©1997 International Monetary Fund
March 1997
IMF Staff Country Report No. 97/19
France—Selected Issues
This selected issues report on France was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with this member country. As such, the views expressed in this document are those of the staff team and do not necessarily reflect the views of the Government of France or the Executive Board of the IMF.
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©International Monetary Fund. Not for Redistribution INTERNATIONAL MONETARY FUND
FRANCE
Selected Issues
Prepared by a staff team headed by J. R. Artus and C. M. Watson, with K. Habermeier (all EU1), and including O. Dore (EU1), C. Dziobek (MAE), I. Halikias and J. Levy (EU1), and C. Van Rijckeghem (RES)
Approved by the European I Department
February 4, 1997
Contents Page
Basic Data 5
L Health Expenditure 8 A. Introduction 8 B. Institutional Setting 8 C. Health Expenditure Trends 9 D. Factors Underlying Past and Future Spending Pressures 10 E. Past Reforms in France and Elsewhere: Some Comparisons 14 F The Current Reform in France: The "Juppe Plan" 19 G. Concluding Remarks 24
Text Table Financial Position of the Health Care Branch 24
Tables 1 Total Expenditure on Health Care 26 2 Public Share in Total Spending on Health 27 3 Growth in Per Capita Health Spending, 1980-92 28 4 Volume Growth of Health Outlays in France 29 5 Price Increases of Health Services in France 30 6 Breakdown of Health Expenditure 31 7 Health Status and Outcome Indicators, 1992 32 8 Studies of the Association Between National Income and Health Care Spending 33 9 Effect on Health Spending of Changes in Age Structure 34
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10. Public Expenditure on Health 35 11. Hospital Care Statistics, 1990 36
Boxes 1. Global Hospital Budgets 15 2. Controlling Physician Spending 17 3. Efficiency in Health Care 19
References 37
EL Social Security, Tax Reform, and Unemployment: A General Equilibrium Analysis 39 Executive Summary 39 A. Introduction 41 B. The Model 43 C. Simulation Results 45 D. Alternative General Equilibrium Results 50 E. Conclusion 51
Tables 1. Response to Employer Social Security Tax Reduction Without Offsetting Tax Increases 53 2. Response to Employee Social Security Tax Reduction 54 3. Response to Employer Social Security Tax Reduction with Offsetting Tax Increases 55 4 Sensitivity Analysis: Effect of a 1 Point Increase in Employer Social Security Tax 56 5 Long-Run Effect of Employer Social Security Tax Reductions in Various Models 57
Appendix I The Simulation Model 58
References 64
IIL Monetary Transmission 67 A Introduction and Overview 67 B Survey of the Literature and Topics on Transmission Channels 68 C The Impact of Interest Rates on the Economy 71 D The Role of the Credit Channel 77 E Conclusions . 81
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Charts 1. Cumulative Output Loss from a Half Percent Increase in Interest Rates 76 2. Effect of an Increase in the German Interest Rate on Output 80
Appendix I Impulse Responses 82
Appendix I Charts Al. Impulse Responses 83 Al. Impulse Responses (continuation) 84 A2. Results of a "Structural" VAR 85
References 86
FV. Recent Problems and Current Policy Issues in the Banking Sector 89 Executive Summary 89 A. Introduction 92 B. Structure, Performance, and Regulation of the Banking Sector 92 C. Recent Banking Problems 95 D. Response of the Authorities 109 E. Current Policy Issues 144
Appendix I Structure of the Banking Sector 123 Appendix II Medium-Term Issues in the Banking Sector 126
Tables 1 Credit Institutions by Type and Class of Ownership 130 2 Concentration in the Banking Sector 131 3 The Largest Banks, 1994 132 4 Net Foreign Direct Investment in the Banking Sector 133 5 Profitability of Major International Banks in 1994 and 1995 134 6 Selected Indicators of Performance of Banks 135 7 Bank Restructuring: Employment and Staff Costs 136 8 Branch Networks and Workforce of Banks 137 9 Performance of French Banks 138 10 Purchase Price of Offices 139 11 Costs of Public Rescue Operations Relating to Financial Institutions 140 12 Real Estate Loans (at end-1995), Nonperforming Loans (NPL), and Banks1 Assets 141 13 Selected Performance Indicators of Financial Institutions 142 14 Performance Indicators by Type of Bank 143 15 Funding and Lending Indicators 144 16 Bank Restructurings (1993-96) 145
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17. Ownership Structure and Cross-Shareholdings of Selected Financial Institutions 146
Charts 1. Employment in the Banking Sector (AFB Banks) 94 2. Growth and Real Interest Rates in Europe 99 3. Selected Economic Indicators 100 4. Short-Term Interest Rates and Lending Margins 108
Boxes 1. Key Features of Liberalization of the Banking Sector in France 97 2. Lending to Small Enterprises 98 3. Savings Instruments: General Features and Collection Privileges 102 4. The Credit Lyonnais Restructuring Ill 5. Cross-Shareholdings and Other Aspects of Capital Structure in the Banking Sector 118
References 147
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France - Basic Data
Area 549,200 square kilometers Total population (1994): 57.2 million GDP per capita (1994): US$23,236
1992 1993 1994 1995 1996 :/ 1997 I/
(Volume changes: in percent)
Demand and supply Household consumption 1.4 0 .2 1.4 1..8 2. 4 2. 1 Public consumption 3 . 4 3 . A 1.1 0.,9 1. 3 0. 9 Gross fixed investment -2 .6 -6 .7 1.3 2.,7 -0.2 3. 1 Public 3 .9 -0 . 4 -0 .4 -1..1 -0. 6 1. 5 Residential construction -4 .5 -7 .8 2 .0 3..0 2. 0 2. 5 Other private -4 .0 -8 .2 1.5 3..8 4 . 8 6. 4 Stockbuilding 2/ -o .6 -1.5 1.7 0..2 -0. 4 0. 3 Total domestic demand 0 .2 -2 .2 3 .0 2.,0 1. 2 2. 3 Exports of goods and services 4 .9 -0 .4, 6 .C 6..1 1. 8 5. 0 Imports of goods and services 1.2 -3 .5 6 .7 5..4 1. 7 4. 5 Gross Domestic Product 1.2 -1.3 2 .8 2.,2 1. 3 2. 4
(Contribution to growth of GDP: in percent) 2/
Household consumption 0. 6 0..1 0..8 1.1 1.4 1.3 Public consumption 0. 6 0..6 0..2 0 .2 C .3 0 .2 Gross fixed investment •0. 6 -1..5 0..3 0 .5 -0 .1 0 .6 Exports of goods and services 1.3 -0 .1 1,.6 *^ .7 0 .5 1.4 Imports of goods and services C. 3 -1,.0 1..6 1.5 0 .5 1.3 foreign balance 0. 9 0..9 -0 .2 0 .2 0 .0 0 .1
(Annual averages)
Employment and unemployment Labor force (Bullions) 24.9 25.0 25.2 25.5 25.7 25.8 Unemployed 2.6 2.9 3.2 3.2 3.2 3.2 (In percent of total labor force) 10.3 11. 4 12.3 11.6 12.4 12.1 Employment (Change in percent) -0.6 -1.1 -0.2 1.4 0.5 0.9
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1992 1993 1994 1995 1996 I/ 1997 I/
(Annual changes in percent) Prices and incomes GDP deflator 2.1 2.5 3.5 1.6 1.7 1.7 Consumer price index 2.4 2.1 1.7 1.8 2.1 1.6 Import unit values -3.2 -3.9 1.3 2.3 2.1 1.9 Average hourly compensation (manufacturing) 4.6 3.5 3.5 2.4 2.0 3.4 Unit labor costs (in manufacturing) 0.3 3.6 -4.8 -0.3 0.0 0.6 Real disposable income of households 1.9 0.9 1.2 2.5 0.5 2.0 Household saving ratio (in percent) 13.6 14.1 13.6 14.3 12.7 12.6
(Ir. percent of GDP) Public finances 3/ General Government Expenditure S2.1 54.6 54.3 53.8 54.1 53.4 Revenue 48.1 48.8 48.5 48.8 50.1 50.3 Balance -4.0 -5.8 -5.8 -5.0 -4.0 -3.0
General Government Debt (gross) 4/ 39.7 45.7 46.6 52.9 56.2 ,57.3 (In billions of francs) 2.781 3.236 3.591 4.064 4.446 4.718
(In billions of francs) Balance of payments Trade balance 12.7 43.0 44.2 63.9 88.5 97.7 Other 7.5 9.0 0.3 27.1 25.8 26.1 Current account 20.2 52.0 44.5 91.1 114.3 125.8 (In percent of GDP) 0.3 0.7 0.6 1.2 1.4 1 5 Long-term capital 117.9 -23.7 -256.0 -39.0 Capital transfers 2.1 -0.4 -25.6 -1.1 ...... Short-term capital -1S1.5 -43.2 212.8 -51.6
Net change in official reserves ( - - increase) 5.3 30.9 -13.9 -3.7
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1992 1993 1994 1995 1996
(Annual changes in percent) Exchange -rates (averages) U.S. dollar per French franc 6.5 -6.5 2.0 11.2 -2.1 I/ Deutsche mark per French franc 0.3 -1.1 0.2 -1.8 2.2 5/ Effective rate (MERM) 3.7 0.5 0.7 4.7 0.0 I/ Relative unit labor costs (in manufacturing) 1.7 2.3 0.1 0.5 -1.1 y
(ThrouKh-the-vear changes in percent) Monetary data Money (Ml) -0.7 -0.4 3.1 1.7 6.2 y Broad money (M3) 5.5 -3.2 1.7 4.7 0.6 y Total domestic debt 4.7 1.6 3.8 1.8
(Period averages: in percent) Interest rates Three-month interbank money rate 10.4 8.4 5.8 6.6 4.0 5/ Differential with Germany 1.0 1.2 0.5 2.1 0.7 */ Government bond yield 8.6 6.6 7.2 7.6 6.5 y Differential with Germany 0.6 0.3 0.3 0.7 0.1 i/
Sources: Data provided by the Fr«r.ch authorities; and staff estimates.
\/ Data for 1996 are staff projections. 2/ Changes expressed as a percent of pxevious year's GDP. 2/ National accounts basis. ±/ Maastricht definition V Average to September 26, 1996. percent changes calculated relative to the average fcr the previous year. 6_/ 1996 second quarter over the same period in 1995.
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I. Health Expenditure1
A. Introduction
In November 1995, the French government announced a far-reaching social security reform, including major new measures to address the financial imbalance in health care, which alone accounted for nearly half of the estimated 60 billion francs social security deficit expected in 1995. The health care reform reflected a recognition that France's health care system and its financing needed to be fundamentally restructured.2 At over 9 percent of GDP, health care spending in France is by far the highest in Europe, and it has continued to rise more rapidly than overall public spending. Earlier reform efforts slowed these trends, but did not deal with many of the underlying causes of spending growth. This paper reviews developments in health care spending in France and discusses the recent measures to improve the functioning of the system and contain costs. It argues that by addressing many of the issues that had bedeviled past reforms (e.g., micro-efficiency, regulatory reforms), the new measures offer a reasonable hope of containing France's health expenditures.
Following a brief review of the institutional background and of past trends in health care spending, an analysis of the major forces behind the recent and projected growth in expenditure is presented in Sections C and D. An overview of past reforms in France, with reference to some other country cases, is presented in Section E. The reform proposals contained in the "Juppe plan1' and some observations on their design in light of earlier experience are presented in Section F. Some concluding remarks are offered in Section G.
B. Institutional Setting
The French health care system is based on the social insurance (or Bismarckian) model. It combines universal health insurance, involving significant cost-sharing and supplementary insurance on the financing side with a pluralist system of provision involving both independent and public providers on the supply side Almost the entire population is covered by the statutory health insurance (a part of the social security system) which is managed by the unions and employers1 federations, but is in many respects under the control of the government
'Prepared by Ousmane Dore
2 An extensive debate on the future of the health care system culminated in the Livre Blanc sur le systeme de sante el d'assurance-maladie (1994), which provides a complete analysis of the system
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Despite extensive government controls,3 the system is largely based on the principle of medecine liberate. For ambulatory care, a patient may choose any medical practitioner on a fee-for-service basis and can later file a claim with social security for reimbursement of a portion of the bill. While fee levels are not subject to government regulation in principle, reimbursement by social security follows a national fee and drug reimbursement schedule, which is below established standard costs, the patient paying the difference (ticket moderateur)4 In the hospital sector, patients have virtually free choice between using a private or public hospital. Services in both are covered by the national health insurance, for the private sector in the generous limits set by the fee schedule.
On the financing side, about 80 percent of total health care expenditures are paid by the insurance fiinds, and a further 5 percent by the central government. Most of the remaining 15 percent is borne directly by patients (notably through the so-called ticket moderateur for the non-reimbursable part of the standard cost of consultations and drug prescriptions). Statutory health insurance funds (the largest being the CNAMTS—Caisse Nationale d'Assurance-Maladie des Travailleurs Salaries—which insures most employees), cover about 70 percent of expenditure.5 Mutual-insurance companies (mutuelles) cover 6 percent of expenditure and are mainly financed by voluntary contributions. Private-insurance schemes, and the Ministry of Health and other public institutions cover, respectively, 3 percent and 4 percent of total expenditures. Contributions vary by scheme, but all are income-related. Currently, employers contribute 12.8 percent and employees 6.8 percent of total salary without an upper limit.6
C. Health Expenditure Trends
The French health care system has been characterized by rapidly rising expenditure for several decades. The share of health expenditure in GDP rose from 4 percent in 1960 to over
3The government exercises control over the health care system through the regulation of social security contribution rates, the control of global budgets for public hospitals and of wages and posts in public hospitals. It also supervises the negotiation of fees and prices for doctors and private hospitals and directly controls the prices paid by the statutory insurers for drugs and medical goods
4ln mid-1993, the ticket moderateur for consultations with a doctor was 25 percent of the conventional fee, for necessary drugs it was 30 percent, and for comfort drugs, 60 percent
*There are also about 15 smaller fiinds, which cover for example farmers and the self- employed (including self-employed miners and transport workers)
6 The employees' contribution has been lowered from 6 8 percent to 5 5 percent under the tax reform proposed by the government
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9 percent in 1995 (Table 1). Health care consumption in per capita terms is well above the OECD average. In 1992, for example, the per capita volume of health care expenditures in France was some 25 percent higher than in Germany and as much as 60 percent higher than in the U.K. Worldwide, only the United States spends more per capita than France. Health spending by the public sector rose even more rapidly than total health spending during 1960-80 (Table 2) as the coverage of public insurance expanded.
In addition to a higher level of costs, real per capita health care spending has grown more rapidly in France than in other European countries. Since the 1960s, it has risen steadily by about V/2 percentage points per decade; real spending, while growing less rapidly during the 1980s than the 1970s, advanced much faster than the OECD average. In contrast to other industrialized countries, most of the increase in nominal health spending reflected volume rather than price increases. Per capita spending in volume terms increased by 4.5 percent annually in the 1980s, double the OECD average, while price levels for health services were considerably below OECD averages (Tables 3, 4, and 5).
Growth was pronounced in nearly all sectors: ambulatory care, private hospitals, and drug consumption. The contribution of the main components of health care to total spending has not been even. In the 1970s, hospital services were the major factor behind expenditure growth. During the 1980s, hospital spending, which now accounts for about half of total health care consumption (Table 6), grew at a much slower rate, but this was partially offset by faster growth in the ambulatory, pharmaceutical, and residual components. During 1992-95, expenditure growth on ambulatory care decelerated appreciably, while spending growth in the hospital sector has accelerated again.
Despite the high level of spending on health care in France, public health has not improved markedly more than in other countries (Table 7)7 Moreover, as was highlighted by the High Commission on Health, France is only a mid-ranking country in terms of life expectancy at birth.
D. Factors Underlying Past and Future Spending Pressures
Health expenditure in France has been and continues to be driven by a mix of supply and demand-related factors: increased income, ageing, and advances in medical technology
7 In general aggregate health outcomes are only weakly related to medical care spending This weak association between health spending and available outcome indicators partly reflects well-established evidence that direct spending does not capture the full array of social, environmental and cultural factors which influence health status
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However, while these factors contributed to the growth of spending, they do not appear to account for all of the increase in health expenditure during the past decades. Institutional factors have probably also played a role. These include the role of the government in paying for health care facilities and providers, and the role of the private insurance market as an alternative or a supplement to the national health system.
Increased income
As income levels rise, consumers demand relatively more health care, controlling for the effects of changes in insurance coverage and other variables. A close association between income and spending on health care in OECD countries has been highlighted in a number of studies [Newhouse (1975, 1977), McGuire et al., (1988), Culyer (1988), Parkin et al., (1989), OECD (1993)]. Table 8 reports the income elasticities found in various studies, which for the most part use international cross-section data. In most of these studies, GDP is the income variable. Even after taking account of the effect of a number of other variables (for example relative health care prices, the share of public financing of health care, and the age structure of the population), the implied income elasticity of health care expenditures in all cases exceeds one, suggesting that health care is a luxury good. These results contrast with the evidence obtained from national household level data, where numerous studies have revealed a low income elasticity for the utilization of health care. Nonetheless, the international cross-section estimates are probably more telling, as the within-country income elasticities may be distorted by the endogeneity of income at the household level. In particular, sickness may simultaneously depress income and raise medical spending
However, the income hypothesis does not explain fully why health care spending in France, relative to GDP, is the highest in Europe. It is estimated that France spends close to 20 percent more than can be explained by a cross-sectional model of the type discussed in the previous paragraph (OECD, 1994). Institutional factors clearly play a role as well, both in explaining the growth rate of health spending and its high level. Recent studies (e.g., OECD, 1994) find that, correcting for a variety of institutional factors (notably the extent to which the health care system provides universal coverage, and the size of the health care infrastructure), the income elasticity for health care spending in France is less than one. This also implies that changes in the regulatory environment could break the link between higher income and higher health care spending
Ageing
A second factor underlying the increase in health care costs is the aging population old people tend to consume more health care than younger ones A calculation based on the 1980 Health Survey by the CREDES indicates that people aged over 80 consume three times as much as those aged between 20 and 40 years In France, as in other OECD countries, the proportion of the elderly in the population has been growing steadily for the past five decades Between 1981 and 1991, the proportion of people 60 and over rose by 2 1 percentage points
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Simulations performed by the OECD indicate that aging could add on average 0.3 percent per year to health spending in the 1990s (Table 9).8 Estimates by the Ministry of Finance (1992) point to smaller increases. However, the figures could well be higher if account is taken of "generational effects": given income and prices, older individuals would choose more health care than previous generations of elderly.9 The OECD study also reckons that in order to offset the impact of aging on health spending, it would be necessary to hold growth in per capita real public health spending about !/2 to 1 percentage point lower than productivity growth.
Technological progress
Technological change and improvements in medical science have also contributed to the growth of health spending worldwide (Evans, 1983, Waldman, 1972, Davis, 1974).10 New technology often involves expensive equipment and skilled staff to use it. In France as elsewhere, it is difficult to evaluate the contribution of technology to health spending growth, for only in the last fifteen years has the need for comprehensive technological assessment been recognized. The Commissariat General du Plan (1993) estimates that about four-fifths of medical procedures and two-thirds of medical goods have never been evaluated with respect to their effectiveness or cost in France. Also, Beraud (1992) and the CNAMTS (1992) found that in many instances, the use of more expensive technology was not warranted by improved health outcomes.
Institutional factors
As alluded to earlier, institutional factors explain a considerable portion of the growth in health care spending in France These factors range from market imperfections and regulatory provisions to incentive structures that are a particular feature of the provision of health care services through increased coverage. As noted above, the French health care
1 Using as a broad rule of thumb that persons aged over 65 consume on average roughly four times as much health care as those below 65
* For example, Hourriez (1992) found that in 1950 persons aged 70 saw generalists and specialists, respectively 1 5 and 0 8 times more than persons aged 40. b\ 1990, this had increased to 2 6 and 1 1 times
10 Improved cataract operations, renal dialysis, organ transplants, coronary bypass, micro- surgery, and hip and knee replacements have increased the range of conditions which can be successfully treated Advances in anaesthetics have reduced the risks of operating on older patients New imaging and other technologies (echography. improved radiology', magnetic resonance scanners, endoscopy and biological tests) have improved diagnosis
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system is based on universal social insurance.11 In such an insurance-based system, the potential for "excess" demand and supply of services exists because of moral hazard both from the consumer and provider sides.12 On the demand side, there is an increase in the demand for health care because patients do not pay the fiill marginal cost. On the supply side, incentives exist to over-supply medical services whenever a third party pays for the bulk of services that doctors choose to provide, a situation that is exacerbated by a fee-for-service payment arrangement.
Typically, the moral hazard problem can be countered by the use of copayments, whereby the insured person pays some fraction of the supplier's charge. France's social insurance is characterized by the widespread use of such cost-sharing arrangement, but their effects are generally undermined by supplementary insurance.13 More than 80 percent of the population carry such supplementary health insurance, and some 10 percent are exempted from the ticket moderateur. Provider moral hazard has been exacerbated by the fee-for-service system, which allows consumer choice and flexibility, but which also tends to increase the volume of activity and therefore costs. With prices subject to national fee schedules, doctors tend to increase turnover in pursuit of their income targets.
Asymmetry of information is another source of higher costs. The vast majority of patients lack the information necessary to make an informed choice. Hence, to varying degrees, they are compelled to delegate treatment decisions to the medical professionals who also supply the services demanded, creating a potential conflict of interest. This situation has led to a supplier-induced demand for medical care, as patients often confuse quality with the quantity of treatment and medicine prescribed, and providers are eager to oblige. For example, the high level of prescription drug usage was driven not only by the freedom of doctors to prescribe, but also by fierce competition among doctors who often use prescriptions to retain patients Excessive resort to specialists and overly technical and expensive treatment have been further consequences of asymmetric information.
Finally, administrative costs have risen with the size and complexity of the health enterprise. France's double layer of social security and complementary insurance has also
11 Compulsory health insurance dates back to the aftermath of World War I, when the provinces of Alsace and Lorraine, where the German health insurance (Bismarckian model) had been established, were returned to France A 1920 law creating compulsory insurance did not become operative until 1930, due largely to the opposition of doctors to the capitation of pay
12See the seminar paper by K. Arrow (1963).
13 There are numerous non-profit insurers (or mutuelles) and private insurers providing supplementary voluntary insurance in the system. They cover the ticket moderateur, some extra billing, and a few benefits not covered by the social security scheme
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added to such costs. It is estimated that when all costs are included, health care administration accounts for a higher percentage of total health outlays in France than in other European countries with similar social insurance systems.14 The problem is most acute in the public hospital sector. The involvement of elected officials who chair the hospital boards helps to explain the strong growth of employment in the health sector. Labor costs alone represented about 70 percent of hospital costs in 1995.
£. Past Reforms in France and Elsewhere: Some Comparisons
Faced with budgetary pressures, nearly all OECD countries introduced some land of health care reform in the past decade. Governments attached different weights to equity, income protection, micro-efficiency and macro-efficiency considerations in designing these reforms. Still, according to a recent OECD study, all governments that undertook reforms enjoyed some degree of success in limiting health expenditures. In France, where contribution rates to the statutory system had reached an unprecedented level, continuing strong expenditure growth led to policy changes during the 1980s aimed at controlling expenditures in at least part of the health care system.15 This section reviews and assesses these reforms in light of the experience in other countries.
Global budgets for hospitals
The most important reform in France's hospital sector over the past decade was the introduction of global budgeting for public hospitals in 1984, which was later extended to private hospitals The budgets cover operating costs, as well as debt service expenses for hospital construction and high-cost medical equipment Hospitals receive monthly installments from the health insurance funds, with payments distributed among the funds according to their shares of total patient days. The government uses its participation in the budget negotiations to set a nationwide spending limit. Rates of increases in hospital budgets have been determined centrally and have on the whole been applied evenly to all hospitals.
Prior to this reform, hospitals faced controlled rates of increase in per diem prices, which had given incentives to hospital managers to extend the average length of stay The introduction of global budgets has resulted in a marked deceleration in the rate of growth of expenditure on public-sector hospital care, with growth rates in this sector just half of those in the private sector (Table 3) Consequently, from 1992 on, private hospitals were also subjected to global budgeting, previously these hospitals had been paid on a per diem and fee-
14 In 1992, the Caisses Primaires d'Assurance Maladie were employing some 80,000 staff, not counting personnel collecting contributions See Poullier (1992) l5The typical household currently pays about 20 percent of gross compensation on health care, including voluntary contributions to mutuelles
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for-service basis. Any over- or under-shooting relative to budgets is compensated by downward or upward revisions in fee schedules. The success of this reform is difficult to evaluate given that doctors in private hospitals were not covered by the global budget constraints, even though they are mainly responsible for the level of hospital activity. Global budgets for hospitals were also introduced, and met with success, in Belgium and Germany in early 1980s.
Box 1. Global Hospital Budgets: The Belgian Experience
A prospective global budget system, which involves differentiation of the budget into separate components for support and medical services, was introduced in Belgium in 1982. This financing reform also had the objective of standardizing budgets across hospitals in accordance with case-mix and other criteria that were considered critical to the financing of hospital services. A budget and a quota of days were fixed for each hospital. Days in excess of this quota were paid at a rate which reflected variable costs; any shortfall in actual days was paid at a rate which reflected fixed costs only. A case-mix adjustment was applied to the budgets for laboratory service beginning in 1990 and radiology beginning in 1992. Providers were obliged to engage in a continual assessment of patterns of clinical services and outcomes.
The 1982 reforms of the hospital sector also included steps to reduce the number of hospital beds. A moratorium was imposed to prevent the number of hospital beds from exceeding the number reached in 1982. No new hospital could be opened without the closure of an equivalent one. In addition, financial incentives were introduced for closing hospitals or converting beds, leading to a 14 percent decrease in the number of acute hospital beds between 1982 and 1989, half of the targeted reduction Belgium also proposed a method to cap expenditures related to diagnostic testing in 1986, which consists of giving each teaching hospital a global budget for all MRI (magnetic resonance imaging) operating and amortization costs, including radiologists' fees.
As the Belgian experience in the 1980s suggests, global budgets can be a successful cost containment mechanism However, a global budget does not guarantee cost effectiveness Much depends on how budgets are determined and implemented First, if the budget is too small, care that is economically appropriate will be denied Second, since hospital managers and local politicians have an incentive to resort to political maneuvering in order to increase funding for their own institutions, clear and strongly enforced policies are necessary to pre- empt such attempts Third, hospital budgets are often based on historical costs and tend to penalize efficient producers while placing little pressure on inefficient providers to improve In France, budgets were initially set at generous levels, they were not correlated with the efficiency of the individual institutions, and they did not make allowance for shifts in demand
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Moreover, the ceilings were not enforced for all of the health professions. While successful in breaking volume-oriented production attitudes, the budgeting procedure thus did not do much to promote structural change and cost effectiveness.
Another reform in the public hospital sector was the introduction, in 1993, of an information system to track hospital costs and spending (programme de medicalisation des systemes d'information, PMSI), which had been developed and implemented on a trial basis in 1982-83. This program was among the first in Europe to experiment with case-mix measurement and costing within the acute hospital sector. Its success has been modest. Excess capacity in hospitals has been reduced only slightly; the utilization of beds remains low and the number of beds per inhabitant high by international standards (Table 11). The government estimates that there is currently a surplus of 60,000 hospital beds. Furthermore, the state's ability to cut services has been severely limited for political reasons as local mayors usually head the public hospital administration and hospitals are often major local employers.
Global budgeting for physicians
In ambulatory care, global budgets for aggregate payments to physicians have been introduced in several other countries. Germany adopted such a system after 1977. Belgium also extended global budgets (retaining fee-for-service) to those parts of its system which lacked them in 1991. Another cost control measure in the ambulatory sector has been the capitation payment system, which was introduced in Ireland in 1989, and recently in Italy (with some fees), the United Kingdom, and Sweden (1994). Capitation systems as implemented in the United Kingdom allow flinders to control the overall level of primary expenditures, and the allocation of funding between general practioners is determined by patient registration.
Only France, among EU countries, had until recently no means of capping payments to physicians outside hospitals. Instead, doctors and other providers of health care services had in recent years been subject to negotiated expenditure ceilings This began to change in 1992, when a spending target was first set for medical laboratories The new policy also provided that spending in excess of the target would be refunded to the social security system If spending was below the target, an indemnity would be paid (in the form of a higher estimate for volume growth the following year) and the fee schedule would be adjusted upward During the same year, an annual budget ceiling was negotiated with private practice nurses. the quantity of nurse visits was restricted to 22,000 per nurse per year, after which only half the costs are refunded by the social security system Both of these policies have met with some success in restraining the growth of spending on these services
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Box 2. Controlling Physician Spending: The German Experience
Since 1986, Germany has controlled physician payments on the basis of spending caps that are negotiated between physician organizations and sickness fund associations. Increases in the caps are tied to the growth rate of sickness fund members' wages and are enforced by adjusting fees downward when the volume of health services exceeds the level consistent with the spending limit. These adjustments are made by the regional physician associations, which receive a prospective lump-sum from the sickness funds and in turn monitor the quality and volume of services of each physician. Largely as a result of these cost containment efforts, health care spending as a share of GDP fell from 8.4 percent in late the 1980s to 8.1 percent in early 1990.
In 1992, the expenditure cap was replaced with an expenditure targeting mechanism. Under these targets, the growth in physician payments was no longer capped each quarter by the growth in the income of sickness fund members during that quarter. Instead, an annual target was set, which could be exceeded in certain circumstances (for example to increase the volume of services deemed appropriate). In response to the continued high growth rate of health care spending, especially on physician services, further legislation was put in place by the beginning of 1993. It aims to cap overall spending by controlling the volume as well as the price of physicians and drugs. The new law limits the growth rate in spending on physician services in 1993-95 to the growth rate in the income of members of the sickness funds. Given the expenditure target, unit prices are calculated for each service based on a volume target. During the first two quarters of each year, these unit prices are negotiated prospectively. If actual total expenditure exceeds the limit, the unit prices are reduced in the third and fourth quarters to compensate.
However, this system provided for no direct restrictions on volume, which continued to expand at an excessive rate. Mindful of this, the government adopted a new mechanism to limit the number of practicing physicians and to favor family practitioners over specialists. First, the new law limits the licensing of new ambulatory care physicians in a region if physician density there exceeds a given norm by 10 percent Second, beginning in 1999, physicians over the age of sixty-eight will have their licenses revoked. Third, the practice of family medicine will be financially upgraded by transferring savings in laboratory services to family practitioners. To offset incentives for overspending, physicians are subject to random audits of their practice patterns by a committee representing the sickness fund and the physicians' associations The committee compares a physician's overall level of services, including prescribing patterns, with the average level for the physician's specialty group If the physician's level of services is 15 percent above the norm for his specialty, an audit will be ordered If the physician's provision of services is 25 percent above the norm, he is required to return his excess earnings It is hoped that these changes will both limit spending and force physicians to compete on quality
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Increased cost-sharing in the publicly financed sector
France and Germany both introduced negotiable cost-sharing for specific services under their public schemes. In France, out-of-pocket payments account for approximately 15 percent of total payments for health care. Copayment levels are 25 percent for physician visits, 20 percent for hospital services up to the 30th day of care (plus 30 francs daily room charge), 30 percent for laboratory tests and dental services, and 30-70 percent for covered prescription drugs (plus 100 percent for non-covered prescription drugs).
Regarding pharmaceuticals, France has introduced a positive list of medications that may be prescribed and a negative list of those that are not covered. Pharmaceuticals must be approved for reimbursement at a price set, product by product. Prices for innovative products are in principle set at a level that will help to defray research and development costs. However, if a new drug offers no therapeutic advantages over its rivals, it will be added to the list only if its cost is lower. Since 1990, pharmacists have been paid according to a sliding scale, which is related to the cost of the drug dispensed. Recently, Germany and the Netherlands have introduced a somewhat stricter system of reference pricing: a price is fixed based on the cost of similar products (generics), and if the product prescribed costs more, the difference is paid by the patient.
While increased cost-sharing reduces the cost to the government and possibly the volume of health care, total spending may not necessarily fall. For this to happen, the increase in the copayment must be significant enough to affect behavior and private insurance must not replace the coverage removed through cost-sharing under the public scheme. Given the existence of numerous mutuelles which pay a significant part of shared costs, it is not clear how effective cost sharing has been as a cost-containment tool in France
Efficiency and competition
A common feature of past reforms in France has been their emphasis on macro- controls, which alone rarely appear to have encouraged greater micro-efficiency and effectiveness of providers, and in some cases may even have weakened the achievement of those objectives Although these macro-controls on health spending have clearly yielded a marked slowdown in the growth of expenditures, it is difficult to assess their success in terms of efficiency Concerns about micro-efficiency emerged in other countries' operating systems similar to that in France Recently, a few countries (Germany, the United Kingdom, and the Netherlands) have started to instil an element of competition among providers and insurers, while keeping a universal social insurance system Such moves towards managed markets are likely to offer better choice, producer autonomy, and efficiency in the health system, without sacrificing equity considerations and cost control
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Box 3. Efficiency in Health Care: The Case of Finland
Finland's health system is recognized as one of the most efficient in the world. At the same time, Finland has kept health expenditure to less than 7 percent of GDP throughout the 1980s. The centerpiece of the Finnish system of cost control is a rolling 5-year operating expenditure plan controlled by central government agencies that allocate monthly national government subsidies to municipal health collectives. Hospitals and primary care clinics prepare annual incremental operating expenditure requests for both personnel and minor capital expenditures. These budgets are reviewed first by the health collective that owns the hospital and/or the clinic and then by a series of local and national government bodies. In general, 40 percent of the expenditure requests are accepted and adopted in the 5-year plan. Although local health collectives have the option of funding unaccepted personnel and equipment, the government maintains the right to cut off funding for previously accepted costs as "punishment".
Competition in Health Care: The United Kingdom Experience
The central idea that underpins the recent reforms of the National Health Service is the distinction between the purchaser and the provider of hospital and community health services. The providers compete with one another to provide such services by means of contracts with purchasers of health services. There are two kinds of purchasers. First and largest are the District Health Commissions (DHC), which operate under a budget. The reforms recast their role from one of organizing and providing hospital care to selecting the services required to meet those needs and then contracting with various health services providers. A greater role than formerly is attached to identifying the health needs of the district population. DHC are monopsonists in contracting for many hospital services.
The second type of purchaser comprises fundholders (self-employed primary care doctors) who manage a budget which they must use to secure a defined range of hospital and primary care services for their patients. The fundholder's practice receives a transfer of roughly 1/5 of the per-capita costs of hospital and community health services to purchase a variety of services and products, including some surgical treatments, diagnosis, prescriptions, and community nursing services. Since GP fundholders compete with DHC and private insurers in purchasing certain services (with the area of competition being defined by health care regulation), the purchasing side of the market is now also subject to some competitive pressures.
F. The Current Reform in France: The tf Juppe Plan"
Because of the fragmented nature of the reforms, the dozen plans d'urgence implemented since the mid-1970s had little success in curbing health expenditures, and despite
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significant measures taken by the previous government in the spring of 1993 (lot Veil), the financial situation of the social security system continued to deteriorate. By 1995, health insurance accounted for about half of the F 60 billion (0.8 percent of GDP) deficit of the regime general social security funds.
While these deficits partly reflected a delayed response of revenue to the recovery,16 they were also attributable to structural factors, notably the tendency of health spending to grow more rapidly than potential output. It became apparent that fundamental structural reform would be needed in order to durably reduce social spending. In the health care sector, this implied the necessity of addressing not only the huge financial imbalance in the short-run, but more importantly the need to put in place measures that could ensure that spending targets are met without jeopardizing the quality of health care.
Main elements
The objectives of the health care measures contained in the Juppe plan are threefold. First, to achieve financial balance by 1997 through strict limits on expenditure growth in ambulatory and hospital sectors in 1996 and 1997. Second, to put in place detailed regulations and incentive mechanisms designed to keep health spending under control. Third, to improve the efficiency of the system through a series of structural measures so that more and better quality health care is delivered at a relatively lower cost than is presently the case These objectives are reflected in the measures contained in the constitutional law adopted on February 19, 1996, and in the three decrees—adopted by the Council of Ministers on April 24—dealing with the management of social security fiinds, the reform of hospital administration, and the control of ambulatory medical services
The main element of the reforms is a constitutional amendment giving Parliament final authority over social security expenditure. This amendment puts responsibility for the management of the social security system primarily in the hands of the government and the legislature rather than in the hand of the social partners (employers and trade unions, with the government as arbiter) as is presently the case. Thus, it will have the effect of subjecting social spending to the disciplines of financial management.
In the context of the Social Security Financing Law, Parliament will each year set quantitative targets for the growth of health expenditure (these targets will take account of revenue developments) It will also take a decision on the national health goal as defined by the National Conference on Health Once the national spending target has been set, quantified
16 This delay may be attributed to the financing of social security through payroll taxes, which tend to reflect the lagged response of employment to output
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objectives will be defined for each sector within multi-year agreements between the state and the social security funds, starting on January 1, 1997. This means that care provided by medical doctors, the remuneration doctors derive from reimbursable fees, and hospital spending will henceforth be subject to constraints based on the annual decisions taken by Parliament.
The multi-year conventions, which are based on contracts between the state and the health insurance funds, are aimed at clarifying the respective role of each agent and also at providing greater autonomy to sickness funds in the area of financial management. The conventions provide a framework for the government's health policy. A surveillance committee (made up of citizens and elected officials) will be created to monitor the implementation of these agreements.
The health administrative boards will be replaced with a view to promoting greater social democracy and strengthening administrative controls (four qualified government- appointed persons will sit on each board). Regional associations of health insurance funds (URCAM) will be created before January 1, 1998.
The most important element of the reform of the hospital sector is the creation of regional hospital agencies, which will be headed by a director appointed by a ministerial council. These agencies will be in charge of managing both public and private hospitals. In addition to allocating global budgets to individual hospitals (the overall increase in spending has been limited to 2.1 percent annually in 1996 and 1997), regional agencies will be responsible for coordinating with the activities of national agencies and insurance funds, and for ensuring that hospital activities are in line with the directives of the regional health conference. To foster a better management of hospital resources, the establishment of multi- year contracts setting objectives for each hospital are envisioned. Regional agencies will also have considerable leeway to decide which hospitals to restructure or close.
The hospital reforms aim at increasing the role of doctors and other medical personnel in the management of hospitals, with the ultimate goal of ensuring the participation of all hospital staff (administrative, technical and medical) in the organization and management of these institutions. It is envisaged that, in view of their preeminent function as health service providers, doctors could form at their own initiative new decision centers, exercising some management functions Another objective of the plan is to foster a better integration of hospitals into their environment by requiring them to adapt their activities to the needs of the local population
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To help maintain good health care quality, hospitals are required to initiate, over the next five years, an external review of their activities. This review will take place under the aegis of an accreditation agency made up of independent experts. Following the Canadian model, a national review agency (Agence Nationale ^accreditation et devaluation en same, ANAES) will be created to monitor the standard of health care. This agency will be administered by a board composed of health professionals. Continued training of hospital doctors and patient feedback are further elements of the hospital reform.
In the ambulatory sector, the short-term financial objective is to limit the increase in spending to 2.1 percent in 1996 and 1997. To achieve these objectives, controls are being imposed on the activities of physicians. Beginning in 1997, physicians' reimbursements will not be raised if there are overruns in the previous year. Moreover, physicians' rates of remuneration could be lowered retroactively by decision of Parliament if the expenditure targets for the previous year are exceeded; any increase in reference fee schedules will be reimbursed at the end of the year if and only if the spending targets set by the convention are met, with the new fees taking effect the following year.
The reform envisages sanctions in the form of reimbursements by doctors to the insurance fund if the spending targets are exceeded. The practice since 1993 of setting medical guidelines (RMO) which define norms and includes penalties, will be extended. However, in contrast with the last two years, these guidelines will be set by a national health commission. Likewise, expenditure on drugs will be controlled through a wider recourse to generic drugs and stricter dispensing by pharmacists of the exact quantity of drugs required by a prescription.
Another element of the reforms in this sector is the creation of regional physicians' associations, which will monitor the development of medical services and technology, while insuring that doctors participate in mandatory training A number of administrative reforms such as the introduction of centralized individual medical files (to avoid duplication of treatment) and more intensive use of information technology are also envisaged Individual medical files will be introduced between now and 1997, and a computerized coding of treatments and diseases will be introduced before the end of 1996 in order to assess doctors1 performance and encourage preventive medicine. By 1999, all insured patients and doctors are to have an electronic health card
Some observations
A salient feature of the "Juppe plan" is its emphasis on structural measures to durably reduce the growth of health expenditures Thus, while still reiving on global macro-constraints through "OQNs" (objectifs quantifies nationaux). its main focus is on achieving greater micro-efficiency by providing a mix of services which maximizes a combination of health
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outcomes and consumer satisfaction, given the overall budget constraint. The creation of regional hospital agencies and the linkage of doctors' funding to the respect of OQNs provide a mechanism that should help achieve this objective. As the German experience in the areas of mobile care suggests (Box 2), accompanying incentive mechanisms are necessary in order to support the targets for overall expenditure restraints.
An important element of the reform is that it seeks to clarify and strengthen the role of health funders. Under the existing system, flinders (in this case the social security funds) have been relatively passive intermediaries between health consumers and providers. Their function had been to allocate available funds among an established group of health care institutions, employing payment methods such as ticket directeurs, per-diem payments, or fee-for-service, which paid little attention to resource allocation and in many cases permitted supplier-driven spending increases to go unchallenged. The current reform redefines the role of health funders, making them accountable to the state. The creation of regional associations of health insurance funds to be in charge of coordinating activities in the ambulatory sector and setting up global management strategies is intended to serve this goal.
Moreover, there is an attempt in the current reforms to make funders more effective purchasing agents for health consumers. This means that they will now be in a position to be much more active in assessing the relative merits and cost-effectiveness of different treatment strategies, and in selectively buying health services from potential suppliers, thereby becoming accountable to consumers for the quantity and quality of medical services provided. The extension of medical guidelines (RMOs), which will henceforth be defined by a national agency, and the introduction of generic drug use in the pharmaceutical sector, should both contribute to the achievement of these goals.17
Another feature of the reform is its emphasis on fostering greater market competition through better contracting. In contrast to bulk funding all the outputs of a supplier, or to passively reimbursing bills submitted by providers, contracts provide the scope for competitive bidding for particular services sought by the purchasers and the transfer of resources to alternative providers. As the UK experience (Box 3) demonstrates, contract-based systems may provide a formal mechanism for performance indicators (such as quality, quantity, and cost dimensions of services) to be specified and monitored At the provider level, competitive contracting for health services would require providers to improve their management capacity and to face appropriate accountability arrangements (including relevant objectives and goals, and information systems which permit their achievement to be assessed)
17 The experience with the 1994 law concerning a set of some 30 references medicales opposables (RMO), setting out "good practice" procedures and treatments for a range of illness and provides for sanctions in case of abuse has been quite successful, during the first eight months of 1994, physicians' fees and pharmaceutical spending fell by around 4 percent compared with a year earlier (CNAMTS, 1994)
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While recent reforms are far-reaching, a central question is whether, from a budgetary perspective, they will help to slow the growth of public spending. It is somewhat too early to answer this question. However, the Commission des Comptes has already observed that the deficit of the regime general would have been worse in the absence of these reform measures (see tablulation below). The failure to meet spending targets in early 1996, particularly in the ambulatory sector, probably stems from the fact that a number of recent measures have not yet come into effect. In particular, the built-in sanctions and penalties would not start to bite until 1997.
Financial Position of the Health Care Branch
1996 1994 1995 With Without measures measures
Revenues 489.9 506.7 527.4 - Expenditures 521.4 546.4 5597 - Deficit 31.5 39.7 32.3 45.5
Source Comptes de la secunte sociale
In addition to measures to restrain spending, a number of revenue measures were also taken, including a 2.4 percent increase during 1996-97 in the preferential rate of contribution for health care insurance (applying to old-age pensioners and to the recipients of unemployment benefits in excess of the minimum wage)
G. Concluding Remarks
France has enjoyed considerable success in providing high quality health services to the whole population, achieving considerable equity in access, and protecting insured persons from catastrophic financial burdens However, policy has thus far been less successful in containing the cost at which these services are provided Although this difficulty arose in pan from circumstances outside the control of the government, such as the aging of the population and the continued development of expensive medical techniques, it also reflects inappropriate incentives and other institutional weaknesses
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Reform steps implemented during the past decade have attempted to slow the growth of health expenditure, but have not been too successful in achieving this objective. To address the underlying long-run spending pressures highlighted in this paper, this first set of reforms needed to be supplemented by measures to increase the micro-economic efficiency of the health care system.
The current reforms contained in the "Juppe plan" have made some headway in addressing some of these micro-economic issues through hard budget constraints and other structural measures. Their success, however, will depend on their firm and credible implementation. The measures consisting of conditioning doctors' funding to overall spending restraints would need to be firmly enforced if the growth in ambulatory care is to be contained. This would need to go hand in hand with a consistent application of sanctions and penalties. In the hospital sector, a rapid move to put in place regional hospital agencies would help to reduce excess capacity, while at the same time keeping operating expenditures in the sector (notably on personnel) under control.
On the structural front, further efforts could well be needed to achieve greater efficiency in the system, for instance by introducing performance-based reimbursements. Reimbursements for performance rather than the use of resources, as is presently the case with hospital budgets, may give incentives to boost productivity, depending on how performance is measured and compensated. For example, in the hospital sector, per diem reimbursement could be replaced by reimbursement per treated patient (paiement a la pathologic), as classified by Diagnosis Related Group (DRG). Such a system has since 1993 been tested in a pilot project in Languedoc-Roussillon. When a similar system was introduced in Sweden, productivity rose by nearly 10 percent the first year and 3 percent in the second year (Charpentier and Samuelson, 1994). For physicians in general practice, fee-for-service could eventually be replaced by a capitation fee as in Ireland in 1989
Finally, the long-run effectiveness of the reforms may be hampered if users of health care are not given additional incentives to consume health care wisely. As noted earlier, a system of universal coverage performing both insurance and solidarity functions is bound to generate higher demand for health care than is economically efficient. Greater emphasis would need to be placed on demand-side measures. One possible measure would be to automatically adjust copayments (the so-called ticket moderateur) in the event of spending slippages
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Table 1. France: Total Expenditure on Health Care
(Percent of GDP)
1960 1970 1980 1990 1991 1992
France 4.2 5.8 7.6 8.9 9.1 9.4
United States 5.3 7.4 9.2 12.4 13.2 14.0 Japan 3.0 4.6 6.6 6.6 6.7 6.9 Germany 4.8 5.9 8.4 8.3 84 8.7 Italy 3.6 5.2 6.9 8.1 8.4 8.5 United Kingdom 3.9 4.5 5.8 6.2 6.6 7.1
Canada 5.5 7.1 7.4 94 10.0 10.3 Average G-7 4.3 5.8 7.4 80 8.9 9.3 OECD average 3.9 5.5 7.2 7.9 7.9 8.4
Source OECD Health Data File. 1992.
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Table 2. France: Public Share in Total Spending on Health
(In percent)
1960 1970 1980 1990 1991 1992
France 57.8 74.7 78.8 74.5 74.8 74.8
United States 24.5 37.2 42.0 42.2 43.9 45.7
Japan 60.4 69.8 70.8 70.8 71.6 71.2
Germany 66.1 69.6 75.0 71.8 71.4 71.5
Italy 83.1 86.4 81.1 77.8 78.3 75.2
United Kingdom 85.2 87.0 89.6 844 84.3 84.4
Canada 42.7 70.2 74.7 73.1 73.4 72.2
OECD average 63.9 73.8 78.1 76.9 75.3 74.7
Source. OECD Health Data File, 1992
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Table 3. France: Growth in Per Capita Health Spending, 1980-92
(In percent)
Health care Nominal per capita Real per capita price growth
France 9.3 4.4 4.7
United States 9.3 2.4 6.7 Japan 5.7 3.4 2.2 Germany 5.3 2.0 3.5 United Kingdom 9.8 3.4 7.6 Canada 8.5 3.9 5.8
Source: OECD, Health Data File.
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Table 4. France: Volume Growth of Health Outlays in France
(Average rates of change)
1970-75 1975-80 1980-85 1985-90 1991 1992
Hospital 8.9 6.8 3.4 2.4 2.6 3.5 Public 9.4 7.7 3.1 2.0 1.8 3.1 Private 7.6 3.9 4.5 3.8 5.2 4.9 Ambulatory care Doctors 5.3 4.2 6.1 5.8 5.4 3.7 Dentists 5.6 6.0 5.3 5.7 5.1 4.2
Laboratories 15.2 10.3 10.6 134 5.8 4.4 Pharmaceutical 10.7 4.3 8.3 8.1 6.1 5.6
Total consumption 8.7 6.0 5.5 48 4.5 4.3
Source SESK1993)
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Table 5. France: Price Increases of Health Services in France
(Average rates of change)
1970-75 1975-80 1980-85 1985-90 1991 1992
Hospital 10.2 11.0 9.1 3.7 2.6 2.8
Public 10.3 11.1 9.2 3.9 3.0 3.0 Private 10.2 10.5 8.7 3.1 1.4 2.0 Ambulatoiy care
Doctors 9.2 9.1 8.0 3.2 2.0 3.1
Dentists 9.4 10.5 6.3 2.2 1.0 0.9 Laboratories 4.1 4.2 5.1 -3.1 0.0 0.0 Pharmaceutical 2.6 6.1 51 0.3 0.5 0.7
Total consumption 7.5 9.4 7.8 27 1.9 2.2
Source SESI (1993)
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Table 6. France: Breakdown of Health Expenditure
(In percent)
1970 1980 1990 1991 1992
Hospitals 41.0 51.5 46.6 46.1 46.0
Public 29.8 40.1 35.6 35.0 34.9
Private 11.3 11.3 11.0 11.0 11.1
Ambulatory care 14.6 12.0 13.5 13.7 13.7 Doctors 2.9 3.0 4.3 4.4 4.4 Dentists 7.1 7.0 6.6 6.6 6.5 Laboratories 2.4 2.6 3.2 3.2 3.2
Drugs 25.2 17.0 17.8 17.8 17.8
Preventive medicine 2.8 2.9 2.2 2.1 21
Other 164 16.6 22.1 22 1 22.5
Source SESI(1993)
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Table 7. France: Health Status and Outcome Indicators, 1992
Female life Male life expectancy expectancy Perinatal mortality Infant mortality at birth at birth
France 81.3 73.1 0.82 0.68
United States 79.0 72.3 0.87 0.85 Japan 82.2 76.1 0.53 0.45 Germany 79.3 72.9 0.56 0.60 Italy 80.4 74.0 1.04 0.83 United Kingdom 79.0 74.0 0.81 0.66 Canada 80.4 73.8 0.77 0.68 OECD average 79.2 72.9 080 0.91
Source OECD Health Data File
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Table 8. France: Studies of the Association Between National Income and Health Care Spending
Period of Income Standard t-values Sample Method study elasticity error one-sided size used
Culyer 1982 1.31 0.105 2.95* 20 OLS
Culyer 1988 1.35 0.157 1.97* 20 OLS
Newhouse 1977 1.31 0.11 2.72* 13 OLS Leu 1974 1.36 0.09 4.04* 19 OLS
Leu 1974 1.18 0.07 2.43* 19 OLS
Gerdtham 1987 1.33 0.31 1.05 19 WLS ct al., 1987 1.44 0.31 1.42** 19 WLS
Keiman 1969 1.14 0.09 1.55** 16 OLS Murthy 1985 1.25 0.07 3.67* 22 OLS
Parkin 1987 1.18 0.18 0.55 18 OLS etal. 1980 1.12 0 11 1.09 18 OLS
Summers 1975 1 46 007 663* 34 OLS
* significant at 5% level. ** significant at 1% level OLS - ordinary least-squares, WLS * weighted least-squares
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Table 9. France: Effect on Health Spending of Changes in Age Structure
(Percentage point change in growth of health spending)
1980-90 1990-2000 2000-20 2020-40
France 0.38 0.60 0.51
United States 0.26 0.12 0.48 0.46 Japan 0.69 1.03 0.77 0.18 Germany 0.38 0.47 0.48 Italy 0.69 0.51 0.68 United Kingdom 0.16 -0.02 0.25 0.30 Canada 0.33 0.51 070 045
Source: OECD.
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Table 10. France: Public Expenditure on Health
Expenditure in percent of GDP
Age-dependent spending ratio* 1960 1992 2000+ 2030+
France 2.4 2.4 7.0 6.9 8.5
United States 9.0 1.3 6.0 6.4 9.3 Japan 4.8 1.8 5.0 5.1 6.2
Germany 2.2 3.2 6.2 6.1 7.5 Italy 2.2 3.0 6.5 6.3 8.0 United Kingdom 3.2 3.3 5.9 5.8 7.0 Canada 4.5 2.3 7.5 7.1 10.1
* Ratio of per capita public spending on health of those aged 65 and over and of those aged less than 65. + Projection, assuming 1 1/2 percent productivity growth per year
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Table 11. France: Hospital Care Statistics, 1990
Total beds* Occupancy rates** Admission rates***
France 9.7 77.3 21.4
United States 4.7 66.8 12.4
Germany 10.4 86.4 18.5
United Kingdom 5.9 76.2 13.2
Canada 6.3 82.7 13.8
Source: OECD.
* Number of beds per 1000 inhabitants. ** Ratio of beds filled to beds available *** Ratio of number of patients admitted to hospital per year to population
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Schieber, G, J.P Poullier, and L Grecnwald, 1994,"Health System Performance in OECD Countries, 1980-1992," Health Affairs. Vol 13, tfo 4. pp 100-12
Wolf, P and D Moran, 1993, "Global Budgeting in the OECD Countries/1 Health Care Financing Review. Vol. 14, No. 3 (Spring)
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n. Social Security, Tax Reform, and Unemployment: A General Equilibrium Analysis1
It should be known that at the beginning of a dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.
Ibn Khaldun, An Introduction to History, 1377.
Executive Summary
The French authorities have introduced a number of reforms to the systems of taxes and social contributions over the past few years, with a view to achieving positive effects on the labor market. In particular, sizable targeted cuts have been made in social contributions paid by employers in respect of low income workers. Currently, a reduction is planned in social security contributions paid by employees (financed by increasing a broad-based income tax), although this measure is not primarily aimed at increasing employment.
To shed theoretical light on the possible policy impact of measures of this kind, this paper develops a simple general equilibrium model with two types of labor and capital to analyze the effects of social security tax reform for the French economy. The model permits an evaluation of various tax policies in terms of their impact on the labor market and economic activity, as well as their budgetary impact. The model is used to assess both the impact of past policies, notably targeted reductions in employer social security taxes, and of the proposed reform of health care financing, which will involve reductions in employee social security taxes.
Employer social security tax reductions targeted to unskilled (low-income) workers which are financed by an income tax on all incomes to offset the short-run budgetary loss appear to have the following effects:
In the short run (i.e., before capital adjusts), overall employment increases by 0 1 percent, while unskilled employment increases by 0.3 percent for each point reduction in the social security tax Skilled employment declines slightly, while the net-of-tax rate of return on capital increases
In the long run, employment grows by 0 4 percent and the tax reform makes a positive contribution to the budget This employment increase is associated with a reduction in after-tax wages of unskilled workers Returns to skills, taking into account higher employment probabilities for the unskilled, decline The employment effect of this targeted reduction in
Prepared by Caroline Van Rijckeghem
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employer social security taxes is about six-fold the size of the employment effect of an untargeted reduction in employer social security taxes (for equal initial budgetary cost).
Employee social security tax reductions financed by a broad-based income tax, on the other hand, have a negative effect on employment in the long run, as higher taxes on income from capital act as a disincentive to investment, while labor costs are not reduced.
In the short run, employment increases by 0.1 percent. The after-tax rate of return on capital declines substantially, however.
In the long run, employment declines by 0.2 percent and the tax reform has a negative impact on the budget.
To the extent that taxation of capital was less comprehensive while taxation of transfers was more comprehensive than modeled, as would indeed be the case under the envisaged reform of health care financing, or minimum wages evolved differently, these long run costs would be mitigated.
The results of exercises that are not budgetarily neutral indicate that various types of tax reductions—be they reductions in employer or employee social security contributions, or reductions in income taxes—have positive effects on the budget in the long run. This finding of a form of self-financing (also obtained by Laffargue (1996) for France) results as much from lower unemployment insurance outlays—an aspect which has not received much attention—as from a higher tax base.
While this result is sensitive to the assumption that wages are not very responsive to unemployment (as a result, workers do not capture the benefits of lower employer taxes), it strongly suggests the presence of a virtuous circle indicating the desirability of reducing various taxes as soon as permitted by the budgetary situation.
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A. Introduction
In recent years, industrial countries have come to see high social security taxes as an important impediment to employment creation. As a consequence, a number of countries have reformed the financing of their social security systems. France, in particular, has since 1993 taken an active stance in reducing social security contributions, notably for unskilled workers.2 In France today, labor cost reductions at the level of the minimum wage based on exemptions from employer social security contributions range from 12 percent to 21 percent for the long-term unemployed. For part-time workers, the reduction in labor costs can be as high as 19 percent. Workers earning as much as 1.33 times the minimum wage benefit from partial exemptions. All-together more than 5 million persons benefited from social security tax reductions in 1995.
French economists have noted that these policies may be bearing some fruit: the number of long-term unemployed declined by 6.4 percent between end-1994 and end-1995, notwithstanding the economic slowdown. Also, since 1993 low-wage employment has been growing more rapidly than expected based on output developments (Duchene, et. al. 1996). A precise estimate of effects cannot be obtained empirically, however. While many countries have carried out social security reforms, the modalities of these reforms have varied (targeted versus across the board cuts, cuts in employer versus employee contributions, various financing methods) so that there are few observations for specific types of reforms. It is also difficult to control for a myriad of other factors, including cyclical effects, technological change biased against unskilled labor and competition from low-income countries.3
In view of the above, this paper takes a modeling strategy to assess the effect of past and prospective reforms of social security taxation. It follows a long tradition of general equilibrium analysis of taxation pioneered by Harberger in the 1950s and 1960s and computable general equilibrium analysis first applied by Shoven and Whalley in the early 1970s.4 Such models capture interactions between various markets, unlike partial equilibrium
2The United Kingdom, the Netherlands, and Belgium have introduced social security tax exemptions for low-income workers. In the case of the Netherlands and Belgium these exemptions amount to reductions in labor costs of 5 and 10 percent, respectively, at the level of the minimum wage Germany has focussed on providing temporary exemptions from social security taxes to the long-term unemployed (Conseil Superieur de 1'EmploL des Revenus. et desCoQts, 1996) See also OECD (1995)
'The survey of empirical work in this area by Zee (1996) indicates that there is considerable uncertainty surrounding the magnitude of effects of tax changes (see also below)
4See Shoven and Whalley (1992) and Dervi§, de Melo, and Robinson (1982) for literature surveys
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models, where (most) prices are taken as given.5 The model has the simplest structure compatible with the need to study the effects of tax reform on the labor market. It assumes an open, price-taking economy, with three factors of production (skilled labor, unskilled labor and capital), involuntary unemployment, and capital mobility.6 There is only one (competitive) sector—thus the model does not contain an input-output matrix as do many computable general equilibrium models.7 The labor market is characterized by both "wage curves" (a sort of "surrogate labor supply curve" which can be rationalized by a variety of models, including bargaining, efficiency wage, and implicit contract models) and minimum wages.8 Long run equilibrium is achieved when after-tax domestic and foreign rates of return achieve a certain balance, thus removing any incentive for capital flows. The demand side need not be specified, as this equilibrium condition is consistent with any behavior for consumption (e.g., Keynesian or optimizing).
The set-up of the model closely resembles previous work by Agenor and Aizenman (1996), which also stipulates a surrogate labor supply curve for skilled labor in a general equilibrium model. This stipulation permits one to move away from the standard analysis of incidence of social security taxation which assumes inelastic labor supply and inevitably concludes that the burden of social security taxation is on wages.9 Specific functional forms are adopted here in order to obtain numerical results.10 The paper is also similar to recent French work by Laffargue (1996) and by Germain (1996) in a number of respects, notably the computable general equilibrium approach, the absence of labor market clearing, and the assumption of an open capital account. The three models are complementary in the sense that
5 Hamermesh (1993) provides an overview of partial equilibrium studies of the effects of social security taxes (pp. 166-182)
6 See Lenjosek and Whalley (1986) for a model with similar structure, but several goods
7 More sectors could be introduced should the focus be on consequences of tax reform for individual sectors or for foreign trade.
1 See, Blanchflower and Oswald (1994) for a good survey of the empirical and theoretical literature on equilibrium wage curves and a formal exposition of various models generating wage curves
* See Hamermesh (1993), pp 172-173, for example
10 The model developed by Agenor and Aizenman is more suitable for qualitative analysis The model developed in this paper also differs from Agenor and Aizenman in that the long-run equilibrium condition for the rate of return of capital is determined by an interest parity condition, where Agenor and Aizenman rely on the optimally condition for consumption in an intenemporal optimization model of a closed economy The qualitative effects of social security tax reductions are also examined by Arms (1995) in a two-sector, two-factor (skilled and unskilled labor) theoretical model
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they build on different characterizations of production and the labor market (see below). A contribution of the present model is that it provides a direct link to the empirical literature on the wage curve, while also being transparent in its effects and solvable using the simple log- linearization method.
The model is used to explore the impact of a reform package in which a cut in employer social security taxes is offset by an increase in a broad-based income tax to avoid any short run loss of revenue. This broad-based income tax covers all income from labor (without income threshold) and capital. In an alternative scenario, social security tax reductions are targeted on low-income workers. In a third scenario, which mimics the current proposals for the reform of health care financing, a reduction in employee social security taxes is financed by a broad-based income tax.11 For each scenario, the budgetary implications without offsetting financing are also examined. The results are compared and contrasted with the results obtained from other models of the French economy constructed by Laffargue (1996) and by Germain (1996).
B. The Model
A one-sector, three-factor general equilibrium model with different wage-setting mechanisms for skilled and unskilled labor is developed (see Appendix I for more details). The model is solved for both the short run and the long run, in which capital has adjusted to its new equilibrium and elasticities of substitution have reached their long run levels. Wages of the unskilled are determined by the minimum wage and wages of the skilled are determined according to a surrogate labor supply curve as a function of unemployment.12 Minimum wages are assumed constant, reflecting the leeway of the government in according annual increases in line with economy-wide developments l3
In a nutshell the model functions as follows. Employment and output respond to tax reform through the interaction of labor demand and (surrogate) labor supply, hence
11 The extent to which capital will be taxed under current French proposals for the reform of health care financing is smaller than modeled here This mitigates the negative long run effects obtained in the simulations of this paper
12 In the case of France, the minimum wage covers about 10 percent of employees (Moghadam, 1995), so that the labor supply of low-wage earners can be considered to be elastic
13 Minimum wages are adjusted according to three mechanisms First, a rise of 2 percent or more in the CPI automatically triggers an equivalent rise in the SM1C, second, on July 1 each year, the SM3C is adjusted by half the change in real hourly wages in industry, third, the Government can accord discretionary increases
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employment eflfects depend critically on the elasticities of labor demand and (surrogate) supply. The more inelastic is (surrogate) labor supply, the more labor appropriates the "room" created by, say, a reduction in social security taxes, through higher wages (and the smaller the employment impact and increase in rate of return on capital).14 The elasticity of demand for various types of labor, in turn, is a function of the degree of substitution between factors (the substitution effect), as well as of the slope of the marginal cost function (the expansion effect).15
What distinguishes the approach taken here from the partial equilibrium approach, is the interactions between various labor markets. In partial equilibrium the effects on employment of skilled and unskilled workers of, for example, a reduction in social security taxes of unskilled workers, are calculated assuming that wages of skilled workers remain constant. Here, there will be a partial offset to the substitution of unskilled for skilled labor (induced by lower relative costs of unskilled workers) through the effect of higher unemploy- ment among skilled workers on their wages. Substitution and expansion effects are also simpler to calculate.16
The factor price frontier plays a critical role in the model. In the short run, capital is constant. The rate of return on capital is determined residually by the factor price frontier. If the net rate of return on capital increases as a result of tax reform, capital accumulation receives positive impetus. In the long run, capital adjusts so as to eliminate any excess returns. The gross rate of return on capital adjusts so as to offset any changes in taxation of capital, while the labor cost of unskilled workers adjusts mechanically to changes in employer social security taxes on unskilled labor. The factor price frontier in turn determines the labor cost of
14This corresponds to the usual result ("Dalton's Law") according to which a factor which is provided inelasticically bears the full burden of a tax (in this case, the full benefit of a tax reduction). For a formalization of "Dalton's Law" of proportionality between incidence and relative elasticities of demand and supply of various factors see Keller (1980), p 17
15 See Johansen (1972), p. 125, for a derivation of the elasticity of factor demand in terms of expansion and substitution effects.
16 Knowledge of the direct elasticities of substitution (the percent change in relative quantities demanded corresponding to the percent change in relative factor costs) is sufficient, as these correspond to the partial elasticities in the nested CES function, in whose terms the model's solution is expressed. In partial equilibrium analysis, substitution effects are expressed in terms of Allen elasticities (the percent change in factor demand corresponding to a one percent change in the cost of a factor, at constant output), which are more difficult to calculate from the basic parameters of the production function For a derivation of Allen elasticities from the partial elasticities in the nested CES function, see Keller (1980), pp 79-84
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skilled workers. Employment of skilled workers adjusts so as to ensure compatibility between unemployment and wages, as determined by the surrogate labor supply curve.
C. Simulation Results
Three types of simulations were conducted. The first involves reducing various social security taxes in a number of ways without requiring a balanced budget, i.e., without altering the broad-based income tax. The second involves a balanced budget reduction in various social security taxes. The third is a sensitivity analysis to gauge the impact of critical parameters, notably those capturing (a) the effect of unemployment on wages and (b) the effect of the unemployment insurance replacement ratio on budgetary expenditures. In interpreting the results it should be recalled that certain complexities of the French tax system and economy are not taken into account in the model.17
Social security tax reduction without offsetting tax increases
Employer social security taxes
Table 1 presents the results of two simulations The first simulation reflects the effect of a 1 point reduction in the social security tax which does not distinguish between skilled and unskilled workers. In the second simulation the social security tax is reduced only for unskilled workers, by an amount which has the same short run budgetary cost as the first policy experiment (that is, by 6 points). Results are presented both in the short run and the long run
The first striking finding is that a reduction in social security taxes actually leads to budgetary savings in the long run. This finding amounts to a type of Laffer curve result, perhaps first noted by the social historian Ibn Khaldun in his An Introduction to History in 1377 and also observed by Adam Smith in 1776 and Jules Dupuit in 1844.18 Here the budgetary savings result from the combination of increases in the tax base (the focus of most previous work) and savings on outlays for unemployment insurance. The latter are quite important in a country such as France, given high replacement ratios in the first year of lThe broad-based income tax is close in spirit to both the CSG and RDS Its coverage of capital income is somewhat broader than of the RDS and in particular the CSG The broad- based income tax of the model does not cover unemployment benefits, pensions, or family allowances This is of limited consequence in estimating the effects of the Government proposal for reforming health care financing, as the introduction of the new broad-based health tax on unemployment benefits and pensions will be offset in large part by reductions in social security contributions levied on these incomes. Consumption, labor force participation, and tax evasion are also not modeled.
!8The references to Smith and Dupuit are from Fullerton (1980)
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unemployment. The relationship uncovered here is in fact not a LafFer curve, as a reduction in tax rates (from the current rate of 69 percent of gross wages) does lead to a decline in tax revenues, notwithstanding the expanding tax base.19 20
In the first policy experiment, employment growth on average is 0.2 percent in the short-run and 1 percent in the long-run. Employment of skilled workers increases by 0.2 percent, while employment of the unskilled increases by more, by 0.3 percent, reflecting the fact that wages of the unskilled remain constant at the minimum wage. Wages of skilled workers increase, as part of the reduced tax burden on employers is shifted to employees, ensuring a balance between higher wages and higher employment. The rate of return on capital increases in the short run, leading to increased investment and a higher capital stock (+0.8 percent) in the long run.21
The second policy experiment leads as expected to a stronger growth of employment of the unskilled (1.7 percent in the short run and 7.9 percent in the long run). The capital stock and output also increase by more in the long run than under the first experiment, while net wages of skilled (i.e., after-tax wages) increase by equal amounts in both experiments in the long run. The long run budgetary savings are also higher under the second experiment.
Finally, note that returns to skills, as captured by differentials in labor incomes between skilled and unskilled (including unemployment benefits) increase under the first policy experiment, but decline under the second experiment (in both the short and long run), reflecting the strong employment growth for unskilled when social security tax reductions are targeted to the unskilled.
Employee social security taxes
Table 2 presents the effects of a 1 point reduction in employee social security tax rates The budgetary cost is 0.7 percent of GDP in the short run. Even in the short run, important increases in skilled employment, labor incomes, and the rate of return on capital are recorded (first column). In the long run, a cut in employee social security taxes by itself contributes to
**The tax rate which maximizes revenue is 74 percent in the simulations
20 These results are sensitive to the assumed relationship between wages and unemployment For a discussion of the sensitivity of the finding of self-financing to the assumptions on (a) the relationship between wages and unemployment and (b) the effective unemployment replacement ratio (see the sensitivity analysis below).
21Note that in the long run the model can be solved recursively from the factor price frontier At unchanged income taxes, the required rate of return on capital is constant, so that, given labor costs of unskilled workers as determined by the minimum wage and employer taxes, labor costs of skilled workers follow from the factor price frontier
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budgetary savings (as did a cut in employer social security taxes) and leads to an expansion of output and employment of one percent, and in labor incomes of over one percent, while income differentials between skilled and unskilled workers widen somewhat (second column).
Budgetarily neutral reduction of social security tax
Employer social security taxes
The overall and targeted reduction in social security taxes are now examined assuming a broad-based income tax is levied so as to offset any short run budgetary losses.
The results of the first two balanced-budget experiments parallel those found in the experiments (see Table 1) where broad-based income taxes were not increased. Overall employment and employment of the unskilled increases markedly more when the social security tax reduction is targeted to the unskilled. In the short run, overall employment increases 0.4 percent in the second experiment compared to 0.1 percent in the first experiment (see first two columns of Table 3). Unskilled employment increases by 1.7 percent compared to 0.3 percent. However, skilled workers fare worse both in terms of employment (-0.1 versus +0.1 percent) and net wages (-0.2 versus 0.1 percent). For the unskilled the increase in income taxes involves a reduction in net (i.e., after-tax) wages of 0.4 percent.22 Finally, note that the income tax increase required is 0.37 points, or markedly below the share of labor in GDP (0.67).23
In the long run, the above tax reforms lead to substantial employment gains and a positive budgetary contribution (see third and fourth column of Table 2). The negative effects of higher income taxes on capital accumulation fail to outweigh the positive effects of lower social security taxes Note that the impetus to higher employment results in part from the fact
Recall that the broad-based income tax covers unskilled workers.
reflects two factors: higher employment and higher gross wages As long as (surrogate) labor supply is not fully elastic, a one for one shift from employer taxes to employee taxes (whether income or social security taxes) will lead to higher gross wages Since gross wages constitute the tax base for both employer and employee taxes, a one for one shift from employer to employee taxes also has a positive effect on the budget. This turns out to account for 80 percent of the shortfall between labor's share of 0 67 and the required offset in income taxes of 0.37. Twenty percent of the shortfall is accounted for by the increase in employment (which is quite small in the short run because employment has not fully adjusted)
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that minimum wage is not compensated for higher income taxes (leading to a reduction in net wages of the unskilled of 0.44 percent).24
Employee social security taxes
The third and fourth columns of Table 2 give the results of the simulations of a cut in employee social security taxes which is neutral in budgetary terms in the short run. A first result is that a 1 point reduction in the social security tax requires an offsetting increase in the income tax of 0.68 points in the short run (column 3).25 In the short run, overall employment increases by 0.1 percent, which is folly accounted for by increases in skilled employment. The mechanism which allows this to occur is a reduction in gross wages of skilled workers, who shift part of their reduced tax burden onto employers. Net incomes increase for both skilled and unskilled workers. Finally, the net rate of return on capital drops substantially and investment declines. In the long run, this tax reform has a negative impact on the budget (of 0.3 percent of GDP; see column 4), unlike the result observed for a reduction in employer social security taxes. This reflects the reduction in the real rate of return on capital, as labor costs for unskilled remain rigid, and the resulting decumulation of capital. Employment declines by 0.2 percent, with the brunt of the decline borne by unskilled labor. Income differentials between skilled and unskilled workers narrow.
Sensitivity analysis
The first parameter which is investigated is the unemployment elasticity of wages in the surrogate labor supply curve. This parameter is critical as it determines the level of employment (and hence tax revenues) which is compatible with the new long run equilibrium wage (itself determined by the factor price frontier, the rate of return constraint, and the fixed minimum wage).26 The elasticity adopted in the base-line scenario corresponds to the estimate obtained by Blanchflower and Oswald (1994) for other European countries that a one point
24 When minimum wages are compensated for higher income taxes, all variables remain essentially unchanged from base-line in the long run. When the unskilled are exempt from the levy of (or increase in) the broad-based income tax, employment and output do expand in the long run, but at the cost of declining employment and net wages of skilled workers These results are not reported here
:5Smce one type of employee tax is being replaced by another of smaller magnitude (given taxation of capital), and some of the benefits are shifted to employers, gross wages of the skilled decline, thereby reducing the tax base This is offset by the effects of higher employment on the budget, so that overall, the required income tax increase just corresponds to labor's share in value added
26 See, for example Fullerton (1980), for work on the relationship between labor supply elasticities and tax revenues in the US
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increase in the unemployment rate leads to at most a 0.1 percent reduction in the wage. While this estimate was obtained for a number of countries, there is uncertainty as to whether it reflects an equilibrium relationship or a supply relationship.
Other work, taking a different vantage point, indicates that the elasticity could be much higher than 0.1. The findings of Cotis (1990) for France, for example, indicate that labor taxes are borne in full by labor. This is echoed by Zee (1996) who concludes that many studies do find "that the impact of taxes on unemployment and/or on their forward shifting into wage costs are strongest in the short run, and that the effect fades or even disappears in the longer run when the real wage level has adjusted to the tax change." These findings are compatible with a number of explanations, notably competitive labor markets with inelastic labor supply, strong substitutability of contributions and net wages, and insider-outsider wage-setting.27 A first experiment is then to check the results when the unemployment elasticity of the wage is infinite.
The results are given in the first four columns of Table 4. A reduction in social security tax now does involve a budgetary cost in the long run (column 4), as (un-)employment of skilled workers remains constant, imparting a smaller increase in the tax base and a smaller reduction in outlays for unemployment benefits. Nevertheless, the negative budgetary impact diminishes over time (-0.35 percent of GDP in the short run and -0.17 percent of GDP in the long run) (columns 3 and 4). The contrast with the scenarios where the elasticity was -0.1 is less stark for the case of the balanced budget experiments. The same rate of income tax is required for a balanced budget; the positive contribution to employment is somewhat lower but of the same order of magnitude (columns 1 and 2 of Table 4 compared to columns 1 and 3 of Table 3).
The second variable to be examined is the unemployment benefit replacement ratio Previous simulations assumed, in line with existing evidence on job search, that persons filling newly created jobs had been unemployed for only a short-time. When tax reform is accompanied with active labor market measures, the long-term unemployed might come to fill these jobs. In that case, budgetary savings would be less given the French system of lower replacement rates for longer-term unemployed. The last column of Table 4 shows the long run effects of assuming that unemployment benefit replacement rates are 30 percent for the skilled and 60 percent for the unskilled (compared to previous assumptions of 60 percent and 75 percent respectively) The striking finding is that a uniform social security tax reduction continues to generate some budgetary savings in the long run when effective unemployment benefit replacement rates are low. Apparently, tax rates are sufficiently close to revenue- maximizing rates (69 percent compared to 74 percent, as obtained from simulations) that even
:?This assumes that the wage is initially sufficiently below the sum of the reservation wage and the cost to the firm of replacing insiders with outsiders (consisting of severance pay, training costs, and costs which insiders can inflict by withdrawing cooperation from new hires or by striking) See Lindbeck and Snower (1988) for further details
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small savings related to lower expenditures for unemployment benefit suffice to generate self- financing. The savings are about two thirds of savings under the baseline scenario (column 3, Table 1). Otherwise the findings are identical, except for the fact that total labor incomes (including unemployment benefits) increase by more now that the transition from unemployment to employment involves larger increases in income.
Approximation errors
Gauging the effects of tax reform of a large magnitude is subject to approximation errors as the linearization of the equations in the model is valid only for small changes. For example, the change in tax revenue is approximated by the sum of (1) the change in tax rates multiplied by the old tax bases and (2) the change in tax bases multiplied by the old tax rates. Thus the interaction between change in tax base and change in tax rate is missed. To capture this interaction would introduce non-linearities. Another approximation error results from the use of constant shares in the production function, whereas factor shares are not constant in CES production functions. The errors appear small, however. For example, a general social security tax reduction financed by an increase in income tax would really involve a positive contribution to the budget of about 0.02 percent of GDP, rather than budgetary neutrality, in the short run.28
D. Alternative General Equilibrium Results
This section presents results of two recent general equilibrium models of the French economy designed to study the effects of social security tax reform The labor market structure in these models allows for involuntary unemployment as above The model by Laffargue (1996) is the most comprehensive. It includes modules for government debt dynamics, intertemporal optimization of consumption, bargaining, imperfect competition, and a complete specification of the French tax system, covering inter alia, social security, income, and profit taxes, taxation of returns to savings, VAT, investment taxes, and production taxes Germain (1996) employs a simpler model, where the surrogate labor supply is based on a relationship between labor's share in value added and unemployment. While the results of the three models are qualitatively similar—all models exhibit positive employment effects and small or no budgetary costs in the long run—the precise estimates of the employment and budgetary effects vary across the models
The results—summarized in Table 4—can be understood in terms of the different assumptions of the models. First, employment effects are strongest in Germain, who assumes the strongest response of wages to unemployment Employment effects are weakest in
2tThis result should not be surprising Fuller, Henderson, and Shoven (1982) report that approximation errors are small for the Harberger two-sector, two-factor model, based on a comparison of results based on linearization and Scarf algorithm
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Laffargue, apparently on account of lower elasticities of substitution between skilled labor and capital and skilled and unskilled labor. Second, in both papers positive long run budgetary effects are smaller than in the model developed in this paper. While Laffargue also finds a positive effect on the budget, this effect is of a much smaller magnitude. Germain finds that tax cuts lead to a small budgetary deficit. He nevertheless finds important supply effects: without changes in the tax base and unemployment outlays, the negative budgetary effect would have been 10 times as high. The differences can be traced to the specification of the French tax system (Germain) and to effects on activity (and to a lesser extent assumed unemployment benefit replacement rates) (Laffargue). Germain models tax gains from higher activity as proportional to the overall increase in value added, whereas both Laffargue and this paper specify more complex relationships. Laffargue obtains weaker employment effects than both the model in this paper and Germain.
Given the uncertainty surrounding, inter alia, the appropriate formulation for both the production function (see Appendix I, section 1) and the surrogate labor supply curve, one set of estimates is not clearly superior to another. The results from the three models should rather be seen as spanning a range of estimates for the effects of social security tax reform.
As regards the effects of a financed social security tax reduction, Laffargue and Germain identify combinations of policies which lead to both net employment creation and positive budgetary contributions. In the case of Laffargue, one possible combination is that of a tax on output and a social security tax reduction. In the case of Germain, it is a combination of an income tax which covers pensioners and a social security tax reduction
£. Conclusion
The model developed in this paper produces both encouraging and sobering results Budgetarily neutral reductions in employer social security taxes, whether global or targeted, that are financed through a broad-based income tax can generate positive employment effects, but not without reducing after-tax wages of unskilled workers The simulation results indicate that, in the long run, the employment effects range from 0.3 percent for reductions in global employer social security taxes to 2.2 percent for targeted cuts with equal budgetary impact (reductions in tax rates of 1 and 6 points respectively) These reductions are associated with a decline in after-tax wages of unskilled workers of 04 percent Reductions in employee social security taxes, while not involving a reduction in after-tax wages of unskilled workers, have less of an effect on employment in the short run and have negative effects on employment in the long run These sobering results on budgetarily neutral tax reform follow from the negative impact of capital taxation on capital accumulation and the assumption that investment needs to meet a rate of return test on world capital markets, which seems to be a reasonable assumption in the context of increasing capital market integration
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On the other hand, reductions in social security taxes which are not financed by a broad-based income tax generate powerful positive employment and income effects, and are self-financing in the long run. The finding of self-financing is also present in other recent work on the French economy, notably by Laffargue (1996). This finding is sensitive to the assumptions of the model, especially the relationship between wages and unemployment, where the simulations assume that a one point increase in unemployment leads to a 1 percent reduction in wages. With greater responsiveness of wages to unemployment (i.e., a less elastic surrogate labor supply), tax reform tends to contribute less to the budget. The possibility of a virtuous circle cannot be dismissed, however: the elasticity estimate of 0.1 was obtained for a number of countries in empirical work by Blanchflower and Oswald and seems reasonable. One policy implication of the presence of self-financing is that it may be desirable to reduce the tax burden fairly quickly, subject to budgetary constraints.
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Table 1. France: Response to Employer Social Security Tax Reduction Without Offsetting Tax Increases
(Percent change, unless indicated otherwise)
Short Run Long Run Overall Unskilled Overall Unskilled 1 percent 6 percent 1 percent 6 percent (1) (2) (1) (2)
Surplus (percent GDP) -0.39 -0.39 0.32 1.19
Output 0.13 0.19 0.83 1.84
Capita] stock 0.83 1.84
Total employment 0.21 0.51 1.00 2.80
Employment, skilled 0.18 -0.01 0.62 0.60
Employment, unskilled 0.29 1.73 1.87 7.92
Labor income, skilled 0.30 -0.01 1.03 1.02
Labor income, unskilled 0.06 0.38 0.41 1.73
Rate of return 0.95 1.34 ~ — Labor costs, skilled -0.45 -001 0.14 0.82
Labor costs, unskilled -0.69 -406 -069 -4.05
Wages, skilled 0.24 -001 083 082
Wages, unskilled — — — — Net wages, skilled 0.24 -0*01 083 082
Net wages, unskilled ~ — — — Investment/ net rate of return 0.95 1 34 — —
Source: Fund staff simulations.
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Table 2. France: Response to Employee Social Security Tax Reduction (Percent change, unless indicated otherwise)
Without Offsetting Taxes With Offsetting Taxes Short Run Long Run Short Run Long Run (1) (2) (3) (4)
Income tax (points) ~ 0.68 0.68
Surplus (percent GDP) -0.73 0.12 - -0.26
Output 0.19 0.99 006 -0.32
Capital stock 0.99 -- -0.68 — Total employment 0.25 0.99 0.08 -0.22
Employment, skilled 0.35 0.99 0.11 -0.02
Employment, unskilled -0.01 0.99 -- -070
Labor income, skilled 0.58 1 64 019 -0 04
Labor income, unskilled 1.06 128 034 019
Rate of return 1.37 0 44 0 73
Wages, skilled -0.85 -0 27 -0 45
Wages, unskilled „ — Net wages, skilled 047 1 32 0 15 -003
Net wages, unskilled 121 121 038 038
Investment net rate of return 1.37 -0 30
Source Fund staff simulations
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Table 3. France: Response to Employer Social Security Tax Reduction With Offsetting Tax Increases
(Percent change, unless indicated otherwise)
Short Run Long Run Overall Unskilled Overall Unskilled 1 percent 6 percent 1 percent 6 percent 0) (2) (3) (4)
Income tax (points) 0.37 0.37 0.37 0.37
Surplus (percent GDP) — 0.12 0.99 — Output 0.06 0.12 0.13 1.14
Capital stock -0.06 0.95 — — Total employment 0.12 0.42 0.34 2.15
Employment, skilled 0.05 -0.14 0.08 0.07
Employment, unskilled 0.29 1.73 0.96 7.00
Labor income, skilled 0.09 -0.27 0.13 0 12
Labor income, unskilled -0.32 -001 -0 18 1.11
Rate of return 045 0.84 0.39 0.39
Labor costs, skilled -0.14 0.30 -0 .10 0.58
Labor costs, unskilled -0.69 -4.06 -069 -4.03
Wages, skilled 0.55 0.30 059 058
Wages, unskilled — — — — Net wages, skilled 007 -0 18 0 11 0.09
Net wages, unskilled -044 -044 -044 -0.44
Investment/ net rate of return 0.05 045 — — Source: IMF staff simulations.
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Table 4. France Sensitivity Analysis: Effect of a 1 Point Increase in Employer Social Security Tax (Percent change, unless indicated otherwise)
Balanced Budget Without Offsettine Tax Increases Short Run Lone Run Short Run Lone Run Long Run Inelastic labor supply Low replacement
Income tax (points) 0.35 0.28 — — — Surplus (percent GDP) -0.35 -0.17 0.22 — — Output 0.03 0.09 0.03 0.21 0.83
Capital stock -0.06 0.21 0.83 — — Total employment 0.09 0.29 0.09 0.38 1.00
Employment, skilled 0.62 — — — — Employment, unskilled 0.29 0.97 0.29 1.25 1.87
Labor income, skilled 0.21 0.27 066 079 1.23
Labor income, unskilled -0.31 -0.08 006 0.27 067
Rate of return 0.23 0.30 0.23 - — Labor costs, skilled -0.01 -0.04 -0.01 0 14 0.14
Labor costs, unskilled -0.69 -0.65 -0.69 -069 -0.69
Wages, skilled 069 0.67 069 083 0.83
Wages, unskilled « — — — — Net wages, skilled 0.22 0.28 069 083 083
Net wages, unskilled -0.43 -0.33 — — — Investment/net rate of return -0 15 023 -- — — Source: Fund staff simulations.
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Table 5. France: Long-Run Effect of Employer Social SecurityTax Reductions in Various Models
Germain (1996) Laffargue(1996) This paper
Effect of 1 point targeted reduction
Employment (percent) 0.71 0.16 0.48
Budget (percent of GDP) -0.03 0.02 0.20
Effect of 1 point overall reduction
Employment (percent) 1.83 0.70 1.00
Budget (percent of GDP) -0.21 0.04 0.32
Assumptions unskilled amount to unskilled amount to unskilled amount to 20 percent of employment 20 percent of employment 30 percent of employment
for skilled and unskilled, the for skilled, the union share in elasticity of after-tax skilled semi-elasticity of labor's Nash bargain assumed to be wage to unemployment rate share to the unemployment 0.005 to obtain reasonable is -0. 1 ; unskilled are paid rate is - 1 . 1 (a one point "supply*1 curve; unskilled are the minimum wage increase in the rate causes a paid the minimum wage 1 . 1 per-cent reduction in the share)
interest rate determined from interest rate determined by interest rate determined foreign interest rate and tax risk-premium which from foreign interest rate rate on capital develops as a result of the and tax rate on income from need to borrow abroad when capital savings decline in response to higher income tax rate
translog with 3 types of labor nested CES with nested CES with and capital intermediate aggregate intermediate aggregate consisting of unskilled labor consisting of unskilled and and capital skilled labor
effect of higher tax base unskilled not subject to skilled unemployed subject calculated by assuming income tax. gross to income and social GDP is subject to a tax rate replacement rate is secuntv tax. unskilled not of 54 percent 60 percent subject to income tax. but subject to employee social secunn lax gross replacement rate is ^5 percent tor unskilled and 60 percent for skilled
Sources Laffargue( 19%) and Germain (19%)
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The Simulation Model
1. Production and Labor Demand
Output, X, is a function of three factors of production, employment of skilled workers, LS, employment of unskilled workers, LU, and capital, K. A two-stage CES production function is adopted following EC (1994), which used the model to investigate the effect of a reduction in payroll tax financed by a tax on energy. The first stage CES function combines effective labor, L, with capital, K, to produce output, X. The second stage CES function combines skilled and unskilled labor, Ls and LU, to produce effective labor, L.
Note that the formulation implies equal degrees of substitution between capital and different types of labor, which corresponds to the finding of Sneessens and Shadman-Mehta (1993) (the literature is not unanimous in this regard: Maurin and Parent (1993) find that substitution possibilities with capital are large for unskilled labor and small for skilled labor). Firms are assumed to maximize profits:
Here II represents profits. Wu and Ws are unskilled and skilled wages and Tp is the employer social security tax rate. The output price, wages, tax rates and the capital stock are taken as given. The output price is taken as the numeraire and set equal to one. The first-order conditions for profit maximization (the usual equality between factor costs and the value of marginal products) are:
Substituting the expressions for marginal products from the CES production function and ising the chain rule for differentiation one obtains the following labor demand functions:
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2. Wage-formation
Wages of unskilled workers, Wu, are assumed to be fixed at the minimum wage. For skilled workers wage determination is modeled following the extensive literature on equilibrium wage curves developed in the 1980s according to which "labor market equilibrium [...] lies at the intersection of the derived labor demand curve with a surrogate labor supply curve that lies to the left o£ and is flatter than, the true Marshallian labor supply curves'* (Woodford (1992), p. 396, as quoted in Blanchflower and Oswald (1994)). Specifically, after-tax wages of skilled workers are assumed to be a positive function of the reservation wage—assumed to be equal to the (constant) after-tax unemployment benefit 6S and a negative function of the unemployment rate of the skilled labor force, Us:
where Tn and Tpe stand for income and employee social security tax rates respectively. The applicability of such a surrogate labor supply goes beyond economies characterized by a high degree of unionization and collective bargaining. A surrogate labor supply also obtains based on efficiency wages or implicit contract theory (see e.g. Phelps (1994b) and Blanchflower and Oswald (1994)). In the functioning of the model, this wage curve will take the role of the labor-supply curve in competitive models. Note that inelastic surrogate labor supply can be modeled by setting the unemployment elasticity of the wage at infinity.
The skilled and unskilled labor forces are assumed to be constant.
3. Government Budget
The budget surplus, BS, can be written (in simplified form) as follows:
where R represents the rate of return on capital, Tn represents the income tax rate, 8 refers to the after-tax level of unemployment benefit, BILL refers to the wagebill, and U to the level of unemployment. Other components of the budget are not included as they are not affected by the variables in the model. The actual simulations will take into account differential tax rates for skilled and unskilled workers, as well as income from capital.
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4. Investment
Investment I is assumed to be a positive function, g, of the ratio of the after-tax rate of return on capital to the foreign rate of return, Rf. Note that this is not a very restrictive formulation. Investment can be positive even if the foreign rate of return exceeds the domestic rate of return. The assumed functional form only implies that a larger the rate of return differential is associated with greater incentives for investment. Note also that investment and the capital stock are not formally linked. However, since the model only calculates results for the short and long run, not for intermediate points, consistency between investment and the capital stock is not affected.
5. Solution
The model is solved using the well-known logarithmic linearization (see Johansen (1960) for the first empirical implementation of general equilibrium models (using linearization) and van de Klundert (1984) for a more recent example). The equations are written in terms of deviations in percent change around an initial path. The deviations from this path are equal to zero, except following a disturbance, which here will take the form of changes in payroll and income taxes. All deviations can then be expressed in terms of the changes in payroll and income taxes.
In the notation which follows, all variables in lower case represent percent changes from the e corresponding capitalized notation, with the exception of tax rates, tn, tp , and tp, which represent point changes and the budget surplus, bs, which is expressed in percent of GDP.
The production function can be re-written in percentage change terms as follows, where X's stand for production elasticities of various factors (the percent change in output corresponding to a one percentage change in the input). Given equality between factor costs and marginal products X's also correspond to the share of factors in output.
The percent change in factor demand can be expressed in terms of the elasticities of substitution between effective labor and capital, olf and between skilled and unskilled labor, o2. noting that oA-i/(i-pA).
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Ics and leu stand for percent change in labor costs. These can in turn be expressed in function of their components:
The rate of return on capital corresponds to the part of output not paid out to other factors:
Substituting the production function into this expression yields the factor price frontier:
In percentage change terms the investment equation can be written as follows, assuming a constant foreign rate of return:
where e is the elasticity of investment with respect to the rate of return.
The assumptions for wage determination of skilled workers and of a constant minimum wage applicable to unskilled workers translate into the following expressions:
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where \|/ is the unemployment elasticity of the wage and EURS represents the ratio of employment to unemployment of skilled workers. Finally, the change in the government budget surplus (as a percent of GDP), bs, can be expressed in terms of changes in income tax and social security tax rates. Writing first in levels, and then taking first differences and expressing in percentage terms yields:
Depending on the policy experiment, employer or employee social security tax rates are assumed unchanged:
This 12 equation model is then solved for the 14 variables, bs, tn, tp or tpe, x, k, r, 1, ls, lu, Ic*, leu, Ws, Wu, and i. The restriction i=0 in the long-run or k=0 in the short-run constitutes the 13th equation. The budget constraint, bs=0, or an assumption for some other tax rate (for non-balanced budget exercises) constitutes the 14th equation. Net-of-tax wages w^t and Wunet, and labor incomes (which include income from unemployment benefits), ins and inu then follow readily. EUR represents the ratio of employment to unemployment.
6. Relevant Parameters
Following EC (1994), it is assumed that total labor costs represent 67 percent of total costs, whereas the cost of unskilled labor (defined as the 3 bottom deciles) represents 16.8 percent of total labor costs. The elastidties of substitution are also from the same source, and are higher in the long-run than the short-run.
1 j«0.67 Labor's share in total costs
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Share of skilled labor in total costs
Elasticity of substitution between effective labor and capital Elasticity of substitution between skilled and unskilled labor
Tax rates and replacement rates are from Moghadam (1995). Replacement rates in the baseline scenario refer to those at initial stages of unemployment, as it is reasonable to assume that employment increases will draw on the short-term unemployed. Payroll tax rates are equal for skilled and unskilled workers. Only skilled workers and skilled unemployed pay income taxes. Income from capital is taxed at the average income tax rate.
Average income tax rate
Average employer social security tax rate Average employee social security tax rate
After-tax unemployment benefit level, skilled workers
After-tax unemployment benefit level, unskilled workers
Employment-unemployment ratios were calculated based on an assumption of an unemployment rate of 7 percent among the skilled and 16 percent among the unskilled, for a combined total of 10 percent. Corresponding to the estimate of Blanchflower and Oswald (1994), the elasticity of wages with respect to unemployment is assumed to be equal to - 0.1 (so that a 1 point increase in the unemployment rate leads to a 0.1 percent reduction in wages). For simplicity (as this has no consequence in the model), the elasticity of investment with respect to relative rates of return is assumed to be equal to 1.
Employment-unemployment ratio skilled workers
Employment-unemployment ratio unskilled workers
Elasticity of wages with respect to unemployment, skilled workers
Elasticity of investment with respect to relative rates of return
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References
Agenor, Pierre-Richard and Joshua Aizenman, 1996, "Does a Reduction in Payroll Taxes Lower Unskilled Unemployment," mimeograph International Monetary Fund (March).
Artus, Patrick, 1995, "Reduction du Cout du Travail Non Qualifier Un Cadre d1 Analyse," Working Paper, Caisse de Depots et Consignations, Service des Etudes Economiques et Finantieres.
Blanchflower, David and Andrew J. Oswald, 1994, The Wage Curve (MIT Press: Cambridge).
Coe, David T. and Dennis J. Snower, 1996, "Policy Complementarities: The Case for Fundamental Labor Market Reform," mimeograph International Monetary Fund (March).
Conseil Superieur de lEmploi, des Revenus, 1996, et des Couts, L'Allegement des Charges Sociales sur les Bos Salaires (Paris: La Documentation Fran^aise).
Cotis, Jean-Philippe and Abderrahim Loufir, 1990, "Formation des Salaires, Chomage d^Equttibre" et Incidence des Cotisations Sociales sur le Cout du Travail," Economic et Prevision, pp. 92-93 and pp. 97-110.
Dervi§, Kemal, Jaime de Melo, and Sherman Robinson, 1982, General Equilibrium Models for Development Policy (Cambridge: Cambridge University Press).
Dreze, Jacques H and Edmond Malinvaud, 1994, "Growth and Employment: The Scope of a European Initiative," European Economic Review\ V 38 (pp 489-504)
Duchene, Sandrine, 1996, Gerard Forgeot, and Alain Jacquot, "Analyse des Evolutions Recentes de la Productivite Apparente du Travail," Note of the Direction des Etudes et Syntheses Economiques, INSEE, No. 44/G221.
European Community, 1994, Economie Europeenne, Rapport Economique Annuel 1994 (No 56), Annexe pp 182-190.
Fullerton, Don, 1982, "On the Possibility of on an Inverse Relationship between Tax Rates and Government Revenues," Journal of Public Economics (October)
Fullerton, D A , A T King, J Shoven, and J Whalley, 1982, "Tax Integration in the USA General Equilibrium Approach/' American Economic RevieM
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Fullerton, Don, Yolanda K. Henderson and John B. Shoven, 1982, "A Comparision of Methodologies in Empirical General Equilibrium Models of Taxation," NBER Working Paper No. 911.
Germain, J.M., 1996, "Fiscalite et Heterogeneite du Marche du Travail. Presentation d!une Maquette dtquilibre General du Marche du Travail," mimeograph, Ministry of Finance, Direction de la Prevision.
Johansen, L., 1960, A Multisectoral Study ofEconomi Growth (Amsterdam: North-Holland).
Keller, W.J., 1980, Tax Incidence: A General Equilibrium Approach (Amsterdam: North Holland).
Laffargue, Jean Pierre, 1996, "Fiscalite, Charges Sociales, Qualifications et Emploi: Etude a L'Aide du Modele dtquilibre General Calculable de I'Economie Fran?aise "Julien," mimeograph .
Lenjosek, G. and J. Whalley, 1986, "A Small Open Economy Applied to the Evaluation of Canadian Energy Policy Policies Using 1980 Data," Journal of Policy Modelling, V. 8(1986), pp. 89-110.
Ljungqvist, Lars and Thomas J. Sargent, 1996, "The European Unemployment Dilemma," mimeograph Federal Reserve Bank of Chicago.
Johansen, L., 1960, A Multi-Country Study or Economic Growth (Amsterdam: North-Holland)
Habermeier, Karl F., 1995, "Labor Market Dynamics and Economic Policy," Background Paper to 1995 France Article IV discussions .
Hamermesh, Daniel S., 1993, Labor Demand (Princeton. Princeton University Press).
Maurin, E. and Parent, M.C., 1993, "Productivite et Cout du Travail Par Qualifications," Communication a La 18e Journee des Centrales de Bilans (23 novembre, Paris)
Moghadam, Reza, 1995, "Why is Unemployment in France so High0" in Paul Masson, ed , France: Financial and Real Sector Issues (Washington IMF)
O'Callaghan, Gary, 1995, "The Taxation of Returns from Personal Savings in France," in Paul Masson, ed , France Financial and Real Sector Issues (Washington IMF)
OECD, 1995, Jobs Stud\\ Taxation, Employment and Unemployment (Paris OECD)
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Phelps, Edmund S., 1994a, "A Program of Low-wage-employment Tax Credits," Working Paper No. 55 (New York: Russell Sage Foundation).
-, Structural Slumps, 1994b, (Cambridge: Harvard University Press).
Shoven, John B. and John Whalley, 1992, Applying General Equilibrium (Cambridge: Cambridge University Press).
Sneessens, Henri R. and Fatemeh Shadman-Mehta, 1995, "Real Wages, Skill Mismatch and Unemployment Persistence. France 1962-1989," Annales d'Economie et de Statistique, No. 37-38. van de Klundert, Theo, 1983, "The Energy Problem in a Small Open Economy," Journal of Macroeconomics, V. 5, No. 2 (Spring).
Zee, Howell, 1996, "Taxation and Unemployment," IMF Working Paper 96/45.
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HL Monetary Transmission1
A. Introduction and Overview
This paper attempts to characterize the main patterns of the monetary transmission mechanism in France. The objective is to examine how changes in the monetary authorities1 policy instruments affect some key macroeconomic variables (nominal and real), as well as the principal channels through which these effects operate. While the primary focus is on the effects of variables that are closely controlled by the monetary authorities, the impact of autonomous shocks to other, intermediate, transmission variables is also examined. The paper employs variants of the vector autoregression (VAR) methodology, building on the methodology presented in SM/96/118.
While this paper shares a number of features with other recent work on the subject, it also deviates from it in several respects. First, empirical work on the transmission mechanism in the case of France, as for other EU countries, has typically focused on a short-term domestic interest rate as the monetary policy instrument, very much in line with VAR models on the transmission mechanism for the U.S. economy. While such a choice would indeed appear natural for a relatively closed economy whose monetary authorities do not target the exchange rate, it appears less appropriate for a smaller and much more open economy where a central aspect of monetary policy is the stability of the exchange rate vis- a-vis other core ERM countries. This paper therefore examines separately the impact of changes in the short-term interest rate of Germany (by far the largest of the other core ERM countries) and changes in the French-German interest rate differential. Separate examination of the impact of these two variables appears justified on the following grounds: there are good theoretical reasons to postulate that the two components may affect the economy quite differently; such a decomposition would appear to capture better the context in which French monetary policy has been conducted; and it provides a convenient perspective from which to look at some of the possible consequences of EMU. Second, a "structural" VAR is implemented to allow short-term interest rates to be immediately affected by changes in the exchange rate, thus capturing an important aspect of the way French monetary policy has been conducted since the mid-1980s. Finally, the paper attempts to assess the importance of credit in the transmission mechanism.
The estimation results presented in this paper suggest thai the decomposition of the French interest rate into a German rate and a premium over the German rate is indeed fruitful. An important conclusion is that the two interest rate components affect certain key variables (both ultimate target variables and intermediate transmission variables) quite differently. This difference is particularly striking with regard to real activity: while the German component of the French short-term interest rate turns out to have had a
Prepared by Joaquim Levy and loannis Halikias
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significant impact on real GDP, the estimation results fail to indicate a similar impact from the short-term interest differential. In addition, simulations suggest that in France credit has an important role in the transmission of monetary policy.
The plan of the paper is as follows: Section B provides a brief summary of the literature and a discussion of the main channels through which monetary policy is usually thought to be transmitted, with a particular emphasis on the "money" and "credit" channels. Section C discusses the impact of interest rates on the economy. Section D examines the relative strength of the "money" and "credit" channels of monetary transmission. Section £ concludes.
B. Survey of the Literature on Transmission Channels
Previous empirical work
Empirical investigation of the monetary transmission mechanism typically attempts to describe how changes in certain key variables, whether policy instruments or intermediate transmission variables, affect the nominal and real variables that constitute the ultimate targets of the monetary authorities. Since the application of the VAR methodology to the study of monetary transmission in the United States by Sims (1980, 1981, 1986), and its further refinement by Litterman and Weiss (1984), the methodology has become a standard empirical tool in this area.2 Following the application of unrestricted VAR models to the study of monetary transmission in the United States, the methodology has more recently been applied to a number of European countries.3 Recent VAR-based studies of the monetary transmission mechanism for the case of France include Sims (1992), BIS (1995), and Barran, Coudert and Mojon (1996).
Sims (1992) attempts an international comparison of the monetary transmission mechanism in the G-7 countries. For the case of France, this paper estimates a six-variable VAR consisting, in that order, of the call rate (as the monetary policy instrument), the French franc/SDR exchange rate, a commodity price index, Ml money supply, the consumer price index, and industrial production, seasonally adjusted. Monthly data were used, and the model was estimated over a very large sample, ranging from 1965 to 1990. The paper identifies a discernible impact of the policy variable on both prices and real activity. Thus, a positive shock to the short-term interest rate is estimated to have a
:See SM/96'118 for a description of the methodology
3See, for instance. Dale and Haldane (1993) on the United Kingdom, Escnva and Haldane (1994) on Spain, and Boeschoten, van Els and Bikker (1994) and Garretsen and Swank (1994) on the Netherlands
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depressing impact on industrial production, with the effect materializing almost immediately in the wake of the shock and persisting over a period of 48 months. However, the estimated effect is rather small compared with the results for the other G-7 countries considered in the paper.4 The estimated impact on prices is rather surprising. An increase in the short-term interest rate is estimated to result in a rise of the CPI above its baseline path, with the effect persisting almost throughout the 48 month simulation period. Moreover, this effect is in sharp contrast to the estimated effect for the other G-7 countries: whereas some of them do experience an increase in prices in the wake of the interest rate increase, the effect is nowhere as persistent, and in fact consumer prices start to decline beyond a certain point, eventually falling beyond their baseline path.
Baran, Coudert and Mojon (1996) attempt a similar international comparison, though their focus is on EU countries. The authors estimate a five variable model including a short-term money market rate, the bilateral D-mark exchange rate, the consumer price index, real GDP, and a world export price index. They employ quarterly data and estimate the model over the period 1976-94. The estimation results for France are only in part consistent with Sims (1992). A positive shock to the short-term interest rate is estimated to result in a moderate depressing effect on output; however, the effect becomes statistically insignificant midway though the simulation horizon. On the other hand, an increase in short-term rates is estimated to have a small (but statistically significant) depressing effect on prices, almost throughout the simulation horizon. This latter conclusion is thus in sharp contrast to the results of Sims (1992) described above.
Transmission channels
The channels through which a tightening of monetary policy, via an increase in interest rates, exerts its impact on the economy have generated considerable theoretical and empirical debate. Until recently, the dominant view held that monetary policy operated mainly through its impact on monetary aggregates. More recently, however, an independent role for bank credit has been explored, and greater attention has been devoted to financial market prices as capturing important aspects of monetary transmission.5
The theoretical formulation underpinning the "money" channel of monetary transmission relies on a two-asset model, in which money and bonds are viewed as
Interpretation of the results is rendered more difficult by the fact that confidence intervals around the impulse response functions are not provided
5For a survey of the literature on the credit channel, with particular emphasis on its policy implications, see Alexander and Caramazza (1994)
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imperfect substitutes.6 Put rather simply, the transmission according to the money view works as follows: a tightening of monetary policy via an increase in the central bank's official rates leads to a decrease in commercial bank reserves, and hence reduces the ability of the banking system to generate deposits.7 This also implies that net bond holdings of banks must fall as well. Hence, the household sector must hold less money and more bonds. Under sluggish price adjustment, households will also find themselves holding lower money balances in real terms as well relative to the level they consider desirable, and asset market equilibrium will require an increase in real market interest rates. This, in turn, can have real effects on investment and spending on consumer durables, and ultimately on the aggregate level of economic activity; the more sluggish the price adjustment the larger will be the likely effect on economic activity.
On the other hand, transmission via a "credit" channel formally entails an extension of the menu of assets to three, by including bank loans as an imperfect substitute for bonds both on the liability side of firms' balance sheets and on the asset side of the balance sheet of banks.8 To gain insight on how the credit channel can operate independently of the money channel in such a setting, it may be useful to imagine for a moment that money and bonds are perfect substitutes. In that case, households would be indifferent to the composition of their asset portfolio, and hence would be perfectly willing to hold the lower amount of money and higher amount of bonds that a monetary tightening entails. Accordingly, there would be no need for market interest rates to adjust, and monetary policy would have no impact via the money channel. However, monetary policy can still have an effect via the credit channel, to the extent that the decrease in reserves brought about by the monetary tightening induces banks to cut back the supply of loans. In that case, the cost of loans relative to bonds will rise, and those firms that rely primarily on bank lending (say, because they do not have access to bond markets) may cut back investment, thus depressing aggregate economic activity.
Finally, a strand of the literature also favors modeling the monetary transmission mechanism as taking place primarily via financial market prices, rather than via
6 Apart from this two-asset feature, the "money" channel is consistent with a wide variety of theoretical formulations For instance, it is consistent with the textbook IS/LM model as well as with the dynamic equilibrium/cash in advance models of Rotemberg (1984), Grossman and Weiss (1983) and Lucas (1990)
"Because this effect operates at the margin, it is valid even when reserve requirements are low (as in France)
'See, for example, Bernanke and Blinder (1988, 1992) and Bernanke and Gertler (1995) for original formulations of such models Kashyap and Stein (1993) provide a good theoretical survey.
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quantities.9 From an empirical viewpoint, this approach has been partly motivated by the rather well-documented tendencies of money demand functions to display instability since the early 1980s, in turn reflecting the extensive capital flow liberalization and financial innovation that have been taking place during the last two decades. This may pose problems for the implementation of a VAR model that includes monetary and credit aggregates as important transmission variables. Accordingly, this family of models specifies market interest rates of different maturities, as well as the exchange rate, as capturing the essence of the transmission of a monetary policy shock to prices and economic activity. For economies that display a large degree of openness to international trade, the exchange rate channel is thus often considered to be among the most important components of the monetary transmission mechanism. The relevant effect in this case is quite straightforward. A monetary policy tightening, via an increase in the central bank's official intervention rates, would tend to lead to a nominal appreciation of the currency. To the extent that price adjustment is sluggish, this will entail a real appreciation, thus reducing aggregate demand.
C. The Impact of Interest Rates on the Economy
Choice of variables and specification of the model
The choice of the variable to serve as a proxy for the monetary policy instruments raises a number of questions. A natural choice would obviously be one of the Banque de France official intervention rates. However, given the changes over time in the monetary authorities1 intermediate targets, as well as the nature and function of the central bank's lending facilities themselves, it is difficult to identify a single official rate that could accurately be described as the key policy instrument throughout the period under consideration. Accordingly, and in line with other research in this area, a call-money rate was chosen as the closest proxy for the policy instrument.10
*For a VAR model of the monetary transmission along these lines, see, for example, Taylor (1993)
I00fficial rates form a "corridor" and hence at different points in time the ceiling rate (the 5-to- 10 day repo rate), the floor rate (the intervention rate) may be binding, or none of the two may be binding
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Components of the French interest rate
Taking only the French interest rate as the proxy for the monetary policy instrument, while formally correct, does not pay adequate regard to a central feature of French monetary policy: the fact that throughout the period under consideration it has to a large extent been geared to supporting the exchange rate of the franc vis-k-vis core ERM currencies. Viewed in this way, the French short-term rate can be thought of in terms of two distinct components: the German interest rate and the differential vis-a-vis this interest rate. In effect, the approach generally adopted in the literature on the monetary transmission mechanism in European countries implicitly imposes the restriction that the impact of the two components of the French short-term rate is identical. It is argued below that such a restriction may be unwarranted.
In fact, it can be argued that there are theoretical reasons to expect that the impact of the two components of the French short-term rate may be fundamentally different, so that including them separately, and in an unrestricted fashion, in the analysis may prove worthwhile. In the first place, to the extent that the exchange rate stability vis-a-vis the strongest currencies in the system can be regarded as reasonably credible in the long-run, French long-term interest rates could be expected to be largely driven by German long- term rates. Accordingly, it can be conjectured that a change in the French short-term rate that reflects a change in the short-term differential may have less of an effect on French long-term rates than one originating from a change in the short-term interest rate in Germany (at least to the extent that a positive term structure effect is in operation in Germany). In that sense, the impact of a change in the interest rate differential on aggregate demand may be conjectured to be smaller than the impact of an interest rate change originating in Germany.
A second reason why the two components of the French short-term rate might have different effects is that they may lead to different changes in the effective exchange rate. In this case, however, the relative strength of the two interest rate components is somewhat ambiguous. An increase in the differential might be associated with effective appreciation (depreciation) of the franc, depending on whether during periods of general ERM stress the French authorities were more (less) successful than other ERM members in maintaining exchange rate stability. On the other hand, vis-i-vis non-ERM currencies, increases in the differential might be expected to have less of an impact than increases in the German rate.
More generally, even in a situation where an increase in the differential may represent a response by the monetary authorities to unfavorable market perceptions regarding the long-run credibility of the franc/Deutsche mark parity, the impact of the two components of the French short-term interest rate can be expected to be different because they are likely to be perceived as implying different changes in the real rate. Given the French monetary policy strategy during the period under consideration, the French monetary authorities, under the conditions of such a credibility crisis, attempted to raise the
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differential sufficiently so that market participants were indifferent to holding francs or D-marks, given expectations of a franc devaluation. Under these conditions, to the extent that expectations of a franc devaluation were associated with inflationary expectations,11 it could be argued that the increase in the ex ante real interest rate resulting from a rise in the differential could be smaller than that resulting from a rise in the German rate. Indeed, in the (extreme) case where inflationary expectations are based on purchasing power parity, the increase in the ex ante real interest rate resulting from a rise in the differential would be zero.
Contemporaneous response to exchange rate shocks
In specifying the model, it is also important to take into account the specific context in which French monetary policy has been conducted in recent years. A major goal of monetary policy in France has been to support the stability of the franc vis-a-vis the strongest currencies in the ERM. Therefore, it could be surmised that the policy reaction function of the Banque de France could well involve within-period adjustment of its policy instrument in response to a shock to the exchange rate vis-a-vis these currencies, as well as to a shock to the long-term interest rate to the extent that this reflects perceived policy credibility. To the extent that such contemporaneous feedbacks into the policy instrument are indeed important, their inclusion in the specification employed is relevant to assess the impact of the policy instrument on certain key variables. Hence, in order to side-step the problems associated with the more commonly used recursive structure implied in the standard Cholesky decomposition (as described in SM/96/118), an econometric approach is adopted here that entails a non-recursive contemporaneous structure, while at the same time retaining the advantages of an unrestricted lag structure.12
This paper therefore discusses a VAR model that includes both financial market prices and quantities as intermediate transmission variables, in which the two components of the French interest rate are separated, and that allows contemporaneous shocks in intermediary target variables to affect the response of monetary authorities. Specifically, the model consists of monetary policy instrument variables (the German interest rate and the French-German interest differential), five intermediate transmission variables (the nominal effective exchange rate, the franc/core-ERM-currencies exchange rate, credit to
HNo matter in which direction the causality might run i:The econometric technique follows closely Blanchard and Watson (1984), Bernanke (1986), and Sims (1986) To the extent that the a recursive structure is limiting only with regard to some variables, there is no need to completely discard the original ordering, which in itself reflects the way monetary policy is broadly presumed to be transmitted. Instead, marginal changes (i e , in those variables where recursiveness is not considered an attractive assumption) are made in relation to the Cholesky orthogonalization
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the private sector, the long-term bond yield, and the narrow money aggregate—Ml), and two target variables (consumer prices and a real activity variable).13 Moreover, we allow the interest rate differential to be contemporaneously affected by the exchange rate between the franc and core ERM currencies, as well as by the long-term interest rate. Further deviating from strict recursiveness, we allow credit to be contemporaneously affected by prices.14 15 For each variable, a 12-lag structure was imposed.
The model was estimated using monthly data over the period 1983-95. The sample period chosen covers only part of the period of the franc's participation in the ERM. Specifically, it deliberately includes only the period of the hard currency policy, and excludes the period of experiments with reflationary policies in the early 1980s.
Empirical results
Empirical results are reflected in the so-called impulse response functions, which summarize the impact of a shock to the (orthogonal component of) each variable under consideration on all other variables of the system, including itself, over a specified period of time, thus capturing the essence of the transmission of monetary impulses across the economy (see SM/96/118 for more details).
The most striking conclusion that emerges from the impulse response functions is that the impact of the German rate and of the differential on the target variables, as well as on the intermediate transmission variables, is indeed substantially different (see Appendix I). With respect to the target variables, this difference is particularly pronounced in the case of output. Thus, a 1 percentage point increase in the German short-term rate is
13 All variables are included as logs, with the exception of the interest rate variables which are entered as a percent. The proxy for economic activity is constructed by interpolating quarterly GDP using monthly data on industrial production. A list of symbols, as well as a detailed description of the variables and data sources, is provided in the Data Appendix uln order for the system to remain just-identified, we impose no contemporaneous feedback from credit to the long-term interest rate, from the long-term interest rate to prices, and from the franc/core ERM exchange rate to output. The relevant methodology to compute the factorization implied by the above restrictions is discussed in Doan, 1992, and Hamilton, 1994
15 An alternative structural VAR could entail restricting the long-run impact of aggregate demand shocks to be zero, along the lines of Blanchard and Quah (1989) This formulation is quite attractive in distinguishing between competing structural models of the economy For the purposes of the present paper, however, as the impact of demand shocks was estimated to die out by the end of the simulation period, the relevant long-run restrictions would probably not be binding.
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estimated to entail a depressing effect on output, which turns statistically significant 6 months after the shock and remains statistically significant thereafter (it gradually increases in the first 12 months after the shock, stabilizing thereafter).16
By contrast, this analysis does not identify a discernible effect on output of a shock to the interest rate differential: the respective point estimate is very close to zero, and the effect remains statistically insignificant throughout the simulation period. This result casts doubt on the widespread notion that raising interest rates in defense of the franc in periods of market pressure entailed substantial output costs. These results may reflect the historical behavior of the interest differential, where shocks last for just a few months. Simulations reflecting a somewhat different stochastic process indicate that a sustained increase in the short-term interest differential would have a significant impact on output. On the other hand, the point estimate of the impact of both components of the short-term interest rate on the price level is close to zero. The latter result lies somewhere in-between the finding of Sims (1992) of a persistent positive impact and that of Barran, Coudert and Mojon (1996) of a moderate, but significantly negative impact (the definition of significance in the latter paper is, however, weaker than that used here).
Chart 1 provides information on the relative quantitative importance of each component of the German rate and the French-German differential. The Chart shows the cumulative loss in output associated with a 0.5 percentage point shock to the German short- term rate and the interest rate premium, respectively. Thus an increase in the German short-term rate is estimated to entail a loss in output of some 0.3 percent within the first year following the shock (a one standard deviation confidence interval around this point estimate would put this effect approximately between 0.2 percent and 0.5 percent). By contrast, the corresponding cumulative output loss associated with a positive shock to the premium is estimated to be 0.1 percent.17
A stronger impact of the German rate relative to the differential can also be identified for most intermediate transmission variables as well (Chart Al). Thus, a 1 percentage point increase in the German rate is estimated to have a pronounced positive impact on the long-term interest rate, with the effect peaking at some 0.9 percentage points and remaining statistically significant 10 months after the shock. By contrast, a shock to the differential has no discernible impact on the long-term rate, either in terms of the size of the point estimate and in terms of statistical significance.
!6These results are robust to both a Choleski decomposition usin a different ordering of the variables under consideration, i.e., one that places the differential after the bilateral exchange rate, as well as to the relaxation of the assumption of full recursiveness (see Appendix I).
17ln fact the cumulative output loss over 2-year period is zero (see Appendix I)
©International Monetary Fund. Not for Redistribution - 76 - CHART 1 FRANCE Cumulative Output Loss from a Half Percent Increase in Interest Rates (In Percent of Annual GDP)
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Similarly, the impact of the German rate turns out to be larger with regard to the money and credit variables. Thus, a 1 percentage point increase in the German rate is estimated to have a substantial depressing impact on credit, which at the end of the simulation period stands some 5 percent below its baseline path; the effect is statistically significant during most of the simulation period. The same shock to the German rate is estimated to also have a sizeable negative impact on money; this latter effect, however, turns statistically significant only in the second year of the simulation period. These results provide a preliminary indication that the money and credit channels may play an important part in the transmission mechanism, with credit in particular being a major transmission channel. By contrast, the corresponding impact of a 1 percentage point shock to the differential is estimated to be much weaker. Specifically, the impact on money is essentially zero and statistically insignificant throughout the simulation period. While the impact on credit is statistically significant for part of the simulation period, the respective point estimate is very close to zero. The question of the relative strength of the money and credit channels is discussed in section D below.
With regard to the effective exchange rate, the estimated impact of the interest rate differential turns out to be stronger than that of the German rate, albeit only marginally. Specifically, a shock to the German rate is estimated to have a statistically insignificant effect on the nominal effective exchange rate throughout the simulation period. On the other hand, the effect of the differential turns out to be statistically significant during the first 6 months after the shock. The magnitude of the effect is, however, very small: a 1 percentage point rise in the interest rate differential is estimated to lead to a brief effective appreciation, with the effect peaking at some 0.5 percent above the effective exchange rate's baseline path. Taken together, the results for both components of the interest rate would suggest that the effective exchange rate is a weak channel for the transmission of monetary policy shocks in the case of France.
With regard to the autonomous impact to shocks on the intermediate transmission channels, an autonomous appreciation of the effective exchange rate is estimated to exert a depressing impact on both output and prices, an effect which remains significant during most of the simulation period. Furthermore, an upward shock to the long-term interest rate is estimated to lead to a fall in output and prices, with both effects being marginally significant during part of the simulation period.
D. The Role of the Credit Channel
The credit channel can be expected to play an important role in monetary transmission if bank loans and bonds are imperfect substitutes as sources of financing for firms—a presumption typically justified on the grounds of asymmetric information and/or
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moral hazard arguments.18 Under these circumstances, it is worthwhile devoting some resources to monitoring, and delegating this to a specialized group of intermediaries, namely banks. A second important prerequisite is that banks must view bonds and loans as imperfect substitutes in their asset portfolios, so that they do not respond to a monetary tightening by running down their bond holdings to keep loan supply unchanged.19 A bank can be expected to hold a certain minimum level of liquid securities on precautionary grounds so as to be able to accommodate random deposit or withdrawals while still meeting reserve requirements. Thus, in general banks would not be indifferent to their relative holdings of bonds and loans. The existence of risk-based capital requirements (under which the risk weight on loans is higher than that on bonds) would tend to reinforce this argument (at least if these requirements are binding for some banks).
A number of considerations would suggest that the credit channel may indeed constitute a significant component of the transmission mechanism in France. In the first place, while recourse to commercial paper (an important type of non-bank financing in other countries) increased in the 1980s, the market remains small, suggesting that bank lending retains a dominant position in this regard.20 Secondly, the importance of small and medium-sized enterprises in total private sector value added could again lead one to expect a role for the credit channel, as these enterprises are traditionally viewed as being largely dependent on bank financing. Thirdly, the need faced by banks to improve their capital position in view of the phasing in of higher risk-adjusted capital requirements would suggest they would be reluctant to reduce their stock of securities in order to maintain loan supply unchanged under circumstances of a tightening of monetary policy.
The results of section C provided some preliminary empirical indications (in addition to the considerations made above) that the relative strength of the money and
''These features of the market for bank loans were first analyzed in Blinder and Stiglitz (1983)
|9See, for example, Bernanke and Gertler (1987)
Recourse by French firms to domestic money market amounts to about 5 percent of the debt of these firms, negotiable instruments as a whole represent about 15 percent of total credit to firms
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credit channels of monetary policy transmission may be worth exploring. The approach adopted in this section is an investigation along the lines suggested by Ramey (1993);21 while not particularly rigorous, it has the advantage of being relatively simple to implement and interpret.22 Ramey's method of assessing the strength of each monetary transmission channel essentially entails setting the coefficients that describe the impact of each transmission variable on the other variables of the system equal to zero (thus effectively "muting" the transmission channel in question), and comparing the resulting impulse response functions to the baseline impulse responses derived from the unrestricted VAR. The closer the "constrained" impulse response function turns out to be to the baseline impulse response, the weaker the transmission channel in question is postulated to be.
For the problem at hand, the relative strength of the money and credit channels in transmitting the impact of a shock to the German interest rate to economic activity are explored. Chart 2 presents the corresponding impulse response function derived from a system that in one case mutes the impact of the money channel and in the other case mutes the impact of the credit channel (along with the baseline impulse response function). The impulse response functions suggest that the money channel of monetary transmission is relatively weak. This would appear consistent with a view that emphasizes the endogeneity of the money stock in the case of an open economy in which the authorities are pursuing exchange rate stability. It also probably reflects the well-documented instability of money demand over the period under consideration; see for example Cassard, Lane, and Masson (1995).
The picture regarding the impulse response functions for the case of the credit channel is quite different. In this case, the estimated impulse response function that "constrains" the impact of credit to be zero is far (i.e., between one and two standard deviations) from the baseline impulse response. In fact, muting the credit channel results in virtually no impact of a change in the German interest rate on output. This result suggests that bank credit is an important potent channel of monetary transmission in France.
21 Alternatively, one could directly test the microfoundations of the credit channel model using firm level data Unfortunately, data limitations in the case of France precluded such an approach In addition, in order to assess the quantitative importance of the credit channel in transmitting monetary policy shocks, a macroeconomic framework would appear to be indicated
::Given that the results of the previous section suggested that alternative identification restrictions do not materially alter the impulse response of shocks in interest rates, for the purposes of this investigation we use the Choleski decomposition
©International Monetary Fund. Not for Redistribution CHART 2 FRANCE Kffprl of an Increase in the German Interest Rate on Output ("Money" Channel versus "Credit" Channel)
Source: Staff calculations.
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E. Conclusions
Two main conclusions emerge from the empirical findings in this paper. First, the decomposition of the French interest rate into a German rate and a premium over this rate reveals sharp differences between the effects of these two factors on certain key variables (both ultimate target variables and intermediate transmission variables). Differences are particularly striking with regard to real activity: while the German component of the French short-term interest rate turns out to have had a significant impact on real GDP, the estimation results fail to indicate a similar impact from the short-term interest differential. A l/z percentage point upward shock to the German rate leads to an output loss of about 0.3 percent within one year. Therefore, in assessing monetary conditions in France it would appear important to identify the origin of a given change in the French short interest rate. A temporary increase of the premium to defend the franc would have a much smaller impact on economic activity than a comparable increase in interest rates in core ERM countries (this impact of the premium would, however, be stronger in the case of a sustained shock). Second, on the question of how the impact of monetary policy is transmitted, it would appear that the role of credit is particularly important. This empirical finding is consistent with the significant role in the economy of small and medium-size enterprises (which rely predominantly in bank lending). It is also consistent with the view that banks would be reluctant to run down their holdings of securities to maintain loan supply in response to a monetary tightening, especially given constraints imposed by a need to strengthen their capital base.
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Impulse Responses
The charts in the following pages present the estimated impact of a shock to the innovation of each variable (impulse) on all variables of the system, including itself, over a period of 24 months. Chart Al shows responses to a 1 percent shock using a Cholesky decomposition; standard errors are computed using Monte Carlo simulations. Chart A2 contrasts the responses under the Cholesky decomposition (which imposes full recursiveness) with responses of the structural VAR described in the body of the paper.
Each column of panels portrays responses to shocks in one variable (the variable shocked is marked with an asterisk and its name is indicated on the top of the column) on the other variables (which names are indicated in each row). Variable names, as well as their definitions, are listed in the table below.
List of Variables
RHSG: German call-money interest rate (Source: IMF) RHSF: French call-money interest rate (Source: IMF) LBILATX: Bilateral f/core E.M. currencies exchange rate, in logs (Source: IMF and staff calculations) LNEER: Nominal Effective exchange Rate, in logs (Source: IMF) LCREDIT: Credit to the Economy, in logs (Source: IMF) YIELF: Long-term (10 year) bond yield (Source: IMF) LM1: French stock of Ml, in logs (Source: IMF) LPCP: French consumer price index, in logs (Source: IMF) LGDPIND: Quarterly GDP (at constant price) interpolated using monthly industrial production figures, in logs (Source: INSEE) DIFF: RHSF - RHSG
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©International Monetary Fund. Not for Redistribution - 84 - CHART Ai FRANCE Impulse Responses (Continuation)
©International Monetary Fund. Not for Redistribution - 85 - CHART A2 FRANCE Results of a "Structural" VAR (Asterisks Indicate Origin of Shocks)
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References
Alexander, W.E., and F. Caramazza, 1994, "Money versus Credit: The Role of Banks on the Monetary Transmission Process," in TJ.T. Balino, and C. Cottarelli (eds.) Frameworks for Monetary Stability, Washington, IMF.
Barran, F., V. Coudert and B. Mojon, 1996, "The Transmission of Monetary Policy in the European Countries," CEPI1 Document de Travail No. 96-03 (February).
Bank for International Settlements, 1995, "National Differences in the Interest Rate Transmission" Basle, (March).
Bernanke, B.S., 1986, "Alternative Explanations of the Money-Income Correlation," Carnegie-Rochester Conference Series on Public Policy, Vol. 25.
Bernanke, B.S. and A.S. Blinder, 1988, "Credit, Money, and Aggregate Demand," American Economic Review, Papers and Proceedings, (May).
, 1992, "The Federal Funds Rate and the Channels of Monetary Transmission," American Economic Review, Vol. 82, No. 4, (September).
Bernanke, B.S. and M. Gertler, 1995, "Inside the Black Box: The Credit Channel of Monetary Policy Transmission," Journal of Economic Perspectives, Vol. 9, No. 4, (Fall).
Blanchard, ).J. and D.Quah, 1989, The Dynamic Effects of Aggregate Demand and Supply Disturbances," American Economic Review, Vol. 79, No. 4.
Blanchard., O.J. and M.W. Watson, 1984, "Are Business Cycles All Alike?" NBER Working Paper No. 1392, (June).
Blinder, A. S. and J. E. Stiglitz, 1983, "Money, Credit Constraints and Economic Activity," American Economic Review, Papers and Proceedings, (May).
Boeschoten, W.C., P.J.A. van Els and J.A. Bikker, 1994, "Monetary Transmission in a Small Open Economy: The Case of the Netherlands," The Netherlands Bank, Research Memorandum WO&E. No. 406/9413, (August).
Boeschoten, W.C. and P.J.A. van Els, 1995, "The Importance of Monetary Transmission/ The Netherlands Bank, Quarterly Bulletin. (March).
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Cassard, M., T. Lane, and P.R. Masson, 1995, "ERM Money Supplies, and the Transition to EMU," in P.R. Masson (ed.), "France: Financial and Real Sector Issues," Washington IMF.
Dale, S. and A.G. Haldane, 1993, "A Simple Model of Money, Credit, and Aggregate Demand," Bank of England Working Paper No. 7.
Doan, T., 1992, "Rats User's Manual, Version 4," Estima.
Escriv£, J.L. and A.G. Haldane, 1994, "The Interest Rate Transmission Mechanism: Sectoral Estimates for Spain," Bank of Spain, Working Paper, No. 9414.
Garretsen, H. and J. Swank, "The Transmission of Interest Rate Changes and the Role of Bank Balance Sheets: A VAR Analysis for the Netherlands," De Nederlandsche Bank, MEB Series, No. 4, 1994.
Grossman, S. and L. Weiss, 1983, "A Transactions-based Model of the Monetary Transmission Mechanism," American Economic Review, (December).
Hamilton, 1994, "Time Series Analysis," Princeton: Princeton University Press.
Kashyap, A.N. and J.C. Stein, 1993, "Monetary Policy and Bank Lending," NBER Working Paper, No. 4317.
Litterman, R. and L. Weiss, 1985, "Money, Real Interest Rates, and Output: A Reinterpretation of Postwar U.S. Data," Economemca, No. 53.
Lucas, R.E., Jr., 1990, "Liquidity and Interest Rates," Journal of Economic Theory (April).
Ramey, V., 1993, "How Important Is the Credit Channel in the Transmission of Monetary Policy?" Carnegie-Rochester Conference Series on Public Policy, No. 39.
Rotemberg, J., 1984, "A Monetary Equilibrium Model with Transactions Costs," Journal of Political Economy (February).
Sims, C.A., 1980, "Macroeconomics and Reality/ Economemca. No. 48.
, 1982, "Policy Analysis with Econometric Models," Brookings Papers on Economic Activity.
, 1986, "Are Forecasting Models Useful for Policy Analysis?" Federal Reserve Bank of Minneapolis Quarterly Review (Winter).
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, 1992, "Interpreting the Macroeconomic Time Series Facts: The Effects of Monetary Policy," European Economic Review, No. 36.
Taylor, J.B., 1993, "Macroeconomic Policy in a World Economy: From Econometric Design to Practical Operation," New York: W.W. Norton.
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IV. Recent Problems and Current Policy Issues in the Banking Sector1
Executive Summary
During the past four years the banking sector in France has experienced serious stresses, the main features of which were a crisis in real estate lending and problems with credit to small and medium-sized enterprises, in a broader setting of protracted weakness in the economy. By 1994, nine percent of total bank loans (equivalent to seven percent of GDP) were non-performing. The total cost to banks of their real estate portfolio problems alone is estimated to have amounted to some F 200 billion—an amount equal to two-thirds of the original value of loans to developers.
These problems paralleled developments in a number of other industrial countries, with a rapid expansion in real estate lending in the wake of banking deregulation, and subsequently a sharp decline in asset values. Moreover, banking margins declined progressively with the impact of deregulation and greater capital mobility, against the background of the single banking market in Europe.
The impact of these common trends was compounded, in France, by additional factors. First, the real estate cycle was intensified by the removal of restrictions on the commercial real estate market soon after banking deregulation. Second, new bankruptcy laws in 1985 reduced the seniority of bank claims to help ailing firms, but spurred defaults on small business loans in the recession. Third, financial liberalization in the 1980s was incomplete—with numerous large banks remaining in the hands of the Government, and an uneven playing field in which some institutions continued to benefit from residual funding privileges Finally, these developments took place against a European background of lower growth and higher real interest rates in money and capital markets.
Problems were experienced widely across the financial sector, including banks owned—or whose management was appointed—by the State, most notably Credit Lyonnais This latter case was exceptional in the combination of very large losses and the call on public funds; but some key weaknesses that caused these losses, including poor internal control systems and other failures of governance, were not confined to this case or to the state-owned sector
Overall, prudential supervision has proved effective in enforcing adequate provisioning for non-performing loans and helping to preserve public confidence in the financial sector In the worst affected institutions, the approach has typically been to segregate the problem loans in separate entities where they can be worked out over time by parent companies or bank shareholders Because no large private bank failed and banking insurance is not financed by
Prepared by C Dziobek (MAE) and J. Levy (EU1)
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the public sector, there was no bail-out of private banks with public money. By contrast, the cost of restructuring government-owned banks has been substantial; while the accounting treatment has deferred most recorded fiscal costs, these may well amount to some 2 percentage points of GDP. It is notable, however, that the problems in major banks were not allowed to derail the monetary policy pursued by the authorities.
The banking system as a whole now appears to have largely weathered the real estate crisis. In 1995, with many bad loans written off in previous years, new loan loss-provisioning by commercial banks declined to 1 percent of the stock of loans outstanding. Real estate prices are generally considered to have bottomed out, and investors (including foreign investors) have begun to buy property loan portfolios. The bankruptcy law was amended in 1994 in ways that help to protect creditors, and thus encourage a prudent resumption of lending to sound companies. Nonetheless, experience elsewhere suggests that in the near term the need for banks to rebuild balance sheets may hold back lending, in favor of investment in government securities. While large corporations are currently very liquid, this may restrain the contribution of small and medium-sized enterprises to the economic recovery. At the same time, the sluggishness of the corporate sector's demand for credit has been a major factor in the recent downward trend in bank loans.
A number of measures have been taken or are under consideration to strengthen market and regulatory discipline. The Government is proceeding with the privatization of banks, beginning with Credit Industrie! et Commercial and Societe Marseillaise de Credit. The authorities are also preparing changes to strengthen the mandate of the Commission Bancaire in order to ensure that it can monitor risks more fully and insist on information systems that will permit better internal and external controls—thus improving banks1 own controls, as well as their reporting to supervisors. (The implementing regulations for the European Union Directive on Investment Services are expected to be a main vehicle for these reforms.) The authorities are also considering whether other steps should be taken to strengthen the systems of checks and balances in banks at a strategic level (e.g, through requiring banks to have effective audit committees). Finally, a strengthening of accounting and disclosure standards is also under consideration.
These priorities appear fully warranted to reduce the likelihood of future problems and to counter the moral hazard resulting from official intervention It is particularly important to accelerate privatization, preceded where necessary by essential restructuring, this will help eliminate a culture, with its inevitable conflicts of interest, in which the State has been the shareholder and regulator of the banks, as well as the owner of many of their major clients It is also crucial to strengthen the mandate of the Commission Bancairc in supervising internal control systems, and to enhance accounting and disclosure standards
In addition to these actions, it would appear important to remove any obstacles to a reduction of staffing costs in banks Legislative changes may be needed to facilitate this and to allow more flexible work arrangements (which are inhibited by a 1937 decree governing work practices in commercial banks) It would also be desirable to finish leveling the playing field in
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the banking sector by removing residual privileges affecting funding and the remuneration of capital. Other market-based changes will likely be needed over the next few years. The equity base of the banking system, while meeting international prudential standards, is rather limited, and profitability is not strong. Mergers are an obvious route to achieve consolidation; and it would also be desirable to see a move away from the present system of widespread and fragmented cross-shareholdings, which tend to make valuation of banks difficult and may inhibit the attraction of capital from outside the domestic financial sector.
The reforms currently in preparation and under consideration by the authorities, together with steps to improve flexibility in managing labor costs, would build on the strengths of the French financial sector in technology, payments systems, and the management of advanced financial products. Banks would thus be well-placed to support economic growth and to meet the competitive pressures that will likely intensify in the financial sector in Europe, as EMU unfolds, and indeed throughout the global financial market
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A. Introduction
This paper reviews the stresses experienced in the banking sector in France during the past four years, the main features of which were a crisis in real estate lending and lesser problems with credit to small and medium-sized enterprises, in a broader setting of protracted weakness in the economy and high real interest rates. It discusses the sources and scope of the problems, their impact on the economy and the public finances, and reforms in the areas of governance and regulation. The paper is organized as follows. Section B outlines key features of the banking system and the regulatory framework. Section C sets out the economic background to the crisis and discusses the main problems that emerged. Section D reviews the actions taken by the authorities in recent years. Section E examines market pressures for change in the sector, some macroeconomic implications of the recent problems, and reforms in governance and regulation recently adopted or currently envisaged by the authorities.
B. Structure, Performance, and Regulation of the Banking Sector
Structure and performance
Historically, financial intermediation in France was effected through three groups of institutions: commercial banks; specialized, government-backed credit institutions which did not receive deposits and were oriented toward financing such activities as housing and industry; and deposit institutions such as mutual banks that lent mainly to these specialized financial institutions. These three groups still remain recognizable, although since 1984 most barriers have been broken down In all, 1,445 financial institutions—including 547 banks—are currently subject to the Banking Law (for detail see Appendix I)2 However, a large proportion of these institutions is controlled by about twenty groups (Table 1) Five major banks hold more than two-thirds of the deposits and two-fifths of the assets of the private sector (see Tables 2 and 3). Foreign investment in French banks has been significant (Table 4).
Several banks were privatized in the mid-1980s, a few years after the nationalization of banks Nevertheless, until 1993 the Government continued to own two of the largest banks (Credit Lyonnais and BMP) and the three largest insurance companies (which in turn owned many banks) Even after the privatization of BNP and the insurance groups UAP and AGF in the last three years, the assets of state banks still amount to about one-fifth of total assets in the banking sector Mutual and savings banks are not owned by the Government, although the latter (i e . the Caisses d'Epargne) are under partial control of the State and of representatives
2This paper follows broadly the classification of institutions used by the Commission Bancaire Institutions are classified as (i) banks (i e , mainly commercial/universal banks), (ii) mutual or cooperative banks, (iii) savings banks (Caisses d'Epargne et de Prevoyance), (iv) municipal credit unions (Caisses de Credit Municipal), (v) financial societies, and (vi) specialized financial institutions
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of local bodies. The State also engages in near-banking activities through, inter alia, the Post Office, the Caisse des Depots et Consignations (CDC), and the Tresor.
Profitability in the banking sector has been low by international standards (Tables 5 and 6). The return on capital in the 1990s has been below 2 percent for commercial banks (with some notable exceptions), and around 5 percent for mutual and savings banks. Net interest revenues, which in the 1970s were among the highest in Europe, have fallen as margins declined with disintermediation. Service fees still make only a modest contribution to earnings, despite a rapid increase in derivative operations and other exchange trading since the 1980s. Operating costs have grown at a moderate pace since the mid-1980s, but are large relative to income; while staff costs are low relative to total assets, again they are high relative to income (Table 7). Employment in the sector grew rapidly in the 1970s following a first wave of liberalization, which led to an increase in the number of branches and heavy recruitment (Chart 1 and Table 8); many of the clerical employees hired during those years, who account for a large part of the workforce, are considered to lack skills that are increasingly required in the industry.
Against this background, profitability was seriously affected by loan loss experience in the early 1990s (Table 9). The ratio of nonperforming loans to gross loans in the banking sector increased from 4.5 percent in the 1980s to about 9 percent in 1994. The coverage of such loans by provisions declined from about 60 percent to less than 50 percent, despite large new provisions made in the period. In 1995, following a period during which heavy write-offs had been made, new provisions declined and provision coverage rose slightly. Liquidity has not been a problem in the sector: assets maturing within one month continue to be well above minimum requirements. Despite a significant increase during the period up to 1993, Tier 1 capital (i.e., essentially equity funding) for several of the major banks is around 5 percent of their risk-weighted assets—in conformity with Basle requirements, but again low by comparison with many industrial countries. In the case of commercial banks. Tier 2 capital (such as subordinated debt) accounts for about one-third of total capital
Regulation and supervision
The Banking Law of 1984 (as revised) provides the legal basis for banking activity, regulation, and supervision, and complies fully with European Union directives and regulations A single set of prudential rules applies to all banks and hence lends support to market integration However, some institutions performing near-banking activity are exempt from the Law * The Minister of Finance chairs the Comite de la Reglementation Bancaire et Financiere, which sets regulations The main supervisory body, the Commission Bancaire, is chaired by the Governor of the Banque de France, since the Banque de France became
3These are the Tresor, the Banque de France, the financial services of the Post Office, the Institut d'Emission des Departements d'Outre-Mer, the Institut d'Emission d'Outre-Mer, and the CDC
©International Monetary Fund. Not for Redistribution CHART 1 FRANCE Employment in the Banking Sector (AFB Banks) (In Thousands)
Source: Bmque de Trance.
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independent in 1994, the Governor is appointed by the Government for six years and cannot be removed. There are a number of other councils relevant to formulation of banking policy, on which both the Ministry and the Banque de France are also represented (Appendix I).
The authorities have a broad set of instruments to address problems, albeit with some weaknesses in the area of internal control systems (discussed in Section E below). The Commission Bancaire has powers to take corrective action when it detects banking practices that are inconsistent with the regulations.4 The approach to resolving banking problems stresses market principles, but has some features inherited from the time when government intervention was much stronger. Article 52 empowers the Governor of the Banque de France—as Chairman of the Commission Bancaire—to invite shareholders to recapitalize a bank that does not satisfy capital adequacy ratios or where the overall situation of the bank is deemed to make this necessary. Consistently with the principles of limited liability enjoyed by corporations, shareholders are free to decline the invitation; thus, this approach depends on the persuasiveness of the Banque de France, and its effectiveness reflects in part the concentration of ownership and close links within the financial community.5 This article also permits the Governor to call upon the banks to provide emergency loans. Upon the failure of a bank, deposit insurance is arranged by banks through their associations—the Association Fran?aise des Banques (AFB) in the case of commercial banks—with resources collected as needed (see Appendix I). Historically, this system has proved efficient, achieving a quick reimbursement of deposits.
C. Recent Banking Problems
Economic background
The historically rigid structure of French banking, with its heavy dependence on government guidance and funding, started to change in the late 1960s and early 1970s, when a liberalization of bank lending rates and branching led to a rapid expansion of the financial system, in particular deposit institutions. Liberalization lost impetus in the late 1970s, but was
4 While the staff of the Commission Bancaire makes recommendations about disciplinary actions, these have to be approved by the Commission (see Appendix I for the composition of the Commission)
sThe bankruptcy of Pallas-Stern in 1995 illustrates this issue The bank was privately owned and specialized in investment and private banking, its main owners were the oil company Elf, the insurance companies AGF, GAN, UAP, the commercial group Pinault-Printemps- Redoute, and several foreign banks There was no agreement among the Pallas-Stern shareholders to recapitalize the bank, and the Commission Bancaire ultimately suspended the activities of the institution in mid-1995 Prompt action by the AFB enabled most depositors to be reimbursed within a few months
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rekindled with sweeping reforms in the financial market framework in 1984 (Box 1). These reforms formalized the concept of universal banks—thus opening new markets to the commercial banks—and granted greater freedom to other deposit-taking institutions, increasing their ability to compete with commercial banks across a broad range of activities. They also led to the introduction of many new financial instruments and vehicles, including commercial paper, mutual funds, and exchange-traded derivative products. However, these changes took place shortly after the banking sector was nationalized: there was thus a tension between, on the one hand, a less directly regulated and increasingly sophisticated financial market, and, on the other, incentives and constraints (for example, on capital raising) that would not to be typical for private sector banks.
Competition for credit, financial innovation, and the elimination of exchange controls sparked a process of disintermediation and an increase in the remuneration of savings that is still underway. A main response of the large commercial banks to these changes was a rapid expansion of lending, including to the real estate sector (Chart 2), and an increase in participations in industrial firms; but these strategies proved fragile when the economic boom faded in the early 1990s.
The performance of the banking system has been affected in several ways since 1992 by developments in the economy, which took place against a European background of lower growth and higher real interest rates in money and capital markets (Charts 2 and 3), as well as disinflation in the real estate market (which was, however, also part of a more global trend) . First, bank lending leveled off, and during the period 1993-95 the stock of bank loans declined in real terms.6 Second, there was a sharp rise in the number of bankruptcies, especially among small and medium-sized firms (Box 2) Third, the banking system was seriously affected by the protracted decline of real estate values Finally, developments in interest rates, including episodes of increases in short-term interest rates in defense of the franc, affected in particular the position of those banks whose financial situation was already precarious
More generally, the banking sector may have been affected by an increase in funding costs when short-term interest rates were raised, despite the increasing indexation of loans to market rates instead of to the prime rate, which has followed market developments only sluggishly However, the effect on the banking system of increases in short-term interest rates has varied over time as banks have re-arranged their balance sheets In the late 1980s, spread
*For an assessment of the impact of monetary- policy on credit, see Section III of this paper
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Box 1. Key Features of Liberalization of the Banking Sector in France
An initial program of financial liberalization in 1967 aborted following repeated difficulties in restraining credit at times of strong demand, due to inadequate institutional reforms. A second, phased reform was undertaken in 1984-90, and benefitted from a number of lessons that emerged from the earlier episode, as well as from experience elsewhere:
• Domestic reforms included the removal of bank lending ceilings, the development of liquid markets in short- and long-term debt, a restructuring of the securities industry, and the encouragement of an active derivative products market.
• Taxation changes played a role in stimulating securitization, including the development of certificates of deposit and commercial paper markets after 1985. The pace of disintermediation was exceptionally rapid—by the late* 1980s intermediation in France had already fallen to 60 percent of credit flows, from 80 percent in the late 1970s.
• The dismantling of exchange controls was phased in line with domestic deregulation until the last restrictions on personal transactions were lifted in 1990; changes in taxation of savings aimed at reducing the risk of large capital outflows tended to increase the cost of funding for banks.
• Banking regulations were revamped, and supervision was strengthened.
• Some major financial groups among those nationalized in 1982 were privatized (e.g., Societe G6nerale, Pan has, and Suez), although government-owned institutions kept important minority shareholdings in some of them.
• The macroeconomic framework from 1984 onward was conducive to economic and financial stability: medium-term fiscal consolidation, and operation of the exchange rate as a nominal anchor, were already in place when financial liberalization was initiated. The second half of the 1980s was also characterized by a rapid decline in consumer price inflation, an acceleration of economic growth, and positive real interest rates.
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Box 2. Lending to Small Enterprises
Small enterprises were particularly badly affected by the slowdown of the economy in the early 1990s: about twice as many bankruptcies were filed in 1993 as in 1989. Job destruction was also quite significant (exceeding 160,000 positions in 1993) and was particularly felt by small firms in the industrial sector, in which dismissal rates tripled in 1989-93. The increase in bankruptcies of small firms affected commercial banks severely for a number of reasons. First, in the portfolio of these banks this class of loans amounts to more than 3/4 of all loans to enterprises. Second, the bankruptcy law of 1985 extended the customary precedence for claims from labor in the case a failed firm (which is common to many countries) to most new claims by suppliers and other creditors. Third, the period of reorganization following a filing for bankruptcy often extended for a lengthy period, increasing the time during which original loans were not serviced, and burdening the firm with new debt when the firm had no realistic prospects for resuming normal activities (CNC, 1995 notes that despite the significant increase in the number of filings, the proportion of firms being liquidated only decreased marginally—about 2 percent—vis-a-vis previous cycles). Finally, given these protracted reorganization periods, when firms eventually failed very little of the original value of the loan could be recovered, even in cases where guarantees given at the time the loan was granted originally appeared adequate.
Market estimates of the losses arising from loans to small businesses are on the order of F 75 billion (since 1992 the Commission Bancaire has not provided a breakdown of bank provisions against non-sovereign risks). According to the Commission, because of these losses banks were extremely careful in extending new loans to small enterprises in 1994-95. Indeed, in the last two years banks have tried instead to give greater weight to factoring activities, which are deemed to be safer than normal lending. Following a further fall in the outstanding stock of loans to small enterprises in 1995, a modest recovery was observed in the spring of 1996, perhaps foreshadowing a strengthening in the sector if economic growth picks up as projected in the second half of the year.
The authorities have devoted considerable efforts to alleviating the difficulties faced by small enterprises since the supply of credit began to contract. Four major approaches have been adopted. First, since 1993 the Government has increased the amount of funds available to insure loans (granted by pnvate banks) to small enterprises through the mechanism of SOFARIS. Second, the bankruptcy law was reformed in 1994, leading to a strengthening the seniority of original bank loans and providing tor a greater role of creditors in shaping the pace and direction of the reorganization process. Third, the Commission Bancaire and the Conseil National du Credit have proposed several market-oriented measures permitting a better credit "scoring" of firms, thus favoring a pricing of loans which takes individual firms' nsks into account more adequately than current methods (which are based chiefly on the size of the borrowing firm) and the constitution of (tax-deductible) reserves at the moment credits are granted. Finally, the new Government created a small-business bank (BPME), by recapitalizing and expanding the specialized institution CEPME. and merging it with SOFARIS.
©International Monetary Fund. Not for Redistribution - 99 - CHART 2 FRANCE Growth and Real Interest Rates in Europe (In Percent)
Source: IMF. Wor»C Economic Outlook
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Sources: IMF. International Financial Statistics; WET A; and staff calculations
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income in the banking system as a whole appears to have benefited, on balance, from increases in short-term rates. While it has been argued that this situation may have reversed in the early 1990s,7 recent studies by the Banque de France indicate that, overall, banks were again net beneficiaries of increases in short-term rates by 1994 as a result of the scale of their fixed rate liabilities.8 However, during brief periods the yield curve was inverted as short-term interest rates were raised to defend the exchange rate. In the context of increased downward pressure on lending rates, this situation may have brought to light difficulties in some banks, to the extent they were unable to pass these rates on to end-users of funds in the real economy by adjusting the prime rate. It should also be noted that—as discussed below and in Box 3—the funding structure of commercial banks results in these institutions being more vulnerable than other banking groups to increases in interest rates.
On balance, it appears likely that the negative impact of monetary conditions on the performance of the banking sector as a whole mainly came indirectly, through developments in the real economy and in asset markets, rather through the impact of interest rates on their funding costs. It is notable, finally, that the problems in the banking sector were not allowed to derail the monetary policy pursued by the authorities, which was oriented toward price stability.
As a result of the stresses in the banking system in the early 1990s, nonperforming loans soared and profitability worsened sharply. Problems were especially serious in banks lacking effective internal controls and a system of check and balances at the strategic level—which appears to have been the case of several government-owned banks and, to varying degrees, of some large privatized institutions (Mutual banks, by contrast, appear to have avoided the most risky exposures.)
The real estate cycle and bank lending
The major bank lending problems in France flowed from involvement in real estate financing. As in Japan and the United Kingdom, real estate development was accompanied by "asset inflation" (a sharp increase in asset prices relative to consumer prices) in combination
"See Klempeter( 1995)
*For example, Gervais and Jacolin (1996)
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Box 3. Savings Instruments: General Features and Collection Privileges
Funding and loan distribution privileges are a heritage of the time when financial activities in France were rigidly divided in three sectors, with specialized lending institutions—mainly publicly owned and operated—being responsible for channeling the resources originating from regulated savings collected by deposit institutions. Since 1984, deposit institutions (e.g., Credit Mutuel, the Caisses d'Epargne, and the Post Office), while holding the privilege of offering several regulated contractual saving instruments, gained the ability to offer new free-market saving instruments, such as mutual funds. This freedom permitted them to take full advantage of the large number of branches they had opened in the 1970s, and provided them with the opportunity to offer a large menu of complementary instruments to their clients. For instance, when market interest rates were high, clients could move towards mutual funds; when interest rates fell, clients could return to regulated instruments whose rates were stickier. Offering regulated instruments also provided a cushion to those institutions, because the Government remunerates the collection of regulated savings by paying banks a fixed percentage of deposits collected.
These and other privileges inherited from the past have often been considered controversial. However, the Government has been more inclined to extend privileges to a larger group of beneficiaries than to eliminate them. For instance, over the years the Government has allowed commercial banks to offer tax-favored accounts aimed at financing industrial activities (CODE Vis), as well as a number of contractual saving instruments (Pel, PEA, etc.). More recently, all banks were entitled to collect the so-called Livret Jeune (tax-exempt savings accounts for young people) and to distribute the "zero-interest1' housing loans. Both instruments benefit from government subsidies, while being attractive to banks: resources from the Livret Jeune are not tied to a specific activity—in contrast with those originating at the Livrets A, which are channeled to CDC to finance housing construction, while the amount of zero-interest loans are limited to 20 percent of the value of the house—the rest being usually financed by the distributing institution.
From the perspective of savers, the relative importance of regulated savings instruments vis-a-vis market-rate instruments such as mutual funds has vaned in the last 10 years, depending on the level of interest rates and tax incentives (mutual funds experienced a rapid expansion in the late 1980s and early 1990s. total resources amounted in December 1995 to F 2.5 trillion (or about three limes the volume of Livret A deposits)
From the perspective of banks, mutual funds have played an important role, because their contribution to the funding of financial institutions exceeds F 1 trillion, largely via the purchase of long-term securities and C.Ds issued by banks (CNC, 1993) and chiefly substituting for deposits (the share of deposits fell from 71 percent in 1980 to hah0 of that by 1993-Plihon, 1995). Of course, these resources are more expensive than sight deposits, with net margins from loans funded with mutual funds estimated to be of only half of those funded v\»th conventional deposits (CNC, 1993) Nonetheless, depending on operating cost* and service fees, mutual tunds can still provide funds at a lower cost than the interbank market Commercial banks, which manage about of total assets in mutual funds have thus been aggressive in the market The claim that savings banks distributes the Livret A) and Credit Mutuel (which distribute the equivalent Livret Bleu) benefit from svnerg) in marketing mutual funds to "captive clients" needs to be weighed against the fact that these institutions actual!) manage less than 10 percent of total assets in mutual funds
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with a rapid expansion of banking loans collateralized with these assets.9 In France, the cycle mainly affected commercial real estate—in particular offices in large and prestigious buildings—and was accentuated by commercial banks1 concern to expand in new markets (where specialized institutions wished to preserve their own market shares).10 Moreover, buildings were viewed as good collateral, regardless of possible fluctuations in their market value. Finally, there was a perception that demand for offices would grow steadily apace with the expansion of the service sector, and in 1985 the Government eliminated the 25 year-old regulation requiring developers of large office projects to show that they had sufficient committed tenants or buyers before starting construction.
The stock of credit to real estate developers increased by more than one-and-a-half times in 1988-90, reaching some F 300 billion in 1992.11 Until 1990, the increase in prices and rents of commercial real estate dwarfed the cumulative service cost of bank loans. The average price of offices (new and old) almost doubled in 1986-90 (Table 10), compared with a rise of 12 percent in consumer prices.12 A sharp reversal followed, however: real estate prices halved in the course of 1990-94.13 The downswing in the real estate cycle resulted in serious stresses in the banking sector, as was the case also in a number of other countries (Table 11).
9The ultimate causes of the worldwide asset inflation in the 1980s are unclear. Minsky (1982) suggests that asset inflation is a natural outgrowth of increasingly complex financial markets (new layers of intermediaries providing a de facto increase in financial liquidity—mainly to investors); most studies associate it with financial liberalization. Samiei and Schinasi (1994) study asset inflation in the United States and Japan following liberalization in the 1980s. Renaud (1995) suggests that increased liquidity in Japan led to capital outflows which added to pressures on commercial real estate in a number of industrial countries. l°Private housing loans experienced less of a boom than the commercial real estate, although lending expanded in the late 1980s—the share of so-called "free" sector loans (i.e., non- official, non-subsidized) more than doubled in 1986-89, when it represented about one-third of total housing loans. House prices increased modestly over the cycle—except in Paris, where they showed steep increases, in particular in late 1990. By now, they have fallen back to their 1988-89 levels nOfficial data on the stock of credit to developers is not available, this estimate is based on market reports
I2ln France, commercial rents are renegotiated every three years so that variations in the supply of, and demand for, office space can be reflected relatively quickly in large changes of both rents and asset prices
13 While there is no agreement on the main causes of the inflation of asset prices in many industrial countries in the late 1980s, the reversal of asset inflation is likely to have been amplified by the rise in interest rates
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In the second half of 1995 real estate prices began to stabilize, and in early 1996 the price of new buildings increased slightly. There was a surge in sales of nonperforming loans. These developments suggest that the downsizing of the real estate cycle has tailed off. The absorption of space in the Paris region is expected to be achieved largely at the expense of old offices: it is unlikely that the 250 thousand new jobs required to occupy all vacant offices will be created in the near future.14 Responding to this trend, the Government has supported the conversion of offices into apartments, and put in place a number of fiscal and regulatory measures reducing the supply of, and increasing demand for, new space.15
It took some time after the peak of the cycle for banks and the authorities to become persuaded that real estate prices were not on the eve of a rebound. By late 1993, however, a number of write-offs supported by parent companies or major shareholders started to take place. Although no estimates are available from the Commission Bancaire or other official sources, the overall cost of the real estate downturn to financial institutions is estimated at F 200 billion (3 percent of GDP, see Table 12); this includes both the capital losses and the carrying cost of the loans. 16 The narrowness of the market made it difficult to attempt a large- scale sell-off of nonperforming loans in 1993-95; recently, however, banks (and insurance companies) have succeeded in selling sizeable portfolios, albeit at a substantial discount.17
Real estate losses were spread across a number of sizable banks, including banks belonging to large and diversified insurance companies, rather than being concentrated in specialized institutions. This spreading of risks explains why a wave of liquidations was averted; however, a handful of state-owned institutions specialized in real estate had to be heavily restructured, and in the case of Credit Lyonnais other serious problems were substantially aggravated by a very weak real estate portfolio, prompting the Government to rescue the bank
MThe overhang of excess space shrank by some 8 percent in 1995, but there are 20 million square feet of vacant offices in Paris intra-muros (of which 4 million are new buildings), 15 million square feet in adjacent suburbs, and another 15 million spread over the metropolitan region; the supply of office space in some of the latter areas almost doubled in 1988-93 and is very unlikely to find use in the near future
15About a million square feet of old offices are being reconvened into apartments (i.e., about one-sixth of the area that the City of Pans considers suitable for reconversion) The main fiscal incentive has been the extension of VAT deferrals on property sales leThis assessment is derived from market sources rBarclays Bank France sold about F 1 billion in loans to Lehman Brothers in December 1995, Suez sold F 0.8 billion to Goldman Sachs in early 1996, UAP sold F 3 2 billion also to Goldman Sachs in June, AGF sold about F 5 billion of loans to a French investor in July, and Suez is reportedly planning to sell % of its remaining exposure
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Banks where the state was involved in ownership or management
The problems of Credit Lyonnais became visible in the course of 1992-1994 as the bank began to report major losses. These losses resulted fundamentally from risky loans and investments, and insufficient equity capital to sustain a growth strategy adopted in the late 1980s, which tripled the size of the bank between 1989 and 1991—privatizations had been suspended in 1988, and this source of additional capital was thus foreclosed. As with other French banks, the single largest source of problems lay in real estate losses—which, with inadequate internal controls, amounted to F 23.4 billion at the end of 1993. A subsidiary of the bank also financed the purchase of a U.S. film studio, resulting in losses of F 16.5 billion in 1993. In addition, the bank purchased financial firms through a company bought from the state-owned Thomson S.A., in an operation originally aimed at strengthening the capital base of Credit Lyonnais; as a result of inadequate risk management and weak controls, losses on derivatives and high-yield bonds in these companies reached some F 8 billion. Finally, losses arose on the bank's shareholdings in some state-owned companies, which became unprofit- able in the early 1990s; these participations were acquired through share exchanges—again, to boost the bank's equity without recourse to private capital.
The problems of Credit Foncier surfaced in late 1995 and stemmed from attempts to diversify its real estate activities, in anticipation of the loss of its privileges in distributing subsidized housing loans; the bank thus entered the commercial real estate market at its peak. Credit Foncier is a private bank, owned by individuals and institutions; however, its Governor and Vice Governors have been appointed by the State since 1851, as provided in the Articles of Association of the bank as a counterpart to the state guarantee on a portion of its liabilities (see Appendix I).18 These links were reflected in market perceptions that the Government, in a broad sense at least, stood behind the bank: its non-guaranteed securities historically carried only a small premium over government paper.19 With an outstanding stock of bonds in excess of F 200 billion. Credit Foncier is the second largest issuer of bonds in France. The majority of its loan portfolio comprises subsidized housing loans carrying a guarantee from the state and funded mainly through bond issues. Following the elimination of government funding for the subsidized housing loans, the bank experienced some difficulties in rolling over its debt in late 1995, despite the fact that profits, albeit on a modest scale, had been posted in previous llAs in any private bank, management is accountable to the private shareholders, which include the insurance company AGF, Credit National, CDC, Union des Banques Suisses, and the Templeton Fund of the United States. CFF used to have the virtual monopoly of distribu- ting subsidized housing loans (prets d'accession a la propriete—PAP) New management was appointed in 1994
|9This premium increased significantly in late 1995 and early 1996, when the problems of the bank were made public, but narrowed after the Government made a public announcement of "comfort*1 on April 29, 1996, underscoring its "commitment" to the soundness of the debt floated by the bank
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semesters. At that time the publicly-owned institution CDC offered a credit line of F 20 billion to Credit Foncier. In April 1996, the management announced a consolidation of the accounts of more than 170 subsidiaries (which had sprung up in the early 1990s), and disclosed a substantial increase in nonperforming loans. Management also decided at once to provision very heavily against those nonperforming loans, and to revalue downward other assets owned by the bank.20 These measures appear to have reflected, in part, a conclusion that spreading the losses over time was not advisable because the main source of income of the bank—i.e., subsidized loans—was set to shrink in coming years. The volume of bad loans is sizable (some F 15 billion), albeit much lower than at Credit Lyonnais.
Other institutions that faced major problems included the government-owned Banque Hervet (whose real estate losses exceeded its capital) and Societe Marseillaise de Credit (which also required recapitalization to cover nonperforming loans to small firms), as well as specialized institutions which incurred heavy losses in the real estate sector, such as the Comptoir des Entrepreneurs (CdE).21 CEPME, a specialized institution devoted to lending to small business, and several regional development banks, also experienced substantial losses.
The fact that some of the most serious banking problems occurred in institutions owned by the state, or where the state appointed the management, must be seen as indications of weaknesses in public governance that go somewhat beyond specific factors, such as particular managers and lending decisions. The potentially conflicting roles of the state as owner and regulator of lending institutions, and as shareholder of some key corporate customers, may have contributed to a culture in which strategic errors were difficult to check Also, the mandate of supervisors in key areas relating to governance was deficient Significant measures to improve governance and strengthen the mandate of the supervisors are currently being implemented or under consideration (see Section E below)
Lending margins and funding privileges
Commercial banks have attributed the decline in banking margins, and resulting pressures on profitability, in part to privileges enjoyed by saving and mutual banks in collecting regulated savings. These issues have gained much prominence as these capital-rich and profitable banks started to compete in markets previously dominated by the commercial banks (Table 13) However, it is notable that deregulation and elimination of exchange
Management also added F 2 billion in provisions on performing loans and created approximately a further F 5 billion in reserves by writing down the book values of real estate properties owned by the bank whenever these book values were deemed above market values (while not revaluing properties when book values were below market values) Market estimates of undervalued assets are currently around F 4.3 billion
2lln addition, major problems arose in the Banque du BTP, pan of the capital of which was historically held by state-owned banks
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controls, in France and world-wide, have tended to increase competition and decrease the role of traditional bank intermediaries—thus putting pressure on bank margins and profits even in absence of distortions.
The lending margins of the commercial banks halved between 1988 and 1993, when they amounted to only 1.6 percent of total assets excluding interbank loans (Table 14). The reduction in margins of mutual and saving banks has been much less severe. Information on lending rates does not, however, suggest that mutual and savings banks lent at lower rates than commercial banks, at least through 1994 (Table 15): lending rates at commercial banks were lower than those at savings and mutual banks in 1993—and increasingly so in 1994. More broadly, lending rates do not appear to have been the main source of the narrowing of margins. The margins of large and small loans over Treasury bill rates were not significantly lower in 1994-95 than in 1990 (see Chart 4)21
The secular trend toward narrower margins in recent years thus appears in part to have reflected increases in funding costs. Indeed, following deregulation of financial markets, the importance of sight deposits decreased in favor of a number of liquid savings instruments such as mutual funds. This trend was far from unique to France, although initially fiscal incentives increased the appeal of securitized savings instruments vis-a-vis deposits. It has, however, affected the funding costs of commercial banks particularly, since they became still more dependent on interbank loans and CDs. Mutual banks—in part because of their large network of branches—can rely more on sight deposits and low-cost savings instruments. On average commercial banks' funding costs have been higher than those of mutual and savings banks. One way for commercial bank groups to lower their net cost of funds and increase fee income would be through an increase in the share of mutual funds in their mix of funds; indeed they appear to be inclined to bid aggressively for a larger stake in this market.
The issue of residual funding privileges in the banking market nonetheless needs to be considered It has been argued (i) that the Post Office and savings banks have benefited from a rent element in the fee they receive for administering regulated saving accounts
"Temporary declines in banking margins appear to be explained in large part by adjustment lags following sharp fluctuations in money market rates For instance, while margins rose in 1993 when short-term rates fell, they narrowed significantly in the first quarter of 1995 when the defense of the franc led to a sharp increase in short-term rates. The reduction in short-term interest rates over the past year will have provided a larger temporary benefit to commercial banks than to other banks, because a decline in interest rates would narrow the difference in remuneration of different instruments (in 1993 the average deposit and CD rate paid by commercial banks was 150 basis points higher than that of mutual banks, this difference more than halved in 1994) In addition, fixed rates on long-term loans appear not to have increased as much as bond yields in 1994.
©International Monetary Fund. Not for Redistribution CHART 4 FRANCE Short-Term Interest Rates and Lending Margins I/ (In Percent)
Source: Btnque de France I/ Measured in relation to the yield of 3-month T bills.
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(Livrets A);23 (ii) that they have benefited from this monopoly through an ability to sell other financial products including mutual funds to "captive" clients (Box 3); and (iii) that the Post Office has cross-subsidized near-banking activities from the Government's payments for provision of its mail services (the published accounts of the Post Office do not separate the costs of these two activities). The AFB has recently announced that, if the Livret A privileges were extended to commercial banks, they would charge the Government a lower fee than that received currently by the savings banks. The savings banks and the Post Office, however, consider that these fees would be insufficient to cover their operating costs.24
D. Response of the Authorities
The response of the authorities to the banking problems of the past four years has included several different strands: prudential and regulatory measures taken by the Commission Bancaire, including when necessary the restructuring or closure of institutions; actions taken by the State as a shareholder of banks; measures to alleviate possible effects of financial fragility on credit to small and medium-sized enterprises (Box 2); and, finally, actions to address the concerns of commercial banks about competitive inequalities.
Response to problems in banks
Since 1993, when banks and the authorities realized that the real estate slump would not be short-lived, the enforcement of prudential rules by the authorities has been effective in bringing about higher levels of provisions for nonperforming loans, which has helped to preserve the overall soundness of the system. In the case of real estate loans this approach required very close scrutiny of banks. Defeasance structures were set up to isolate loans, and
^Livrets A are tax-exempt passbook accounts distributed by savings banks and the Post Office: the resources raised are directed to finance low-income housing under the auspices of the CDC; a so-called Livret Bleu is the same instrument but distributed by Credit Mutuel. The rate of remuneration is 1.2 percent for the savings banks, 1.35 percent for mutual banks (Credit Mutuel), and 1.5 percent for the Post Office.
24In particular, the Post Office has stated that these costs absorb about 3/4 of the fee received from the Government, with the proportion being significantly higher in small villages or less affluent neighborhoods—where there is a concentration of small and very active accounts, which generate little income but large expenses. Mutual banks have suggested that the AFB is probably aiming at the top of the market (2 percent of the accounts) with deposits close to the ceiling of F 100,000 However, half of the passbooks have a balance of less than F 1,000 and small accounts can be expensive to operate because withdrawals, which are not subject to fees, are quite frequent For the institutions offering Livret A accounts, the aggregate income from this activity is estimated by the staff at some F 11 billion
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the Commission Bancaire monitored closely the transfer of nonperforming assets to these structures to ensure that remaining risks were effectively isolated from banks.
A number of banks were also subject to intervention by the Commission Bancaire due to violations of prudential regulations, and required to undertake more extensive restructuring programs (Table 16). Emphasis was generally laid on measures that placed the financial burden of bank restructuring on the owners and major creditors. In cases where the authorities believed that long-term viability could be restored within a reasonable time period, the banks were required to downsize their operations; recapitalization while maintaining the existing size of the bank was explicitly excluded. This approach to restructuring contributed to the avoidance of any substantial cost to the public finances in these banks, and appears not to have adversely affected public confidence.
The response to problems in banks owned by the State, or where the State appointed the management, has not been essentially different. However, losses in the banks owned by the State inevitably affect the public finances directly or indirectly, while the size of Credit Lyonnais—and the prominence of Credit Foncier in the securities market—meant that any major problem with these institutions could have become a source of systemic risks. Hence, as shareholder or appointer of the management of these banks, as well as ultimate guarantor of financial market stability, the Government provided them with extensive support.
The situation at Credit Lyonnais became of concern to the authorities as early as mid- 1991, due to the strategy pursued by the bank. Issues of concern to the authorities were pursued in the on-site examinations of the Commission Bancaire. Subsequently, in September 1992, the Minister of Finance wrote to the chief executive of Credit Lyonnais concerning the situation of the bank. New management was appointed to the Bank in November 1993, and in March 1994 a first restructuring plan was implemented, including a state guarantee of F 18 4 billion on a portfolio of F 43 billion of nonperforming loans transferred to a defeasance structure, and an injection of F 4.9 billion in new capital by the state Following a re- assessment of the value of assets, and of the large losses realized in 1993, the Chairman of the Commission Bancaire notified the Government in autumn 1994 that the capital of the bank was insufficient to cover its losses and that a rescue plan was necessary A much broader restructuring plan was thus announced in early 1995 (see Box 4) It was approved by the European Commission in July of that year after the Government decided on a downsizing plan, involving inter alia a 35 percent reduction in the activities of the bank outside France and its privatization before the year 2000 (for details see SM/95/266)25 In October 1995, the restructuring plan was approved by the National Assembly
Since late 1995, the defeasance agency CDR has invited bids for assets, and has sold assets with a face value of about F 30 billion (i.e., about one-fifth of its portfolio), generating
:5Some French banks had made formal complaints to the European Commission relating to the terms of the Government's rescue of Credit Lyonnais.
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Box 4. The Credit Lyonnais Restructuring
Credit Lyonnais began with on-balance sheet nonperforming loans (NPL) (resulting in an operating loss for the bank). The situation was alleviated by a transfer of the NPL to a newly-created agency, CDR. Assume that CDR "pays" for the purchase of the NPL with cash (with a condition attached). CDR in turn receives the cash from a further agency EPFR in the form of a loan. EPFR is able to advance this loan only because Credit Lyonnais, the ultimate beneficiary of this loan, agrees to pass on the money to EPFR, again in a form of a loan which in this case is guaranteed by the state. The result of the operation is that CL is relieved of its NPLs; on its balance sheet nonperforming assets are replaced by performing assets (with a state guarantee). EPFR on the other hand has assumed a liability to Credit Lyonnais and is thus obligated to pay interest on the loan. On the asset side, EPFR has a loan outstanding to CDR of doubtful quality: CDR took out the loan on the understanding that debt service is linked to its ability to liquidate the NPL. (It is assumed here that CDR has other assets and liabilities of F 60 billion.) In the meantime, CDR incurs costs to set up operations, pays salaries to employees, rents premises, etc., as well as normal costs associated with the business of loan collection. It is thus obvious that the risks are borne entirely by EPFR (the state).
Simplified Bank Restructuring Scheme for Credit Lyonnais (In billions of francs)
Balance Sheet Transactions I/ Credit Lvonnais (CL) EPFR Assets Liabilities Assets Liabilities +135 Loan to EPFR +135 Loan to CDR + 135DuetoCL -135 NPL
Consortium de Realisation (CDR) Assets Liabilities + 135 NPL + 135 Due to EPFR •^60 Other Assets + 60 Other Liabilities
As shown below, income and expenditure streams are also changed as a result. Before the operation, on this section of its balance sheet, CL had no income earning assets. After the operation it was to receive a 7 percent annual interest payment in the first year, and 85 percent of market rates afterwards, from EPFR (the latter rate was subsequently adjusted upward to market rates). Regarding CDR, revenues depend on loan collection and asset sales. EPFR has contractual interest costs, but its revenue prospects are tied to CDR's success. In its first year, CDR posted losses amounting to about 21 billion franc* despite receipts of about F 20 billion.
Balance Sheet Item Income (+)/Expenditure (-)
CL Loan to EPFR + 1% in first year, then close to market rates CDR NPL uncertain EPFR Loan to CDR uncertain
The management of CDR has stated that about one third of its assets is likely to be sold without major losses; 44 percent of total assets are quite doubtful and may produce little revenue, and about 20 percent have yet to be evaluated.
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receipts of about F 20 billion. Part of these receipts were used to service or repay liabilities that turned out to be attached to several of the assets transferred from Credit Lyonnais in 1995. These liabilities are considered by the authorities to be covered by F 60 billion of performing assets (were this assessment to prove too sanguine, then, of course, the final cost to the State of the rescue package would be commensurately increased). Meanwhile, Credit Lyonnais continued its policy of divestment abroad (including the reduction of activities in Europe, and the complete sale of its subsidiaries in Latin America), and has announced the dismissal of 5,000 employees (about 10 percent of its workforce in France) by the end of 1997, bringing the total number of dismissals under the restructuring plans to some 10,000.26
While Credit Lyonnais achieved a small profit in 1995 and the first half of 1996, it has experienced difficulties in attracting and keeping new clients, and its low ratings have affected the terms of its access to wholesale financial markets. In addition, the contractual interest on its loan to the intermediary agency in the defeasance structure (EPFR) declined in line with the fall in interest rates (notwithstanding the fact that part of this loan has been swapped and securitized to lock the interest rate and cut net funding requirements). As a short-term measure, the Government decided in September 1996 to inject an additional F 3.9 billion into Credit Lyonnais, and this was approved by the European Commission. Subsequently, the Government increased the interest rate on the loan to EPFR to be fully equivalent to market rates for both 1995 and 1996, resulting in rates of 7.45 percent and 5.84 percent, respectively; this adjustment was approved by the European Commission also. It is clear that additional measures will be required to permit the bank to recover: this would appear to imply inevitably a more aggressive downsizing of activities in France. The Ministry of Finance has recently underscored its commitment to privatizing Credit Lyonnais.
In 1995, the Cour des Comptes (the general auditing and financial review office of the state) published a detailed analysis of the problems at Credit Lyonnais. The analysis placed less emphasis on the type of lending that led to the losses than on some of the underlying principles involved. It concluded that Credit Lyonnais had lacked the capital, competence, organizational structure, and sophistication to engage in such a growth strategy' Top management was considered to have received extremely poor information. However, the report also placed some of the responsibility on the Commission Bancaire, suggesting that problems had emerged as early as 1989, and should have prompted a swifter response The Commission Bancaire (in a statement issued when the Cour des Comptes presented its report) has argued that no sign of deterioration in the risk policy of the bank, or any indication of abnormal developments in its activities, appeared before 1991. The Commission Bancaire has also noted that it was the first public authority concerned with surveillance of the activities of state-owned banks to discover and signal the difficulties at Credit Lyonnais, when reviewing the accounts of the bank in 1992, it had insisted on significant provisions on top of those envisaged by the management of the bank, and discouraged further expansion of some
26Credit Lyonnais' remaining operations abroad—in particular in the United States and the United Kingdom—have been relatively profitable
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subsidiaries, but these early warnings were ignored by senior management and the expansionary policy continued until 1993.
In the case of Credit Foncier, following the provisioning in early 1996, the capital to assets ratio of the bank was below the minimum required levels. The Ministry of Finance set time limits for a solution to be found: a first deadline lapsed at the end of July; a second deadline was set for the end of October 1996. Annual accounts for 1995 were approved by a general assembly in late June; given that all bad loans were generously provisioned, and that the remaining portfolio continued to generate income, the bank is projected to make a profit in 1996. No public funds were directly injected into Credit Foncier.
In late July CDC—acting essentially as an agent of the Government—offered to buy all outstanding shares in Credit Foncier at the price of F 70 per share. (Since April the value of the share had oscillated between F 30 and F 40; and recent independent valuations of the bank's assets had placed the value of its shares between F 60 and F 100—still well below the average price of about F 300 in 1993-94.) With 37.5 million shares outstanding, the proposed purchase of two-thirds of the capital was estimated to cost F 1.7 billion. (Such payments do not constitute a direct subsidy to the bank and may therefore not be subject to investigation by the European Commission). While the restructuring plan required CDC to purchase two- thirds of the voting stock, in the event more than 90 percent of the shares were tendered, implying a cost of some F 2.4 billion. Under the plan, a new institution is to be created. The bank's performing assets (mainly PAPs) are to be transferred to the existing Credit Immobilier de France (CEF), while the newly-created Caisse Nationale du Credit Foncier is to take over all shares purchased by CDC and manage the nonperforming assets and associated liabilities The merger is likely to entail a large reduction in the current workforce of 3,600 (earlier plans had called for a trimming of one quarter of the staff); CIF is committed to retain about 1,500 workers to operate branches transferred, and the state is attempting to find positions for the other workers The rescue plan has been developed by the Ministry of Finance, departing from the established tradition of working out restructuring operations under the guidance of the Commission Bancaire. The banking supervision agency is not involved because Credit Foncier will cease to exist; CDC is not subject to the banking law, and hence not subject to banking supervision. The plan will need to be approved by the Parliament
The Government has recapitalized several other state-owned banks These include two small banks on the privatization list (Banque Hervet and Societe Marseillaise de Credit), where the injections totaled some F 2 billion Comptoir des Entrepreneurs (owned by the public and several public-owned financial institutions, some of which did not agree to participate in the write-offs of the bank) received support from the state (including guarantees) amounting to F 17 billion.
Some other banks belonging to publicly-owned insurance companies were also recapitalized in part by the transfer of shares of privatized enterprises still owned by the Government Finally, Banque du BTP was recapitalized in an amount of F 0 8 billion by, among other shareholders. Credit Lyonnais and Credit Foncier, before pan of its portfolio was
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sold to Credit Cooperatif (minority shareholders—mainly large private construction firms—declined to inject more capital).
Competition policy
In response to the narrowing of margins observed in 1995, the Governor of the Banque de France issued a severe warning against this practice, and asked banks to report any loans granted at rates below the yield of government bonds to the Commission Bancaire. Indeed, the French authorities have viewed the recent narrowing of margins as a serious threat to the long-run viability of banks (in apparent contrast to their reaction to the narrowing of margins observed in 1992). They have rejected arguments based on the internalization of both costs and benefits relating to individual clients, which could be viewed as justifying an apparent cross-subsidization between activities: the CNC has argued that in light of the inadequate management accounting systems in French banks, it was unlikely that losses made in such lending were recouped elsewhere. While there may be dangers in very narrow lending margins, the effectiveness of measures such as these—as with interest rate ceilings—is always open to question, in particular when banks provide a wide gamut of financial and administrative sendees to corporate clients for which they are free to charge any fees. Ultimately, of course, it is for the management of banks to take individual pricing decisions.
As regards conditions of competition among different types of banks, the Government has been sensitive to the case presented by the AFB. Recently, two important monopolies were weakened (see Box 3). In addition, the Government has been sympathetic to the idea of reducing taxes levied on banks1 labor costs (currently at 12 percent), and to the system of lending consortia proposed by the AFB.27 An earlier measure led to the integration of the pension schemes of the sector into the national system of supplementary pensions (thus diluting the heavy future pension liabilities of the sector).
E. Current Policy Issues
While the banking system in France appears to have largely weathered the real estate crisis, the general profitability of the sector is not strong, and it faces the continuing intense
rThe system attempts to improve information sharing among creditors—in principle without fostering a cartelization of credit, but reducing the incentives faced by borrowers to shop for better interest rates, sometimes at the expense of a more long-lasting relationship between parties, a strand in academic literature on banking has recently emphasized the advantages of increasing the information available to banks even if reducing competition among lenders (eg., Galetovic, 1994; and Boot and Thakor, 1995).
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pressures of competition that characterize the industry world-wide. Competition will certainly intensify in the years ahead, especially with the advent of European Monetary Union, which is bound to prompt financial institutions to take fuller advantage of the European single-market regulations introduced since 1993.28
A first broad question is how the sector may respond to these challenges, including the estimated F 20 billion required to adjust payment systems to operate with the single currency, and the potential loss of about one quarter of the overall income currently generated by foreign exchange business. In particular, it is important to assess whether official policies inhibit actions that are needed to improve flexibility, profitability, and capitalization. A second issue is the extent to which problems in the sector may affect monetary and fiscal policy, and economic activity. Finally, a crucial question is whether the reforms that are being ushered in or considered by the authorities in the areas of governance and supervision are appropriate and adequate to minimize the chance of renewed problems and to counter moral hazard flowing from official intervention.
Medium-term market pressures
French commercial banks will need to go through substantial changes in the next few years: some such changes are already underway, but more actions will be needed to accelerate cost-cutting and consolidation in the industry, while additional equity investment in banks will likely be called for from outside the domestic financial services sector. Most French banks, including mutual and savings banks, will also need to enhance their management accounting systems and reduce the size of their labor force, while increasing its flexibility, in order to reduce their operating costs (see Appendix II). These are areas in which the remnants of the structure that prevailed in the 1970s have acted as major obstacles to overhauling the sector, and these are discussed below. If French banks overcome these challenges and strengthen their capital base, they will be well-placed to benefit from their technical expertise in areas such as the management of advanced financial products, and from the infrastructure put in place by both banks and the Government in the last decade (e.g., in the payments system and the interbank market).
The rigid cost structure of French banks in part reflects the pervasive lack of flexibility of the labor market. Although wages and employment in the banking sector have not
2*The Second Banking Coordination Directive of 1993 and the more recent directive on financial services (translated into French law in July 1996) have made it possible for financial institutions established in one European Economic Area (EEA) country' to establish branches in any other such country by simply notifying the host country. The directives have also set the framework for financial institutions to offer cross-border services.
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increased very rapidly in recent years, labor costs have increasingly appeared high relative to revenues, and are likely to become more so in view of technological progress in the industry world-wide.29 More pressingly, the downsizing of a number of banks appears essential to improve their profitability in the short run, but dismissal costs are a major obstacle in this regard. Under the general labor laws governing collective lay-offs (e.g., the "Loi Aubry"), such lay-offs are granted only if the firm is facing economic hardship and a large number of options have already been considered, or upon the payment of very large compensation. Without changes in current restrictions, a rapid downsizing of the industry would be extremely expensive (see Appendix II). For instance, a 10 percent cut in the workforce of 400,000 persons (on top of the 3 percent a year decline due to attrition) could cost the sector some F 30 billion (or roughly the equivalent of the provisions for bad loans made in 1995).30 In addition, a 1937 decree concerning work practices specifically in the commercial banking sector seriously limits the flexibility of banks to shift to more flexible work hours. Thus, from a policy standpoint, effectively addressing the problem of labor costs in the banking sector implies a broader initiative to deal with rigidities in the labor market.
The equity base of most commercial banks is rather limited and profitability is low. Some consolidation is required: while this could take various forms, the imbalance between well-capitalized banks and others with lower capital suggests that mutual banks (as well as foreign investors) may play an increasingly important role in ownership.31 However, this consolidation may be hindered by some features of the ownership structure of commercial banks, especially the widespread cross-holdings with other financial institutions, the reliance on complex structures permitting full account for regulatory purposes of the capital of technology is reducing the demand for labor through changes within the branch structure (automatization, subcontracting of clearing activities, etc ), as well as developments which bypass that structure, such as home and telephone banking sen/ices (Cressey and Scott, 1993) This trend is likely to be intensified by the advent of monetary union, which will give greater scope for cross-border telephone banking services and the consolidation of back-office activities, which are quite sensitive to labor costs.
"Because banks tend to keep dismissal costs confidential, their average amount is hard to quantify The order of magnitude can be illustrated by the F 280 million that CDR claimed it would have cost to fire 220 employees of the former Credit Lyonnais subsidiary SBDO Hence, a yardstick cost of F 750,000 per dismissal is used of 3 years labor costs The wage bill of the banking sector is some F 150 billion a year, witfi about half corresponding to costs of the AFB banks
31 The capital of mutual banks is held by their long-term depositors, saving banks are non- profit organizations and do not have shareholders (see Section B), reflecting the legal status enjoyed by this class of institution in several European countries. The purchase of mutual or savings banks by a corporation is not allowed, although commercial banks can buy subsidiaries of those banks
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partially-owned subsidiaries (in accordance with Basle guidelines and EU directives), and the wide recourse to subordinated debt (Table 17 and Box 5). The cross-holdings of shares, in particular, impede the valuation of institutions by potential investors—buying a share in one bank actually means being exposed to risks in the activities of several banks.
Macroeconomic issues
It is difficult to gauge the direct consequences of the recent problems in the banking sector for economic activity. Because the most severe manifestations of the real estate cycle were concentrated in commercial property, the direct wealth effects on households may have been relatively modest (especially outside the Paris area); and since loan portfolio problems were spread across a range of institutions, systemic risks were lessened. Moreover, with loan demand weak, the effect on credit availability of subsequent adjustment in banks' balance sheets has probably not been significant so far. In the period ahead, however, the need of banks to rebuild their balance sheets may affect the transmission of monetary policy, particularly given the current setting of low short-term interest rates and an upward-sloping yield curve. In particular, if banks have a relatively weak capital base, the positive slope in the yield curve may result in their choosing to invest in government securities instead of extending credit, because by so doing they can achieve a positive spread without increasing their minimum capital requirements, except for some adjustments for interest rate risks.32 Although it is not clear that such a phenomenon is developing in France to the extent documented for the United States in the early 1990s (e.g., Keeton, 1994), the increase in bank holdings of government securities since mid-1995 has been noticeable. If indeed banks prove unusually reluctant to expand credit in the period ahead, this may not be a serious problem for many large enterprises, which have ample liquidity, but could restrain the expansion of small and medium-sized firms, which are much more reliant on bank credit
With regard to the fiscal impact of the recent problems, the direct, recorded costs of restructuring banks have to date been limited mainly to the recapitalization of small public banks, often in the context of their privatization. As noted above, and in contrast to experience elsewhere, the authorities did not have to bail out private banks, in pan because deposit insurance is guaranteed by banks themselves, and shareholder institutions have generally been ready to support the banks they owned Indirect costs have comprised mainly the transfer of assets belonging to the state (e.g., minority shareholdings in privatized companies) and support from government-owned financial institutions, such as CDC (see Section D) Much larger fiscal costs, however, loom ahead, because the Government itself will bear the burden of the residual claims arising from the defeasance structure set up in the case of Credit Lvonnais and other institutions
3:See Thakor (1995). Calomiris and Wilson (1996), and Ramos (1996)
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Box 5. Cross-Shareholdings and Other Aspects of Capital Structure in the Banking Sector
Large cross-shareholdings, although proving effective in providing a certain institutional stability to the sector following the privatization of the main banks, can weaken corporate governance—especially in the case of institutions where the weight of major shareholders is more or less even. In contrast to bona fide consolidations, or explicit alliances, cross-holdings may reduce the effective diversification of financial institutions without increasing their synergies or helping the definition of clear strategic goals. Cross-holdings may also result in a problem with one bank having an impact on a number of other banks. This tends to increase the fragility of the system, in addition to make the valuation of an individual banks very difficult. Cross-holdings can also lead to a growing discrepancy between voting power and invested capital (cross-holdings between banks are netted out of their capital for regulatory purposes, but can support important voting blocks). To this extent, they could inhibit the entrance of new capital, which—through new investment and competition for management talent—may increase the efficiency of firms and thus strengthen the banking sector (see Hubbard and Palia (1995) and Jensen and Murphy (1990) for a discussion of this hypothesis in the U.S.). The authorities consider, however, that the large cross-shareholdings in France do not impede competition or prevent mergers, noting in this connection the recent takeover of Banque Indosuez by Credit Agricole.
The joint ownership of banks by several institutions can raise problems of coordination, by comparison with wholly-owned subsidiaries; when the owned bank faces difficulties, institutions may not feel obligated to respond to an invitation to recapitalize the bank. The authorities have established procedures designed to overcome these difficulties: the Conseil des Etabiisements de Credit has dealt with the problem of the absence of a major shareholder by asking the largest of the minority shareholders (or the leading financial institution among them) to provide a "comfort" letter to the Chairman of the Commission Bancaire recognizing its commitment to support the bank if the latter faces difficulties, and the Chairman can also take the course of using Section 52 of the Banking Act to ask other shareholders to contribute support (This approach is described in Section B of this paper, and is discussed below in Section E ) Finally, specific codes of conduct and professional rules apply to investors in, and managers of, credit institutions.
The practice of recording the full capital of partial]}-owned (but fuUy-cont rolled) subsidiaries in the capital base of the parent company, is expressly provided for under international and EU standards If such participations or turn out to be unprofitable, of course, the short-term gain to the capital base through this leveraged operation can be eroded (as was the case at Credit Lyonnais) For regulatory purposes, the authorities require banks to deduct from the capital base of the parent company instruments associated with such partial ownership, which is a stringent approach.
Reliance on subordinated debt instruments lends to reduce the flexibility of bank*, since servicing this debt reduces the resources available to he distributed as dividends and failure to pay interest on them does constitute a default In addition, although the nsk premium on subordinated debt could be viewed as a signal thai bankers receive from the market, empirical evidence in the case of U S banks indicates that "the potential lor market discipline to effectively and constructive!) augment regulatory controls via these instruments is weak* i Avcry. ct al. 1988) Until recently about 40 percent of the total capital base of the major commercial banks in France comprised subordinated debt The ratio of equity to total capital of these banks needs to be seen in the context of the relatively low overall capital to total assets ratio exhibited by French commercial banks, but it is above international minima and does not compare significantly unfavorably with that of banks in other industrial countries Moreover, including all categories of banks, the sector has a relatively iou reliance on subordinated debt by comparison with other industrial countries
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Currently, the financial structures created for handling the sale of "bad" assets of Credit Lyonnais fall outside the scope of the general government accounts. Therefore, until the Government transfers funds to EPFR (Box 4), the rescue of the Credit Lyonnais will have no effect on the government accounts. Indeed, if transfers to the defeasance intermediary EPFR are funded by the sale of government assets (e.g., from privatization) they will still have no direct impact on the fiscal deficit. Nevertheless, the total losses accumulated in EPFR are likely to amount to F 80-90 billion (well above the initial estimate of F 50 billion incorporated in the 1995 rescue plan). Taking into account the losses arising from CdE, and likely at Credit Foncier, the medium-term fiscal cost arising from past losses could be on the order of l!/2 percentage points of GDP. The total cost of restructuring these institutions will include, in addition, the expenses arising from downsizing—in particular dismissal costs. Although hard to quantify, it appears that a radical cut in the workforce of those banks could add more than F 10 billion to the overall costs.33
The impact of these additional government liabilities on economic activity is again hard to measure. Costs potentially amounting to about 2 percent of GDP need to be seen in the context of other nonconsolidated liabilities of the government (which are put in some estimates at F 1-1 !/2 trillion). Moreover, to the extent that these costs do not impose liquidity constraints on households, their adverse effect is smaller than that of a collapse of the housing market or of savings institutions; nonetheless, taxpayers may well be sensitive to the potential fiscal impact.
Governance, supervision, and regulation
The major challenge for the regulatory authorities has been the orderly management of the recent banking problems, to avoid jeopardizing public confidence With this aim achieved, lessons are now being drawn from these problems—particularly with regard to governance issues, and the handling of these through the regulatory and supervisory framework Specifically, attention is focussing on aspects of bank governance, including the adequacy of internal control systems, and the existence of checks and balances to the abuse of executive power—areas where the Commission Bancaire has lacked sufficient enforcement powers
Governance
While all the episodes in institutions with serious losses have specific features, all point strongly to a lack adequate of internal controls. They also illustrate how difficult it can be to recapitalize a bank with many minority shareholders, and how the effect of a bank on one sector of the economy can induce the Government to support the full cost of recapitalizing such an institution
33See the previous Section for the method used in this estimate
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The case of Credit Lyonnais, in particular, brought to light weaknesses in the corporate governance structure of the bank, including notably its internal control system. The state as shareholder was not regularly informed by management of the full extent of the bank's risk exposure. In this and several other cases, activities in subsidiaries were not adequately reported to management or the supervisors, or covered in the published accounts.
The authorities are committed to privatizing all banks that remain under state ownership over the next few years, which should strengthen governance, improve efficiency, and attract new capital to the sector. Privatization is also crucial because it will end the conflicts of interest inherent in the different roles of the State vis-a-vis the banks. A landmark in the privatization program will be the outcome of the efforts to privatize the Credit Industrie! et Commercial.
Governance and management problems are not limited, however, to the realm of state banks. The banking association has responded to initiatives of business groups (e.g., the Conseil National du Patronat Fran9ais, CNPF) in the area of governance by developing a set of guidelines for corporate governance. Recently, a draft code to improve corporate governance generally was prepared for the Government by members of the National Assembly.
Changes that would strengthen corporate structures and standards of public disclosure have thus been under active discussion, and there is a need to move to decisions in these areas (see also the discussion under banking supervision below). In terms of corporate structure, an important mechanism to improve the checks and balances at the highest decision levels in banks would be the appointment of Board-level audit committees. Such committees, in addition to reviewing current operations, can be empowered to examine the main strategic decisions taken by bank management. The mandatory introduction of effective audit committees, if it were to be considered necessary by the authorities, would require changes in the law no such legislation has been presented, and the idea has faced some resistance among bankers; but the National Assembly has studied the advisability of moving in this direction. Such committees could help ensure—and reinforce the effect of—the improvements in management and control systems discussed below.
Greater emphasis on public disclosure is also necessary In March 1995, the Governor of the Banque de France, as Chairman of the Commission Bancaire, wrote to the AFB to urge bankers to improve the quality of their published accounts in line with the highest international standards A primary focus of this initiative was the coverage of market risk (especially in derivative products); but the letter also reiterated an earlier proposal to publish mid-year statements, and stressed the need for a more homogeneous treatment among banks of the profit and loss account and of balance sheet capital In February 1996, a group of major auditing firms also jointly urged banks to strengthen the principles for loan valuation and provisioning (including less discretion in the use of the general reserve for banking risks and a more rigorous treatment of interest due but unreceived on doubtful debts), to make fuller
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statements of exposure to market risks and to real estate (disclosing valuation methods used for real estate); to present a geographic and product-based analysis of operating profits; and to provide more adequate information on internal risk control systems. The drive for increased transparency and disclosure appears a very high priority, and new accounting standards may need to be promulgated to enforce this.
Finally, the elimination of privileges would contribute to a more level playing field, and eliminate an element that is distracting attention from more fundamental issues. In particular, it would appear that the Livret A has somewhat outlived its raison d'etre. Although in the short-term it represents an attractive savings instrument to households, the choice of market instruments (including pension instruments) is continuing to expand, while there is no longer the acute shortage of housing that prevailed when the passbooks were introduced. Moreover, with new technology for making payments, the use of these accounts as quasi- checking accounts by less affluent people is likely to decrease. More generally, it appears preferable to phase out privileges rather than to extend them to wider groups of institutions. Similarly, it would appear logical, where banking activities are conducted in near-banking institutions, to bring these activities under essentially the same system of regulation and supervision as such activities in the banks.
Prudential supervision and regulation
The French system of banking supervision is in conformity with international standards (EU directives and Basle agreements), and in general is rigorously applied The main area in which strengthening is under consideration, and is needed, relates to banks' internal controls and management information systems, which are fundamental to assist the rapid detection of incipient problems by banks themselves and by supervisors Although banks provide periodic reports to the Commission Bancaire, and the Commission Bancaire makes frequent on-site inspections, it is not possible to detect problems sufficiently quickly in the areas of exchange and interest rate risk, and the experience of the past few years illustrates the need for more adequate information on credit exposures, including in subsidiary companies.
Currently, a regulation is under consideration (in conjunction with the implementation of the EU directive on financial services) which would help to assure stronger internal controls in banks and clarify the mandate of the Commission Bancaire in this area. A main object of this regulation is to improve the quality, comprehensiveness, and timeliness of information available to management with regard to credit and market risk—including notably overall interest rate risk, and the adequate incorporation of this in banks' risk management systems Regulations under preparation are also expected to empower internal audit units to decide when to examine the accounts of entities within a banking group (for example a subsidiary or a department) at present, in some cases, they can review these accounts only by invitation of the head of the entity concerned
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As the range of banking operations expands, the authorities will need to ensure that the supervisory authority has the means to keep abreast of developments. This is likely to entail a strengthening of on-site and off-site supervision through additional enquiries into specific activities. The staff of the General Secretariat of the Commission Bancaire may need to be expanded, especially in areas of technical specialization including the surveillance of market operations. Fuller and more timely information and a clear supervisory mandate should help avoid delays in responding effectively to problems in the banking system, and ensure that supervisory warnings are heeded.
Finally, with regard to the authorities9 approach to dealing with banks in difficulties, the Banque de France has in the past succeeded more often than not in persuading owners to recapitalize problem banks, but this may not hold in the future, as was illustrated in the case of the Pallas-Stern bank. In particular, problems may arise in cases where ownership is very fragmented. Such a development is not unwelcome in itself, since the retrenchment of the state should reduce the discretionary powers of the Government, and is consistent with the principle of limited liability. However, if the system is becoming less "managed," then risks to confidence, and indeed risks to the public purse if there is a need to counter systemic problems, can only be greater in the future. This underscores strongly the case for enhancing market discipline and strengthening the regulatory framework.
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Structure of the Banking Sector
The major groups of banks
The French banking system (excluding 46 banks from EU countries which operate under a license issued by their country of origin) was composed of 547 banks at end-1995 (572 in 1993) and 829 financial companies (1,007 in 1993). In total, 1,445 institutions were subject to the banking law and subject to banking supervision by the Commission Bancaire at end-1995 (1,649 in 1993). A further decline in the number of banks is underway in 1996, due to mergers and liquidations.
Concentration in the French banking sector is somewhat higher than in other major OECD countries. For instance, the largest five banks have a market share of 41 percent (in terms of assets), while in Germany the market share of the major three banks is about 13 percent. Moreover, the largest 10 banks hold about 56 percent of total assets but 83 percent of total deposits and 63 percent of total loans.
State ownership and control
Several banks (including Societe Generate, Paribas, the Suez holding, and some specialized banks) were privatized in 1986-87, a few years after the 1982 nationalization of the sector. The insurance company UAP, and the large commercial/universal bank BMP, were privatized in 1993; the insurance company AGF, was privatized in early 1996. The State still owns the majority of the shares of Credit Lyonnais, Banque Hervet, Societe Marseillaise de Credit, and (through the insurance company GAN) Credit Industriel et Commercial (CIC). The State has also appointed the management of Credit Fonder, even though the bank is privately owned; the rationale for this mechanism was the bank's quasi-monopoly on distributing home loans carrying a government guarantee.
The group Caisses d'Epargne (which comprises 35 regional non-profit savings banks) is not publicly owned. Similarly to saving banks in several European countries, the Caisses d'Epargne have a special ownership status—regional and local banks were founded with a small capital base, which is held under the "main morte", and therefore have no owners in the corporate sense For this reason all profits are retained, which coupled with a somewhat conservative administration has led to very comfortable solvency ratios The supervisory' body (Conseil de Surveillance) of the Caisses D'Epargne includes client representatives, members of the Senate and a commissioner of the Government (from the Tresor) In addition to this central body, control is exerted by the about 2000 annual assemblies, convened at different levels within the structure of the group
There are also a number of state-owned near-bank institutions that engage in typical banking activity but are subject to special legislation rather than the Banking Law (e.g., the Tresor, the Banque de France, the financial services of the Post Office, the Institut d'Emission des Depanements d'Outre-Mer, the Institut d'Emission d'Outre-Mer. and the Caisse des
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Depots et Consignations). The banking services offered by the Post Office are focused on retail deposit-taking. The Tresor Public engages in deposit-taking (from certain professions), acts as a bank for public entities, grants loans and guarantees, and manages participations. The Caisse des Depots et des Consignations (CDC) acts as the central clearing bank for the savings banks and the financial services of the postal bank. The CDC engages in long term loans to local government and low income housing (both loans to individuals and to developers of low income renting units known as HLM—usually with resources from regulated savings instruments such as the Livret A). CDC also acts as manager of various financial bodies, in addition to holding a large portfolio of public debt.34
Regulatory institutions
A number of official bodies are involved in the oversight of banking developments, and their key functions are as follows.
Commission Bancaire
The Commission Bancaire is the body responsible for banking supervision (i.e., all credit institutions and, since the translation of the EU directive on financial services in July 1996, investment firms). It monitors credit institutions' observance of laws and regulations and takes disciplinary action. The Commission Bancaire is chaired by the Governor of the Banque de France and comprises the Director of the Tresor and four members appointed by the Minister of Finance; one of the appointments is drawn from the administrative court (Conseil d'Etat) and one from the appeal court (Cour de Cassation). The General Secretariat of the Commission Bancaire carries out the day-to-day monitoring and disciplining of banks, including both on-site and off-site supervision The staff and the resources of the General Secretariat are currently provided by the Banque de France (Article 39) The General Secretariat draws up the reporting requirements to be filed by banks. The on-site supervision reports are forwarded to the governing boards of the banks and to their auditors. The authority for sanctions rests solely with the Commission Bancaire Appeals to its decisions are heard by the Conseil d'Etat
Conseil National du Credit (CNQ
The main role of this council is to study the working of the banking and financial system, particularly with respect to customer relations and payment systems issues (Article 24 of the Banking Law) The council is chaired by the Minister of Finance and includes the Director of the Tresor, as well as parliamentarians of various levels, and a wide spectrum of interested parties The Governor of the Banque de France is deputy chair
34Among those bodies are the Fond de Soutien des Rentes and the Caisse Nationale des Autoroutes
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Comite des Etablissements de Credit et des Entreprises d'Investissement (CECEI)
The committee authorizes new banks and investment firms (licensing requirements are laid down in the Banking Law as revised to reflect this translation of the EU directive on financial services). It withdraws institutions' authorizations either at their request or when the condition of the authorization is no longer fulfilled. (As a disciplinary measure, a bank's authorization can also be withdrawn by the Commission Bancaire.) The committee is chaired by the Governor of the Banque de France, as Chairman of the Commission Bancaire; its members are drawn from within the CNC.
Comite de la Reglementation Bancaire et Financiere (CRBF)
The committee sets specific regulations applicable to credit institutions and investment firms; it establishes regulations governing all aspects of prudential regulation of financial markets including capital requirements, branching, equity holdings by banks, joint services, and internal controls. The Committee also establishes the chart of accounts, independent audits, and rules for consolidation and disclosure, and on deposit protection. The Committee is chaired by the Minister of Finance (or a representative), with the Governor of the Banque de France (as Chair of the Banking Commission) as deputy; its members are chosen from within the CNC.
Banking insurance
Bank insurance is arranged by banks themselves, under regulations drawn up by the CRB In the case of commercial banks, the AFB is the responsible for reimbursing depositors Upon the occurrence of a banking failure, the AFB chooses one institution in which it opens an account from which all reimbursements are drawn. Usually, the association contacts depositors in the space of a few days after the failure is determined, and starts reimbursements well before the other liabilities of the failed bank are sorted out. After all depositors are reimbursed (up to the limit of the collective insurance, which is F 400,000 per account), AFB computes how much should be the contribution of each bank associated to the collective insurance scheme and bills them accordingly (the sharing is based on publicly known formulae). All contributions are expected to be deposited on the same day, permitting the closing of that account at that time The AFB believes that raising these resources only when they are needed is better than pre-funding a collective instrument, which it considers might weaken the discipline of participants The mutual sector has its own distinctive set of arrangements, similar to a deposit guarantee system bu with the objective of forestalling rather than correcting problems. Recently other credit institutions (e g , financial societies) were also required to set up their own guarantee schemes.
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Medium-Term Issues in the Banking Sector
Management accounting systems and service fees
There are two main approaches to attributing banks' costs in determining institutional strategy: one is based on a line-by-line assessment of profitability, while the other takes a view based on synergy among different services provided to a client. For both approaches, in a context of increased competition, efficient management accounting systems are crucial: even if not every service is priced according to its cost, this cost has to be known with precision if the actual return of a "relationship11 is to be known. In France, the development of management accounting has been hindered by the widespread use of cross-subsidies, stemming from the fact that sight deposits are not remunerated, and standard services (such as checking accounts) are usually not charged. Traditionally, costs were recouped via relatively high interest margins (which in the 1970s were among the highest in the world). Financial innovations and competition have put pressures on these margins, making the need for charging for services more acute. Improved managerial systems, of course, depend on banks and cannot be achieved by governmental fiat.35
Regarding service fees as such, while it would be inconsistent with market principles for the State to impose a schedule of fees, market pressures are resulting in the gradual introduction of fees, sometimes as new technologies are adopted (an attempt in 1978 to charge for checks failed, leaving lasting memories in the industry). New technologies are not only permitting a reduction in the excessive use of checks, but habituating customs to the idea of paying for services received (as in several other countries, electronic payment instruments generate fees in addition to being much less expensive). The introduction of the Euro may offer an opening for an overhauling of the system. Because the single currency will make clear the differences in remuneration of sight deposits across European countries, banks may take the opportunity to align their practice to those of other countries where the counterpart of remuneration of deposits is a larger reliance on service fees (see table below)
"The Commission Bancaire has nevertheless, emphasized its importance and given a signal by regulating the so-called software risk (which is linked to internal controls) and making available statistically based credit scores targeted at helping banks to adjusting their lending rates to the idiosyncratic risk of small firms.
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Non-French Institutions from the European Economic Area
Branches from foreign Banks entitled to offer banks cross-border services Country of origin 1992 1993 1995 1993 1995
Austria 2 Belgium 2 2 3 6 15 Finland 1 1 ~ Germany 4 6 8 1—4 2—5 Ireland -- 2 — — Italy 5 —6 5 Luxembourg 1 —3 2—4 Netherlands —3 —3 3 4 6 Portugal 5 5 5 4 4 Spain 9 11 10 1 — Sweden 1 1 1 1 United Kingdom 4 10 —5 14 — Total 34 35 46 36 94
Source Comite des Etablissements de Credit
Labor market
Labor relations in the commercial banks are largely regulated by a decree dating from 1937, which established general labor conditions, including restrictive working hours and limited geographical and functional mobility. Although in recent months unions and management in several AFB banks have agreed on initiatives aimed at increasing labor flexibility (e g., increasing part-time, late-hour, and weekend work), working conditions are manifestly more restrictive than in the United States and the United Kingdom and provide insufficient flexibility to contribute to rapid downsizing
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Options for dismissal envisaged in the Aubry law comprise transfers of personnel to other activities, and early or partial retirement schemes. However, the scope for reducing costs through the redeployment of workers appears limited (especially at low skill levels), even if linked to higher use of part-time work.36 Recourse to early retirement schemes appears also to be constrained because they entail significant costs to the government (which has to compensate the general supplementary pension scheme for shorter contribution and larger retirement periods) and have seldom been accepted by the authorities. However, some modest schemes substituting young workers for people retiring with the minimum number of contributive years have been worked out.
Aspects of recent mergers and acquisitions
In recent months a number of mergers, acquisitions, and alliances have taken place. The merger of Credit National (CN) and Banque Franpaise du Commerce Exterieur (BFCE) illustrates the case of two specialized banks operating in somewhat distinct markets, which expect to increase the return on their capital by using their skills in different areas, while cutting costs where their activities overlap (a 15 percent cut in personnel is expected to increase profits by 30 percent).37 The purchase of a majority of the shares of Indosuez, whose activities center on investment and private banking (and which was facing difficulties in refinancing its liabilities in financial markets), by Credit Agricole illustrates how an institution with a solid capital base can be instrumental in increasing the profitability of a debilitated bank (following the acquisition Moody's increased the ratings of Indosuez's from A2 to Aal). It is also notable that the sale of Indosuez was preceded by a radical restructuring of the bank, which included the definition of new strategic goals (with the help of outside consultants), the appointment of new management, and the enhancement of its management accounting
Reboin law, enacted in mid 1996 provides for substantial schemes along these lines, many firms are applying for the schemes offered under this law, raising questions about the fiscal sustainability of the measure
rCN, which is listed in the Paris stock exchange and has one quarter of its shares controlled by CDC, AXA, UAP, CFF, and Credit Agricole, used to focus mainly on the financing of investment, although it entered other markets—including real estate—in the mid-1980s BPCE, which was owned by the government until its purchase by CN\ was originally dedicated to the financing of foreign trade and has several branches abroad The merger entailed a complex pact among shareholders and double voting schemes—favoring long-term shareholders—and required an increase in subordinated debt
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systems.38 The alliance of Credit Local de France and Credit Communal of Belgium illustrates the geographic expansion of another capital-rich French financial institution in search of a greater size to solidify its activities at the European level.39 Finally, the purchase of consumer credit company Sovac by General Electric illustrates the continued interest of foreign investors in French banking in light of the new prospects in retail banking opening in theEU.
"In addition, Indosuez's balance sheet was revamped, including through the transfer of non- performing loans to Suez and the sale of a troubled subsidiary in the UK The bank plans to achieve a 10 percent return on capital in the near future technically, CLF is an specialized institution The new institution, which will be controlled by an strategic committee with four members appointed by each panner. is ranked among the 15 largest banks in Europe, and plans to take its basic business line of financing local governments throughout the continent.
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Table 1. France: Credit Institutions by Type and Class of Ownership
(By type)
Type No. of Institutions Share of Total Assets (In percent)
Licensed in France Banks (commercial/universal banks 360 58.2 Mutual Banks 15.8 16.8 Savings Banks 35 6.1 Municipal Credit Unions 20 0.1 Financial Societies 821 10.5 Specialized Institutions 31 8.13 Licensed in other countries of the European Economic Area (EEA) 46
(By ownership—banks only)
Holders No. of Groups No. of Banks
French owners Large public banks 2 34 Large private banks 5 66 Mutual banks <% 17 Other public banks 2 7 Insurance companies 12 Industrial groups 29 Private owners 16 Other
Foreign owners Licensed in France 141 Licensed in the EEA 46
Source Comite des Etablissements de Credit et des Entreprises d'Investissements
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Table 2. France: Concentration in the Banking Sector
(In percent)
Largest 5 banks Largest 10 banks Largest 20 banks Share of 1993 1995 1993 1995 1993 1995
Assets 41 41 56 56 67 67 Deposits 67 68 83 84 88 89 Loans 46 46 63 65 75 76 Housing 61 60 81 81 87 86 Consumer 39 36 60 55 75 74 Industrial 58 60 79 79 88 89
Source. Banque de France.
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Table 3. France: The Largest Banks, 1994
Total Assets Capital (in billions of francs) Employees
In Share of Equity/ billions assets total of (in (in In francs percent) Total Equity percent) thousands
Credit Agricole 17 1,743 11 129 107 83 7227 Banque Nationale de Paris 1,268 8 101 60 59 53 21 (BNP) Credit Lyonnais 1,294 8 98 31 31 6827 Societe Generate 1,377 8 91 54 59 3527 Caisse d'Epargne 1,004 6 47 47 99 3827
Credit Populaire 458 "y 30 22 73 Credit Mutuel 477 3 44 44 100 Five specialized banks 996 6 Credit Foncier 348 2 Eight other banks 1,715 14 Total, largest 5 banks 6.686 41 466 300 64 267
Total, largest 20 banks 10.942 67 • •• • •• ...... Total, all banks 16,356 100 1,323 787 59 400
Sources Commission Bancaire (1994), The Banker (July 1996). The Bankers' Almanac (1996). and Institutional Investor (1996)
1 The takeover of Banque Indosuez (307 billion assets. 12 1 thousand employees) in 1996 is likely to expand the market share of Credit Agricole 2- 1995 figures
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Table 4. France: Net Foreign Direct Investment in the Banking Sector
(In billions of francs)
1985-1990 1991 1992 1993 1994 1985-1994
Outward
Overall 43.7 8.3 6.5 5.4 -0.8 63.1
EU 25.5 6.3 2.5 3.4 -2.7 35.0
Inward
Overall 20.7 5.8 3.8 6.6 87 45.6
EU 12.6 3.8 2.3 5.7 8.6 33.0
Source: Association Frangaise des Banques (AFB).
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Table 5. France: Profitability of Major International Banks in 1994 and 1995
(In percent of total assets)
Return on Net assets interest Operating (pre-tax) Provisions margin costs
Number of banks 1994 1995 1994 1995 1994 1995 1994 1995
France 6 0.17 0.27 0.63 0.39 1.60 1.54 2.04 2.00 Germany 2 0.52 0.50 0.35 0.23 1.82 1.57 2.06 1.98 United States 12 1.81 1.80 0.33 0.31 3.57 3.35 3.80 3.49 United Kingdom 4 1.22 1.27 0.31 0.34 2.45 2.44 3.02 2.98 Japan I/ 21 -0.21 -0.75 0.33 0.31 3.57 3.35 3.80 3.49
Source: Bank for International Settlements (BIS), 1996.
I/ Data for Japan are partly based on estimates.
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Table 6. France: Selected Indicators of Performance of Banks
(As percent of assets excluding interbank deposits)
1988 1989 1990 1991 1992 1993
France Net interest income 3.7 3.3 3.1 2.8 2.6 2.2 Staff costs 1.7 1.5 1.5 1.3 1.3 1.3 Provisions 0.5 0.5 0.5 0.6 0.8 1.0 Profits 0.8 0.7 0.6 0.6 0.4 0.2
Germany Net interest income 2.8 2.7 2.6 .6 2.7 2.7 Staff costs 1.6 1.6 1.5 1.4 1.4 1.4 Provisions 0.3 0.6 0.6 0.4 0.5 0.6 Profits 0.8 0.7 0.6 0.8 0.7 0.8
United Kingdom Net interest income 4.0 3.7 3.5 3.5 3.0 2.9 Staff costs 2.4 2.3 2.1 2.1 1.9 1.8 Provisions Profits 1.8 0.2 0.8 0.5 0.4 09
United States Net interest income 3.7 3.7 3.6 3.7 40 40 Staff costs 1.6 1.6 1.6 1.6 1.7 17 Provisions 06 1.0 1.0 1.0 08 0.5 Profits 1.2 0.8 08 0.8 1.4 1.8
Memorandum items (In percent) Staff costs/net interest income France 45.3 46.6 48.1 47.7 51.5 60.9 Germany 56.1 58.7 587 544 536 50.5 United Kingdom 600 60.2 61 4 61.3 630 624 United States 437 444 45.2 437 41 8 41 6
Source OECD. 1995
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Table 7. France: Bank Restructuring: Employment and Staff Costs
Employment I/ Staff costs 2/ 1980 I/ 1990 1994 A/ Peak 1980- 1986- 1992- 82 5 / 88 94 % As a percentage Number (in thousands) year change 6/ of gross income
U.S. I/ 1,900 1,979 1,891 2,136 1987 -12 36 31 27 Japan 612 597 618 622 1993 -0.6 44 33 39 Germany fi/ 533 621 658 658 1994 48 44 39 France 399 399 382 401 1988 -—5 47 44 44 Italy 277 324 332 333 1993 -0.3 46 48 44 U.K. 324 425 368 430 1989 -15 47 38 36 Canada 170 211 202 211 1990 -4 42 33 33 Australia 265 356 311 356 1990 -13 ...... • • • Belgium 68 79 76 79 1990 -5 41 33 34 2/ Finland 42 50 36 53 1989 -32 43 33 24 Netherlands 113 118 112 119 1991 -6 42 41 38 Norway 24 31 23 35 1987 -34 42 35 30 Spain 252 252 245 256 1991 -4 47 43 37 Sweden 39 45 42 46 1991 -5 29 23 22 Switzerland 84 120 112 120 1990 -7 40 37 33
Source: BIS. J7 In deposit-taking institutions; for Japan, excluding various types of credit cooperative; for Canada, excluding trust and loan companies (employment in 1995, 25,000); for Australia, finance and insurance industry. 2.1 For Belgium, the Netherlands and Switzerland, all banks; for other countries, commercial banks (OECD definitions). I/ For France, 1985; for Australia, the Netherlands and Sweden, 1984; for Spain, 1981. 4/ For Italy, Australia, Norway and Spain, 1995. £/ For France and Belgium, 1981-82; for Canada, 1982. £/ From peak to most recent observation where applicable. I/ Employment data excluding credit unions: 1994, 1,732; percentage change, -14 percentage points. £/ For employment, Western Germany only. (Data for the whole of Germany: 1994, 728.) S./ 1992.
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Table 8. France: Branch Networks and Workforce of Banks
France Germany U.K. Italy Spain
Employees/million of inhabitants 7,194 9,259 10,000 5,714 5,359
Branches/million of inhabitants 460 653 329 382 903
Employees/branch 16 14 30 15 7
Sources: BIS, Carrel-Billiar (1995).
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Table 9. France: Performance of French Banks
1993 1994 1995
Capital (equity and reserves) 11 (as a percentage of total assets) 4.6 4.8 4.5 Nonperforming Loans (as a percentage of total loans) 7.9 8.9 8.1 Liquidity ratio 2/ 155 155 160 Change in operating costs (in percent) 3.4 1.1 1.0 Change in after tax profits (in percent) 147 -248 133 Change in volume of credit (real, in percent) -1.8 -50 -0.2 3/ Change in share prices (in percent) 4/ 42.2 -264 -150
Source: Commission Bancaire and Salomon Brothers
I/ This aggregate is comparable to 'Tier 1" capital under the Basle guidelines 2' Liquid (one month or less) assets as a percentage of liquid liabilities 3/ Net of defeasance structures 4.' Salomon Brothers, January 1996
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Table 10. France: Purchase Price of Offices
(1986=1.0)
Pa r i s
General East side Defense Downtown Lyon
1986 1.0 1.0 1.0 1.0 1.0 1987 1.1 1.0 1.0 1.1 1.3 1988 1.2 1.4 1.2 1.3 1.3 1989 1.4 1.7 1.6 1.6 1.4 1990 1.7 2.0 1.7 1.5 1.8 1991 1.5 2.0 1.7 1.5 1.8 1992 1.2 1.7 1.2 1.2 2.0 1993 1.2 1.1 0.9 1.8 1994 1.0 0.9 0.8 1.4
Sources: Jones Lang Wootton (in BIS, 1993); Renaud (1995); and Leparmentier (1995).
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Table 11. France: Costs of Public Rescue Operations Relating to Financial Institutions I/
Period Total As per cent Cost 21 of GDP 31
United States Deposit insurance 1980-1992 195.0 4/ 3.2
Japan Deposit insurance 1991-1992 0.6 0.0
Australia 51 State governments 1989-1991 4.4 1.6
Finland Central government 1991-1992 1.8 1.7 Government funds 1991-1992 3.1 3.0 Central bank 1991-1992 2.9 2.7 Total 7.8 7.4
Norway Government funds 1988-1992 3.2 2.8 Central government 1988-1992 0.2 0 1 Central bank 1988-1992 0.2 0 1 Total 36 3 0
Sweden Central government 1991-1993 12.7 5.2
Source OECD (1995). I/ The figures are based on official or widely accepted estimations and do not include more uncertain estimates relating to banking problems in France and Spain Costs are estimated as perceived at the time of the capital injections and do not take account of any re-evaluations 11 Cumulative cost in billions of U S dollars at 1992 exchange rate 3.' GDP in 1992 4/ Figure comprises present value estimates of resolutions conducted by the FSL1C and the RTC (US$180 billion) and lower-bound of estimates of Bank Insurance Fund losses (USS15 billion) Sources CBO (1994) and IMF (1993) 5/ Capital injections
©International Monetary Fund. Not for Redistribution - 141 - Table 12. France: Real Estate Loans (at end-1995), Nonperforming Loans (NPL), and Banks' Assets (In billions of francs)
Tota1 stock Provisions/ Total assets of i•eal Stock of NPLs Institution (end of 1994) estate loans NPLs (in percent)
Credit Lyonnais 1,294 45 5 58 Suez 307 30 23 70 Societe Generate 1,377 29 10 52 Banque Nationale de Paris 1 ,268 23 11 63 Credit Agricole 1,743 21 9 68 Credit Foncier de France 378 16 8 97 Paribas (group) 1,400 14 12 54 Union Europeenne de CIC 97 9 3 62 Union Industrielle de Credit 43 7 5 61 Banque Int de Commerce 6 4 60 (BRED) Comptoir des Entrepreneurs 55 6 3 66 Credit Commercial de France 273 3 2 63 Other 16 7
Memorandum items: Total 315 185 51 Of which Banks 225 103 60 Defeasance structures C Lyonnais (OIG/CDR) 50 CdE (Volney) 16 160 Worms (Soffapi/UAP) 13 13 23 U1C (Baticredit/GAN) 22 15
Source Immo Press, Annual Reports, and staff estimates
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Table 13. France: Selected Performance Indicators of Financial Institutions
(In percent)
1992 1993 1994 1995
Gross Income/Capital AFB banks 58.4 60.6 54.4 Mutual banks 72.1 78.9 64.4 Savings banks 64.5 65.0 55.8
Net Income/Capital AFB banks 16.4 13.2 7.0 Mutual banks 27.1 29.7 21.5 Savings banks 15.5 17.3 10.0
After-Tax Profits/Capital AFB banks -0.5 -3.2 -7.3 1.4 Mutual banks 6.6 6.5 5.5 5.9 Savings banks 5.3 4.3 3.0 34
Personnel Costs/Employee i/ AFB banks 333 368 Mutual banks 284 309 Savings banks 301 319
Sources: Commission Bancaire; and AFB.
i/ In thousands of francs per year
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Table 14. France: Performance Indicators by Type of Bank (In percentage of assets excluding interbank deposits)
1988 1989 1990 1991 1992 1993
All Banks Net Interest Income 3.7 3.3 3.1 2.8 2.6 2.2 Staff Costs 1.7 1.5 1.5 1.3 1.3 1.3 Net Income (before provisions) 1.6 1.4 1.3 1.4 1.4 1.2 Before Tax Profit 0.8 0.7 0.6 0.6 0.4 0.2 Commercial Banks Net Interest Income 3.7 3.0 2.8 2.4 2.1 1.6 Staff Costs 1.9 1.7 1.6 1.5 1.5 1.3 Net Income (before provisions) 1.5 1.3 1.1 1.2 1.1 0.9 Before Tax Profit 0.6 0.4 0.4 0.4 0.1 -0.1 Mutual Banks Net Interest Income 5.1 4.7 4.4 4.1 4.3 4.1 Staff Costs 2.2 2.0 1.8 1.7 1.8 1.9 Net Income (before provisions) 1.7 1.7 1.5 1.7 2.0 2.0 Before Tax Profit 0.7 0.7 0.6 0.7 0.7 0.8 Savings Banks Net Interest Income 5.0 5.6 5.3 4.7 5.2 4.5 Staff Costs 3.1 3.0 2.9 2.4 2.5 2.5 Net Income (before provisions) 1.6 1.7 1.5 1.6 1.7 1.4 Before Tax Profit 1.0 0.9 0.8 0.6 0.8 0.8 Memorandum Items : Wage Bill Growth (in percent) Commercial Banks • • • 4.5 5.2 3.0 3.3 4.5 Mutual Banks ... 5.8 5.3 3.3 4.1 2.4 Savings Banks 8.2 8.9 8.9 16.6 6.2 Assets Excluding Interbank Loans I/ Commercial Banks 49.3 51.4 52.2 52.5 53.8 54.4 Mutual Banks 18.7 20.6 21.1 20.3 19.5 18.4 Savings Banks 3.2 3.2 3.2 3.2 1.1 1.6
Source: OECD, 1995. I/ In percent of total assets of credit institutions, excluding interbank loans.
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Table 15. France: Funding and Lending Indicators
Funding and Lending Interest Rates JL/ Share of instrument (in percent) in total 27
1993 1994 1994
Com. Mut. Sav. Com. Mut. Sav. Com. Mut. Sav. Deposits & C.D.s Sight Deposits 0.7 0.2 0.1 0.6 0.2 0.1 9.1 17.1 5.5 Saving Deposits (regulated) 4.6 4.9 4.7 4.6 5.0 4.7 6.5 34.4 73.2 Saving Deposits (standard) 7.3 7.4 8.7 5.7 6.4 7.1 6.0 7.1 2.0 Saving Certificates 6.5 7.8 8.3 4.7 7.3 7.5 1.2 3.9 5.8 C.D.s 9.2 9.6 9.5 6.6 6.8 6.1 15 .3 7.2 0.5 Other Resources 23.7 12.3 1.0 20.4 4.5 0.3 0.6 2.1 2.9 Total 6.4 5.0 4.7 4.9 4.3 4.5 38.7 71.7 89.8 Credits Loans and discounts 9.4 9.6 10.7 7.9 8.9 8.9 29 .0 54.0 32.6 Overdrafts 10.6 14.6 17.9 8.0 12.3 16.8 4.5 2.1 0.2 Other loans 12.8 1.5 8.0 11.8 16.3 15.8 2.3 3.0 1.1 Leas ings 12.6 10.1 ... 12.1 9.9 ... 0.3 0.1 ... Total 9.7 10.1 9.5 8.2 9.4 9.2 36.2 59.2 33.9 Securities (including subordinated debt and long-term bonds) Liabilities (excl. C.D.s) 7.6 9.8 8.7 7.7 9.2 ... 10.7 9.8 5.6 Assets 8.9 9.1 9.7 3.5 5.7 6.0 17.5 13.4 14.1 Interbank Liabilities 9.2 10.8 6.5 7.2 50.6 18.4 4.6 Assets 9.3 9.5 5.8 6.8 6.4 5.6 46.3 27.4 52.0 Margins Credits-Deposits 3.3 5.0 4.8 3.3 4.7 4.7 Total Assets-Total Liab. 1.5 3.3 2.6 0.8 2.8 2.1
Source: Commission -Bancaire (Analyse Comparative, 1994) I/ For commercial (Com.), mutual (Mut.), and savings banks (Sav.)* 2/ In percent of total assets or liabilities, respectively.
©International Monetary Fund. Not for Redistribution - 145 - Table 16. France: Bank Restructurings (1993-1996)
Action taken to restore Bank Assets I/ Cost borne mainlv by: soundness 21
Pallas-Stem 10.037 Deposit insurance AFB banks Under liquidation Owners, creditors
Banque Commerciale Deposit insurance AFB banks Privee Under liquidation Owners, creditors
BAC/BEFI4/ Liquidation Owners, creditors
Regional development 47.9 5/ banks: Lordex Recapitalized Owners, creditors Picardie RDC Recapitalized Owners, creditors Centrest Recapitalized Owners, creditors Champex Takeover Owners(Caisse d'Epargne)
Credit Naval-Soderbank ;is.4 Loan sales Owners Liquidation (of Owners, creditors Soderbank)
Credit Lyonnais 1,294.2 Equity injection Owner (state) Partial loan guarantees Asset sales
Credit Foncier 348.5 Emergency credit line CDC Verbal guarantee State
Comptoir des 55 1 Emergency loans ( )ther banks, Owners Entrepreneurs (CdE) Emergency loans Other banks. Owners extended Sale of loans Securiuzation State (guarantee)
Compagnie du BTP 230 Recapitalization CDC, CL. CFF, CdE Sale of loans
Banque Hervet 205 Recapitalization Owner (state)
Societe Marscilleise de 262 Recapitalization Owner (state) Credit
Source Commission Bancaire. and staff estimates
!' In billions of francs. December 1994 2 Actions are listed in the chronological order the) were taken V Staff estimate (no official accounts foi 1994) 4> BAC is the Banquc d'Arbitrage et dc Credit. BEFl is the Banque d'Entrepnses Financiered et Industnclles. a subsidiary of BAC 2 Aggregates all regional development hanks
©International Monetary Fund. Not for Redistribution Tnhlc 17. France: Ownership Structure and Cross-Shareholdings of Selected Financial Institutions (In percent)
BNP Paribas Societc*G6n6rale Suez UAP AGF
Shareholders Shareholders Shareholders Shareholders Shareholders Shareholders
UAP 14 Axa 10 French Financial UAP 6 BNP 19 Socie*t6 Gen. 5 FJf 4 AGF 9 Institutions 22 BNP 6 Suez 5 Paribas 3 Saint Gobain 2 Parfinancc 7 Alcatel, Commercial Credit Agr. 3 Albert Freres 2 CDC 2 Rhone -Poulcnc, CN Mixtc 12 Union, and Saint Gobain 6 Westdeutsche Cred. Lyonnais 1 PSA, Renault 10 Other Large Meiji Life 15 Elf 4 Landesbank 2 Suisse de Re* 3 Shareholders 20 Foreign invt. 23 Inst. Inv. 18 Saint Gobain 1 France Tel. 2 Public 33 Public 18 Credit Suisse 2 Employees 7 Other Large Shareholders 11 Employees 7 Inst. Inv. 43 Public 21
Holdings Holdings Holdings Holdings Holdings UAP 17 Axa 8 Soci6t6Gen.de BNP 14 Paribas 6 Sue/ 6 Parfinance 10 Belgique 62 Suez 6 Soci6t6 Pc*chincy 8 CN Mixtc I/ 30 Indosuez 49 Paribas 4 Generate 3 1 lavas 4 UAP 5 Lyonnaise des Crd. Lyonnais 2 Saint Gobain 4 Lyonnaise des Eaux 5 Crd. Fonder 3 Eaux 17 General des Com. Entrep. 30 Saint Gobain 6 Eaux 5 Worms & Cic 10 Elf 1 Saint Gobain 4 Rhone-Poulen 6 B. National 3.5 Pechiney 6 Havas 3
Sources: ICBA; Agcli; Nouvcl Economistc; and annual reports.
I/ Before takeover.
i Vl
©International Monetary Fund. Not for Redistribution - 147-
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©International Monetary Fund. Not for Redistribution