TUESDAY 31 MARCH 1998
SPEECH BY HOWARD DAVIES
CHAIRMAN, FINANCIAL SERVICES AUTHORITY

Inevitably, much of the attention focused on EMU has centred on the economic effects - on growth rates, inflation and unemployment. Fortunately, my job of Chairman of the Financial Services Authority does not require me to take up a position in the debate on the merits of EMU. But the FSA does look at the impact of the Euro on financial markets. We need to do that to ensure that our regulation is appropriate, but also to identify new risks which financial institutions, or indeed their customers, may run in a single currency environment. The single currency will have major consequences for financial markets, and for financial institutions, too. The changes will affect wholesale markets, first, as from 1 January next year. And they will offer potentially significant opportunities for British businesses and financial institutions, even if the UK does remain outside the Euro zone for a number of years.

There will also be, however, new risks for British businesses, both financial and non-financial, especially for the unwary. So understanding the nature of the changes in prospect, and how they might affect business, is vital.

The most obvious consequences of EMU will be seen in short term financial instruments and markets. There will, from 1 January next year, be one short term interest rate across Europe, and one principal yield curve. In wholesale markets there will be no significance in the denomination of bank accounts or short term borrowings, since the currencies fixed into the new Euro will be inter-changeable, without limit. From 1999, the Franc and the Deutschemark, while they will continue to exist in note form, as far as bank accounts and the inter-bank market are concerned should be seen as non-decimal expressions of the Euro. In other words they will simply represent a fixed number of Euro cents. In principle, each central bank within the Euro zone should be prepared to exchange currency of any member country for its own, without limit.

As far as companies are concerned, particularly those with considerable trade in Euros, it should therefore soon be possible to improve cash management considerably, with one Euro account, netting off all ins and outs and debits and credits across the Euro zone at the end of each day. It should be possible to hold that account anywhere in Europe, including in London, which will also have access to the central payments system for the Euro - though the terms of that access are yet to be finalised.

The short point is that companies should be thinking now about cash management in Euros in the future, and how they wish to organise themselves to take advantage of the undoubted opportunities there will be for economies in working capital.

There will also be very rapid changes to European bond markets. Governments in the Euro zone, and maybe outside it, will issue future bonds in euros, and are likely to re-denominate bonds already in existence very quickly. It is highly probable that corporates across Europe will do the same.

This will create a very large and deep bond market in Europe very quickly. The European bond market will rapidly become comparable in size to that of the US. There will be a wide range of derivatives of one sort or another. There is currently hot competition as to where those derivatives should be traded, whether Frankfurt, Paris or London.

This new deep market will attract investors and issuers. It seems likely that European companies traditional reliance on bank finance will lessen. And, on the investor side, there will be demand from institutions, boosted by likely moves to funded pensions elsewhere in Europe, for corporate assets.

From the point of view of a British company, all this is likely to open up new opportunities for funding. I am sure some British companies will wish to issue eurobonds, or perhaps Euro eurobonds. If you look at the US market, and speculate about how the Euro market might develop, we can see that in the US there is a much wider range of maturities and types of borrower, with far more high yielding debt issued by smaller, riskier, and in some cases start-up companies. That kind of market might well develop in Europe. If so, it will open up interesting new possibilities, particularly for small and medium sized companies.

We can also expect greater cross-border trading of equities, and deeper equity markets in general. Fund managers across Europe will take the opportunity to diversify their holdings once exchange risk disappears and stock prices are quoted in euros.

Once again, there should be significant opportunities here for ambitious British companies with sizeable business in the Euro to seek new investors and, perhaps, lower their cost of capital. But of course it is inherent in the changes I have described that there will be significantly increased cross-border competition between companies seeking finance, and between financial institutions themselves. Europe's financial markets will, in economists' jargon, become more contested.

Separate currencies represent a significant barrier to competition across borders, creating conversion risks which hold banks back from competing in each others markets. These barriers will soon be definitively removed for eleven countries. There is lively speculation in Europe about what this will mean for the structure of our financial markets. They are very different from one country to another in Europe today.

If we just look at the number of banks, the differences are remarkable. In the UK there are 16 banks per million inhabitants; (and most of them are foreign-owned, essentially wholesale institutions in the City). In Austria there are 131 banks per million. If we look at delivery mechanisms, we can see that the number of people per bank branch in the big economies varies from just over a thousand in Spain to over 3,500 in the UK.

Unsurprisingly, the profitability of banks also varies dramatically, with UK banks typically earning considerably higher returns on equity than most of their continental European counterparts.

How will this change in the future?

The answer is not yet clear.

But it seems at least probable that there will be, over a time, a significant shake out in the banking systems of some European countries. I would expect banks and other financial institutions to seek, in the first instance, to sell products across borders, trying to pick off the most profitable, juiciest, hitherto protected domestic markets. There is likely to be cross-border selling of insurance products, for example, and mortgages. There is already cross-selling of fund management on a growing scale.

We can see, already, that this process is beginning to promote some consolidation in the banking markets of individual European countries. Indeed that is happening in the UK even though our banking system is already more consolidated than is typically the case elsewhere in the EU. There will be some big opportunities in all this for ambitious and well organised banks, and other financial institutions, too.

But it goes without saying that there are big risks too, if the profitability of core businesses comes under significant threat.

Fortunately, we do have in this country an already competitive and quite consolidated banking system, which looks better able than those of some other countries to compete in this new, more bracing environment. But they will still need to be fast on their feet.

So a single currency will present a number of exciting opportunities for British companies to improve their cash management, to reduce their cost of funds and, if they are involved in financial services, to take advantage of new market opening opportunities. But they will need to be careful.

Many companies here tonight will know that entering new markets can be a risky business at the best of times. And doing so on the back of a very major change in the economic environment adds to that risk.

Furthermore, while Britain remains outside the Euro zone, there are particular risks for British companies. They remain exposed to exchange risk. And that could be material. I do not wish tonight to trespass on matters reserved for the Treasury and my former colleagues in the Bank of England, but it is apparent that the volatility of the pound sterling has not diminished in recent years. And it is conceivable that, as the Euro zone is built, sterling remains the tail on the dog, which moves sharply in relation to perceptions of the strength or weakness of the Euro in future. So however large a proportion of British companies export business is done in euros in future - and it will be a large proportion - companies cannot afford to regard Europe as their domestic market in the same way as Euro zone members will be able to do.

So there are exciting times ahead. One forecast I would make is that the price of good finance directors will be bid up in the market. Whether that adds to the sum of human happiness, I am less sure.

But I am convinced that most British financial institutions, and indeed most British companies, are quite well equipped to compete in Europe. That does not apply to Manchester United, of course, but there are exceptions to every rule. And the North West, with its outward looking bias, is as well placed as any region to capitalise.

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