Single market for financial services – vision or reality?
Speech by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECB, Luxembourg Financial Market Forum 2005Europe – United States – AsiaLuxembourg, 14 October 2005
Ladies and gentlemen,
I am delighted to be here today to address this year's Luxembourg Financial Market Forum. I would like to start my speech by quoting from a report that is associated very closely with the name of a great Luxemburger. “The extension of the liberation of movements of capital and the realisation of the right of establishment and of the free rendering of services by banking and financial undertakings have not progressed far enough. The delay has been caused by the absence of sufficient coordination of economic and monetary policies and by local peculiarities of law or of fact.”
Although this is a quote from the 1970s, it could scarcely be more appropriate today. It is a quote from Pierre Werner. When he presented his vision of a monetary union, people just smiled. It all seemed too futuristic for the Member States to voluntarily give up their national monetary policies and introduce a single European currency. Now, 35 years on, we see that Werner’s vision has become a reality. His plan – although not implemented at the time – made an important contribution to creating Monetary Union.
This quote from the Werner Report relates, however, to a second vision that is closely associated with the goal of economic and monetary union: namely, a single market for financial services. The rudiments of this vision were set out in the Treaties of Rome. It is the core element of European economic integration. Werner’s criticism of the situation in 1970 is still valid today, and even takes on extra significance now that we have attained the goal of Monetary Union.
In this context, the main thrust of my speech is as follows: namely that, in Europe, although we have long had a clear vision of a single market for financial services, we must step up our efforts to make this vision a reality. If we do not, and instead only make half-hearted attempts, we will have to bear the "costs" of European rhetoric and European regulation, without reaping the benefits of further economic integration in Europe. Given the global competition in the financial sector, there is a danger that we ourselves block progress because the short-term benefits of not integrating appear more lucrative. In the long term, however, this would be detrimental to Europe: from a macroeconomic point of view, financial integration will contribute to the desperately needed increase in long-term growth potential.
Today’s banking environment is already significantly different to that of 20 years ago. And over the next 10 to 20 years, it will continue to change dramatically. Within this process, I see two basic kinds of banks forming: large, pan-European and global banks; and smaller regional players. And there is room for both. Traditionally the banking system comes from an environment of legal protection; liberalisation in this field began relatively late. Banks therefore have some concerns at this development. The issue is how to surmount these concerns and see increasing financial integration as an opportunity; because I am convinced that both types of bank have a future.
Although European financial markets are fairly well integrated, further convergence and integration is necessary, particularly in the fields of retail markets, the financial infrastructure, supervisory practices and aspects related to the legal framework. This is what I would like to discuss with you today. And I will look, in particular, at the contributions of the ECB and the Eurosystem as a whole to this process of increasing financial integration.
2. State of integration of the European financial system
I would now like to give you a brief overview of the state of integration of the European financial system. In doing so, I will make a distinction between the three components of the financial system: financial markets, institutions and the financial infrastructure. By way of comparison, I shall take as a benchmark the level of integration in the US financial system. Of course, comparisons with the United States are not without their problems, due to the specific characteristics of each sector. However, it is useful to look at the US situation for two reasons. First, certain parallels can be drawn between the United States and Europe as regards the timing and process of banking sector liberalisation. It is therefore interesting to see to what extent liberalisation has affected what were sectorally and geographically fragmented markets in both regions. Second, European banks stand in the global market alongside the large US banks, which already have a strong presence in the European market. A comparison with the United States is not therefore purely academic, but gives information about how European and US banks have used their respective integration processes for their own benefit.
2.1 Integration of financial and banking markets
Only two weeks ago the ECB published, for the first time, a series of indicators regarding the state of integration of euro area financial and banking markets. Let me summarise our findings.
While the euro has undoubtedly acted as a catalyst for financial integration in general, it is true that the degree of integration differs from market segment to market segment, with integration being more advanced in those market segments that are closer to the single monetary policy, notably the money market. There we have achieved almost complete integration, thanks, inter alia, to the establishment of the necessary pan-European payment infrastructure, the TARGET system.
Integration in bond markets has also progressed significantly. Government bond yields have converged to a large degree and they are now mainly driven by euro area-wide shocks and news. The euro area corporate bond market has grown considerably in recent years, to five times its size, and is also fairly integrated, in the sense that the country of issuance is only of marginal importance in explaining yield differentials.
The integration of equity markets in Europe is a slow and more laborious process of overcoming fragmentation. That said, there are encouraging signs of an increasing degree of integration, such as the substantial decrease in the so-called “home bias” in the equity holdings of investment and pension funds, and a more homogeneous reaction of equity prices across the euro area to monetary policy signals.
The pace of integration in the banking sector has been uneven. Integration is well advanced in wholesale and capital-related activities, while it is lagging behind in the retail markets. This partly reflects differences in the nature of competition in these segments of financial services. Proximity to clients, bank-customer relationships and access to information play a key role in retail banking, while they are less crucial for investment banking and for corporate banking aimed at large companies.
Overall, the rather modest progress in the integration of the banking sector translates into persistent cross-country differences in bank lending and deposit rates. These differences stem from differing national regulatory arrangements, practices and product characteristics; and they result in different levels of collateralisation, average maturities and periods of fixation. Especially in the retail sector, the low degree of integration causes different pass-through of changes in monetary policy rates to retail bank interest rates.
Let me now make a few brief comments on an important retail market, namely the European mortgage market. The importance of this retail market segment is evident from its size alone: an outstanding volume of more than EUR 4 trillion in residential mortgage debt in the EU, corresponding to around 40% of EU GDP.
The lack of integration entails costs for households deriving from higher rates and unavailability of products, while issuers and investors suffer from unrealised economies of scale and higher funding costs.
When compared with intra-US rates, euro area mortgage rates are overall more heterogeneous across countries. Even limiting the comparison to the five most active markets in the United States, since January 2003 the cross-country standard deviation of euro area mortgage loans over ten years has been on average around 50 basis points, while that of the US 15 year fixed rate has been around 4 basis points. This means that the consumers in the euro area face a much bigger difference in rates on mortgage loans between the euro area countries compared to households in the different US states - in the displayed case of longer maturities, the difference in rates is more than ten times bigger!
Differences in the funding structures of euro area mortgage banks, which is likely to impact on the type of product provided, may partly explain some of the heterogeneity in the rates on loans for house purchase across the euro area countries. Moreover, the euro area mortgage market is significantly more fragmented in terms of funding practices; varying from deposit funding to mortgage bonds and mortgage-backed securities. In addition, mortgage rates may differ across the euro area countries owing to variations in product characteristics and customer preferences (exemplified by different loan maturities and loan-to-value ratios) as well as diversity in regulation.
2.2 Integration of financial institutions
In addition, the structure of the banking sector may help to explain the current situation. The European banking sector has undergone considerable consolidation in recent times, and the banking markets in the different EU countries have become fairly similar in terms of their market structures, not least because the euro has created more transparency across national borders. Let me briefly compare the European banking system with that of the United States, which is usually considered more integrated.
At the start of the 1990s, both the EU and the United States witnessed a major regulatory change in their respective banking industry. In the United States, the “Interstate banking and branching efficiency act” or Riegle-Neal Act made interstate banking a bank right. In Europe, the Second Banking Coordination Directive allowed credit institutions authorised in an EU country to establish branches or supply cross-border financial services in the other countries of the EU without further authorisation.
Both regulations were induced by the belief that the liberalisation of the respective banking markets would increase their integration with a beneficial impact on efficiency and profitability.
There is no doubt that both banking sectors have undergone consolidation processes following the regulatory changes. First of all, the pace of consolidation is almost identical. The number of credit institutes in the euro area fell from roughly 8,700 in 1997 to 6,400 in 2004. In the United States the number of commercial banks fell from more than 11,000 in 1997 to approximately 8,000 in 2004.
The pattern of the consolidation process displays similarities and differences. In both regions, intrastate/national consolidation is still dominant and expansion is mainly in contiguous areas.
Nevertheless, the share of interstate mergers in total mergers in the United States passed from below 5% before the Riegle-Neal Act to around 30% in the years after. In Europe, instead, there have been rather few cross-border mergers.
Indeed, the presence in EU countries of large pan-European banking groups through branches and subsidiaries is relatively limited. The average share of foreign branches and subsidiaries accounts for only about 15% of the euro area banking market. From a euro area-wide perspective, the lack of progress in creating pan-European banks is hindering the realisation of economies of scale and blocking the beneficial effects of increased efficiency within the EU economy.
Greater financial integration opens up the following opportunities for the banking sector. First, integration widens business opportunities for individual institutions. Assuming that the more efficient institutions gain market share at the expense of the less efficient banks, overall efficiency gains can be realised.
Furthermore, a wide risk diversification can lead to efficiency gains. Under the assumption that the markets differ in terms of business cycles and industry structure, geographical diversification of loans improves the risk-return profile; and diversification of deposits reduces liquidity risk.
Finally, larger markets through geographical diversification offer efficiency gains via the realisation of economies of scale and scope.
Some features of the European banking industry make it difficult to make fair comparisons of banks’ profitability and cost indicators within the EU and even more between aggregates of EU banks and US banks.
Nevertheless, from a comparison across EU countries and with the United States, it can be seen that there is probably “excess capacity” in the European banking industry in that there are too many small banks that are unable to secure economies of scale, there is excessive banking infrastructure (e.g. the branch network), and employment levels are relatively high.
Data seem to indicate that US banks are more profitable than banks in the EU. This represents a challenge to the EU banking sector since US banks are direct competitors with European banks and increasingly active in the European market.
The banking industry is called to make efforts to improve levels of efficiency and reap the benefits of further integration. Innovation and creativity are needed to ensure good profitability of EU banks and high customer satisfaction. Good profitability and high customer satisfaction will enable European banks to compete successfully with global banks.
2.3 Integration of the financial infrastructure
Let me now briefly summarise the state of integration of financial infrastructure, comparing the number of infrastructure systems in the euro area to the United States.
As regards large-value payment systems, I would say that integration is quasi perfect. The consolidation process has helped convergence towards an efficient infrastructure similar to that in the United States.
In contrast, the situation in the retail payment area today does not differ from that prevailing before 1999. Looking at the US situation, the euro area clearly has scope for further consolidation of the retail payment system infrastructure. Also in the field of securities settlement systems, where some consolidation has taken place, still a lot remains to be done when we compare it with the United States. I will come back to these points in more detail.
3. Instruments to foster the process of European financial integration
What are the factors driving the process of European financial integration?
Financial integration is in the first place a market-driven process. Deeper financial integration can offer more possibilities for financial institutions to better manage and diversify their relevant risks and realise economies of scale.
That said, and speaking generally, I see it as the basic task of public authorities to create a framework whereby all potential market participants in a given financial instruments or services market, are subject to a single set of rules when they decide to deal with those financial instruments or services, have equal access to this set of financial instruments or services and are treated equally when they operate in the market.
In this respect, I would like to recall the European Commission’s Green Paper on the priorities of the financial services policies over the next five years, where the Eurosystem also provided its view. The Eurosystem supports the general policy orientation of the Green Paper, which highlights the need for focusing on the consolidation and consistent implementation of the legislative framework for financial services that has been mostly introduced by implementing the FSAP in the last few years. Also, the proposed “better regulation” based on openness and transparency of policy-making and evidence-based initiatives is fully supported. Finally, I would also like to stress the need for the pursuit of supervisory convergence and the effective interaction between the home and host authorities. It is important that home-host coordination is developed on a robust and consistent basis for the financial groups involved that ensures effective supervision, on the one hand, and reduces compliance costs on the other.
Increased global competition is matched by enhanced international dialogue. For example, the EU-US regulatory dialogue, initiated in 2002, aims at fostering a better common understanding of regulatory approaches with the shared objective of achieving a more efficient global market via the enhancement of mutual recognition, equivalence and convergence. Among the issues on the EU-US dialogue agenda let me just recall the convergence or equivalence of International Accounting Standards and more in general the creation of a simple framework for transatlantic compliance, such as best practices on corporate governance.
4. The role and contributions of the ECB – some selected examples
While I have just touched upon some major EU policy initiatives, let me now turn to the contributions of the ECB and the national central banks for fostering European financial integration. I will restrict myself to some selected examples.
4.1 Central banking services
First of all, we can provide central banking services that are conducive to fostering financial integration.
The establishment of TARGET and its next generation, TARGET2, illustrates well how the Eurosystem is leading the way in the integration of Europe's large-value payment environment. Already TARGET1 has substantially contributed to financial integration by ensuring transferability of liquidity and therefore the smooth implementation of the single monetary policy.
The figures of TARGET speak for themselves. Over time, the success of TARGET has been due to a continuous increase in both domestic and cross-border payments. Most strikingly, TARGET settles just over EUR 1.7 trillion every day. In so doing, it has emerged as the largest payment system in the world, alongside Fedwire in the United States.
TARGET2 will continue to further improve financial integration in several respects. The consolidation of TARGET’s technical infrastructure will ensure a healthy balance of increased cost effectiveness on the one hand, and the provision of a harmonised service level ensuring a level playing field for banks across Europe on the other. This will be supported by the implementation of a single price structure for both domestic and cross-border payments. Moreover, TARGET2 will offer, on a TARGET-wide basis, new functionalities enabling banks to better integrate their euro liquidity management. Besides, TARGET2 will bring benefits to its users in terms of consolidated account information: whereas, in the past, it has not been possible for an institution’s head office to see the information being held across its various branches, with TARGET2 it can automatically monitor and process all its data from a single location. I am confident that with TARGET2 Europe will have not only the largest but also the most modern payment system in the world.
Correspondent central banking model
Let me mention another area where the ECB helps to encourage further infrastructure integration by providing central banking services. In the current framework, partners may transfer cross-border collateral for Eurosystem credit operations via two main channels: the correspondent central banking model (CCBM), since 1999, and eligible links between securities settlement systems. As the chart documents, partners increasingly tend to substitute domestic with foreign collateral in recent years. In 2004 the total amount of cross-border collateral represented 41% of the total collateral against only 16% in 2001.
Single List of collateral
My next example also relates to use of collateral. As you know, the Governing Council of the ECB approved last year the gradual introduction of a Single List in the collateral framework of the Eurosystem to replace the current two-tier system of eligible collateral. The purpose of having 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. The decision for the Single List in the collateral framework underlines also the determination to foster financial integration.
One of the key challenges for the implementation of the Eurosystem Single List of collateral has been the design of a Eurosystem Credit Assessment Framework (ECAF) to adequately assess debtors in the Single List context. The final scope of the Single List of collateral will comprise a variety of debt instruments, such as government bonds, Pfandbriefe, bank loans, etc. The ECAF will need to provide a consistent response across these different asset types as well as guarantee pan-euro area coverage. To this end, the future ECAF will consequently consist of four equally ranked credit quality assessment sources: external credit assessment institutions, NCBs’ in-house credit assessment systems, counterparties’ internal ratings based systems, and third-party providers’ rating tools. In doing so, ECAF will not only present a combination different credit assessments in a unique and innovative way but also foster integration of different credit assessment tools, both in terms of comparability and compatibility.
Foreign reserve management
Matching the efforts of European banks to benefit from integration, the Eurosystem as an organisation also tries to pursue its functions in an effective manner. Let me briefly present to you some changes in the set-up of the management of the ECB’s foreign exchange reserves, to be introduced at the beginning of next year.
The management of the ECB’s foreign exchange reserves can be described as a strategic management of foreign reserves which is carried out by the ECB in cooperation with the national central banks, culminating in decisions by the Governing Council and the Executive Board of the ECB, and an operational management, which is the responsibility of national central banks. As regards the latter, in particular, each NCB manages at present a portion of both the ECB’s US dollar and Japanese yen portfolios.
In view of future enlargement of the euro area, the ECB’s Governing Council approved a number of changes for the operational management. For instance, NCBs can abstain from the operational management of a portion of the ECB’s foreign reserves. Moreover, NCBs will no longer necessarily manage both dollar and yen portfolios. In other words, there will be a specialisation among NCBs in terms of the currency denomination of the managed portfolios.
This is an example of how the Eurosystem copes with the challenges of euro area enlargement, combining effectiveness and efficiency, on the one hand, with decentralisation, on the other.
4.2 Helping hand for private sector activities
I would state that both TARGET and the specialisation in our foreign reserve management are examples of effective cooperation amongst central banks. I would equally say that such cooperation is not always as easy to achieve among entities that are in competition between themselves.
This leads me to the next category of ECB activity that contributes to the European financial integration process, namely that the ECB can act as a helping hand for private sector activities by facilitating collective action and assisting with possible coordination problems.
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. 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 welcomes the EPC as project leader for SEPA as market participants are often best placed to find the most appropriate solutions for the development of standards. The ECB is assisting this process by acting as a helping hand to resolve the coordination problem and the resulting grid-lock that banks may face if they have to act on their own. In this respect, I would like to give you a few examples of how the ECB has contributed as an active helping hand to promote the SEPA project. First, the introduction of a first deadline, SEPA for citizen, already in 2008 where banks should be able to offer SEPA payment instruments also for the processing of national payments in parallel to national instruments. Second, establishing a dialogue with SEPA end-users to understand what the expectations from consumers are, SMEs, merchants and corporates, and bring these expectations into the discussion. Third, arranging high-level meetings with CEO level in banks to ensure that decision-makers are also contributing with the necessary investments.
Another supporting role for the market is being played in the context of the Short-Term European Paper (STEP) initiative, which was set up by the ACI – The Financial Markets Association that aims at overcoming fragmentation in the European short-term securities markets. The short-term securities markets in Europe continue to be rather fragmented among several domestic markets and the international Euro Commercial Paper (ECP) market. The STEP initiative promotes the convergence of the standards and practices prevailing in the fragmented European short-term securities markets through market players’ voluntary compliance with the standards set out in the STEP Market Convention. The ECB has decided to support the introduction of a STEP label for the first two years after its launch as well as, under some conditions, to produce and publish STEP yield indices as well as statistics on volumes.
4.3 Advice on the regulatory and legislative framework and standard-setting
Finally, I turn to another kind of activity, namely to give advice on shaping the regulatory framework. The development of an adequate legal framework is a difficult but a very important task. Allow me to quote another report from the first decades of European integration:
“Active participation by the various types of financial institutions in the creation of a European capital market may be hampered by the rules under which they operate and the supervisory controls to which they are subjected. The differences in these rules and controls are, moreover, liable to distort competition and therefore constitute an obstacle to the process of integration.”
Although we have achieved a good deal of convergence and harmonisation, this assessment from 1966 still makes a very valid point for today’s situation.
In the field of financial market infrastructures, for example, the ECB has discussed with other regulators and with market participants for several years the future framework of securities settlements and central counterparties. The possible mixing of regulatory needs and business interest in one basket has made the progress in this field extremely difficult. By developing a long-term vision for this issue and a cooperative framework with other authorities (including the Commission) further improvement can hopefully be made.
Overall, all these examples illustrate the ECB’s activities in the field of financial integration. I am referring to them not because I think they are the most significant initiatives in the field, but for underscoring the more general argument that public authorities can help to prepare the ground for more integration. But that essentially it is for the market to seize the opportunities that integration offers.
4. Concluding remarks
Ladies and gentlemen,
Allow me to conclude. It is not that Europe is lacking a clear vision of a single market for financial services. What is needed, however, is for European banks to understand that it is in their very own interest to allow this vision to become a reality. In the long run, Europe’s financial sector can only hold a globally competitive edge through European integration and cross-border consolidation. Major progress has been made over the past few years, and further initiatives have been launched. It is important, however, for both politicians and, above all, economic agents, to step up efforts to drive forward economic integration in Europe.
There is a link between economic integration and political integration. Currently there are some doubts about Europe's political integration: I am thinking in particular of the rejection of the European constitutional treaty in referenda in France and the Netherlands. Can these political doubts also hinder economic and financial integration? I do not think so. As I have shown, financial integration is driven primarily by market forces, which can diversify risks better and which can realise returns to scale.
And I would like to go a step further. I am convinced that financial integration in Europe also promotes political integration. For example, the desire to no longer make consumers pay still higher fees for cross-border transactions than for domestic payments. Or the necessary integration of the European mortgage loan markets I mentioned, which would mean that consumers in one European country would not have worse mortgage conditions and a smaller range of products than borrowers in another country.
I am well aware that financial integration cannot be the magic solution to all of Europe's problems. But it plays a significant role in the further development of the European financial sector and for economic growth in Europe in general. The ECB and the national central banks also make their contribution. You, the financial market actors, can also help to make greater financial integration, higher growth and advanced political unity in Europe a reality.
Allow me to finish by quoting another great Luxemburger. Emperor Sigismund (1368-1437), together with his father Karl IV (1316-1378), was one of the great emperors of the Holy Roman Empire of the German Nation in the late Middle Ages that came from the House of Luxembourg. Sigismund was known as an important imperial and church reformer. In a large empire, with many internal conflicts of interest, he was only able to achieve these reforms through skilled diplomacy and persuasive argumentation. He is quoted as saying: “Wer nicht übersehen und überhören kann, taugt nicht zum Regieren” (People who cannot overlook and overhear things are not suitable to govern). I do not want by any means to advocate Middle Ages Machiavellianism; but I do think that, to fulfil our vision of a single market for financial services, we need to look at the bigger picture. We need to make Europe fit for global competition. It is therefore counterproductive to insist on maintaining national biases and protected market positions. Instead, let us together support an integrated Europe and make use of the opportunities it offers.
 Report to the Council and the Commission on the formulation of a plan by stages with a view to the creation of economic and monetary union (Werner Report), Special supplement to Bulletin 11/1970, p. 9.
 European Economic Community Commission (1966): The Development of a European Capital Market, Report of a Group of Experts appointed by the EEC Commission, p. 31.
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