The Impact of EMU on Banks' Activities




The Ecu Banking Association General Meeting of 25 June 1993 decided to create a study committee with the mandate to discuss and assess the possible impact of the future Economic and Monetary Union (EMU), on banks' activities. The EMU Impact Study Committee, chaired by Dr. Walter Damm, met on five occasions to structure its analytical approach and to discuss the practical effects on banks' activities resulting from the introduction of a new currency.

This article is a broad excerpt of the EBA Committee's Report reflecting the discussions and the written working papers contributed by individual members. It provides a general overview of the present thinking of the Committee, its initial findings and also an outline of areas that need further analysis.

1. Chronology of events leading to EMU: options and uncertainties

1.1 Time span between the decision to start Stage 3 and the change-over to the ECU

The Treaty stipulates that at the starting date of the Third Stage of EMU, ''the Council shall adopt the conversion rates at which the participating currencies shall be irrevocably fixed and at which irrevocably fixed rate the ECU shall be substituted for these currencies'' (art. 109 l 4). In the same paragraph it is stated that the Council shall also take the other measures necessary for the "rapid introduction of the ECU as the single currency", without providing a specific time frame for this introduction. At the time of drafting the Report, there are suggestions that there may be a lapse of several years between the start of Stage Three and the change-over to the single currency. Therefore, for the purposes of the Report, the period between the decision to create a monetary union and the change-over to the ECU is split into three separate phases. Each phase is marked either by a change in the institutional environment or by the elimination of specific uncertainties. The date of each decision begins a new period in the process of managing a massive technical undertaking.

Phase A: Commences with the announcement of the start date for EMU and ends with the actual start date -- the beginning of the Third Stage specified by the Treaty on the European Union.

Figure 1: Chronology of events leading to the Single Currency

Phase B: Runs from the start date -- when exchange rates between participating currencies are irreversibly locked against each other and the ECU -- and ends with the announcement of the date on which national currencies of countries participating in EMU will cease to exist.

Phase C: Covers the period between the announcement of the date when national currencies will cease to exist and the actual date that this occurs. On that day, the ECU becomes the sole legal tender for participating countries ("E-Day").

1.2 Open questions regarding the starting date of EMU and participating currencies

At present, it is difficult to determine whether a decision to start EMU on 1 January 1997 can be taken or not. Similarly, it is difficult to determine which currencies will form part of the EMU, for a starting date between 1 January 1997 and 1 January 1999. These uncertainties are destined to create difficulties.

If a sufficient number of EU countries is visibly approaching the convergence targets in late 1995 and 1996, expectations about the timing of, and participation in, EMU would become even stronger. As a result, some of the uncertainties mentioned in the report would diminish and difficulties would be significantly reduced.

In these circumstances, anticipation effects could lead to a rapid spread of the use of the present basket ECU, which in turn would put considerable competitive pressure on the banking sector to provide efficient ECU-denominated services. Also the settlement infrastructure for ECU-denominated transactions would have to cope with considerable increases in volume and value.

1.3 Difficulties related to the duration of Phase A

In Phase A the planning environment for banks will depend on whether EMU is likely to start on 1 January 1997 or later on, and on 1 January 1999 at the latest. If the decision can be taken to start on 1.1.1997, then the lapse of time between the decision to start Stage Three and its actual start may be very short, e.g. months, if not days.

Should there be no decision before the end of 1997 to start Stage Three, EMU is scheduled to start 'automatically' on 1 January 1999. In this case, however, the decision on which currencies will participate in EMU may only be taken in July 1998. The present performance of the EU countries complying with the convergence criteria makes it difficult to anticipate now which currencies will participate in EMU at the outset. However, the European Commission's Spring economic forecasts have recognised the upturn in the EU economy and indicates the beneficial impact on public finance -- the most difficult convergence criterion.

As it is unlikely that all currencies will participate in EMU from the beginning, volatility may remain in the exchange rates and interest rates of non-participating currencies vis-à-vis participating currencies. This volatility may have a disturbing effect on the basket ECU and its transition to the ECU issued by the European Central Bank (ECB) for the following reasons:

  shortly before the start of Stage Three, the currencies eligible to participate in EMU should all find their interest and exchange rates stabilised at a similar, if not identical, level by market forces;

  as of the beginning of Stage Three, the participating currencies will have fixed parities and, accordingly, their interest rates will be identical, i.e. at a level which in principle should be the same as shortly before the start;

  the ECB ECU will have fixed parities with the participating currencies and its interest rates will therefore also be identical to those of the participating currencies. However, shortly before Stage Three starts the basket ECU should reflect the interest and exchange rates of all 12 EU currencies and their volatility.

This discrepancy will be essentially of the same kind as on the occasions when the composition of the basket ECU was modified, i.e. in September 1984 and 1989. Accordingly, the differentials between the market and the theoretical exchange and interest rates of the ECU may fluctuate significantly. This issue will have to be addressed by those banks and institutions that take an active part in offering ECU liquidity to the market.

The risk of volatility of the basket ECU in the period between the decision to start EMU and the actual start of Stage Three makes a powerful case to keep this period as short as possible.

1.4 Uncertainties on the duration and content of Phase B

The period between the start of Stage Three of EMU and the final replacement of national currencies by the ECU may be shorter or longer. It will be marked by:

  the creation of the ECB

  the fixing of exchange rates between participating currencies and the ECB ECU and, as a result, the uniformity of interest rates of the participating currencies and of the ECB ECU

  the issue of ECB ECUs and the conversion of basket ECUs into ECB ECUs

If all the currencies of the EU Member States do not participate in EMU -- as seems likely -- Phase B will see the co-existence of participating and non-participating currencies.

Although the Treaty stipulates that the full change-over to the single currency should occur rapidly after the start of EMU, there is no certainty on the duration nor on the mechanics of the change-over. If at the start of EMU there is no decision on the length of time until the change-over is to take place, there may well be a great temptation to believe that the fixing of parities is a good enough state of affairs to support the Single Market for an extended period of time. This situation would have a considerable impact on the adjustment process which the banking sector will face. There are two main categories of open issues:

(1) The uncertainty on the use of the ECU during Phase B, for example:

  since the ECU will have legal tender status, how will the ECB ensure scriptural (money represented by the deposit liabilities of commercial banks) circulation of its ECUs and how will it regulate liquidity, so that ECU interest rates are in line with those in participating currencies?

  which banks will participate in what kind of ECU payment systems?

  will the ECB issue its own fiduciary notes before a full change-over or only at the moment of the change-over?

(2) The difficulties arising from the fact that participating currencies will have fixed parities.

The issue here is not only the parallelism between the ECU and a given national currency, but also the parallelism between all the participating currencies -- a 'multiple parallelism'. The issue is whether banks should charge conversion costs between participating currencies. If they do levy significant charges, holders of such currencies will tend to keep them because all participating currencies represent an identical store of value, remunerated at the same rate. Accordingly, banks would then have to offer services of similar quality and efficiency in all participating currencies. If banks do not charge conversion fees, this tendency may still be true, although to a lesser extent. Therefore, there is a risk of generalised demand for multiple currency services if Phase B lasts for a prolonged period.

In the absence of interest and exchange rate differentiation between participating currencies, the choice of a currency for denominating financial or commercial transactions may be more and more driven by emotional or fiscal considerations, cementing old behaviour patterns and risking a loss of momentum towards a complete change-over.

1.5 Phase C

Phase C is the period between the decision to fix the date for the change-over to the single currency and the actual change-over. Only then will market operators have a precise time frame and, hopefully, exact rules and procedures for the change-over.

Market operators may well wait for this decision before they start planning and implementing the changes required to adapt to the new currency. The problems of this phase are detailed in chapters 2, 3 and 4.

1.6 The evolution towards EMU from the perspective of non-EU banks

During Study Committee discussions, it was stressed that banks operating mainly outside the EU, e.g. the rest of Europe, US or Japan, will also have to adapt to the introduction of a new currency. These banks and their customers will have assets and liabilities in national currencies that will be replaced by the ECU. Although it was not the purpose of the report to address the specific organisational and legal changes such banks will face, they have a legitimate claim to obtain appropriate guidance and notice periods so that they can adapt to the change-over requirements.

1.7 The evolution towards EMU from the perspective of other financial institutions

Organisations like stock exchanges, clearing houses, payment card services, information services and other support service suppliers will have to prepare for the introduction of the new currency in order to avoid any disruptions in their operations and in the service they provide to banks.

2. Changes that EMU could bring to banks' operating patterns

2.1 Changes due to the replacement of several currencies by a single currency

As a result of the replacement of several currencies by a new one, certain bank services will disappear while others will change progressively.

Market-driven foreign exchange activities between participating currencies, whether on a cash basis or in derivatives, will disappear, at the latest once their parities become fixed. On the other hand, the trade between the former national currencies and third currencies will be replaced by foreign exchange trading in ECU. The replacement of the former national currencies by the ECU will generate an ECU money market of significantly increased size, entailing important scale effects (see chapter 2.2.).

The effects on correspondent banking are more complex as they affect the cross-border payment structure. The Committee wishes to emphasise strongly that the term 'cross-border' will lose part of its significance once a number of countries have the same currency. Today's correspondent banking relations based on different currencies, e.g. a Paris-based bank having a Deutschmark account with a Frankfurt-based bank and vice versa will change because both banks will then participate in EMU-wide integrated payment systems for the ECU. More generally the Committee believes that the present network of correspondent banking relations will progressively be replaced by bilateral or multilateral payment arrangements in ECUs. The formation of such arrangements, whether at the level of central banks or commercial banks, is an issue of strategic relevance to every bank based in a participating country because it affects its own position in the wholesale and/or retail payments business. The Committee has identified this issue for further examination.

2.2 Changes resulting from scale effects due to the quantum leap in the size of the 'new domestic currency' market

The creation and introduction of a new single currency in a number of EU countries represents the creation of a considerably enlarged domestic market for the single currency. The present 'one country-sized' money markets, bond markets and credit markets, etc, which are supported by local payment services, settlement services and correspondent banking services, will be replaced in the EMU environment by an EMU-sized market, bound together by one single currency.

This leap in magnitude will bring about scale effects in the banking industry. These effects (which are to some extent comparable to the effects of a large scale deregulation) pose a challenge to the development strategy of each bank. Each bank will be faced with the task of redefining its size, customer segment and geographical spread in line with its available resources: capital, staff and managerial capabilities. This process will lead to adjustments in the banking industry as a whole and will have a considerable impact on each bank's activities. The magnitude of the impact obviously depends on the number and size of countries participating in EMU.

2.3 The specific situation of banks in EU countries which do not participate in EMU

With the above considerations in mind, the Committee examined the impact EMU may have on the position of those banks having their 'home base' in a country whose currency does not participate in EMU.

In general, it was felt that non-participating currencies will be perceived as weaker currencies, whereas the ECU is designed to be perceived as strong. This perception will affect the behaviour of investors in all countries. There may be a greater reluctance, even on the part of residents in those non-participating countries, to buy investment instruments denominated in a non-participating currency. In addition, the business community in non-participating countries may well shift towards using the ECU as its currency for international transactions.

As a result, banks in non-participating countries will be required to offer large-scale ECU-denominated services in addition to their services denominated in the local currency. Depending on the extent to which the use of the ECU is preferred to the domestic currency, banks in non-participating countries may be obliged to offer quasi 'dual-currency' services. This constraint may put some handicap on them when they compete with banks based in an EMU country because:

  they will have no 'domestic' funding base in ECUs

  they will have greater difficulty in offering ECU services at the same cost because the dual-currency constraint will limit the scale of their ECU services

 there is a risk that these banks may lag behind in the adjustment process resulting from scale effects in EMU countries (see point 2.2). If their home country subsequently joins EMU, under the multi-speed scenario, this lag may represent a significant competitive disadvantage.

2.4 Changes to the internal support systems and preparation of change-over

The advent of EMU will have a major impact on accounting, information technology and documentation. In addition, banks will have to organise the actual exchange of existing currencies against the new single currency. Such changes demand substantial efforts and so deserve careful analysis and planning; they depend to some extent on the quality of the banks' organisation but, in large part, on adequate guidance by the authorities together with a reasonable time frame. Banks which prepare well in advance for these changes, both at the systems level and at the level of administrative procedures, will probably have less difficulty in coping with the change-over.

The Committee discussed a recommendation for industry-wide co-operation which would aim at establishing a consensus on procedures and standards to be used in order to ensure an orderly change-over process. Inasmuch as contractual arrangements between banks and customers are affected by the change-over, the Committee strongly recommends that legislative initiatives are taken in order to establish legal certainty in this area and to avoid parties to an agreement being obliged to renegotiate their contracts. This applies to contracts denominated in the present basket ECU which will be replaced by the ECB ECU at the beginning of Stage Three. It is, however, also applicable to contracts denominated in a national currency that will be replaced by the ECU after change-over. The scope of this analysis did not include the examination of the legal aspects related to the introduction of the single currency. However, the Committee would like to draw attention to the uncertainties in this area and recommends that the relevant EBA committee studies these aspects.

The Committee also felt that any change-over should take place on the first day of a new financial year, i.e. on a 1 January. Such a change-over date would avoid complicated adjustments and conversions of accounts during the year, which might render end-of-year figures difficult to interpret. It would also be made easier given the fact that business activities normally slow down during the year-end period and that the December bank holidays provide additional room for preparing the change-over implementation.

As part of ensuring a successful change-over, the Committee underlines the need to prepare adequate training of bank staff on the following issues:

  internal strategy to prepare for the change-over

  operational changes resulting from the change-over

  resulting effects on customers and the banks' communication policy on these effects

  more generally, background information on EMU, its rationale and its features

The Committee is not yet in a position to offer an estimate of the cost that the change-over may cause the different types of banks, though various figures have been mentioned by other organisations such as the Association for the Monetary Union of Europe (AMUE). It is recognised that such a changeover will entail significant costs, but banks should segregate those costs related to the normal process of general overhaul and rationalisation of internal systems, which may be triggered by the change-over from those related exclusively to the change-over.

The Committee looked at the experiences of the UK in adopting a decimal-based currency system and the experience of Germany when introducing the Deutschmark in the former GDR. Useful insights were gained into the nature of the structural and regulatory changes, and the length of time required to make them.

The Committee concluded that the success of the decimalisation change-over could be attributed to the fact that it was carefully planned and that during all stages of the project there was intensive co-operation between all relevant parts of the private sector and the Government.

The experience with the introduction of the Deutschmark in the former GDR shows that currency change-over can take place successfully and with a minimum disruption, even within a very short time frame, if change-over is properly managed and driven by a clear political will.

3. The need for banks to help their customers through the transition to EMU

The members of the Committee strongly emphasised the psychological aspects on the general public regarding the replacement of their national currency with a new currency. While it is difficult to measure this effect at this stage, it is recognised that both the symbolic meaning of a currency as a stable store of value and its use as a scale for measuring value considerably amplify the sensitivity to any change. It is therefore of the utmost importance that political leaders only take the decision to move to EMU when economic circumstances ensure that the new currency is as good as, if not better than, the currency which it will replace. The public authorities must ensure that the populace understands this. Accordingly, the Committee emphasised that the replacement of a domestic currency by the ECU must not be perceived by the public as a covert devaluation, whether through an inappropriate conversion rate or the perception that the new currency has not the same strength as the former domestic currency.

Quite apart from the task of carrying out the change-over, a major burden will fall on the banks to explain to their customers the various aspects of the physical exchange of currencies and the change in the denomination of their investments and borrowings. A vast number of issues will have to be addressed. While the Committee has not yet achieved a comprehensive view on the best way for banks to prepare for this task, it recommends that a co-operative approach should be devised, involving the European Monetary Institute, the banks and the public authorities. This should help to establish the detailed change-over procedures and to formulate the appropriate information campaigns.

The Committee stressed that skilfully prepared information campaigns are necessary. The experience gained during the UK decimalisation process was carefully noted. The understanding of the British 'man in the street' was greatly enhanced by the education authorities introducing this issue into the national school curriculum and preparing the ground intellectually for the transition. The Committee therefore recommended that, in conjunction with the national educational authorities and the European Commission, there should be a review of school and college syllabuses as these should be complemented with ample information to equip the younger generations properly for the era of a single currency in many European States.

The Committee considered that preparations for EMU need to be based on a thorough analysis of the present attitudes in the general public towards this issue and of the main factors that influence these attitudes. These may vary from country to country and between both age and ability groups. To that effect, it recommended that appropriate analysis in undertaken and the success of the educational campaigns monitored by regular opinion polling.

Given the importance of the psychological dimension of a currency change-over, the introduction of a new currency should be presented constructively as the start of a new era. Therefore, the suggestion was made to have the change-over date coincide with the start of a new millennium, i.e. the 1 January 2000. This should be one year after any convergent States will have entered EMU, at the latest.

There is evidence to suggest that the public has already gone some way towards acceptance of a single currency at that time. According to a Harris Research opinion poll published on 1 June, 47% of EU voters believe that there will be a single currency in at least three Member States by the turn of the millennium. Recession and rising unemployment have dented the EU's image today, so it is somewhat surprising that banks' customers already attach such a probability to using the ECU in 2000. Banks should be cautious about lagging behind their customers' expectations for the provision of basic services.

4. Options for implementation of a single currency

The Committee made a first examination of the two major EMU implementation scenarios that are presently discussed within the banking community: the 'Parallel Currency' scenario and the 'Big Bang' scenario.

  The Parallel Currency scenario consists of a prolonged period during which there would be circulation of fiduciary and/or scriptural money denominated in ECUs with legal tender status, in parallel to the national currencies.

  The Big Bang approach consists of such ECU circulation only after the substitution, on a specified date, of the national currencies.

Given the difficulties that banks may have in coping with the customer demands for dual-currency services under the Parallel Currency approach, the Committee favours the Big Bang approach, although the true, i.e. marginal, cost of the two systems has not yet been established.

The Committee recognises that the Parallel Currency versus Big Bang alternative models are to some extent a problem of definition. Both scenarios will be examined further to identify whether an intermediate approach can be established.

5. Proactive development of a strategic approach to manage change

The Committee identified the need for each bank to design its own strategy to cope progressively with changes, if and when they are needed. During the coming years, banks will have to move over ground which cannot be mapped precisely because the future is blurred by major uncertainties. However, if the events that have been agreed upon in the Maastricht Treaty take place within the time span foreseen, banks have little time to waste before starting to prepare themselves. This is all the more important as the future environment that will be created by EMU will profoundly affect some of the banks' business lines. Pursuing a business strategy that does not take into account the eventuality of EMU, or one that considers it at too late a stage, may put a bank's competitive position at risk.

Similarly, banks that do not plan the changes in information technology, accounting or their needs in staff training well enough in advance, may find themselves in a very difficult position to offer efficient and competitive services to their customers.

Accordingly, it seems advisable for banks to design a development strategy to guide a progressive prepa-ration of their organisation to correspond with any increase in the certainty that EMU will happen. At the same time, this strategy should avoid an overspend in a direction that may not materialise for some years.

In this context, members of the group highlighted the benefits that the thorough examination of a bank's internal procedure and systems, etc might bring. This would need to precede the creation of such a development strategy and could prove to be an extremely helpful opportunity to cast a fresh look at its organisation in general. In that sense, cost estimates related to a bank's internal preparations for the change-over need to be carefully segregated into those related to modernising and streamlining EDP support systems and the costs related to the introduction and use of a new, single currency. The Committee sees great benefit in developing a framework to analyse these costs.

6. Conclusion

During the five meetings of the Study Committee, discussion focused mainly on understanding the phenomena that may surround the creation of a monetary union across EU countries and the replacement of their currencies by a new, single currency. The Committee tried to identify the possible impact of the change-over process, as stipulated in the Maastricht Treaty, on the organisational structure of banks and their business activities. It tried to identify specific effects on bank operations in countries that would not initially participate in EMU. As a result of its discussions, the Committee has chosen not to analyse in detail the cost aspects related to the preparation of the change-over because continuous development of information systems should enable the banks to add the flexibility to operate using ECU at marginal extra cost.

The Committee believes it is crucial to draw EBA members' attention to the need to plan now for the probability of an eventual change-over. When planning changes to their internal systems and procedures, banks should recognise the probability of a change-over so that disruption and expense can be minimised.

The Committee would also like to draw the public authorities' attention to the need to develop a co-operative approach with the commercial banking sector when devising, well in advance of the change-over date, the procedures and information campaigns necessary to ensure the successful outcome of the project.