Universal Banking, Intertemporal Smoothing and European Financial Integration

As international financial systems become increasingly integrated, the need to reform each country's system has become clear. How to reform those systems is a hotly debated policy issue. Much of this debate has centered on universal banking and the relationship between banks and financial markets. These issues have particular importance for the European Union. The stated goal of creating a single European financial system, without any barriers between member countries, implies a movement toward a single kind of financial system. Should a market system be the goal or would a German-style intermediated system be more desirable? The theories that have been invoked to justify many of the moves to market-based systems are based on traditional neoclassical models. Competition is thought to be desirable because it leads to increased efficiency. Opening up new financial markets is thought to be desirable because it offers increased risk-sharing opportunities. Much of the financial reform that has occurred in countries such as France and Spain has been concerned with moving away from a German-style intermediated system and allowing access to global financial markets. In doing this they gain the advantages of cross-sectional risk sharing. However, they may be losing the advantages of intertemporal smoothing and other forms of risk sharing. It may be that this change is desirable, but it is important that the trade-off be properly understood before moving in this direction. This is particularly true for Germany, where the potential already exists for a system of intertemporal smoothing. Once the move to a market-based system has been made, it is much more difficult to regain the advantages of an intermediated system. The authors identify two types of financial systems. A market-based system promotes cross-sectional risk sharing. An intermediary-based system promotes intertemporal risk smoothing. Which system is best in a particular situation depends on the degree of homogeneity in each generation. According to this view, it is not immediately clear that a move towards a single European financial system will lead to an improvement in welfare. The parts of the European Union which currently have intermediary-based financial systems such as Germany, may well be made worse off because there will be disintermediation and possibilities for intertemporal smoothing may be eliminated. The European Union is not the only place where the issue of financial integration is an important one. The Clinton administration has made it a priority to encourage the Japanese to open their financial system and allow foreign competition. Just as the analysis above suggests the German financial system might be damaged by the move towards a single market in the European Union, the effectiveness of the Japanese financial system might also be reduced by such a change. Similarly, with NAFTA and the extension of this free trade zone to the rest of the Americas, it is again not immediately clear that moving towards a single financial market will benefit all countries.