Mr. Bäckström speaks on the topic "EMU - a further step in financial integration"
Address by the Governor of the Bank of Sweden, Mr. Urban Bäckström, at the Danish-Swedish Business
Council in Copenhagen on 29/9/98.
Stage Three of EMU will soon be here. Something that many people felt was impossible
just a few years ago is now taking place. The EMU project is probably the greatest change that has even
happened in the domain of exchange rate policy. The economies of eleven countries are being linked
together by a single currency. Both the population and the economy of the euro area will be on a par with
the United States. Today, the euro area's share of the industrial countries' output is about 30 per cent and
the United States has 35 per cent.
The introduction of the euro will affect conditions for the financial system throughout
Europe. But the advent of a single currency should not be discussed as an isolated phenomenon in the
financial sphere. The move to Stage Three is simply accentuating a process that is already in train. In the
1980s and '90s we have seen the beginnings of a financial revolution on a global scale. This in turn has
been a combined consequence of financial deregulation, a general globalisation of trade and production,
major developments in technology and new demographic trends.
In my address today I shall be pointing out discernible trends in the development of the
financial system and how this process is being reinforced by the coming European Monetary Union. In
conclusion I shall consider what this requires of economic policy, its decision-makers and various
authorities.
A financial revolution
It is hardly an exaggeration to say that a revolutionary process of financial transformation
and development has got under way in the past decade, with consequences that we probably cannot yet
fully foresee. Deregulation, globalisation, advanced information technology and new methods for
valuation and risk management have initiated a dynamic process in which financial markets, institutions
and instruments are interacting. There are clear similarities with the expansion of real economies in the
past hundred years; a stream of new, more efficient and specialised production processes and new
communication facilities are leading to a growing volume of trade. Basically, the financial trend and its
internationalisation are a natural development of the market economy, a logical consequence of
persistently rapid economic transformations that call for new financial solutions for households and
firms.
Challenges for banks
The foreseeable developments will alter or at least affect the future role of banks. New
trends in traditional banking are already discernible.
Competition for bank deposits is growing in that people are increasingly choosing to
place assets in securities, either directly or via mutual funds. Specialised agents of various types, such as
niche banks, have also entered this field. Savings instruments that attract customers are even being
provided, at least in Sweden, by food chains and petrol companies.
In the case of loans, a growing proportion of credits is being arranged in the securities
markets. Then there is more uncertainty about the social security system's future ability to generate
adequate pensions. The demographic trends are also entailing changes in saving behaviour; a growing
proportion of people in the industrialised world are approaching retirement and are more prone to save
than to borrow.
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Cross-border investment is rising. People in Sweden, for example, are placing their
longterm savings to a growing extent in assets issued abroad. At the same time, non-residents are increasing
their holdings of Swedish financial assets.
Furthermore, technological advances are making it possible to supply traditional banking
services without the aid of a large branch network. This in turn makes new banking establishments less
costly than before and a bank with just a few branches or a business concept based on telephony or the
Internet can gain a competitive advantage in certain segments of the market. Products are also becoming
more sophisticated and their construction and production are increasingly dependent on specialist
knowhow that may become available outside the banks.
The speed of these processes varies from country to country. The structure of bank
earnings is already changing, with a growing share from a range of commissions compared with the
traditional income from net interest.
There is nothing to suggest that the rate of and pressure from these changes will ease off
in the years ahead. On the contrary, international integration seems to be becoming more intense. The
establishment of EMU means that this trend will accelerate.
EMU affects the financial system
The introduction of the single currency will affect the financial system in various ways.
The most obvious change is the end to exchange transactions between the national currencies in the euro
area. This also means an end to forwards and swaps in these currencies. By itself, this will leave its mark
on the earnings of European banks.
The coming of the euro will also affect financial activities in Europe more profoundly
and may necessitate a number of changes. The euro area will constitute a larger and more uniform market
with a population of about two hundred million. This market, moreover, is likely to attract investors from
other European countries and other parts of the world.
Via growing competition, a larger market normally leads to lower costs and increased
liquidity. With more investors and the elimination of exchange risks, it will cost less to diversify savings
by placing them in more countries. In other words, savers in one country will transfer some of their assets
to other countries. This process has, in fact, already begun. Briefly, then, all at once there will be a much
larger and much more liquid European capital market that in time may resemble the US market in size
and nature.
A competitive factor that has been important for national banks-familiarity with their
domestic monetary policy-will disappear when the single currency is introduced. This could lead to a
centralisation of trading in treasury bonds. It is quite conceivable that in time, treasury bond transactions
are concentrated to one or two financial centres in Europe.
The elimination of exchange risk means that risks of other types will attract more
attention. I am thinking in particular of liquidity and credit risks. This could well result in the
development of trans-national European markets for different categories of bonds, for example, corporate
bonds, housing bonds and local authority bonds. A contributory factor here will probably be a propensity
for investors to spread risks by diversifying portfolios so that potential losses are limited. Nor is it only
trading in these instruments that will be affected. New knowledge will have to be acquired by the various
players.
Share trading is already showing clear effects of EMU. Stock exchange mergers are
occurring here and there in Europe. Another expression of what is at least a related tendency is remote
participation in the national stock exchange. At the same time, the two principal competitive factors in
share dealing will continue to apply, namely local customer relationships and knowledge of national
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accounting, taxes and laws in the company's home country. But even these factors will be modified as
investors learn more about conditions in other countries, harmonisation between countries continues and
the production of goods and services is increasingly globalised.
Even this very summary review illustrates how the changeover to a single currency in
Europe will affect conditions for the financial system. The financial markets will become larger,
accompanied by increased competitive pressure. Some activities will be modified or disappear entirely.
Others will be concentrated to one or a few financial centres. But there will probably also be some new
activities.
These developments will leave their mark even in countries that do not join the euro area
but are adjacent to it. This, too, is a process that has already begun. Banks are being merged into large
units. Cost-cutting has come to the fore. Modes of distribution are being overhauled along with a
buildup of specialist knowledge. Systems for pricing different products are being changed.
Financial transformation not straightforward
Today there is a widespread conviction that free trade in goods and services enhances
prosperity in the long term. In the same way, most things suggest that in time, free trade in the financial
field leads to increased economic growth.
But we have also learned that the transformation and development of the financial field
are not without problems. In the past decade there have been bank crises in a number of countries as well
as several heavy corrections and large fluctuations in money, equity and currency markets around the
world.
There is nothing inherently new about financial crises. On the country, they have
occurred from time to time for many centuries. Experience shows that free trade and transformations in
the financial field require a great deal from economic policy, its decision-makers and various authorities,
as well as extensive cooperation between countries. This is all the more the case in that, with the
increasingly integrated financial system, mistakes in one part of the world may quickly lead to economic
repercussions elsewhere.
Many financial crises in the past decade
The financial problems at present in countries in Asia and other parts of the world are in
many respects similar to the situation in Mexico a couple of years ago, as well as to the Swedish crisis in
the early 1990s. Financial problems arise in an economy essentially as follows.
Banking involves accepting deposits from the non-bank public and transforming these
short-run savings into loans with longer maturities to households and firms. This transformation of
maturities is normally an economic benefit for society as a whole. The banks provide payment services
and mediate credits.
However, the commercial practice of borrowing short and lending long is associated with
risks. If people perceive a bank's position as uncertain and withdraw their savings, the bank will need to
obtain liquidity elsewhere; otherwise it will have to suspend payments and ultimately go bankrupt. In the
latter event the bank ceases to contribute to the workings of the economy. If this happens to a single
bank, the economic consequences may not be serious. If it involves the whole of the banking system,
however, economic activity may be profoundly weakened. That is why banking operations need to be
safeguarded.
One safety measure is the possibility, in exceptional circumstances, of the central bank
intervening as the lender of last resort. This is a matter of providing liquidity-as long as the banks are
fundamentally solvent-when the stability of the entire financial system is threatened. In that way it is
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possible to avoid more serious economic consequences and, provided the problems underlying the crisis
are managed, stabilise the situation in the banking system and the economy in general.
However, a central bank's unique possibility of providing liquidity is restricted to the
national currency. If a country has an external deficit and revenue from exports does not cover imports,
to make up the difference it has to borrow in foreign currency. The vulnerability this involves increases if
the loans are short-term, sizeable and have been channelled via the banking system to long-term
investment projects. If a country in this situation encounters problems with the renewal of foreign loans,
the central bank will have limited opportunities of coming to the rescue with liquidity unless it happens
to have sufficient foreign exchange reserves or borrowing facilities.
That is more or less what has happened in the countries that have recently been hit by
problems. Sudden shifts in confidence as to a country's real economy, the value of its assets or its
political system are examples of factors that have triggered crises in economies that have been highly
vulnerable.
In some countries the State has been able to obtain foreign loans and thereby contribute
liquidity to banks with problems. Meanwhile, these countries have made their own efforts to implement
confidence-enhancing measures that would stabilise the situation.
Other countries have been obliged to turn to the international community, headed by the
International Monetary Fund, for assistance with foreign liquidity. Private banks have also been engaged,
as one might expect considering that they are the banks which have exposures in these countries. In
return, the countries have been required to take measures so that confidence can be restored. In other
words, the underlying problems must be tackled. By itself, liquidity support does not suffice.
The required measures include the orderly winding up of insolvent banks, a clearer
account of the problems, a reduction of current-account deficits, a consolidation of government finances
so that expenditures for restoring the financial sector can be covered, and a construction of monetary
policy that guards against the risk of the country been suddenly hit by massive currency outflows. In such
a situation one cannot expected the necessary adjustment to be painless or free from difficult decisions.
Attempts by a country to isolate itself from the international exchange of financial
services would probably lead in time to effects on growth and prosperity that are just as disastrous as
protectionist measures in other fields. A country that chooses to impose controls for a time would find it
hard to re-enter the international credit market once the crisis had subsided. Currency restrictions of the
type we have seen some examples of recently therefore lead the country that introduces them into a
deadend.
When problems of this type arise in one country, the effects are liable to spread to other
countries. Recently we have seen a global increase in various asset risk premia as a consequence of the
turbulence in Asia and the problems in Russia. This has affected countries that geographically are a long
way away from the countries in question. A part of the adjustment of risk premia probably represents a
normalisation. It is not to be expected that stock markets around the world can generate capital gains year
after year that deviate from the long-term development of corporate profits. Neither is it unreasonable
that the terms on which countries borrow should become more differentiated than before to reflect the
various risks involved. But adjustments of this type are seldom smooth. Exaggerations in one direction
sometimes give way to excesses in the opposite direction. The so-called flight to quality that occurs in
connection with financial turbulence in parts of the world is a sign that investors want a rapid reduction
of portfolio risks. This leads to increases in risk premia.
One way of adjusting portfolio risk is to sell shares and buy treasury paper. That is why
financial turbulence often has a negative effect on shares prices, accompanied by a downward movement
in long-term - and sometimes even short-term - interest rates. Moreover, in a particular country, even if
its economic fundamentals look good, such a situation can give rise to downward pressure on both the
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exchange rate and share prices at the same time as interest rates rise. That suggests that certain investors
are reducing all types of holding in the country in question, which is a signal to the country's
decisionmakers that more must be done to enhance general economic policy's credibility.
High standard of discipline throughout economic policy
While it is obviously important to discuss how a financial crisis, if it occurs, should be
managed, it is at least as important to minimise the risks of a crisis ever materialising. This applies in
particular when the financial system is undergoing rapid developments. The transformation in Europe in
the coming years must therefore be followed closely.
One key factor is economic policy in general. An economy characterised by low, stable
inflation, sound government finances and good economic policy credibility also provides a generally
stable economic environment. This in turn promotes a sound development of the financial domain.
By itself, however, this is not enough. Another highly important matter is the appropriate
government supervision of the financial sector. Even central banks that are not directly engaged in this
supervision must monitor tendencies in the financial field in order to fulfil their primary tasks of ensuring
price stability and financial system stability. There are several reasons for this.
Monetary policy is implemented through the financial system's agents. The banks'
ability to transmit monetary policy effectively may be jeopardised if they have problems. The central role
of the banks in the payment system - as the channel for payments of every type - makes it important that
the banks are financially healthy and operate efficiently and reliably. Otherwise the traffic in payments is
liable to be disturbed. If the problems become so great as to constitute systemic risk, it is incumbent on
the central bank to consider support for liquidity. Moreover, in that central banks provide settlement
systems for large-value payments, they also have a direct, operative function in the payment system. All
inter-bank payments are channelled through the settlement system, which is thus the hub of the entire
payment system.
In Sweden the Riksbank now regularly publishes a Financial Market Report, in which we
present our appraisal of the financial system's development and stability. The Report is thus a way of
monitoring one of our primary functions - the promotion of a safe and efficient payment system. There
are some parallels here with the Inflation Report, which we publish regularly as part of the work on our
other primary function - safeguarding a stable value of money.
The rapid pace of financial developments, particularly in the international payment
system, also calls for extensive international cooperation. The issue of financial system stability will be
up for detailed discussion in various fora in connection with the coming annual meetings of the World
Bank and the International Monetary Fund. The central banks also cooperate on matters of this type in
the framework of the Bank for International Settlements in Basle, Switzerland, where representatives of
central banks throughout the world meet regularly once a month.
Conclusion
To sum up, the financial system is undergoing a rapid transformation and development.
The middle of the 19th century is commonly associated with the industrial revolution. Perhaps future
historians will see the late 20th century as the era of the financial revolution. Europe's move towards a
single currency will accelerate the trend.
The transformation and development of the financial system will ultimately contribute to
future prosperity. But experience has taught us that it is a development which needs to be monitored very
closely and presupposes a high degree of discipline in economic policy. It requires a great deal from
decision-makers in the political system and the supervisory authorities, as well as from those of us who
work in central banks.
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Developments in the financial field are creating large opportunities. But it is also
important to bear in mind that major, far-reaching changes normally entail risks. In view of these risks,
every agent in the financial system needs to act wisely and discerningly. Only in this way can the full
benefits be drawn from the opportunities that financial developments are providing.