José Manuel González-Páramo: Globalisation, international financial
integration and the financial crisis - the future of European and
international financial market regulation and supervision
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the Institute of International and European Affairs, Dublin,
19 February 2010.
* * *
Introduction1
I would like to thank the Institute of International and European Affairs for organising this
conference and for giving me the opportunity to speak in front of such a distinguished
audience. I am particularly glad to be able to participate in the Institute's series of speeches
dedicated to the theme of "Fixing finance". Both the prominence of the subject and the high
quality of past contributions have made this series of speeches an important source of
interesting ideas and proposals on how to render our financial systems more stable and
resilient.
Following the nature and objective of the series, I will dedicate part of my address to the
issue of the future framework for European and international financial market supervision
and, in particular, to the role of the ECB in macroprudential supervision in the European
Union, but first let me briefly discuss the relationship between international financial
integration and the financial crisis.
International financial integration and the financial crisis
Over the past decade or so, financial crises seem to have become more frequent and
perhaps more disruptive than in the past. They also seem to propagate more rapidly. This
experience has spurred intense interest among academics and policy-makers in
understanding the link between financial integration and crises, and in better assessing the
merits of financial integration in general.
The debate on the benefits of international financial integration is certainly not
uncontroversial:
•
One extreme opinion sustains that integrated financial systems improve the
allocation of productive resources, foster entrepreneurship and innovation, enhance
market discipline, and help countries to insure against macroeconomic fluctuations.
•
At the other extreme, it is argued that the free flow of capital widens the wealth gap
between rich and poor countries and exposes domestic financial systems to the risk
of instability.2
More recently, the financial crisis of 2007-08 and its aftermath have shown that increased
geographical interconnection among financial markets and the deepening of cross-market
integration, when coupled with the under-regulation of securitisation and other banking
activities as well as with significant complexity in the design of financial instruments, may
contribute to undermine market efficiency, fuel systemic risk and exacerbate the cross-border
transmission of financial shocks.
Pros and cons of financial integration
In response to the crisis, a debate in policy and academic circles on how to enhance the
resilience of the global financial system has gained momentum, while retaining the benefits
of free, integrated, and competitive financial markets. Indeed, it is important not to forget that
financial integration can potentially yield many benefits to our economies, particularly by
rendering them more stable and resilient.
Indeed, one key channel through which financial integration improves the resilience of the
global financial system is risk sharing.
Academic research has established beyond doubt that financial openness enhances both
consumption and income risk-sharing, and reduces volatility of consumption growth.3 The
same is true for banking integration, which has been shown to lead to more synchronised
business cycles (as measured by GDP, employment, and income growth) at the country
level, the evidence of which stems from both Europe and the US.4
In general, improved risk-sharing opportunities allow economic agents to smooth their
consumption and investment patterns better over time. And while this is mostly true for
developing countries, the risk-sharing provided by financial integration and increased foreign
capital flows have also benefited relatively developed countries, for which the integration of
the central and east European countries since 1989 has served as a prime example.
Besides, improved risk-sharing enhances in turn the ability of countries to specialize in their
most productive sectors, leading to increased economic efficiency.5
Furthermore, pre-crisis research had suggested that the cross-border diversification of large
banks improves the soundness of the banking system by making individual bank failures less
likely. On a related issue, we should recall that a primary role of interbank markets is to
provide banks with an efficient risk-sharing tool.
Another channel through which financial integration improves macroeconomic stability is
allocative efficiency and economic diversification. Cross-border banking, for instance, tends
to improve overall economic performance by ensuring that productive capital is channelled
towards the most efficient firms, thereby reducing the risk of crises stemming from the
mispricing of investment risk.6
Financial integration in general assists domestic financial systems in allocating resources
across industrial sectors in a way which improves the overall diversification of the economy
and lowers its volatility. As a result, an optimally diversified economy is less prone to
recessions, and so its real sector responds less to the same shock than an economy which
relies on just a few sectors.7 While not directly, this result gives some grounds to one popular
3
Bekaert, G., Harvey, C., and C. Lundblad, 2006. "Growth volatility and financial liberalization." Journal of
International Money and Finance 25, 370-403.
4
Kalemli-Ozcan, S., Papaioannou, E., and Jose-Luis Peydro, 2009. "Financial integration and business cycle
synchronization", NBER Working paper 14887; Morgan, D., Rime, B., and P. Strahan, 2004. "Bank integration
and state business cycles." Quarterly Journal of Economics 119, 1555-1585.
5
Kalemli-Ozcan, S., Sorensen, B., and O. Yosha, 2003. "Risk sharing and industrial specialization: Regional
and international evidence." American Economic Review 93, 903-918.
6
Giannetti, M., and S. Ongena, 2009. "Financial integration and firm performance: Evidence from foreign bank
entry in emerging markets." Review of Finance 13, 181-223.
7
Manganelli, S., and A. Popov, 2010. "Financial markets, diversification, and allocative efficiency: International
evidence." ECB Working paper (forthcoming).
BIS Review 19/2010
claim these days, namely that countries with excessively reliance on specific sectors
(whether the construction sector or the financial industry) may suffer more during large-scale
economic crises.
So much about the stabilising effects of financial integration. However, the recent crisis has
also sharpened our understanding of the destabilising potential of financial integration. Two
separate questions beg for an answer in this regard:
•
Does financial integration increase the likelihood of a financial crisis?
• Does integration exacerbate the impact of a financial crisis?
The crisis has added to our knowledge of the circumstances under which the answer to both
questions is "yes":
First, while financial integration is not a destabilizing force per se, stability risks may arise if
the driving forces underlying stronger international financial integration reflect global
economic
imbalances. It is reasonable to argue that the pre-crisis boom in US real estate
and securitisation markets reflected to some extent high foreign demand for safe US assets
resulting from "excess world savings" in the context of persistent global imbalances.
Consequently, foreign asset demand not only pushed down the US risk-free interest rate, but
also compressed the risk premia on risky assets. The low cost of financing fostered in turn an
increase in the level of leverage of the domestic financial sector which exacerbated systemic
risk.8 This interpretation of the events makes an important point, namely that increasing the
stability of the global financial system should not be done by pushing back financial
globalization, but by first addressing the problem of the global imbalances.
A second example of the nuances involved in assessing the destabilising potential of
financial integration is banking integration. While in principle it is associated with enhanced
efficiency, certain circumstances, such as regulatory arbitrage and lack of transparency in
transactions, can exacerbate information problems associated with cross-border banking and
lead to misaligned incentives, excessive risk-taking, and underestimating the social cost of
contagion.
It has also been observed that, while banking integration benefits efficient firms through
lower cost of external finance, very rapid integration induces firms to take on excessive
leverage, exacerbating the effect of financial crises on the corporate sector.
Finally, in the context of this crisis, cross-border banking integration has been associated
with the transmission of financial distress from banks' balance sheets to the corporate sector
of countries which were not the origins of the shock.9 However, this effect has mostly worked
through banks which relied predominantly on wholesale funding, rather than on a strong
deposit base.10
per se
And so again, we are left to ponder over a subtle point: it is not integration that is to
blame for financial instability and its impact on the real economy, but lack of transparency,
wrong incentives, sub-optimal regulation, and certain flawed banking business models - all
of which may, but certainly must not necessarily accompany financial integration.
Given this picture, it is clear that the challenge of the day is how to strengthen financial
stability without reducing long-term growth. The current academic and policy debate has
already given us some guidance as to which measures could serve this purpose best.
Among the critical issues under consideration, I would like to mention: (1) shortening
securitization chains and making them more transparent; (2) promoting greater
standardisation of the various credit risk transfer instruments; (3) moving over-the-counter
derivatives trading - in particular that of credit default swap markets - to central clearing
counterparties; (4) demanding greater transparency of the assets, liquidity and leverage of
non-bank financial intermediaries; and (5) improving frameworks for the resolution and
recapitalisation of large cross-border financial groups.
The ongoing reforms of supervisory and regulatory institutions, both at the European and
international level, are one vital step in this direction.
Policy responses to increased international financial integration
In response to the extraordinary global impact of the financial crisis, the G20 has forcefully
taken the leadership in advancing the agenda for reforming the international regulatory and
supervisory framework. In an unprecedented way, the G20 has become the global forum for
international coordination and has agreed on a broad set of measures to be followed by
national authorities and international standard setters.
In order to further advance the process, the newly established Financial Stability Board
(FSB) has been entrusted with the task of overseeing concrete regulatory steps and
monitoring the implementation of the reform agenda. The participation of the main
international fora and institutions - the International Monetary Fund (IMF), the Bank of
International Settlements (BIS) and the International Organization of Securities Commissions
(IOSCO) - in the FSB is also proving instrumental in ensuring cross-sectoral coordination.
International coordination cannot be dispensed with when dealing with the additional layers
of complexity posed by the modern integrated financial system. Indeed, the decision to
switch towards the enlarged composition of the G20 (as opposed to the G7) and the parallel
broader country representation in the FSB are themselves an acknowledgement of the forces
of globalisation and financial integration. It can be safely argued that the current framework
for decision-making at a global level explicitly recognises the fundamental role played by new
countries and markets in the global economy as well as the existence of a complex, if
somewhat fragile, web of interconnections between economies, markets and institutions.
The challenges posed by a globally integrated financial system and the ensuing need for
higher international coordination are therefore well recognised. The establishment of colleges
of supervisors for all major cross-border financial institutions is a clear instance of enhanced
co-operation among international authorities. In order to ensure international harmonisation,
the FSB is also developing a system of peer reviews among member countries. These will
comprise both single-country and thematic reviews to assess progress and convergence in
the implementation of international financial standards and of policies agreed in the FSB.
Let me now turn to the thrust of the banking reform - in itself a major overhaul of the
prudential framework - put forward by the Basel Committee of Banking Supervision (BCBS),
under the aegis of the G20. The Basel Committee has agreed on a package of measures
which aim at increasing the resilience, safety and soundness of the banking system in a way
consistent with long-term economic growth, without hampering the functioning of the market
and the pending economic recovery.
•
First and foremost, the Basel Committee proposals will significantly raise quality,
quantity, consistency and transparency of capital, to ensure permanent higher
capacity to withstand losses. A common international definition of capital and
appropriate disclosure of its components will contribute to increased transparency
and comparability.
• Second, in addition to a revised treatment of the trading book and securitisations,
capital requirements for counterparty credit risk exposures arising from derivatives,
repos and securities financing activities will be introduced, as well as parallel
incentives for the central clearing of over-the-counter derivatives.
•
Third, a non risk-based leverage ratio will supplement risk-based capital
requirements and help to curb excessive balance sheet growth.
•
Fourth, a framework of countercyclical capital buffers above the minimum
requirement coupled with more forward-looking provisioning rules will contribute to
dampen rather than amplify the financial and credit cycles: banks will adjust their
capital in such a way that capital is built up in good times and drawn upon in times of
stress.
•
Fifth, a harmonised treatment for liquidity risk will be introduced, requiring banks to
hold sufficient high-quality liquid assets to withstand episodes of financial stress.
These proposals, currently under consultation, will be the object of an extensive assessment
as regard their impact on both the banking sector and the broader economy. This
assessment should result in appropriately calibrated global standards, which will promote a
more sustainable trade-off between financial stability and balanced long-term growth.
Beyond the prudential framework, the relevant organisations are actively conducting work in
other crucial areas where co-ordination remains key, most notably: (1) the development of a
framework for macro-prudential supervision, (2) devising effective mechanisms to address
the moral hazard problem and the risks posed by "too big to fail" institutions, and (3) legal
regimes to allow an ordered resolution of complex financial institutions.
The global financial crisis requires a global response and the recent initiatives I just
mentioned are clear illustrations of this. At the same time, I believe that in Europe we have to
go much further in our response, not in the least because the European countries are much
more interlinked with each other than with the rest of the world. Economically, financially and
institutionally the setting is indeed very different, since it is most clearly epitomised by the
presence of the Single Market and the single currency.
Fortunately, policy makers in Europe quickly realised that there was an urgent need for
quick, bold and coordinated responses. I want to single out two very important initiatives in
this respect:
•
The adoption of the ECOFIN roadmap of 20 October 2009 on financial supervision,
stability and regulation.
•
The proposals for a new supervisory framework in the EU based on the
recommendations by the so-called de Larosière Group which were published in
September last year.11
The ECOFIN roadmap is an ambitious set of policy priorities adopted by the Council in the
wake of the financial crisis, with the aim of strengthening financial supervision and regulation
in the EU. The international initiatives I mentioned earlier fit well into the framework implied
by the roadmap, but, at the same time, the latter goes significantly further. For example,
regarding the issue of the colleges of supervisors that I mentioned earlier, the Committee of
European Banking Supervisors (CEBS) is additionally developing common operational
guidelines and a common risk methodology. Indeed, in a single banking market, a common
approach is a necessity to avoid inconsistencies and regulatory arbitrage.
A mandate for financial stability for central banks
A very important component of the roadmap is the revision of the EU supervisory framework
covering both the micro and macro dimensions. The extraordinary nature and consequences
of the global financial crisis have demonstrated the need for upgrading the regulatory
framework. A broad consensus has arisen in favour of a macro-prudential orientation of
supervision.
Macro-prudential oversight focuses on the financial system as a whole and involves the
monitoring, assessment and mitigation of systemic risk. Crucially, it recognises that systemic
risk is partly endogenous as it depends on the collective behaviour of financial institutions
and their inter-connectedness, as well as the interaction between financial markets and the
macro-economy. Macro-prudential policies aim to mitigate the build up of financial
imbalances and ensure that the financial system is able to withstand their unwinding and be
resilient to shocks.
In the EU, the European Systemic Risk Board (ESRB) will be in charge of macro-prudential
surveillance. Its task will be to identify and assess risks to the stability of the EU financial
system and issue risk warnings when the identified risks appear to be significant. When
appropriate, the ESRB could complement its risk warnings with policy recommendations for
remedial action.
As stressed by the de Larosière Group, central banks are especially well suited to take up
the main responsibility for macro-prudential supervision because of their expertise and
analytical capabilities in the fields of monetary and financial stability analysis, and because of
their closeness to the money and financial markets.
The tight interlinkages between the financial system and the macro-economy provide a
further rationale for entrusting the central banks with the responsibility for macro-prudential
analysis and the formulation of relevant policy recommendations. Macro-prudential policies
will help reduce the contribution to pro-cyclicality of various factors in the financial system.
Since policies will involve regulatory and supervisory action to a considerable extent, they
may take the form of general guidelines or concrete recommendations relating to the
calibration of prudential tools.
In the specific case of the EU, the ECB will provide analytical, statistical, administrative and
logistical support to the ESRB. In particular, the ECB will assist the ESRB in the development
and collection of new statistical data. The ECB will also assist the ESRB by developing and
maintaining new analytical tools and methodologies for the identification and assessment of
systemic risks and the issuance of risk warnings. This task poses significant challenges
because it requires special skills and the further development of analytical tools. Models
must be developed to help structure and analyse the vast amount of information collected for
risk assessment. As financial stability and macro-prudential analyses are at a relatively early
stage, it is advisable to employ a multiplicity of approaches.
It goes without saying that the creation of the ESRB does not change in any manner the
allocation of responsibilities among policy-makers enshrined in the Treaty, notably the
unambiguous establishment of the maintenance of price stability as the primary objective of
the ECB's monetary policy. At the same time, the assignment of specific tasks related to the
functioning of the ESRB to the ECB actually enhances its ability to fulfill the task of
contributing to the maintenance of financial stability, as foreseen by the Treaty.
Conclusions
The current financial crisis has spread across the world at an unusual speed and with
surprisingly strong consequences. The fact that the tensions originating from a relatively
small segment of the international financial market (the US market for sub-prime mortgage
loans) evolved over time into a global crisis of a magnitude unseen in decades - wreaking
havoc on a number of economies and the lives of millions - may deceive some into thinking
that worldwide financial integration has gone too far and that we would better off under
financial autarchy.
It is therefore worthwhile to recall what the benefits of financial integration are, especially in
Europe. Integrated financial markets help to realise the full economic potential by increasing
competition and expanding markets. This results in lower intermediation costs and a more
efficient allocation of capital, which in turn raises the potential for increased economic
growth.
For those European Member States which have gone even further by adopting the euro as
the single currency, there are added benefits in terms of price transparency, lower interest
rates, reduced transaction costs and the elimination of exchange rate fluctuations. These
benefits are very substantial.
At the same time, the financial crisis has been a rough reminder that, although financial
integration improves the access to financial markets and the opportunities for risk
diversification, it may also increase the scope for financial contagion across countries. It is
therefore paramount that the financial stability arrangements keep pace with the degree of
financial integration. Such arrangements should be particularly ambitious in the EU and the
euro area, which are characterised by a very high degree of financial integration. This is why
it is important that we fully and quickly implement the reforms of the European and
international supervisory and regulatory framework which are needed to enhance the
robustness of our financial systems.