Lorenzo Bini Smaghi: Monetary union, regulation and supervision
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the 9th Annual European Financial Services Conference "Taking Stock of Reform:
Fragmentation or Convergence?", Brussels,10 February 2011.
* * *
I wish to thank Cécile Meys and Huw Pill for their contributions to this speech. I remain solely responsible for the
opinions contained herein.
Introduction
The title of this session is "Assessing the EU's re-regulation effort". To be clear from the
outset, we are striving not simply for re-regulation, but for better regulation. What constitutes
"better"? In my remarks this morning, I will offer a central banker's view of where we should
be heading in this domain - and of what work still needs to be done.
As recent events have shown, the financial crisis has complicated the implementation of
monetary policy, in particular by creating instability in the transmission mechanism. And,
within a monetary union, differences between member countries - either created by the
financial turmoil or exacerbated by it - have added to the uncertainty and complexity.
During the crisis, the ECB has implemented a set of non-standard measures to address such
concerns. We consider that these measures have been successful in ensuring that monetary
policy remains effective. Another important factor throughout the crisis has been the firm
anchoring of inflation expectations, which strengthened our stance against deflationary
pressures in the worst part of the crisis. Such an anchoring is the result of all the decisions,
each one of them, taken during the first decade of the euro. Overall, we believe that our
ability to maintain price stability remains unimpaired.
The post-crisis world will face two potentially conflicting challenges. The first one is to
achieve stronger financial integration as a factor of growth. In other words, we need more "E"
in EMU. Deepening financial integration is a key aspect of the economic part of EMU.
Deeper cross-border banking activities, especially at the retail level, are one way of achieving
this objective. Enhancing and harmonising the regulatory and supervisory framework across
Europe is a crucial step towards this goal. However, greater integration may imply greater
risk of contagion, as financial systems, markets and institutions become more intimately
entwined. Better regulation means achieving both a more integrated European financial
sector, with deeper markets and more diversified institutions as well as a more robust
financial system. Attaining this twofold objective would allow the benefits of integration to be
reaped, while managing the associated spillover risks.
More "E" in EMU
The financial and economic crisis over the last three years has exposed the main supervisory
and regulatory failures both at national and global levels. In Europe, it has also revealed how
financial integration has increased the likelihood, scope and pace of contagion across the
European financial sector.
The institutional framework for managing the euro area economy and financial system has
proved to be inadequate. To be more specific, the monetary part of EMU has worked well.
Price stability - the primary objective of the single monetary policy - has been maintained,
before, during and after the crisis. But the economic dimension has been insufficient. As I
just said, we need more "E" in EMU, with a view to creating an economic area that is more
closely, deeply and irreversibly integrated.
The origins of the recent economic crisis lay largely in the financial sector. A more resilient
financial sector is key to building a euro area framework that will be more robust and
effective in facing future shocks. Deepening and broadening financial integration in Europe is
an essential - although neglected - component of the economic dimension of Economic and
Monetary Union.
efficient allocation
Stronger integration will not only ensure a more of resources across the
EU, but also enhance the shock-absorbing capacity of the financial system and the economy
as a whole, thanks to increased opportunities for risk-sharing, and improved market and
funding liquidity. Research using data from the United States has demonstrated the
important role played by financial markets and capital flows in absorbing the impact of
idiosyncratic regional shocks.1 The risk-sharing across regions resulting from an integrated
financial system in the US has a far greater smoothing effect on regional consumption
patterns than that achieved via explicit fiscal transfers through the federal government's
budget. This shows that it is an integrated financial sector, rather than the federal budget,
which plays the most important role in ensuring that regional disturbances do not disrupt the
functioning of the American economy as a whole.
Research undertaken by ECB staff confirms that greater banking integration within the EU
has increased consumption risk-sharing.2 But there is clearly some way to go before the
level of integration - and thus the extent of risk-sharing - seen in the United States is
achieved.
These results have important implications for the current debate on further European
integration. There is a lot of talk about the need to move towards a more integrated fiscal
union and debt financing in the euro area, as a means to enhance stability. A more
integrated f inancial market is likely to be a more efficient way to enhance euro area
resilience.
Financial integration did advance rapidly after the introduction of the euro, particularly in
wholesale markets. But in certain segments, markets have remained fragmented along
national lines - not least retail banking. This is a politically sensitive sector, due to concerns
about consumer protection and the financing of small businesses. But when retail banking
markets are fragmented, governments are more likely to resort to "national solutions" in the
face of a financial crisis - possibly in an uncoordinated fashion. Experience shows a
piecemeal approach can be very disruptive to financial stability and monetary transmission.
For example, we have seen the externalities created by the Irish government's decision to
guarantee all Irish bank liabilities in the immediate aftermat h of Lehman's failure in 2008. We
are still dealing with the consequences of those decisions.
To ensure that the benefits of greater financial integration more than outweigh the risks -
including that of a more concentrated banking system - the EU regulatory and supervisory
framework needs to be enhanced and harmonised, taking the necessary are a-wide
perspective and thereby recognising and internalising the cross-border externalities.
One objection to a more integrated banking system in Europe is the role of national budgets
in crisis resolution. As long as budgets remain national - so goes the argument - crisis
resolution has to remain national, and so does supervision. The crisis has shown that bank
resolution and restructuring are more complicated for cross-border institutions, given that any
fiscal costs have to be distributed across several host sovereigns. As Charles Goodhart has
said, "...cross-border banks are international in life, but national in death".3
As I see it, enhanced financial integration in the euro area does not necessarily imply a need
for greater fiscal union - if that is understood as a pooling of tax revenues, harmonisation of
tax rates or issuance of a common bond. Instead, we must develop the capacity at the
specific
areawide level to address financial tensions that threaten to spill over to the area as a
whole, minimising disruptions to market integration and supporting the transmission of
monetary policy.
The recent crisis - and, in particular, developments in Ireland - have demonstrated that,
despite the imperfect integration of the European financial system, very strong cross-border
contagion takes place within the financial sector. The instruments available at presen t to
block this contagion are not efficient and have side-effects. In practice, much of the burden to
contain contagion has fallen on central banks. This is neither desirable nor appropriate.
In my view, the European authorities need to develop a capacity to conduct a "surgical strike"
on problematic financial institutions or market segments in the event of a financial crisis.
Through such actions, the area-wide externalities created by specific problems can be
contained. In practice, this means ensuring that programmes such as the European Financial
Stability Facility (EFSF) or the European Financial Stabilisation Mechanism (EFSM) - and
their envisaged permanent successors - are given sufficient financial resources and the
required flexibility by the Member States to act as necessary to support financial stability. To
do so, these bodies may also need to be able to support the recapitalisation of an ailing
banking system, if its weakness threatens the stability of the area as a whole. All this of
course comes with strict conditionality in the context of an overall EU/IMF programme.
This has been the case in both the Greek and Irish programme s, in which funds are
dedicated to the recapitalisation of the weak banks. A more systematic approach should be
pursued, making it easier for countries to implement such a scheme.
Developing an enhanced and harmonised regulatory and supervisory framework
The ECB has a keen interest in ensuring that the regulatory and supervisory structure, at
both national and EU level, provides all players with incentives to avoid excessive risk-taking
that could lead to destabilising the financial system. In addition, consistent rules and
convergent sup ervisory practices are essential to the creation of a level playing field and
avoidance of competitive distortions, which would otherwise hinder financial integration within
the euro area.
The financial crisis has prompted a significant development of the regulatory and supervisory
framework. Under the auspices of the G20, a remarkable amount of work has been done to
mend the regulatory shortcomings revealed by the crisis at global and European level. A key
element in strengthening the resilience of the financial system has been the adoption of the
new Basel III framework. Concrete efforts have also been made to reinforce the supervisory
framework, with greater emphasis placed on monitoring and assessing macro-prudential
risks. The powers and tools of micro-prudential supervisors have also been enhan ced. Other
important regulatory initiatives, notably work on systemically important financial institutions,
shadow banking, crisis management and resolution frameworks, are under way.
In Europe many initiatives have been or are being taken to strengthen the regulatory and
supervisory framework. Amendments to the Capital Requirements Directive (CRD) have
been made to correct the adverse incentives relating to securitisation and remuneration. A
further review of the CRD is under way, aligning the European regulatory framework with the
Basel III framework, which is expected to improve the resilience and stability of the banking
system by enhancing the quality and quantity of capital and introducing leverage and liquidity
requirements. Other important initiatives have also been taken or are under way to improve
and extend the scope of regulation. Examples include the regulation of hedge funds through
the adoption of the Alternative Investment Fund Managers Directive and credit rating
agencies, and the upcoming review of the Markets in Financial Instruments Directive (MiFID).
In addition to the ongoing initiatives to reinforce the regulatory framework, the supervisory
framework in Europe has also been enhanced through the establishment of the European
Systemic Risk Board (ESRB) and the three European Supervisory Authorities (ESAs). These
authorities should help to strengthen the oversight of risks. The risk warnings and
recommendations to be issued by the ESRB should become a powerful tool to identify
significant risks in the financial system. And the powers of the thr ee ESAs - notably their
mediation and coordination powers, their envisaged role in emergency situations and, in
particular, their mandate to create an EU rule book through the issuance of binding technical
standards - should further harmonise the regulatory and supervisory framework within the
EU.
Even though the framework has been substantially enhanced, challenges remain. Whether
the framework will reach its full potential depends on many factors.
First, it is important that the new authorities are empowered to act decisively and swiftly.
Rapid decision-making as well as the independence of regulatory authorities is essential to
safeguard financial stability. In this context let me mention that in the US the Financial
Stability Oversight Council and the Federal Deposit Insurance Corporation have been
granted more regulatory powers than their counterparts in the EU, although the effectiveness
of those powers will ultimately depend on the way they are applied.
Second, it is important that within our relatively complex institutional framework, the ESRB,
the three European Supervisory Authorities and the national authorities collaborate
effectively. Information-sharing is key. It has been insufficient in the past. Will it change in the
future?
Third, the creation of an EU rule book is, of itself, not enough. Only when its implementation
is harmonised can such a rule book facilitate cross-border activities, and thus contribute to a
more integrated f inancial system. The ESAs have an important role here to ensure that the
rule book is implemented in a consistent way also through their coordination of the activity in
colleges of supervisors. In addition, the ESAs, crucially, have to ensure that the EU-wide
stress tests are conducted in a uniform way. We have seen from experience that the
credibility of the results of the EU-wide stress tests depends on whether they are conducted
with sufficient rigour in all the countries. Lack of rigour in one country can undermine the
credibility of all.
All these elements of the new European supervisory framework are expected to address the
challenges related to an integrated area su ch as the EU. However, in the euro area the very
existence of the single currency amplifies the interconnectedness between countries and
financial systems and thus the potential for contagion in stress situations. The new EU
supervisory framework must therefore be capable of addressing this specificity of the euro
area through tailored coordinated actions.
Financial stability and monetary policy
Within this changing institutional landscape, close collaboration is required between central
bankers, regulators and supervisors, given the intimate connection between monetary policy
and financial stability. The European arrangements, with the close links they have
established between the ECB and the ESRB, recognise this need, while retaining distinct
mandates and maintaining a clear division of responsibility.
Recent events have amply demonstrated how financial crises influence macroeconomic
prospects, the outlook for price stability and thus the appropriate setting of the monetary
policy stance. At the same time, we have seen how monetary policy measures - of both
standard and non-standard varieties - can support the functioning and stability of f inancial
institutions and markets. After all, central banks are the ultimate providers of liquidity, and
thus have a pivotal role to play in any financial turmoil or panic.
The interactions between monetary policy and financial stability are complex. They need to
be managed carefully, avoiding any confusion of mandates and responsibilities. In particular,
we need to avoid moral hazard. Liquidity support provided to banks that face funding
difficulties cannot delay the necessary fundamental restructuring of such institutions.
Recent experience confirms my view that central banks must be closely involved in
addressing financial tensions, cooperating closely with supervisory bodies in supporting
financial stability, even while recognising the primacy of their own price stability mandate.
Concluding remarks
To sum up, deeper financial integration within Europe is critical in making the economic
dimension of Economic and Monetary Union function better. It will not only offer direct gains
in terms of allocative efficiency, but also make monetary policy transmission more effective
and robust, thereby supporting the achievement of our primary objective of price stability, as
well as wider macroeconomic stability. Greater cross-border banking activity, especially at
the retail level, has an important role to play in this regard.
These conclusions are consistent with the main message of the Lamfalussy report, p ublished
as far back as 2001.4 This report argued that progress with financial integration in the EU
should be regularly reassessed and, if necessary, initiatives taken to further deepen and
accelerate the integration process.
The recent crisis has demonstrated that the European financial system was insufficiently
robust. Further measures to deepen integration and bolster stability are required. Looking
forward, we have to identify any remaining weaknesses and seek to address them.
Until now, it has generally been argued that the main responsibility for financial supervision
has to remain at national level. The consequences of failures in supervision ultimately fall on
the taxpayers of the country where the bank resides. To align incentives and ensure
appropriate accountability, nationally defined tax bases imply nationally defined supervisory
institutions.
However, the crisis has demonstrated that the implications of supervisory failures extend well
beyond national boundaries. First, cross-border contagion has been magnified by
externalities and spillovers arising from greater area-wide financial in tegration. Second,
experience has shown that, within a more integrated market, greater specialisation may
imply that financial systems in one country outgrow the capacity of national taxpayers to
support them.
The implications of this experience are profound. As I have argued, they point to the need for
a much greater euro area and EU perspective in the supervisory and regulatory framework.
While progress has been made in this domain, much remains to be done.
Thank you for your attention.