Jean-Claude Trichet: European financial integration and the management of
inflation expectations by the European Central Bank
Remarks by Mr Jean-Claude Trichet, President of the European Central Bank, at the conference "The
euro: one currency, one financial market" organised by the European Commission, New York, 19 April
2005.
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1. Introduction
Ladies and gentlemen,
It is a great pleasure to speak at this conference.
I would like to share with you today some thoughts on two important topics. First, I would like to
address the process of European financial integration, this important European endeavour to which
the ECB contributes in many different ways. And then, I would like to address an issue of mutual
relevance for the ECB and for market participants, i.e the monitoring and the management of inflation
expectations by the ECB.
2. The process of European financial integration
Turning to the process of European financial integration, my remarks will focus on two main issues.
The first relates to the reasons why financial integration should be pursued, i.e. what are the economic
benefits of financial integration. The second issue to which I would like to draw your attention concerns
the state of play, i.e. where does the European financial system stand in the process of integration.
2.1 Why financial integration should be pursued
As we all know, financial systems - composed of financial institutions, markets and the infrastructure -
serve some basic purposes: among other things, to trade, hedge, diversify and pool risk, to allocate
resources and to mobilise savings.
These functions determine the economic benefits that can be derived from financial integration. Two
widely accepted economic benefits of financial integration are: the better sharing and diversification of
risk and the potential for higher economic growth. Let me explain this in more detail.
Financial integration increases the opportunities to share risk and smooth consumption over time. The
increase in the available set of financial instruments resulting from financial integration, as well as the
increased cross-ownership of assets, offers additional possibilities to the agents to diversify portfolios
and share idiosyncratic risk across regions.1
As we know from theory, when risk is fully shared in an area, a co-movement in consumption results
between agents belonging to different regions of that same area, while consumption does not co-move
with region-specific shocks. The evidence suggests that consumption growth rates in the euro area
are less correlated than are GDP growth rates, which means that the opportunities to share risk could
still be further exploited in the euro area, thereby creating opportunities for further economic benefits
from enhanced financial integration.2
Let me now turn to the second economic benefit of financial integration. Financial integration increases
the potential for higher economic growth. To explain this, I need to introduce the concept of financial
development.
The link between financial integration and economic growth is typically derived by first establishing the
link between financial development and economic growth, and then the link between financial
integration and financial development. If we were to describe it with the picture of a chain reaction, the
sequence would be: financial integration positively impacts on financial development that in turn has a
positive impact on economic growth. But let us look at each individual element separately.
There is strong evidence to suggest that financial development, i.e. the level at which the financial
system fulfils its respective functions, which I mentioned earlier, is positively linked with economic
growth.3 This link is established via two main channels: financial development can lead to a more
efficient allocation of capital and it can reduce the cost of capital.
Let me give just one example for each of the two channels. As regards the efficient allocation of
capital, economic growth is spurred by the fact that in a more developed financial system, the
intermediaries are more effective in dealing with problems of asymmetric information, so more funds
will be allocated to more profitable projects and the productivity of the economy will increase. As
regards the reduction in the cost of capital, more developed financial systems can raise the fraction of
savings channelled to investment.
So I now turn to the link between financial integration and financial development.
The economies of scale involved in financial intermediation can foster the expansion of the
established intermediaries and markets of the financially developed regions, thereby leading to further
financial development.
Financial integration will increase the supply of funds for investment opportunities in less financially
developed regions of the integrating area. The integration process will increase competitive pressure,
and thereby increase the efficiency of the financial system of less developed regions; it will reduce the
cost of financial services, and thus expand the size of the local financial markets. In some cases, the
additional supply of financial services may be provided by intermediaries entering the local market
either by acquiring local banks or by merging with them.
Given that greater efficiency stimulates the demand for both funds and financial services, this should
also result in financial markets increasing in size.
Let me conclude this review of the benefits of financial integration with an empirical result regarding
the link between financial integration and economic growth. While acknowledging the difficulty of
measuring empirically the effect of financial integration on financial development and growth, the
overall conclusion of such studies is that the effects are significant. Let me mention here a study that
estimated additional growth - resulting from financial integration of the European bond and equity
markets - of 1.1% over a period of ten years.4 Despite all caveats that apply to the model underlying
the simulations, this result is impressive.
Having laid down the general economic benefits of financial integration, I would now like to discuss the
reasons for fostering financial integration which are specific to the ECB and which explain why we
attach the highest importance to this process.
First, financial integration has implications for monetary policy. Since monetary policy is implemented
through the financial system, this system should be as efficient as possible in order to guarantee the
smooth and effective transmission of monetary policy throughout the euro area. The degree of
financial integration is therefore important in determining how effectively this transmission will work in
practice. In this regard, I also mention the ECB's task of promoting the effective operation of payment
systems, as well as its interest in the smooth running of securities settlement systems.
As to the contribution to financial stability, the interconnection between financial integration and
financial stability has to be addressed. I will not discuss in detail here the link between financial
integration and financial stability: this fascinating issue deserves a speech of its own!
Let me just highlight the following.
There is no simple, clear-cut answer to the question on the link between integration and stability.
There are complex interrelations, the net impact of which is difficult to gauge. Deeper financial
integration, on the one hand, widens the possibilities for financial institutions to manage their relevant
risks. On the other hand, it can change the interplay of vulnerabilities and the way in which systemic
risk stemming from contagion or moral hazard problems spreads in the financial system.
Clearly, competition emerges as a relevant intermediary in the link between financial integration and
financial stability. On one side, financial integration brings about the unleashing of competitive forces.
On the other side, too fierce competition can also lead to less prudent risk-taking behaviour by
financial institutions.
As you may know, in 2004, the ECB started to publish its financial stability review. In this report, we
summarise our monitoring and assessment of the stability of the euro area financial system.
So, to conclude on the process of financial integration, it is generally agreed that deepening financial
integration is beneficial on the whole. Given the overall economic benefits, as well as the additional
reasons specific to the euro area, the ECB and the Eurosystem as a whole support and complement
the private actors' and public authorities' actions in the process of financial integration, and I will give
you a number of specific examples in this respect.
Given the economic benefits that result from financial integration, but also given its implications for and
interaction with financial stability, it is of the utmost importance that we monitor the process of financial
integration closely and understand what is happening. And this is what the ECB does. As one of our
main contributions, we invest resources, on the theoretical side, in research on all aspects of
European financial integration, and we invest resources, on the empirical side, in monitoring the
process of European financial integration.
2.2 Integration of the European financial system
Let me turn now to the second issue, namely where do we stand in the process of European financial
integration.
In addition to the research, monitoring and measuring I have already mentioned, there are three other
kinds of possible actions on our side: first, we contribute to financial integration by providing specific
central banking services; second, we give advice on shaping of the legislative and regulatory
framework of the financial system and we act as a rule-maker by issuing regulations; and, third, we
can act as a catalyst for private-sector activities.
These are the multi facets contribution of the ECB to European financial integration.
I would like to start by giving you my summary assessment of the process of European financial
integration. I would say that quite considerable progress has been made over the recent years
although a lot of works remains to be done.
Let me elaborate on this by reviewing the process of integration for the various components of the
financial system: financial markets and related infrastructures on the one hand, and financial
institutions and the regulatory framework on the other hand.
2.2.1 Financial markets and related infrastructures
Assessing the state of integration is probably rather straightforward for the financial markets
component of the financial system. Normally, a price exists for a financial instrument or financial
service, so one can also use quantitative indicators, based on the law of one price, to measure the
degree of integration. I should like to mention here that ECB staff is doing substantial research and
statistical work in this area.
Indeed, the euro has acted as a catalyst for financial integration. The degree of integration distinctly
differs between the market segments, with integration being more advanced the closer the market
segment is to the single monetary policy. As we all know, the unsecured interbank deposit market was
almost completely integrated right at the start of Monetary Union. A good example of the ECB acting
as a catalyst for private sector action is its calculation and publication of the EONIA rate.
And I would also like to mention the related infrastructure, i.e. the TARGET system, which now
represents around 90% of the total traffic in large-value payments in euro. With EUR 1.7 trillion settled
every day, TARGET is already one of the two largest wholesale payment systems in the world,
alongside Fedwire in the United States. TARGET is a good example of where we have taken direct
action by providing central banking services that foster European financial integration. We are
currently building TARGET2, which is due to go live in 2007 and which will replace the current
decentralised system with a single technical platform. With the functionalities that will be introduced in
TARGET2, we also expect it to be one of the most sophisticated payment systems in the world.
TARGET2 will also further improve financial integration. It will increase cost effectiveness. It will allow
for the provision of a harmonised level of services across Europe, supported by the implementation of
a single price structure for domestic and cross-border payments. And finally, it will offer new
functionalities enabling banks to better integrate their euro liquidity management.
Moreover, to also mention a retail aspect, the ECB, and the Eurosystem as a whole, fully support the
establishment of a Single Euro Payments Area (SEPA) from 1 January 2008. This means that citizens
and enterprises will be able to make payments throughout the euro area from a single bank account
using a single set of payment instruments, as easily and safely as today in the national systems. In
addition, national infrastructures should progressively migrate towards a pan-European payments
infrastructure with a view to achieving it by the end of 2010. Consequently, decisions related to the
next generation of national systems should be made from a pan-European perspective to ensure
compliance with the SEPA. The ECB is in a regular contact with the banking industry to seek market
participants' support for these objectives. So, this is another example of where we are acting as a
catalyst for private sector action to foster financial integration.
Let us now review the money market. The growing repo market is still somewhat less integrated than
the unsecured segment which is fully integrated, but integration progresses. The creation of the
EUREPO index - the benchmark for secured money market transactions in the euro area - three years
ago was an important market initiative for promoting the repo market's integration. Anecdotal evidence
collected via market survey from counterparties active in the repo market suggests that the share of
euro area cross-border transactions increased further to around 30% in December 2004.
The least integrated segment of the money market is 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 borders 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 is amounting to around EUR 750 billion. Fragmentation of short-term paper
market reduces its depth and liquidity as well as the diversification opportunities for issuers and
investors.
But I can also give you an example of the ECB's approach to fostering financial integration by acting
as a catalyst for private sector initiatives. The Short-Term European Paper - the so-called 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 Governing Council of the ECB has decided to support in principle 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.
After the money market, the market segment closer to the implementation of monetary policy is the
bond market. As regards government securities, a high degree of integration has also been achieved.
Yields are driven by common news - euro area-wide shocks - and only a very small fraction can still be
explained by local risk factors, although this also varies between the maturity segments. Local shocks
play the smallest role in the highly liquid ten-year maturity segment, but there is scope for further
integration, particularly in shorter maturity segments.
As regards the euro corporate bond market, despite the exceptional growth it has witnessed since
1999. In terms of new issuing, the gap with the United States as regards the outstanding volume is still
large. For example, the outstanding volume of bonds issued by non-financial corporations, for
example, is now around USD 2.9 trillion in the United States, compared with EUR 600 billion in the
euro area. The degree of integration of the corporate bond market is, however, fairly high. The yield
differential between corporate bonds is explained predominantly by the rating and by common,
maturity and coupon effects, whereby the yield variance explained by the country of issuance is close
to zero.
One measure for the integration of equity markets is the cross-sectional dispersion of the country and
sector returns. For the euro area, the dispersion of country-specific returns remains non-negligible, but
it has become relatively less important in recent years, suggesting a higher degree of integration. This
development is also supported by the increasing share of investment funds applying a euro area-wide
investment strategy - or, in other words, we are observing a decreasing "home bias" in their
investment strategy. This share stayed at the still moderate level of 29% at the end of 2003 and there
is still considerable room for it to increase.
I mentioned earlier the money market and its payment systems. Full integration of financial markets
will call for appropriate integration of securities trading, clearing and settlement infrastructures. A
significant process of consolidation has taken place since the introduction of the euro, although the
European securities infrastructure remains fragmented.
The ECB has a particular interest in an integrated securities infrastructure because it uses it for
collateralisation in the context of its monetary policy implementation and for intraday credit operations
for payment system purposes. In addition, a major disruption in a securities settlement system could
undermine the stability of the financial markets.
Let me give you an example of the contribution of the ECB, and the ESCB as a whole, to financial
integration in the field of securities infrastructure. This time, I will refer to our responsibility of giving
advice to the shaping of the legislative and regulatory framework of the financial system.
The ESCB and the Committee of European Securities Regulators (CESR) have jointly drawn up the
"Standards for Securities Clearing and Settlement in the European Union". Should a framework
directive on clearing and settlement be adopted, which we support in principle, this directive would
stipulate high-level principles to be further developed by implementing measures. We agree with the
European Commission that the ESCB/CESR standards might form the basis of such implementing
measures. In this respect, we also invite the Commission to explicitly recognise the overall
responsibilities and tasks of the ECB, together with the national central banks, and in particular their
role in the oversight of the securities clearing and settlement infrastructure.
Let me now address financial integration from the stand point of financial institutions.
2.2.2 Financial institutions and the regulatory and supervisory framework
Given its pivotal role in channelling funds into the EU economy, a well-integrated banking sector is a
prerequisite for achieving a truly single financial market. I would like to describe the degree of
integration in the euro area banking sector along three dimensions: first, cross-border consolidation or
ownership; second, magnitude of cross-border activities; and, third, cross-border competition (i.e. the
price component), where I would like to look at aspects of retail banking.
As regards the integration in ownership of euro area banks, banking consolidation has mainly taken
place at the domestic level, and it witnessed peaks in the late 1990s when around 80% of all M&As in
the EU banking sector involved domestic banks only. However, between 1999 and 2001 in particular,
cross-border banking consolidation increased in both absolute and relative terms.
As regards cross-border activity of banks in the euro area, cross-border holdings of securities and
inter-bank loans have 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 were granted cross-border, also up from around 20% in 1998. In
contrast, cross-border loans to non-banks remained unchanged and low at less than 5% of all loans to
non-banks.
This brings me to a third indicator of banking integration, cross-border competition and, in particular,
the pricing of retail bank products. Of course, I fully acknowledge that the process of integrating retail
markets is bound by some persistent home biases in lending to and borrowing from non-financial
corporations and households. I also see some similarities to the observed lack of full cross-state
penetration in the United States, after restrictions on cross-state banking were removed in the 1970s
and 1980s.
The research findings are widely known: in the euro area, retail banking markets remain predominantly
local. Apart from geographical barriers, there are many other reasons for cross-country interest rate
differentials, such as economic, structural and institutional factors. These factors relate, for example,
to differences in regulation, competition, bank-customer relationships and the overall development of
the financial system.
Let me give a specific example of a retail banking market: the mortgage market. There is some
evidence that mortgage rates are less correlated in the euro area than in the United States. Taking
into account the size of the mortgage credit market, which in the EU represents an outstanding volume
of around EUR 4 trillion, the costs incurred, through incomplete integration, cannot be ignored. In this
regard, the ECB supports initiatives from both the private sector and the European Commission to
encourage further integration.
So what we need to do is to remove the remaining obstacles to effective cross-border banking in order
to foster cross-border competition and further banking integration. Let me mention a few examples.
In the area of financial regulation and supervision, a key objective is to achieve a high degree of
regulatory and supervisory convergence across countries. This will help to reduce the compliance
burden on financial institutions, thus addressing one of the largest remaining obstacles to enhanced
cross-border activities.
The extension of the Lamfalussy approach to the banking sector and the establishment of the
Committee of European Banking Supervisors (CEBS) are milestones in this respect. The work of the
CEBS is crucial to develop common benchmarks and best practices for the consistent implementation
of EU Banking Directives as well as principles for cooperation between home and host supervisors. In
addition, the forthcoming revision of the Codified Banking Directive will enhance cross-border
co-ordination between supervisors and, in particular, it will provide an enhanced role for the authority
responsible for consolidated supervision. Such an enhanced role will encompass co-ordination in the
information exchange and a decision-making process for approving advanced approaches at group
level under the Basel II framework.
More generally, the ECB welcomed the extension of the Lamfalussy approach to regulation and
supervision to all financial sectors.5
The ECB Governing Council also provided its view on the European Commission's recent review of
the Lamfalussy process.6 These are further important examples of where we have contributed to
financial integration by giving advice to the shaping of the legislative and regulatory framework of the
financial system.
And here I come to the preparation of the "post-FSAP strategy" that will soon be formally initiated
when the European Commission issues its Green Paper for public consultation.
A promising framework has been established through the completed FSAP measures. And I clearly
see the post-FSAP period as a "window of opportunity" for further enhancing financial integration. The
ECB will certainly make its contribution in this respect. Let me already now mention three important
elements.
First, the focus of the post-FSAP strategy should be on the effective and consistent implementation of
the FSAP measures at the national level, with new legislation being kept to the strictly necessary
minimum. In this respect, the implementation of the Lamfalussy framework represents a unique
opportunity to achieve a consistent regulatory and supervisory framework for financial services.
Second, the policies relating to the regulatory and supervisory framework should be complemented by
and closely coordinated with other relevant policies for financial services, for instance competition
policy. And, third, incentives should be provided for the private sector to play its role in exploiting the
opportunities offered by the public action.
3. The role of inflation expectations in the ECB monetary policy strategy
Let me now turn to the second topic I would like to address today, namely the role of inflation
expectations in the ECB monetary policy strategy.
3.1 Why do central banks care about inflation expectations?
The notion lying at the core of modern economics is that the expectations held by private agents or
market participants about the future economic developments may have an immediate and eventually
significant impact on actual economic outcomes. For example, focussing on inflation, which is the
primary concern of a modern central banker, in many standard models used for quantitative policy
analysis there is a direct impact of inflation expectations on the dynamics of actual inflation. It is easy
to rationalise this mechanism by thinking about the effect of, say, higher expected inflation on workers'
wage claims, which will be increased today in order to compensate for the expected loss of purchasing
power tomorrow. More generally, one may also think of the effect of higher expected inflation on firms'
current pricing decisions: these will tend to push up the price of their output in order to compensate for
the expected increase in marginal costs of production. In both examples, the outcome is that when
inflation is expected to increase in the future, it may immediately put upward pressure on prices.
Hence, a modern central bank with a public mandate of maintaining price stability must take into
account, among other indicators, those related to inflation expectations in order to evaluate at any
point in time the overall risks surrounding the attainment of its objective.
This implies assessing the possible effect of inflation expectations on actual inflation and measuring
the degree to which the public regards the central bank's commitment to attain price stability credible
and worthy of trust. Unstable inflation expectations dynamics might emerge because market
participants do not believe that the central bank is truly committed to maintain price stability or that its
assessment of the current, and most likely, development of the economy is not consistent with that
objective. In such a situation, the task of monetary policy becomes very difficult. Reigning in inflation
expectations will demand a tighter monetary policy stance than it would have been deemed necessary
in case of full central bank credibility. In the end, in those circumstances, social welfare will suffer.
3.2 Monitoring a wide range of expectation indicators
The ECB does not rely on a single indicator when monitoring expectations but rather takes a
comprehensive and pragmatic approach that balances off the information provided by various sources.
By their very nature, inflation expectations are not directly observable or measurable. Furthermore, the
way private agents form and update their view on the likely developments of an economic variable,
including inflation, is likely to be different in important dimensions across different types of agents.
From this perspective, relying on a single measure of expected inflation in the context of its
assessment of the monetary policy stance may mislead the central bank, even if that measure is
constructed on the basis of the central bank's own internal analysis.
It is for those reasons that the ECB makes constant use of several measures of inflation expectations
that are either based on surveys, thus providing a direct measure of agents' expectations, or are
based on the analysis of information contained in asset prices, which provide an indirect gauge of the
inflation path expected by market participants.
To be sure, both measures only represent an imperfect gauge of inflation expectations thus requiring
careful analysis and full awareness of the limitations inherent in the information they convey. The
survey measures that are typically analysed by the ECB, like the ECB Survey of Professional
Forecasters, the Consensus Economics forecast or the European Commission's monthly Business
and Consumer Survey, suffer, like all survey measures from the inherent limitation that they are
constructed on a restricted and heterogeneous sample of respondents and from the uncertainties
linked to the design and the implementation of the survey.
Furthermore, also those indirect measures of inflation expectations extracted from asset prices, like
the "break-even" inflation rates that are calculated from the yields offered by nominal and
inflationprotected bonds with the same maturity present some limitations. In particular, several premia, like an
"inflation risk premium" but also a "liquidity premium," are potentially embodied in their calculation.
Changes in break-even inflation rates over time could therefore reflect changes in the level of
expected inflation, but also changes in the perceived degree of uncertainty about future inflation,
changes in the perception of the liquidity risk, or a combination of the three.
The information that we gather from these diverse sources at present is consistent with a picture of
stability.
For what concerns the survey evidence, it has been extremely stable at the level consistent with the
ECB's definition of price stability since 1999. In the most recent survey, conducted in the 1st quarter of
2005 the mean point estimate for HICP inflation indicated by the respondents to the ECB survey
remained close to and below 2%, in line with the ECB's quantitative definition of price stability and with
the Survey results for the previous quarter. This holds true for the expectations relating to the years
2005 and 2006, but also for the five-year period up to 2009. The comparison with the results of the
Survey for the last quarter of 2004 confirms that the uncertainty surrounding these forecasts remains
contained, and for the longer horizon has even slightly decreased recently.
Inflation expectations as embodied in asset prices have also been quite stable. The "ten-year"
breakeven inflation rate calculated from the index-linked both with maturity 2012 and issued by the French
Treasury in 2001 has averaged approximately 1.9% since its issuing. This reflects a fairly sound
anchoring of inflation expectations in the euro area around levels consistent with the ECB's definition
of price stability. We nevertheless observed an episode of transient instability occurring during the
Spring and the Summer 2004, when the dynamics in oil prices caused global inflation expectations to
increase. As a consequence, in the euro area, the break-even inflation rate peaked at 2.4%. Those
movements proved to be short-lived and the break-even inflation rate has since returned to levels that
are closer to our definition of price stability, albeit marginally above 2%, possibly owing to the recent
renewed upward pressures on oil price, which have increased beyond the 50 US Dollar threshold
since February 2005.
The slight discrepancy between break-even inflation rates and survey expectations does not suggest
at the moment, that long-term inflation expectations are not correctly anchored in line with the
definition of price stability: We must take into account, in particular, the "inflation risk premium"
embedded in the break-even inflation - given the uncertainties prevailing in oil markets - and the
tendency of that discrepancy to diminish over the last months. However, these evolutions of
breakeven inflations rates command continuous monitoring.
3.3 Concluding remarks: The role of the ECB monetary policy strategy in anchoring
inflation expectations
Let me conclude my interven