## Mr Clementi comments on UK financial services following the launch of the euro
Speech by Mr David Clementi, a Deputy Governor of the Bank of England, at the Econom Conference in London on 23 April 1999.
It is a great pleasure to be here this morning. My announced topic - UK financial services the launch of the euro - is obviously a large one. But ambition is a fine thing, and so not just that, I want also to say a little about the wider forces - especially technological c are shaping changes in financial services markets and institutions everywhere, not just in E
The importance of financial services to the UK economy is enormous, and I do not need to much time to underlining it. Financial services are a major invisible export and con substantial proportion of GDP. The UK does more foreign exchange business, more OTC derivat business, more international bank lending, more bond origination and trading, and more equ management than any other country. Personally, I have no doubt that - provided we a complacent - the UK will retain its dominant position for the foreseeable future. But th nature of the financial markets in which UK-based practitioners have to operate will continue to change.
The plan for my march through this difficult terrority is as follows. First, by way of b want to say a bit about the 'new' Bank's role in relation to the financial services secto the arrival of monetary independence, and the departure of banking supervision and management, what exactly is our interest, as central bankers, in the way financial servic After that I will talk a bit about some of the forces which are working to produce fairly in the financial services landscape.
One of these forces - and certainly one of the most prominent just at this moment - is th the euro. So I will undertake a spot of crystal ball gazing, and try to assess how financi Europe may develop over the next ten to fifteen years, and what this means in terms of opp and challenges for UK financial services. It is in the nature of an assessment of this kin deal of it may turn out to be wrong. But making judgements about an uncertain future is pa business, and there is no reason why central bankers should shy away from it more than any so long as the uncertainties involved are acknowledged from the start.
Another, almost certainly more persistent, factor is the pace of technological change. Rela we are seeing a trend towards consolidation - at first nationally, but now also intern amongst financial services providers. So I also want to make a few remarks about these facto
Before I go into these issues in more detail, I just want to sketch out how the Bank stand to UK financial services. Obviously the changes in the Bank's remit announced in May 1997 incoming Labour Government, and largely enshrined in the 1998 Bank of England Act, w profound ones. The arrival of monetary independence meant that the work of the MPC - of w am one of the nine members - has scarcely been out of the news. Less obtrusively, the dep banking supervision to the new FSA meant the end of one substantial - though actually compa recently acquired - function; and the shift of debt management to the DMO brought to an end much older one.
So does the 'new' Bank have a new relationship with the financial services sector?
Let me first say that, though the Bank has been through a period of profound change, its cor remain the same. One is obviously to promote monetary stability; and there our role is n more substantial and overt. But the Bank has two more core purposes, and both relate direc financial services sector.
The first is to promote the overall stability of the UK financial system. This role is not new, has recently been set out explicitly in the Memorandum of Understanding between the Bank, HMT and the FSA. Broadly, promoting systemic stability means working to ensure that the financial sy continues to perform its key roles in support of the wider economy - settling transactions, pro liquidity and allocating savings. In pursuit of this we look at factors affecting the und robustness of the financial system, as well as potential 'triggers' which, especially at t structural weakness, could bring on a crisis. Our remit is of course in relation to the UK f system - but this work has a substantial international dimension, given the openness of the economy, and the international character of much of the City.
What does this mean in practice? The Bank's financial stability work include such things overseeing the UK payments systems; analysing broader developments in the banking, securities an insurance sectors, and the evolving strategies of London's securities exchanges; looking developments in emerging market economies; and contributing to the debate on the reform of t international financial system. In short, the Bank's financial stability team has to analyse and to any developments - market or institutional; structural or temporary - that could threaten fi stability.
Our second relevant core purpose is to promote the competitiveness of the UK financial servi sector. This is not a lobbying function; we are concerned with the promotion of effectiveness efficiency, not the acquisition of favours. Nor is it a responsibility exercised only in respe owned firms. The UK financial services sector is more truly international than that in any country in the world. The Bank, and the other authorities in the City, have an unwaver commitment to openness, and the provision of a level playing field to all firms regardles nationality.
Finally, it is worth underlining that the Bank of England has an interest in the evolving stru financial markets because, as well as being a policy body, it is also a bank. We have a substantial and diverse balance sheet to manage, and that balance sheet is the basis for our f market operations in support of our policy responsibilities.
The Bank is banker to the government, and to the banking system as a whole, and maintains a operational presence in various key financial markets. In the sterling markets, the Bank obvi stands at the centre of the short term money markets, providing liquidity to the banking syste thus maintaining control over short term interest rates. We are also, as managers of the na foreign exchange reserves as well as various currency assets and liabilities on the Bank's own ba sheet, active in the foreign exchange and some foreign bond markets. Finally, although no lon responsible for debt management, we retain an operational capability in the gilts market, primarily to manage our balance sheet and provide services to customers. Being close t developments in these markets provides a vital source of information used in the pursuit of financial stability, as well as monetary policy, objectives. And any operations that were, in needed in support of our financial stability objectives could take place in any of these markets.
Now I will turn to some of the various forces for change in the financial services industry.
First, the euro. The arrival of the euro marks a profound and almost certainly irrevocable cha the financial landscape - perhaps the most important event in the international monetary system Bretton Woods in 1944. Instantly, a major new reserve currency has appeared; indeed the euro already being used in international transactions more extensively than any currency other tha dollar.
As the most international financial centre anywhere in the world, London's business has already profoundly affected by the euro. This is because, although the UK is 'out', London is 'in'. conversion weekend - the changeover from participating national currencies to the euro in wholes
markets at the beginning of this year - was one of the biggest logistical operations that market has ever undertaken. It was also arguably more complex in London than in some count the euro area, because London traded in all the euro area national markets, and they all c to the euro in slightly different ways. And, though hard numbers are difficult to come confident that London is maintaining its market share. In exchange traded short-term int derivatives - one of the few areas where we have precise figures - LIFFE has around 80% o business. On the London Stock Exchange, over 40% of turnover in the first two months of t was in stocks of firms in the euro area. Similarly, in other markets, London's dominance exchange trading, OTC derivatives, fund management and bond origination means that London i financial centre for euro wholesale financial services. Even in the area of payment syste accounts for a significant proportion of the euro payments flowing through TARGET, even thou us the euro is a foreign currency.
But these are just the immediate, first round effects of the euro. The more substantial ch posed by the more uncertain outlook as to just how the euro markets will develop in the medi So I want now just to say a little about how the euro markets may develop over the next ten years.
One thing to keep in mind here is that some of what may happen, though driven by events in will reflect factors beside the single currency. I think we may well see more privatisat reliance on private provision of pensions, and other structural reforms. If we do, it will affect European, and hence, euro financial markets. But such trends have their roots in general process of creating a single market, rather than EMU itself. Considerable progress single EU market for financial services had been made long before the euro. A considerable of directives are already in place, perhaps most significantly the Investment Services Dire was implemented in 1996 and gave regulated firms and exchanges from one Member State 'passport' to do business in another Member State. I will now turn to possible develop particular markets.
First the market for euro area bonds. In aggregate, the euro area government bond marke broadly similar size to the US Treasuries market. So it is one of the largest securities world. It is of course not yet as fully integrated as the Treasuries market. Substantial f in that direction probably depends on how quickly the various initiatives to link together trading and settlement systems come to fruition. And there are, and will remain, credit between particular issuers. But I would nevertheless expect the market to become incr integrated and, with other bond markets, more sophisticated over time.
This 'cash' market is of course important in its own right; and London based market partici remain very big players in it. But as far as the development of UK financial services concerned, the other interest rate markets which spin off the government bond market may be where we see the most rapid growth, and the greatest scope for innovation. Good examples w the markets for repo, swaps, and other interest rate derivatives.
I think that in terms of new market opportunities, one of the most important areas in th euro-denominated markets could be that for corporate bonds. At the moment, although the Eu and US government bond markets are of comparable size, the non-government bond market in Eur is 'only' a third to half the size of that in the US; and much of that is bank issued debt.
I would expect the euro corporate bond market to develop significantly in the medium term. it, I would expect to see other product markets develop, as they have elsewhere (in th especially in the US) - for instance markets for asset backed securities and commercial pap of this I think we will see a trend to greater issuance at the lower credit end of the ma yield', as it is politely named). In the euro area around 70% or corporate bond issuance i
rated Aa2 and above. In the US, it is around 30%. I would expect that gap to close a bit, and there are already signs of life in the European high yield market.
While I am on the subject of European bond markets, I would like to make just a few remarks abo the proposed EU withholding tax. The stated objectives of the scheme - reducing tax evasion a reducing structural unemployment - are clearly desirable ones. But in thinking about any kind withholding tax a judgement has to be made about the trade off between the efficiency of collection and the efficiency of capital markets. In this particular case, I think the open nat EU economy sets very serious limits on the proposal's potential impact on the collection of tax, the same scope for avoiding tax would continue to exist outside the EU as it does at present; seems unlikely that countries outside the EU area would voluntarily follow the same policy. So I there is a very real danger that legitimate business would relocate, not just outside Londo outside the EU, thus further undermining any economic rationale for the proposal. This does not m that work should not continue to see whether there are amendments to the scheme that could sati the interests of all the parties involved. But the Bank continues to believe that it is importan any scheme that would damage EU financial markets.
Turning to equities, I expect to see growing emphasis on analysis and investment according European sectors, not countries. Thus you would expect to see investment banks' researc departments focusing more on pan-European sectors, rather than dividing their teams on natio lines. In many firms this is happening already.
More generally, I think we can expect to see greater 'equification' in continental Europe. In th the equity market's capitalisation is around 165% of GDP. Among the 'ins' it is generally mu lower: in Germany and Spain it is perhaps 35%, in France 40% and in Italy 25%. Only the Netherlands really stands out, at around 130%.
This is partly a reflection of cultural investment differences; greater reliance on bank finance state and family ownership (still equity of course, but not easily marketable); and reliance on rather than private pensions. As a result equities form rather less than 20 % of institutional p in France, Germany and Italy. In the UK they represent more than 70% of portfolios.
In the medium term, I would expect to see more equity issuance; and much greater institutio holdings, especially cross border. The latter is one area where the euro may have a fairly rapid on institutional portfolios, since many institutions remain unable to diversify into foreign c assets. This process of equification will of course take time - but there are signs that it is especially in the relatively strong growth in the market for continental high technology stocks.
What about the traditional banking market? I leave this to last because some of the likely chang just the counterpart of factors I have already mentioned. But for instance, greater reliance by users on equity as opposed to debt capital, and bond as against bank finance, would, other t being equal, be expected to lead to some shrinkage in banks' balance sheets in relative terms extent to which this may happen is of course uncertain. It will depend on many factors, includin impact of any changes to the Basle Accord. But even if there is substantial disintermediation, not mean that banks will cease to be dominant players. My point is just that as euro securities develop and deepen, more of the finance banks arrange will be off balance sheet. I'm inclined to also that we will see further consolidation within the European (and indeed global) banking sec though I think that will not primarily be a function of the euro, and is something I will touch minute.
Now, all these developments offer opportunities for financial services firms globally. This i zero sum game. I expect to see financial centres within the euro zone growing in size over the few years. But London will grow too, and I think it is significant that many of these pot developments depend on market practices and techniques pioneered in London.
I see London as the engine for growth and innovation in the European capital markets. This narrow parochial point. As I have already emphasised, UK financial services are internationalised and many of the UK-based beneficiaries of this process are owned elsewh the US, Europe, Asia and elsewhere. Nor does it reflect complacency. Although London tremendous critical mass - especially in the crucial area of human capital - one major imp what I will say in a minute about technological innovation is that certain aspects of finan - especially trading and settlement - are potentially more geographically mobile now than i We are already in a market where it is possible for a trader in London to deal on a German call for delivery in Luxembourg and make payment in Paris.
So, the advent of the euro is just one factor transforming the environment in which U financial services firms must operate. I would now like to talk about a few others.
First and foremost, technological advances. Even from just a few years' perspective it is financial services have been transformed by technological innovation. Arguably we are movi world in which more and more trading and settlement processes will use automated, ele systems. And the pace of change is probably increasing. The LSE moved away from a trading f 1986. It has since moved to electronic and largely dematerialised share settlement in CREST and to the electronic order book SETS for its largest 100 or so stocks in 1997. Last y decided to switch from floor trading to its new electronic CONNECT system.
More broadly, electronic trading systems have been, or are being, introduced in a whole government bond, repo, Eurobond and foreign exchange markets. Initiatives are well advan introduce electronic 'straight-through-processing' in various markets, allowing the transact to be automated from the initial trade right through to settlement.
On top of all this there is the as yet unknown potential of the internet. In the US, ther explosion of retail investment activity through the internet; in Europe we are still way b of the internet business that is already taking place - here or in the US - is essentially speaking to a broker, and the brokers that have adjusted most quickly to this change in t benefited accordingly. But use of the internet has already led to a change in retail inves in the US. And if the internet is eventually to have a really profound impact on the landscape - wholesale as well as retail - it may come through its capacity, as an almost open system, to link investors of all types directly into order and execution systems. But easier said than done. There are a whole range of factors - technological limitations, issues, settlement and the like - which mean that the eventual impact of the internet is ver
## What are the implications of all this?
First, electronic trading widens access to markets. It removes any need for geographical p an exchange and relaxes any limit on the number of firms that can participate directly (sub credit or regulatory constraints). Greater participation in a market increases liquidity a market more attractive still.
Second, since firms can switch from one electronic trading platform to another, and since also often access exchanges cross border, broadly speaking any exchange can potentially com the business of any firm. This creates greater competition between exchanges to maximis trading volumes and realise economies of scale. It also means that an exchange which offer advanced trading system can win business, even from established rivals, provided it can critical level of liquidity. So electronic trading makes markets more contestable and p pressure on exchanges to update their technology and offer an attractive overall 'package' t
Third, technological change means that distinctions between exchange traded and OTC market becoming more blurred. As exchanges adopt electronic trading platforms, and in some
demutualise, they become less akin to associations of particular types of firm and closer to competing providers of trading, and perhaps even clearing and settlement services. At the same t many traditional OTC markets are moving away from pure, decentralised bilateral trading to establ some common market infrastructure. So for example, in the foreign exchange market, most tradin now occurs over electronic platforms provided by Reuters or EBS. Another example is that th London Clearing House is establishing Swapclear as a central counterparty clearing house for O derivatives.
Another factor transforming the financial services landscape, and quite closely related t technological factors I have just mentioned, is the globalisation and consolidation of the main participants. The last decade has seen a global consolidation of the main intermediaries in the capital markets to leave a relatively small number of large players, with large balance sheet operations spanning each of the world's major markets. Since these firms are the major users an some cases, owners of the market infrastructure in each country, their interests have a strong in on market structure. Now I think that big is not always best, and actually smaller niche player more of a future than is sometimes imagined. But that said, in twenty years I think that it i possible that the financial world will be dominated by perhaps twenty truly international whol banks, including a few genuinely pan-European ones.
Now it is possible that these large banks will want to use their own balance sheets to offer a f of services to their customers, so that they rather than an exchange-based central market becom focus for liquidity. If so, such firms would be in competition with infrastructure provider example, when offering in-house trading or custody services to their clients. On the other hand firms will also want to continue to trade with each other, in order to manage their own risk inventory. For that purpose, they will still want low cost trading and settlement mechanisms minimise their exposure to counterparty risk and the impact on their balance sheets.
So there are perhaps some tensions between the various forces at work here. To take another examp economies of scale in trading, clearing and settlement suggest that to minimise costs firms s encourage consolidation and integration of these activities within a market. Yet the major firms understandably, been very reluctant to allow the dominance of a single supplier. For example, (Electronic Broking System) was set up by the major banks to offer an alternative system for fo exchange trading.
Ladies and Gentlemen, let me finish by saying that it is difficult to draw firm conclusions ab future structure of the financial services industry. If it was, strategic decision making would than it seems to be. But financial service businesses based in the UK start from a strong positi are well placed to thrive in an environment that will evolve at an increasing pace, become even competitive, and place an even greater premium on innovation. The Bank of England will monitor an analyse the developments very carefully - both because we want UK financial services to thrive, because in the pursuit of our financial stability responsibilities we need to be able to spot problems as quickly as possible.