Category: Economics: Ch 18

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A single European market in banking

Large European banks call for further integration, but is it in consumers’ interests?

Those of a certain age may remember the fanfare which heralded the introduction of the Single European market (SEM) on 1 January 1993. It promised the removal of internal barriers to the movement of goods, services, capital and people. One sector that was noticeably absent from the single market, however, was banking.

Moves towards banking union only started after the global financial crisis in 2008. However, as a report published on the 2 September 2025 by the Association of Financial Markets in Europe (AFME) highlights, the institutional frameworks of banking in the EU are still deeply fragmented – the promised integration through the European Banking Union (EBU) is still incomplete. This has put European banks at a competitive disadvantage in global markets compared with rivals from the USA and Asia, thereby reducing their profitability and growth prospects. The report called on the European Central Bank (ECB) and national regulatory authorities to remove hurdles to cross-border banking services in the EU. This would enhance the strategic position of European banks.

In this blog we will trace the development of the EBU and analyse the current state of integration. We discuss the AFME proposals for achieving greater integration and highlight their benefits for large banks. We also analyse the barriers which limit full integration and examine the risks that retail customers might see few benefits from the proposed changes.

What is meant by European Banking Union (EBU)?

The 1993 Single European Market (SEM) in goods and services removed internal barriers to the movement of goods, services, capital and people within the EU. As part of this, there were harmonised standards and regulations for goods and services, no capital controls, mutual recognition of professional qualifications and common regulations on consumer protection, product safety, environmental protection and labour rights.

This integration of previously restricted domestic markets was designed to boost economic growth, employment and competitiveness by increasing trade and investment flows. Offering consumers greater choice would expose firms to greater competition. This would drive down prices and encourage greater efficiency and innovation. It has generally achieved these goals across many industries.

However, banking was excluded from integration. The 1985 White Paper, Completing the Internal Market, proposed the liberalisation of financial services, but banking remained regulated at the national level. This was influenced by interrelated economic, political and institutional forces, national sovereignty and political sensitivities, fragmented regulation and concerns about risk.

Even as the EU moved towards economic and monetary union (EMU) during the 1990s, there was no discussion of integration for the banking industry. However, that changed following the 2008 financial crisis and 2011 eurozone crisis. Both episodes exposed vulnerabilities in the EU banking system which required taxpayer support. It was proposed that deeper integration of the banking sector would ensure its stability and resilience. This stimulated moves towards European Banking Union (EBU), starting with the European Council agreeing its creation in 2012. There are three institutional pillars to the Union:

  1. The Single Supervisory Mechanism (2014) for systemically important financial institutions (SIFIs) ensures consistent oversight. SIFIs are banks with over €30 billion of liabilities or 20% of national GDP.
  2. The Single Resolution Mechanism (2016) manages the orderly resolution of failing banks with minimal costs to taxpayers. There is a central board for resolution decisions and a fund financed by the banking industry to support resolution actions.
  3. A European Deposit Insurance Scheme (still under negotiation) is proposed to protect depositors uniformly across the banking union against bank default.


The Union is intended to operate under a harmonised set of EU laws, known as the ‘Single Rulebook’, which includes implementing the BASEL III capital requirements, regulating national deposit insurance and setting rules for managing failing banks.

What is the state of integration at present?

Moves towards European Banking Union (EBU) have contributed to enhancing the resilience of the European banking system. This was one of its major objectives. European banks are much more secure having increased capital and liquidity levels, reduced credit risks and become less reliant on state-aid. They are also less profitable.

The AFME report points to remaining gaps in Banking Union which raise the cost for banks offering cross-border retail banking within the EU and limit the incentive to do so. The report identifies four such gaps.

1. Ring fencing.  Although there is a single supervisory mechanism for large systemically important institutions, since the financial crisis national regulators have implemented ‘ring-fencing’. This aims to protect retail banking activities from riskier investment banking. Ring-fencing retains liquidity, dividends and other bank assets within national borders to protect their retail banking sectors from contagion. The ECB estimates €225 billion of capital and €250 billion of liquidity is trapped by such national restrictions. Further, unharmonized and unpredictable use of capital buffers adds complexity for capital management at a multinational level. This particularly impacts large institutions. Banks’ cross-border activities are impeded since they are restricted in the way they can use capital and liquidity across the bloc.

The report argues that the stringent requirements of the ECB and the multiple layers of macroprudential requirements imposed at national level have led to an unnecessarily high level of capital. This disadvantages large European banks compared to their international competitors.

2. Impediments to cross-border M&As in banking within the EU.  This is due to cumbersome authorisation processes, involving multiple authorities at both national and supra-national level. Further, national authorities may interfere in the process of M&As in a bid to prevent domestic banks being acquired by ones from other parts of the EU. A recent example is UniCredit’s bid for Germany’s Commerzbank, which the German government opposes. These characteristics restrict opportunities for consolidation and efficiency gains for European banks.

The AFME report estimates that once eurozone banks grow beyond €450 billion in total assets, they suffer from negative synergies putting them at a competitive disadvantage to global competitors. Indeed, US banks are able to leverage scale economies from their domestic market to enter large EU markets. An example is JP Morgan’s entry into multiple EU markets through its Chase brand.

3. Contributions to the Single Resolution Fund (SRF) are complex and lack transparency.  This makes it difficult for banks to predict future commitments. The fund itself and its target level were determined at a time when banks had low buffers. Since then, European banks have raised their loss absorbing capacity and the AFME report proposes that further increases in contributions to the fund need to be carefully considered and reviewed.

4. The Deposit Guarantee Scheme remains unimplemented and there are still differences in national schemes.  This situation creates uncertainty for banks, which would like the European scheme for large systemically important institutions to be implemented fully.

These AFME proposals focus on the aspects of banking union which benefit large European institutions in their strategic competition with global rivals. These aspects would create ‘European’ banks as opposed to ‘national’ ones. This would give them the scale to be ‘champions’ in global competition. In particular, the large banks want lower capital requirements and the relaxation of national ring-fencing for retail banking to allow them greater freedom to achieve scale and scope economies across the bloc.

To what extent this will benefit retail customers, however, is debateable.

Will retail banking customers benefit?

Retail banking across Europe remains deeply fragmented, with significant price differentials from country to country. The following table illustrates pricing differentials for two retail products – loans and mortgages – across a sample of EU countries for July 2025.


The data show a range of average interest rates offered across the countries with a range of 5.03% for loans to households and 0.92% for new mortgages. These price differentials reflect a broad array of factors, not least the different institutional legal and risk characteristics of the national markets. They also reflect varying degrees of competition and the lack of cross-border trade in retail banking products. Retail banking remains a largely domestic industry within the EU. Cross-border banking services remain a marginal activity with non-domestic retail deposits rising by just 0.5% and non-domestic retail loans rising by just 0.3% between 2016 and 2024.

There are both natural and policy-induced barriers, which means that retail banking will remain largely segmented by nation.

On the demand-side, retail banking is largely a relational rather than a transactional service, with consumption taking place over a long time-period with significant financial risks attached. Even with deposit insurance and a lender of last resort (the central bank), consumers exhibit significant loss aversion in their use of retail banking services. Consequently, trust and confidence are important characteristics for consumers and that means they are likely to prefer to use familiar domestic institutions.

Further, perceptions about switching costs mean that consumers are reluctant to change suppliers. Such costs are exacerbated by language, cultural and legal differences between European countries, which can make the perceived costs of banking beyond national boundaries prohibitively expensive and create a preference for local institutions.

Consumer preferences can also create idiosyncratic market structures for retail banking services in particular countries. For instance, in several countries across the EU, notably Germany, mutualised credit unions account for significant shares of retail banking. This may limit the potential for foreign banks to penetrate Europe’s largest market.

There are also policy-induced obstacles to cross-border retail banking which operate on the demand-side. These include discriminatory tax treatment of foreign financial services which deters their purchase by consumers. Further, there are still eight different currencies used in the EU across the 27 member states (Denmark, Poland and Sweden are three significant examples). This creates costs and risks associated with currency exchange for consumers that may deter their use of cross-border deposits and loans. The full adoption of a single currency across the EU seems a long way off, which will limit the potential for a single banking market, particularly in the retail segment.

Retail banking as a public utility

Some argue that retail banking is a public utility and should be regulated as such. It has a simple business model, taking deposits, making payments and making loans. Like other utilities, such as water and energy, retail banking is an essential service for the smooth functioning of the economy and society. Like other utilities, bank failures create severe problems for the economy and society.

Since the financial crisis, stability in retail banking has been much more highly valued. In the period preceding the crisis, banks had used retail deposits to cross-subsidise their risky investment banking. The bank failures that resulted from this had severe economic consequences. The danger today is that by relaxing capital and liquidity restrictions too much, large banks may once again engage in risky behaviour, subsidised by retail banking – for example, by engaging in cross-border M&As. These may benefit their shareholders but provide little benefit to retail customers.

Further, allowing these large banks freedom to move funds around the bloc may lead to capital being concentrated in the most profitable markets, leaving less profitable markets / countries underserved. Retail banking, as a public utility, should be required to provide services there.

Who ultimately benefits?

The integration of banking services in the EU has progressed since the financial crisis, producing a more resilient system. However, there are features of retail banking which mean that integration which benefits consumers may be difficult to achieve.

Addressing the policy gaps identified by the AFME report may benefit large European banks by facilitating the scale economies to make them competitive internationally. However, until consumers are prepared, or able, to source banking services beyond national borders, they will see little benefit from European Banking Union (EBU) through lower prices and/or better service. The nature of retail banking in the EU suggests that this is unlikely any time soon.

Furthermore, since retail banking exhibits features of a public utility, regulators need to be wary of permitting the type of behaviour by large institutions which creates dangerous systemic risk. The worry is that, in the drive to create ‘European Champions’ in banking, regulators ignore the potential impact on retail customers.

Articles

Book

Report

Data and Information

Questions

  1. Using an average cost (AC) schedule, illustrate the efficiency benefits for large European banks from banking union.
  2. Analyse the sources of efficiency gains that European banks can gain from cross-border M&As.
  3. Explain how European retail banking customers could gain from such efficiency.
  4. Analyse why they may not.
  5. Analyse whether retail banking in Europe needs to be regulated as a public utility.
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Stress testing shadow banking: new channels but the same old risks

On the 29 November, the Bank of England published the results of its latest stress test of the UK financial system. Annual stress testing was introduced in the wake of the 2008 financial crisis. It models the ability of the financial system to withstand severe macroeconomic and financial market conditions. Typically, the focus has been on testing the resilience of the banking system.

This year’s was the first system-wide exploratory scenario (SWES). This recognises the growing significance of ‘shadow banking’. Shadow banking involves borrowing and lending involving non-bank financial institutions (NBFIs). Such institutions sit outside the regulatory cordons around banking but have become significant actors in the financial system.

However, this obscure part of the financial system poses systemic risks which are not clearly understood and from time to time require costly interventions. Examples include: problems in liability-driven investments (LDIs) for pension funds in September 2022; the money market liquidity crisis involving hedge funds in March 2020; the collapse of Long-term Capital Management (LTCM) in 1998 following the Russian Federation’s default (LTCM had significant holdings of Russian government bonds – see linked article on LTCM below).

The growing significance of shadow banking means that regulators have become increasingly concerned about the vulnerabilities in the financial system which arise from outside the traditional banking system.

In this blog we will explain stress-testing of the financial system and trace the rise in shadow banking which motivated the recent system-wide exploratory scenario (SWES). We will discuss the findings of the stress test, highlighting the systemic risks of shadow banking. Finally, we will discuss the implications for the regulation and supervision of the financial system.

What is stress testing?

Stress testing was introduced by the Bank of England after the financial crisis to assess the ability of the financial system to withstand severe economic and market scenarios.

In the run-up to the 2008 financial crisis, the liquidity and capital buffers of many banks had been extremely thin. These were only able to withstand moderate economic shocks and moderate conditions and buckled under the stresses of the crisis.

Regulators argued that the buffers needed to become much more robust and be able to withstand rare but severe economic and market conditions. The stress testing analogy was derived from engineering, where parts are expected to work not just in benign conditions but also in extreme, hostile environments.

Since 2014, the Bank of England has conducted annual stress testing. Stress testing models the impact of adverse economic conditions on banks’ liquidity, profitability and capital. The results are used to set policy for individual banks (microprudential) and for the system as a whole (macroprudential). Stress test results have allowed the Bank to adjust the loss-absorbing capital that banks must hold to reduce their likelihood of failure.

The scope of the testing has expanded over time to incorporate insurers, central counterparties (financial institutions that provide clearing and settlement services between financial traders) and cyber security. The most recent scenario recognised the increasing significance of non-deposit taking financial institutions in channelling credit. Fifty City of London institutions modelled how a period of intense stress would ripple through the shadow banking sector.

The arcane world of shadow banking

Shadow banking refers to borrowing and lending which occurs outside the banking sector. Traditionally banking involves taking deposits and using these to finance lending.

Shadow banking involves non-deposit taking financial institutions (NBFIs) such as hedge funds, insurance companies, pension funds, private equity funds, as well as some activities of investment banks. These institutions channel funds in different ways from lenders to borrowers. Typically, they use funds from investors to buy securities through financial markets. The emergence and growth of shadow banking has been explained by changing regulation and innovation.

Its first significant period of expansion in the late 1980s was driven by financial innovation. Increased use of ‘disintermediation’ – the replacement of credit channels through banks with ones through markets – meant an increase in the assets invested through NBFIs.

Despite this process playing a major role in the expansion of housing credit in the run-up to the 2008 financial crisis, it was the significant bailouts that banks received that drew the attention of regulators, not the role of shadow banking. This led to more stringent liquidity and capital requirements for banks under the BASEL III international regulations.

This regulatory tightening limited banks’ ability to offer credit, which meant that much of this activity migrated to the shadow banking sector.

Data from the Bank of England show that the percentage of total assets held by NBFIs rose from 41% in 2007 to 49% in 2020. The chart illustrates the total financial assets held by non-bank financial institutions in the UK between 2019 Q4 and 2023 Q3 (click here for a PowerPoint). The amount held has growth by approximately a third in that time, from £4321bn to £6069bn, peaking at £6670bn in 2022 Q3.

The lack of regulatory oversight stems from the nature of the activities in the shadow banking sector. While NBFIs conduct maturity transformation, provide liquidity and help manage risk, unlike banks, they do not accept deposits and are not part of the payments system involving the general public.

Consequently, the consensus among regulators has been that their activities do not pose the same systemic risks as banking of the breakdown of the payments mechanism and associated collapse in business and consumer confidence. Therefore, NBFIs are not subject to conventional regulation and supervision involving liquidity and capital requirements.

However, as the scale of borrowing and lending running through the sector has grown, this argument has become less difficult to justify. There is a concern that ‘regulatory arbitrage’ is happening and that the systemic risks associated with shadow banking are being underestimated.

The familiar risks of shadow banking

The systemic consequences of liquidity and solvency problems in the shadow banking sector may not seem obvious. Much of their activities are arcane and technical. However, there are plenty of examples of instances where the problems of hedge funds or pension funds have caused systemic issues.

While the consequences are not the same as those involving banks, in that the payments mechanism is not directly affected, the risks are. Just like banks, these institutions are exposed to liquidity risks, credit default risks and counterparty risks. The concern is that they do not have the same levels of liquidity or capital buffers as banks to insulate them from the consequences of such risks. Therefore, it might not take much economic stress for one or more of these institutions to fail and, given the increasing significance and interconnectedness of these activities, impose significant costs on the rest of the financial system.

It was for this reason that the Bank of England conducted its first system-wide exploratory scenario to analyse the impact of economic and market stress on these institutions and assess the nature and extent of systemic risks which resulted. Fifty City of London institutions modelled how a period of intense stress would ripple through the non-bank sector.

The scenario involved rising geopolitical tensions which caused a sharp rise in risk aversion and a demand for higher expected rates of return as compensation. This produced sharp rises in both sovereign and corporate bond yields and matching sharp declines in asset prices (remember bond yield and prices have a negative relationship).

The scenario found that the position and behaviour of NBFIs amplified the shock. These institutions invest significantly in marketable financial securities and their liquidity and solvency are susceptible to such falling prices.

The sharp decline in asset prices triggered margin calls – payments to cover open loss positions in financial securities. In response to these demands, while some NBFIs’ internal risk and leverage measures were breached, others illustrated greater risk-aversion and took precautionary action. These institutions acted to deleverage, derisk and recapitalise. Given the interconnectedness of financial markets, the individual actions of institutions rippled across financial markets, causing problems in other segments.

The significant decline in asset prices led insurance companies and pension funds to seek to improve their liquidity and solvency position by liquidating positions in money market funds and hedge funds. This, in turn, required these funds to seek liquidity. Such institutions tend to rely a lot on the repo market (involving short-term sale and repurchase credit agreements) to provide liquidity to investors. This avoids them having to sell assets. This practice has echoes of the banking sectors use of the short-term wholesale markets in the run-up to the 2008 financial crisis.

However, the SWES found that while banks were willing to take on some of the risk, their own concerns about liquidity and counterparty credit risk meant they did not offer sufficient short-term liquidity through the repo markets. If such funding dried up because of a higher risk perception, it could compromise the hedge funds’ ability to raise funds, requiring asset sales. This would amplify the shock to financial markets, driving prices of financial securities even lower.

The scenario concluded that the resulting heavy selling could seize up financial markets, particularly the UK sovereign and corporate bond markets, reducing the ability of companies to finance investment. This is a different type of credit crunch from 2008, which was restricted to banks – but a credit crunch, nonetheless.

At the same time, funds may make capital losses as they sell securities in the downturn. This creates solvency problems and the potential for failure.

In the SWES the institutions were often not able to anticipate how their counterparties, investors, or markets they operate in would behave in the stressed scenario, which echoes the experience of banks in 2007 and 2008 – a significant reason for the ‘crunch’ in banking credit was uncertainty about the creditworthiness of counterparties, meaning that banks were not prepared to lend to anybody.

Conclusion

Since the 2008 financial crisis, there has been a tightening of the regulation and supervision of banks which has limited their ability to channel credit. This has produced an expansion in the shadow banking sector.

However, while the shadow banking sector has not been subject to the same regulation and supervision as banks, there are still potential systemic risks associated with its operations. There have been several examples of such risks in the shadow banking sector which have led regulators to pay more attention. These underpinned the 2024 system-wide exploratory scenario (SWES) conducted by the Bank of England.

The scenario showed the possible transmission mechanism through which problems for NBFIs can have broader consequences. The report nevertheless concluded that:

…the UK financial system was well-capitalised, maintained high levels of liquidity and that asset quality remained strong.

Therefore, the UK financial system was resilient enough to withstand problems in shadow banking.

Although the results of the exercise provide a ‘framework of future system-wide analysis which can be embedded in future market-wide surveillance,’ history indicates that risks tend to exist in obscure and arcane parts of the financial system and that these never tend to be fully appreciated until a crisis occurs. This then tends to involve significant costs for taxpayers.

Articles

Bank of England documents and reports

Data

Questions

  1. Explain stress testing.
  2. What is shadow banking? Explain the factors driving the growth of credit in this part of the financial system.
  3. Compare and contrast the liquidity problems of banks with those of non-bank financial institutions (NBFIs).
  4. Analyse how financial crises can heighten problems of asymmetric information in financial markets.
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France’s rising risk premium: converging with southern Europe

On 25 October 2024, Moody’s, one of the major credit ratings agencies, announced that it was downgrading France’s economic outlook to negative. This was its first downgrading of France since 2012. It followed a similar revision by Fitch’s, another ratings agency, on 11 October.

While Fitch’s announcement did not have a significant impact on the yields of French government bonds, expectations around Moody’s did. In the week preceding the announcement, the net increases in the yield on generic 10-year government debt was approximately 9 basis points (0.09 percentage points). On the day itself, the yield rose by approximately 5.6 basis points (0.056 percentage points).

The yield rose further throughout the rest of October, finishing nearly 0.25 percentage points above its level at the start of the month. However, as Figure 1 illustrates, these increases are part of a longer-term trend of rising yields for French government debt (click here for a PowerPoint).

The yield on 10-year French government debt began 2024 at 2.56% and had an upward trend for the first half of the year. The yield peaked at 3.34% on 1 July. It then fell back below 3% for a while. The negative economic outlook then pushed yields back above 3% and they finished October at 3.12%, half a percentage point above the level at the start of the year. This represents a significant increase in borrowing costs for the French government.

In this blog, we will explain why the changes in France’s economic outlook translate into increases in yields for French government bonds. We will also analyse why yields have increased and examine the prospects for the markets in French government bonds.

Pricing signals of bond yields

A bond is a tradable debt instrument issued by governments to finance budget deficits – the difference between tax receipts and spending. Like any financial instruments, investment in bonds involves a commitment of funds today in anticipation of interest payments through time as compensation, with a repayment of its redemption value on the date the bond matures.

Since the cash flows associated with holding a bond occur at different points in time, discounted cash flow analysis is used to determine its value. This gives the present value of the cash flows discounted at the appropriate expected rate of return. In equilibrium this will be equal to the bond’s market price, as the following equation shows.

Where:
    P = the equilibrium price of the bond
    C = cash coupon payments
    M = redemption value at maturity
    r = yield (expected rate of return in equilibrium.

Interest payments tend to be fixed at the time a bond is issued and reflect investors’ expected rate of return, expressed as the yield in bond markets. This is determined by prevailing interest rates and perceived risk. Over time, changes in interest rates and perceptions of risk will change the expected rate of return (yield), which will, in turn, change the present value of the cash flows, and hence fundamental value.

Prices move in response to changes in fundamental value and since this happens frequently, this means that prices change a lot. For bonds, as the coupon payments (C each year and the redemption price () are fixed, the only factor that can change is the expected rate of return (yield). This is reflected in the observed yield at each price.

If the expected rate of return rises, this increases the discount rate applied to future cash flows and reduces their present value. At the current price, the fixed coupon is not sufficient to compensate investors. So, investors sell the bonds and price falls until it reaches a point where the yield offered is equal to that required. The reverse happens if the expected rate of return falls.

The significant risk associated with bonds is credit default risk – the risk that the debt will not be repaid. The potential for credit default is a significant influence of the compensation investors require for holding debt instruments like bonds (ceteris paribus). An increase in expected credit default risk will increase the expected return (compensation). This will be reflected in a lower price and higher yield.

Normally, with the bonds issued by high-income countries, such as those in Europe and North America, the risk of default is extremely low. However, if a country’s annual deficits or accumulated debt increase to what markets consider to be unsustainable levels, the perceived risk of default may rise. Countries’ levels of risk are rated by international ratings agencies, such as Moody’s and Fitch. Investors pay a lot of attention to the information provided by such agencies.

Moody’s downgrade in its economic outlook for France from ‘stable’ to ‘negative’ indicated weak economic performance and higher credit default risk. This revision rippled through bond markets as investors adjusted their views of the country’s economic risk. The rise in yields observed is a signal that bond investors perceive higher credit default risk associated with French government debt and are demanding a higher rates of return as compensation.

Why has France’s credit default risk premium risen now?

As we have seen, credit default risk is not normally considered a significant issue for sovereign borrowers like France. Some of the issue around perceived credit default risk for the French government relate to the size of the French government’s deficit and the projections for it. Following a spike in borrowing associated with the COVID-19 pandemic in 2020, the annual government budget deficit and the overall level of debt as percentages of GDP have remained high. The annual deficit is projected to be 6% for 2024 and still 5% for 2025. The ratio of outstanding French government debt to Gross Domestic Product (GDP) ballooned to 123% in 2020 and is still expected to be 115% by the end of 2025. France has been put on notice to reduce its debt towards the Eurozone limit of 60% of GDP.

Governments in France last achieved a balanced budget in 1974. They have run deficits ever since. Figure 2 illustrates the French government budget deficits from 1990 to 2023 (click here for a PowerPoint). The figure shows that France experienced deficits in the past similar to today’s. These, however, did not tend to worry bond markets too much.

So why are investors currently worried? This stems from France’s debt mountain and from concerns that the government will not be able to deal with it. Investors are concerned that both weak growth and increasingly volatile politics will thwart efforts to reduce debt levels.

Let’s take growth. Even by contemporary European standards, France’s growth prospects are anaemic. GDP is expected to grow by just 1.1% for 2024 and 1% for 2025. Both consumer and business confidence are low. None of this suggests a growth spurt soon which will boost the tax revenues of the French government sufficiently to address the deficit.

Further, political instability has grown due to the inconclusive parliamentary elections which Emmanuel Macron surprisingly called in July. No single political grouping has a majority and the President has appointed a Centrist Prime Minister, Michel Barnier (the former EU Brexit negotiator). His government is trying to pass a budget through the Assemblée Nationale involving a mixture of spending cuts and tax hikes which amount to savings of €60 billion ($66 billion). This is equivalent to 2% of GDP.

The parliamentary path of the budget bill is set to be torturous with both the left and right wing blocs in the Assemblée opposing most of the provisions. Debate in the Assemblée Nationale and Senate are expected to drag on into December, with the real prospect that the government may have to use presidential decree to pass the budget. Commentators argue that this will fuel further political chaos.

France looks more like Southern Europe

In the past, bond investors were more tolerant of France’s budget deficits. French government bonds were attractive options for investors wanting to hold euro-denominated bonds while avoiding riskier Southern European countries such as Greece, Italy, Portugal and Spain. Since France has run persistent government deficits for a long time, it offered bond investors a more liquid market than more fiscally-parsimonious Northern European neighbours, such as Germany and the Netherlands. Consequently, France’s debt instruments offered a slight risk premium on the yields for those countries.

However, that has changed. France’s credit default risk premium is rising to levels comparable to its Southern neighbours. On 26 September 2024, the yield on generic French government 10-year debt rose above its Spanish equivalent for the first time since 2008.

As Figure 3 illustrates, this was the culmination of a trend evident throughout 2024, with the difference in yields between the two declining steadily (click here for a PowerPoint). At the start of the year, the yield on Spanish debt offered a 40 basis points premium over the French equivalent. By October, the yield on Spanish debt was consistently below that of French debt. All of this is due to bond investors’ rising expectations about France’s credit default risk. Now, France’s borrowing costs are not only above Spain, but also closer to those of Greece and Italy than of Germany.

Strikingly, Spain’s budget deficit was 3.5% in 2023 and is expected to narrow to 2.6% by 2025. The percentage of total debt to GDP is 104% and falling. Moreover, following Spain’s inconclusive election in 2023, the caretaker government put forward budgetary plans involving fiscal tightening without the need for legislation. This avoided the political wrangling France is facing.

For France, these developments raise the prospect of yields rising further as bond investors now see alternatives to French government debt in the form of Spain’s. This country have already undertaken the painful fiscal adjustments that France seems incapable of completing.

Articles

Data

Questions

  1. What is credit default risk?
  2. Explain why higher credit default risk is associated with higher yields on France’s government debt.
  3. Why would low economic growth worsen the government’s budget deficit?
  4. Why would political instability increase credit default risk?
  5. What has happened to investors’ perceptions of the risk associated with French government debt relative to Spain’s?
  6. How has this manifested itself in the relative yields of the two countries’ government debt?
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UK banking regulation: ring-fencing revisited

The UK government announced on 14 October 2024 in a ministerial statement that it intended to raise the threshold for the ring-fencing (separation) of retail and investment banking activities of large UK-based banks. These banks are known as ‘systemically important financial institutions (SIFIs)’, which are currently defined as those with more than £25bn of core retail deposits. Under the new regulations, the threshold would rise from £25bn to £35bn.

Ring-fencing is the separation of one set of banking services from another. This separation can be geographical or functional. The UK adopted the latter approach, where ring-fencing is the separation of core retail banking services, such as taking deposits, making payments and granting loans to small and medium-sized enterprises (SMEs) from investment banking and international operations. The intention of ring-fencing was to prevent contagion – to protect essential retail banking services from the risks involved in investment banking activities.

Reducing regulation to increase competition

Raising the limit is intended to facilitate greater competition in the retail banking sector. In recent years, US banks, such as JP Morgan and Goldman Sachs, have been expanding their depositor base in the UK under their respective brands – Chase UK and Marcus.

These relatively small UK subsidiaries were not ring-fenced from their wider investment banking operations as their retail deposits were under (but not far under) the £25bn limit. However, this restricted their ability to increase market share further without bearing the additional regulatory burden associated with ring-fencing that much larger incumbents face. Raising the threshold would allow them to expand to the higher limit without the regulatory burden.

The proposals are part of a broader package of reforms aimed at reducing the regulatory burden on UK-based banks. The hope is that this will stimulate greater lending to SMEs to boost investment and productivity.

The proposals also include a new ‘secondary’ threshold. This will exempt banks providing primarily retail banking services from the rules governing the provision of investment banking accounts. This exemption will apply as long as their investment banking is less than 10% of their tier 1 capital. (Tier 1 capital is currently the buffer which banks are required to retain in case of a crisis.) The changes were the outcome of a review conducted in 2022 but had not been implemented by the previous government.

The announcement has sparked a debate about ring-fencing, with some commentators calling for it to be removed altogether. Therefore, it is timely to revisit the rationale for ring-fencing. This blog examines what ring-fencing is and why it was introduced, and explains the associated economic costs and benefits.

Why was ring-fencing introduced?

Ring-fencing was recommended by the Independent Commission on Banking (ICB) in 2011 (see link below) and implemented through the Financial Services (Banking Reform) Act of 2013. The proposed separation of core retail banking services from investment banking were intended to address issues in banks which arose during the global financial crisis and which required substantial taxpayer bailouts. (See the 2011 blog, Taking the gambling out of high street banking (update).)

Following deregulation and liberalisation of financial services in the 1980s, many UK banks had extended their operations so that they combined domestic retail operations with substantial investment and international operations. The intention was to open up all dimensions of financial services to greater competition and allow banks to exploit economies of scope between retail and investment banking.

However, the risks associated with these services are very different but, in the period before the financial crisis, were provided alongside one another within banking groups.

One significant risk which was not fully recognised at the time was contagion – problems in one dimension of a bank’s activity could severely compromise its ability to provide services in other areas. This is what happened during the financial crisis. Many of the UK banks’ investment operations had made significant investments in off-balance sheet securitised debt instruments – CDOs being the most famous example. (See the 2018 blog, Lehman Brothers: have we learned the lessons 10 years on?.)

When that market crashed in 2007, several UK-based banks incurred significant losses, as did other banks around the world. Given their thin equity buffers and the inability to borrow due to a credit crunch, such banks found it impossible to bear these losses.

The UK government had to step in to save these institutions from failing. If it had not, there would have been significant economic and social costs associated with their inability to provide core retail banking functions. (See the 2017 blog, Ten years on.)

The Independent Commission proposed that ‘the risks inevitably associated with banking have to sit somewhere, and it should not be with taxpayers. Nor do ordinary depositors have the incentive (given deposit insurance to guard against runs) or the practical ability to monitor or bear those risks’ (p.9). Unstructured banks, with no separation of retail from investment activities, increase the potential for both of these stakeholder groups to bear the risks of investment banking.

Structural separation of retail and investment banking addresses this problem. First, separation should make it easier and less costly to resolve problems for banks that get into trouble, avoiding the need for taxpayer bailouts. Second, structural separation should help to insulate retail banking from external financial shocks, ensuring that customer deposits and essential banking services are protected.

Problems of ring-fencing

Ring-fencing has been subject to criticism, however, which has led to calls for it to be scrapped.

It must be noted that most of the criticism comes from banks themselves. They state that it required significant operational restructuring by UK banks subject to the regulatory framework which was complex and costly.

In addition, segregating activities can lead to inefficiencies, as banks may not be able to take full advantage of economies of scope between investment and retail banking. Furthermore, ring-fencing could lead to a misallocation of capital, where resources are trapped in one part of the bank and cannot be used to invest in other areas, potentially increasing the risks of the specific areas.

Assessing the new proposals

It is argued that the increased threshold proposed by the authorities may put UK institutions at a competitive disadvantage to outside entrants that are building market share from a low base. Smaller entrants do not have to engage in the costly restructuring that the larger UK incumbents have. They can exploit scope economies and capital mobility within their international businesses to cross-subsidise their retail services in the UK which incumbents with larger deposit-bases are not able to.

However, the UK market for retail banking has significant barriers to entry. Following the acquisition of Virgin Money by Nationwide, only six banking groups in the UK meet the current threshold (Barclays, HSBC, Lloyds Banking Group, NatWest Group, Santander UK and TSB). Indeed, all of those have deposits well above the proposed £35bn threshold. Consequently, raising the threshold should not add significant compliance and efficiency costs, while the potential benefits of greater competition for depositors and SMEs could be a substantial boost to investment and productivity. Furthermore, if the new US entrants do suffer problems, it will not be UK taxpayers who will be liable.

Have we been here before?

In many ways, ring-fencing is a throwback to a previous age of regulation.

One of the most famous Acts of Congress relating to finance and financial markets in the USA is the Glass-Steagall Act of 1933. The Act was passed in the aftermath of the 1929 Wall Street crash and the onset of the Great Depression in the USA. That witnessed significant bank failures across the country and problems were traced back to significant losses made by banks in their lending to investors during the speculative frenzy that preceded the stock market crash of 1929.

To prevent a repeat of the contagion and ensure financial stability, Glass-Steagall legislated to separate retail banks and investment banks.

In the UK, such separation had long existed due to the historical restrictions placed on investment banks operating in the City of London. In the late 20th century, the arguments for separation became outweighed by arguments for the liberalisation of markets to improve efficiency and competition in financial services. Banking was increasingly deregulated and separation disappeared as retail banks increasingly engaged in investment activities.

That cycle of deregulation reached its nadir in 2007 with the international financial crisis. The need to bail out banks made it clear that the supposed synergies between investment and retail banking were no compensation for the high costs of contagion in the financial system.

Regulators must be wary of calls for the removal of ring-fencing. Sir John Vickers (chairman of the independent commission on banking) highlighted the need to protect depositors, and more importantly taxpayers, from risks in banking. It is the banks that should bear the risks and manage them accordingly. Ultimately, it is up to the banks to do that better.

Articles

Bank annual reports

Access these annual reports to check the deposit base of these UK banks:

Information

Report

  • Final Report: Recommendations

    • The Independent Commission on Banking, Sir John Vickers (Chair), Clare Spottiswoode, Martin Taylor, Bill Winters and Martin Wolf (September 2011)

Questions

  1. How did the structure of UK banks cause contagion risk in the period before the global financial crisis?
  2. How does ring-fencing aim to address this and protect depositors and taxpayers?
  3. Use the links to the annual reports of the covered banks to assess the extent of deposits held by the institutions in 2023. How far above the proposed buffer do the banks sit?
  4. Use your answer to 3) and economic concepts to analyse the impact on competition in the UK market for retail deposits of raising the threshold.
  5. What are the risks for financial stability of raising the threshold?