European financial integration: the views of the ECB
Speech by Jean-Claude Trichet, President of the ECBEUROPLACE International Financial Forum6 July 2005, Paris
Ladies and gentlemen,
I accepted with great pleasure the invitation to speak today at the 2005 Paris EUROPLACE International Financial Forum. After one and a half days of discussions, during which you have covered such a wide spectrum of financial markets issues – including a session on the competitive challenges for European capital markets in the global environment – I am very honoured to provide the closing remarks for this event.
In my speech today, I will address a topic that is also directly related to this conference’s themes as it is of big importance for making Europe more competitive: European financial integration.
Generally speaking, financial integration can be said to be achieved when market participants with the same relevant characteristics have equal access to the market, face a single set of rules and are treated equally, and when the opportunities arising from such conditions in place have been substantially exploited by market forces.
It follows that the achievement of financial integration implies the emergence of rules, practices and standards common to all market players and service providers as well as the removal of obstacles to the optimal exploitation of economies of scale and scope available to market participants. Progress in financial integration therefore requires an effective interplay between market forces and action by public authorities.
In particular in the European context, there is still a need for market participants to develop the coordination of their joint interests further. Market forces alone may not always be able to drive financial integration forward or towards an optimal outcome. Therefore, they have to be complemented and enhanced by collective action to overcome possible coordination problems.
We at the ECB see the fostering of collective action on the part of the private sector to overcome possible coordination problems as a very important contribution by public authorities. Also the ECB plays this ‘catalyst function’, and I will give you some specific examples later.
Let me summarise the issues I would like to address today. I will first review the economic benefits of financial integration. I will then present the state of integration of the European financial system. In so doing, I will explain the ECB’s various contributions to fostering financial integration, which extend to all parts of the financial system, namely the financial institutions, the financial markets, and the financial infrastructure. Finally, I will outline prospects for the future.
Financial integration: economic benefits
Our road to the single European market in financial services has been marked by important milestones, including the Single European Act in 1987, the liberalization of capital flows in 1990, the Financial Services Action Plan (FSAP) from 1999 to 2005, and the Green Paper on Financial Services Policy that looks ahead for the period to 2010.
The Lisbon Agenda gave further stimulus to progress. The Agenda was launched in 2000 to enhance structural reforms in order to increase the competitiveness and growth potential of the European economy. While not confined to the “real” side of the economy, one such structural reform is the process of European financial integration.
While we understand that financial integration is not an end in itself, it is generally accepted to be a key factor in the development and modernisation of the financial system which, in turn, leads to greater productivity and competitiveness, a more efficient allocation of capital and the potential for increased economic growth. In short, the European economy will experience ever greater and more sustainable non-inflationary growth as its financial system becomes more integrated. To give one example, one empirical study estimated additional growth resulting from financial integration of the European bond and equity markets to be 1.1% over a decade or so.
Against this background let me reiterate that the ECB strongly supports the Commission’s policy of pushing forward the Lisbon strategy by focusing reform efforts, at both the national level and the European levels, on “delivering stronger, lasting growth, and creating more and better jobs”.
The ECB’s most important contribution in this regard is to continue to act as a strong and reliable anchor for safeguarding monetary stability, thus providing a vital condition for sustainable output growth.
There are also benefits directly related to the ECB’s primary task, as the relationship between monetary stability and European financial integration is mutually beneficial. Most importantly, an integrated financial system promotes the smooth and effective transmission of monetary policy throughout the euro area.
Furthermore, the integration of the financial system is highly relevant to the ECB’s task of maintaining financial stability. A financially integrated system, on one hand, offers more possibilities for economic agents and financial institutions to manage and diversify their relevant risks. On the other hand, particular attention has to be given to the profound changes in challenges to financial stability due to the structural transformation of the financial system, including intensified cross-border links. The ECB thoroughly considers the interaction between financial integration and financial stability.
I will now briefly present the state of integration of the European financial system and the specific ECB contribution.
The state of European financial integration and the ECB contribution
The degree of financial integration varies across the main segments of the financial system - financial institutions, financial markets and the financial infrastructure.
To start with financial institutions, notably the banking sector, integration is already well advanced in wholesale, interbank and capital market-related activities, including trading and sales, asset management, agency services and syndicated lending. Indeed, cross-border holdings of securities and interbank loans have in relative terms experienced substantial growth. For example, at the end of 2003 around 45% of the securities issued by non-banks were held cross-border – twice as many as five years earlier. Around 25% of all interbank loans granted were cross-border loans, up from around 20% in 1998. Together with the largest US investment banks, major European banks are among the leading underwriters of bonds issued by European corporations and are leading arrangers of their international syndicated loans. And pan-European groups, i.e. groups active in many EU countries, typically engage in significant wholesale and investment banking activities on a cross-border basis.
As regards the financial markets, I can summarise my assessment in three points. First, the degree of integration of the wholesale financial markets is very advanced, but the retail financial markets are still relatively fragmented. Second, the degree of integration differs quite significantly between the segments of the wholesale financial market. And third, the nearer a financial market segment is to the single monetary policy, the more integrated it is.
Without doubt, the euro has played a major catalysing role in enhancing financial market integration. I would say that integration is almost fully achieved in the money market and in the, related interest rate derivatives markets. Regarding the latter markets, let me just mention the Overnight Index Swap (OIS) market, where contracts are exchanged in which one party pays a fixed rate of interest for the duration of the contract, while the other party pays an average of the overnight EONIA rate realised over the period. The OIS market is the largest swap market in the world. The euro swap market is nearly 50% larger than the equivalent US dollar segment. The launch of the EONIA Swap Index on 20 June is evidence of both the importance and the further potential of this market segment. Furthermore, the volume of interest rate over-the-counter (OTC) derivatives is larger in the case of the euro segment than for the US dollar segment. According to the latest BIS triennial survey published in April, interest rate derivatives denominated in US dollar amounted to around USD 350 billion, while those denominated in euro are about 30% larger.
So, monetary union has been a major factor in fostering the integration and competitiveness of the European financial system. The ECB contributes also with a number of concrete activities. A first kind of involvement I have already mentioned is our catalyst function for private sector activities. As regards the money market, a good example of this is the ECB’s calculation and publication of the EONIA rate.
A second type of activity is our provision of central banking services that can also be conducive to fostering financial integration. The primary example of this is the infrastructure related to the money market, i.e. the TARGET system and its current consolidation into TARGET2. Today, TARGET handles around 90% of the total traffic of large-value payments in euro. And with payments totalling EUR 1.7 trillion being settled every day, TARGET is one of the two largest wholesale payment systems in the world, the other being Fedwire in the United States. Moreover, TARGET2, due to go live in 2007, will foster financial integration even more. It will be based on a single technical platform, it will increase cost effectiveness and it will put in place a single price structure for domestic and cross-border payments. We expect TARGET2 at the first rank of efficient and sophisticated payment systems in the world.
From the unsecured interbank deposit market, which is the most fully integrated market, I would now like to turn to the least integrated money market segment, namely the short-term paper market. Indeed, this market is not only much smaller than its counterpart in the United States, but it is also segmented along national lines in the EU. In the United States there is a single and very well developed market for commercial paper, with an outstanding volume of almost USD 1.5 trillion. In the EU, the market for comparable instruments only amounts to around EUR 750 billion. Fragmentation of the short-term paper market reduces its depth and liquidity as well as the diversification opportunities for issuers and investors.
Here also, the ECB has contributed to fostering financial integration by acting as a catalyst for private sector initiatives. The Short-Term European Paper, or “STEP”, initiative was set up by the ACI Financial Markets Association. It aims to promote the convergence of the practices through market players’ voluntary compliance with the standards set out in the STEP Market Convention. The ECB has undertaken to support the activities pertaining to the introduction of a STEP label for the first two years after its launch and to produce and publish related statistics.
Turning to the bond market, in my view the degree of integration in the government bond market segment is quite high from the standpoint of market participants. Government bond yields, at different levels of yield, are predominantly driven by common (euro area-wide) news.
In the corporate bond market, growth has been impressive since the launch of the euro. As regards bond issues by non-financial corporations, the average annual growth rate in the euro area between January 1999 and December 2003 was around ten percentage points higher than in the United States, which is the converse of the situation that prevailed before the introduction of the euro. Nonetheless, corporate bond markets in the euro area in terms of outstanding amounts are still comparatively small: the outstanding volume of such bonds is around EUR 600 billion in the euro area compared with USD 2.9 trillion in the United States. However, the degree of integration of the corporate bond market is fairly high. The yield differential between corporate bonds is predominantly the result of the rating and of maturity and coupon effects, while the yield variance due to country of issuance is negligible, even inexistent.
An increasing trend towards market-based financing can also be seen in the growing importance of securitisation transactions – be they off-balance sheet, such as mortgage- and asset-backed securities and collateralised debt obligations, or on-balance sheet, such as covered bonds. However, obstacles to cross-border transactions still remain in Europe’s securitisation markets.
Integration is probably least advanced in the equity market, although it is increasing. Euro area stock market capitalisation increased from 21% of GDP at the end of 1990 to 45% of GDP at the end of 2003. Furthermore, the number of listed companies in the euro area grew from around 4,300 at the end of 1990 to around 6,700 at the end of 2003. Growing integration is evident from changes in the fundamentals underlying equity markets, such as increasing synchronisation of macroeconomic activities across the euro area or the growth of international corporate ownership and international corporate activities. Returns in the various euro area equity markets are increasingly determined by common euro area factors and investors more and more diversify their equity investments across Europe.
There are also clear signs that further consolidation of the securities trading and post-trading infrastructure is on its way. The ECB has a particular interest in integrated securities markets infrastructures because all central banking credit operations need to be fully collateralised. More generally, efficient securities trading platforms and clearing and settlement institutions are of fundamental importance for the functioning, integration, and efficiency of financial markets.
In addition to the wholesale financial infrastructure, I would like to mention the field of retail payments, namely the Single Euro Payments Area (SEPA) project, an initiative of the European banking industry led by the European Payments Council. According to the regulation issued by the European Commission, the price charged by banks for a cross-border transfer must be the same as that of a transfer within a country. While prices to the end-customer have been homogenised through legislation, the level of service cannot be influenced by legislation. A real SEPA will therefore only be achieved when payments can be made throughout the whole area from a single bank account, using a single set of payment instruments, as easily and safely as in the national context today.
The banking industry is now working hard to develop pan-European payment instruments and a “SEPA compliant” infrastructure within the suggested timetable. The ECB – together with the European Commission – strongly supports the integration of retail payments. Another example of the ECB’s catalyst role is that we regularly discuss related issues with the industry and act as a broker to balance the needs of different stakeholders, including end-customers.
Integration is not only lagging behind in the area of retail payments, but also in retail markets, such as for loans granted to households and small and medium-sized enterprises. Cross-border loans granted to non-banks in other euro area countries remain low, at less than 5% of all loans granted to non-banks. I expect that bank customers will also contribute to fostering the process of retail integration as they raise their cost and product awareness, therefore increasing demand for more transparency and availability of information, notably in the wake of electronic means, like the internet, etc.
Let me also shortly refer to some overall structural indicators of banking integration, such as cross-border merger and acquisitions and geographical expansion via branches and subsidiaries.
Cross-border banking integration allows banks to diversify their loan portfolios, to improve their risk/return profile, and to reduce their liquidity risk by diversifying their deposit base, reaping the full benefits of economies of scale and scope.
Looking at the total number of credit institutions in the euro area, this figure declined from around 9,500 in 1995 to 6,400 in 2004, which means that almost one-third of the credit institutions active ten years ago have since disappeared. Banking consolidation in the euro area witnessed peaks in the late 1990s, and it has mainly taken place at the national level. The incidence of large European banking groups gaining a presence through branches and subsidiaries is still relatively low, with the average share of foreign branches and subsidiaries only accounting for about 15% of the euro area banking market. Only recently we have witnessed an increase in the interest in cross-border merger within the euro area. I welcome this recent evolution which I trust necessary to reap the full benefits of financial integration.
As you see, my overall assessment of the state of integration of the European financial system is positive but a lot remains to be done. I have given several examples of where the ECB contributes to this process, either by acting as a catalyst for private sector activities or by providing central banking services that are also conducive for fostering financial integration.
Let me also underline that a major activity of the ECB is the research and analyses we conduct on all aspects of European financial integration, and our monitoring – in collaboration with the European Commission – of the financial integration process by means of quantitative and qualitative indicators. By this means we aim to raise awareness of the need for further financial integration and to indicate how it can be achieved.
In this regard, I am pleased to announce that the ECB will publish soon a first set of indicators of financial integration. This initial set of around 20 indicators measures the state of financial integration in various market segments, covering the money market, government bond market, corporate bond market, credit market and equity market, and it will be enhanced over time by the addition of further indicators.
Until now I have mentioned the action of the ECB facilitating financial integration through the very existence of the single currency, through the provision of central banking services and through its action as a catalyst for the private sector. There is a fourth type of activity that we are engaging on, namely we provide advice on the shaping of the legislative and regulatory framework of the financial system, in accordance with our role assigned by the Treaty.
The definition of the post-FSAP strategy
We are now at a turning point as regards financial services policy action, as the FSAP has nearly been completed and the priorities for the next five years are being reflected on.
The Commission engaged in the preparation of the post-FSAP strategy in a very transparent manner, involving interested parties and benefiting from input by specialist teams. The outcome of these deliberations was the release of a Green Paper which is open for public consultation until 1 August in order to stimulate the debate on the post-FSAP strategy and priorities. I think that this is a tremendous opportunity for market participants to make their voices heard. All of you should consider, from the perspective of your business, what improvements should be made to the current regulatory environment in order to correct market failures and overcome barriers to the Single Market.
Let me now share with you what I believe to be amongst the main elements related to the financial services policy in the years to come.
In general, the ECB supports the key political orientation of the Green Paper that reflects also contributions given by the ECB to the debate on the matter. Over the next five years, financial services policy should aim primarily at consolidating and simplifying the existing Community legislation, while ensuring that the measures adopted thus far under the FSAP are effectively and consistently implemented and enforced at the national level.
I think that in the years to come, the further development of the Single Market will be mainly based on two areas of action.
First, the refinement of the current regulatory framework, which should ultimately accommodate, to the extent possible, all the different characteristics and regulatory needs of market segments and participants. This is an onerous process and will only be successful if the market participants themselves are closely involved and their requests are carefully balanced against supervisors’ needs. It is like the work of a skilled tailor, who first prepares a loosely fitting garment and then marks with chalk the points where the garment is either too large or too tight and needs further alterations. To use this analogy, it is now time to “use the chalk” to further refine the preparation of the EU regulatory framework. This approach will entail the application of a rigorous “better regulation” approach and measures that do not deliver the intended benefits will have to be amended or repealed.
In this context, I strongly support the proposal in the Green Paper to launch a feasibility study on whether all rules at the national and European levels can be fused into a single body of consistent law - a “financial services rulebook”. This would be proof that we have achieved a single market for financial services and, simultaneously, a very efficient means to deepen it. It would constitute a homogeneous set of financial rules which could be used by financial institutions with cross-border operations, regardless of which EU country they do business in. In this sense, the Commission’s proposal may constitute a significant contribution to reducing complexity and possible inconsistencies in the overall regulatory framework for the single financial market. The process would include the identification of supplementary requirements introduced at some point at the national level, for instance when directives were transposed into national legislations that may need to be re-assessed in the light of developments in financial markets, the need for further financial integration and the importance of achieving greater convergence.
Second, further impetus will be given to the consistent implementation of the regulatory framework and supervisory convergence. The level 3 committees play a crucial role in this respect ensuring that Community legislation is enforced consistently across Member States by national authorities. Although they were established only recently, the level 3 committees have already carried out an impressive amount of work. The definitive assessment of their actual deliverables in terms of consistent application of rules by national supervisory authorities, agreements on common approaches and compliance will take place by end-2007. A successful output by the level 3 committees is crucial both for reducing compliance costs for financial institutions operating on a cross-border basis and for addressing supervisory challenges arising as the integration of the European financial market progresses.
The ECB also supports the emphasis placed by the Commission to the need to enhance synergies among different public policies (single market, competition, consumer protection, etc.) as a means to support financial integration in the post-FSAP context.
Let me turn now to reflect on two specific areas identified by the Green Paper as the possible object of new, targeted regulatory initiatives: retail financial services and asset management.
First, as I have said before, when considering the whole spectrum of market segments from the perspective of financial integration, the retail market appears to be the least integrated. To address this particular segment, the combined approach proposed by the Commission of targeted regulatory actions and a more active application of competition policy seems to be the way forward.
Second, asset management has been touched upon during this conference from different angles and I would like to make some remarks about this sector.
As you know, the Commission is soon to publish an ad-hoc Green Paper that will focus mainly on consolidating and enhancing the framework laid down by the UCITS (Units of collective investments in transferable securities) legislation. In general terms, let me underline that improvements to the current legislation on harmonised funds seem to be necessary in order to allow the industry to improve its efficiency and flexibility. However, one of main questions raised is whether an EU regulatory framework should be applied to the non-harmonised investment funds, which comprise in particular private equity funds and hedge funds.
As you are well aware, hedge funds are currently at the centre of an intense debate. They are of increasing interest for regulators and supervisors since the hedge fund industry has grown very rapidly in recent years. Although it is not easy to obtain definitive data, due to the largely unregulated nature of hedge fund operations, according to the latest global estimates nearly 8000 hedge funds have assets under management of approximately EUR 850 billion or USD 1 trillion. In addition, close to EUR 300 billion (USD 325 billion) of assets are estimated to be in private managed accounts run by hedge fund managers. Total assets under management in the European hedge fund sector are estimated to have been more than EUR 200 billion (around USD 250 billion) at the beginning of 2005, up from less than EUR 150 billion (USD 170 billion) one year ago.
Since the near collapse of LTCM in 1998, the issue of the regulation of hedge funds has been raised regularly and it focuses either on financial stability or investor protection concerns. Whereas the former have always been a primary source of attention, the latter have emerged more recently in relation to fact that the products offered by hedge funds are no longer held by sophisticated investors only. From the perspective of financial stability, a key issue - already identified in the aftermath to the LTCM case - remains whether banks are well equipped to manage the risks associated with the different forms of exposure to hedge funds. This is linked also to the implementation of the revised framework agreed by the Basel Committee on Banking Supervision (“Basel II”). In particular, the supervisory review process (“Pillar II”) of banks’ internal risk assessments, is expected to provide supervisors with the necessary tools to address the risk management practices of banks, also in their dealings with hedge funds.
Recent surveys on banks’ practices at the EU level show that banks have, in general, significantly improved the management of risks associated with hedge funds in the recent past. However, the possibility that specific areas of risk management might still require further improvement should not be ruled out. Such improvements should be given priority as they are first way to respond to the increased challenge stemming from hedge funds.
As regards possible regulation of this particular industry, in line with the aim of “better regulation” set out in the Green Paper, I would say that, given the global nature of the hedge fund industry, a regulatory response can only be given on the basis of a solid international consensus and in particular a transatlantic consensus.
Ladies and gentlemen,
Let me summarise my main messages today.
First, Europe urgently needs structural reforms and further financial integration is one of these reforms. I think that the overall process of European financial integration is on a good track. It is an additional reason to concentrate efforts and energy on what remains to be done.
The ECB intends to reinforce its close working with the Commission, policy-makers and market participants. Among the many ways in which we contribute, we will particularly concentrate on our role of catalyst for private sector initiatives.
And finally, the broad post-FSAP strategy, as highlighted in the Commission’s Green Paper, is strongly supported by the ECB. The industry now has a very important opportunity to express its views for the preparation of the strategies for financial services policies in the next five years. I am fully confident that the industry is ready to participate actively in this preparation. I count on it.
Thank you very much for your attention.
 London Economics (2002), “Quantification of the macro-economic impact of integration of EU financial markets”, Report to the European Commission.
 The EONIA Swap Index has been launched jointly by Euribor FBE and Euribor ACI.