Vítor Constâncio: Risk sharing and macroprudential policy in an
ambitious capital markets union
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the Joint
conference of the European Commission and European Central Bank on European Financial
Integration and Stability, Frankfurt am Main, 25 April 2016.
* * *
Ladies and gentlemen,
An integrated and developed capital market is of key relevance to the European financial
system and the economy as a whole. In my speech today, I would like to provide a
foundation for this statement from two interlinked perspectives. First of all, well-functioning
capital markets are particularly beneficial for an area like the euro area if they lead to what
economists call "financial risk-sharing". At the same time, however, the process of financial
integration and capital market development that can enhance such risk-sharing may be
accompanied by the emergence of new financial stability risks that could undermine the
envisaged benefits. Therefore, in order to reap the benefits of a true Capital Markets Union
(CMU), we need to provide the conditions under which capital markets can flourish, whilst at
the same time making sure that regulatory and supervisory measures keep financial stability
risks in check.
In order to make progress on how this balance can be struck, I shall first review the case for
cross-country risk-sharing via capital markets, review the evidence for the euro and consider
how it can be enhanced. Next, I shall discuss the threats to financial stability that can be
associated with complementing a more bank-based financial system, like the European one,
with strengthening capital markets. Third, I shall let you know my views on which
macroprudential policy reforms should be considered.
The benefits of financial risk-sharing for the euro area
One of the main reasons why financial integration is beneficial is that integrated financial
markets help support constant consumption growth "in good and in bad states" of the world.1
Consumption smoothing between countries, also known as risk-sharing, can increase
welfare by hedging consumption against country-specific risks. In theory, in a perfectly
integrated world, full risk-sharing can be achieved where consumption in regions or countries
grows at a constant pace and is insensitive to local fluctuations in income and wealth.
Normally, high levels of risk-sharing are achieved across jurisdictions within a country, or
within a federation that represents a functioning political, economic, and monetary union. For
example, evidence suggests that three quarters of shocks to per capita gross product of
individual states in the United States are smoothed, with about 40 percent smoothed by
insurance or cross-ownership of assets, a quarter smoothed by borrowing or lending, and
one-eighth smoothed by the federal transfers and grants. In other words, the contribution of
markets is five times higher than the contribution of fiscal tools.2 Regions within federations
in Europe exhibit high levels of risk-sharing, too. For example, in pre-unification Germany,
virtually all shocks to per capita state gross product were smoothed. However, due to less
developed capital markets than in the United States, the largest portion - 50 percent - was
smoothed through the federal tax transfer and grant system, and 36 percent were smoothed
through financial markets.3
For countries in a monetary union such as the euro area, risk-sharing is particularly important
because the single monetary policy is unable to address asymmetric shocks. With disjoint
business cycles across countries, idiosyncratic shocks to EMU member states need to be
insured through robust market or fiscal mechanisms. Reducing the volatility of aggregate
consumption through various risk-sharing mechanisms can provide significant welfare gains
for countries hit by specific shocks. And, by reducing internal divergences and facilitating
macroeconomic adjustment, risk-sharing can be beneficial for the monetary union as a
whole.
At this point it is quite clear that, in the foreseeable future, a number of mechanisms that
have the potential to improve risk-sharing across countries will not progress quickly in
Europe. For example, labour mobility will likely remain below levels achieved in
commonlanguage federations such as the United States or Germany. Similarly, building a European
supra-national system of taxes and transfers to mimic the United States or the situation
within some European countries is, at present, not a realistic prospect. Finally, the rules on
fiscal deficits imposed by the Stability and Growth Pact will continue to set limits on national
governments for smoothing large shocks.
For these reasons, it is more pressing than ever to boost Europe's risk-sharing potential
through financial market mechanisms. First, cross-border holdings of productive or financial
assets can provide members of a currency union with insurance against idiosyncratic shocks.
Second, well-functioning credit markets can contribute to smoothing consumption against
relative income fluctuations, especially if most cross-border lending takes the form of direct
lending to households and firms rather than of wholesale lending and borrowing in interbank
markets.4 The conclusion is that greater progress in risk-sharing in the euro area would
require significantly more developed and integrated capital markets, as well as more banks
operating at a pan-European level.
Quantitatively, the risk-sharing benefits of integrated financial markets can be large. By far
the most important source of risk sharing are cross-regional and cross-border asset holdings,
that is, various forms of equity holdings and firm ownership claims. Financial integration in
Europe was expected to be greatly facilitated by the introduction of the common currency.
However, in the years since the introduction of the euro, progress in capital markets and
credit markets integration has been uneven. At present, the cross-border ownership of
assets in the EU is still limited, despite the fact that the single currency in the euro area
reduced some of the information barriers and transaction costs. Corporate financing through
bond and equity markets is much more limited in Europe too, with banks being the
undisputed primary source of funding for firms.
For all these reasons, the overall contribution of markets to risk-sharing has, on average,
been somewhat limited.5 Chart 1 demonstrates the contribution of various factors to
risksharing over time. It shows that after the adoption of the euro, smoothing through factor
income flows resulting from cross-border ownership of assets increased substantially, yet it
remained on average below US levels. The notable exception is a brief period in the early-to-
mid 2000s when capital markets smoothed between 30 and 40 percent of country-specific
shocks to GDP. The contribution of capital markets declined substantially during the financial
crisis and especially during the sovereign debt crisis. The contribution of credit markets has
been lower, and it became even negative during the financial crisis when the European
banking sector was particularly heavily hit. At present, almost 80 percent of the idiosyncratic
shocks to a country's economy remain unsmoothed, and changes in relative prices
contribute the most to risk-sharing.
Contributions of various channels to risk sharing in EA, 1991 - present6
To speed up the process of capital markets and credit markets integration, two initiatives
have emerged in Europe: the Banking Union and the Capital Markets Union (CMU). The
Banking Union aims at a sustainable and deep integration in banking markets, through single
supervision, joint resolution and common deposit insurance. Risk-sharing is particularly
fostered through direct cross-border bank lending, emphasising the importance of the
European Commission's recent initiative on fostering retail financial services. The CMU, in
turn, aims at mobilising capital by creating deeper and more integrated capital markets in the
EU. Ideally, the CMU should achieve the completion of the single market for capital within a
common-currency union. This completion is vital to reap the full benefits of risk-sharing
across borders and not be limited by border effects from past institutional legacies.
Overcoming these border effects is to be achieved through regulatory and non-regulatory
actions, including the harmonisation of key legislation related to financial products. While the
regulatory and non-regulatory actions will be instrumental in capturing market-provided
risksharing, deeper capital markets have a particularly high potential to smooth risks across
national borders.
Consequently, we need an ambitious CMU which requires a concrete roadmap in terms of
goals and milestones. Broad objectives such as capital market development, deepening
financial integration and achieving risk-sharing should be at par with specific proposals such
as facilitating funding for corporates in general and for SMEs in particular. Key areas such as
securitisation, insolvency regimes, securities holders' rights and tax legislation need to be
prioritised. All these are important to ensure equal treatment of users of capital markets
across Member States, the very essence of a CMU.
Financial stability implications of enhanced risk-sharing and other aspects of capital
market development
This brings me to the second part of my talk, where I would like to discuss the financial
stability implications of enhanced risk-sharing. Indeed, financial integration and the further
development of non-bank financing may also create new financial stability risks.
At a general level, greater integration can exacerbate the size and speed of cross-border
contagion. International risk-sharing and cross-border contagion can be two sides of the
same "financial integration coin".7 This explains why taking a macroprudential perspective on
the financial system is extremely important for addressing potential new sources of systemic
risk.
With respect to the banking sector, the further development of capital markets increases
9
competition and may incentivise banks to take on more risk to maintain profitability.8, To
ensure that there are no unintended financial stability risks, we need to strengthen the
European macroprudential regulatory toolkit for banks under the Capital Requirements
Directive (CRD IV)/Capital Requirements Regulation (CRR).
The European Commission's review of the CRR/CRDIV will provide an opportunity to revise
and complement the current macroprudential toolkit for banking at the European level. It
should entail, firstly, ensuring that instruments currently available are more targeted and
overlaps are eliminated; secondly, broadening the toolkit with additional instruments such as
the Net Stable Funding Ratio (NSFR), Leverage Ratio (LR), Loan-to-Value
(LTV)/Loan-toIncome (LTI) and Debt-Service-to-Income (DSTI) ratio; and thirdly, streamlining the process
for notification or information procedures both in the EU and within the SSM, by revising in
particular Art 458 CRR. This would simplify the co-ordination mechanism, ensuring that
macroprudential authorities can decide and implement the measures in an effective, efficient
and timely manner.
Moreover, the strong growth of non-bank financing creates new risks in a part of the financial
system that is much less regulated. In particular, the investment fund sector has grown
rapidly over the past few years. Between end-2009 and the first quarter of 2015, assets
managed by investment funds other than money market funds almost doubled from
€5.4 trillion to €10.5 trillion. Excluding valuation and reclassification effects, the sector has
grown by 30 percent since 2009.10
Importantly, this rapid growth comes together with increased risk-taking. Funds have shifted
their asset allocation from higher- to lower-rated debt securities, increased the average
residual maturities of debt securities' holdings and continued to expand their exposure to
emerging markets.11 In addition, the interconnectedness of the fund sector with the financial
system, the wider use of synthetic leverage, and the increasing prevalence of demandable
equity imply that the potential for a systemic impact would increase, should the investment
fund industry come under stress.
Therefore, I want to clearly state that the financial regulatory reform has to be completed and
extended through further efforts to contain risks in the shadow banking sector and to
strengthen macroprudential policies.
Developing the macroprudential framework beyond banking
Please allow me to elaborate on three important aspects of this task, namely tools to address
the excessive use of leverage by investment funds, tools to address liquidity risks, and a
framework for macroprudential margin and haircut requirements.
As regards leverage in investment funds, we need to ensure that the use of leverage remains
within acceptable limits. Highly leveraged funds can create and amplify systemic risk. When
leverage is created through derivatives' exposures or repo and securities lending
transactions, margin calls or increasing haircuts on collateral can trigger a deleveraging by
funds.12 Notably, such a "margin spiral"13 can even occur when funds are closed and
investors cannot redeem their shares at short notice. To the extent that many funds are
forced to sell assets in less liquid markets and at substantial discounts, this can reinforce
price falls in financial markets and become a risk of systemic nature.14
In order to curb the use of leverage by investment funds in the EU, it is useful to distinguish
between funds that are subject to the regulatory framework of the Undertakings for Collective
Investments in Transferable Securities (UCITS) Directive and those subject to the Alternative
Investment Fund Managers Directive (AIFMD).
In principle, all UCITS-funds have restrictions on the use of balance sheet and synthetic
leverage. In practice, however, funds applying more complex investment strategies can
calculate their use of leverage based on the Commitment Method or a Value at Risk (VaR)
approach, resulting in a less stringent limit for synthetic leverage. Therefore, it is important
that we examine the use of leverage by these UCITS-funds, and address any existing
shortcomings in the UCITS regulations.
As for the alternative investment funds that operate under the AIFMD, there are no hard
limits for the use of leverage. Importantly, national competent authorities do have the power
to impose leverage limits under the AIFMD, but no authority has exercised this power so far.
In order to put this potentially powerful macroprudential tool into practice, we need to develop
an operational framework at the EU level. In this context, let me highlight three important
issues.
First, the use of leverage within the banking system and the existing leverage ratio for banks
may not always be a useful benchmark for all types of funds. Unlike bank capital, investment
fund shares of open-ended funds can be an unstable source of funding when investors can
withdraw their equity at short notice.15
Second, an assessment of liquidity risk by funds should be part of the assessment of
leverage. Indeed, the risk of redemptions by investors on open-ended funds can be closely
related to the use of leverage.
Third, the framework should have a clear macroprudential perspective, providing authorities
with the guidance and flexibility to set limits for groups of funds, where necessary to address
a "too many to fail" risk.16 Even if investment funds are small and thus not "too big to fail",
they may be "systemic as a herd", and pose a risk to financial stability due to common
exposures to the same type of shock.17
Next to tools addressing excessive leverage, we need to develop tools targeting liquidity in
non-bank financial institutions. With regard to investment funds, "liquidity spirals" remain a
risk.18 Such spirals could be triggered if funds were to be confronted with high redemptions19
or increased margin requirements, as these could result in forced selling on markets with low
liquidity. To address such risks, guided stress tests could be developed jointly by ESMA,
ECB and ESRB, together with national competent and macroprudential authorities, and
additional intervention powers for competent authorities to deal with large scale redemptions
should be discussed. As regards the latter, the UCITS directive already provides member
states with the option to allow competent authorities to require the suspension of the
repurchase or redemption of units in the interest of the unit-holders or of the public. We
should explore whether this provision can be effectively used for macroprudential purposes.
Finally, the creation of leverage via derivatives and securities financing transactions (SFT)
and the pro-cyclical effects of margin and haircut-setting practices in these transactions
would also need to be addressed. Macroprudential authorities should be given the power to
set floors on haircuts and margins on derivatives and SFT at the transaction level.
Furthermore, they should be able to change these in a time-varying manner. The current
margin and haircut-setting practices stimulate the build-up of leverage via these transactions
in good times - when there is a tendency to under-price risk - and amplify deleveraging in
bad times. While a number of policy measures aimed at limiting the pro-cyclical effects of
margin and haircut-setting have already been adopted or are underway, none of these steps
envisage their time-varying implementation by macroprudential authorities.
This new macroprudential framework could build on the current regulatory frameworks and
policy recommendations as applicable to derivatives and SFTs at EU and global level. These
frameworks include the FSB policy recommendations for haircuts on non-centrally cleared
securities financing transactions, the BCBS-IOSCO margin requirements for non-centrally
cleared derivatives and the European Market Infrastructure Regulation (EMIR).
Standardised margin and haircut schedules exist within these frameworks, and could form
the basis for setting macroprudential margins and haircuts. For example, macroprudential
authorities could build on the standardised FSB/BCBS-IOSCO haircut and margin schedules,
which offer a transparent means of calculating initial margins as well as explicit numerical
haircut values that can be set as floors to haircut and margin calculated with internal models.
Concluding remarks
Let me conclude. Europe needs to further integrate and develop its capital markets, and
substantially so. In the absence of other cross-country risk-sharing mechanisms for the time
being, this has a lot of promise for insuring European households and firms against national
business cycle fluctuations. We need to be determined and ambitious in pursuing a Capital
Markets Union that will deliver these benefits. This means to provide the conditions under
which capital markets can flourish across the euro area and EU and at the same time, to
design a regulatory and supervisory framework under which financial stability risks are under
control. I am now looking forward to the upcoming discussion of the high-level policy panel,
that it will give us further food for thought on how to create a long-term vision for CMU, thus
striking the right balance between the two dimensions I have discussed.