* The bank-based economy, where the capital market is underdeveloped and only a small portion of corporate financing needs are met through the issuance of securities, whereas bank financing predominates.
* The market-based economy where companies cover most of their financing needs by issuing financial securities (shares, bonds, commercial paper,s etc.) directly to investors, whereas bank financing is less fundamental.
The market-based financial system is usually attributed to Anglo-Saxon countries, which were the first to deregulate their financial market, while bank-based financial system is associated to continental Europe. When observing data concerning the relative size of ecorporate bond and equity markets in the OECD countries we can however notice that France isn’t that far from countries like the UK or the US and isn’t that close to countries like Germany. Amongst continental European countries French financial system seems more like a market-based financial system than like a bank-based one. Deregulation occurred in the mid-1980’s in France and only in the early 1990’s in Germany.
Understanding what happened during the 1980’s in France is crucial to understand the specific features of the French financial system. Before we describe the main reforms composing the mid-1980’s deregulation, we will make a brief come back to what was the French economy before these reforms. To conclude this article we will analyze a bit more deeply the impact of these reforms which shaped what is the French financial system today.
I. The French financial system before the 1980’s reforms
At the end of the 60’s, France’s banking system was still governed by the Act of 13 June of 1941, amended in 1945. This Act distinguished between deposit banks, investment banks, medium and long-term credit banks and financial institutions (all classified now as commercial banks). Each category of banks had a restricted role and this restriction was based on the duration of transactions. A deposit banks were only allowed to engage in short-term transactions, as opposed to medium- and long-term credit banks. The purpose of this compartmentalization was to regulate money creation and the allocation of savings at a time of strong economic growth. This control was the result of the post WWII consensus about the role of the state in the economic reconstruction.
According to this idea, the French Treasury set up a deposit network, consisting of several selected banks, which had a monopoly over the distribution of subsidized loans. By 1979, subsidized loans amounted to nearly half of all new loans granted to the private sector of banks. We could distinguish around 200 subsidized loans. This French banking system was particularly opaque, impeding the good allocation of savings with market interest rates playing almost no role in this allocation. As interest rates were of no use in the conduct of monetary policy, credit was restricted to limit inflation. In the context of accelerating inflation of the 1970’s this control was even more important.
The French capital market was extremely few developed with only credit institutions and "authorised non-financial institutions" (1) having access to the money market and very few big sized firms allowed to issue stocks or bonds. In such a context, non financial institutions financed their activities mostly through the intermediation of credit institutions. Another factor explaining this underdevelopment of financial markets at this time was the strict capital control limiting foreign capital inflows
This excessive control over the French financial system had been criticized early in 1960’s and modernization started in the sixties with reforms implemented in 1966 and 1967 under Finance Minister Michel Debré. Despite increased flexibility (especially about the opening of new branches) many economists still felt that France’s banking system was not competitive enough to continue to expand significantly. A real change was needed to prepare France’s entry into the European Monetary Union and to adapt the French economy to an increasing international competition, led by the development of the Eurodollar market in Londin, creating a risk of capital flows out of France. Deep reforms of the banking system and of the capital market therefore took place in the 1980’s.
II. The reforms of the 1980's
a. The 1984 Banking Act
The 1984 Banking Act unified the legal framework for the banking industry. With this act, there is no more distinction between all financial entities which are all called “credit institutions”. All these institutions are ruled under the same laws and controlled by the same commission: the Banking Commission (2). Competition is now possible between credit institutions.
b. The modernization of the money market
An important evolution to point out is that normal banks are since this reform authorized to act also as investment banks. We will see later how this greatly impacts banks and enterprises behavior on financial markets.
In 1985 the money market has been reorganized with the creation of two distinct compartments: the interbank market and a market for negotiable debt instruments. With this modernization of the money market, small-sized firms are now able to borrow short-term capital. Non resident investors and issuers are also admitted on the negotiable debt instrument market.
The end of credit controlCredit control by the Banque de France has been gradually suppressed between 1985 and 1987, so as a large part of subsidized loans. With these reforms bankers are much more responsible for their choices, when determining loan size and interest rates, which will have a significant impact in their management of risk.
The introduction of risk hedgingThe French futures market, called MATIF (3) has been created in 1985 and the French option market, called MONEP (4) is created in 1987.
The elimination of currency controlIn 1988, the currency control has been abolished, allowing free foreign capital inflows and outflows. This permits the entrance of a large amount of new capital, ready to use the new channels created by the reforms.
The 1984 banking act partly unified the French banking system and lead to more competition within this sector. This led to the closing down of institutions unabled to evolve in a more competitive environement, like family-owned banks, and to mergers of institutions. As a result, we observed a movement of concentration in the banking industry with the top ten banking groups controlling more than 85% of the total retail banking business in France. Due to increased competition and the abolishment of subsidized loans, banks initially became more conservative in their lending decisions and it became progressively harder for non performing firms to obtain a loan. A survey conducted in 1985 amongst French bankers showed that bank managers increasingly focused on reducing costs, controlling risks and introducing tighter performance monitoring. This survey proved also that the reform has allowed for a better allocation of savings and for an acceleration of the Schumpeterian movement of "destructive creation" (5). Banks also faced more competition from other source of external finance, such as the bond and equity markets.
Adding to this transformation of the banking system a gradual liberalization and modernization of the capital market, the result is an important movement of disintermediation. Since these reforms, it is easier for firms of all size to intervene directly in the capital market without passing through a bank. We can notice that since banks usually have a conservative stance concerning the allocation of savings, firms are much likely to increase equity finance. To understand the relative important role of market financing nowadays, comparing with its role a few years ago, we can look at the intermediation rate (see chart). It is a concise indicator of the relative importance of the role of financial markets in the economy.
Source: Banque de France (6)
Deigned by the “Banque de France”, the financial intermediation rate measures the contribution of resident financial institutions (credit institutions, central banks, mutual funds and insurance companies) to the overall financing received by non-financial agents. When only loans granted by these institutions are taken into account, it is defined as a “narrow” intermediation rate. When investments of these institutions in securities issued by non-financial agents (equities, bonds and debt securities) are included, it is defined as a “broad” intermediation rate. It is indeed important to distinguish intermediated finance and direct finance. Banks can however continue to play their role of intermediaries not only by according loans but also by playing on the capital market for their own benefit or for the benefit of other economic agents.
The chart above shows us the clear trend towards the disintermediation of the financing of the French economy, illustrating the increasing role of the capital market since the 1980’s reforms. The less important decrease of the FIR in a broad sense shows that banks continue to play in important role in the capital market. However, most recent developemnts (see chart below) suggest that the financial crisis has provoked another wave of disintermediation, which is logical since banks have now less willingness to lend and to take risks on financial markets.
Source: Banque de France
- Developments in France’s banking system since the late 1960s, Annual Report Commission Bancaire 2002, p. 185 – 201
- Comprendre la finance contemporaine, n° 3 –2008/1, La découverte
- Banking Deregulation and Industry Structure: Evidence from the French Banking Reforms of 1985, Marianne Bertrand, Antoinette Schoar and David Thesmar, journal of finance, 2008
- Développement des marchés de titres et financement de l’économie française, André Icard and Françoise Drumetz, Bulletin de la Banque de France – n°6 – juin 1994
- Banques: votre santé nous intéresse, Alain Lambert, Commission des Finances - Rapport 52 1996 / 1997
- Financial Intermediation rate, Method, Banque de France, 2008
(1) In French : Etablissements non bancaires admis au marché monétaire (ENBAMM)
(2) The lawmakers nevertheless preserved the specific features of several institutions: Banque de France, Caisse des Dépôts et Consignations, the financial arm of the Post Office and the overseas note-issuing banks.
(3) Marché à terme international de France
(4) Marché des options négociables de Paris
(5) Thesmar and al.
(6) Current calculation and former calculation refer to different statistical methods.