Lucas Papademos: Integration and development of financial markets - a key to
faster sustainable growth in Europe
Speech by Mr Lucas Papademos, Vice President of the European Central Bank, at the annual
meeting of the Institut International d'Etudes Bancaires, Athens, 20 October 2006.
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I. Introduction
This impressive gathering of the Presidents and Chairpersons of Europe's top banks brings to mind a
statement made by a famous economist: "People of the same trade seldom meet together even for
merriment and diversion, but on those occasions when they meet the conversation ends in a
conspiracy against the public or some contrivance to raise prices". It was Adam Smith who expressed
this view in the 18th century. If he could have seen this gathering of top bankers from across Europe,
would he have expressed such an opinion, which would also be a cause of alarm for a central banker
because of the potential "contrivance to raise prices"? I very much doubt it. I am in no position to judge
the degree of "merriment and diversion" you have experienced during this annual meeting of the
Institut International d'Etudes Bancaires - the 111th meeting since the Institute's establishment. I am
sure, however, that today's sessions must have provided very useful opportunities to exchange views
on current banking matters and major economic policy issues. It is a privilege for me to be here with
you tonight and I would like to thank you for inviting me to be the speaker at this gala dinner. At the
same time, I am aware that it is a challenging task to stand between an audience and the first course
of the meal. However, this is not necessarily an unfamiliar position for a central banker to find himself
in. After all, it is said that it is the very job of the central banker to take the punchbowl away just when
the party starts to get going.
The nature of your meeting and the current favourable prospects for a sustained recovery in Europe
suggested to me four issues on which I would like to share some thoughts with you:
First, how can financial markets - and the banking system in particular - promote faster and
sustained economic growth in Europe?
Second, and more specifically, how can increased integration, competition and development
in Europe's financial markets foster innovation and productivity growth, which are crucial for
enhancing Europe's growth performance?
Third, how far have we advanced in reaping the benefits of a more integrated and developed
financial system? And, what can we do to speed up this process?
And, finally, can the current supervisory arrangements in Europe function effectively and
efficiently in a rapidly changing financial environment and help to promote integration and
efficiency while safeguarding financial stability?
Let me give you the general message of my remarks first: we have good news to report in answering
these questions and we, the European Central Bank in particular, are committed to making further
progress in the areas of our responsibility.
II. The contribution of financial markets to growth - what do we know?
While the outlook for growth in the euro area in the coming quarters appears to be very positive
indeed, we cannot deny that the growth performance of the continental European economies over the
past decade has been rather disappointing - especially if we compare this to the impressive growth
rates recorded in the United States over that period. A plethora of analyses of the causes of Europe's
less-than-satisfactory performance has been presented, and I am sure that in your discussions on the
various features of European social models - the theme of this year's annual session - you certainly
touched upon many of the explanations put forward in this regard: inadequate labour utilisation;
insufficient competition in product and services markets; excessive bureaucracy and administrative
burdens; tax and benefit systems that create the wrong incentives; insufficient investment in
education, research and development, etc. I think we can all agree on the diagnosis - the supply side
of our economies is less than optimal. Thankfully, we also have a shared understanding of what the
remedies should be. The necessary measures and policies are laid down in the so-called Kok report
and the revised and refocused Lisbon strategy of the EU: structural reforms in labour, product and
services markets to improve flexibility; removal of obstacles to cross-border competition and the
completion of a genuine Single Market in the EU; policies to improve education and training and to
boost (both public and private sector) research and development; measures to improve the business
climate. Last, and by no means least, we should tackle the obstacles to competition and innovation in
our "trade" and the area of our responsibility - the financial sector - and we should promote financial
integration and development. It is this last point - financial integration and development as a key to
faster sustainable growth - that I will explore next.
As you know, the fundamental function of financial markets and intermediaries is to channel funds
from economic agents who have a surplus of savings to those who have a deficit. If financial markets
are functioning efficiently and are supervised effectively, they contribute to an optimal allocation of
resources, reduce the cost of capital, and allow for risk-sharing and risk-diversification. But are
markets sufficiently efficient and effectively regulated in Europe? Do they perform their tasks as
optimally as they should? These questions can be addressed from various perspectives: allow me to
concentrate on two angles, that of financial integration and that of financial development.
Intuitively, it seems obvious that segmented markets - with higher transaction costs and reduced
possibilities for risk-sharing and optimal resource allocation - are not efficient and hence are hindering
growth. Financial integration could thus be conducive to growth. What I mean by financial integration is
the establishment of a fully integrated market, in which all potential market participants with the same
relevant characteristics face a single set of rules, have equal market access and are treated equally
when they are active in the market.
Moreover, the process of financial development can also further improve the performance of already
well-integrated markets and thus enhance growth. What I call financial development is the process of
introducing financial innovations and organisational improvements in the financial system that reduce
asymmetric information, increase the completeness of markets and the contracting possibilities of
agents, reduce transaction costs and increase competition. Both financial integration and development
are therefore crucial in contributing to the efficiency and stability of the financial system.
This is the theory. But what do we make of this? What are the practical consequences and policy
implications of the theoretical perspective? Leonid Brezhnev - a man not usually remembered for
scholarly discourse - is said to have stated that "there is nothing more practical than a good theory".
Well, this is definitely not good enough for me. We should try to assess the facts and take the
necessary action to improve the situation if this is warranted. Can we measure the degree of
integration and the state of development of financial markets in Europe? Can we estimate
quantitatively the effects of further integration and enhanced financial development on economic
growth? The answers to these questions are important in order to know where we stand, to assess the
expected benefits of further progress and to implement the appropriate policies to achieve our
objectives.
At the European Central Bank we are making a systematic effort to measure and assess the extent of
financial integration and the degree of development of Europe's financial markets and to estimate the
impact of the associated processes on the economy. To this end, we have developed a set of
indicators of financial integration and we are also monitoring and evaluating the process of financial
development in Europe on the basis of another wide-ranging set of indicators measuring the degree
and process of development of financial markets. Let me briefly report on some of the results and
findings of this work.
Overall, the good news is that we now have some solid evidence to prove the theoretical propositions I
previously mentioned and their quantitative implications. For example, there is strong empirical
support, based on the analysis of data for many countries and many sectors, that the size and depth
of capital markets has a significant positive impact on economic growth - the larger, more liquid and
also more integrated, the better. Financial development is good for productivity growth and capital
accumulation, and financial liberalisation generates sizeable growth benefits.
Why is this the case? There are several reasons. But a central explanation is that well-developed and
efficient financial markets are better at channelling capital from sectors in decline to those with growth
opportunities, in a process of Schumpeterian "creative destruction" that ultimately drives economic
growth. It is particularly beneficial for firms with good investment prospects, which depend more on
external finance, especially for small and medium-sized enterprises and start-up companies. The
practical implication of this empirical analysis is that it demonstrates - quantitatively - that productivity
improvements and economic growth will be fostered by a more integrated and efficient European
financial system, in which private capital is more easily channelled into financing innovations and in
which risk-taking and venture capital markets are better developed.
An equally strong message can be conveyed about the beneficial effects of financial integration on
growth from the American experience. It has been estimated that the removal of restrictions on
branching and cross-state ownership for US banks contributed to an increase in real per capita growth
by between 0.6% and 1.2%, mainly as a result of enhanced productivity. Moreover, the "quality of
banking" improved. For instance, the share of non-performing loans and write-offs declined by 0.3% to
0.6% after the removal of these restrictions. Deregulation, which allowed for financial integration
across states, also fostered bank consolidation, thus allowing banks to realise economies of scale and
specialisation benefits. The result was not only lower borrowing rates for firms and households, but
also positive spillover effects in other markets, enhancing competition and fostering entrepreneurship.
Finally, and quite interestingly for us central bankers, banking deregulation and the increased financial
integration it entailed played a significant role in reducing output volatility in the United States and in
improving risk-sharing.1
Of course, these findings cannot be applied exactly to Europe. Moreover, deregulation and the
removal of legal barriers is a necessary, but not a sufficient, condition for more integration, as there
remain other obstacles, not least those of a prudential or tax nature. Nevertheless, the general and
practical message of the evidence available is clear: if we further pursue financial integration in
Europe, we can realistically expect significant tangible benefits in terms of higher productivity and
economic growth.
III. Improving the functioning of the European financial system
The good news, the second piece of good news, is that this message is better and more widely
understood. The creation of a true single financial market in Europe is a clear priority. And the euro, of
course, plays its part. If the original justification for the single currency was neatly encapsulated in the
title of the European Commission's Report "One Market, One Money"2 that set out the potential
benefits and costs of an economic and monetary union, we should now aim, more specifically, to fully
complete the process and achieve the twin objectives.
Are we there yet? Again, let me mention a few hard facts. The ECB's research and its monitoring of
financial integration portrays a somewhat mixed integration picture. Recently, a few weeks ago to be
precise, we published our second report on financial integration indicators3 and a study on interest
rates across the euro area countries4. One of the findings, perhaps unsurprisingly, is that there is a
close link between the degree of market integration and the available underlying market infrastructure.
The euro money market is essentially fully integrated, thanks to the integration of large-value payment
systems. By contrast, retail banking continues to be fragmented for various reasons, but an important
one is that there are too many retail payment infrastructures. This is one reason why the ECB is
strongly supporting the establishment of the Single Euro Payments Area (SEPA) as quickly as
possible. The completion of SEPA will not only have direct benefits for the consumer, but will also
further promote integration in retail banking. More generally, the further and faster integration of
clearing and settlement systems in Europe is an essential motive behind the ECB's initiative to offer in
the future securities settlement services in central bank money in euro - the so-called
TARGET2Securities system. Yesterday, the ECB's Governing Council decided to further investigate the
feasibility of this project, and to take a final decision in February next year. Afterwards, we intend to
launch a broad public consultation of all interested parties.
Another sign of incomplete integration is that bank interest rates still vary considerably across
countries. I should stress, though, that such differences are also partly the consequence of various
other factors, such as product characteristics and business practices. Some press commentators
concluded from the ECB's report that these high cross-country differences reflected insufficient
competition. This is only part of the explanation. Market fragmentation also affects the financial
system's efficiency. Again, a comparison between Europe and the United States is quite revealing.
Whereas the cost-to-income ratio of banks in the euro area is 64% on average, it is only 58% on the
other side of the Atlantic. This superior US performance can be explained, at least partly, by a more
integrated market and a more harmonised regulatory environment.
Many of you experience first hand the obstacles that continue to hamper financial integration and
cross-border banking in Europe. Some of these obstacles are related to legal and fiscal differences,
while others may relate to the regulatory and supervisory framework. The latter are of particular
interest to us considering that a task of the ECB, which is enshrined in the Treaty, is to contribute to
the smooth conduct of policies by national authorities in the field of supervision and financial stability.
Financial regulation and prudential supervision have a significant role to play in the financial system: to
address market failures and safeguard financial stability. However, it is also true that in an evolving
and integrating financial system, banking regulation and supervision need to evolve in order to keep
up with developments.
This, of course, begs the question whether the European regulatory and supervisory framework has
kept pace with the development and integration of European financial markets. There are two aspects
to this question: first, whether the current framework may be an obstacle to further financial
integration. Bankers often see the decentralised institutional set-up in Europe as a major hurdle to
efficient cross-border operations. Much has already been done to alleviate the concerns, though
perhaps not to the extent some of you would have wished. The second issue is whether the current
institutional framework is able to effectively maintain financial stability in a context of increased
financial integration. Allow me to touch upon both issues.
Since March last year, the Lamfalussy framework for financial regulation and supervision has been
formally extended to the banking sector. I see this extended Lamfalussy framework as a major step to
achieve the objective of consistent supervisory action across the EU and, in this way, to further
promote financial integration. In its young existence, the Committee of European Banking Supervisors
(CEBS) has already delivered an impressive amount of work in this area. Rightfully, the Committee
has focused extensively on defining common approaches in the supervisory tools and practices
(mainly relating to the implementation of the Basel II Framework) as well as on the cooperation
between home and host supervisors. Both aspects are clearly of great interest to banks with
crossborder presence. Looking ahead, what I see as the main challenge is the consistent implementation of
the agreed standards and guidelines by the national supervisors. In this respect, I consider the recent
decision of CEBS to establish operational networks (or colleges of supervisors) for specific
crossborder groups and to create a coordination mechanism among them to be two important steps in the
right direction.
But there is more. Work is underway which aims at the development of a common supervisory culture;
the adoption of a non-binding mediation mechanism among supervisors; the possible use of the
crossborder delegation of supervisory tasks and responsibilities; and a further streamlining of banks'
reporting requirements.
The ECB very much supports both the work of the CEBS and the concrete measures I have just
mentioned in order to achieve the necessary convergence in supervisory practices. The aim is to
exploit the opportunities offered by the existing institutional framework to the maximum possible
extent.
Is this enough? I am aware that for some of you the present arrangements and initiatives do not go far
enough, and a number of much more far-reaching proposals have been put forward, such as
extending the coordinating role of the consolidating supervisor, the establishment of a lead supervisor
or the move towards a federal system for supervision. But, in my view, it is essential that the existing
framework should be given sufficient time to show that it can indeed deliver on its promises. By the
end of next year, we will have the findings of the review that is currently underway of the processes
and procedures. It would seem reasonable to me to await this before embarking on another major
assessment.
Ladies and gentlemen, before I close, let me make a couple of brief remarks on the nexus between
financial integration and financial stability. You are undoubtedly aware that only a few weeks ago, we
witnessed the largest ever loss incurred by a hedge fund, 6.4 billion US dollars, suffered by the
USbased fund Amaranth Advisors. Fortunately, there was little market disruption. I mention this, because
this episode should serve as a solitary reminder that the channels through which financial innovation,
development and integration can potentially affect the financial system's resilience are manifold,
diverse, and complex. One could expect financial integration to affect financial stability in two
directions: on the one hand, there is an increased risk of contagion and a larger exposure to common
shocks; on the other hand, there are more opportunities for funding as well as for risk-sharing and
risktransfer. The net effect is difficult to gauge. In my view, it is likely to be positive for the stability of the
financial system. What is certain, however, is that, in the case of banking strains, the likelihood that
they will remain confined within domestic borders is less in comparison with the past.
Therefore, it is necessary for the supervisory framework as well as for the arrangements for financial
stability in the EU to be able to cope effectively with the management of a possible crisis of
crossborder banking groups. These issues are a central main topic of discussion at the moment in the
policy-making circles in the EU and, indeed, globally. In Europe, a lot of progress has been made in
clarifying the roles of, and the procedures to be followed by, the competent authorities (central banks,
banking supervisors and ministries of finance) in crisis situations. In addition, the degree of
preparedness of the authorities to manage a situation of stress can be enhanced through crisis
simulation exercises. However, there are other areas, such as deposit insurance schemes and the
winding-up of financial institutions, where there is room for regulatory intervention at the EU level.
Reflections on possible legislative proposals in this regard are underway.
The general conclusion from all these observations is that any future modification to the supervisory
framework should follow a holistic approach, carefully considering all the implications of any such
change for all the components of the financial safety net. The stakes are indeed high, as an efficient
and effective supervisory framework for a more integrated, competitive and developed financial
system is crucial for Europe's growth.
IV. Concluding remarks
Ladies and gentlemen, a "holistic" approach to this gala dinner should also mean combining the food
for thought, which I hope to have provided, with our attention to the more tangible nutritional elements,
that is, our dinner. Let me conclude by returning to Adam Smith and some pertinent views of his, as
assessed by Alan Greenspan: "Modern economic analysis has confirmed much of what Adam Smith
inferred from a far less impressive set of data. Today's economists generally point to three important
characteristics influencing growth: (1) the extent [...] of a country's integration with the rest of the
world, (2) the quality of a country's institutional infrastructure, and (3) the success of its policy-makers
in implementing measures necessary for stability". As I have highlighted tonight, each of these three
elements - integration, institutional infrastructure and stability (both for macroeconomic and financial)
- remain of crucial importance to Europe's economic growth and prosperity.
Thank you very much for your attention.