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Erosion of Barriers to Entry in the Banking Industry
Evidence from the Impact of the Emerging Financial Markets
on the Swiss Banking Structure 1850-1920
Oxford Economics History Workshop
5th June 2008
Andreas Mattig
University St. Gallen
Organization
1 [Idea, Motivation und Central Argument]
2 [Theory and Background]
3 [The Swiss Financial Market Landscape 1850]
4 [Globalization of Financial Markets‘ Impact?]
2
1
Idea, Motivation and Central
Argument
3
Idea and Motivation

„History Motivation“:


„Policy Motivation“:


Few is known about the banking and capital market in Switzerland. No doubt, the
financial system‘s most dynamic period was the post-WW II years, however the bank‘s
reputation in the war years had to be have its roots earlier…
What happens to the banking industry structure under increased capital openness? We
have a set of emerging economies, but the corresponding results are often strongly
biased by local political, cultural or legal mechanisms. The analysis of non-regulated
market data under similar conditions might be valuable
„General industry structure and Theory Motivation“:

Industry data is often not to easy to be handled and analyzed: Multicollinearity is a
permanent issue and in today‘s market efficiency is often too high to really measure
structural shifts over time
4
Methodology and Data

This is no empirical paper! The approach relies on inductive theory
building and starts with a central argument as „quasi-hypothesis“. The
methodology can be grouped into four stages:
(1) We observed descriptive patterns and analyzed the existing data set
(2) A model (Veloce-Zellner) was applied to describe the economics behind the patterns
formally
(3) The model was adjusted for the specific conditions and re-solved, resulting in a dominant
role of the individual firm‘s cost of liquidity for survival and growth dynamics in the
emerging industry
(4) The evidence was summarized in four propositions

Data is derived from the Swiss National Bank, various state archives
and a first descriptive approach by Ritzmann (1963)
5
Central Argument

The Central Argument in this presentation is that

the emergence of an international capital market in Switzerland came as some kind of an
economic shock after the country was turned into a capital lender after producing and
exporting surpluses for years

the emergence of an international capital market in Switzerland lead to a re-valuation of
asset prices

the role of financial intermediaries changed from foreign agents and asset managers
towards transformation of risks and maturities

the value of bank liquidity was sharply increased during this process

new entering banks won a sustainable comparative advantage over the incumbents
within a short period of time
6
Evidence I

In the absence of regulatory boundaries, the relative value of input
factors are the crucial element in banking, allowing to build absolute
cost advantages

The critical element for banks is the price for liquidity, either to be
funded by internal (equity or saving) or external (capital market)
sources

In the observed time period, saving stocks were initally low and capital
demand high

Pre-19th century banking was mostly an equity-story

Access to capital markets and flexibility in balance sheet management
prooved to be crititical for success and industry (re-) formation
7
Evidence II

Incumbent banks generally have an advantage over new entrants
(existing reputation, customer base, regulatory and technological
barriers to entry)

There is evidence that for all bank classes, this incumbent-advantage
was replaced by a new-entrant advantage for the period of 1850-1870

This evidence correlates with the initiation of external capital markets
in Switzerland (first capital market financed banks and first stock
exchanges)

When modelling the entry formally and controlling for regulatory
barriers to entry (that is focussing on absolute cost of capital
advantages, the relative cost of liquidity (not capital) for the bank
remains as sole explanatory factor
8
Evidence III

The critical role of the cost of liquidity is in line with general
expectations:


Capital Markets tend to be more liquid than internal conglomerate markets
Excess Capital Supply due to „openness“ to small and foreign investors

Increased demand for funds (growing middle-class and infrastructure)
was more than met by available capital, thus affecting the „price“ of
liquidity

But: No evidence for inflation/ capital oversupply


Hint towards increased productivity of capital as financial intermediation innovated from
payment transaction and lend lending, towards maturity and risk transformation
General (historic assumption: Harrod-Domar Model – like effect for development; i.e.
Capital Increase, but argument for an instutional efficiency effect seems fair
9
„Summary of the Argument“
“A bank holds only that much equity that is required to cover losses or
draw backs likely with respect to counterparty and market risks. In an
almost closed national banking system (such as the Swiss banking
system in the observed period), the endogenous probability of cash
withdrawal will be neglectable as the system is, adjusted for some cash
hold in the individual households is closed (Jöhr 1940). Total liquidity is
thus the individual bank’s levels of liquidity at hand. In a cleared
market (CLE equilibrium), it can be assumed that this level equals the
amount of ri. ri prooved to be the critical variable for increased
competitiveness of new entrants versus incumbents.”
10
Four Propositions:

The relative price of liquidity deteriorated between 1980 and 1910
compared to the decennials prior and after, unveiling a structural beak
in the entry dynamic patterns in the banking industry

Bank type specific cost of capital is affected directly depending on the
relative elasticity between external markets and their own balance
sheet structure

The absolute cost of capital or cost of market entry deteriorated in
such an environment for incumbents

Banks with balance sheet structures open to external market
instruments enjoyed higher growth rates
11
2
Theory and Background
12
Switzerland in the 18th century
French troops invaded Switzerland in 1798, broke the power of the
ruling élites there and temporarily destroyed the cantonal system by
creating the centralised Helvetic Republic.
During the 18th/19th century, great advances were made in scientific
agriculture. New industries got off the ground, including clockmaking
and textiles.
Napoleonic policies („embargo against UK“) allowed to build one of the
leading textile industry and manufacturing centres on the continent by
taking advantage of a protected (French market) and established
capabilities
The 19th century was a period of relative peace and prosperity, after
the turmoils following the Napoleonic wars had ended
Patriotic societies sprang up all over the country. They promoted Swiss
national awareness, going beyond narrow cantonal/state boundaries
what ultimately lead to a short civil war and the establishment of
Switzerland (1848).
What determines Market Structures in Banking?

Beyond Capital demand and suppy, banking generally refers to two
strings of argumentation when observing changes in market structure
in more detail:

Endogenous Factors

Exogenous Factors
14
What drives banking structures today? Endogenous
Arguments
Demand-Side Aspects
Market
Power
Services
Technology Aspects
Int. Systems
Value
Creation
Value
Recognition
Behavioural
Arguments
Risk Mgmt. Aspects
Meta
Risk
Endogenous
Innovation in
Financial Services
Normative Issues
FirmPolitics
Ethics
Compliance
Volatility
Systemic
Risk
What drives banking structures? Exogenous Arguments
Law and Regulation
Macro Economic
Conditions
Exogenous
Innovation in
Financial Services
Technological Advances
Internationalization of Markets/
Co-Movement in Asset Prices
Market Structure/
Competition
3
The Swiss Banking Market
Landscape 1850
17
18
19
A shift in bank types and evidence for attribution of this shift
to the entry dynamics of „U“ and „L“
New entry dynamics (Equ.3):
Or: How much did the number/size of new entrants advance compared to the total market?
U, L and B grew due to improved re-financing cost structures (savings and capital markets
S and P as traditional banking forms before 1850 lost ground or grew below market average, whilst
at the same time displaying high volatility in their overal balance sheet size
Industry growth: Annual Growth rates of Banking Industry
Market Volatility: Annual Growth volatility of Banking Industry
20
Structural Breaks

The key idea was to measure at what point in time a specific category/
type of banks enjoyed what level of dynamics compared to its peers.

Structural breaks are those decils wherein one bank type significiantly
outperformed its peers in terms of growth rate of new entrants
(market entry)

And of growth rates of new entering firms compared to incumbent
firms of the same bank type (new entry dynamics)
21
Focus on „Bodenbanken“
22
Focus on „Sparkassen“
23
Focus on „Universalbanken“
24
Focus on Lokalbanken
25
Balance Sheet Structure Shifts
B
Cross Section
1850
G
L
S
B
Cross Section
1900
G
L
S
Assets
Cash
Wechsel
Credit
Mortgages
Assets
Other Assets
Total Asset
14.44%
14.40%
14.44%
28.06%
14.44%
14.21%
100.00%
0.00%
0.00%
0.00%
0.00%
83.33%
16.67%
100.00%
27.14%
15.61%
0.00%
12.64%
7.43%
37.17%
100.00%
0.00%
0.00%
0.00%
92.51%
0.00%
7.49%
100.00%
16.25%
16.25%
16.25%
18.06%
16.25%
16.95%
100.00%
11.30%
11.14%
12.45%
42.06%
11.43%
11.63%
100.00%
13.03%
18.53%
31.96%
13.90%
9.27%
13.30%
100.00%
7.66%
6.86%
12.68%
53.40%
11.34%
8.06%
100.00%
Liabilities
Money bills
Checks
Credit-Notes
Savings
Bonds
Equity
Total Liabilities
18.16%
16.14%
10.76%
24.98%
14.71%
15.25%
100.00%
0.00%
0.00%
0.00%
0.00%
83.33%
16.67%
100.00%
25.44%
11.61%
0.00%
18.34%
7.43%
37.17%
100.00%
0.00%
0.00%
0.00%
92.51%
0.00%
7.49%
100.00%
4.72%
5.00%
33.76%
23.56%
26.02%
6.94%
100.00%
0.00%
0.00%
0.00%
0.00%
97.29%
2.71%
100.00%
16.24%
8.18%
0.00%
18.34%
28.41%
28.84%
100.00%
0.00%
0.00%
0.00%
90.91%
0.00%
9.09%
100.00%
26
Problems, Implication, Future Research





Data Quality and Availability
Implications with respect to emerging capital markets and capital
efficiency through institutionalization
Institutionalization moves along fungibility
Stronger Focus on Cummulative defaults statistics
Comparative approaches with other country evidence
27
Alternative explanations
An alternative explanation for the structural peculiarity could be seen
in the banking crisis that hit especially English Commercial Bank
between 1860-1913 (Baker, Collins 2002; Collins 1989). However, this
explanation is less likely due to the limited direct exposure of Swiss
banks (especially the regional banks) to the UK economy in these
days. Other boundaries can be identified when referring to the so far
only anectodical evidences. Here, limits can be seen as the observed
above normal growth of universal banks might as well be attributed to
their reluctance to participate in the money-issuance functions allowed
under freebanking conditions. In this respect, Hickson and Turner
(2004) showed that early joint-stock banking systems did not equally
likely adopt free banking as local branch banking did. Especially these
open alternative explanations lead the way to future research in the
field. This could be addressed by more detailed modeling and further
considerations on the interplay between the relative value of liquidity
and the effects on banks – and here beside industry structure also on
the effects on the valuation of the asset side of the balance sheet.
28
4
Globalization of Financial
Market’s Impact
29
What can be learned from 19th century data for today‘s
problem sets with respect to banking market structure?

Problems and Logic of financial intermediation is constant over time



Risk Transformation
Maturity Transformation
Liquidity/ Payment System

But, data availability and industry business modells are not

Data Sets on industrial level are extremely noisy

Industry structure is shaped by conglomerates and intransparent
pricing and accounting standards

Nevertheless: 19th century as focus for analysis has advantages



No regulatory impact
Observable start of regulatory work
Slower price/information transmission makes effects more visible over time
30
What can be learned with respect to the current era of
globalization?

Globalized markets are in many aspects comparable



Increased Efficiency of Capital Utilization rather than capital oversupply
Therefore institutionalized mechanisms needed
Lack of fungibility/market liquidity ; control problems
„Public Debt-to-Equity-Swap in UK as an often used explanation for the start of
institutional markets applicable“
„Evidence for foreign investments in 18/19th century only in markets under
parliamentary control“

No global regulation – Free banking Parallels?

Industry Structures in Emerging Economies comparable in terms of
capital intensity of textiles and the like?
31
Q&A / Discussion
32
Back-up
The Free Banking Idea
The idea behind „free banking“ today is that the systemic costs is lower for self-organizing
institutions compared to external regulation, hence state regulation is not necessarily
required.
Market control is excerted through default risk. The proponents of the theory argue that in
absence of a de-facto state guarantee for banks (as it exists today in virtually all mature
markets)
(i) risk aversion will be higher within banks
(ii) monitoring of counterparty risk by other banks will be more sincere
(iii) actual costs- and benefits of risk-taking will be more transparent (in asset prices of the
banks
Money Markets Mechanisms
Bilanzgeschäft
Geschäftsbanken
Interbankgeschäft (Geldmarkt im engern Sinn)
Notenbank
Unternehmungen
Private Haushalte
Staat
Ausland
Geldanlagen
bei Banken
Geldmarktaufnahmen
von Banken
Geldmarktanlagen/
Geldmarktkredite
Bankkredite
(Bankenkreditmarkt)
Geldmarkteinlagen
von Nichtbanken
Kundengelder
(Bankeneinlagenmarkt)
Geldaufnahmen
am Kapitalmarkt
Geldanlagen
am Kapitalmarkt
Notenbank
Unternehmungen
Private Haushalte
Staat
Ausland
Ausser-Bilanzgeschäft
Trauhandanlagen,
Geldmarktpapiere / Geldmarktbuchforderungen
Kapitalmarktanlagen von Nichtbanken
(Aktien, Obligationen)
Andere Finanzintermediäre
Anlagefonds
Versicherungen, Pensionskassen
Finanzgesellschaften
Source: M.Lüscher
Der Repomarkt:
Hauptnutzungsarten und wichtigste Marktakteure
Liquiditätsinduziertes Segment:
Repoverkäufer
(hält Wertpapiere, möchte Kasse
Repokäufer
(hält Kasse, nimmt Sicherheiten in Form
von Wertpapieren
Hauptnutzung
Liquide Mittel
Kassenkredit zu günstigen Bedingungen
Finanzierung von Wertpapier-Kaufpositionen
Zugang zu kurzfristiger Liquidität.
Hauptnutzung
Minderung des Adressenausfallrisikos
Eigenkapitalentlastung
Diversifizierung
Hauptakteure
Investmentbanken, Wertpapierhäuser
Geschäftsbanken
Unternehmen
Hauptakteure
Zentralbanken
Geschäftsbanken
Unternehmen
Wertpapierinduziertes Segment:
Wertpapiere
(in der Regel GC)
Repokäufer
(hält Kasse, möchte Wertpapiere
Repoverkäufer
(hält Wertpapiere, nimmt Kasse als Sicherheit
Hauptnutzung
Finanzierung von Wertpapier-Kaufpositionen
Zusatzertrag aus Portfolio
Spezifische
Wertpapiere /
„Specials“
Hauptakteure
Investmentbanken, Wertpapierhäuser,
Inhaber grosser Portfolios (Investmentfonds,
Zentralbanken)
Liquide Mittel
Hauptnutzung
Deckung für Wertpapier-Verkaufspositionen
Einlieferung in Terminkontrakte
Deckung für nicht zustande gekommene Abwicklung
Hauptakteure
Investmentbanken, Wertpapierhäuser
EZB - Monatsbericht - Oktober 2002

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
The rise and fall of the Anglo-American wheat trade
The story of the development of the early transatlantic trade, never previously
told, makes for fascinating reading in its own right. Britain was a net exporter of
wheat until the late eighteenth century, but even for these years a bad harvest
meant that the American colonies were looked to in order to make up the
shortfall.
The onset of the Industrial Revolution, however, combined with the associated
population explosion, meant that domestic production was no longer sufficient.
From this point on, the United States was considered an important source for
wheat imports.
The ultimate proof for eighteenth-century proto-globalisation is that prices of
grain in the United States and Britain influenced each other. As far back as the
1770s, when Britain became a net importer of wheat and large volumes started
to be imported from the United States, there is evidence that prices on both sides
of the Atlantic were moving together.
A relaxation of the Corn Laws in 1773 ushered in a period of almost free trade in
grain, and American wheat began to flood into British ports. But if globalisation
might have started at this time, it was soon knocked off course – perhaps not so
much by the American War of Independence, but rather by a plague of insects:
the Hessian fly (so called because it was commonly supposed to have been
introduced to the country in the straw bedding of the hated British Hessian
mercenary troops).
These insects devastated the American wheat crop, and it was many years until
the wheat export trade began to recover. Even when it did, the Corn Laws turned
protectionist again, and it was not until Prime Minister Robert Peel’s famous
”repeal” in the 1840s, that the trade again resumed major importance.
18th century Economic Environment





Eighteenth-century globalisation
The evidence for the early importance of the transatlantic wheat trade comes
from two sources.1 First, statistics survive for the wheat trade between the
American colonies and the early years of the United States and Britain. These
show the beginnings of intercontinental trade in a bulky product, which at the
time was a leading component of consumption in Britain.
Second, lending support to the trade statistics is primary evidence, ranging from
presentations, to Parliamentary select committees to the correspondence of
individual farmers, which all suggests that contemporaries were aware of the
significance of this trade. Indeed, by 1800, the British Board of Trade wrote that
‘America be, or is hereafter to be the granary of Europe’, a role which it only
fulfilled at the end of the century.
In fact, when the United States did finally emerge as the major supplier of wheat
in the 1860s and 1870s, it appears that contemporaries considered this to be a
new development, seemingly unaware of the events of the previous century.
Their reason for this mirrors the belief that many hold today that globalisation is
a modern phenomenon: the early growth in trade was continuously being
knocked off course by ‘extraordinary’ events, such as war, politics and even
plagues of insects.
Moreover, the trade was finally closed down altogether by the imposition of
prohibitive new Corn Laws after the Napoleonic Wars in 1815. That observers had
forgotten the importance of this trade after half a century is similar to
commentators now often being unaware of the level of globalisation prior to the
First World War.