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Furthermore, one of the main current trends for global banks is financial innovation in risk management where sophisticated approaches have developed such as the use of credit derivatives and securitisation. Such complex financial instruments; are used as part of the banking business as well as end-products for customers.

The widespread use of technology is not without risks (ECB, 1999). Strategically, banks run the risk of investing in IT resources that could quickly become outdated. Legal risk is related to the uncertainty surrounding the applicable laws and regulations on a number of aspects relating to technology (e.g., the legal status of remote banking, validity and proof of transactions, the respect of customers' privacy), However, innovation can and does arise from efforts to circumvent regulation (Frame and White, 2002). Another issue relates to the increase in operational risk (that is the risk associated with the potential of systems failure) as banks may tend not to upgrade their systems of internal control to cope with the new operational environment (see Molyneux and Shamroukh, 1999). Finally, the possibility of systemic risk may increase since technology increasingly links banks to each other I through alliances and joint ventures, standardisation and the possibility of using similar software and hardware. As a consequence, technological developments in banking also have important consequences for prudential regulation and supervision.

2.6 Responses to the forces of change

This section highlights banks' main responses to the abovementioned forces of change. In particular we will focus on the conglomeration process (through mergers and acquisitions) and the processes of internationalisation and globalisation.

2.6.1 Mergers and Acquisitions

Mergers and Acquisitions (M&As) are changing the structure of many banking sectors. They are not a force of change in themselves, but rather a response to the forces of change and to changes in market structures.

M&As refer to the combining of two or more entities into one new entity. They are often explained by the equation that one plus one equals more than two, because a common motive is to increase the value of the new entity. Although the terms 'mergers' and 'acquisitions' are sometimes used interchangeably to refer to the combination of two (or more) separate enterprises, they have slightly different connotations:

•A merger is when two, usually similarly sized, banks agree to go forward as a new single bank rather than remain separately owned and operated.

•An acquisition is when a bank takes over another one and clearly becomes the

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new owner. Acquisitions are also known as takeovers and they normally occur when big institutions buy smaller ones.

Some of the most common motives for M&As include the following:

•Economies of scale are achieved by creating a combined institution of larger size capable of achieving lower unit costs of producing financial services. The financial services industry is an information and distribution intensive industry with high fixed costs implying relatively high potential for economies of scale and cost cutting. These can be achieved for instance, through consolidation of the credit department and branch delivery system.

•Economies of scope can generate cost savings from delivering services jointly through the same organisation rather than through specialised providers. Economies of scope can arise internally, through joint production and marketing or externally, through joint consumption. For instance, there are potential scope economies available if both banking and insurance products are supplied by the same institutions.

•Eliminating inefficiencies. Poor management may leave banks with unexploited opportunities to cut costs and increase sales and earnings. Such banks are natural targets for being taken over by other institutions with more efficient management. Cost efficiency can be considerably improved by takeovers in which relatively more efficient banks acquire relatively less efficient banks and increase the efficiency of the target bank after the operation.

Other motives can include increasing market power, for instance through removal of a competitor and political power enhancement; and diversification of product lines and improvement of marketing and distribution. These potential gains will likely produce higher margins and improve the profitability and value of the combined institutions.

In the European banking sector the recent wave of M&As has brought about significant structural changes3. In the United States M&As have dramatically transformed the banking sector: over the period 1980-2003 the number of banking institutions halved from about 16,000 to about 8,000; and the asset share of the ten largest commercial banks rose from 22 per cent to 46 per cent (Pilloff, 2004). As reported by Pilloff, over the ten-year period there have been 3,517 mergers that involved the acquisition of about $3.1 trillion in assets. Most deals (about 75 per cent) involved the purchase of a commercial banking organisation by another commercial banking organisation and concerned relatively small institutions. However, the few acquisitions of very large banks accounted for a significant share

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of the assets, deposits and branches acquired over the period so they were responsible for the major changes derived from consolidation in the industry.

Recent trends indicate that mergers among foreign banks and cross-border mergers are becoming increasingly common. There have been many domestic M&As over the last 15 years in the European Union that have consolidated national banking markets. As concerns international conglomeration, in June 2005 Unicredit, Italy's largest bank announced the takeover of HVB Group, Germany's second biggest bank. EU banks have also expanded in Latin America, Turkey and China: Latin America attracted expansion from the major Spanish banks; whereas the financial crisis that occurred in Turkey in the late 1990s created buying opportunities for British, French and Greek banks. Some of the major Dutch, British, French and German banks have increased their foothold in the United States. In fact, the most important transactions involving EU banks outside the European Economic Area (EEA) in terms of deal value were acquisitions in the United States by ABN-AMRO, Deutsche Bank and HSBC . The entrance of China into the World Trade Organisation (WTO) and the forthcoming opening of the Chinese financial markets have increased the interest of some European as well as US banks in making Chinese bank acquisitions. Indeed, China is a very attractive market for foreign banks because it has well over $ 1 trillion in household savings, almost all of it 'lying fallow in four sprawling and dysfunctional state banks².

3A report prepared by the Banking Supervision Committee (BSC) reports the results of an analysis of M&As involving European banks see ECB (2000).

2The Economist (2003). 'Banking in China: strings attached', 6 March.

2.6.2 Conglomeration

Consolidation in the global banking industry has resulted in the emergence of financial conglomerates that conduct an extensive range of businesses with a group structure. In the European Union, financial conglomeration was encouraged by the Second Banking Directive (1989) which enabled banks to operate as universal banks offering the full range of financial services including commercial banking, investment banking, insurance and other services. In United States, the passing of the Gramm-Leach-Bliley Act of 1999 enabled banks to establish financial holding companies that can now engage in a full range of financial services (as did the 'Big-bang' reforms in Japan).

Financial conglomerates are defined as a group of enterprises, formed by different

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types of financial institutions, operating in different sectors of the financial industry. Group organisational structure is believed to bring about, on the one hand the possibility of exploiting greater cost economies and, on the other hand the capac ity of the group to isolate risk from its different activities. On the revenue side, the ability of financial conglomerates to distribute a full range of banking, securities and insurance services may increase their earning potential and lead to a more stable profit stream. Customers may value a bundled supply of financial services more than separate offers for reasons of transactions and information costs. On the other hand, it is argued that such structures may have drawbacks, such as conflicts of interest and concentration of power.5 The process of conglomeration is mainly bankdriven, as banks have been actively expanding into other areas, in particular asset management.

Similar to, but different from, conglomeration is the establishment of jointly owned enterprises offering specialised financial services. In some European countries, for example, savings banks and co-operative banks have set up such jointly owned enterprises that provide asset management, stockbroking and settlement activities as well as insurance, all of which are sold to or distributed by the member institutions of the sector. An example would be the jointly owned investment management firm of the savings bank sector in a country. In economic terms, such jointly owned enterprises provide equal opportunities of marketing and servicing as financial conglomerates. The development of such enterprises as well as co-operation agreements is common, in countries such as Austria and Germany. According to the ECB (2000), domestic conglomeration has been driven by banks; and banks are mainly expanding into asset management and the business of investment services in general.

2.6.3 Globalisation

The structural changes in the financial system and banking sectors, brought about by the process of financial liberalisation, have allowed an increase in the overall level of competition. Globally, many nations have removed regulatory barriers to international banking. At the same time, growth in international activities and trade of multinational corporations has increased the demand for services from financial institutions that operate cross-border. This trend towards globalisation is occurring in most private sectors of the economy. As companies and individuals requiring financial services are becoming more globally oriented, they demand appropriate financial services.