The European banking industry is in turmoil. The pace of mergers and acquisitions has accelerated and banks that have long been in trouble are disappearing more rapidly. All this happens in 'suspicious' coincidence with the preparations for EMU. Is EMU really driving this acceleration? Where is the industry heading? What risks lie ahead in the transition? The authors of this report analyse why EU financial markets are so segmented. On the supply side - savings behaviour - is the 'home-bias' of European households. On the demand side - the behaviour of firms - one needs to understand why European corporations stay clear of the bond market and typically borrow from banks. The US experience, particularly the transformation of US banks in the past 15 years, illuminate these phenomena, but a clear understanding of the background issues is essential in predicting the changes that EMU will bring about. The major policy implication is related to regulation and bank supervision. Risk in the industry is likely to increase both in the transition and in steady state. European countries come to EMU from very different initial positions as far as banks are concerned. In the steady state a more competitive industry will squeeze margins and raise risk. EMU confronts these changes without a clear strategy in the areas of regulation and prudential supervision. The European Central Bank claims that it will not be involved in those activities, which will remain the responsibility of national governments and national central banks. A coordination problem may arise which will make dealing with crises more difficult and possibly riskier. This CEPR report is a significant and timely addition to what will be a growing debate in the years immediately ahead.' (David Folkerts-Landau, Deutsche Bank)