Benoît Coeuré: Completing the single market in capital
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the ICMA Capital Market Lecture Series 2014, Paris, 19 May 2014.
* * *
Ladies and gentlemen,
Thank you very much for inviting me to speak at ICMA today.
It is good news that the euro area capital markets are now starting to show some signs of
defragmentation. The ECB's financial integration report, released last week, shows
improvements in integration of money markets, bond markets and equity markets. Indeed,
price and quantity based indicators of financial integration point out that, although still worse
than before crisis, the integration in European financial markets has significantly improved.1
Yet I think there is a risk that, as we celebrate receding fragmentation, we miss the key
question. And that is: what are we trying to achieve via de-fragmentation?
I sometimes perceive a tacit assumption that getting back to the status quo ante, where
prices on euro-denominated financial assets converge, would constitute success.
Impairments to monetary policy transmission would diminish. Access to finance for firms and
households would improve. Even the infamous bank-sovereign nexus could turn into a
strength as bond prices on banks' balance sheets rise.
Yet we must keep in mind that convergence is not the same thing as integration. We saw
substantial price convergence in the euro area in its first decade, only to be faced with a
sudden fragmentation of financial markets when the region was hit by the crisis.
Convergence is a welcome process; but it does not in itself guarantee deep and resilient
financial integration.
Indeed, convergence may even be a sign of trouble ahead. Narrowing spreads in that first
decade may have been a sign that markets were underpricing risk and that financial
imbalances were building up. In this sense, convergence was probably a leading indicator of
financial instability and hence financial de-integration.
In short, if we see the return of price convergence as "job done", we risk making no progress
at all. We may even be planting the seeds of the next crisis. The objective of
defragmentation therefore has to be more than this. We have to be aiming at genuine financial
integration. But what is this?
In the Eurosystem, we define financial integration as a situation whereby there are no
frictions that discriminate between economic agents in their access to and investment of
capital. But while this is useful as a theoretical benchmark for measuring financial integration,
it is perhaps too maximalist to form an agenda for policymakers.
I think for policy purposes it is more useful to think in terms of creating a single market in
capital. The single market in goods and services was created for, and is still primarily geared
towards the EU-28. And indeed, a single market in both, goods and services and in capital,
has benefits in its own right for an economic area even without a common currency. But in a
monetary union, as I will argue, the creation of a single market in capital is not only
beneficial, but essential. And what matters, as I will further argue, is not the intensity but the
quality (in other words, the composition) of capital market integration.
To structure my remarks, I would like to begin by thinking about the objectives we want to
achieve from such a single market, and then consider the policies that are necessary to get
there.
What is the objective of a single market in capital?
In the context of monetary union, there are two objectives of a single market in capital. The
first is to improve what economists call allocation - that is, credit is allocated efficiently and
without reference to location. The second is to improve diversification, i.e. financial markets
are integrated in such a way as to help companies and households cushion local shocks. In
this sense, it is complementary to the single market in goods and services, which also raises
allocative efficiency and may make local shocks less likely through trade integration.
There are some academics, however, who argue that the single market in goods and
services may in time make local shocks more likely by increasing regional specialisation.2 If
this is correct, completing the single market in capital becomes even more essential for the
euro area: the greater the risk of local shocks, the greater the need for shock absorption
through capital markets. In other words, the single market in capital is not a luxury, but an
essential stabilising force within monetary union. It is essential for the euro to be stable, and
for it to deliver its full effects in terms of growth and jobs.
So how do we currently fare in achieving the two objectives of the single market, allocation
and diversification?
Allocation
Looking at credit developments in the euro area, in my view we still have a way to go to
separate allocation from location. There are two ways in which I see that location still matters
for credit: via the location of borrowers and of lenders.
First, in the euro area today it is the location of borrowers, rather than their creditworthiness
per se, that matters most for access to finance, in particular for SMEs.
Credit supply in the euro area as a whole is most likely sufficient to meet aggregate credit
demand. The problem is that cross-border frictions and high levels of uncertainty prevent
credit markets from clearing. In a true single market, a creditworthy SME that could not
borrow from a domestic bank would borrow directly from a bank located in another member
state instead. Thus, the more efficient supplier would take market share at the expense of
the less efficient one. But the mismatch between credit conditions in the euro area core and
periphery shows this is not the case.
Part of the explanation is that banks' credit assessments are influenced by the health of local
sovereigns - rather than just the characteristics of the firm. But this is not the whole
explanation. Even if sovereign risk were zero across the euro area, most banks are not
structurally set up to provide cross-border lending. Direct cross-border loans to non-financial
corporations account for just 7.5% of total loans to firms. And local affiliates of foreign banks
represent on average only around 20% of national markets, and much less in larger
countries.
The upshot of this lack of contestability in national markets is that domestic banks gain
significant market power. And recent research suggests that this is negative for allocation:
where banks face limited competition in their domestic markets, and firms are more
dependent on them, financing constraints for SMEs have been higher.3 This suggests that a
more integrated retail banking market and more balanced financing mix would better support
growth in the euro area.
The second way in which location can affect allocation - the location of lenders - matters to
the extent that non-economic factors influence banks' business decisions.
One dimension to this issue is the connection between local banks and local interests. There
is intrinsic value for retail banks in being physically present in local markets as it lowers the
costs of monitoring. Yet we also know there is a risk that local banks can become engaged in
so-called "connected lending", which tends to be inefficient.4 Research suggests that in this
context retail banking integration - in the form of cross-border M&A - can improve allocative
efficiency by increasing the distance between the main shareholders and management of a
bank and the vested interests in the country where the bank operates.5
Another dimension is the connection between national banks and national interests. There
may be allocative inefficiencies that arise from trying to build up or defend "national
champions" in the context of an integrated EU financial market.6 One example of this
phenomenon during the crisis was the decision of several national authorities to merge failing
banks with other domestic banks rather than resolve them, which probably increased
concentration. Indeed, in the US the FDIC has resolved around 500 banks since 2008; the
equivalent figure for the euro area is around 50.
This underlines that reaping the allocative benefits of a single market in capital is linked not
only to having a more integrated banking system, but also having more arms' length
governance of it - that is, having European rather than national supervision and resolution.
European banks should finance the European economy. This is the essence of the European
project and it benefits us all. Renationalising savings may provide short term protection but in
the longer term it would be harmful to growth and jobs.
Diversification
Turning to diversification, we see a similarly incomplete picture as for allocation. Most studies
on risk-sharing within the euro area suggest that financial markets in the euro area do not
provide much cross-border insurance. Indeed, a recent study by Bruegel found that, during
the crisis, credit and capital markets absorbed only about 10% of the shock to GDP in net
terms.7 By contrast, in the US it has been estimated that capital and credit markets smooth
around two-thirds of a given shock.8
What might be the reason for the lack of risk diversification in the euro area? In my view, on
top of the lack of cross-border bank lending, the problem stems from the underdevelopment
3
Ryan, R., O'Toole, C. and McCann, F. (2014), "Does bank market power affect SME financing constraints",
Journal of Banking and Finance, January.
4
According to Cuñat and Garricano (2009), the Spanish cajas whose chief executives were appointed on the
basis of political standing, rather than banking experience, extended more loans to real estate developers and
fared substantially worse both before and during the crisis. See Cuñat, V. and and Garicano, L. (2009), "Did
good cajas extend bad loans? The role of governance and human capital in cajas' portfolio decisions",
October.
5
Giannetti, M., and Ongena, S. (2009), "Financial Integration and Firm Performance: Evidence from Foreign
Bank Entry in Emerging Markets." Review of Finance 13, 181-223.
6
An example of this view is Véron, N. (2013), "Banking nationalism and the European crisis", October.
7
Van Beers, M., Bijlsma, M. and Zwart, G. (2014), "Cross-country insurance mechanisms in currency unions:
an empirical assessment", Bruegel Working Paper 2014/04, March.
8
Sørensen, B. and Yosha, O. (1996), "Channels of interstate risk sharing: United States (1963-1990)", The
Quarterly Journal of Economics, November.
of two cross-border risk-sharing channels: private ownership of financial and non-financial
firms and private insurance against banking crises.
First, private ownership structures in the euro area do not offer much possibility for risk
sharing. For one, European firms tend to have a preference for debt financing over equity,9
which has so far been less suitable for absorbing losses - that is, until the adoption of the
new bail-in rules for banks. And there is a pronounced home bias in the holding of that
equity, meaning losses are not shared across borders. Only 44% of equity issued in the euro
area is held by other euro area residents. Thus, equity market integration falls well short of
what we might expect in a single market in capital.
The low level of cross-border ownership of retail banks also matters for risk-sharing. This has
an equity aspect: whereas cross-border banks, in particular those that operate via branches,
can in principle offset losses in one jurisdiction with gains made in other jurisdictions, national
banks are exposed to concentrated risks. And it has a funding aspect: cross-border banks
are less likely to be exposed to "sudden stops" as intragroup funding acts as a
shockabsorber. This is, for example, one explanation why banks in the Baltics, where foreign
ownership was high, did not see as high capital outflows as banks in the euro area
periphery.10
The second channel for potential risk-sharing - private insurance against banking crises -
was virtually non-existent in the euro area when the financial crisis struck. Although
bankfinanced resolution funds existed, they were not uniformly funded ex ante, and there was no
mechanism for cross-border lending between authorities. Thus, losses that exceeded
national funds ended up on sovereign balance sheets, which equated to a sizeable
percentage of GDP.11 For the euro area as a whole the total commitment to bank rescue
packages amounted to 26% of 2008 GDP.
Insofar as these fiscal outlays raised government borrowing costs and threatened market
access, the effect of insufficient insurance against banking crises was also to over-burden
fiscal policy when it was the most needed to support growth, thus making the euro area even
more unstable at a national level. This experience contrasts unfavourably with that in the US,
where private insurance against banking crises was organised federally and proved quite
cost effective. The FDIC restructured bank assets amounting to almost 1.9 trillion dollars
from 2007-13 and recorded losses of just 33 billion dollars (which will ultimately be recouped
from the US banking sector).
This again underscores the importance of European rather than national governance
arrangements in a European banking market.
How can we achieve a single market in capital?
This discussion reveals that there is still some way to go to build a genuine single market in
capital in Europe, both in terms of allocation and diversification. This is not about reverting to
the pre-crisis situation: this is about rebuilding the system as it should have been to avoid the
crisis. It also reveals that having such a single market would be extremely beneficial for the
euro area, if not indispensable. And the conclusions that emerge in terms of policy are
relatively clear: there is a need for greater governance integration in the euro area, greater
retail banking integration, and greater capital market integration.
So how are we progressing in implementing this agenda?
Governance integration
Governance integration is clearly the area where the most rapid progress has been made, at
least in the banking sector. We now have the first two elements of a genuine Banking Union:
the Single Supervisory Mechanism (SSM) and Single Resolution Mechanism (SRM), with the
Single Resolution Fund (SRF). A Single Deposit Guarantee Scheme should come one day,
but it may be less urgent now that financial sector reform and bail-in rules have made insured
deposits safer. These developments have been much discussed so I will not dwell on them
much today.
The SSM and SRM (at least after 8 years, when the SRF is fully mutualised) will be
indifferent to geographical factors in their supervision and resolution strategies. Banking
Union can also be expected to improve risk-sharing, in particular via the new resolution
framework, which offers two new channels for private insurance.
First, the new bail-in regime shifts the costs of bank failure where it ought to be shifted, that
is, onto private shareholders and creditors. Whereas bail-out is concentrated in the home
government,12 bail-in can spread losses across jurisdictions, to the extent that bank equity
and debt is partially held abroad. Hence the importance of a strict and uniform enforcement
of bail-in rules, compliant with the Bank Resolution and Recovery Directive (BRRD). Second,
the resolution fund allows resolution costs to be shared across the euro area banking sector,
as the fund is financed ex ante and ex post by contributions from the whole sector.
In the transition period while the resolution fund is being built up, however, it is important that
we have in place an enhanced borrowing capacity. The credibility of the FDIC in times of
systemic stress in part depends on the fact that it can immediately access a credit line of
$100 billion from the US Treasury, which can be expanded to $500 billion under federal law.
Let me insist that a backstop is not a transfer system between taxpayers: any outlays are
recovered by additional levies on the banking sector in the future. Thus, it is still private
insurance; the only transfer is an intertemporal one among banks.
Retail banking integration
Governance integration in turn provides a more permissive environment for retail banking
integration, although we have yet to see much progress here.
As until the crisis banks integrated mainly through wholesale markets, it is unlikely that they
will gravitate straight from this to direct cross-border retail lending. More probable is an
intermediate phase where cross-border M&A expands - indeed, this is what we saw in the
US after the Riegle-Neal Act on interstate banking in 1994. As I said, physical presence
matters for banks in local markets, especially given cultural differences in the euro area, and
this is also beneficial from a risk-sharing perspective as banks have equity in the game.
M&A activity has been weak in the euro area since the crisis - from 2008 to 2012 the overall
value of deals decreased fourfold to just €10 billion, with cross-border deals the most
affected. The SSM nonetheless increases the potential to reap economies of scale within the
single market, for instance by allowing banks to optimise their internal management of capital
and liquidity. The mere presence of the SSM could induce restructuring as banks seek to
reduce margins in anticipation of increased euro area competition. This will be compounded
with the competitive pressure created by the expansion of e-banking.
That said, policy should acknowledge the trade-off between the benefits of retail banking
integration and the systemic dangers of size.
On the one hand, there are benefits to size: banks need a certain capacity to be able to
diversify idiosyncratic risks by lending to a broad enough range of firms. This is why the three
biggest originators in each euro area country represent on average 80% of the outstanding
amount of the SME loans. On the other hand, we have to beware concentration - that is,
simply replacing large national banks with larger European banks may end increasing banks'
market power. It may also contradict the new regulation aiming at reducing systemic risk, in
particular the leverage ratio.
I am confident that the new framework can steer us towards the right balance. Banking Union
and the regulation against "too big to fail" should encourage banks to reach optimal size
relative to the European market - that is, large enough to operate across borders and
diversify risks but small enough to be resolved with the resources of the Single Resolution
Fund. Regulatory initiatives on banking sector structural reform should support this process
by distancing deposit-taking and trading activities, thus making large and complex banks
easier to resolve.
At the same time, supervisors have new tools to help ensure that size does not equate to
systemic risk, such as the "systemic risk buffer". The leverage ratio will also be an important
safeguard. And supervisors should be aided in this task by greater market discipline. As
bailin removes the implicit state guarantee for bank debt, we can expect shareholders and
creditor to exert more scrutiny over the sustainability of bank business models.
Capital market integration
While Europe is and will remain a bank-financed economy, I see achieving a greater role for
capital markets as central to a more efficient and financing mix. This brings me to the issue
of capital market integration.
It is likely that the ongoing deleveraging of the banking sector will provide an impetus for
capital market development in Europe. And indeed, we are already seeing capital markets
complementing banks in the euro area: as bank credit to corporates has fallen, it has been
approximately matched by issuance of corporate bonds.
Capital market access, however, is not evenly distributed in the euro area. There are two
ways in which the playing field is not level. First, corporate bond issuance is strongly
concentrated in non-distressed countries, where there has been no decrease in the net flow
of bank loans.13 And while in principle firms from distressed countries can issue in those
markets, in practice it is legally complicated, due to issues of governing law. While the
original buyer and seller may agree on governing law, it becomes more complex for investors
within a chain of financial intermediaries to understand which legal regime applies.
This points to a key missing piece in the single market in capital which is a harmonised
framework for cross-border securities trading. The Commission has made good progress
here in recent years, in particular in harmonising the rules needed for the transparency and
integrity of securities markets - notably market abuse.
We are also seeing progress in dismantling operational and technical barriers to integration,
that is, payment and cross-border securities settlement. TARGET2-Securities (T2S) will go
live in June 2015 and will be the common securities settlement platform of 24 Central
Securities Depositories (CSDs), both inside and outside the euro area, for settlement in
central bank money.
But despite these encouraging signs, the integration of European corporate bond and
equities markets is still hindered by lack of harmonisation in key areas. One area is laws
relating to rights in securities,14 which prevents investors for being able to assess the
investment risk in another jurisdiction on the same basis. A key step forward here would be a
Securities Law Directive, and the Commission is working on this issue.
Another area is differences in insolvency law across jurisdictions. While full harmonisation of
insolvency law in the EU is not realistic for the near-term, it makes it all the more necessary
to initiate the process leading to it. An intermediate step could be to develop an equivalent of
the BRRD to cover systemically important non-bank financial institutions. Moreover, the ECB
is in favour of adopting a comprehensive regime for the resolution of CSDs.
Still another area where more harmonisation would be helpful is corporate governance. For
example, withholding tax and relief collection procedures for intermediated securities held by
non-resident investors remain diverse and fragmented, although the Commission has issued
a recommendation to simplify procedures in these areas. Further tax regime integration at
the EU level is therefore a key part of further capital market integration.
The second way in which the playing field is not level for capital market access is between
smaller and larger firms. Even with a more integrated European capital market, most SMEs
do not disclose enough financial information to directly tap capital markets. Thus, relationship
lending through banks will continue to play a key role in SME financing. Capital markets can
nonetheless play a role, if in a more complementary way, in helping small firms to secure
access to finance at various stages of their lifecycle. There are two channels here.
The first channel is for younger firms and relates to deepening venture capital markets in
Europe. Venture capital investment in Europe is consistently much lower than in the US and
rates of returns are worse.15 This is in part a vicious circle reflecting the fact that the industry
is fragmented across Europe: similar to bank lending to SMEs, successful venture capital
depends on a large deal flow to cover the majority of investments that will fail. As most net
new job creation comes from young firms, and young firms tend to be more sensitive to
changes in investment opportunities,16 this is missing part of the single market in capital that
has substantial economic ramifications.
The second channel is for more established firms and relates to reviving high-quality
securitisation markets in Europe. A deeper asset-backed securities (ABS) market would help
SMEs to diversify their funding sources by tapping the funds of non-bank investors.
Moreover, to the extent that ABS allows banks to partially remove SME credit risk from their
balance sheets, smaller, less diversified originators should be better placed to enter the
market. In this way, ABS could mean that SME lending is less dependent on a handful of
large banks in each country, which would increase the contestability of domestic markets.
The ECB is working with the Bank of England on the causes and roadblocks of the impaired
securitisation market and will propose ways to deal with them.17
Conclusion
Let me conclude.
The main point I have tried to illustrate today is that de-fragmentation must have an aim, and
that aim goes deeper than price convergence. True financial integration implies a single
market in capital, where there is efficient allocation and effective diversification. It implies
sizeable cross-border holdings of debt and equity; a European market for banking M&A; and
direct cross-border exposures from banks in one jurisdiction to firms and households in
another. And as we are still some way from reaching this goal, current favourable market
developments are no reason to slow down the reform agenda.
I am convinced that laying the foundations of true financial integration will require concerted
action and new pieces of legislation extending far beyond the domains today covered by
Banking Union. I trust that the remarkable job accomplished under the leadership of Michel
Barnier will be taken forward by the new Commission and Parliament.
But this is not all. Ultimately, the sustainability of financial integration depends on fiscal and
economic integration as well. Remember that one cause of resource misallocation before the
crisis was closed product and services markets that generated excessive rents and distorted
prices signals. Remember that the collapse of cross-border lending during the crisis was
aggravated by diverging fiscal positions of sovereigns. Hence, a single market in capital
requires not just a banking union, but a fiscal union and economic union as well. We should
not lose sight of these linkages.
Thank you for your attention.