Andreas Dombret: How to overcome fragmentation in the European
financial market
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank,
at the 23rd European Banking Congress, Frankfurt am Main, 22 November 2013.
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1 Introduction
Ladies and gentlemen,
It is a pleasure for me to share some thoughts with you on the subsequent discussion of how
to overcome fragmentation in the European financial markets.
When introducing a panel discussion, a sensible piece of advice is always to be briefer than
anybody dared hope. I intend to follow this recommendation and will therefore limit my
introductory remarks to no more than 15 minutes.
Allow me to talk about four aspects that we at the Bundesbank consider of particular
importance when thinking about fragmentation within European Monetary Union. First of all,
let me note that diagnosing financial fragmentation requires normative judgement. Moreover,
fragmentation is, to some extent, natural. It reflects structural differences between national
markets, which are not bad per se.
Second, let me share my thoughts on fragmentation and its implications in a monetary union.
And third, we also need to look at supervision when talking about fragmentation and its roots.
I will argue why the European banking union, in the Bundesbank's view, is an important step
towards a more integrated European financial market. Finally, let me briefly touch upon the
issue of fragmentation in the real economy.
2 Financial market fragmentation: A bad thing or to some degree natural?
Let me come to my first point: The reasons for fragmentation. The most obvious source of
financial market fragmentation is the existence of different currencies. As we all know, in the
euro area this source of fragmentation was eliminated by the introduction of the euro. But
even before 1999 there were various political initiatives with the objective of overcoming
market fragmentation in Europe. Most notably, let me mention the EU's internal market,
which guarantees free movement of goods, capital, services, and employees.
Nevertheless, financial market fragmentation within the euro area has been discussed in
quite some depth over the past few years. Probably most observers would agree that
financial markets in today's European Monetary Union are still segmented or fragmented -
especially when compared with the situation before the crisis.
But diagnosing financial fragmentation is by no means a purely technical exercise with a
clear result. In the end, it requires a normative judgement, offering answers to questions
such as: Which differences are well-founded and therefore justified? Which differences are
not well-founded and, hence, potentially a sign of a dysfunctional market? Obviously,
reasonable people can disagree substantially on the answers to these questions.
Strongly diverging prices of, for instance, government bonds may well be a sign of market
fragmentation. However, determining the adequate risk premium as part of an interest rate is
a highly difficult exercise. And central banks usually do not know better than market
participants what the adequate risk premium or price should be. Coming from the private
sector myself, let me add that central bankers should not even attempt to know better. And
even if central bankers were to observe differences in prices or risk premia, this may be due
to structural causes.
Allow me to make this point as clear as possible. Segmented markets are primarily the
symptoms of underlying structural causes, which usually explain most of the differences. This
applies, for example, to government bond markets, to the corporate credit market as well as
to the interbank money market. Even if prices on these markets differ markedly among
market participants or countries, it would be premature to interpret such differences as a
definite sign of market exuberance or market malfunction, as a sign of irrationality or as a
sign of inefficiencies.
Nevertheless, financial fragmentation can pose a challenge for the single monetary policy in
the European Monetary Union (EMU), not least with respect to the monetary policy
transmission channel.
3 How can the Eurosystem contribute to reducing fragmentation?
The single monetary policy cannot make a distinction between differing economic and
financial conditions among EMU member countries. Instead, what matters for the single
monetary policy is the aggregate situation of our monetary union. In this context, a
well-known mechanism applies: The more similar economic conditions and economic
policies of member states are, the more suitable the single monetary policy becomes for
each member country.
Does this, in turn, mean that economic conditions as well as economic outcomes need to be
the same in every single member state of a monetary union? No - in fact, on the contrary: If
national economic policies and national public preferences are different from one country to
another, national economic outcomes will differ as well. These differences will then be
mirrored in different financial market conditions.
Therefore, even in a monetary union, different economic conditions are basically the rule and
not necessarily an exception or a sign of a market dysfunction. Differing outcomes - not only
in the financial sphere - are, in fact, compatible with a monetary union - as long as
economies do not diverge too strongly and as long as important stability requirements are
met.
So what is the role of the Eurosystem in the context of financial fragmentation? My central
point is that the Eurosystem cannot overcome the structural causes of the market
segmentation, because these causes are beyond its control. As the Eurosystem cannot solve
the sovereign debt crisis, it cannot solve the ensuing market fragmentation, either.
I firmly belief that it is primarily the task of European governments to provide sound and
lasting solutions to the various challenges posed by the sovereign debt crisis. Three things
are particularly important in this context. First, in order to restore confidence, member states
have to set both their public finances and their banking systems in order. Second, distressed
member states have to implement the necessary structural reforms in order to become more
competitive. And third, the present framework of our monetary union has to be strengthened
and needs to be made more consistent.
The central banks in the euro area can, at best, cure the resulting fragmentation symptoms,
but only to a certain degree. However, administering "central bank medicine" in order to treat
fragmentation symptoms does not come without unintended consequences. It is more than
important that such medicine does not prevent policymakers from tackling the underlying
causes of the fragmentation.
Two very important structural reasons for fragmentation that became apparent during the
crisis are the sovereign debt crisis and the nexus between the solvency of sovereigns and
banks. This nexus is something we need to overcome. And here I see a prime role for the
banking union to which I wish to turn now.
4 Banking union and the treatment of sovereign exposures
The European banking union will be a very important step - actually the most important
European integration effort in the financial market since the introduction of our single
currency. So far, financial markets in Europe are not the only entities which are to some
extent fragmented along national borders - financial supervision is as well. This absence of a
true level playing field has certainly contributed to financial market fragmentation. The
application of uniform standards by a single European banking supervisor will foster
integration. But single supervision has to be complemented with a single resolution
mechanism. Only if a bank can be resolved in an orderly manner, without endangering
financial stability, will authorities have the ability, and the courage, to declare such a bank
non-viable. We still have too many banks in Europe lacking a viable business model but not
exiting the market. A credible resolution framework can reduce supervisory forbearance as
well as market turbulence and thus reduces the likelihood of a government bail-out. This will
be essential in breaking the link between the balance sheets of banks and public finances.
But even a sound banking union will not be sufficient to reach our goal of making the
financial system more stable. Apart from supervision and resolution, we have to look at bank
regulation. The current regulatory framework, too, promotes this nexus between bank and
sovereigns because it encourages banks to invest in sovereign debt. This reinforces the
"doom loop" between the sovereign sector and the banking system. Should doubts about the
sustainability of government debt arise, the national banking sector will also be negatively
affected. This is particularly relevant in the European Monetary Union as European banks
often only invest in the sovereign bonds of their home countries.
The current regulatory framework is biased towards sovereign debt in several ways.
Generally, bank exposures to a single counterparty are limited to a quarter of a bank's
eligible capital. But this does not apply to exposures to sovereigns, which are exempt from
such rules. Furthermore, sovereign exposures are also privileged by low or zero capital
requirements, as they are seen as more or less risk-free. Reassessing the regulatory
treatment of financial institutions' sovereign exposures is crucial. More effective financial
market regulation is necessary to ensure that a "doom loop" between sovereigns and banks
cannot emerge.
But let me come back to fragmentation. We do not only observe natural differences and
fragmentation in financial markets, but also in the real economy. And I would claim that we
should not interpret this generally as a malfunction there either.
5 Fragmentation also exists in the Real Economy
Germany has been criticized for its relatively high current account surpluses. The current
account balance in Germany is, however, not the result of distinct government policies or
even central economic planning. It is, first and foremost, the result of market-driven
processes reflecting the investment and saving decisions of millions of market participants.
And they simply reflect structural causes. For countries like Germany, a current account
surplus helps to absorb future burdens induced by its demographic development. In this
sense, current account surpluses are not an economic harm but an economic asset.
Neither fellow European Monetary Union countries nor the European Monetary Union as a
whole would be better off if Germany were to be weakened artificially. Especially, since the
relatively strong balance sheets of German households, businesses, and of the public sector
provide a certain degree of stability not only for Germany, but for the euro area as a whole.
We have to accept the structural differences between economies.
This brings me back to the main points of my speech. First, that diagnosing fragmentation
requires normative judgement. Second, fragmentation often reflects structural differences
and is not bad per se. Third, that the banking union will be an important step towards more
integrated financial markets. And last but not least, differences or fragmentation in the real
economy may be justified as well.
Since a speaker should exhaust the topic, not the audience, I will close my introductory
remarks here.
Thank you for your attention today, and I wish you a productive and rewarding discussion.