Jean-Claude Trichet: European financial integration
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at Danmarks
Nationalbank, Copenhagen, 3 October 2005.
* * *
1. Introduction
Dear Bodil, Ladies and Gentlemen,
When Danmarks Nationalbank invited me to speak today, I had no hesitation in accepting its
invitation, although my feelings towards the occasion being marked are somewhat
ambivalent. When our host, Ms Bodil Nyboe Andersen, leaves her post as Governor of
Danmarks Nationalbank at the end of this month the European System of Central Banks
(ESCB) and the ECB will lose a highly esteemed member of its General Council. As much as
we regret saying farewell to you, dear Bodil, we are also looking forward to an equally fruitful
cooperation with your successor, Mr Nils Bernstein.
Dear Bodil, during our many years of collaboration, I, like so many others, have come to
admire your manifold achievements. Let me name but one: the skill with which you have
managed the Danish exchange rate regime. During your tenure, the credibility of this policy
has gone from being very high to being exceptionally high. This is illustrated by the fact that
during the past year the exchange rate of the Danish kroner to the euro has fluctuated by
less than 0.5%.
This is a remarkable success on the part of Danmarks Nationalbank, but it is also your
personal success. The exchange rate policy is undisputed in your country, not least because
the central bank and its Governor enjoy such a high degree of credibility. This also means
that, in an economic sense, Denmark is closely linked to the euro area economy and is thus
also in a position to participate to a large extent in financial integration. This brings me to the
topic of my speech today.
Today, I would like to speak about European financial integration. In so doing, I will address
two main questions:
1. Why is the Eurosystem so deeply interested in European financial integration? and
2. What can the Eurosystem do to contribute to fostering European financial
integration?
Let me mention here also that I use the term "European" financial integration in a broad
sense. Of course, as the President of the ECB, my primary area of responsibility lies with the
euro area. However, there are numerous links between the euro area and the remainder of
the European Union.
2. The Eurosystem's interest in European financial integration
There are several reasons for the Eurosystem's interest in European financial integration.
The basic, institutional reasoning is that under Article 105 of the Treaty the ECB and the
entire Eurosystem "shall without prejudice to the objective of price stability, [...] support the
general economic policies in the Community".
As we know, financial integration is an important component of the general economic policy
of the European Union. While I will explain in a moment that financial integration is indeed
conducive to the smooth implementation of the single monetary policy within the euro area,
let me reiterate that, as the Treaty states and as the ECB has demonstrated since its
inception, monetary stability is the primary objective of the Eurosystem.
Of course, financial integration is not an end in itself but it has various economic benefits.
Financial systems - composed of financial institutions, markets and the financial
infrastructure - serve a number of basic purposes, such as trading, hedging, diversifying and
pooling risk, as well as allocating resources and mobilising savings. These functions
determine the economic benefits that can be derived from financial integration. Two widely
accepted economic benefits of financial integration are better sharing and diversification of
risk and the potential for higher economic growth. Let me explain this in more detail.
First, the better diversification and sharing of risk brought about by financial integration helps
to fulfil the conditions for the optimality of a currency area. In recent years, an interesting
development with regard to the theory of optimal currency areas has been the idea that the
optimality of a currency area is not necessarily something that needs to be fully reached
before monetary union but can be helped achieving by monetary union itself. The
introduction of the euro clearly fostered financial integration. Economic agents from a given
region can, by more easily investing in other regions of the area, diversify the risk of potential
shocks. Steps towards increased financial integration reduce the risk of local factors
impacting on the income and consumption of a given region within the area, thereby helping
to fulfil the conditions for an optimal currency area.
Second, financial integration is a key factor in the development of the financial system,
which, in turn, increases the potential for greater and more sustainable non-inflationary
economic growth. It is generally accepted that financial integration fosters financial
development and, ultimately, economic growth. Financial integration allows economies of
scale and increases the supply of funds for investment opportunities. The integration process
fosters competition and the expansion of intermediation and markets, thereby leading to
further financial development. Financial development, in turn, leads to lower intermediation
costs, a more efficient allocation of capital and, thus, a potential for higher economic growth.
You will probably share the view that the growth performance of the euro area cannot be
deemed fully satisfactory. From 1999 to 2004, real GDP in the euro area grew by an average
of 1.9% per annum. Looking back over the last ten years, the average annual growth rate in
the 12 countries that today form the euro area has been 2.1%. But it is equally true to say
that the single monetary policy, geared torwards price stability and the anchoring of inflation
expectations, lends ongoing support to economic activity. Across the maturity spectrum,
interest rates in the euro area are low by historical standards. Thus, if you will allow me to
look at a third time span, it is worth noting that we are in fact delivering today a nominal yield
curve at historically low levels, as low as ever observed in Europe since the beginning of the
20th century!1
Allow me now to look briefly at the "real" side of the economy.
Long-term potential growth in the euro area is estimated to be between 2% and 2.5%,
probably much closer to 2% than to 2.5%, given demographic trends and prevailing market
structures, and assuming that economic policies remain unchanged.
As regards structural reforms, the European Commission recently presented the "Community
Lisbon Programme", which contains a list of measures at the EU level for relaunching the
Lisbon strategy. The programme focuses on enhancing knowledge and innovation in order to
strengthen growth, on making Europe a more attractive place to invest and work, and on
creating more and better jobs. The Community Lisbon Programme will be complemented by
the introduction of national action plans for growth and jobs, which the Member States will
present this autumn.
That such economic reforms can indeed be implemented in a successful way has been
demonstrated by the Nordic European countries.
Structural reforms are urgently needed for labour, goods and services markets in Europe.
Labour markets need to become more flexible in order to support the creation of new jobs.
Structures in goods and services markets still present considerable barriers to competition,
hindering the process of Schumpeterian "creative destruction" and preventing possible
productivity gains.
And while not confined to the "real" side of the economy, one such structural reform along
the lines of the Lisbon strategy is the process of European financial integration. To give a
concrete figure (despite all caveats that apply to the model underlying the simulations), let
me mention that a recent study estimates that financial integration of the European bond and
equity markets would result in additional growth of around 1% over a ten-year period.2 It is
worth noting that 1% of EU GDP amounts to around EUR 100 billion!
But in addition to the general economic benefits of financial integration that I have
mentioned, fostering financial integration is of particular importance for the ECB's tasks.
First, integrated and efficient financial markets enhance the smooth and effective
transmission of monetary policy impulses throughout the euro area. The higher the degree of
financial integration, the more effectively this transmission will work in practice.
In this context, I should also mention another basic task of the Eurosystem under the Treaty,
namely the promotion of the effective operation of payment systems, as well as the
Eurosystem's interest in the smooth running of securities settlement systems. Payment and
settlement systems are the main channels through which liquidity flows, and only if the whole
infrastructure is adequately integrated can the system function smoothly. The integration of
these financial infrastructures is therefore very relevant for the smooth implementation of
monetary policy.
Furthermore, the integration of the financial system is highly relevant to the ECB's task of
safeguarding financial stability. On the one hand, deeper financial integration can increase
the capacity to absorb economic shocks. It can also offer more possibilities for financial
institutions to better manage and diversify their relevant risks and realise economies of scale,
leading to greater efficiency of the financial system. On the other hand, particular attention
has to be given to the profound changes of nature of the financial stability challenges due to
the structural transformation of the financial system, including intensified cross-border links.
Let me mention here that among the ECB's various contributions to the discussions on
financial stability, we have, since December 2004, provided the public with our biannual
Financial Stability Review, which is the outcome of our euro area-wide financial stability
monitoring activities, conducted with the support of the Banking Supervision Committee.
Danmarks Nationalbank also introduced, in 2002, an annual financial stability report for
Denmark, and this, dear Bodil, is another of the many achievements of your term as
Governor of Danmarks Nationalbank.
So let me conclude my response to the first of the two main questions which I wish to
address today. I have explained the institutional and economic reasoning underlying our
interest in European financial integration, i.e. the "Why?". In fact, all of these reasons have
found expression in the Eurosystem's mission statement formulated by the Governing
Council of the ECB, the relevant part of which reads as follows:
"The Eurosystem, which comprises the European Central Bank and the national central
banks of the Member States whose currency is the euro, is the monetary authority of the
euro area. We in the Eurosystem have as our primary objective the maintenance of price
stability for the common good. Acting also as a leading financial authority, we aim to
safeguard financial stability and promote European financial integration."3
The mission statement of the Eurosystem brings me neatly on to the second question which I
would like to address today, namely the "What?" - i.e. what kind of contribution can the
Eurosystem make to fostering European financial integration?
3. The Eurosystem's contribution to the fostering of European financial
integration
We generally distinguish four types of activity.
First, we contribute to financial integration by providing central banking services that also
foster European financial integration.
Second, we can act as a catalyst for private-sector activities by facilitating collective action
and assisting with possible coordination problems.
Third, we give advice on shaping the legislative and regulatory framework for the financial
system.
And fourth, we try to enhance knowledge and raise awareness of the state of and need for
European financial integration, and we measure the progress made torwards its
achievement.
I will examine all these four kinds of activity. I will start with the one I mentioned last, i.e.
enhancing knowledge and raising awareness of European financial integration, and
measuring the progress made torwards its achievement. In this respect, I will take the
opportunity to present a number of facts about the state of integration of the euro area
financial markets.
3.1 Measuring the progress of European financial integration
Only last Friday the ECB published, for the first time, a series of indicators regarding the
state of integration of euro area financial and banking markets, together with an explanatory
report entitled "Indicators of financial integration in the euro area". This publication, aimed at
measuring and monitoring financial integration in the euro area on the basis of quantitative
indicators, is a new initiative by the ECB and is in line with our understanding of our mandate
to contribute to the process of European financial integration. The indicators will be regularly
updated and published on the ECB's website.
The publication provides an overall assessment of the degree of financial integration in the
broad spectrum of segments of the euro area financial markets, ranging from retail loans to
wholesale equity trading. Let me now present our findings in more detail.
Our 20 indicators cover the money market, the government bond market, the corporate bond
market, the equity market and banking markets.
While the euro has undoubtedly acted as a catalyst for financial integration in general, it is
true that the degree of integration differs from market segment to market segment, with
integration being more advanced in those market segments that are closer to the single
monetary policy.
Money market
The money market is broadly defined as the market for interbank short-term debt or deposits
and consists of various segments. Our report suggests three indicators for measuring
financial integration, based on the dispersion of lending rates - namely overnight rates,
unsecured lending rates, and repo rates - offered by banks among euro area countries, with
the data referring to actual transactions or offered rates by EONIA, EURIBOR and EUREPO
panel banks.
These indicators point to a high overall degree of integration. The unsecured interbank
market has, since shortly after the introduction of the euro, been integrated to a quasi-perfect
extent, shown by the respective indicators that display a euro area cross-country standard
deviation of only around one basis point and below. While some lower degree of liquidity of
the repo market, in particular in the longer-term segment, should be borne in mind, the
indicator for this market also suggests a high degree of integration. In this respect, the
indicators reveal that the euro area cross-country standard deviation of 1-month repo rates is
today at around 0.5 basis points, while the one for the 12-month maturity stands at around
1.5 basis points.
Government bond market
As we know, the integration of euro area government bond markets had already been
progressing before the start of Monetary Union, in particular from the mid-1990s in the run up
to Monetary Union. Given comparable relevant characteristics, measures of integration in
government bond markets, of which we suggest five indicators, are based on yield
differentials with respect to a benchmark bond for different maturities, namely ten, five and
two year maturities. A simple measure is, for example, the standard deviation of yield
spreads over time: the lower the dispersion, the higher the degree of integration. The
available indicators show that, with the introduction of the euro and the removal of the
exchange rate risk, government bond yields have converged in all countries, with the
standard deviation in yield spreads being less than 0.1 percentage point for all three
maturities.
The indicators therefore show that the euro area government bond market has reached a
high degree of integration, increasingly driven by common news. Local factors, however, will
continue to have an impact. Among those are differences in liquidity, in the availability of
derivatives markets, and of course of perceived credit risks. The impact of these factors
should, from our own standpoint, not be seen as indicating a lack of integration since we
consider it important that the markets assess the quality of the signatures concerned.
Corporate bond market
The euro area corporate bond market has grown considerably in recent years. But let me
mention the fact that, despite this exceptional growth, the gap between the euro area and the
United States is still large. For example, the outstanding volume of bonds issued by
nonfinancial corporations is now around EUR 2.4 trillion in the United States, as compared with
around EUR 900 billion in the euro area.
The yield differential between corporate bonds can be explained by a number of factors,
such as the credit rating, time-to-maturity, liquidity and cash flow structure. Under full
integration, the respective impact of such factors should be totally independent of the country
of issuance. Using such a set of specific factors, it is possible to obtain measures of
corporate bond market integration by investigating whether or not risk-adjusted yield spreads
have a systematic country component. In an integrated market, the proportion of the total
yield spread variance attributable to country effects should be close to zero.
We published three (model-based) indicators of the state of integration of the corporate bond
market. The indicators show that the euro area corporate bond market is fairly well
integrated, in the sense that the country of issuance is only of very minor importance in
explaining yield differentials.
Equity market
It is very important for monetary policy-makers to understand the dynamics of equity market
integration. As equity markets grow in size, wealth effects on consumption become
increasingly relevant, resulting in a tighter link between stock market fluctuations and
fluctuations in real economic variables.
Overall, we published three (model-based) indicators of the degree of integration of the euro
area equity market. These measures for the euro area equity market indicate that the degree
of integration is rising, although room for further integration remains.
One means of measuring the degree of integration in euro area equity markets is to look at
the relative importance of sector versus country-based investment strategies. Generally
speaking, the more integrated the euro area equity market, the greater the benefits of
spreading investments across sectors as opposed to country-based equity investment
strategies. By comparing the cross-sector dispersion with the cross-country dispersion of
equity returns, it is possible to derive indicators of financial integration.
One finding is that, since the end of 2000, the advantages of sector diversification seem - for
the first time in the last 30 years - to have surpassed those of a geographical diversification
among euro area countries. Still, diversifying across sectors and countries at the same time
might result in portfolios with a lower risk than those constructed on a country or sector basis
only. Thus, the importance of the country effect is still too great for it to be concluded that the
euro area equity market is satisfactorily integrated.
Furthermore, equity returns in the euro area countries are increasingly determined by
common factors. Based on a factor model, our finding is that the average sensitivity to
common shocks has increased significantly over the last 30 years, in particular as regards
euro area-wide return shocks. This can also be interpreted as an indication of increased
integration of euro area equity markets.
Banking markets
The assessment of integration in banking is conceptually complex. While banks are a
welldefined type of firm, banking is a multi-product industry, in which various banking products
can be exchanged in different markets of different size and geographical coverage and with
different counterparts. One generally distinguishes between interbank (or wholesale)
activities, capital market-related activities and retail banking.
In our report, we started with a set of six indicators related to banking markets. We found that
retail banking markets in particular are generally far less integrated, while the euro area
interbank (or wholesale) market and capital market-related activities show solid signs of
increasing integration.
Indeed, cross-border inter-bank loans and cross-border holdings of securities have, in
relative terms, experienced substantial growth. For example, although domestic loans
granted between monetary financial institutions (MFIs) still account for more than 50% of the
total of EU MFI loans, the respective euro area cross-border activity has increased from
around 15% at the end of 1997 to around 23% at the current time. Capital market-related
activities have been even more impressive. While securities issued by non-MFIs of another
euro area country accounted for around 15% of the securities held by euro area MFIs at the
end of 1997, this share has now reached almost 40%.
By contrast, integration in retail banking has not progressed to any great extent. This is
suggested by both price and quantity-based indicators. Integration in the retail banking
markets can be measured by the cross-country dispersion (standard deviation) of interest
rates on consumer credit, lending for house purchase and deposits with an agreed maturity,
with a high degree of cross-country dispersion indicating a low degree of integration. Our
finding was that the degree of dispersion remains relatively high. This picture of a
comparatively low degree of integration is also borne out by the level of banks' cross-border
retail lending activity within the euro area, which, while increasing slightly from around 2% at
the end of 1997 to around 3.5% today, remains low.
Let me now make a few brief comments on an important retail market, namely the European
mortgage market. The importance of this retail market segment is evident from its size alone:
an outstanding volume of more than EUR 4 trillion in residential mortgage debt in the EU,
corresponding to around 40% of EU GDP.
Very clearly, there are costs incurred through incomplete integration, such as the costs for
households arising from differences in prices and products, and for issuers and investors as
a result of unrealised economies of scale and higher funding costs.
Indeed, the secondary market for mortgage funding is still quite fragmented within the EU.
Overall, retail funding via deposits still accounts for the largest part of the funding of
mortgage loans. However, securitisation is becoming more and more important as the
markets for covered bonds (i.e. on-balance sheet securitisation) and mortgage-backed
securities (i.e. off-balance sheet securitisation) are growing. For example, euro-denominated
bonds covered by mortgage loans amount to around
EUR 0.4 trillion by now, as, over the last few years, we have seen issuance of covered bonds
begin to increase in several European countries.
Such capital market funding instruments could indeed also facilitate the integration of
mortgage markets, as mortgage loans could more easily be granted cross-border, without
first requiring costly access to a local deposit base for their funding. Accordingly, we are
witnessing numerous initiatives by the private sector to achieve some progress in the
integration of these important market segments.
The situation of the European mortgage market, and that of retail financial services in
general, has also been brought to our attention by the European Commission.
First, in December 2004, the report of the European Commission's Forum Group on
Mortgage Credit was published, in which a number of recommendations for tackling barriers
to the further integration of EU mortgage credit markets were made. Second, the European
Commission's Green Paper on the priorities of the financial services policy over the next five
years, which was open for public consultation until 1 August, identified retail financial
services as one of the areas in which financial integration is clearly lagging behind. And third,
in July, the European Commission issued a Green Paper on "Mortgage Credit in the EU" for
public consultation by end November.
Connected to this Green Paper consultation, the European Commission asked a research
institute to prepare a study on the estimated costs and benefits of the integration of EU
mortgage markets, to assess the degree to which EU mortgage markets are integrated and
to identify the obstacles to their further integration. The study, which was published in August
of this year, concludes, with all caveats that apply to the model underlying the estimation,
that full integration of EU mortgage markets would raise EU GDP by 0.7% and EU private
consumption by 0.5% in 2015, i.e. ten years from now.4 This would thus constitute a further
step in the direction of raising the EU's growth potential which I referred to earlier.
Having dealt with how the Eurosystem can foster European financial integration by
enhancing knowledge and raising awareness of the state of and the need for fostering
European financial integration and by measuring the progress made, let me now turn to the
other three kinds of activity mentioned earlier: providing central banking services that are
also conducive to fostering financial integration, acting as a catalyst for private-sector
activities and advising on the legislative and regulatory framework for the financial system. I
will begin with the latter.
3.2 Advising on the legislative and regulatory framework for the financial system
As we see it, the basic task of public authorities with regard to the process of financial
integration is to create a framework whereby, generally speaking, all potential market
participants in a given financial instruments or services market, are subject to a single set of
rules when they decide to deal with those financial instruments or services, have equal
access to this set of financial instruments or services and are treated equally when they
operate in the market.
The Eurosystem is fully committed to this principle of integrating financial markets and the
financial system as whole, both in the euro area and the European Union. We are committed
to it both because it is required by European law and because we think it is good for the
economy of the euro area and the European Union, and for the best possible functioning of
the level playing field in this sector. In line with this commitment, we also advise on the
legislative and regulatory framework for the financial system. Let me give you a few
examples.
Very recently, at the start of August, the Eurosystem provided an opinion in response to the
European Commission's consultation on the priorities for financial services policies over the
next five years.5 As detailed in our opinion, the Eurosystem supports the key policy
orientation of the Green Paper, in particular the proposal for "better regulation" based on
open, transparent and evidence-based policy-making, and the need to focus on the
consolidation and consistent implementation of the legislative framework for financial
services. To this end, we are of the view that the potential of the Lamfalussy framework
should be exploited as far as possible. In this respect, let me also recall the position
expressed earlier this year by the Eurosystem in relation to the review of the so-called
Lamfalussy process.6
With regard to the supervisory framework, the Eurosystem fully supports the Commission's
view that the current institutional set-up should be exploited to the maximum extent before
any potential structural change is considered. In particular, the Eurosystem agrees that the
main policy objective in the area of financial supervision is twofold: first, to enhance the
competitiveness of EU financial markets and institutions and to facilitate the development of
cross-border finance both in terms of institutions and in terms of products and services; and
second, to ensure the effectiveness of standards for oversight and supervision in a more
integrated financial system.
In addition to giving advice, the Eurosystem also provides standards and conditions for its
own operations, or by issuing its own regulations - for example in the field of promoting and
ensuring efficient and sound clearing and payment systems. In the field of promoting the
integration, efficiency, and security of the European securities infrastructure, let me mention
the "Standards for Securities Clearing and Settlement in the European Union" developed by
the ESCB in cooperation with the Committee of European Securities Regulators (CESR).
The field of securities clearing and settlement is an area in which further integration is
needed to exploit in full the benefits arising from a pan-European securities market. As a
directive can complement the market-led removal of the "Giovannini barriers", which is a
necessary condition for competition, cost savings and improved efficiency to come fully into
effect, the Eurosystem also supports the Commission's intention to put forward a proposal for
a Directive on securities clearing and settlement.
I should now like to move on to the third kind of activity, namely the provision of central
banking services that are also conducive to fostering financial integration
3.3 Providing central banking services conducive to European financial
integration
I have just mentioned the area of securities settlement systems. From a central bank
perspective, securities settlement systems play a crucial role in the Eurosystem's collateral
framework as they provide the infrastructure that allows counterparties to transfer collateral
to the Eurosystem. In the current framework, counterparties can transfer cross-border
collateral to the Eurosystem via two main channels: via links between securities settlement
systems (SSSs) and via the correspondent central banking model (CCBM). I would like to
say a few words on the CCBM.
The CCBM was created as an interim model that would cease to operate as soon as the
market had developed comprehensive and reliable alternatives. That said, it is still the main
instrument for mobilising cross-border collateral, with a share of over 80% at the end of 2004.
Despite considerable improvements in the efficiency of CCBM processing procedures,
market participants have on various occasions expressed the view that the CCBM is not yet
able to meet all of banks' needs. Taking note of these trends in collateral business practices,
the Eurosystem has invited market participants to rethink current arrangements by focusing
on possible future alternative cross-border collateral facilities.
Another obvious example in the area of providing central banking services is our payment
system, TARGET, which has clearly fostered European financial integration. TARGET was
operational from the first day of Monetary Union as a platform for balancing liquidity surplus
and deficits. TARGET today represents around 90% of the total traffic in large-value
payments in euro and is one of the two largest wholesale payment systems in the world,
alongside Fedwire in the United States. And TARGET2 will further improve financial
integration, as it will enable the provision of a harmonised level of services across Europe,
supported by a single price structure for domestic and cross-border payments and new
functionalities to enable banks to better integrate their euro liquidity management. Our next
TARGET2 progress report, to be issued in November 2005, will provide further information
on our work.
3.4 Acting as a catalyst for private sector activities
I now turn to the fourth way in which we contribute to the process of European financial
integration. In areas such as standard-setting and the establishment of common
infrastructures, cooperation between private agents of the financial sector is as necessary as
competition. However, cooperation often fails to materialise without the aid of a catalyst. In
most countries, the central bank plays the crucial role of catalyst, thanks to its acknowledged
competence and objectivity and the numerous contacts with market participants which ensue
from its basic tasks. With regard to financial integration in the euro area, the Eurosystem can
assume such a catalyst function in several areas. Let me mention two examples.
Having touched, some moments ago, on the wholesale payment system, let