Financial Integration and Stability in Europe. Concluding remarks
Speech by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECBConference on “Financial Integration and Stability in Europe” organised by the Banco de España, the Center for Financial Studies and the European Central BankMadrid, 1 December 2006
Ladies and gentleman,
I would like to thank the Banco de España and the ECB-CFS Research Network for inviting me to participate in this conference which is, as you know, already the network’s eighth conference. The interesting papers and the lively discussions of the last two days have shown that the choice of topic, namely financial integration and stability in Europe, was indeed a good one, and I think we will all return home with new insights and suggestions for further research.
Allow me, however, to start with one critical remark: I think that Europe needs to be careful not to weaken itself by questioning its own success too much. Financial integration is an essential part of the wider process of political and economic integration in Europe. The Single Market and Economic and Monetary Union (EMU) are unthinkable without the clear objective of an integrated financial sector. The question of what the consequences of financial integration are for financial stability in Europe is a very relevant and legitimate one. However, this question should not, in my view, put in doubt the great opportunities that financial integration has to offer. Instead, we should try to understand better the institutional and political requirements that need to be fulfilled in order to make Europe as stable and integrated as other economies of a similar size and degree of development.
Against this background, I would like to make the following three points:
As financial integration is beneficial for Europe, it is important to continue to remove legal and commercial barriers.
Stability concerns are not a reason to halt the integration process.
Further integration will be conducive to stability, especially when a high level of financial integration is reached, when cooperation at the European level is further enhanced and when a forward-looking approach is adopted.
Let me now explain these three points in more detail.
1. Financial integration in Europe
Forty years ago, an expert group from the European Commission – that included Alexandre Lamfalussy – presented a blueprint for “The Development of a European Capital Market”. The report clearly identified obstacles to further integration and stressed the need for convergence and harmonisation in financial regulation and supervisory practices.
Twenty years later, the Delors Report returned to the vision of a financially integrated Europe and linked it closely to monetary union. Concerning the first stage of EMU, the report says: “In the monetary field, the focus would be on removing all obstacles to financial integration and on intensifying cooperation and the coordination of monetary policies … Through the approval and enforcement of the necessary Community Directives, the objective of a single financial area in which all monetary and financial instruments circulate freely and banking, securities and insurance services are offered uniformly throughout the area would be fully implemented”.
While the Delors Report envisioned a fully integrated financial area as a precondition for the introduction of the single currency, in fact Stage One of EMU was far from complete when Stage Three was implemented.
Why did financial integration lose some of its prominence in the run-up to EMU? I think one of the major reasons was the expectation that it would follow automatically from the abolishment of the restrictions on capital mobility. As it turned out this expectation was too optimistic. The single currency has increased liquidity through an integrated money market but financial integration has not come automatically.
Lamfalussy’s message from the 1960s remains valid. Financial integration only succeeds when it is underpinned by a common legal and supervisory framework. The European Commission’s Financial Services Action Plan illustrates that this message has been now understood. However, I believe that further progress on the removal of legal and supervisory barriers is needed.
Over the last few years, we have also realised the importance of a pan-European market infrastructure for financial integration. Europe is fragmented not only because of differences in regulation and supervision but also because market participants rely on infrastructures that are still distinctly national. Removal of these barriers is a key priority for the ECB. Building on the success of TARGET, the Eurosystem will next year launch the more integrated TARGET2 system, which is based on a single shared platform. In the securities field, it is currently evaluating the opportunities for providing a common securities settlement service which would greatly facilitate the cross-border use of securities.
2. Financial integration and financial stability
Are financial stability concerns a reason not to advance further with financial integration in Europe? My answer would be no. In fact, I believe that further financial integration can enhance European financial stability, but, for this to happen, we need two things: first, a much more integrated European financial system and, second, intensified cooperation at the European level and a more forward-looking approach.
From the theoretical papers presented at this conference – for example the paper presented by Hans-Peter Gruener and his co-authors – and also from the seminal papers in the literature – such as those by Allen and Gale or Freixas, Parigi and Rochet – the analysis of this matter is not fully conclusive. On the one hand, increasing financial integration improves financial stability: it broadens and deepens financial markets, increases liquidity and the possibilities for risk sharing and thus strengthens the overall resilience of the European financial system. On the other hand, greater financial integration may mean that national financial systems are increasingly exposed to common risks, and financial disturbances may be transmitted more easily across borders (i.e. there is greater potential for financial contagion and systemic risk).
However, Allen and Gale show us in their 2000 paper in the Journal of Political Economy that a very complete financial system (i.e. a financial system in which every financial institution interacts with all other financial institutions) allows all the liquidity in the system to be shared by all financial institutions and, at the same time, makes the economy more robust in the face of shocks to financial institutions. Thus, when the market is complete and, hence, financial integration is very high, financial stability is enhanced. In my opinion, this is the benchmark we should aim at in Europe.
At the same time, I take the stability concerns seriously. Over the last 15 years, the financial sector has grown significantly faster than other parts of the economy. It is thus now more important to the economy than it was in the past. Moreover, a wide range of financial innovations and greater interdependence among financial institutions have drastically changed the financial landscape. As a result, risks stemming from the financial sector for the economy as a whole may indeed be higher, new risks may arise and the magnitude of a possible financial crisis may now be greater than before. However, this is clearly a world-wide phenomenon and certainly not specific to the European context.
3. Cooperation at the European level and a forward-looking approach
What is the solution? First, we need convergence and harmonisation in the regulatory framework and in supervisory practices. This is a precondition for financial integration but also an important ingredient for a stable European financial sector. Convergence and harmonisation are closely linked to cooperation among supervisors, central banks and finance ministries. For crisis management, especially, common procedures that are well established among the different authorities are of paramount importance. Second, we should pursue a forward-looking approach that identifies new risks and intervenes at an early stage.
Let me elaborate these points in turn.
Cooperation at the European level
As the integration of our capital markets deepens, it is of utmost importance, from a financial stability viewpoint, that we be able to rely on an efficient financial and banking supervision framework. The success of the “Lamfalussy process” in the securities field prompted EU authorities and Member States to propose its extension to, inter alia, the field of banking regulation and supervision. As a matter of principle, these processes should lead to a more flexible regulatory process and a more consistent implementation of EU legislation in Member States, and foster the convergence of supervisory practices.
In this respect, I believe that coordination between supervisors and central banks is key. An illustration of this can be found, for instance, in the Memorandum of understanding on high-level principles of cooperation in crisis management situations that has been agreed between the EU banking supervisory authorities and central banks. Although, day-to-day supervision remains at the national level, the Lamfalussy Committees should strive towards both enhancing convergence of supervisory rules at the EU level and improving cooperation between competent authorities in day-to-day supervision. Again, memoranda of understanding can facilitate the bilateral exchange of supervisory information, for instance covering the special information needs that arise in the event of financial troubles.
Most recently, the Committee of European Banking Supervisors (CEBS) has launched a new strand of work to support the establishment and functioning of the group-specific colleges of home and host supervisors which will be set up under the Capital Requirements Directive. While the operation of these networks of supervisors – referred to by the CEBS as “operational networks” – is the responsibility of the supervisors involved, the CEBS will offer assistance, notably with a view to ensuring that the approaches taken are consistent within and across networks.
To be completely successful, however, the Lamfalussy approach needs to receive active political support. The work of the Level 3 Committees is expected to promote supervisory convergence and cooperation, thus providing an effective response to challenges arising from financial integration in the EU. However, as noted in the First Interim Report of the Inter-institutional Monitoring Group, the Lamfalussy process is still a “learning-by-doing process”, and some issues may need further consideration. For instance, the report notes that there is “a potential danger in the fact that the results of the Level 3 Committees may be more “consensus” than “best practices” driven”. Unfortunately, it would appear that national considerations might be slowing down the legislative process.
It is even more important that the Lamfalussy approach is strong and efficient now that it has been extended to banks. Everything should be done to explore as fully as possible the opportunities that the Lamfalussy structure offers. Next year’s review of the achievements of the Lamfalussy committees will allow us to take stock of the progress made and reflect on possible improvements.
However, the Lamfalussy approach alone is not sufficient to bring about the adoption of new legislation fostering integration. Integration and pan-European stability will not be achieved without strong institutions and political will. We need commitment and a specific plan (set by the EU Council) with clear dates and steps that set out how the process is to progress. Next year’s review may show that the Lamfalussy committees need a stronger legal basis to make measures to achieve supervisory convergence more effective.
A forward-looking approach
One type of risk which is receiving attention in financial markets is liquidity risk. The materialisation of this risk is more difficult to predict than for other risks, such as credit risk, and therefore the nature and the level of coordination between supervisors, researchers and central banks may be different.
In this conference, empirical papers have shown that large European banks now interact much more than in the past and that they are also more and more exposed to common risks. Large banks are key players to enhance liquidity in the system, both funding liquidity (for example, through loans) and market liquidity (for example, by facilitating the trading of a wide range of securities in different markets and across national borders). Liquidity is a critical component of well-functioning financial systems. Yet we have witnessed several liquidity strains in the past few decades, in which investors have been unable to trade securities or access capital markets adequately. These include: the 1987 US stock market crash; the Russian default in 1998; the Long Term Capital Management (LTCM) episode in the same year; and, most recently, the period following the credit downgrades of General Motors and Ford in May 2005.
Market liquidity risk is highly non-linear: it arises primarily when asset prices fall sufficiently to push intermediaries close to their funding limits. Lower market liquidity further aggravates the funding position of intermediaries due to an increase in hair-cuts and margin requirements, as well as the deterioration of collateral values. When illiquidity is high, the correlation among assets rises significantly because all share scarce liquidity; this, in turn, implies that there is a possibility of contagion among different classes of assets and markets.
The problem for regulators and central banks is that it is very difficult to predict when there will be a liquidity crisis in financial markets. Research in this area is still at an early stage. But I believe that research has a significant role to play. We need tools that can assess, ex-ante, the liquidity risks and their impact on financial stability.
A forward-looking approach should also include the move towards prompt corrective action via structured early intervention and resolution, as presented by Charles Goodhart at this conference. I share Charles’s hope that these instruments can prevent a crisis before it escalates. Supervisors should be given the legal support for a set of sanctions, culminating in the ability to force a bank’s reorganisation by recapitalisation, merger or closure once it becomes seriously undercapitalised but before it becomes insolvent. Again, further cooperation between supervisors, researchers and policy-makers would be desirable for the task of defining the instruments and parameters on which such early interventions would be based.
Let me conclude saying that effective and efficient banking supervision is essential, both to promote financial integration and to safeguard financial stability. The introduction of the euro and the single monetary policy, the existence of a single payment area and the growing process of financial and banking integration in Europe are good reasons for an enhanced common European approach to prudential supervision and financial stability. The main factors of relevance to financial stability – risks, information, payments, liquidity, crisis, contagion – now have a European dimension. Thus if we want to enhance financial stability in Europe, more financial integration is needed, as well as strong and forward-looking coordination among supervisors and central banks.
Thank you very much for your attention.
 European Economic Community Commission, “The Development of a European Capital Market – Report of a Group of Experts appointed by the EEC Commission”, 1996.
 See Allen, Franklin and Douglas Gale, “Financial Contagion”, Journal of Political Economy, 2000; Falko Fecht, Hans Peter Grüner and Philipp Hartmann, “Financial Integration, Specialization, and Systemic Risk” Mimeo, 2006, http://www.eu-financial-system.org/Madrid2006_Papers/Gruener.pdf; and, Freixas, Xavier, Bruno Parigi, and Jean Charles Rochet, “Systemic risk, interbank relations, and liquidity provision by the central bank”, Journal of Money, Credit, and Banking, 2000.
 See e.g. Acharya, Viral and Stephen Schaefer, “Understanding and Managing Correlation Risk and Liquidity Risk”, report prepared for International Financial Risk Institute (IFRI) Roundtable, 29-30 September 2005.
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