With national attention focused so completely on the events in the Persian Gulf, there is great danger that fundamentally important developments elsewhere will be overlooked. An example is the continued movement of Western Europe toward a single financial market, a change that is bound to have a powerful, long-term impact.
The European Community has begun to carry out Phase One of the Delors Plan for financial integration, which is designed to culminate in a single Western European currency. The steps now being taken are far more modest, such as the consistent application of the exchange-rate mechanism of the European Monetary System to the currencies of the eight current member nations. This limits exchange rate volatility and puts additional pressure on the member governments to coordinate their domestic monetary policies.
Subsequent phases of the Delors Plan will include setting up a European central banking system (already being referred to as Euro-Fed) and ultimately adopting a single currency for the entire EC. However, these latter developments may be a long time in coming. A more wide-ranging and current aspect of the Delors Plan is the call during Phase One for abolishing all remaining restrictions on capital flows across the borders of the 12 EC member nations and for ending discriminatory financial market regulations within the community.
The implications of these near-term policy changes will be far more basic than is apparent at first blush from merely reciting the technical details. Peter G. Rogge, senior vice president of the Swiss Bank Corp. and one of the most astute observers of the EC economic scene, has identified several fundamental features of the emerging financial market order in Europe.
One likely development is that financial institutions based in any of the EC nations will ultimately have full freedom to supply financial services to customers in any of the other member countries.
An American-owned bank with an established presence in, for example, Great Britain or France, would fully qualify. The American bank would be free to set up branches or subsidiaries in any other EC nation and be subject only to the regulatory supervision of the home EC country (e.g., Great Britain or France). This would replace the cumbersome system of "host country control" of banks in each country where they do business, a regulatory regime that greatly limits Continent-wide competition.
This new national treatment or "home country control" is far more liberal than the powers that the United States grants foreign banks. From our point of view, we treat them fairly--the same as domestic financial institutions. The catch is that our regulations are far more restrictive than the new European approach, especially with regard to the limits on interstate banking and the wall separating investment banking from commercial banking. (Within the existing framework, the United States is very generous in providing deposit insurance to commercial banks, regardless of the composition of their assets and liabilities.)
In the EC, the principles of mutual recognition and home country control are likely to be extended to financial institutions that supply investment services and are active in the securities business. Thus an EC-wide market is in the offing for financial activities generally.
These regulatory changes are not being imposed on a static structure of EC financial institutions. Many private sector responses will be generated, including surely some not now foreseen. It seems clear that there will be more competition among banks in Western Europe than there is now. After all, the 12 national borders have encouraged the development of a concentrated structure of banking in each EC country. The result is that European financial institutions often operate below the size levels that would achieve maximum economies of scale.
The prospects for business financing in the EC will be enhanced. One of the expected results is an increase in corporate mergers and acquisitions. Unlike previously, EC-based firms are now doing more cross-border acquisitions in Western Europe than are U.S. firms. Moreover, Japanese companies are increasing their European acquisitions at a rapid rate, but from a very modest initial base. Almost half of Japanese direct investment in the EC is now in the form of acquisitions rather than partial ownership or joint ventures.
The pressures of a Continent-wide financial market are likely to enhance productivity and lower the costs of financial services to consumers. The initial pattern of adjustment to the regulatory changes may be confusing on the surface, because the more virulent competition will force weaker banks to merge, thus reducing the total number of depository institutions in the EC. However, it is likely that the growing cross-border competition will mean that there will be more banks competing in each nation for the business of taking deposits, lending funds and performing other financial services.
From the viewpoint of the United States, our domestically based banks will be faced, in the years ahead, with larger and stronger European competitors in the battles for growing global financial markets. That, in turn, should increase the pressure on Congress to repeal such archaic restrictions as the McFadden Act (limiting interstate banking) and the Glass-Steagall Act (preventing commercial banks from offering investment banking services).
American companies (other than financial institutions) may reap some special benefits from the growing international competition for their business. It is intriguing to note that, already, about 70% of all international bond issues where European firms were the lead underwriters involved non-EC corporations and institutions. The higher savings rate in Western Europe than in the United States clearly generates potential capital for American firms. EC-based financial institutions (including those that are American-owned) are in an especially good position to assume the middleman role in bringing together European savers and American firms seeking investment capital.
On the other hand, as the EC moves toward more complete economic integration--and the firms located there enjoy greater regulatory freedom and growing economies of scale--Europe will become a more attractive place for new investment. That development, too, should put pressure on Congress to slow down the proliferation of regulatory burdens in the United States. Unfortunately, it seems easier for legislators to continue berating American business for a lack of international competitiveness while taking legislative actions on the tax and regulatory fronts that erode their productivity.
All of these trends point in the same direction--the growing likelihood that, as the 1990s unfold, Western Europe will become, once again, the leading financial center in the world. That development is not written in the stars and it will provide advantages as well as disadvantages to American businesses and consumers. But in the absence of comparable reforms in our domestic economy, the reemergence of European economic and financial dominance becomes a growing possibility.
Over the longer run, it is likely that the governments of North America and the Pacific Rim will respond competitively to the EC challenge. As they join the growing movement to reform and open up their financial systems, the prospects will improve for the establishment of a truly global financial market.