Willem F Duisenberg: The future of banking supervision
and the integration of financial markets
Speech by Dr Willem F Duisenberg, President of the European Central Bank, at the conference
organised by Euro Group entitled "Improving integration of financial markets in Europe", held in
Turin, on 22 May 2000.
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I should like to thank the organisers for the opportunity to participate in this interesting event. We are
here to discuss the important and profound changes taking place in the banking industry and financial
markets worldwide. In Europe, these changes have been significantly intensified by the introduction of
the euro. I wish to offer my remarks today on the issue of preserving financial stability for the euro
area in this rapidly changing environment.
Ensuring effective banking supervision and crisis prevention plays a key role in this respect, and is
facing challenges from two major sources: the internationalisation of financial activities and the
geographical split between the jurisdiction of monetary policy and banking supervision. The monetary
policy function now embraces the 11 countries that have adopted the euro, while supervision remains a
national responsibility. This situation introduced by the Maastricht Treaty is a novelty; it does not have
historical precedents.
It is the view of the ECB that the existing institutional arrangements can provide an adequate and
flexible basis for safeguarding financial stability - also in the future. However, the practical
functioning of supervision needs to be developed and cooperation between competent authorities
needs to be enhanced in order to ensure the effective execution of supervision and corrective action in
the increasingly integrated euro area financial system. Moreover, authorities should be able to take an
area-wide - or even a global - view whenever the situation so requires. The desirability of these
enhancements is also acknowledged in the recent report on financial stability prepared by the
Economic and Financial Committee and endorsed by the ECOFIN Council at its meeting on
8 April 2000.
Let me proceed by describing in more detail the two challenges for supervision that I just mentioned.
After that, I should like to evaluate the necessary steps for promoting adequate cooperation and
coordination among the authorities concerned.
Increasing cross-border banking
There is no doubt that the introduction of the euro has fostered the internationalisation of banking
activities. In particular, the rapid integration of the wholesale and capital markets, as well as
large-value payment systems, has already produced more and new kinds of linkages among banks. As
a result, banks are increasingly exposed to risks originating from abroad, and risks to financial stability
are less and less confined to national borders.
The most substantial increase in cross-border activity and market integration has taken place in
wholesale activities. For example, the currency-based segmentation of the markets for unsecured
interbank deposits disappeared very quickly after the euro was introduced. The differences in
quotation spreads across countries fell during the first weeks of 1999 to an average of around two
basis points from significantly higher levels. These spreads are deemed to indicate normal thresholds,
beyond which arbitrage is no longer profitable. Wider price differentials still prevail in the repo
market, reflecting lower liquidity and remaining segmentation of the national markets owing to legal
and other factors.
Market integration has not only been reflected in price quotations, but also in trading volumes. The
share of cross-border transactions currently accounts for more than 50% of overall activity in both the
unsecured and repo markets. Some large institutions are starting to act as "money centre" banks
assuming an area-wide scope of activity. The smaller institutions still mainly operate with their
domestic counterparts, but nonetheless benefit from the equalised market conditions. Accordingly, the
share of cross-border transactions in the large-value payment transfers through the TARGET system
has been increasing - from 36% in the first quarter of 1999 to 41% in the fourth quarter. The values
exchanged cross-border are of substantial magnitude. The average daily value of TARGET
cross-border payments is close to 400 billion euro, representing mostly interbank payments. In
addition, a large amount of payments is channelled through EURO 1 (EBA) and Euro Access
Frankfurt.
In addition to the single monetary policy and the creation of the single risk-free yield curve, two main
reasons explain the rapid integration of the wholesale activities in the euro area - of the market for
unsecured interbank deposits in particular. First, the smooth functioning of the settlement of
cross-border payments, mainly performed through the TARGET system, allows banks to trade safely
throughout the euro area. Second, the swift acceptance of euro area indices (EONIA and Euribor)
forms a common basis for pricing. The experience with TARGET demonstrates the importance of the
market infrastructure in allowing arbitrage to operate effectively. The unsecured market can rely
entirely on TARGET for settlement, while no similar integrated system exists for the clearing and
settlement of securities and for managing collateral at the cross-border level, relevant for repo
transactions and for all securities transactions in general. For instance, there are currently 22 securities
settlement systems in the euro area, facing increasing demands for consolidation.
The broadening of the market size and increasing share of cross-border transactions has had a positive
impact on financial stability. If there were only a few market participants and the concentration of the
interbank liabilities were high, the likelihood of a bank failure having stronger repercussions on the
viability of other institutions would be greater. In addition, the wider euro area money markets can
now absorb liquidity shortages more easily than before, as banks can borrow more readily from
foreign institutions. However, if some banks should nonetheless enter into a distressed situation, the
probability of the problem spilling over to other euro area countries is significantly greater than before.
The wholesale market is a major channel of the transmission of potential financial instabilities.
Moreover, the existence of a common framework for accessing central bank liquidity is tying together
euro area financial institutions to a much larger extent than usually recognised.
Let me now turn from wholesale activities to banks' customer businesses. As European banks are
typically universal banks, they combine at a single institution a wide range of products. The markets
for these products have varying degrees of integration - some are already global or European, while
others have remained national or even local. At least the major banks already operate in strongly
internationalised markets for a number of their products and already have geographically diversified
activities. This makes them subject to various influences originating from outside their national
markets. Even if banks remain nationally based, they are increasingly subject to international market
developments and the national tendencies are increasingly influenced by international developments.
Hence, the usual argument that cross-border mergers and acquisitions are a necessary condition in
order to achieve a more integrated and international banking system does not seem very strong.
In particular, many of the asset management and investment banking services are already quite
internationalised, as the capital markets have taken strong steps towards integration and growth after
the introduction of the euro. Banks' own securities holdings have also become increasingly diversified
across borders. The trend has been quite strong for government paper, as well as for corporate bonds.
The amount of instruments issued by other euro area governments rose by 38% in 1999, and those by
firms located in other euro area countries by 23% in banks' portfolios.
To take an example of the financial services provided by banks in the capital market area, the leading
underwriters of bonds issued by European firms are the major European banks, alongside the largest
US investment banks. The "league" in which these players compete is clearly not a domestic one.
Another example - which is especially telling of integration - can be drawn from the rapidly expanding
new European markets for technology and growth companies. Underwriting the Initial Public
Offerings (IPOs) of this type of firm is the kind of service where we should expect the greatest degree
of national segmentation, since the companies are usually accessing the capital market for the first
time - possibly as captive customers of local banks. However, the new listings during the first months
of the present year show that in most cases a foreign institution was present alongside a domestic one.
There are significant economies of scale associated with the shift in the dimension of the capital
markets from national to euro area-wide. This seems to have already been one significant motive
behind the recent bank mergers and acquisitions, also in the case of the deals that have taken place
within national borders. Although most mergers have been domestic, cross-border deals also increased
in importance in 1999.
By contrast with the services provided to other financial institutions and large corporations, retail
activities referring to personal customers and small and medium-sized firms are still quite strongly
confined to national borders. Within the euro area, both lending and deposit-taking by banks are
largely conducted with domestic residents - 91% of loans and 87% of deposits still refer to domestic
counterparties. Nevertheless, internationalisation is also progressing in this area; the business with
customers located in other euro area countries is growing faster than the domestic business in respect
of all major balance sheet items of banks.
Separation of central banking and supervision in EMU
I should like to discuss next the relation between central banking and supervision in the new
institutional framework defined by the Treaty. As I mentioned, the third stage of Economic and
Monetary Union introduced a geographical separation of monetary policy and banking supervision - in
addition to the possible functional separation of the two functions that already existed in some
countries. This is the case because, for the euro area as a whole, banking supervision is now entrusted
to institutions that have no independent monetary policy functions (even if they are central banks) and
the Eurosystem has neither direct responsibility for supervising banks nor for banking system stability.
The main risk entailed in this institutional setting is the potential absence of an area-wide perspective
of the banking and financial sector for the euro area.
The national central banks continue to be strongly involved in the supervisory tasks: only in three euro
area countries - Belgium, Luxembourg and Finland - is the national central bank not directly involved
in banking supervision. In all other eight countries, they are extensively or even exclusively entrusted
with banking supervisory tasks.
Let me be a little more specific about the role and interests of the Eurosystem. One could say that the
Eurosystem plays the role normally reserved for the central bank in countries where it does not have
direct responsibility for supervision - such as the Bank of England after the creation of the Financial
Services Authority. In this context, central banks still maintain a vital interest in a stable banking
industry and closely monitor its developments and major systemic risks. This stems from the fact that
the banking industry is the key channel for the transmission of monetary policy, the counterpart of
monetary policy operations, and the main provider of payment services, which all relate to the basic
central banking tasks.
Therefore, the Eurosystem is keen to see its actions complemented by an effective conduct of the
supervisory function by the competent supervisory authorities. Central banks are keen to be sure that
supervision is conducted in such a way as to ensure that banking problems do not jeopardise the
conduct of monetary policy. This interest is clearly recognised by the Treaty, which assigns to the
Eurosystem and the ECB some tasks relating to prudential supervision and financial stability. The
Eurosystem has the duty to "contribute to the smooth conduct of policies pursued by competent
authorities relating to the prudential supervision of credit institutions and the stability of the financial
system". Given the separation between monetary and supervisory jurisdictions, this provision is
clearly intended to ensure a smooth interplay between the two. In addition, the ECB must be consulted
on any draft Community and national legislation in the fields of banking supervision and financial
stability, and the ECB can provide, on its own initiative, advice on the scope and implementation of
the Community legislation in these fields. Central banks are normally involved in the process of
drawing up legislation relating to, for example, regulatory standards, safety net arrangements and
supervision, since this legislation contributes crucially to the attainment of financial stability.
Moreover, in the event of a financial crisis, the possible provision of emergency liquidity assistance,
which is the responsibility of the competent national authorities, may have an effect on the common
monetary policy, which is the direct competence of the Eurosystem. To limit central bank
interventions and the associated moral hazard problems, it is necessary for crisis prevention
mechanisms to be in good shape. Also for this reason, the Eurosystem needs to be assured of effective
banking supervision and crisis prevention. In general, the crucial issue is that the risk management
systems of individual institutions guarantee their safety and soundness, and the supervisors should
assure themselves of this fact.
Enhanced cooperation needed
At the moment, banking supervision relies on national arrangements that still show a wide range of
features. Furthermore, the strategies for corrective actions in cases of bank fragility vary across
countries. Having supervision located at a national level - closest to the institutions that can give rise
to financial stability concerns - favours timely access to information and allows detailed monitoring of
banks' activities. At the same time, the principle of cooperation between the responsible authorities is
forcefully stated in the EU Single Market legislation, and several Directives establish a number of
common regulations, in order to avoid the drawbacks of a fully decentralised approach vis-à-vis an
increasingly integrated market.
Hence, we could say that cooperation is already a "second pillar" of the supervisory framework,
alongside national competence. Bilateral cooperation has been established through a nexus of
memoranda of understanding. In addition, supervisory forums for multilateral cooperation have been
set up. The Banking Supervision Committee of the European System of Central Banks is the key
present forum for this form of cooperation. It is composed of the representatives of the banking
supervisory authorities of the EU countries, either forming part of the respective NCB or separate
bodies, and the ECB. The Committee facilitates cooperation among supervisors and the exchange of
information between supervisors and the Eurosystem, and assists the Eurosystem in performing its
duties in this field. The Committee has already established its functions and developed activities in
several useful fields. It has also published a number of reports dealing with the structural changes and
systemic concerns in the EU banking system. Another forum for dealing with multilateral cooperation
is the Groupe de Contact, a group of EU banking supervisory authorities which, for many years, has
also discussed individual banking cases in a multilateral way, but at a lower organisational level than
the high-level Banking Supervision Committee.
The need for multilateral cooperation has been strengthened by the introduction of the euro. In fact, I
am convinced that the only way the supervisory function is able to cope effectively with the increasing
integration and to bridge the potential shortcomings arising from the geographical separation of
monetary policy and banking supervision, is for the competent authorities to enhance their multilateral
cooperation.
What should be achieved through multilateral cooperation? Ideally, a situation should be reached in
which the group of European supervisors works collectively as effectively as a single supervisor, when
needed. This is required when the problems involved are area-wide - because of the institutions or
markets involved - or there are concerns of systemic problems spreading across borders. Multilateral
cooperation can also enhance the quality of supervision by examining common trends in the financial
system that may not be revealed from the national perspective only.
We need to strengthen cooperation between supervisors and central banks to ensure that, if problems
at a major bank or a financial group have contagion effects in other countries, this information is
effectively distributed to the relevant authorities and - possibly - common solutions are sought. These
developments were seen as vital in the recent report on financial stability prepared by the Economic
and Financial Committee, which I have already mentioned.
I see the Banking Supervision Committee as a natural forum for the deepening of cooperation along
these lines. It allows a smooth interplay between EU authorities involved in safeguarding financial
stability and it is in a good position to address these issues, since both supervisory and monetary
authorities need to be involved in the cooperation. The Bank for International Settlements is currently
fostering the discussion of issues of common interest to supervisors and central banks from a global
perspective.
The national differences in the tools and style of supervision are not harmful, as long as there is
effective cooperation, which allows supervisors to exchange views and to select best practices. A
greater convergence of supervisory practices needs to be pursued in order to increase the effectiveness
of the instruments aimed at preventing instability in a more integrated market for banking services.
Another important tendency, which I have not addressed in my remarks, is the ever-closer linkages
and blurring differences between banking and other forms of financial activity. In some countries - but
not all - financial conglomerates have also gained important market positions. To this end, it is useful
and reassuring that the EU Commission has started work in the area of regulation of financial
conglomerates. Moreover, it has facilitated a round table discussion among the Chairs of the
Committees of the different disciplines: banking, securities market and insurance.
Finally, it is important that the ministries of finance and supervisory authorities regularly exchange
views on the adequacy and necessary adjustments of financial regulation - as they already do - in the
context of the relevant European regulatory fora, as well as in the national context. Central banks also
contribute to this area of work, as I have already indicated.
To summarise, the present institutional setting for banking supervision in the euro area can cope with
the challenges brought about by the increasingly integrated banking and financial system, as well as
the issues raised by the separation of monetary policy and supervisory functions. However,
cooperation between competent authorities needs to be further stepped up in order to ensure the
effective supervision and preservation of financial stability. Will the extensive cooperation necessary
for the system to be effective actually materialise? I am confident that it will. Both supervisors and
central bankers are well aware of the new environment in which their tasks and responsibilities now
have to be performed.