Possible effects of EMU on the EU banking systems in the medium and long term
Speech delivered by Ms Sirkka Hämäläinen, Member of the Executive Board of the European Central Bank, at the General Assembly of the European Mortgage Federation, Brussels, on 5 November 1999
First of all, I should like to thank the European Mortgage Federation for inviting me here today. It is always a pleasure for me to be in Brussels, a city so closely associated with the process of European integration. It is also a particular pleasure and honour for me to address, on the occasion of this General Assembly, such a distinguished audience of professionals, active in the field of mortgage lending - a field in which many interesting structural developments are currently under way.
Indeed, many of the recent developments in the housing financing sector in Europe are closely linked to the introduction of the single currency and a common monetary policy. There are two main aspects to consider in this respect: First, the process of establishing Economic and Monetary Union (EMU) has helped to foster an environment which is generally supportive to the development of the mortgage sector - i.e. an environment of price stability and low interest rates throughout the euro area. Second, the introduction of the euro has helped to accelerate the process of structural change in the European financial markets, thereby affecting both the lending and funding side of the activities of banks and mortgage institutions.
In my presentation today, I should first like to describe the importance of housing finance for the transmission of monetary policy impulses in the economy, in order to give a background to the Eurosystem's interest in developments in this segment of the financial markets. I shall then consider the macroeconomic and structural effects of the single currency on the development of the financial markets and the banking sector in Europe, focusing on the market for housing financing in particular. Finally, I intend to comment briefly on the current economic developments in the euro area in the light of yesterday's decision by the Governing Council of the Eurosystem.
1. Housing financing and the transmission of monetary policy
The introduction of the euro at the start of this year meant that the Eurosystem (comprising the European Central Bank and the 11 national central banks of the participating countries) assumed responsibility for monetary policy in the euro area. The single monetary policy implies that monetary policy analysis is based on euro area-wide considerations and, consequently, the same policy interest rates are applied in all the participating countries.
However, the fact that monetary policy is fixed at a single level for all euro area countries does not mean that the transmission mechanism of monetary policy impulses is identical throughout the euro area - at least not in the initial phase of EMU. Indeed, the channels for the transmission of monetary policy are numerous and complex in any economy and, for the central bank, it is important to gain knowledge about the working of the transmission mechanism. One of the most important elements of the transmission mechanism is how - and how rapidly - central bank interest rates affect the interest rates on housing financing.
In the euro area, the assessment of the appropriate overall monetary policy stance is, admittedly, to some extent complicated by the fact that the structure of the markets for housing financing differs considerably across the euro area. For example, the amount of outstanding mortgage loans as a share of GDP varies between 5% and over 50% in different euro area countries. Other important differences are, for instance, the share of variable as opposed to fixed rate mortgage loans, the tax treatment of mortgage loans, the structure of and competition in the mortgage loan market as well as consumer protection regulations. All these factors affect the transmission mechanism and they also reflect the fact that the housing financing markets continue to be highly segmented.
From the perspective of the Eurosystem - and with a view to the efficiency and liquidity of the market - it would of course be helpful if the housing financing market was more integrated across the euro area. This would facilitate the Eurosystem's monetary policy analysis and would also help to ensure that any monetary policy actions affect all parts of the euro area in a similar way. For this reason, the Eurosystem takes a great deal of interest in the development of the mortgage markets in the euro area.
2. Housing financing in a stability-oriented economic environment
The use of a single currency and the conduct of a common monetary policy provide important opportunities for the development of the financial markets in general, not least as regards housing financing in the euro area.
First of all, the single currency is supported by the Eurosystem's firm commitment to price stability and other elements aiming at ensuring a stability-oriented framework for economic policies, such as the Stability and Growth Pact.
From today's perspective, the virtues of stability-oriented economic policies may seem self-evident. However, it should be recalled that only one or two decades ago, many European countries placed much less emphasis on price stability. One after another, these countries found that insufficient commitment to price stability invariably led to a loss of credibility and sharp fluctuations in exchange rates and interest rates. The volatile environment contributed to uncertainty among lenders and borrowers alike, as well as sharp fluctuations in house prices.
It was only in the aftermath of the boom-and-bust economy of the late 1980s and early 1990s that a general consensus emerged on the need to pursue stability-oriented economic policies. It is clear that the process of convergence leading up to the establishment of EMU was very useful in that it helped policy-makers to focus their efforts and it also facilitated the acceptance of these policies among the general public.
The Eurosystem's commitment to price stability (defined as a year-on-year increase in consumer prices of below 2% over the medium term) is in fact enshrined in the Maastricht Treaty. The logic behind the price stability objective is clear. By ensuring price stability, expectations concerning future inflation are stabilised at a low level, thereby contributing to low and stable interest rates. Such an environment makes it easier for companies and individuals to take well-founded inter-temporal decisions on investment and consumption.
For many individuals, buying a house is the largest and most important investment decision they will ever make. It is, of course, good for the individual if this decision can be taken in an environment of stable prices and little uncertainty about future economic developments.
In this way, stable macroeconomic conditions are generally conducive to the development of a market for housing financing. The positive effects of EMU can already be seen in this context. Over the last few years, we have experienced a period of historically low interest rates in most Member States. At the same time, there is evidence of a pronounced upswing in the demand for housing financing services in some Member States where the development of these services was previously hampered by persistently high and volatile interest rates.
3. The single currency and the structure of the financial sector
The introduction of the single currency is also fostering rapid structural change in the financial sector. So far, the European financial markets and banking industry have remained segmented into rather small national markets. The introduction of the euro seems to have given momentum to the start of cross-border integration, as a result of the disappearance of certain barriers implied by national currencies. For several years, large-scale mergers and acquisitions have been taking place in Europe, but only very recently have we started to see such deals taking place across national borders.
We are still in the early phases of the structural reshaping of the European financial markets, and the banking sector in particular. At present there are more than 8,000 credit institutions in the euro area. Large benefits from economies of scale are to be gained from consolidation, whereby the number of universal banks may be significantly reduced. It is important to look to the challenges and opportunities ahead, rather than adopting a defensive and protectionist approach.
However, the market for housing financing is in some respects facing slightly different challenges to other segments of the banking sector. Housing financing services are much less standardised than other types of retail banking services and they are also more dependent on national regulations and practices. It is likely to take a long time to achieve a cross-border integration of the markets for mortgage financing - much longer than in other segments of the financial markets. The use of a single currency is not enough to ensure an integration of the markets for borrowers, although it is an important first step.
A further progression of cross-border competition is evident on the funding side of the activities of banks and mortgage institutions. Although most institutions currently rely almost entirely on a domestic client base in their lending, they increasingly seek their funding throughout the euro area or even globally. This is the case for those institutions financing themselves through the issuance of bonds. In the bond markets liquidity is improving and the issuance and transaction costs are decreasing. In this respect, it is interesting to note the substantial increase in the size of the issues of German Pfandbriefe as well as the widening of the placement of recent issues. These instruments were traditionally held predominantly by domestic German investors. However, some of the most recent large issues were acquired predominantly by non-resident investors.
The increased resort to the bond markets for the funding of housing finance is a clear structural development, which is also partly related to the new economic environment shaped in by the single currency. Until recently, deposit-taking was the dominant form of funding in all the euro area countries, except Germany. However, the low interest rate environment has reduced the incentives for investors to make long-term bank deposits. The development of the euro area bond market has at the same time increased the attractiveness of this funding channel. In the last few years important progress has been made - or is under way - in developing the mortgage bond markets in, for example, France, Ireland and Spain.
A similar development is also evident in the field of corporate financing. All in all, the euro area bond market is increasingly becoming an alternative to traditional banking intermediation. Clearly, this development poses a challenge to the European financial sector, which has so far been dominated by the traditional banking services of taking deposits and granting bank loans. The developments in the United States may well also indicate a possible path of development for Europe. In the United States, mortgage institutions are specialised in "packaging" mortgages into securities which are subsequently floated. The mortgage institutions are hence only acting as brokers, while the funding and pricing are left entirely to the market.
4. The need to achieve a better integration of bond markets
It is clear that a further integration of the euro area capital markets would enhance the possibilities to ensure a more efficient mobilisation of funds. So far, the bond markets are still characterised by a high degree of national segmentation. This is due to differences in legal frameworks, market practices and tax treatment, as well as an insufficient technical infrastructure supporting the cross-border transfer of securities.
Yet the drive toward integration seems to be strong at the level of dealers and investors. Most banks seem to have reorganised their trading activity for bonds according to the maturity range of the instruments, or the type of issuer, rather than by the nationality of the issuer or the location of the bonds. At the same time, there is evidence that investors have been and still are trying to diversify their portfolios across the euro area and market liquidity now seem to be more important than the country of issue. This is reflected in the increasing effort devoted to the field of credit research. It is also reflected in the increasing interest among investors in new, pan-euro area reference indices for bond markets.
As for the legal frameworks, there is, in particular, a need to harmonise the provisions which affect the functioning of markets, including the regulation of primary and secondary markets, property rights and the protection of investors, and fiscal treatment. Admittedly, some progress has been made in this area recently. For example, work is in progress to establish standardised repo agreements. Another important initiative was the "Financial Market Action Plan" of the European Commission, as endorsed by the Heads of State or Government at the meeting of the European Council last summer.
Progress in the various fields I have mentioned may be rather slow, but it is encouraging that initiatives are under way in all sectors. A dialogue exists between providers of infrastructure, banks, issuers, investors, and of course the public authorities, to improve the existing frameworks. The driving force behind these constant improvements is enhanced competition. I should like to present two examples of welcome reforms which have been greatly facilitated by the enhanced competition due to the single currency.
The first example is the issuance of government and corporate bonds. As investors now have access to a wider pool of assets denominated in the same currency, they become more demanding as regards such aspects as the liquidity of the assets they purchase, their creditworthiness or their legal structure. So governments and private corporations are under increased pressure to issue bonds with competitive characteristics. Indeed, there is a general consensus that the structure of government bonds has improved steadily in the euro area over the past year.
The second example relates to competition between legal and regulatory systems. While it seems impossible to fully harmonise the legal systems across the euro area - at least in the short or medium term - investors compare national legal frameworks and assess which of them provides the safest environment. This creates pressures to upgrade national legal frameworks to meet the highest standards in the euro area.
In fact, a very interesting example of this enhanced competition between legal systems can be found in the sector of mortgage financing. At the start of the year, it was widely considered that the benchmark for the legal and regulatory environment for mortgage bonds was provided by the German system of Pfandbriefe. Within months of the introduction of the single currency, laws had also been passed in France and Spain that provide a legal framework for mortgage bonds comparable to the German system. I find it particularly revealing that some aspects of the French or Spanish frameworks are now being described as a possible way forward to further improve the system of Pfandbriefe in Germany. These examples testify that there is a clear process of emulation, which should lead to a deeper integration of euro area financial markets, based on the highest possible standards.
5. The collateralisation of monetary policy operations
The integration of the European bond markets is also hampered by the lack of an appropriate technical infrastructure for cross-border transactions. Securities transactions are generally carried out through domestic settlement systems to which foreign institutions - in most cases - do not have direct access. Even during the preparatory work for the introduction of the euro, it was recognised that the lack of links between the securities settlement systems in the euro area would be particularly problematic for the conduct of the single monetary policy. The Eurosystem's monetary policy operations are implemented on the basis of repurchase agreements or collateralised lending. This requires a smooth and swift settlement of the securities transactions with the counterparties before the liquidity can be provided. In order to ensure equal treatment among counterparties, it is essential that all collateral fulfilling the Eurosystem's eligibility criteria can be used by all counterparties, regardless of the Member State in which the underlying assets are located.
In the absence of a reliable infrastructure in the private sector, the Eurosystem launched its own initiatives in this field. The correspondent central banking model (CCBM) operated by the Eurosystem allows the cross-border use of collateral for monetary policy operations. This has effectively contributed to a further integration of European financial markets, insofar as it has promoted the holding of pan-euro area portfolios by credit institutions participating in central bank operations. The cross-border holdings of collateral in custody with the Eurosystem currently represent approximately 14% of the total amount of the assets that could potentially be used in the Eurosystem's credit operations.
However, the CCBM is only used for transactions with the Eurosystem. In order to support the integration of the securities markets in the euro area, it is essential that the infrastructure for cross-border transactions among market participants is also improved. Recently some new initiatives have been instigated in this respect and it is expected that market forces will bring about further developments in the near future.
The collateral policy of the Eurosystem, in fact, has a major bearing on the development of the mortgage bond market. At present mortgage bonds constitute approximately one fifth of the total amount of assets eligible for the collateralisation of monetary policy operations. This share is likely to increase further if the mortgage market continues to develop rapidly. Hence, from the standpoint of monetary policy implementation, a further increase in eligible private debt instruments, including mortgage bonds and corporate bonds, is highly desirable given that the government bond issuance is falling as a result of the consolidation of public finances. At the same time, the reduced need for government issuance creates an environment favourable to mortgage financing.
6. Current economic developments in the euro area
I have outlined some prospects for structural development, many of which are already becoming apparent. The first ten months of the euro have also been very promising in other respects. We have seen that the Eurosystem's decision-making and operational procedures are working efficiently. There is no reason to call into question the Eurosystem's ability to deliver price stability. I should like to conclude my presentation by making a few remarks on the economic prospects for the euro area and the role of yesterday's monetary policy decisions in supporting sustained non-inflationary growth.
The current economic developments in the euro area are favourable. There are now good prospects for a sustained upturn in economic activity. In parallel with the improved economic prospects, the balance of risks to future price stability has gradually moved towards the upside in the course of the year. This assessment led the Governing Council to the conclusion that it would be appropriate, at the current juncture, to adjust the ECB interest rates by 50 basis points with the view to ensure that price stability is maintained over the medium term. In this respect, it should be underlined that a timely rise in interest rates will avoid the need for larger increase in interest rate later and will, hence, contribute to stronger growth over an extended period of time. The timing and size of the rate hike should also be helpful in order to remove unnecessary uncertainties regarding the future course of monetary policy. In this respect, yesterday's decisions by the Governing Council should be seen as a clear contribution to ensuring a stability-oriented economic environment in the euro area, where expectations are stabilised and decisions on investment and consumption are facilitated.
However, monetary policy action is not sufficient to ensure such a stability-oriented environment and the long-term success of EMU. It is also necessary for governments to be committed to prudent fiscal policies and to take urgent action to improve the functioning of the euro area economies through structural measures, notably as regards the functioning of labour markets and in the field of pension and social security systems. Moreover, further initiatives are required to develop regulatory frameworks fostering the development of a true Single Market for goods and services. On this latter point, the private sector - in particular the financial industry - also has major responsibilities in the process to achieve a harmonisation of practices and improved cross-border integration.