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Challenges of financial integration in the post-FSAP period

Contribution of Tommaso Padoa-Schioppa, Member of the Executive Board of the ECB to High level panel: "Where next? Discussion on remaining challenges for financial integration" at EC Conference on European financial integration: Progress and prospects, Brussels, 23 June 2004


1. Before sharing with you my thoughts on the policy challenges on our way to a truly single financial market, it may be useful – precisely because those challenges are daunting – to remind ourselves of the basic motivation for the European project of financial integration.

Indeed, financial integration is not an end in itself. Instead, it is a crucial prerequisite for the development and the competitiveness of the European financial sector, and of the European economy more broadly. By stimulating greater competition and increasing the breadth and depth of financial markets, it contributes to greater market liquidity, reduced costs of capital, and a more efficient allocation of resources. Greater integration would therefore foster the performance of the European financial sector and enable markets and service providers to compete more effectively in the global marketplace. At the same time, it would enable the EU corporate and household sectors to benefit from access to comparatively cheaper and higher quality financial services. Moreover, as numerous studies have shown, the greater economic efficiency achieved with financial market integration would ultimately foster a higher potential growth path of the economy.

Significant progress has already been made following the implementation of the Financial Services Action Plan (FSAP). It cannot be denied however that, unlike the market for manufactured goods where integration is a reality, the financial market has remained rather segmented. Why has this been the case and what can we do about it? This is the topic I would like to discuss today.


2. The building-up of the single financial market has relied on different institutional approaches over the years. A first approach, which remained in place until the mid-1980s, based the production of European legislation on two elements: the unanimity rule and the full harmonisation of rules and regulations. This approach did not lead to meaningful integration, given the combination of a very far destination (full harmonisation) with an almost immobile vehicle (unanimity).

The second approach, still underway, is based on a different combination: first, as far as the vehicle is concerned, the majority rule in the legislative process; second, as far as the destination is concerned, the twin principles of minimum harmonisation and mutual recognition of regulatory standards. This approach, without full legal harmonisation, was used to guide the advancement of financial integration. Indeed, it produced the first UCITS Directive (1985) and the Second Banking Directive (1989), and has remained the basis for the single passport concept in financial services: the authorisation by the home Member State and the application of its law and regulations is valid for all Member States.

The rationale underlying the “two legs” of minimum harmonisation and mutual recognition is that an environment of regulatory competition among Member States would foster at the same time the cross-border provision of services and an overall improvement, further harmonisation and lightening of regulation. On the one hand, market participants would be allowed to operate across the EU to the widest extent possible on the basis of a single regulatory regime, as provided by their home country. On the other hand, as integration progresses, Member States would have incentives to adjust their respective regulatory frameworks both to foster their own financial markets and to prevent excessive regulatory arbitrage. A market-driven harmonisation would also eliminate regulatory barriers to market access. Ultimately, the emergence of a pan-European level playing-field was expected, leading to convergence of the costs of providing financial services across borders and to the EU-wide expansion of financial activities and institutions.

3. Reality has not been fully aligned with expectations so far. It is true that regulatory competition has worked and was effective to a certain extent in a first round of financial market integration. The European passport undoubtedly helped to improve market access across Member States and to spur a process of regulatory convergence towards better, more market-friendly practices. However, these improvements did not translate into the supply to end-users of all types of financial products and services, nor did they produce a significant reduction of the regulatory burden. On the way to a single financial market, market participants still find the obstacle of a patchwork of local regulatory and supervisory requirements. As a consequence, the costs of providing financial services across borders have remained higher than they could be.

In this context we should also keep in mind that, despite the European passport, financial institutions still expand across borders mainly via the establishment of subsidiaries, rather than branches. This is due to a variety of economic, historical and legal factors. Because regulatory and supervisory regimes differ so widely across countries, the large majority of European financial groups with significant cross-border business have to comply with several sets of national rules. And given the costs associated with this institutional set-up, it is not surprising that only a limited number of financial institutions are operating on a truly multinational basis, and even less can be considered pan-European actors.

We should be aware that all the reports of the expert groups representing the various segments of the financial industry – which are being discussed at this conference – call for an improvement of the regulatory and supervisory environment for cross-border activities.

4. The key cause of this state of affairs is that only the first leg of the current approach, namely the minimum harmonisation of requirements, could move at a satisfactory pace. The second leg, namely mutual recognition of national rules, has had a limited effect in stimulating a process towards sufficient regulatory and supervisory convergence because it was not really put to work. This has not favoured the full development of the single financial market since if one leg does not move, the whole body cannot move.

Of course, not only the public sector, but also the private sector bears a responsibility for this development. In particular, the question could be raised whether the financial industry itself set the right incentives to persuade EU and national authorities to develop a more efficient system of mutual recognition, as has happened in the manufacturing sector. Interestingly enough, the segments of the financial sector where a higher level of integration has been achieved – such as the unsecured interbank money market, and bond and government bond markets – are also those where the industry itself took the initiative to harmonise rules and practices, including product specification.


5. I believe that the current approach has been fully exploited with the completion of the FSAP. The measures adopted under the FSAP have substantially filled the legislative gaps at the EU level in the banking, insurance, securities and financial conglomerates fields. The thrust of the existing EU body of directives is, and rightly so, to reinforce the mechanisms for home-country control and mutual recognition. Now, the stage in which the foremost priority was to complete the legislative framework has come to an end. No one can seriously claim that further financial integration is impeded by the lack of one or two directives in one or another field. What we should do now is to turn towards the challenge of creating a lighter and more flexible regulatory structure and a more consistent and less burdensome implementation process. This is what is needed to sustain a truly integrated financial sector and, ultimately, to support economic growth in the EU.

6. In the new stage of building the single financial market, we should therefore focus on the development of a common set of technical regulatory requirements, to which market participants can directly refer in their cross-border activities and which would be interpreted and enforced consistently by Member States’ authorities.

The so-called Lamfalussy approach, now extended to all the segments of the financial sector, has the potential to provide the basis for such a new stage. First, it provides the tool for developing a single EU rulebook for cross-border provision of financial services via the introduction of an enhanced concept of secondary Community legislation. Second, it also establishes the institutional setting for pursuing a greater convergence of implementation and enforcement practices. Together, these two measures should reduce the costs of the cross-border provision of financial services substantially.


7. The concept of the EU rulebook refers to a streamlined regulatory framework for financial institutions, which would be both more uniform and more flexible across Member States.

Currently, the Community source of most financial legislation and regulation is often not even transparent to market players since they fully operate according to national rulebooks. Of course, the “interface” with market participants should remain based at the national level in accordance with the allocation of supervisory competencies. However, it would be immensely beneficial if the financial services industry would be in a position to refer directly to a homogeneous body of rules for their cross-border activities. Moreover, this set of rules should be flexible enough to be easily updated in response to new market developments. The Lamfalussy approach was conceived for this purpose. It allows for an extended recourse to Community secondary legislation (so-called Level 2) which should span not only over the new FSAP legislation, but also over a large part both of existing Community Directives and national regulations.

Implementing the approach in this way would imply, firstly, a real shift of legislation from Level 1 to Level 2. The former should only entail essential principles, while the technical choices and solutions should be agreed on the basis of Level 2 measures. For instance, in the banking field, the forthcoming capital adequacy framework should be ideally written in such a way that the technical provisions are adopted as Level 2 measures, which could be amended without the need to change the text of the Level 1 measures as well. Secondly, the development of the EU rulebook would also require a substantial shift from national rulebooks to Level 2 with regard to those parts that could be dealt with more appropriately by means of EU secondary legislation. National regulations would then be geared towards complementing, rather than adapting or replicating, EU rules by means of specific provisions tailored to local financial business.

8. Overall, this new approach would allow for a clear distinction between the three layers of the overall regulatory requirements market participants have to comply with: (i) common EU principles, laid down in Level 1; (ii) common EU technical provisions, embodied in Level 2; and (iii) national rules, reflecting specific features of local markets. This would favour the accountability of regulatory processes, alleviate the cost of compliance for financial institutions with cross-border business, and ensure a level playing-field.


9. Of course, the EU rulebook would only be effective if implemented and enforced consistently by the authorities in charge. To this end, a considerable harmonisation effort for supervisory practices would be necessary, which should take place through the enhanced cooperation between competent authorities within the newly established supervisory committees. Cooperation at the EU level can help support convergence insofar as it develops transparent standards and agreed best practices to be followed in the implementation and enforcement of the EU rulebook.

Such convergence of supervisory practices may also involve a refinement of the home-country control and mutual recognition principles. Thus far, these principles only apply to the direct provision of services and the establishment of branches. However, given the emergence of very large cross-border financial groups in host markets in recent years, there are increasing demands for further rationalisation of the implementation and enforcement of financial regulations. A financial group operating in several Member States should be able to organise reporting and compliance through a single integrated process rather than by establishing separate procedures for each country. An option, currently under consideration in the banking field, is the extension of the concept of the consolidated supervisor.

10. In sum, the design, implementation and enforcement of an EU rulebook should be pursued essentially through an ambitious application of Levels 2 and 3 of the new method. Only the full use of these two components can, in my view, equip the single financial market with an effective regulatory and supervisory process, and hence make it competitive on a global scale, efficient, and truly supportive of the EU economy.


11. A crucial condition for the development of pan-European marketplaces is a well-functioning cross-border competition process. First, there may be distortions of the competitive process stemming from the behaviour of private agents. Marketplaces are still predominantly organised at the domestic level, which may entail that market participants wish to keep competitive advantages and rents, rather than engage in more intense competition in wider EU markets. Second, public authorities may also set policies aimed at pursuing the legitimate interest of supporting their respective financial centres, which to some extent may unduly interfere with cross-border competition. The result is that consolidation is often realised through complex group structures, with entities in all countries concerned and with an overlapping of jurisdictions.

Competition policy should thus be seen as central to the integration process. Barriers to entry and unequal treatment call for active policies at the EU level, which should complement the monitoring of the correct implementation of EU law at the national level. Competition policy should therefore be seen as a tool to optimise the regulatory process and as an element for further work in the post-FSAP environment. The aim should be to ensure that the broad FSAP objectives of furthering integration are not hindered by anti-competitive behaviour.


12. Efforts in the post-FSAP period should be devoted to best implementing the new framework. If exploited ambitiously, the new framework could work effectively as a new foundation for the single financial market, within the current institutional setting based on the exercise of national competences. The central issue is the need to develop and enforce a genuine EU rulebook for cross-border financial services. Ultimately, this should allow market participants to organise themselves across the single financial market as they currently do in national markets.

However, financial markets are moving very fast and progress along the lines I have described needs to be swift. The challenge of these next steps should not be underestimated. I am sometimes concerned that the adjustment to the needs of more integrated markets occurs too slowly. For example, the Level 3 committees in banking and insurance, which have been just established, need to reach a steady state as early as possible.

It is also important to set up a monitoring framework to review and set in motion the progress to be made in the post-FSAP period. This framework, as the one provided for the monitoring of the FSAP itself, could include several components. Objectives and concrete targets should be spelled out, together with precise timetables and deadlines. An independent structure, which also considers the views of the industry, could be responsible for the regular review of developments during the post-FSAP period. This would enhance the accountability and reliability of the whole process.


European Central Bank

Directorate General Communications

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