Will Europe's financial revolution continue?

Raghuram Rajan and Luigi Zingales Professors of Finance Graduate School of Business University of Chicago Project Syndicate

Over the last two decades Europe experienced a dramatic expansion of financial markets at the expense of its traditional system of financing based on close relationships between large banks and established firms. Since 1980 the ratio of stock market capitalization to GDP soared more than 13-fold, while equity financing rose 16-fold. In 1980, stock market capitalization relative to GDP was five times greater in the U.S. and UK than in Continental Europe; by 2000, it was only 60 percent higher.

Disclosure standards improved throughout the Continent, as did laws to protect minority shareholders. For example, before 1980 no member of today's European Union, except France and Sweden, had an anti-insider trading law -- and in Sweden the law, although introduced in 1971, was not enforced for the first time until 1990. By 2000, all EU members had anti-insider trading laws and most were enforcing them. What caused this change? Is it benefiting all EU countries, and will it persist as EU enlargement proceeds?

Relationship-based financial systems perform better when markets and firms are smaller, when legal protection is weaker, there is little public information, and innovation is incremental. Banks tend to have close, long-term, and protective ties with the managers of such firms, primarily because the bank's holdings are illiquid. This can provide considerable stability -- indeed, the second half of the 20th century saw only four German firms succumb to hostile takeovers -- but at the cost of reducing access to finance and curtailing future opportunities.

By contrast, market-based financial systems perform better when economies and firms are bigger and more formally organized, with better legal enforcement and transparency, and when innovation is constant. A market-based system gives new firms -- hence new technologies -- more chances to obtain financing, because many investors assess firms independently.

But financial systems do not emerge as a result of their superiority in a particular environment. Vested interests distort the process of evolution. Over the last decade, trade liberalization and monetary integration supported the expansion of market-based financing in Europe.

Trade integration exposed domestic banks and firms to foreign competition, limiting national governments' ability to intervene on behalf of favored domestic companies. Similarly, the European Commission deemed subsidies to publicly-owned firms illegal if they distorted competition across member states, while the fiscal discipline imposed by the Euro ended pervasive general government credit subsidies -- the essential lubricant of relationship-based systems.

Moreover, the volume of corporate debt securities almost tripled after the introduction of the Euro eliminated exchange- rate risk. The European Commission also opened up the market for corporate control by vetoing the barriers against hostile takeovers that most EU governments had erected.

But now that Europe's internal economic boundaries have been mostly removed, and the political objective has shifted to political unification, integration may no longer be so market- friendly. The more political power is centralized, the more the central authority can interfere with market development. The pro- market bias that characterized EU policy up to now (with notable exceptions, such as agricultural policy) may well shift in the opposite direction.

In trade zones formed by heterogeneous states, vested interests tend to be diverse and find it hard to lobby at the supranational level. Political integration, by contrast, might have an opposite effect on the development of markets. The threat of capital flight to nearby political entities creates a strong incentive to keep policies market-friendly, but it is suppressed when neighboring political entities coalesce.

Incumbent financiers, meanwhile, have a powerful vested interest in opposing a market-based system, which favors credit evaluation and risk management over their main ``skill'': being well connected. They also have the ability to organize successfully against the market, particularly in small countries, where incumbents form a well-defined group whose members often attended the same elite schools, frequent the same clubs, and intermarry.

The question is not whether Europe should move toward a market-based financial system. The real question is whether Europe retains the political will to continue to do so, and whether EU countries can strengthen the institutions necessary to reap the full benefits of financial markets.

There is a serious danger that reforms that facilitate markets will benefit northern Europe but harm underdeveloped regions in southern Europe by depriving them of the relationship-based system. In these regions, higher rates of corruption and tax evasion, together with smaller average firm size, undermine the production of credible information that financial markets need.

Partly for this reason, EU enlargement is superior -- at least for financial markets -- to political unification, which encourages vested interests to lobby at the central level. Indeed, one benefit of the European Commission's rule that some decisions must be unanimous is that its impedes the exercise of monopoly power, thus reducing the risk that centralized authority will be used against markets.

This is all the more important because leaders in both the U.S. and Europe are beginning to pander to the anti-globalization movement. America's corporate scandals have undermined the market's moral standing, while the end of the Internet bubble has weakened its economic credibility. The adverse distributive effects of market-based finance may serve to further strengthen anti-market forces in Europe, especially in southern Europe.

The EU can buck this anti-market trend by promoting structural reforms in southern European countries and focussing on enlargement to increase economic competition. But it should maintain a clear division of power between local and central authorities at all levels to maintain strong competition and a healthy diversity of interests.