European Financial Integration and the Financial System
Speech by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECB Third conference of the Monetary Stability Foundation
“Challenges to the financial system – ageing and low growth”
Frankfurt am Main, 6-7 July 2006
[Slide 1] Ladies and Gentlemen,
I would like to thank the Deutsche Bundesbank for inviting me to participate in the panel of this conference on “Challenges in the financial system – ageing and low growth”. I will speak today about “European financial integration and the financial system” and the implications of financial integration for economic growth.
[Slide 2] European economic and political integration is now at a crossroads. The rejection of the European constitution by the people of the Netherlands and France, two countries that were among the founding fathers of the European Union, sent the strong signal that European citizens do not fully perceive the benefits of the Union. Although Europe has brought the ultimate gift of political stability and peace to the people of Europe, Europeans are craving for economic prosperity.
Economic growth and prosperity were among the goals of the founding fathers from the inception of the European Union. As early as 1955, Belgium, the Federal Republic of Germany, France, Italy, Luxembourg and the Netherlands declared in Messina that the establishment of a united Europe through, among other things, the creation of a common market, “seems indispensable if Europe is to improve steadily the living standard of the population”. The desire to create a common market has since driven Europe’s economic integration, which reached an apex with Economic and Monetary Union (EMU).
Where then have we failed? Why has economic prosperity still not reached its full potential? I will argue today that the insufficient degree of integration of some parts of the European financial system is one reason why growth and prosperity are lagging behind.
[Slide 3] Financial integration has been an important element of EMU since the very beginning. In April 1989 the Delors Report provided a roadmap for the introduction of EMU in three stages, including the creation of a monetary institution, the European System of Central Banks (ESCB), with at its centre the European Central Bank. The Delors Report was adopted by the Madrid European Council, which decided to launch the first stage of EMU on 1 July 1990. To highlight the implications of this decision, I would like to quote the Delors Report on the first stage of EMU: “In the monetary field, the focus would be on removing all obstacles to financial integration and on intensifying cooperation and the coordination of monetary policies (…) Through the approval and enforcement of the necessary Community Directives, the objective of a single financial area in which all monetary and financial instruments circulate freely and banking, securities and insurance services are offered uniformly throughout the area would be fully implemented” (italics added).
While the Delors Report envisioned a fully integrated financial area as a precondition for the introduction of the single currency, Stage One was far from complete when Stage Three was implemented.
[Slide 4] Why did financial integration lose its prominence in the run-up to EMU? There are two basic reasons. First, the implementation of the idea of financial integration was limited to the elimination of capital mobility restrictions. Financial integration was based on the Council Directive adopted on 24 June 1988 (before the Delors Report was submitted to the European Council, see European Council 1988), which required the abolishment of restrictions on movements of capital between the Member States. However, legal harmonisation was set aside, with the result that agents dealing with a financial instrument or service in two different countries could be subject to two different sets of rules. The second reason for financial integration’s loss of prominence was the broad focus on the achievement of a single market, mixed with the belief that financial integration would almost automatically follow once the euro was introduced. This belief proved to be correct only for some segments of the financial system, particularly the money market.
[Slide 5] I would like to touch on three questions in my presentation today. First, what is the current state of financial integration in Europe? Second, what is the contribution of the financial system to growth in Europe? And finally, what can Europe do to strengthen the financial system?
1. What is the current state of financial integration in Europe?
For some parts of the European financial system, integration remains below potential. This realistic conclusion is based on the information gained via the monitoring framework that the ECB has built up to assess the process of financial integration in the euro area. This framework draws on quantitative indicators of financial integration developed by the ECB. The first set of indicators was published last year (ECB 2005) and will be updated in September 2006.
[Slide 6] In a nutshell, the indicators show that financial integration is very strong in the money market, mostly because of EMU; [Slide 7] it has progressed significantly in government bond markets; [Slide 8] it has improved in the corporate bond market; [Slide 9] and it is slow but progressing in the equity market. [Slide 10] The wave of mergers and acquisitions we have observed in the last 20 years was mainly a domestic development – although very recently there has been a significant increase in cross-border M&A deals. [Slide 11] Financial integration is unfortunately much less advanced in a range of banking market segments.
Retail banking is one of the most important financial markets in which to convince European citizens that Europe is beneficial for them. Any results from integrating these markets will be tangible proof that Europe is part of people’s daily life. We should therefore strive to achieve a higher degree of financial integration in the retail banking markets.
Before giving you concrete examples of how this could be achieved in practice, let me now first explain why an efficient and integrated European financial system can foster economic growth in Europe.
2. What can the financial system contribute to economic growth in Europe?
When referring to economic efficiency, the most important Community objective is the achievement of sustainable economic growth.
What is the link between financial integration and economic growth? To help us understand this link I would first like to introduce some concepts which draw on work done by ECB staff. We view the financial system as being composed of institutions, markets and infrastructures, through which households, corporations and governments obtain funding for their activities and invest their savings. The main role of a financial system is to allocate savings to the most profitable real investment opportunities.
The performance of a financial system is closely connected to the concept of financial efficiency. We define financial efficiency as the condition under which resources available in a financial system are allocated towards the most valuable investment opportunities at the lowest possible costs. A financial system is the more efficient the better it overcomes a number of frictions, such as asymmetric information, differing investment objectives and the dispersion of capital across investors. It is clear that a more efficient financial system can promote economic growth by accelerating the allocation of capital to better investment opportunities.
[Slide 13] Having defined financial efficiency I now turn to the concept of financial development, or financial modernisation. This is the process of innovation and organisational improvement in the financial system that reduces asymmetric information, increases the completeness of markets and contracting possibilities, reduces transaction costs and increases competition. There is clearly a strong positive link between the development and the efficiency of a financial system and its contribution to productivity and economic growth. For example, many new financial instruments improve risk sharing between agents in the economy. Also greater financial development allows countries to adopt new production technology faster and stimulates growth through a process of “creative destruction” by enhancing firms’ entry.
Finally, let me also give the ECB’s definition of the concept of financial integration: we consider the market for a given set of financial instruments or services to be fully integrated when all potential market participants in such a market (i) are subject to a single set of rules when they decide to deal with those financial instruments or services, (ii) have equal access to this set of financial instruments or services, and (iii) are treated equally when they operate in the market. In regions such as the European Union or the euro area, the integration of the financial systems of the different countries is of particular relevance. The reason is that a fragmentation of financial systems across countries normally reduces the efficiency of the area-wide financial system, as it will constrain the range of financing sources and investment opportunities, limit scale economies and negate possible liquidity advantages.
Incidentally, the ECB’s definition of financial integration is very much in line with the issues raised by Professor Guiso in his presentation. If law is harmonised, agents face a single set of rules. Hence, our first condition is satisfied. However this does not mean that financial integration follows. Indeed, legal harmonisation does not guarantee fulfilment of our third condition, i.e. that market participants with the same relevant characteristics are treated equally, since – and allow me to use Professor Guiso’s words here – “differences in non-legal enforcement – such as norms of behaviour, reciprocal trust – can segment markets geographically”.
[Slide 14] As I argued, there is a strong conceptual link between financial efficiency, financial integration, financial development and economic efficiency. The performance of a financial system, and notably its efficiency, is influenced by its fundamental features in conjunction with the processes of integration and financial development. The fundamental features of a financial system include i) the legal system, financial regulation and corporate governance, ii) the financial structure – the balance between markets and intermediaries iii) market infrastructure (payment, clearing and settlement systems) and iv) other conditioning features, such as social norms, religion and political systems.
However, the link between economic efficiency and financial efficiency – although conceptually unambiguous – needs to have an empirical underpinning in order to be of direct policy relevance. Not surprisingly, empirical research has established a strong connection between financial development, certain forms of financial integration, productivity and economic growth.
[Slide 15] The general effects of financial development and financial integration on growth are quantitatively important. It was found that financial development exerts a disproportionately positive effect in industries that for technological reasons depend heavily on external finance (pharmaceuticals, for instance) and have good growth opportunities (Rajan and Zingales 1998). Raising the level of financial development may result in an increase in firm value-added growth of approximately 0.5 to 0.9 percentage point in the countries that made up the EU before 1 May 2004 (Guiso et al. 2005). Also, research by London Economics (2002) found that the benefits of integration in the European bond and equity markets would be equal to around 1% of GDP over a 10 year period, or approximately €100 billion.
A strand of the literature that is most relevant for new EU Member States is that concentrating on large-scale cross-country analysis. These studies investigate the determinants of economic growth and its subcomponents (investment, human capital accumulation and total factor productivity) and they suggest that economies with more liquid capital markets and developed banking systems grow on average more rapidly. In particular, growth accelerates by approximately 0.8 percentage point in countries which have adopted measures to enhance their integration into global financial markets. (Aghion et al. 2005, Favara 2003).
[Slide 16] However, the most important empirical findings are those pertaining to retail banking, since, as I suggested in my review of the state of financial integration in the euro area, retail banking is still among the least integrated parts of the European financial system. Therefore, the most relevant strand of the literature for the ongoing European financial integration process is that which studies the results of bank sector deregulation in the United States. Moreover, these studies investigate the growth effects of financial reforms in a developed country quite similar to the euro area.
Between 1970 and 1994, 38 US states removed restrictions on branching, and between 1978 and 1992, almost all states removed restrictions on intrastate bank ownership. Studies that quantify the growth and productivity effects of banking deregulation in the United States in the period 1970 to 1995 show that annual average state gross product increased after the reforms by approximately 1 percentage point (Strahan 2003). The evidence suggests that the growth gains stemmed from enhanced productivity rather than from increased investment. This work is particularly relevant for the ongoing banking and financial system integration that is taking place in the EU and, as I already pointed out, should encourage us to go further in the integration of the banking sector.
Very recent and still preliminary ECB research seems to suggest first evidence in favour of a specific channel through which the efficiency of the financial system can promote productivity and economic growth. This research suggests that overall capital market size explains the speed with which high and low-income economies reallocate capital from declining industries to industries with good growth prospects. Overall market size, which is itself a measure of financial system development, is explained by a variety of variables. Particularly interesting, for example, is the fact that the public ownership of banks as well as bank concentration are important determinants of market size. This result also seems to hold when the analysis focuses on industrial countries. Therefore, it seems that in countries with more concentrated banking sectors, declining industries will retain capital for longer while rising industries will have more difficulty finding the funding needed for the investment to support their growth. A similar result is also found for public ownership. Too high a share of public banks prevents the financial system from speedily reallocating capital. In other words, the higher the market share of public banks, the slower capital is reallocated to promising industries.
[Slide 17] In conclusion, an efficient financial system is necessary for Europe to deliver the highest economic growth, and considerable effort should be made to further integrate our retail banking markets.
3. What can be done in the European financial system to foster economic growth?
The goal is crystal clear: we want an efficient financial system capable of delivering all of Europe’s economic growth potential. I have argued that there are strong theoretical and empirical reasons to believe that a higher degree of financial integration in those parts where it is still lagging behind will foster financial market development and economic growth.
However, the creation of an integrated financial system obviously presents challenges of its own. For example, financial and economic actors need to be submitted to the same regulatory framework; standards need to be harmonised, so that economic actors face a level playing field in financial services; technologies need to be updated to offer interoperability. In addition to providing a framework for the adoption of a single set of rules, the European Commission has encouraged a market-driven approach to financial integration by promoting competition. Competition induces a selection process among providers of financial services that generally ensures that only the most efficient survive. Competition is therefore the mechanism that will structure financial markets. However, a prerequisite for the market-led process is that closed national markets are opened up.
This is especially true in the field of retail banking, which was identified as a key sector in the post- Financial Services Action Plan (FSAP) phase. As you know, the European Commission issued a White Paper on Financial Services Policy 2005-2010 at the end of 2005. It targeted, among other things, the further integration of retail markets through ongoing or future projects, thus complementing the FSAP of the past five years, which focused mainly on the wholesale markets. However, the integration process in retail banking, induced by competitive forces, will only be successful if incumbent firms are open to playing the market game, and if purely national interests are left aside.
Two examples illustrate the considerable room for improving financial integration in retail banking markets.
(1) Retail payment services: SEPA
The introduction of the single currency in 1999 was only the first step towards a single payments area. In 2002, the European banking community envisaged that the Single Euro Payments Area – or SEPA – project would be completed by the end of 2010. SEPA offers great benefits for each and every European citizen. It will remove all national barriers to payments within the euro area, allowing potential economies of scale as well as a customer experience similar to the situation in national markets today. A cardholder should be able to use his or her card in the same way throughout the euro area without differentiation based on the country of issuance. And a customer should be able to choose a bank anywhere in the euro area and make cashless payments from a single payment account using SEPA credit transfers and direct debits. This requires that the national technical standards, contractual provisions and business practices that currently fragment national markets are replaced by SEPA standards, provisions and practices, which would facilitate the development of SEPA-wide demand (from cardholders and merchants) and supply (from banks and schemes).
This will clearly entail costs and open up competition. While the majority of banks now actively support the SEPA project, some have expressed concerns that the SEPA project will impact negatively on their profitability. As a consequence, these banks are cautiously slowing down adoption of the SEPA. Banks are expressing a legitimate concern, as they argue that the SEPA would negatively affect the revenue side of payment business. However, the possibility of improving the cost side must also be taken into account, and the potential cost savings are certainly considerable. There are currently large national variations in the revenues that banks generate from their payment businesses. When the SEPA eliminates national barriers, it will foster greater competition and, as a result, exert downward pressure not only on banks’ revenues, but also on processing costs. In addition, general and large-scale standardisation will result in better opportunities to share development costs and software products. The overall gains are likely to compensate the short-term losses of some of the market players.
(2) The European mortgage market
My second example of the considerable gains offered by financial integration in retail markets is the European mortgage market. The importance of this retail market segment is evident from its size: the outstanding volume of more than €4 trillion in residential mortgage debt in the EU corresponds to around 40% of EU GDP. I mentioned earlier that the dispersion of interest rates on lending for house purchase across the different countries of the euro area has not shown a clear declining trend over the past few years. Furthermore, if one compares the euro area mortgage market with its US counterpart, it is possible to see that, over the past three years, the cross-country dispersion of rates in the euro area was greater than the cross-regional dispersion of mortgage rates in the United States. All this suggests that the euro area mortgage market is not yet fully integrated. Given the size of this market and given that European citizens are its first customers, it is urgent that progress is made in integrating the market at the EU level. There are important gains to be made from the full integration of the EU mortgage market. It was estimated that full integration would raise EU GDP by 0.7% and EU private consumption by 0.5% in 2015, i.e. ten years from now (see London Economics, 2005).
The Eurosystem contributed to the European Commission’s Green paper on Mortgage Credit in the EU within the framework of the public consultation on this issue. It stressed, among other things, that a growing share of mortgage lending is funded on the capital markets via the issuance of mortgage-covered bonds and mortgage-backed securities. Nevertheless, secondary markets, particularly in mortgage loans, remain fragmented due to differences in the legal, tax and regulatory frameworks that prevail in the various jurisdictions and to the heterogeneity of the standards and practices adopted by market participants. Moreover, there are certain specific impediments to the cross-border origination and transfer of mortgage loans. As a consequence, secondary market liquidity, particularly in mortgage loans, remains low, and economies of scale and cross-country diversification benefits have not yet been fully reaped. [Slide 21] Fostering the development of a pan-European funding market by facilitating the transfer of mortgage loan portfolios across borders could possibly help to promote primary market integration. If the liquidity of the secondary mortgage market is increased, primary mortgage lenders are able to get better deals there, all other things being equal. This, together with competition, should have the effect of reducing the rates offered to borrowers.
Ladies and Gentlemen, let me conclude by briefly summarising the main points of my remarks.
Economic growth and prosperity was one of the main goals for the establishment of the European Union, as stated in the Messina declaration of 1955. Even in Messina, some believed that integration would not work out, such as the British delegate who decided to leave the conference, saying: "I leave because you will never agree, and if you agree you will never implement it, and if you implement it, it will be a disaster". Fortunately, we did not listen and delivered.
The next hurdle is now financial integration. We have to prove the sceptics and the citizens of Europe that it will work out and will bring a higher potential for economic growth to Europe. Our efforts should now concentrate on, among other things, the integration of retail markets, as illustrated by the examples of the SEPA and the mortgage market. There are still large economic gains to be made from a financially integrated euro area, and we should therefore all work towards this goal. Europe will not deliver on its growth promises without an efficient and integrated financial system.
Thank you very much for your attention.
Aghion, Philippe, Peter Howitt and David Mayer-Foulkes, “The Effect of Financial Development on Convergence: Theory and Evidence”, Quarterly Journal of Economics, February 2005, 120(1), pp. 173-222.
ECB, “Indicators of financial integration in the euro area”, September 2005.
European Council, Council Directive of 24 June 1988 for the Implementation of Article 67 of the Treaty, 88/361/EEC, Brussels, 24 June 1988.
Favara, Giovanni, “An Empirical Reassessment of the Relationship between Finance and Growth”, IMF Working Paper 03/123, June 2003.
Guiso, Luigi, Tulli Jappelli, Mario Padula and Marco Pagano, “Financial Market Integration and Economic Growth in the EU”, Economic Policy, 2005, 19(40), pp. 523-577.
London Economics, “Quantification of the Macroeconomic Impact of Integration of EU Financial Markets”, Report to the European Commission, 2002.
London Economics, “The Costs and Benefits of Integration of EU Mortgage Markets, Report for European Commission, DG Internal Market and Services”, August 2005.
Rajan, Raghuram G and Luigi Zingales, “Financial Dependence and Growth” American Economic Review, June 1998, 88(3), pp. 559-586.
Strahan, Philipp E, “The Real Effects of US Banking Deregulation”, the Federal Reserve Bank of St. Louis Review, July/August 2003, 85(4), pp. 111-128.