Speech at the ECB-CFS Symposium 'The Role of the ECB in Financial Integration'
Speech by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECB,
Frankfurt 11 May 2004
Since several years I am trying to understand what is going on in the financial sector of Europe – is it following other industries in exploiting the opportunities of a single market or will we ever see this single market for financial services?
First, I tried to consult economic literature – for instance the article by D. Rodrick (1999) “How far will international economic integration go?” He speaks about the political trilemma of the world economy – international economic integration, the nation state and mass politics.
Can markets become international while politics remain local?
He speaks about the distribution and governance difficulties which result from economic integration. When I found out that the time horizon of his reasoning in the world economy 100 years from now I decided to turn to the ECB-CFS research network to get some answers.
The introduction of the euro 5 years ago has shaken financial markets in Europe only to a certain extent. We have created an integrated money market, the bond market has made considerable progress towards integration, corporate finance is more and more an international market, a bigger role for equity financing is emerging. Markets are shaping their expansion.
What more needs to be done?
The wide ranging FSAP of the European Commission has given financial integration a kick. Now we are turning to implementation and enforcement.
The Lamfalussy Framework has harmonised the institutional set up for rule setting and co-operation of regulators across financial sectors and on a European level.
Policy maker s are doing their best. What else can be done?
I will try to describe the activities of the ECB in this field, the major achievements of our research network and present first ideas of our internal task force on financial integration as well as describe the future of the network.
Role of the ECB in promoting financial integration
The role of the ECB in promoting European financial integration is threefold.
First, it co-operates and acts as a facilitator or catalyst between several parties.
Second, in fields where the mandate of the ECB applies directly, it implements structural reforms that foster financial integration.
Third, it raises awareness by doing specific analysis and assessment of the current state of financial integration.
Co-operation, facilitation and catalyst
Co-operation with the European Commission is of particular importance and will be developed further in the area of financial integration.
Regarding securities settlement systems, the ECB participated actively in the production of the two reports of the Giovannini Group about the structure of the security settlement industry in Europe. The ECB fully supports the conclusions of the reports, in particular regarding the identification of the 15 obstacles to an efficient market infrastructure in Europe. However, consolidation is slow and market forces may be insufficient.
In particular, it is important that traders can chose freely between settlement channels. By offering this choice to traders, more transactions will be directed toward the more cost efficient systems.
Recently the ECB has most extensively played the role of catalyst of collective action in the STEP initiative (Short term European Paper) with ACI (Association de Cambistes Internationales), with the idea to set up a pan-European market for short term debt instruments.
A uniform interest rate for the short term interbank market, was the major contribution of the ECB in January 1999 to the integration of the money and bonds markets.
As shown yesterday in the presentation of the ECB Measures of financial integration, where we look at differences in prices across regions of homogeneous products, frictions in information flows and where we try to quantify the effects of frictions on the supply and demand for investment opportunities, the euro Repo market still shows interest rate differences across countries.
The absence of a uniform legal framework in the euro zone explains in part why the Repo market is still not fully integrated. To improve the integration of the euro Repo markets the ECB supports a standardised and safe contractual basis that can be used in different national jurisdictions.
Repos are collateralised operations, the ECB recently took measures to improve the collateral framework of the Eurosystem. It announced yesterday, the introduction of a “Single List” in the collateral framework to replace the current two-tier system of eligible collateral. The purpose of introducing a Single List is to enhance the level playing field in the euro area, to further promote equal treatment for counterparties and issuers, and to increase the overall transparency of the collateral framework. For short, the Single List will be another step towards European financial integration.
Another objective of the ECB is to guarantee the efficient and smooth operation of payment systems.
As a large number of banks can send their payments through TARGET, our real-time gross settlement system for large transactions, an important condition for the effective arbitrage of interest rates was fulfilled. Our next generation of European RTGS, TARGET 2, will contribute to the further integration of financial markets by further consolidating infrastructures in the market for large value payments and will homogenise practices for users.
So far the practical work we are doing in this field – the plumbing so to say.
Assessment of the state of financial integration and raising awareness.
The ECB encourages its researchers and practitioners to undertake studies to assess the state of financial integration. The Financial Structure Report published by the ECB in 2002 and the Occasional Paper on “Measures of Financial Integration” presented yesterday are good examples of such initiatives. Actually, the measures are intended to be regularly updated, to monitor the progress of financial integration. I also welcome very much the “Financial Integration Monitor” by the Commission, where economic benefits from financial integration are screened on an annual basis.
Other initiatives are drawing also on external expertise. A good example there is the European Financial Markets Lawyers Group (EFMLG) which was established in 1999 to discuss and promote ideas leading to greater harmonisation of European financial market activities (laws and market practices) following the introduction of the euro. This group is chaired by the ECB Director General of Legal Services and is composed of senior lawyers from major credit institutions based in the EU, selected on the basis of their personal expertise. Legal hurdles are identified also by the IMF as a major impediment to further financial integration.
Finally, Research. Research is more than just raising awareness. The ECB-CFS Research Network on “Capital Markets and Financial Integration in Europe” is the most extensive forum through which the ECB carries out and stimulates its research work on financial integration.
Therefore, let me now turn to the past and future work of the ECB-CFS Research Network, and how they relate to the objectives of the ECB in terms of financial integration.
ECB-CFS Research Network on Capital Markets and Financial Integration in Europe
The objective of the network – launched two years ago – was to stimulate research on the current and future structure and integration of the financial system in Europe and its international linkages with the United States and Japan.
First, the network successfully established itself as a “network of people”.
Second, the network kicked off a new research field in the area of financial integration. The most important new area for central bank is the research on securities settlement systems.
Last, but not least, research conducted within the network improved dramatically our knowledge of European financial integration.
The ECB-CFS Research network is a “network of people”
The Network provided the necessary structure to exploit synergies and cross-fertilisation between researchers from different institutions. The results of this type of repeated interaction is a higher productivity and output that goes beyond what can be expected from the simple one-off organisation of traditional seminars and workshops.
Given many people I met in Athens six months ago, during the third workshop of the network - kindly hosted by the Bank of Greece - are here today, and the very collegial atmosphere of this Symposium, I think we can happily conclude that the network achieved fully this difficult goal.
To focus research resources and to ensure medium-term policy relevance, a limited number of areas have been given top priority:
Bank competition and the geographical scope of banking;
international portfolio choices and asset market linkages between Europe, the United States and Japan;
European bond markets;
European securities settlement systems; and
the emergence and evolution of new markets in Europe (in particular start-up financing markets).
In 2002, when the network was created, a lot of knowledge on these issues was lacking as they were under-researched. By creating the network, the ECB strongly signalled the importance of these topics for its activities to the research community as a whole. So, what was the main success of the network?
The ECB-CFS Research Network kicked off securities settlement systems research
The network can safely claim that it kicked off a new research field, namely securities settlement systems. I myself was a witness of that, when I came to the workshop in Athens, where the first papers were presented. This field is of particular importance for central bank involvement in the area of European financial integration. The ECB has a genuine interest in the integration of securities settlement systems.
As you all know, one feature of collateralised lending is that the securities have to be transferred back and forth between the transacting parties. While this is very easy and cheap within a given country, the same does not apply to cross-border securities transfers. The reason is that each country has its own securities settlement systems and a transfer often involves several of those systems. This handicap is of course very pronounced in Europe, as the euro area is composed of different countries. The fragmentation of securities settlement infrastructures in Europe, makes those transfers much more complicated and costly than, for instance is the case in the United States. This is why conducting research in this field is of utmost importance for the ECB.
While research on securities settlement systems was quasi non-existent two years ago, the network spurred enough interest in the field to gather many papers on the topic. A full session was devoted to securities settlement systems in the third workshop in Athens, one paper has been presented this morning and another paper will be presented in the last session of the Symposium.
Major results of the ECB-CFS network
Indeed, the efficient settlement of securities is one of the big challenges for further financial integration in Europe. Figures by a study from the Bank of Finland presented in the third workshop show that the gain from further integration will be important. Securities settlement in Europe is more than 30% more costly than in the US. The difference is mainly due to the average cost of US$40 for operating an international Central Security Depository for a transaction between two European countries, which is to be compared with only US$3 in North America for a domestic transaction.
Two substantial reasons have been highlighted to explain these numbers: market power and a lack of consolidation. Obviously competition is not playing its expected role to lower profit margins in Europe to more reasonable levels. With the absence of competition, there is also no pressure to develop systems that would operate at unit costs. Beyond that, another paper presented in the third workshop, showed that fragmentation and the still relatively little consolidation in security settlement systems, which is a remnant of the epoch with national currencies, prevent the full exploitation of scale economies as shown in the Finnish study.
A second important finding is the positive effect of the euro on the development and integration of European financial market. Two research papers presented in the network illustrate this very well. The first paper shows that the euro led to a reduction in the cost of capital for firms located in the euro area. The second paper documents the drastic reduction in “underwriting fees” (emission fees) of international corporate bonds issued in euro. The enlargement of local markets to a large euro zone market fostered greater competition in investment banking, thus leading to this drastic reduction in underwriting fees. As a result, the level of these fees is now comparable with the level in the dollar sector. Monetary integration therefore improved access to finance for investment and the prospect for growth.
One reason why top priority was given to bank competition and the geographical scope of banking was the surprisingly low number of cross-border bank consolidation in the euro area, despite the adoption of the 'single passport' principle. The aim of this passport was to foster further long distance competition. However, results of the network show that there are obstacles inherent to retail banking activities that limit such competition, such as informational barriers. Cross border mergers are a way to circumvent these barriers.
In addition, as was shown yesterday, there is some evidence of a possible positive relationship between competition in the (retail) banking sector and growth in financially developed systems. There, financially dependent firms will grow at a rate of 1.5 percent per annum more if the country’s financial sector is competitive.
The channel for higher growth has been suggested in previous workshops of the network, where it was shown that loan rates were increasing by at least 18 basis points for each additional mile separating a bank from its competitors.
If these results are confirmed, then more cross-border penetration and competition is needed in the retail European banking sector.
Continuation of the ECB-CFS Research Network
The network achieved more results than the time allows me to present. In two years, the ECB-CFS network undeniably became the main research forum on European financial integration bringing together scholars from academia with researchers from policy making institutions. The policy context as well as the emergence of other initiatives on financial integration suggest that this topic will remain very high on the agenda of policy makers and academics for the years to come.
We therefore need to keep track of new developments and challenges ahead. How will new EU members financially integrate? Will further competition fragilise the banking sector? How will further integration influence growth? And many other challenging questions lead us to conclude that the ECB-CFS Research Network is a necessary tool for the next years to come. I am therefore very pleased to announce that last week, the ECB Executive Board decided to continue the ECB-CFS Research Network for three more years.
In this new phase, three areas will be added to the list of network priorities.
The relationship between financial integration and financial stability,
EU accession, financial development and financial integration, and
financial system modernisation and economic growth in Europe.
These three areas have become particularly important at the current juncture, but have not received particularly strong attention in the past two years of the network. Let me explain why these three new priority areas were selected.
The relationship between financial integration and financial stability
The euro area offers opportunities to share risk and to allocate capital more efficiently to investment opportunities across all countries of the area. However, the necessary financial linkages between regions and countries may also facilitate the fast propagation of shocks. Financial integration, by increasing financial linkages, could raise the risk of cross-border contagion in a financial crisis. As the integration process further advances, numerous policy issues become more pressing, including issues of supervisory and regulatory natures. With the integration of European financial markets going forward, it is important to understand what type of integrated financial structure is the most resilient.
The work of the research network on the relationships between financial integration and financial stability could therefore bring additional elements in shaping a view regarding what a stable financial architecture means.
EU accession, financial development and financial integration
On May 1st ten new countries joined the European Union. Out of these ten, four countries, Cyprus, Estonia, Lithuania and Slovenia, have already expressed the wish to adopt the euro as soon as 2007. It is naturally expected that financial integration will follow swiftly the political, economic and monetary integration of these countries to the European Union, and it is important to understand how these countries will financially integrate with the rest of the euro area.
For instance, Miklós Koren (Ph.D. student at Harvard University and at the Hungarian Academy of Sciences) who received a Lamfalussy research fellowship in 2004 for a project on “financial integration and income volatility” will study how the new member countries’ business cycle will be affected by their integration into the euro area.
More precisely, the purpose of this project is to empirically investigate the relationship between financial integration and income volatility and to provide a theoretical model explaining the findings. The envisaged key mechanism is that financial integration helps countries adopt less risky technologies, which results in long-term income stability.
Financial system modernisation and economic growth in Europe
As you all know, there are only limited empirical underpinnings of the link between higher economic growth and financial integration. In fact, establishing an automatic equivalence between financial integration and financial development is a misconception. Several financial systems can be integrated to a very high degree while still not making possible all investment opportunities. As a result growth performance of the real economy may be rather low.
The capacity of financial systems to be engines for growth depends more on their quality and efficiency to intermediate capital than on their level of integration. In other words, when tackling the issue of economic growth, it would be wrong to place the focus entirely on the level of integration. Rather, the focus should also be on the modernisation of financial systems, which received relatively little attention from the network so far.
We hope that the network will be successful in this new phase in providing us relevant insights for policy making in the above areas.
Let me summarize the main points:
The three key roles of the ECB in fostering European financial integration. It raises awareness, It co-operates with the relevant institutions and acts as a facilitator or catalyst between several parties, and finally, it implements direct measures that foster European financial integration.
Regarding the European banking sector, first integration appears not to be very advanced in retail banking markets. Second, some of the inherent characteristics of traditional loan and deposit business constrain the cross-border expansion of commercial banking, even in a common currency area. Hence, the implementation of some policies to foster cross-border integration may be ineffective.
There is also increasing evidence that the introduction of the euro has contributed to a reduction in the cost of capital in the euro area, in particular for corporate bond underwriting fees. Monetary integration therefore improved access to finance for investment and the prospect for growth.
European securities settlement infrastructures are highly fragmented and further integration and/or consolidation would exploit economies of scale that could greatly benefit investors. Progress with consolidation is visible but the process is slow. Too strong a vertical integration between trading and securities settlement platforms can prevent the efficient consolidation of securities settlement systems. Hence, promoting open access to clearing and settlement systems is warranted in order to achieve efficiency.
I hope that the second phase of the network will bring us new and relevant insights in order to help us in directing the action of the ECB to promote financial integration. I also hope you will continue participating in the second phase of the network. The research network will still organise two workshops per year until 2007 and I am looking forward to seeing you again at one of our future events. Let me now invite you to enjoy a cup of coffee, before the last two parallel sessions of the Symposium take place.