Competition, co-operation, public action: Three necessary drivers for European financial integration

Tommaso Padoa-Schioppa, dinner speech for the launching workshop of the ECB-CFS research network on "Capital markets and financial integration in Europe", Frankfurt am Main, 29 April 2002

I am pleased to be here tonight. As you can imagine, and as the launching of this workshop indicates, the European Central Bank follows very closely the developments of European financial markets. Financial integration plays a major role in the areas of monetary policy, supervision, financial stability, market operations and payment and settlement systems. We expect the Workshop that is launched with this meeting to foster research on European financial markets and to increase awareness and understanding of the issues at stake.

By channelling funds from agents who have a surplus to those who have a shortage of savings, well structured and well regulated financial markets contribute to an efficient allocation of resources, to reduce the cost of capital, allow for risk-diversification and risk sharing. Their structure, functioning, regulation and supervision are therefore crucial for the long run economic performance of an economy.

Market segmentation - the opposite of integration - is associated with high transaction costs, reduced liquidity, inefficiencies in resource allocation, low growth potential and ineffective transmission of monetary policy. This explains the strong focus of the ECB and other European authorities on promoting financial integration. It also explain the great interest the ECB-CFS Research Network on "Capital Markets and Financial Integration in Europe " has raised both among academics and official institutions.

Twenty years ago, I suggested how it was impossible to "aim simultaneously at

i) free trade,

ii) capital mobility,

iii) independent domestic monetary policies, and

iv) fixed exchange rates". [1]

At the time, the inconsistency was mainly resolved by the absence of a single market. Twenty years ago there were, particularly in the financial sector, all sorts of barriers segmenting national markets: foreign exchange controls, restrictions to capital mobility, no freedom to offer banking and other services across borders. Later in the 1980s, the high road to reconcile the "inconsistent quartet" was taken, by completing the single market, liberalising capital movements and finally planning complete monetary union. The "planning" was followed by the "doing". The single currency and its central bank, the Eurosystem, came into being and, with the recent successful introduction of banknotes and coins, this long journey - which has occupied most of my professional life - has come to "an" endpoint. The euro can indeed be considered as the crowning achievement of the European Single market.

I said "an" endpoint and not "the" endpoint, because the multiplicity of currencies (in spite of the Single market having officially started in 1993) was a major factor of segmentation of the financial system and of the European economy in general. Thus, only with the introduction of the euro was a main obstacle to integration removed. And hence, it is right to say that the euro marks not only a crowning, but also the beginning of an integration process.

There is indeed a new and growing academic literature that recognises the impact of currency unification on market integration. [2] As suggested by Andrew Rose's thought-provoking title, "One money, one market", times are ripe to reverse what had become a slogan. There are clear signs that the single currency fosters the formation of a single financial system. By increasing price transparency, reducing transaction costs, and ultimately stimulating competition, the single currency is acting as a powerful catalyst to complete the integration process foremost (but not exclusively) in the financial industry. Significant progress has already occurred in the area of securities markets, the most remarkable example being represented by money markets. Bond and equity markets are moving towards further integration as well.

While ending the transition towards monetary unification, the single currency must therefore be regarded as the starting point towards further financial integration. Indeed, if today we are here discussing the future of the European financial system, it's precisely because - in the euro area - we share the same currency, the same central bank and the same source of liquidity. The financial sector - unlike, say, the manufacturing sector - can be called a "system" (i.e., as the dictionary says, "a set of connected things") first and foremost because it is tied together by the same single currency.

Network externalities are relevant for financial systems. Size matters, and the more traders, investors and borrowers use a system, the more valuable it becomes. Strong network effects and high switching costs, however, have the potential to create "lock-in" situations: since it is expensive to switch from one system to another, existing conventions and market practices might be self-reinforcing. This seems to be exactly the problem of today's European financial industry, which is still a half way house between a collection of (national) systems and a single system. Different conventions and infrastructures are the result of decades of evolution and actions by market participants and public authorities within the national framework. They survive the advent of the euro as an integrating factor because it is quite costly for their users to abandon them. Market forces alone may not be able, at least in the short run, to drive financial integration forward.

As times for "inconsistencies" are gone, tonight I would like to use the catchword "necessary trinity" to state that, in my opinion, the completion of the financial integration process requires the interaction between three (equally necessary) drivers: i) competition, ii) co-operation and iii) public action. Free competition across borders permits market forces to push towards greater integration. Co-operation is needed to overcome situations where the optimal outcome is not achieved by the simple interaction of independent individual decisions. And finally, public action is called for where a public good is at stake or, more generally, a market or a co­ ordination failure occurs. Behind each of these three drivers there is a distinct and well-defined motivation. Competition results from the selfish behaviour of market participants and is driven by the search for profits. Co-operation stems from the awareness of market participants that externalities might impede the realisation of benefits for all firms operating in the market. And public action is motivated by the public interest.

Whoever, like myself, holds the view that freedom and responsibility should pervade economic life, is inclined to let market forces do as much as they can to transform the structure of the market in an optimal way, not only to carry on activity within a given market structure. But I also think it is crucial to be aware that market-led progress towards integration does require co­ operation among economic (private and public) agents. In Euroland, not less (actually more) than in my much longer service as national policy maker, almost every day brings evidence that competition does not suffice to produce the desired equilibrium of full integration. Co-operation is needed, to mention just a few cases, in developing payment and other market standards, adopting pricing conventions, consolidating clearing and settlement systems. Also the driver of co-operation should be, as much as possible, moved by the private sector, i.e. by an enlightened perception of the private interest. However, here again, to hold this principle, and to strive for its implementation in practice, cannot make us blind to the fact that the necessary co-operation among private market participants does not materialise unless public authorities play an important role in promoting it. At the same time, of course, the authorities need to provide genuine public goods such as price stability and a competitive environment. In conclusion, all the three drivers are needed, and there is a significant interplay between them.

In the following, I will elaborate this general idea by going through a few examples.

The first example concerns securities settlement systems. The costs associated with building an integrated market infrastructure for securities settlement would not necessarily accrue to those who stand to benefit the most. Mechanisms to compensate those bearing the costs may be difficult to devise. Further, in the short run some market participants may even benefit (rather than suffer) from fragmentation and, hence, lack the incentive to change. Under these circumstances, one cannot expect competition to work, as too few players and too many externalities are involved. Co-ordination is needed to foster a sensible private sector outcome. The ECB is positioned to act as a catalyst, as it did for the EONIA rate, which was developed with its active contribution and then adopted as the market benchmark.

The second example concerns the retail activity of the banking system. The typical customers of a bank are households and small firms. Therefore, linguistic factors, cultural habits and customer proximity will inevitably keep loan and deposit activities locally rooted. The U.S. experience indeed suggests that geographical segmentation might remain a distinctive feature of European retail banking for some time. However, new technological advances might cause a widening of the playing field of competition here too. Public action may not be needed as much as in other segments of the financial sector, because the case for recognising a market failure may not be strong. Yet, public authorities may play a useful role, for example by imposing standards on customer information, in order to generate consumers' trust.

A third and last example concerns financial services. Here, problems and central areas for public action have been identified by the Commission's Action Plan, and by the recent work of the Economic and Financial Committee. Important obstacles stem from differences in national tax systems as well as in supervisory requirements. Items on the agenda are the reform of corporate take-over legislation, generating efficient, fair and expedient rules for the transfer of ownership of corporations, as well as the taxation of capital. On the regulatory side, the recommendations of the Lamfalussy Committee of Wise Men have started to be implemented. The ECB and the Committee of European Securities Regulators have established a joint group aiming to identify common standards for securities settlement systems at the European level.

Public action, as I said, is an integral component of the "necessary trinity", a driver that cannot be missing if further progress in financial integration - that is desirable, and that only the advent of the euro really permits - is to occur in the coming two or three years. The contribution of public action, however, may not be as easy and straightforward as a textbook (or, for that matter, a single country) case would suggest. Indeed a distinctive feature of the euro area is the problematic meaning of the term "public". "Public" are the actions of the individual countries and national authorities of the European Union, and "public" also are the actions of European institutions, where those same countries and authorities obviously play a role. In a multi-country context, national authorities may not always be the natural promoters of further integration, since their perspective is often mainly domestic. This complicates the functioning of public action as the third driver. And since the three drivers are all needed, this also complicates the process of further integration.

With the above examples I tried to illustrate the crucial importance of the interplay between competition, co-operation and public actions for a successful integration of the European financial system. Actions by market participants, I repeat, should be the primary driver. Whenever market forces fail to remove relevant obstacles to integration, public authorities may intervene either to remove the obstacles, or to act as a catalyst to complete the integration process. Moreover, they have to act to provide genuine public goods. Hence, public agents need to have a broad view of the necessary policies in support of integration, focus not just on lifting the remaining regulatory obstacles, but also on the co-operative arrangements among private agents and maintaining effective competition to the benefit of the users of financial services. Because of their European mandate, the ECB and the European Commission are in a good position to foster beneficial co-operation in the market place.

In furthering the agenda, applied and empirical research has an important role to play. Studies like the one of the European Commission about the development of indicators and methodologies to measure the evolution of financial market integration are most welcomed. [3] In the light of the framework I presented to you tonight, it would be important to also study how the interaction between co-operation and competition can work towards an efficient market structure. This brings forward other questions. Is the persistence of different conventions due to lack of competition, regulatory obstacles, or failure of co-ordination? What are the trade-offs between the use of competition and co-operation in fostering financial integration? Are co­ operative solutions going to decrease or even drive away competition among agents? Will this reduce incentives for product innovation and cost control? If so, how can the public authorities address this problem?

I am sure that by bringing together academics and researchers from official institutions, the new Research Network on "Capital Markets and Financial Integration in Europe " can play a significant role. It can promote fruitful exchanges of ideas, create new synergies and give a decisive contribution to our understanding of the functioning of the European financial system. I wish you a very productive collaboration and I look forward to hearing about the progress of the Network.



[1] Padoa-Schioppa (1982), Address to the 'Second Symposium of European Banks', reprinted in Padoa-Schioppa (2000), "The road to monetary union in Europe . The emperor, the kings, and the genies", page 29.

[2] See Andrew Rose (2000), "One money, one market: the effect of common currencies on trade", Economic Policy.

[3] "Study to analyse, compare, and apply alternative indicators and monitoring methodologies to measure the evolution of capital market integration in the European Union ", prepared by the CSEF (Centre for Studies in Economics and Finance) for the European Commission.

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