The role of the Eurosystem in financial markets
Eugenio Domingo Solans, Member of the Governing Council and of the Executive Board of the European Central Bank, Speech delivered at ACI Ireland - The Financial Markets Association Dublin, 9 October 2003.
I am delighted to be here in Dublin today to discuss with you the tasks of central banks, i.e. the job of central bankers. Before doing so, I should like to thank ACI Ireland very much for its kind invitation.
As you know, one of the popular definitions of the job of a central banker is to remove the wine when the party is livening up. I wonder if this consideration has influenced the timing of my speech this evening, when dinner is about to finish.
In any case, I can assure you that this is not my intention, at least not this evening. Although I certainly believe in the central bank's role of steering the economic "party" via interest rates, I haven't come here to speak about monetary policy. Instead, I wish to make some comments on the role of a central bank in financial markets. Having said this, I should like to stress at the outset that both functions are not independent: on the contrary, they are closely interrelated. In the case of the euro, the role of the central bank needs to be re-stated as the role of the Eurosystem, for two reasons. First, it is the joint responsibility of the European Central Bank (ECB) and the 12 national central banks of the euro area, in contrast to monetary policy decisions, which are the responsibility of the ECB alone. Second, in financial markets many competencies are decentralised; segmentation still remains an unfortunate feature of the euro area financial system in too many areas.
Coming back to the title of my speech, the role of the Eurosystem in financial markets, it is worth recalling that, interestingly, many central banks were founded by governments which wanted to enjoy the financial advantages that could be obtained from such banks. Thus, their tasks were far from what the functions of modern central banks are perceived to be today. Later on, the key role played by these banks and their "political power" as the governments' bank, the control over the reserves of coins as well as their ability to provide extra cash by discounting commercial bills, made them the bankers' bank. In addition, their privileged legal status naturally resulted in a degree of centralisation of bank reserves at the central bank. Almost inevitably, the resulting responsibility led central banks to develop their roles in relation to monetary management and to the support of and responsibility for the health of the banking system at large.
Needless to say, the core function of a central bank is monetary policy. But it is not the only one. If only in order to implement and transmit interest rate decisions in an effective and smooth way, central banks should also play an active role in promoting the efficiency of financial markets.
I shall first discuss the relationship between monetary policy and the financial structure. Thereafter, I shall consider the relationship between the financial structure and financial stability, which essentially means discussing the banking sector. As we all know, the conduct of monetary policy takes place through the banking system and the financial markets. Thus, central banks are interested in knowing and influencing financial structures because they play an important role in shaping the transmission of monetary policy.
The channels through which the interest rate decisions of the central bank affect the economy constitute the monetary policy transmission mechanism. The process is rather complex. It includes bank credit conditions, exchange rate, economic agents expectations, etc. Any change to the policy-controlled interest rate affects inter alia market interest rates and prices of financial assets. These interest rate and asset price changes are then transmitted to the rest of the economy, affecting spending decisions and ultimately the inflation rate. In an environment of well-developed and efficient financial markets, monetary policy normally affects household spending via its impact on interest rates and prices. On the one hand, a change in the interest rate may induce households to modify their decisions related to the consumption of goods and services and residential investment. On the other hand, changes in asset prices may affect households' wealth directly and thus their consumption. Fixed and inventory investment by firms depends on the cost of capital they are faced with and the relation between the market value of capital and its replacement cost. These values are related to interest rates and prices as well. The exchange rate and the expectation channels of monetary policy transmission also play a role in this complex web of economic interactions.
The magnitude and speed of the pass-through of monetary impulses depend on various features of the financial system, such as the importance and the role of banks and capital markets respectively, the maturity structure of non-financial sector financing and the prevalence of variable and fixed interest rate contracts. Other institutional characteristics such as the tax system, corporate governance, banking relationships and competition in the banking sector may also have implications for monetary policy.
In order to implement the best possible monetary policy for the euro area as a whole, the Eurosystem endeavoured to take a euro area-wide approach to economic and financial developments. Furthermore, in many aspects of the economy, including financial structures, an understanding of national structures is essential for a thorough comprehension of the same structures at the euro area level.
The euro area is characterised by a large number of small and medium-sized enterprises, which account for about 60% of private sector employment. Partly related to that, links between firms and banks are marked by relationship lending, in which banks and customers conclude agreements on terms of credit, implying for instance secured access to credit lines at pre-set prices. Thus, a reduction in the availability of relationship lending could have an effect on the euro area's economy and on the workings of monetary policy. Recent developments in bank structures and banking competition seem to point to a reduction in relative terms of the scale of relationship lending activities. In turn, this could affect the euro area business cycle and the transmission of monetary policy as the liquidity provided by banks to small and medium-sized enterprises decreases.
Financial structures are also important. Central bankers must oversee financial structures because of financial stability concerns. Central banks began to be involved in financial stability because of their role as the bankers' bank. They lent to commercial banks and held their liquidity reserves in the form of deposits. As a matter of prudent management of their activities, central banks needed to evaluate the financial soundness of the commercial banks. Thus, central banks were naturally prompted to address financial stability concerns, irrespective of the attribution of formal supervisory tasks. Today, central bank activity in this area concentrates on both systemic stability and the stability of individual institutions.
The analysis of financial stability has traditionally paid close attention to credit risks related to financial cycles. These risks notwithstanding, recent changes in the financial system have brought about additional concerns. More traditional financial systems were characterised by a clear-cut separation between institutions and markets. Thus, the exposure of banks to market volatility was limited, as they largely focused on the transformation of deposits into illiquid loans. Furthermore, there was also a clear separation between banks, insurance companies and brokerage companies, as well as between the products they managed. Most importantly of all, domestic financial systems tended to be insulated from one another. Financial crises taking place in these financial systems followed broadly similar patterns. A lending boom and consequently a significant rise in asset prices was typically followed, at the turn of the business cycle, by failures of some banks.
Economic and Monetary Union has introduced dramatic changes in the interplay of European financial institutions. Above all, the main effect has been enhanced competition. Integration and competition are mutually reinforcing phenomena which are evolving in Europe – though for some observers at too slow a pace.
Further integration can only result from an effective interplay between competitive market forces, cooperative efforts among market participants and the action of public authorities. At the euro area level, the challenge for the public sector is to create an environment where cross-border operations are not overly costly for firms and their customers, and where cooperative solutions among market participants can be found to promote integration, which, in turn, could reinforce rather than restrict free competition. The challenge for banks and other financial firms is to exploit the opportunities of the wider marketplace and hence contribute to a more efficient and coherent European financial system.
As always, the downside of these opportunities is the threat which they can entail. More intense competition requires firms operating in the same market to be more efficient. While clearly promoting further competition, public authorities also have to make sure that the transition process is smooth, so that any severe episodes of financial instability will not prevent us from gaining the full benefits of financial integration.
Only if integration results in a genuine increase in competition will its economic benefits be reaped. It is of the utmost importance that the authorities ensure a sufficient level of competition and remove the remaining constraints. Greater competition over a wider market area will lead to a lower cost of funds and financial services, higher returns for investors and a wider array of available financial products. At the same time, greater competition encourages European banks to become more efficient and thus, in the long term, it improves their profitability and stability. Certainly, competition implies better opportunities for some, serious threats to others and additional challenges for all. Competition compels banks to ensure that they operate efficiently and respond to changes in the habits and preferences of their customers.
Financial integration and deregulation are blurring the distinction between the traditional financial sectors: banking, securities and insurance. This fact in itself increases the possibilities for competition. A prerequisite for turning these possibilities into reality is that banks can compete effectively on the same scale as other institutions in the financial markets. What this means 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, cross-border banking cooperation and integration in their different forms (agreements, shareholdings, mergers and acquisitions) are developing relatively slowly in the euro area, although in some European Union countries, such as Belgium, Ireland, Portugal and the Nordic countries, a very significant proportion of the capital of banks is held by shareholders based in other European countries. European banks have in fact expanded their presence in other European countries mainly by establishing branches or subsidiaries, as is clearly the case with some German banks. Efforts should be made to identify and to remove the obstacles that could discourage further cooperation and integration of the European banking industry.
In this respect, the existence of a common set of rules is a precondition for free and fair competition, as recognised and aimed at by Community legislation. But there remain fields in which inconsistencies between national legislation hamper the full integration of the financial system and certainly – let us put it this way – do not favour the development of a European banking industry. I will mention only two examples to illustrate this fact: the heterogeneity of bankruptcy laws and the absence of a Directive on takeover bids.
The relatively limited number of cross-border deals in Europe is not only due to a lack of legal harmonisation. Rigidities in labour markets as well as excessive administrative rules reduce the possibilities for streamlining and reorganising banks and introducing the cost-cutting measures necessary to fully exploit the economies of scale resulting from cross-border agreements. Differences in culture should also be mentioned, although I am firmly convinced that what ties us Europeans together is larger than what separates us. Occasionally, the attitude of some national authorities, inclined to treat domestic mergers or acquisitions more favourably than similar cross-border operations for nationalistic reasons, explains the relatively low number of such deals in Europe.
Although financial integration provides banks with enhanced possibilities for risk management, it has at the same time increased the probability of systemic risks. Financial integration has increased the risk of contagion and changed its nature and scope. The concept of systemic risks is definitely no longer a national concept; it is a euro-area and even a worldwide concept. This, precisely, is the raison d'être of Article 105.5 of the Maastricht Treaty, which reads as follows: "The European System of Central Banks (ESCB) shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system."
It is crystal clear that the competent authorities for banking supervision are the national ones, in accordance with the subsidiarity principle. Accordingly, the national authorities should decide the optimal organisation of supervisory tasks, taking into account their particular circumstances and national traditions.
In my opinion, the best model is to entrust the national central bank (NCB) with supervisory responsibilities at both the macro and micro level, i.e. prudential supervision related to systemic risks and threats to stability arising from macroeconomic or financial market developments and from market infrastructures, and prudential supervision related to the soundness of individual banks.
I also think that NCBs should somehow be involved in the work of committees dealing with banking regulation, because there is a close synergy between central banking and supervision and regulation.
After the introduction of the euro and the centralisation of monetary policy decision-making in Frankfurt, the best argument against central bank involvement in banking supervision, namely the potential for conflicts of interest between supervision and monetary policy, becomes less valid. Moreover, the arguments in favour of central bank involvement in prudential supervision remain or become even more prominent. To prevent systemic crises, central banks are either the only, or else the best prepared, institutions to deal with liquidity issues, the functioning of payment systems, the assessment and prevention of macroeconomic risks to financial stability, informational requirements regarding money and banking statistics, etc. In short, there are good reasons why NCBs should be entrusted with the national competence for banking supervision or, at least, be involved in it to a great extent.
Some countries have decided to create an independent single authority responsible for the supervision of all financial institutions and markets, following the example of the Financial Services Authority (FSA) set up in the United Kingdom in 1997. The main argument in favour of a single supervisory model is the blurring of boundaries between financial intermediaries that I mentioned before. Certainly, this argument calls for greater cooperation between different supervisors; nobody would be against an exchange of information or some degree of coordinated action when it is appropriate. Nevertheless, to put all the supervisory activities of heterogeneous institutions under the same roof seems to be going too far. Not only do supervisors master specific technicalities and use different tools in their respective areas, but also the missions assigned and even the emphasis put on the principles to be followed by supervisors are different and not always fully compatible. Moreover, the existence of a single supervisor for different financial activities does not prevent coordination problems occurring among the different areas of supervision. Those problems, by the way, would become less noticeable to the general public if they were under a "common roof". In practice, the existence of a single authority could make it difficult to establish Chinese walls for information which not all supervisors need to know at a certain moment. Indeed, Chinese walls are preferable to Chinese whispers.
In any case, I think that the trend towards conglomeration and cross-sector competition, if correctly addressed, would really point towards a need for a fundamental engagement of the NCBs in prudential supervision since the arguments mentioned before, which support their involvement, become even more relevant in a scenario of closer linkages and increased competition in the shared markets of banks, securities companies, asset managers and insurance companies. This is not, of course, a black-and-white issue and there are valid arguments both for and against any solution. Nevertheless, experience both in Europe and the United States clearly indicates that central banks are carrying out supervisory tasks effectively, whereas little experience has been gained of the application of the single agency model.
It seems indisputable that we have made progress – in particular since the launch of the euro – towards an integrated financial market structure. However, the increased transparency resulting from the single currency has also made plain the magnitude of the remaining obstacles stemming from regulatory and fiscal divergences, as well as from the fragmentation of market infrastructures and conventions. Hence, more action by authorities and private market participants – and close cooperation between them – are required. Further financial integration is in the clear interest of both banks and other financial institutions and central banks, and of public authorities in general. For banks, it means the liquidity benefits of deeper and wider markets and lower costs when making cross-border transactions, in particular. From a central bank perspective, it enhances the efficient and consistent implementation of the single monetary policy. Of course, just as important are the indisputable overall economic benefits of financial integration through a more efficient allocation of financial resources and risk-sharing, i.e. for the long-term goal of enhancing potential output growth.
In other words, after all this discussion I come back to where I started: the job of a central banker is to make sure that the economic party is sustainable in the long term. I should like to toast this goal, which is one shared by market participants and central bankers alike.