The current state of European financial integration
Speech by Jean-Claude Trichet, President of the ECB
at the invitation of the University of Stirling
Stirling, Scotland, United Kingdom
11 May 2007
Ladies and gentlemen,
I would like to again thank the University of Stirling for the honour of having appointed me, some few hours ago, as Doctor honoris causa of this highly esteemed university, located in the heart of Scotland, in these beautiful surroundings just between the Scottish Lowlands and the slopes of the Highlands. I would also like to thank the university for organising this dinner with the Scottish business and financial community, under the chairmanship of Dr. Callum McCarthy.
In the more recent past, the European Monetary Union has led to the creation of a new currency, the euro, which has been adopted by 13 European countries. Today, I would like to share with you some thoughts on the benefits that our new currency, the euro, has brought to the European economy through the process of European financial integration.
With my remarks, I basically aim to sketch out some features that we consider to be important in this respect. At the same time, I would like to stimulate your interest and invite the academic world to undertake research and economic analyses on this matter that is of fundamental importance to the European citizens.
So let me start by telling you that the ECB has adopted a definition of financial integration: we consider a market for a given set of financial instruments and/or services to be integrated if all potential market participants with the same relevant characteristics (i) face a single set of rules when they decide to trade in those instruments and/or services, (ii) have equal access to the set of instruments and/or services, and (iii) are treated equally when they are active in the market.
Furthermore, I would like to mention a related but also distinct concept, namely the one of financial development. Financial development (or financial modernisation) refers to the process of financial innovation and organisational improvements in the financial system that reduces asymmetric information, increases the completeness of markets, increases opportunities for agents to engage in financial transactions through (explicit or implicit) contracts, reduces transaction costs and increases competition.
These definitions lead me to pose two basic questions:
What are the economic benefits from European financial integration and development?
What are the main achievements as well as the potential, remaining obstacles for further financial integration in Europe, and are there initiatives underway that address them? In this respect, I would like to draw your attention to a new report entitled “Financial integration in Europe” , which the ECB published for the first time at the end of March and to which I will also refer in my speech.
I will structure my remarks into two parts, in which I will try to answer the two questions that I have posed.
2. The economic benefits from European financial integration and development
With respect to the economic benefits from financial integration and financial development, I would like to distinguish three implications, for (i) monetary policy, (ii) the stability of the financial system, and (iii) economic growth and welfare.
The impact of financial integration on monetary policy
Financial integration is of key importance for the ECB, given the relevance for the conduct of the single monetary policy. To start with, let me argue that the euro area money market is highly integrated. The ECB monitors the state of financial integration for the different financial market segments on the basis of a set of quantitative indicators that the ECB has developed and which are described in the new report I mentioned earlier.  In a nutshell, the evidence confirms that the degree of integration varies according to the market segment, and that integration is generally more advanced in those market segments that are closer to the single monetary policy. In particular, the unsecured money market reached a stage of “near-perfect” integration almost immediately after the introduction of the euro. One of our indicators, the cross-country standard deviation of the average overnight lending rates among euro area countries, was as low as three basis points already in early 1999 and has since decreased to between one and two basis points.
There is another dimension that is of relevance for the effective and efficient conduct of monetary policy: the monetary policy transmission mechanism, which encompasses the different interest rates set by the banks in the euro area countries for the financial products, such as for example the interest rate on a mortgage loan that a bank offers.
Generally speaking, highly integrated and developed financial markets allow economic agents to share risks more effectively, thus improving the ability of firms and households to offset the consequences of idiosyncratic shocks that could affect the national economies of the euro area. With more integrated financial markets, the dynamic adjustments to such shocks are likely to be more similar across the euro area countries. Since monetary policy decisions are implemented and transmitted through the financial system, the degree of financial integration affects the effectiveness of this transmission.
I would like to mention in this context that the Eurosystem Monetary Transmission Network, which is a network composed of the ECB and national central banks of the Eurosystem, conducted an in-depth analysis of the transmission mechanism a few years ago.  The main finding was that the monetary transmission mechanism operated in a broadly similar way in each euro area country. At the same time, the analysis suggested that some of the remaining differences could eventually be related to financial factors and the degree of integration of financial markets across the euro area. Also some research by ECB staff  indicates that there are still differences in bank deposit and lending interest rates across euro area countries, whose cross-country dispersion is higher than the intra-regional dispersion of the same rates in the US. 
However, it is still an open question whether the remaining heterogeneity of financing conditions observed across euro area countries reflects a lack of financial integration in the euro area or rather other factors. For example, recent research presented last November at an ECB conference in Madrid shows that part of this heterogeneity can be explained by the different characteristics of domestic depositors and borrowers on the demand side.  The observed cross-country heterogeneity of retail bank rates would therefore not be due to the existence of obstacles to cross-border capital movements or the lack of financial integration. In other words, thanks to the significant progress achieved in the euro area in terms of financial market integration over the past years, financial factors have become less likely to cause differences in the impact of monetary policy transmission across the euro area.
The impact of financial integration on financial stability
With respect to the second implication, namely the impact of financial integration on the stability of the financial system, I note that the merits of having capital flowing freely across borders have, for many years, been subject to an active debate.
A number of channels could enhance the stability of financial markets and institutions. First, the removal of capital controls and financial integration gives access to a wider range of assets and therefore helps to diversify risks. Second, integration can make markets larger and more liquid, thereby enhancing their resilience to shocks. Third, the greater liquidity, information acquisition and competitiveness of markets through the entry of foreign participants may contribute to better pricing of financial instruments. And finally, competitive pressure arising from foreign financial institutions entering a country will enhance competition, strengthen market discipline and thereby favour robust and healthy financial institutions in the longer term. Of course, despite the positive effects of financial integration on financial stability, we are also aware of new challenges that arise in a more financially integrated world, such as the greater connection of asset prices that may influence cross-border contagion.
Probably the most famous example of the benefits of financial integration for financial stability is the difference in the number of bank failures during the Great Depression between the United States and Canada, where Canadian banks were larger and faced less banking restrictions than in the U.S.  Between 1923 and 1935, no Canadian bank failed, while from 1930 to 1933, more than 9,000 US banks suspended operations.
More and more research studies have recently argued in favour of a positive relationship between financial integration and financial stability, especially for financially developed countries. For example, recent research by ECB staff found that, for all the banking crises in the world between 1980 and 2004, more open countries tend to experience less severe crises than more closed ones.  For the same period, other studies also show that more competition in the banking sector significantly decreased the probability of systemic banking crisis. 
The impact of financial integration on economic growth and welfare
I now turn to the next economic implication of financial integration, namely that it raises the economy’s potential for stronger non-inflationary economic growth. For example, a research study conducted by London Economics a few years ago estimated the benefits of the integration of European bonds and equity markets to be around 1% of additional GDP growth over a ten-year period, or approximately EUR100 billion. 
I would like to mention two possible channels through which financial integration can foster economic growth.
First, financial systems serve to channel funds from those economic agents that have a surplus of savings to those with a shortage; and to trade, hedge, diversify and pool risks. These functions are facilitated by financial integration. As a result, there is a better sharing and diversification of risk and a greater potential for stronger non-inflationary economic growth.
In this respect, it is worth underlining the finding by Asdrubaldi, Sorensen and Yosha (1996)  that, in the United States, capital markets would smooth out 39% of the shocks to gross state product (the equivalent to our GDP), the credit channel would smooth out 23% of such shocks and the federal government, through the fiscal channel, 13%. Around 25% of the shocks are not smoothed out. Hence, in the United States financial markets and financial institutions would contribute 62% to the absorption of state idiosyncratic shocks. We therefore see from the US example that the financial channel can be much more important than the fiscal channel. This is an additional reason to speed up financial integration in Europe. In a more recent study, the same authors found that the EU’s situation has begun to converge towards the situation of the United States since the late 1990s and that there is already a still modest but non-negligible insurance through inter-state capital flows. The authors notably found that in the Euro Area (minus Luxembourg), capital markets would have smoothed out about 10% of the country-specific shocks to GDP between 1993 and 2000. 
A second channel through which financial integration fosters economic growth is cross-border banking. As I mentioned earlier, the integration of banking markets, in particular of the retail component, is less advanced than for example the integration of the euro area money market. In this respect, cross-border banks play a key role in the process of banking integration and in the way financial integration affects economic growth. They enhance competition in the euro area banking markets and provide a channel for the spreading of innovation in financial products and services. They also promote convergence towards more efficient, less costly banking services.
The positive effects of cross-border banking are also apparent with respect to the new EU Member States. For example, some authors showed that foreign lending in Central and Eastern Europe stimulates growth in firm sales, assets, and leverage in these countries.  Further research also explains that foreign banks also offer on average lower lending rates than domestic banks, which stimulates investment.  Foreign bank entry may not only increase the level of output, but also decrease output volatility and dampen the business cycle in the new EU Member States, as the credit supply from foreign banks has also been found on average to be less sensitive to local economic conditions than that from domestic banks. 
To sum up the effects of financial integration on economic growth, I would like to stress the important role of the euro, whose introduction has brought about huge benefits resulting from increased financial integration. Research presented at an ECB conference in 2005 in Vienna indicates that the introduction of the euro would have been associated with an average increase in the growth rate of physical investment of about 5 percentage points for the Euro Area countries (minus Ireland and Luxembourg).  Although this average hides differences across countries (with the strongest effects in Austria and France), the euro seems to have had positive effects on investment growth in most Euro Area countries. As these findings were particularly strong for industries that depend on external finance (for example in industries that require investments in Research and Development, like optical equipment), the author argued that this could be explained by the increase of financial integration after the introduction of the euro.
The impact of financial development on economic growth
Finally, I would like to highlight that as the process of European financial integration is gradually taking place, it is important to also be aware of the related process of financial development and modernisation. By speeding up the reallocation of capital from declining to evolving and promising industries – the Schumpeterian process of “creative destruction” – both processes of financial integration and financial development positively influence the efficiency of a financial system, ultimately leading to a higher potential for economic growth.
There are many channels through which financial development and modernisation may affect economic growth. I will consider three of them: (i) the depth, or size, of the capital markets, (ii) transparency and information and good corporate governance, and (iii) the impact via the legal system.
The size of capital markets has a positive effect on economic growth. Qualitative evidence suggests that in the EU the gains from financial integration and financial development stem not only from increased investment, but also and mainly from increased productivity. ECB staff recently found additional evidence that the reallocation of capital from declining industries to industries with high investment opportunities and high productivity is faster in countries with developed financial markets. For these countries, investment is also more responsive to technical innovation.  These findings suggest that countries with more liquid capital markets and a developed banking system should grow faster on average. Some authors have calculated that if the average size of capital markets in the EU was the same as in the US – that is, broadly 450% of GDP, instead of 220% with an overall indicator measuring total financing in the economy by aggregating bank credit to the private sector, stock market capitalisation and the outstanding amount of domestic debt securities issued by the private sector  – then annual GDP per capita growth in the EU would probably be significantly higher. 
The production and dissemination of information is a crucial part of the functioning of a financial system. This is the second channel through which financial development and modernisation affect economic growth. For example, sufficient public reporting by firms alleviates the control problem between outside investors and firm insiders, with beneficial effects on the cost of capital.  In the same vein, corporate governance addresses potential conflicts between investors and firm managers, as well as among investors (for example large versus small shareholders). Better governance ensures that their interests are more aligned, so that investors obtain better returns and invest more. For example, some authors using European data have recently shown that deviations from the principle of proportional ownership (one share – one vote – one dividend) lead to lower firm values. 
Finally, reliability and efficiency of legal systems are also important for the performance of financial systems. The inter-temporal nature of many financial contracts implies that investors relinquish control of their funds for a promise of future cash flows. The legal system ensures that such contracts are honoured. Research shows for example that international banks’ investment decisions are sensitive to the enforcement of creditor rights  and that private credit and market capitalisation are strongly correlated with the enforcement of shareholder rights.
3. Achievements, challenges and ongoing initiatives to advance European financial integration
I would now like to turn to the second part of my speech and move from the economic analysis of the implications of financial integration and development to some very practical initiatives aimed at fostering further progress. In this respect, I would like to highlight some major achievements, some remaining challenges and some concrete initiatives underway to address these challenges. I will structure this along the different segments of the financial market.
I mentioned earlier that the euro area unsecured money market is integrated to a nearly perfect extent. This success has also been sustained by the high degree of integration of the large-value payment systems, to which our so-called TARGET system – which has been available since the very start of Monetary Union – contributes in an important way. The launch of the single currency necessitated a real-time payment system for the euro area to provide the payment procedures necessary for implementing the ECB’s single monetary policy, and to promote sound and efficient payment mechanisms in euro. TARGET is the real-time gross settlement (RTGS) system for the euro offered by the Eurosystem. It is used for the settlement of central bank operations, large-value euro interbank transfers as well as other euro payments.
To better meet the users’ long-term needs and prepare for the enlargement of the euro area, the Eurosystem is currently developing the next generation of TARGET, namely TARGET2. The launch of this single technical platform in November this year will promote further financial integration, in particular through a harmonised service level, a single price structure, and a harmonised set of cash settlement services.
It is, however, also true that the euro area short-term debt securities market has witnessed only a limited degree of cross-border activity. This may partly be due to the fact that short-term debt securities issued by euro area residents have very similar risk characteristics and therefore offer little scope for international diversification. Our respective indicator, which gives the share of short-term debt securities issued by euro area residents and held by other euro area residents, shows a rising trend – from 7% in 2001 to over 12% in 2005 – but the absolute numbers are small when compared with the corresponding indicators for the bond and equity markets.
With respect to the absolute size of the short-term debt securities market, I would like to highlight the Short-Term European Paper (STEP) initiative. This initiative by the European banking industry promotes the development of a pan-European short-term paper market through market players’ voluntary compliance with a core set of standards encompassed in the STEP Market Convention, which was signed in June 2006. By the end of March this year, 35 STEP-compliant programmes, amounting to €201 billion, had been launched under the STEP label. The ECB regularly produces statistics on yields and volumes in the STEP market and publishes them on its website. 
With respect to bond markets, euro area cross-border holdings of long-term debt securities have increased strongly – from about 10% at the end of the 1990s to nearly 60% in 2005 – suggesting that investors are increasingly diversifying their portfolios across the euro area. As a way of testing the idea that, in integrated markets, bond yields should react to common factors, rather than local ones, one can also make a regression of changes in yields of individual government bonds against changes in yields of a benchmark bond. In the ECB’s new report, we show that the estimated coefficients of this regression varied substantially up to 1998, but converged afterwards towards 1, which is the level of perfect integration, suggesting that the euro area government bond market has reached a very advanced stage of integration. But let me stress an important point. It has to be borne in mind that movements related to changes in the credit risk perceptions by the market do not signal a variation in the degree of integration. Such “local news” will continue to have an impact on bond yields in different countries. Integration of European government bond markets means that yields converge across countries to the extent that the underlying bonds have identical risk-return characteristics. A government bond of a country with a higher fiscal deficit is riskier than a government bond of a country with a lower deficit. Consequently, it is to be expected that yields in the first case are higher than government bond yields of the country with a lower deficit, even with perfect integration of government bond markets. There is, therefore, no contradiction between integrated markets, as shown by our indicators, and the ECB’s view that markets should accurately price different budgetary policies into bond yields.
Finally, the quantity-based measure of euro area equity market integration also indicates a rising degree of integration in the equity markets. Between 1997 and 2005 euro area residents doubled their holdings of equity issued in another euro area country to nearly 30%. This implies that, following the introduction of the euro, euro area investors have partially reallocated their equity portfolio from domestic holdings to holdings elsewhere within the euro area.
As a remaining challenge to the integration of euro area securities markets, I note that the euro area securities clearing and settlement infrastructure underpinning both bond and equity markets is not yet sufficiently integrated. Several initiatives to achieve an efficient and integrated market infrastructure are underway. Last November, for example, at the European Commission’s request, the relevant European industry associations and their members signed a “ European Code of Conduct for Clearing and Settlement”. The Code represents the first self-regulatory approach in the area of EU clearing and settlement. The ECB welcomes this initiative and acknowledges the commitment by the industry to implement the Code.
In this respect, let me also mention that the Eurosystem is considering developing a single platform for the settlement of securities in central bank money – the so-called TARGET2-Securities. The scope of this project is restricted to the settlement layer of the post-trading activity regarding securities settled in central bank money and does not involve custody services and other activities, which remain separate economic activities performed by the central securities depositories. Our next step will now be the definition of user requirements, and these will benefit from a public consultation which we launched on 26 April 2007.
Last but not least, I would like to mention the European retail banking markets which also still display fragmentation in their retail payment infrastructure. The introduction of the euro as the single currency of the euro area will only be completed when consumers, businesses and governments are able to make cashless payments throughout the euro area from a single payment account anywhere in the euro area using a single set of payment instruments as easily, efficiently and safely as they can make payments today in the domestic context.
However, we also see progress in this field as the current fragmentation of the European retail payment infrastructures is being addressed by the so-called Single Euro Payments Area (SEPA) project that has been initiated by the European banking industry with a view to creating a Single Euro Payments Area. SEPA can be described as an integrated market for payment services which is subject to effective competition and where there is no distinction between cross-border and national payments within the euro area. Improved payment service levels will benefit the end-users with transparent prices and cost-efficient services. SEPA will allow the payments industry to become more efficient, thereby providing significant savings and benefits to the wider European economy.
The Eurosystem supports this project in a catalyst role, by providing guidance to banks and the payments industry in setting objectives and defining high-level requirements. I am very glad to report that the self-regulatory approach chosen for SEPA is working well and that we expect the European banking industry to launch the first SEPA instruments according to schedule on 1 January 2008.
4. Concluding remarks
Ladies and gentlemen,
This brings me to the end of my remarks in which I have sketched out the basic economic implications of the process of European financial integration and development as well as some of the major achievements, remaining challenges and initiatives underway.
Thank you very much for your attention.
 See “Financial integration in Europe”, March 2007, available from the ECB’s website at http://www.ecb.europa.eu/pub/pdf/other/financialintegrationineurope200703en.pdf.
 The data underlying the, at present, 42 indicators are published and updated twice per year on the ECB’s website (http://www.ecb.europa.eu/stats/finint/).
 See I. Angeloni, A. Kashyap and B. Mojon (2003), “Monetary Policy Transmission in the Euro Area”, Cambridge University Press, Cambridge.
 See C. Kok-Sorensen and T. Werner (2006), “Bank interest rate pass-through in the euro area: A cross country comparison”, ECB Working Paper No. 580.
 See “Financial integration in Europe” (2007), page 24.
 See M. Affinito and F. Farabullini (2006), “Does the law of one price hold in retail banking? An analysis of national interest rate differentials in the euro area”, paper presented at the ECB-CFS network conference on “Financial Integration and Stability in Europe”, 30 November/1 December, Madrid (http://www.eu-financial-system.org/Madrid2006_programhtm.html).
 See M. Friedmann and A. Schwartz (1963), “A Monetary History of the United States”, Princeton University Press.
 See R. Ferguson, P. Hartmann, F. Panetta and R. Portes (2007), “International Financial Stability”, mimeo.
 See K. Schaeck, M. Cihak and S. Wolfe (2006), “Are more competitive bank systems more stable?”, paper presented at the ECB-CFS network conference on “Financial Integration and Stability in Europe”, 30 November/1 December, Madrid.
 London Economics (2002): “Quantification of the macroeconomic impact of integration of EU financial markets”, Report to the European Commission.
 See P. Asdrubali, B. Sorensen and O. Yosha (1996), “Channels of interstate risk sharing: United States 1963-1990”, Quarterly Journal of Economics, Vol. 111, No. 4, pp. 1081-1110.
 See S. Kalemli-Ozcan, B. Sorensen and O. Yosha (2004), “Asymmetric shocks and risk sharing in a monetary union: updated evidence and policy implications for Europe”, mimeo.
 See M. Giannetti and S. Ongena (2005), “Financial integration and entrepreneurial activity: Evidence from foreign bank entry in emerging markets”, paper presented at the ECB-CFS network conference on “European Economic Integration: Financial Development, Integration and Stability in Central, Eastern and South-Eastern Europe”, Vienna (http://www.eu-financial-system.org/Nov2005_Program. html).
 See S. Claeys and C. Hainz (2005), “Acquisition versus Greenfield: the impact of the mode of foreign bank entry on information and bank lending rates”, paper presented at the ECB-CFS network conference on “European Economic Integration: Financial Development, Integration and Stability in Central, Eastern and South-Eastern Europe”, Vienna.
 See also R. De Haas and I. van Lelyveld (2003), “Foreign banks and credit stability in Central and Eastern Europe: A panel data analysis”, De Nederlandsche Bank, MEB series number 2003-04.
 See T. Dvorak (2005), “The impact of the euro on investment: Sectoral evidence”, paper presented at the ECB-CFS network conference on “European Economic Integration: Financial Development, Integration and Stability in Central, Eastern and South-Eastern Europe”, Vienna.
 See A. Ciccone and E. Papaioannou (2006), “Finance, capital and growth”, paper presented at the ECB-CFS network conference on “Financial System Modernisation and Economic Growth in Europe”, Berlin (http://www.eu-financial-system.org/Berlin2006_programhtm.html).
 See ECB (2007), “The role of financial markets and innovation for productivity and growth in Europe”, ECB Occasional Paper No 55, forthcoming.
 See G. Favara (2006), “An empirical reassessment of the relationship between finance and growth”, mimeo.
 See B. Holmström and J. Tirole (1993), “Market liquidity and performance monitoring”, Journal of Political Economy, Vol 101, pp. 678-709.
 See M. Bennedsen and K. Meisner Nielsen (2006), “The principle of proportional ownership, investor protection and firm value in Western Europe”, paper presented at the ECB-CFS network conference on “Financial System Modernisation and Economic Growth in Europe”, Berlin.
 See E. Papaioannou (2006), “Financial development and intersectoral investment: New estimates and evidence”, ECB, mimeo.
 See http://www.ecb.europa.eu/stats/money/step/html/index.en.html#data.