Will Europe's Financial Revolution Continue?

Over the last two decades Europe experienced a dramatic expansion of financial markets at the expense of its traditional system of financing based on close relationships between large banks and established firms. Since 1980 the ratio of stock market capitalization to GDP soared more than 13-fold, while equity financing rose 16-fold. In 1980, stock market capitalization relative to GDP was five times greater in the US and UK than in Continental Europe; by 2000, it was only 60% higher.

Disclosure standards improved throughout the Continent, as did laws to protect minority shareholders. For example, before 1980 no member of today's European Union, except France and Sweden, had an anti-insider trading law--and in Sweden the law, although introduced in 1971, was not enforced for the first time until 1990. By 2000, all EU members had anti-insider trading laws and most were enforcing them.

What caused this change? Is it benefiting all EU countries, and will it persist as EU enlargement proceeds?

Relationship-based financial systems perform better when markets and firms are smaller, when legal protection is weaker, there is little public information, and innovation is incremental. Banks tend to have close, long-term, and protective ties with the managers of such firms, primarily because the bank's holdings are illiquid. This can provide considerable stability--indeed, the second half of the 20th century saw only four German firms succumb to hostile takeovers--but at the cost of reducing access to finance and curtailing future opportunities.