Financial markets in the European Monetary Union
Prof. Eugenio Domingo Solans, Member of the Governing Council and the Executive Board of the European Central Bank. Speech delivered at the 28th Annual Financial Markets Seminar, Valencia, 8 June 2001.
In the years prior to the introduction of the euro, there was a consensus among politicians, academics, market practitioners and central bankers that the adoption of a single currency for Europe would only be successful if a number of prerequisites were met. The most important of these prerequisites were spelled out in the Maastricht criteria, which you all have in mind. A second set of prerequisites was implicit from the European policies initiated in the mid-80s, with a view to completing a single market for goods and services by 1992. The existence of the single market, which encompasses financial services, is indeed an important requirement to ensure that all the benefits of the single currency can be reaped.
Yet, when we have introduced the euro in 1999, the internal market for capital and financial services was far from being completed. Today, two and a half years after the introduction of the euro, it is still not fully completed. Often I hear the criticism that there remain elements of fragmentation between the national segments of the euro area financial market. And I accept that there are some elements of truth in this criticism.
Yet, it is undeniable that there has occurred since 1999 a considerable acceleration in the process of integration of the euro area financial markets. This process has not been driven only by public policies, but also - in fact mainly - by market forces.
What I conclude from this observation is the following: the integration of the financial markets of the euro area is a dynamic process, in which the single currency itself has acted and continues to act as a catalyst. The relationship of causality does not go only from the existence of a single market to the appropriateness of sharing a single currency, but also the other way round.
In other terms, two and a half years into the life of the euro, we have probably seen only a small part of the beneficial consequences of the introduction of the single currency on our financial market and on our economy. These benefits will continue to materialise gradually over the years to come, until the single market is finally completed, and the benefits of the single currency can be reaped in their entirety.
What I would like to discuss with you today is some evidence of the magnitude of the movement set in motion, as well as some of the questions this integration process raises. If you allow me, I shall organise my remarks in four parts. Firstly, I would like to recall the interest of the Eurosystem, as the central bank of the euro area, in the existence of a well-integrated financial market. Secondly, I will discuss briefly the desirable level of integration. Thirdly, I will underline the benefits of increased competition brought about by the introduction of the euro, and finally I will discuss the limits of competition as well as the involvement of public policy makers in pushing these limits further.
I. The interest of the Eurosystem in a high degree of integration of the financial market
The interest of the Eurosystem in a high degree of integration of the financial market stems, first and foremost, from the requirement that monetary policy be implemented in an efficient and homogeneous manner across the whole euro area. Indeed, the financial markets are an essential element of the transmission process of monetary policy. The money market is even a vital element of this process, since it is the market in which monetary policy is implemented. Clearly, the singleness of the monetary policy of the Eurosystem depends on the efficiency and the high degree of integration of the money market, but also of other segments of the financial market, across the whole euro area.
In fact, I would submit that this requirement was particularly crucial for the Eurosystem at the time of the introduction of the euro, precisely because of the initial conditions we were facing. It is not unusual to have a certain degree of fragmentation of financial markets in the jurisdiction of the central bank, and it is certainly quite common that different sectors of the economy react differently to monetary policy impulses. This segmentation might however have been somewhat stronger than usual in the case of the euro area, at the time of the introduction of the euro. Potential heterogeneity further down the transmission chain of monetary policy made it particularly crucial that the first steps of this chain be as homogeneous as possible. This applied in particular to the money market for unsecured deposits which, as you know, was fully integrated within days of the introduction of the euro. I will elaborate further in the fourth part of my intervention on the particular circumstances that have allowed this success.
But let me come back to the interest taken by the Eurosystem in the integration process of financial markets. Beyond the implementation of monetary policy, a second source of interest is related to the other tasks assigned to us by the Treaty. Among these is the promotion of a smooth functioning of payment systems and contribution to a smooth conduct of national policies in the field of prudential supervision and financial stability. In this context, an efficient and well-integrated financial market is seen as an important element of robustness of the whole financial system. To take but one out of many possible examples, difficulties in the cross-border transfer of securities, especially where they are used as collateral against the supply of credit, may exert tensions on the smooth functioning of the market. A well-integrated securities market infrastructure, where assets can be transferred easily and safely across borders, contributes to alleviating these tensions.
There is however a third element that underpins our deep interest in the development of a mature, well-functioning financial market. This is linked, not to our direct tasks, but more generally to our role as a public policy-making body in the European Union. The Treaty requires from us that, without prejudice to the objective of price stability of course, we support the general economic policies of the Community. In fact, the Treaty further indicates that the purpose of this provision is to contribute to achieving the objectives of the Community, the first of which is to promote economic and social progress. I believe that it is clear that such economic and social progress can best be ensured by an optimal use of the resources available in the European economy, and in particular capital. This alone is a sufficient argument for us to take a keen interest in a high degree of integration of our financial market, which allows capital to be steered towards the best investment opportunities, independently of the countries in which these opportunities arise.
To illustrate this general interest, I will, if you allow me, recall the strategic goal for the European Union decided by the EU Council in Lisbon last year and re-affirmed in Stockholm a few weeks ago: "to become the most competitive and dynamic knowledge-based economy in the world, capable of sustainable economic growth with more and better jobs and greater social cohesion". It is quite undeniable that this ambitious goal will not be reached unless the European Union in general, and the euro area in particular, develops financial markets able to channel efficiently the funds required to finance research and development, innovation, and generally support an entrepreneurial environment.
I would insist here on the superlative used by the EU Council, which does not refer to a competitive and dynamic economy, but to the most competitive and dynamic economy. This, in my view, translates into the requirement that financial markets are not only efficient, but the most efficient. While by no means out of our reach, this is clearly a formidable challenge.
II. What is the desirable level of integration?
Against such a demanding benchmark, I will now turn towards some of the current developments in euro area financial markets. But first, I believe that it is not superfluous to qualify what I mean by integration, a word that I have used many times already. Indeed, I often hear, for instance, that the European financial markets are not well integrated because there is not a single government yield curve, for instance, or a single stock exchange, or a single security settlement system for the whole euro area. This normative interpretation, from my point of view, does not refer to the integration of the market, but to its full unification, which is a different concept. While integration refers to the making up of a whole by adding together separate parts or elements, unification relates to the more demanding concept of reduction to unity or to a uniform system. In other terms, while integration recognises diversity, unification attempts at suppressing it.
In the context of the creation and the development of the pan-euro area financial market, the relevant concept is quite clearly, as I indicated above, that of a market in which capital can be allocated to the most rewarding investment opportunities, independently of the locations of the lender and the borrower. The desirable level of integration is, accordingly, one at which all distortions that may hamper an efficient allocation of resources within the euro area are removed.
This underlying objective provides the yardstick to assess when unification is necessary, and when it would be counter-productive. The approach of that matter should not be normative, but rather positive, and very pragmatic. In principle, diversity is welcome, especially where it introduces an element of efficiency and robustness in the market. For instance, it is important that leading markets remain contestable. While this favours innovation and hinders the emergence of monopolies or oligopolies, it does not prevent rationalisation nor economies of scale.
There are, however, areas where full unification is desirable to ensure that competition can effectively be free and fair. This applies mainly to elements of the financial market environment rather than to its participants, the most obvious example being that of the single currency itself. The euro, in essence, is a monetary unification aiming at ensuring free and fair competition across Europe. At another level, the full harmonisation of market conventions, for instance as regards the calculations of coupons, is another example of unification facilitating the comparison between various financial instruments. This is also conducive to a more efficient and competitive market for capital.
III. The benefits of increased competition
This last remark leads me directly to the third part of my address, which relates, precisely, to the benefits of increased competition in the euro area financial markets.
Indeed, of all the factors of segmentation of the national financial markets of the European Union before 1999, the existence of different currencies probably represented the most powerful. Accordingly, at the time of the introduction of the euro, widespread expectations developed that the European Monetary Union would unleash previously refrained competition forces, which would lead to both qualitative and quantitative improvements in the functioning of euro area financial markets.
Evidence gathered to date shows indeed that the effects of competition forces have been considerable, and sometimes even exceeded expectations, or occurred in sectors where it was maybe not so widely expected. Let me mention but a few illustrations of this remark:
Competition between private market participants
A first form of competition, where the effects of the euro are noticeable, is that of competition between private market participants. This is probably one of the areas which has been the more often commented, and one in which most of you are directly involved. I will therefore limit myself to providing a few examples of the two major consequences of this form of competition.
The first relates to the reduction of costs for the consumer, such as, for instance, the fees levied on stock exchange transactions or bid-ask spreads for transactions in major debt securities.
The second consequence is the trend towards rationalisation and consolidation in almost all sectors of the financial system. For instance, the number of monetary policy counterparties in the euro area has fallen, since the introduction of the euro, from almost 8,000 to just under 7,500. In the field of infrastructure, the merger between (CADE) and (SCLV) to form a new central security depository under the name of IBERCLEAR is one of many examples of consolidation in the euro area.
The trend towards consolidation has also materialised in the area of trading platforms, although here the phenomenon is much less clear as a variety of platforms have also seen the light of day over the past few years. This encompasses both inter-dealer platforms, such as the various elements of the MTS group or dealer-to-customer platforms, such as TradeWeb or Bondlick for instance. In this same field, one example of consolidation has of course been provided, here in Spain, by the creation of SENAF. The development of electronic trading systems serves to underline the remark I made earlier: it is important that markets remain contestable, so that innovation can lead to efficiency gains, where they are possible.
At this stage I should add that the introduction of the euro has not been the only source of reinforced competition in Europe. The trend towards a more globalised economy, and the development of new technologies that, to a certain extent, challenge the concept of national borders, also contribute strongly to a more competitive environment, not only in Europe, but world-wide.
Competition between public issuers
Another field, where competition has developed strongly as a direct consequence of the introduction of the euro is that of competition between sovereign issuers. Indeed, where sovereign issuers benefited from what was essentially a monopsony position in their national market, they now compete with each other for a broader pool of savings. With all due caution, one might argue that sovereign issuers now have to compete for funds in a way similar to private borrowers.
The consequences of the new form of competition between sovereign issuers have also been widely commented, and I will limit myself to recalling a few facts. In the late 80s and early 90s, a few European countries, such as France and Spain, had undergone a reform of their government bond market, with a view, among other goals, to enhancing the liquidity of this core market. With the advent of the competitive environment brought about by the introduction of the euro, those governments that had not previously done so have engaged in a similar restructuring. Clearly a form of emulating process has developed, where all sovereign issuers are attempting to bring their own government debt market in line with the best standards.
Incidentally, the improvements brought to the government bond market extend also to other features, such as in particular the tax treatment of the coupons.
All in all, perhaps because this is one of the sectors where the increase in competition has been the most obviously marked, the sector of sovereign issuance is one where this new competition has delivered some of the most spectacular benefits to investors.
Competition between legal and regulatory environments
But let me now turn to two forms of competition less widely commented upon. The first one refers to competition between legal and regulatory environments. Free circulation of capital across Europe, and beyond, was a reality well before the introduction of the single currency. However, it seems that it is only after the introduction of the euro that pressure has mounted on legislators and regulators alike to provide their national financial centre with a truly competitive legal and regulatory environment. To illustrate the content of my remark, let me take a very practical example.
Prior to the introduction of the euro, the main - albeit not the only - mortgage bond market in Europe was the German Pfandbrief market. The German legal framework allowed for the issuance of asset-backed securities by German banks in conditions that were not available to many banks in other countries. Seen from a certain angle, one could argue that this represented a competitive advantage for German banks, insofar as they benefited from a particularly appropriate instrument for the refinancing of the assets on their balance sheet.
The effect of competition has been felt here too in the sense that other European countries, such as France for instance, have been encouraged to pass legislation aiming at providing their own domestic institutions with a similar legal framework for issuance of asset-backed securities.
What I find very telling in this example is that in almost every case, the new legislation was designed with the German Pfandbrief legislation as a benchmark, and with a view to provide an environment that could compete with it. The clearer evidence to that effect is the wording of the press release issued by the Irish government on February 26th of this year, announcing the approval of a draft legislation - I quote - "which will provide for the introduction of new financial instruments in the Irish market - mortgage and public credit bonds similar in nature to the German Pfandbrief". Finally, and I quote once again, the Irish government draws attention to the fact that "the introduction of the euro and the new monetary policy framework has led to the development of an integrated and competitive money market in the euro area".
I believe that this illustration provides evidence of the new form of competition that I was hinting to, a competition between legislators and regulators themselves. I believe also that the wording of the communiqué of the Irish government points to the potential benefits of such a form of competition, if it effectively leads to a convergence across the euro area of the national legal and regulatory environments towards the "best practice" and the highest standards.
Of course, such a form of competition can only be expected to develop at a relatively slow pace, if only because of the time needed to assess the need for new legislation, draft it and pass it. Furthermore, this form of competition, which consists in an incursion of private interests, those of each financial centre, in the field of public policy, is not entirely without dangers. However, I believe that this is here a new development that deserves perhaps more attention than it received up to now.
Competition between financial structure models: bank finance Vs non-bank finance?
I said earlier that I would discuss not one, but two forms of competitions less widely commented upon. The second is, in my view, the competition that has emerged since the introduction of the euro between two models of financial structure, the intermediated model, based on bank lending, and the disintermediated model, based on securities markets.
Traditionally, the euro area economy, or most of it at any rate, is dominated by bank lending. This contrasts with other economies, such as the United States, for instance, where securities markets have played for a long time a much more significant role in channelling savings towards investment.
At the time of the introduction of the euro, there were strong expectations that the broader euro market, relative to legacy currency markets, would allow a development of non-bank finance, and gradual convergence towards the US financial structure model.
Two and a half years later, the diagnosis on this specific point is mixed. For instance, at end-1997, bank deposits in the (future) euro area represented 84% of GDP, while the ratio was only 55% in the US. At the end of 2000, this situation was essentially unchanged. The ratio of bank deposits to GDP has fallen marginally to 82% in the euro area, while it has remained unchanged at 55% in the US.
Whether bank finance has lost of its importance or not is however, in my view, relatively unimportant. What I find much more important is that, on the side of bank finance, securities markets have developed to the point where they offer a real alternative for potential borrowers. Even though the stock of outstanding debt securities or the stock market capitalisation of the euro area remains well below that of the US (relative to GDP), both the equity market and the private bond market have experienced unprecedented development over the past few years.
Let me illustrate this remark by just one point: between January 1999 and the end of 2000, the outstanding amount of bonds issued by non-financial corporations in euro has increased by 60%. I appreciate that there are lots of caveats that can be opposed to this impressive figure, such as the very small size of the market at the start of the period, or the large share of the net issuance accounted for by non-euro area companies.
But the lesson to be drawn from this development, in my view, is the following:
Prior to the introduction of the euro, borrowers in the legacy currency markets were considerably constrained in terms of the capital they could raise in domestic securities markets. Following the introduction of the euro, issuers have access to a broader and more diversified base of potential investors, which makes it possible to raise capital in much more favourable conditions than previously. An example of this point is the widespread comments heard throughout 1999 and 2000, that many of the large mergers and acquisitions in the euro area would not have been possible, if the purchasers had not been able to finance the transactions by raising capital through the bond market.
However, the development of non-bank finance is not necessarily, as I mentioned earlier, a panacea that should replace bank-based finance. On the contrary, I regard the co-existence of the two, and competition between the two, as positive, precisely because it provides borrowers with a broader range of options. This is likely to allow more entrepreneurs to access capital in the form the most appropriate to their needs. It is in this sense that I welcome what I called initially the competition between the two financial structure models.
Incidentally, the co-existence of the two modes of financing can be mutually reinforcing. For instance, the closing of the window of opportunity for issuance of equity in the new technology sector in early 2001 has certainly made clear the benefits of being able to raise funds through more traditional bank finance. This gives me the opportunity to insist again that I do not have any prejudice in favour of one model of financial structure or another, but that it is rather the existence of a balance between the two models, that I find particularly beneficial.
I find it also noteworthy that also in the United States, the "traditional" European model of universal banking seems now to be attracting much more interest than only a few years ago, as testified by the reform of the Glass-Steagall Act.
At this stage I would like however to underline one prerequisite for the competition between bank finance and non-bank finance to provide all the benefits that one might expect. This prerequisite is that banks can effectively compete on the same scale as financial markets. What I mean by this is that commercial banks must be able to become pan-euro area or even global institutions, in the same way as securities markets have become integrated at the level of the euro area or even globally. From that point of view, it is possible that cross-border mergers or acquisitions in the euro area banking sector develop too slowly at the current pace. I see it as important that efforts are made to facilitate this activity, or at least to avoid discouraging it, by identifying and removing remaining obstacles.
IV. The limits of competition and the role of public authorities
But let me now move to the last part of my intervention, which relates to the role of public authorities in promoting a smooth functioning of the euro area financial markets. Since I have spent a long time praising the benefits of free competition, it is probably fair that I underline at this stage that competition alone does not necessarily allow to reap all the benefits of the single currency.
Indeed, in a number of cases, the removal of the former obstacles constituted by different currencies has revealed co-ordination problems, that cannot be solved by competition alone. Before I illustrate my points with a few examples, I should like to underline that this, I believe, is where the role of public authorities is crucial to ensure that the full benefits of economic and monetary union are obtained. Indeed, almost by definition, public policy consists in the resolution of co-ordination problems between private agents, leading to the production of a public good or the protection of a public interest.
But let me immediately provide two examples of how the Eurosystem, as a public authority, has contributed to solving co-ordination problems, where competition could not be effective. I underline here that I have chosen two very practical - very down-to-earth - examples, for the sake of simplicity. But the same concepts apply to significantly more complex issues.
The role of public authorities as facilitators of the resolution of co-ordination problems: the EONIA
My first example refers to the calculation of the EONIA reference rate, which, as all of you well know, is a weighted average of the interest rate at which major banks active in the euro market conduct their overnight transactions in the unsecured money market. The existence of such a reference rate has some of the properties of a public good, insofar as it has provided the basis for the development of an extremely liquid overnight interest rate swap market, of which no equivalent exists in the world. One of the main interests of the EONIA is that it is calculated on actual transactions, not merely on posted or indicative rates. This contributes, inter alia, to the appropriateness of EONIA swaps as a hedging instrument.
At this stage, I should underline that the EONIA reference rate was not designed by the ECB, nor did the ECB play any leading role in its creation. Whereas the creation of the EONIA was a typical example of a co-ordination problem being resolved by market participants themselves, the ECB was involved as a facilitator of this resolution. What I mean here is that, so that the EONIA could effectively be based on actual transaction rates, it was seen as desirable by market participants that the calculation of the daily EONIA rate be done by a third party, which would receive the contributions of each bank of the panel on a confidential basis. It is the ECB that was asked to play this role.
The role of public authorities as principal in the resolution of co-ordination problems: TARGET
A different example of co-ordination problem, of a considerably more serious nature, relates to the situation prevailing at the start of Stage Three of EMU. You may recall that at the very start of my presentation, I mentioned that the unsecured money market in euro was fully integrated within days of the introduction of the single currency. This outcome, however, could not be taken for granted beforehand. Indeed, the full integration of the unsecured money market implied that there existed a means for banks to exchange liquidity across borders, rapidly, smoothly and safely. Only under these circumstances would it be ensured that interest rates for unsecured transactions would equalise across the euro area, i.e. that there would effectively be a single monetary policy.
This was a typical example of co-ordination problem, insofar as both the banks and the Eurosystem all had a clear interest in the existence of such a payment mechanism across the euro area. In the absence of a satisfactory solution, the Eurosystem took upon itself to design and operate such a payment mechanism, which is of course TARGET, and which I do not need to present.
The role of TARGET at the time of the introduction of the euro cannot be overestimated. In allowing the immediate integration of the whole euro area unsecured money market in the first days of existence of our single currency, it effectively ensured the singleness of monetary policy. The reason why I mentioned this example is because this is one example where public authorities could not act simply as facilitators of the resolution of a co-ordination problem, but had to act as principals in this resolution.
The other merit of this example, in my view, is to highlight the following: the Eurosystem did not integrate the money market. It is the banks themselves, by their activity of arbitraging any remaining difference between interest rates across the euro area, which integrated the money market. What the Eurosystem did was to ensure that there existed an environment, where these market forces could be unleashed. The strict implementation of the single monetary policy with a pan-euro area approach and no consideration for the liquidity situation in each country taken individually participated of course to this environment.
This, I believe, underlines the role of public authorities in the integration of euro area financial markets. The examples I have used are very limited and down-to-earth. When one thinks of public intervention in the field of financial markets, one thinks rather about legislation, such as the work being conducted on European Directives on banking, taxation of savings, or collateral. One also thinks about regulation and, for instance, the work recently conducted by the Committee of Wise Men on the regulation of European securities market. But the underlying principle is the same. The role of the authorities, in each case, is to create, by the resolution of what are essentially co-ordination problems, a safe and competitive environment, where market forces can effectively express themselves, leading to an efficient allocation of resources.
In the course of my presentation I have touched, however briefly, on a relatively large range of issues. The common line to all these issues, and the conclusions that I draw from them all, are the following:
Firstly, the introduction of the single currency is a long-term project. Only a small part of the benefits that can be reaped from the existence of the euro have materialised already.
Secondly, so that all these benefits can be obtained, we need to further the process of integration, in particular in the field of financial markets. This process is well under way, but it is still far from completed.
Thirdly, this integration cannot be the fact of public authorities alone. Our role is to help resolving co-ordination problems. Our role is to create a favourable environment for investment and economic activity. Certainly we, at the European Central Bank, believe that we contribute to this favourable environment by maintaining price stability over the medium-term. But, once again, it is not us who can complete the integration of the markets. It is you, the private participants in the market, who can achieve this integration by taking advantage of all the opportunities that are available to you across the euro area. By this means, it is you that will reap, for the benefit of the entire European people, the full benefits of the single currency.