financial markets and institutions -...

Financial Markets and Institutions

Since the fi rst edition of this book, the world’s fi nancial system has been through its greatest crisis for a century. What made this crisis unique is that severe fi nancial problems emerged simultaneously in many diff erent countries, and its economic impact was felt throughout the world as a result of the increased interconnected-ness of the global economy. Written for undergraduate and graduate students of fi nance, economics, and business, the second edition of this successful textbook provides a fresh analysis of the world’s fi nancial system in light of the recent fi nan-cial crisis. Combining theory, empirical data, and policy, it examines and explains fi nancial markets, fi nancial infrastructures, fi nancial institutions, and challenges in the domain of fi nancial supervision and competition policy. Th is new edition fea-tures three completely new chapters: one on fi nancial crises, a second on fi nancial innovation, and, on the policy side, a third on the monetary policy of the European Central Bank.

J akob de H aan is Head of Research of De Nederlandsche Bank and Professor of Political Economy at the University of Groningen.

S ander O osterloo is Senior Policy Advisor at the Netherlands Ministry of Social Aff airs and Employment.

D irk S choenmaker is Dean of the Duisenberg School of Finance, Amsterdam, and Professor of Finance, Banking, and Insurance at the VU University Amsterdam.

www.cambridge.org© in this web service Cambridge University Press

Cambridge University Press978-1-107-02594-3 - Financial Markets and Institutions: A European Perspective: Second EditionJakob de Haan, Sander Oosterloo and Dirk SchoenmakerFrontmatterMore information

http://www.cambridge.org/9781107025943

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Financial Markets and Institutions

A European Perspective

Second Edition

Jakob de Haan

Sander Oosterloo

Dirk Schoenmaker






www.cambridge.org Information on this title: www.cambridge.org/9781107635920

© Jakob de Haan, Sander Oosterloo and Dirk Schoenmaker 2012

Th is publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press.

First edition 2009 Second edition 2012

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A catalogue record for this publication is available from the British Library

Library of Congress Cataloguing in Publication data Haan, Jakob de. Financial markets and institutions : a European perspective / Jakob de Haan, Sander Oosterloo, Dirk Schoenmaker. – Second edition. pages cm Expanded version of the authors’ European fi nancial markets and institutions, 2009. Includes bibliographical references and index. ISBN 978-1-107-02594-3 (hardback) – ISBN 978-1-107-63592-0 (paperback) 1. Financial institutions. 2. Capital market. I. Oosterloo, Sander. II. Schoenmaker, Dirk. III. Haan, Jakob de. European fi nancial markets and institutions. IV. Title. HG173.H293 2012 332.1–dc23 2012013669

ISBN 978-1-107-02594-3 Hardback ISBN 978-1-107-63592-0 Paperback

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5th printing 2014






v

Contents

List of Boxes page ix List of Figures xi List of Tables xv List of Countries xvii List of Abbreviations xix Preface xxv

Part I Setting the Stage 1

1 Functions of the Financial System 3 1.1 Functions of a fi nancial system 5 1.2 Bank-based versus market-based fi nancial systems 15 1.3 Recent changes 29 1.4 Conclusions 33

2 Financial Crises 39 2.1 Introduction 40 2.2 Th eory 45 2.3 Th e credit crisis of 2007–2009 53 2.4 Th e recent euro crisis 61 2.5 Conclusions 68

3 European Financial Integration: Origins and History 71 3.1 European integration: introduction 72 3.2 European institutions and instruments 75 3.3 Monetary integration 79 3.4 Coordination of fi scal policy 85 3.5 Financial integration 88 3.6 Conclusions 95






Contentsvi

4 Monetary Policy of the European Central Bank 98 4.1 Th e European Central Bank 99 4.2 Monetary policy strategy 106 4.3 Monetary policy instruments 109 4.4 Unconventional monetary policy during the crisis 116 4.5 ECB communication policies 119 4.6 Conclusions 124

Part II Financial Markets 127

5 European Financial Markets 129 5.1 Financial markets: functions and structure 130 5.2 Money market 136 5.3 Bond markets 140 5.4 Equity markets 151 5.5 Derivatives 158 5.6 Foreign exchange market 163 5.7 Conclusions 165

6 Th e Economics of Financial Integration 169 6.1 Financial integration: defi nition and drivers 170 6.2 Measuring fi nancial integration 174 6.3 Integration of European fi nancial markets 178 6.4 Th e consequences of fi nancial integration 185 6.5 Conclusions 191

7 Financial Infrastructures 195 7.1 Payment systems and post-trading services 196 7.2 Economic features of payment and securities market infrastructures 207 7.3 Integration of fi nancial market infrastructures 211 7.4 Conclusions 220

8 Financial Innovation 224 8.1 Financial innovation: causes and consequences 225 8.2 Pros and cons of fi nancial innovation 231 8.3 Risks of fi nancial innovation: two case studies 235 8.4 Credit rating agencies 240 8.5 Conclusions 245






Contentsvii

Part III Financial Institutions 249

9 Th e Role of Institutional Investors 251 9.1 Diff erent types of institutional investors 252 9.2 Th e growth of institutional investors 264 9.3 Portfolio theory and international diversifi cation 271 9.4 Th e home bias in European investment 274 9.5 Conclusions 284

10 European Banks 288 10.1 Th eory of banking 289 10.2 Th e use of risk-management models 296 10.3 Th e European banking system 303 10.4 Conclusions 316

11 European Insurers and Financial Conglomerates 321 11.1 Th eory of insurance 322 11.2 Th e use of risk-management models 335 11.3 Th e European insurance system 341 11.4 Financial conglomerates 352 11.5 Conclusions 355

Part IV Policies for the Financial Sector 359

12 Financial Regulation and Supervision 361 12.1 Rationale for government intervention 362 12.2 Microprudential supervision 365 12.3 Conduct-of-business supervision 372 12.4 Supervisory structures 377 12.5 Challenges for fi nancial supervision 381 12.6 Conclusions 388

13 Financial Stability 392 13.1 Financial stability and macroprudential supervision 393 13.2 Macroprudential policy 397 13.3 Monitoring and analysing systemic risk 400 13.4 Macroprudential instruments and architecture 407






Contentsviii

13.5 Crisis management and resolution 414 13.6 Challenges for maintaining fi nancial stability 417 13.7 Conclusions 423

14 European Competition Policy 427 14.1 What is competition policy? 428 14.2 Th e economic rationale for competition policy 429 14.3 Pillars of EU competition policy 434 14.4 Assessment of dominant positions 442 14.5 Institutional structure 448 14.6 Conclusions 451

Index 456






ix

Boxes

Box 1.1 Financial development and economic growth page 8 Box 1.2 Th e political economy of fi nancial reform 14 Box 1.3 Corporate governance in EU Member States 19 Box 1.4 Does the fi nancial system matter aft er all? 22 Box 1.5 Legal origin or political institutions? 30 Box 2.1 Th e EMS crisis 41 Box 2.2 Th e banking crisis in Sweden 44 Box 2.3 Th e run on the Rock 48 Box 2.4 Bank runs and the business cycle 49 Box 2.5 Off -balance sheet vehicles 57 Box 2.6 Financial crisis management in Europe 60 Box 3.1 Th e role of treaties 73 Box 3.2 Th e Lisbon Treaty 77 Box 3.3 Dynamics of integration 80 Box 3.4 Basel Committee on Banking Supervision 90 Box 4.1 Decision making within the ECB Governing Council 101 Box 4.2 Price stability 103 Box 4.3 Infl ation targeting 108 Box 4.4 Monetary policy transmission 111 Box 5.1 Government-debt management 142 Box 5.2 How much transparency is optimal? 152 Box 5.3 Th e role of the euro-dollar exchange rate in the ECB’s policies 164 Box 6.1 Euro-area vs. non-euro-area member countries 179 Box 6.2 Financial integration of the new EU Member States 186 Box 6.3 Financial integration and economic growth 189 Box 7.1 Core payment instruments 198 Box 7.2 Th e Herstatt crisis 213 Box 7.3 Concentration in credit and debit card markets 214 Box 8.1 Financial innovation and long-run economic growth 236






List of Boxesx

Box 9.1 ABP 256 Box 9.2 Th e LTCM crisis 260 Box 9.3 Institutional investment in the new EU Member States 266 Box 9.4 Th e international CAPM 272 Box 10.1 Liquidity management during crises 293 Box 10.2 When is it optimal to delegate monitoring to banks? 294 Box 10.3 Value-at-Risk 299 Box 10.4 Retail banking market integration 306 Box 10.5 Th e economics and performance of M&As 313 Box 10.6 What to do with big banks? 317 Box 11.1 Th e mathematics of small claims insurance 326 Box 11.2 Flood insurance 331 Box 11.3 Some numerical examples with high- and low-risk individuals 334 Box 11.4 Th e underwriting cycle 337 Box 11.5 Functional or geographical diversifi cation? 354 Box 12.1 Forbearance versus prompt corrective action 366 Box 12.2 Pro-cyclicality in bank lending? 371 Box 12.3 Country experiences 379 Box 12.4 A European SEC? 388 Box 13.1 An EU framework for crisis management in the fi nancial sector 418 Box 14.1 Article 101 cases: MasterCard and the Groupement des

Cartes Bancaires 436 Box 14.2 Algebra of the SSNIP methodology 445 Box 14.3 Which level of (de)centralisation? 450 Box 14.4 Antitrust policy in the EU and the US 452






xi

Figures

Figure 1.1 Working of the fi nancial system page 5 Figure 1.2 Relative shares of credit, equity, and bond fi nance in

the euro area, US, and Japan, 2005–2009 7 Figure 1.3 Th e fi nancial system in the EU-15 and the NMS-12, 2009 16 Figure 1.4 Stock-market capitalisation and domestic bank credit, 1995–2004 16 Figure 1.5 Corporate governance rating in EU Member States, 2010 19 Figure 1.6 Th e IMF Financial Index for industrial countries, 1995 and 2004 24 Figure 1.7 Consumption-income correlations and the

Financial Index, 1985–2005 25 Figure 1.8 Business investment response to business cycles, 1985–2005 26 Figure 1.9 Securitisation 32 Figure 1.10 Long intermediation chain 33 Figure 2.1 Incidence of fi nancial crises, 1800–2009 42 Figure 2.2 Th e standard deposit contract with bank runs 51 Figure 2.3 Business cycle (GDP) versus fi nancial cycle (credit) 53 Figure 2.4 Two modes of levering up 56 Figure 2.5 Loss spiral through the balance sheet 59 Figure 2.6 Financial assistance facilities to euro-area countries 66 Figure 3.1 Th e three stages leading to EMU 82 Figure 3.2 Objectives of FSAP 92 Figure 4.1 Structure of the ECB 100 Figure 4.2 Th e monetary policy strategy of the ECB 106 Figure 4.3 Infl ation and infl ation expectations in the euro area, 1990–2010 110 Figure 4.4 ECB policy rates and EONIA, 1999–2010 113 Figure 4.5 Refi nancing operations, 1999–2010 115 Figure 5.1 Size of the equity markets, year-end market value, 2000–2010 135 Figure 5.2 Bond markets, amounts outstanding year-end, 1999–2010 136 Figure 5.3 Average daily turnover in the money market, 2002–2011 139 Figure 5.4 Euro-area debt issuance, 2004–2010 141






List of Figuresxii

Figure 5.5 Euro-area AAA-rated government bond yields and the term spread, 2001–2011 145

Figure 5.6 Diff erence between long-term euro-area sovereign bond yields and the overnight index swap rate in 2010 and 2011 147

Figure 5.7 High-yield and investment-grade bond issuance in the euro area 148

Figure 5.8 Spreads of corporate bonds over AAA-rated government bonds, 1999–2011 148

Figure 5.9 Covered bond issues, 2000–2010 150 Figure 5.10 Securitisation (new issues) in Europe, 2003–2010 151 Figure 5.11 Securitisation (amounts outstanding) in Europe, 2007–2010 152 Figure 5.12 Market capitalisation of some exchanges in the EU, 2008–2010 155 Figure 5.13 External sources of funding of non-fi nancial fi rms in

the euro area, 2000–2010 156 Figure 5.14 IPOs in Europe: number and value, 2006–2010 158 Figure 5.15 Global derivatives markets, notional amounts, 1998–2010 159 Figure 5.16 Average daily turnover in various OTC derivatives

markets, 2002–2011 161 Figure 5.17 Th e euro-dollar exchange rate, 1999–2011 164 Figure 6.1 Impact of enhanced competition 172 Figure 6.2 Integration of the money market: standard deviation of

interest rates, 1994–2010 181 Figure 6.3 Average distance of intercepts/beta from the values

implied by complete integration, 1995–2011 182 Figure 6.4 Dispersion in fi ve-year CDS premia among leading

telecommunications fi rms and large commercial banks in euro-area countries, 2004–2010 183

Figure 6.5 Proportion of variance in local equity returns explained by euro-area and US shocks, 1973–2011 184

Figure 6.6 Th e degree of cross-border holdings of equity issued by euro-area residents, 2001–2009 185

Figure 6.7 Yield spreads for ten-year government bonds, 2001–2006 187 Figure 7.1 Th e process of initiating and receiving payments

(push transaction) 199 Figure 7.2 Number of non-cash transactions in Europe, 2001–2008 200 Figure 7.3 Evolution of non-cash transactions per inhabitant

per country in Europe and the US, 2001–2008 200 Figure 7.4 Four-party payment scheme 201 Figure 7.5 Th ree-party payment scheme 202






List of Figuresxiii

Figure 7.6 Major large-value payments systems in the world 204 Figure 7.7 Clearing and settlement of a securities trade 204 Figure 7.8 Economies of scale in the payment market 207 Figure 7.9 Simple network consisting of four side-branches 209 Figure 7.10 Two-sided market 210 Figure 7.11 Concentration in payment systems 215 Figure 8.1 Debt and information sensitivity 235 Figure 8.2 Th e ETF market: main characteristics and recent trends 238 Figure 8.3 Simplifi ed functioning of a synthetic ETF on the S&P 500 239 Figure 8.4 Credit ratings 242 Figure 8.5 Total number of sovereigns rated by the big three CRAs 243 Figure 9.1 Portfolio of ABP, 1970–2010 256 Figure 9.2 Global hedge funds market, 1990–2010 262 Figure 9.3 Hedge funds’ sources of capital, 2000–2010 262 Figure 9.4 Investment horizon and decision power about asset allocation 264 Figure 9.5 Institutional investment and economic development, 2005 266 Figure 9.6 Dependency ratio: actual fi gures and forecasts, 2000–2050 270 Figure 9.7 Th e simplifi ed effi cient frontier for US and European equities 272 Figure 9.8 Equity home bias per region, 1997 vs. 2004 280 Figure 9.9 Bond home bias per region, 1997 vs. 2004 281 Figure 9.10 Regional equity bias per region, 1997 vs. 2004 281 Figure 9.11 Regional bond bias per region, 1997 vs. 2004 282 Figure 10.1 Simplifi ed balance sheet of a bank 290 Figure 10.2 Liquidity pyramid of the economy 292 Figure 10.3 Economic capital of an AA-rated bank 297 Figure 10.4 Loss distribution for credit risk 299 Figure 10.5 Loss distribution for market risk 300 Figure 10.6 Calculation of VaR with a confi dence level of X% 301 Figure 10.7 Loss distribution for operational risk 301 Figure 10.8 Cross-border penetration in European banking, 1997–2009 304 Figure 10.9 Convergence of retail banking interest rates, 1997–2006 306 Figure 10.10 Biggest 30 banks in Europe, 2000–2010 310 Figure 10.11 Banking M&As in Europe, 1985–2009 311 Figure 11.1 Simplifi ed balance sheet of an insurance company 323 Figure 11.2 Combined ratios across Europe, 2009 324 Figure 11.3 Th e law of large numbers and fi re insurance claims 328 Figure 11.4 Heavy-tailed distribution 328 Figure 11.5 Th e Rothschild–Stiglitz model of the insurance market 332 Figure 11.6 Th e relative role of risk types in banking and insurance 338






List of Figuresxiv

Figure 11.7 Organisation of risk and capital management in insurance groups 342

Figure 11.8 Biggest 25 insurers in Europe, 2000–2006 347 Figure 11.9 Cross-border penetration of top 25 EU insurers, 2000–2006 347 Figure 11.10 Distribution channels in Europe 351 Figure 12.1 Basel III capital charges 370 Figure 12.2 Assets of European investment funds, 2000–2010 375 Figure 12.3 Supervisory synergies and confl icts 381 Figure 12.4 Th e fi nancial trilemma 383 Figure 12.5 Th e European Supervisory Authorities (ESAs) 384 Figure 12.6 Th e European Supervisory Authorities work closely

with the National Supervisory Authorities (NSAs) 385 Figure 13.1 Conceptual framework of macroprudential supervision 397 Figure 13.2 Two-pillar strategy for macroprudential policy 400 Figure 14.1 Welfare loss from monopoly 431 Figure 14.2 Lerner indices 433 Figure 14.3 Evolution of total state aid granted by Member States

as % of GDP in the EU, 2004–2009 441 Figure 14.4 Flowchart for undertaking abuse-of-dominance investigations 442 Figure 14.5 Enforcement of EU competition policy 449 Figure 14.6 Degree of centralisation 450






xv

Tables

Table 1.1 Th e median size of largest voting blocks, 1999 page 18 Table 1.2 Indicators of investor and creditor protection, 2003 28 Table 1.3 Bank-based vs. market-based fi nancial systems 35 Table 2.1 Debt and banking crises in European countries 46 Table 2.2 Ten largest conduit administrators by size (January 2007) 58 Table 2.3 Government debt in euro-area countries, 2006–2010 62 Table 2.4 Exposure of euro-area banks on euro-area countries,

March 2011 64 Table 3.1 Number of votes of EU Member States 76 Table 3.2 Convergence criteria 84 Table 4.1 Main characteristics of selected Monetary Policy Committees 102 Table 4.2 Monetary policy instruments 114 Table 5.1 Outstanding euro-denominated public-debt securities,

2000–2010 144 Table 5.2 Ratings and outlook of government debt, September 2011 146 Table 5.3 Th e world’s largest equity exchanges, 2010 154 Table 5.4 Amounts of outstanding OTC derivatives, 2003–2010 161 Table 5.5 Notional amounts of CDSs outstanding, 2003–2010 163 Table 6.1 Sigma convergence 179 Table 7.1 Studies examining post-trading costs per transaction for users 217 Table 8.1 Net impact of recent fi nancial innovations 232 Table 9.1 Assets of diff erent types of institutional investors, 2009 253 Table 9.2 Assets of pension funds, 2001–2009 255 Table 9.3 Assets of insurance companies, 2001–2009 257 Table 9.4 Assets of mutual funds, 2001–2009 259 Table 9.5 Th e most important countries with private equity

investments in 2010 263 Table 9.6 Bank and institutional intermediation ratios, 1970–2000 265 Table 9.7 Assets of institutional investors, 1990–2009 267






List of Tablesxvi

Table 9.8 Equity and bond home bias, 1997–2004 277 Table 9.9 Regional equity and bond bias of European investors, 1997–2004 279 Table 9.10 Determinants of the equity home bias 283 Table 10.1 Cross-border penetration in EU Member States, 2009 305 Table 10.2 Biggest 30 banks in Europe in 2009 308 Table 10.3 Development of international banking by continent, 2006–2009 311 Table 10.4 Market structure indicators, 1997 and 2009 314 Table 11.1 Catastrophes: the 25 most costly insurance losses, 1970–2010 329 Table 11.2 Pooling equilibrium 334 Table 11.3 No equilibrium 334 Table 11.4 Separating equilibrium 335 Table 11.5 Insurance penetration in the EU, 2009 343 Table 11.6 Non-life premium income in the EU, 1995–2009 344 Table 11.7 Biggest 25 insurance groups in Europe in 2006 345 Table 11.8 Market structure indicators, 1994/95 and 2009 349 Table 11.9 Market share of fi nancial conglomerates, 2001 355 Table 12.1 Organisational structure of fi nancial supervision 378 Table 13.1 Macroprudential versus microprudential supervision 394 Table 13.2 Commonly used indicators 401 Table 13.3 Cyclical pillar strategy 408 Table 13.4 Structural pillar strategy 409 Table 14.1 Community dimension – threshold I 438 Table 14.2 Community dimension – threshold II 438 Table 14.3 Government support to banks and central banks’

balance sheets; measures taken in the 2007–2009 crisis 440 Table 14.4 Relevant geographical market for fi nancial services 448






xvii

Countries

Member States of the European Union

Country Offi cial abbreviation Year of accession

1 Austria AT 19952 Belgium BE 19513 Bulgaria BG 20074 Cyprus CY 20045 Czech Republic CZ 20046 Denmark DK 19737 Estonia EE 20048 Finland FI 19959 France FR 195110 Germany DE 195111 Greece EL 198112 Hungary HU 200413 Ireland IE 197314 Italy IT 195115 Latvia LV 200416 Lithuania LT 200417 Luxembourg LU 195118 Malta MT 200419 Netherlands NL 195120 Poland PL 200421 Portugal PT 198622 Romania RO 200723 Slovakia SK 200424 Slovenia SI 200425 Spain ES 198626 Sweden SE 199527 United Kingdom UK 1973






List of Countriesxviii

Th e European Union (EU) consists of 27 Member States as of 2012 (EU 27). Before the accession of the New Member States in 2004 and 2007, the EU consisted of 15 Member States, which are usually indicated by EU-15. Th e 10 New Member States in 2004 are indicated by NMS-10 and the total of 12 New Member States in 2004 and 2007 are indicated by NMS-12. EU-25 refers to the EU-15 and NMS-10. EU-27 refers to the EU-15 and NMS-12. Croatia is set to become the 28th Member State of the EU in 2013.

Th ere are 17 countries in the euro area.

Countries in the euro area

Country Year of accession

1 Austria 19992 Belgium 19993 Cyprus 20084 Estonia 20115 Finland 19996 France 19997 Germany 19998 Greece 20019 Ireland 199910 Italy 199911 Luxembourg 199912 Malta 200813 Netherlands 199914 Portugal 199915 Slovakia 200916 Slovenia 200717 Spain 1999






xix

Abbreviations

ABP Algemeen Burgerlijk Pensioenfonds ABS Asset-Backed Securities ACP Asset-backed Commercial Paper ACP Autorit é de Contr ô le Prudentiel AIG American International Group ALM Asset and Liability Management AMF Autorit é des March é s Financiers ATM Automated Teller Machine BaFin Bundesanstalt f ü r Finanzdienstleistungsaufsicht BHB Bond Home Bias BIS Bank for International Settlements BME Bolsas y Mercados Espa ñ oles BoE Bank of England CalPERS California Public Employees Retirement Scheme CAPM Capital Asset Pricing Model CB Central Bank CCP Central Counterparty CD Certifi cate of Deposit CDC Collective Defi ned Contribution CDO Collateralised Debt Obligation CDS Credit Default Swap CEA Comit é Europ é en des Assurances CEBS Committee of European Banking Supervisors CEEC Central and Eastern European Countries CEIOPS Committee of Insurance and Occupational Pensions

Supervisors CEO Chief Executive Offi cer CESR Committee of European Securities Regulators CET1 Common Equity Tier 1






List of Abbreviationsxx

CFO Chief Financial Offi cer CLS Continuous Linked Settlement CRA Credit Rating Agency CRAAC CRA Assessment Centre CRD Capital Requirements Directive CRO Chief Risk Offi cer CSD Central Securities Depository DB Defi ned Benefi t DC Defi ned Contribution DG Directorate General DTB Deutsche Terminb ö rse EBA European Banking Authority EBC European Banking Committee EBRD European Bank for Reconstruction and Development EC European Commission ECB European Central Bank ECFI European Court of First Instance ECJ European Court of Justice ECN European Competition Network Ecofi n Economic and Financial Aff airs Council ECSC European Coal and Steel Community ECU European Currency Unit EDP Excessive Defi cit Procedure EEA European Economic Area EEC European Economic Community EFA European Financial Agency EFAMA European Fund and Asset Management Association EFCC European Financial Conglomerates Committee EFR European Financial Services Round Table EFSF European Financial Stability Facility EFSM European Financial Stabilisation Mechanism EHB Equity Home Bias EIOPA European Insurance and Occupational Pensions Authority EMI European Monetary Institute EMS European Monetary System EMU Economic and Monetary Union EOE European Options Exchange EONIA Euro Overnight Index Average EP European Parliament






List of Abbreviationsxxi

EPC European Payments Council EPM ECB Payment Mechanism ERC European Repo Council ERM Exchange Rate Mechanism ESA European Supervisory Authority ESC European Securities Committee ESCB European System of Central Banks ESFS European System of Financial Supervisors ESM European Stability Mechanism ESMA European Securities and Markets Authority ESRB European Systemic Risk Board ETF Exchange Traded Funds EU European Union Euratom European Atomic Energy Community EUREPO Repo Market Reference Rate for the Euro EURIBOR Euro Interbank Off ered Rate FCA Financial Conduct Authority FDI Foreign Direct Investment FESE Federation of European Securities Exchanges FPC Financial Policy Committee FRA Forward Rate Agreement FSA Financial Services Authority FSAP Financial Services Action Plan FSC Financial Services Committee FSF Financial Stability Forum FSOC Financial Stability Oversight Council FSR Financial Stability Review FTO Fine Tune Operation FX Foreign Exchange GDP Gross Domestic Product GMI Governance Metrics International GVA Gross Value Added HI Herfi ndahl Index IAS International Accounting Standards IASB International Accounting Standards Board ICI Investment Company Institute ICMA International Capital Market Association ICSD International Central Securities Depository IFRS International Financial Reporting Standards






List of Abbreviationsxxii

IMF International Monetary Fund IOSCO International Organisation of Securities Commissions IPO Initial Public Off ering IRS Interest Rate Swap ISD Investment Services Directive ISDA International Swaps and Derivatives Association IT Information Technology LCR Liquidity Coverage Ratio LI Lerner Index LIFFE London International Financial Futures and Options

Exchange LoLR Lender of Last Resort LSE London Stock Exchange LTCM Long-Term Capital Management LTRO Longer-Term Refi nancing Operation LVPS Large-Value Payment System M&As Mergers and Acquisitions MBS Mortgage-Backed Securities MFI Monetary Financial Institution MIF Multilateral Interchange Fee MiFID Markets in Financial Instruments Directive MMF Money Market Fund MoU Memorandum of Understanding MRO Main Refi nancing Operation MSCI Morgan Stanley Capital International MTF Multilateral Trading Facility MTO Medium-Term Objective NAV Net Asset Value NCA National Competition Authority NCB National Central Bank NMS New Member States NSA National Supervisory Authority NSFR Net Stable Funding Ratio NYSE New York Stock Exchange OECD Organisation for Economic Co-operation and Development OFT Offi ce of Fair Trading OIS Overnight Interest Rate Swap OMX Options Maklarna Exchange OTC Over-the-Counter PAYG Pay-As-You-Go






List of Abbreviationsxxiii

P&C Property and Casualty PCA Prompt Corrective Action PSD Payment Services Directive PvP Payment versus Payment RAROC Risk Adjusted Return On Capital RBB Regional Bond Bias REB Regional Equity Bias ROE Return On Equity RTGS Real-Time Gross Settlement SBA Stand-by Arrangement SCP Structure-Conduct-Performance SEA Single European Act SEC Securities and Exchange Commission SEPA Single Euro Payments Area SETS London Stock Exchange’s premier Electronic Trading

System SGP Stability and Growth Pact SIB Systemically Important Bank SIFI Systemically Important Financial Institution SIV Structured Investment Vehicle SMEs Small and Medium Enterprises SMP Securities Markets Programme SOFFEX Swiss Options and Financial Futures Exchange SPO Secondary Public Off ering SPV Special Purpose Vehicle SRO Self Regulatory Organisation SSNIP Small, but Signifi cant Non-transitory Increase

in Prices SSP Single Shared Platform STP Straight-Th rough Processing TARGET Trans-European Automated Real-Time Gross Settlement

Express Transfer System TEU Treaty on European Union TFEU Treaty on the Functioning of the EU T2S TARGET2-Securities UCITS Undertakings for Collective Investments in Transferable

Securities UK United Kingdom US United States VaR Value-at-Risk






xxv

Preface

As a team of authors we have followed the building of the European fi nancial system from diff erent angles. We have contributed to the academic literature on this topic. Moreover, one of us has been teaching a course on European Financial Integration, from which this book has emerged. On the policy side, the authors have been directly involved in the work of national administra-tions (i.e. the Ministry of Finance, the Ministry of Economic Aff airs in the Netherlands, and the Dutch central bank) as well as the European institu-tions (i.e. the Council, the European Commission, and the European Central Bank). As part of our job, two of us have participated in many meetings in Brussels discussing the future of European fi nancial markets and institu-tions, and negotiating new European fi nancial services directives.

Th e authors would like to thank Wilco Bolt, Jean Frijns, Ronald Heijmans, Iman van Lelyveld, Bert Menkveld, Almoro Rubin de Cervin, Martijn Schrijvers and Casper de Vries for their advice on specifi c chapters.

What is new in the second edition?

Since the fi rst edition of this book, the world’s fi nancial system has been through its greatest crisis for a century. What made this crisis unique is that severe fi nancial problems emerged simultaneously in many diff erent coun-tries, and its economic impact was felt throughout the world as a result of the increased interconnectedness of the global economy. Financial innov-ation also played an important part in the fi nancial crisis. Two new chapters deal with (1) fi nancial crises, including an overview of the causes and conse-quences of the 2007–2009 fi nancial crisis as well as the more recent sovereign and banking crisis in Europe, and (2) fi nancial innovation, including the role of securitisation.

Th e chapters on fi nancial markets and institutions are updated with new data. Th ese extensive updates illustrate the impact of the fi nancial crisis on






Prefacexxvi

the process of European fi nancial integration. On the policy side, a new chapter on the monetary policy of the European Central Bank (ECB) has been added. A good understanding of the ECB’s monetary policy is crucial to appreciate the working of the European fi nancial system. Th e policy chapters of the fi rst edition have been updated. New elements are the Basel 3 capital adequacy framework for banking supervision, the emergence of macropru-dential supervision, and state aid control applied to banks.

How does this textbook compare with other books?

Diff erent from other textbooks, Financial Markets and Institutions: A European Perspective has a wide coverage dealing with the various elements of the European fi nancial system supported by recent data and examples. Th is wide coverage implies that we treat not only the functioning of fi nan-cial markets where trading takes place but also the working of supporting infrastructures (clearing and settlement) where trades are executed. Turning to fi nancial institutions, we cover the full range of fi nancial intermediaries, from institutional investors to banks and insurance companies. Based on new data, we document the gradual shift of fi nancial intermediation from banks towards institutional investors, such as pension funds, mutual funds, and hedge funds. In this process of re-intermediation, the assets of institu-tional investors have tripled over the last two decades. As to policy making, we cover the full range of fi nancial regulation and supervision, fi nancial sta-bility, and competition. We deal with the challenges of European fi nancial integration for nationally based fi nancial supervision and stability policies. Competition is a new topic for a fi nance textbook.

Th e existing textbooks in the fi eld of fi nancial markets and institutions generally describe the relevant theories and subsequently relate these theor-ies to the general characteristics of fi nancial markets. An excellent example of a more in-depth textbook is Th e Economics of Financial Markets by Roy E. Bailey. Th e broad coverage of our book is comparable to the widely used textbook Financial Markets and Institutions by Frederic S. Mishkin and Stanley G. Eakins. Whereas our book focuses on the EU, Mishkin and Eakins analyse the US fi nancial system. Th e early European textbooks (e.g. Th e Economics of Money, Banking and Finance – A European Text , by Peter Howells and Keith Bain) typically contain chapters on the UK, French, and German banking systems, but do not provide an overview of European banking. More advanced textbooks that do discuss the specifi cs






Prefacexxvii

of the European fi nancial system mostly do this in the context of monetary policy making.

Finally, the excellent Handbook of European Financial Markets and Institutions , edited by Xavier Freixas, Philipp Hartmann, and Colin Mayer, has a broad coverage of the European fi nancial system, but deals with topics on a stand-alone basis in separate chapters and is not constructed as an inte-grated textbook. Nevertheless, this handbook contains very useful material for further study of a particular aspect of the European fi nancial system.

How to use this book

Financial Markets and Institutions: A European Perspective is an access-ible textbook for both undergraduate and graduate students of Finance, Economics, and Business Administration. Each chapter fi rst gives an over-view and identifi es learning objectives. Th roughout the book we use boxes in which certain issues are explained in more detail, by referring to theory or practical examples. Furthermore, we make abundant use of graphs and tables to give students a comprehensive overview of the European fi nancial system. At the end of each chapter we provide suggestions for further read-ing. Cambridge University Press provides a supporting website for this book. Th is website contains exercises (and their solutions) for each chapter. Th e website also provides regular updates of fi gures and tables used in the book, and identifi es new policy issues.

A basic understanding of fi nance is needed to use this textbook, as we assume that students are familiar with the basic fi nance models, such as the standard Capital Asset Pricing Model (CAPM). Th e book can be used for third-year undergraduate courses as well as for graduate courses. More advanced material for graduate students is contained in special boxes marked by a star (*). Undergraduate students can skip these technical boxes.

Jakob de Haan Sander Oosterloo

Dirk Schoenmaker






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