financial distress costs and
(H=0%)
(H=30%)
(H=60%)
corporate taxes (PV(DC+CT))
PV(DC+CT)
L*(H=0%)
L*(H=30%) Leverage
L*(H=60%)
Figure 3 Combined present value of financial distress costs and corporate taxes
as a function of leverage L for alternative hedge ratios H = 0%, 30%, and 60%
firm (V) as its underlying [Majd and Myers (1987)]. In the same
way, the financial distress costs (DC) can be seen as a put
option which is a contingent claim owned by the firms com-
petitors or other potential beneficiaries of its distressed situ-
ation.
A familiar finding of option pricing theory is that the market
value of any option is, in principle, an increasing function of
the risk inherent in its underlying [Merton (1973)]. As long as
the variance of the firms asset value can be reduced by an
increasing hedge ratio, one would expect the present value of
both external drains to shrink and, as a result, shareholder
value to increase. However, as pointed out by Jagannathan
(1984) in an article that clarifies the role of Jensens Inequality
in option pricing theory, this result would require strictly con-
vex payoff functions. Because the governments and the bank-
ruptcy beneficiaries contingent claims lose this feature when
the firms hedging activity exceeds a certain threshold level,
the present values of taxes and bankruptcy costs may remain
unchanged, although the variance of the firms asset value
simultaneously decreases further.
Therefore, it cannot be concluded from an option-like convex-
ity of the deadweight costs (reflected either by costs of finan-
cial distress or corporate taxes) alone, that only the full hedge
is optimal. With a fixed capital structure, the hedging policies
7 The required confidence level may be derived from the firms target rating. This
idea is implemented in the economic capital approaches that have become an 167
increasingly popular risk management concept during the past few years. See, for
example, Hall (2002) or Schroeck (2002).
 Corporate hedging and capital structure decisions: towards an
integrated framework for value creation
hedging are more likely either to hedge in full or in part. A
second, not surprising finding is that those firms that are
exposed to more volatile operating cash flows derive greater
benefits from corporate hedging. The real reason behind this
result is as follows. A greater level of price volatility in the
firms operating income renders the deadweight options for
the beneficiaries of bankruptcy and of governments tax
claim more valuable. Because the firm chooses its capital
structure such that there is always a positive probability of
bankruptcy, an increase in cash flow volatility leads to an
increase in the marginal benefit that shareholders derive
from corporate hedging. This is the case because the reduc-
tion in market value of both the external put and call options
achieved through a derivates contract is ceteris paribus
higher. Our third, and most important, comparative static
result is that those firms whose indirect bankruptcy cost
functions react more sensitively with an increasing degree of
financial distress derive greater benefits from hedging. In
terms of option pricing theory, firms that have higher bank-
ruptcy betas are characterized by more convex distress cost
functions. Returning to the Chrysler vs. Kelloggs example
discussed above, Figure 5 illustrates why the typical automo-
H=100%
Hedge Ratio
H=0%
L*(H=0%) L*(H=100%) Leverage
Figure 4 Shareholder value as a function of the firms leverage (L) and hedge
ratio (H) in the absence of transaction costs of corporate hedging
8 The idea of hedging away all risk in the first step and then levering up to a higher
debt level in order to minimize the firms tax liability can be attributed originally to
168 MacMinn (1987).
9 Stulz (1996) refers to the variance-minimization-paradigm as the prevailing aca-
demic theory of risk management and Froot, Scharfstein and Stein (1993) summa-
rize that much of the previous work has the extreme implication that firms should
hedge fully completely insulating their market values from hedgeable risk.
tive manufacturing company should hedge more than the
average cornflakes producer. As our hypothetical companys
bankruptcy beta (m) rises from 25% to 30%, its optimal
hedge ratio more than doubles from 17.2% to 35.2%, while
the face value of its optimal level of outstanding debt is
reduced simultaneously by only less than 1%.
Conclusion
In this article, we have demonstrated how the popular trade-
off model of optimal leverage that minimizes the sum of cor-
porate taxes and financial distress costs can be enriched with
the derivatives market. In this market, the firm can eliminate
the market price risk associated with its operations by means
of hedging contracts. It was demonstrated that the optimal
level of outstanding debt is raised by an increase in the hedge
ratio, if the probability of the firm going bankrupt is reduced.
We have illustrated that, for a given capital structure, the
market value of shareholder equity is an increasing function
of the firms hedge ratio. This influence is, in terms of option
pricing theory, due to the convexity of the deadweight claim
payoff profiles. Interestingly, it cannot be concluded from the
convexity of deadweight costs, in conjunction with a fixed
capital structure, that the full hedge is the only optimal solu-
tion, because this convexity may disappear when bankruptcy
risk is reduced. However, it is evident that for an optimally
leveraged firm the marginal benefit shareholders derive from
corporate hedging is always positive in the absence of trans-
action costs of hedging. Consequently, the firm insulates its
future payments completely from hedgeable risk in the simul-
taneous optimum of its hedge ratio and capital structure. This
intermediate result sheds new light on minimizing the vari-
ance of future cash flows as an appropriate goal for corpo-
rate risk management, when transaction costs of hedging are
negligible.
Finally, and most importantly, however, when transaction
costs of corporate hedging are taken into account that can
offset the benefits, it emerges that in a group of otherwise
identical optimally leveraged firms, those firms that face
10 As in Graham and Rogers (2002), information about differences in firms hedge
ratios may be derived from mandatory accounting disclosures. A potential empiri-
cal proxy variable for a firms hedge ratio is the net notional amount of its total
derivatives usage divided by its sales or total assets. Aggarwal and Simkins (2004)
provide a summary of US-GAAP disclosure requirements for derivative financial
instruments during the 1990s.
Corporate hedging and capital structure decisions: towards an
integrated framework for value creation
ment selects both its leverage and hedge ratio simultaneously.
Stulz (1996) suggest that a companys decisions to hedge
financial risks [...] should be made jointly with the corporate
capital structure decision.
We have stressed the fundamental difference between hedg-
ing strategies to reduce total risk, in terms of variance, and
downside risk, in terms of the firms probability of default,
when leverage is exogenous. However, these differences may
vanish in the simultaneous optimization of both corporate
decision variables. To see how this works it is important to
understand that shareholder value always increases with an
increase in the firms hedge ratio, when the firm is optimally
levered and when transaction costs deriving from corporate
hedging can be ignored. Hence, it is an immediate conse-
quence that in the simultaneous optimum the firm fully
hedges all its market price risk (H* = 100%).8
This intermediate finding based on neglecting the potential
costs of corporate hedging is illustrated in Figure 4, which
depicts the contour curves of the shareholder value surface.
In particular, it becomes apparent that total shareholder
wealth always increases with the firms hedge ratio for an
optimized capital structure. Although shareholder value does
not always increase with the firms hedge ratio (the iso-share-
holder-value-ellipses are vertical in the upper left corner of
the base), it does so if further hedging reduces the bankruptcy
risk incurred when leverage is optimal.
Corporate hedging, which Stulz (1996) has characterized as a
substitute for equity, is, in a sense, simply a means of applying
regulatory arbitrage. The risk of future market price fluctua-
tions is transferred completely to the hedge counterparty,
who as the seller of protection effectively assumes the risk
profile of an equity investor in the firm. Of course, this risk
transfer will only take place if the counterpartys marginal
costs of financial distress and taxes, which depend on the cash
flows of all its other assets as well, are lower than those of the
firm, possibly because it needs the firms products as an input
mCars > mCornflakes
H*Cars (L*) > H*Cornflakes (L*)
H=100%
H*Cars (L*)
= 35.2%
H*Cornflakes (L*)
=17.2%
H=0%
L*(H=0%) L*(H=100%) L*(H=0%) L*(H=100%)
L*(H*) L*(H*)
Figure 5 Impact of increasing sensitivity m in the firms financial distress cost
function on the joint optimum of its hedge ratio H* and leverage L*.
factor. Therefore, in equilibrium, the allocation of risk across
the economy through equity, bond, and derivatives markets
minimizes the total deadweight loss imposed by the legal,
regulatory framework. Interestingly, this line of reasoning
leads to an optimal hedging policy for the firm that coincides
with the variance-minimizing solution that emerges from con-
ventional wisdom9.
While our analysis has so far been restricted to the benefits of
corporate hedging and their interrelatedness, we now try to
explain observable cross-sectional differences in corporate
hedging behavior that result from trading off the benefits and
costs of corporate hedging10. In order to establish an empiri-
cally testable theory of corporate hedging we introduce into
our framework transaction costs of hedging (TC) that are
assumed to directly diminish shareholder wealth. These trans-
action costs offset the benefits derived from reduced taxes,
lower distress costs, and higher leverage and can thereby
constitute a unique optimal hedge ratio. It can be shown that
at the simultaneous optimum of both the firms hedging and
leverage variables, several comparative static results hold
unambiguously for the chosen hedge ratio.
The first finding that emerges from the analysis is that those
firms that face lower marginal transaction costs of corporate
169
 Corporate hedging and capital structure decisions: towards an
integrated framework for value creation
lower marginal transaction costs of hedging, more volatile
operating cash flows and, in particular, more convex dead-
weight costs should choose higher hedge ratios. While the
convexity of the firms effective tax function, which is due to
non-linearity of the national tax codes, has already been dis-
cussed extensively in prior empirical research [Graham and
Smith (1999) and Graham and Rogers (2002)], the convexity
of deadweight costs due to potential financial distress, which
plays the central role in our model here, has been neglected
completely. Using anecdotal evidence of greater benefits of
risk management for firms selling credence goods or products
involving long-term relationships, we believe that such differ-
ences in indirect bankruptcy cost functions across firms offer
a promising basis for future empirical research aimed at
explaining observable differences in firms hedge ratios.
170 - The journal of financial transformation
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 Guidelines for manuscript submissions

Guidelines for authors Manuscript guidelines

In order to aid our readership, we have established some guidelines to
ensure that published papers meet the highest standards of thought
leadership and practicality. The articles should, therefore, meet the
following criteria:
1. Does this article make a significant contribution to this field of
research?
2. Can the ideas presented in the article be applied to current business
models? If not, is there a road map on how to get there.
3. Can your assertions be supported by empirical data?
4. Is my article purely abstract? If so, does it picture a world that can
exist in the future?
5. Can your propositions be backed by a source of authority, preferably
yours?
6. Would senior executives find this paper interesting?
Subjects of interest
All articles must be relevant and interesting to senior executives of the
leading financial services organizations. They should assist in strategy
formulations. The topics that are of interest to our readership include:
All manuscript submissions must be in English.
Manuscripts should not be longer than 5000 words each. The maximum
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All manuscripts should be submitted by e-mail directly to the editor@
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details should include address, phone number, fax number, and e-mail
address.
Footnotes should be double-spaced and be kept to a minimum. They
should be numbered consecutively throughout the text with superscript
Arabic numerals.

Impact of e-finance on financial markets & institutions For monographs

Marketing & branding Jensen, M., Corporate Control and the Politics of Finance. Journal of
Organizational behavior & structure Applied Corporate Finance (1991), pp. 13-33.
Competitive landscape
Operational & strategic issues For books
Capital acquisition & allocation Copeland, T., T. Koller, and J. Murrin. Valuation: Measuring and Managing
Structural readjustment the Value of Companies. John Wiley & Sons, New York, New York (1994).
Innovation & new sources of liquidity
Leadership For contributions to collective works
Financial regulations Ritter, J. R., 1997, Initial Public Offerings, in Logue, D. and J. Seward, eds.,
Financial technology Warren Gorham & Lamont Handbook of Modern Finance, South-Western
College Publishing, Ohio.
Manuscript submissions should be sent to
Shahin Shojai, Ph.D. For periodicals
The Editor Griffiths, W. and G. Judge, 1992, Testing and estimating location vectors
Editor@capco.com when the error covariance matrix is unknown, Journal of Econometrics
54, 121-138.
Capco
Broadgate West For unpublished material
9 Appold Street Gillan, S. and L. Starks. Relationship Investing and Shareholder Activism
London EC2A 2AP by Institutional Investors. Working Paper, University of Texas (1995).
Tel: +44 207 426 1500
Fax: +44 207 426 1501

172 - The journal of financial transformation

Request for papers Deadline September 28th, 2006

The world of finance has undergone tremendous change in recent years.

Physical barriers have come down and organizations are finding it harder
to maintain competitive advantage within todays truly global market
place. This paradigm shift has forced managers to identify new ways to
manage their operations and finances. The managers of tomorrow will,
therefore, need completely different skill sets to succeed.

It is in response to this growing need that Capco is pleased to publish the

Journal of financial transformation. A journal dedicated to the advance-
ment of leading thinking in the field of applied finance.

The Journal, which provides a unique linkage between scholarly

research and business experience, aims to be the main source of
thought leadership in this discipline for senior executives, management
consultants, academics, researchers, and students. This objective can
only be achieved through relentless pursuit of scholarly integrity and
advancement. It is for this reason that we have invited some of the
worlds most renowned experts from academia and business to join our
editorial board. It is their responsibility to ensure that we succeed in
establishing a truly independent forum for leading thinking in this new
discipline.

You can also contribute to the advancement of this field by submitting

your thought leadership to the Journal.

We hope that you will join us on our journey of discovery and help shape
the future of finance.

Shahin Shojai
Editor@capco.com

For more info, see opposite page

2006 The Capital Markets Company. VU: Shahin Shojai,

Prins Boudewijnlaan 43, B-2650 Antwerp
All rights reserved. All product names, company names and registered trademarks in
this document remain the property of their respective owners.

173
Design, production, and coordination: Cypres Daniel Brandt and Pieter Vereertbrugghen
2006 The Capital Markets Company, N.V.
All rights reserved. This journal may not be duplicated in any way without the express
written consent of the publisher except in the form of brief excerpts or quotations for review
purposes. Making copies of this journal or any portion there of for any purpose other than your
own is a violation of copyright law.
 Four Key
Questions
for
Wealth
Managers
1
Rising costs, heavier
regulation, tougher clients
in a tougher market
how can a Private
Banking business cope?

2
Can we respond quickly
enough to all these
changes?

3
Should we be redefining SEI knows about the competitive
our private client value benefits of outsourcing in private
proposition? banking institutions.
To get a copy of SEIs special report
Outsourcing and the European
Wealth Management Market*, call
Francis Jackson on + 44 (0)207 297
6308, or Email fjackson@seic.com

4
How do we decide
what is best done in
house, and what needs
Hear what the industry is saying.
* Research amongst CEOs, CFOs and
Senior Executives of wealth management
institutions in 10 European Countries

to be outsourced?
SEIInvestments (Europe) Ltd,
4th Floor, The Economist Building,
25 St Jamess Street, London SW1A 1HA
SEI.
is regulated and authorised by the
Financial Services Authority New Ways. New Answers.
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