Malcolm D Knight: European financial integration in the context of
current financial market turbulence
Keynote remarks by Mr Malcolm D Knight, General Manager of the Bank for International
Settlements, at the 2007 Eurofi Conference "Achieving the integration of European financial
markets in a global context", Brussels, 3 December 2007.
* * *
Let me thank you for the opportunity to address this distinguished group of executives and
policymakers. Eurofi is playing a leading role in identifying key strategic issues that need to
be addressed to advance further towards the fundamental goal of achieving comprehensive
financial integration in Europe, and of promoting a closer dialogue between market
participants and policymakers and in particular financial regulators.
In my brief remarks tonight I want first to underscore several important achievements of
financial integration in Europe thus far that are key to its further progress. Then I will outline
several features of the current international financial market turmoil that have implications for
the future progress of European financial integration. Finally, I will comment on how the
preliminary lessons from the financial disturbances we are currently witnessing may be
important in shaping the ongoing process of financial integration in coming years.
European financial integration
The achievements of European financial integration over the past two decades are truly
impressive. Prior to the advent of the euro in 1999, European authorities took deep and
successful steps to stabilise cross-country exchange rates and eliminate controls on
international capital movements within what is now the euro zone. The introduction of the
single currency less than nine years ago has led to an acceleration of financial integration by
eliminating intra-zone exchange rate risk and achieving low and stable inflation. Indeed, the
establishment of a common currency backed by a European Central Bank with a clear
monetary policy mandate and underpinned by firm fiscal rules has helped to clarify policy
responsibilities and make more transparent the structure of this huge multi-country economic
region. This has had the expected positive effect on European economies and, indeed, on
global markets. Over the past two decades, inflation in what are now the euro area countries
has come down substantially, nominal interest rates have fallen, and inflation expectations
have become well anchored at low and stable levels. As a result of these achievements, the
European Central Bank has rapidly established itself as a key and credible institution in
global financial markets.
In itself, this move towards greater macroeconomic stability has boosted European financial
integration. From the earliest years of the euro, issuance of corporate debt securities surged,
supported by the elimination of exchange rate risk within the currency zone and higher
demand from a larger pool of investors. Likewise, a deep euro area-wide interbank money
market developed rapidly. This is a key component - indeed, perhaps the key component -
of the financial infrastructure of the euro zone. Its rapid development owes much to the major
efforts of the European Central Bank in elaborating its monetary policy procedures and its
liquidity operations. To be sure, European financial integration has not proceeded at the
same pace across all sectors and markets. Integration of the retail banking markets, for
instance, has remained limited, reflecting the persistence of legal, institutional and regulatory
differences. But things are moving. Even a cursory reading of the financial press shows that
financial integration is making visible progress almost day by day.
The current financial market turmoil
But how does the current turmoil in global financial markets impact on the positive picture
that I have just sketched for you? Let me recall that this turmoil follows a prolonged period of
broadly based and aggressive risk-taking that was reflected in unusually low risk premia and
low volatility across many asset classes. Thus, prior to last summer, many careful observers
believed that the price of risk was too low - so an increase in risk premia was widely seen as
healthy from a financial stability perspective.
There was a large element of wisdom in this point of view. Nevertheless, when risk aversion
suddenly jumped last summer there were major surprises. A first surprise was that a shock in
one specific segment of the mortgage sector in the United States led to severe adverse
effects not only in that country, but also in the euro zone, the United Kingdom and Canada.
The impact in the euro zone was a surprise to many observers because increasing financial
integration had greatly strengthened the European financial system.
A second surprise was the sudden evaporation of liquidity in the major interbank markets,
which has persisted since the summer and which has transmitted the tensions in credit
markets to the very heart of the international financial system. The distortions in the interbank
money markets have occurred mainly in the United States, the euro zone and a few other
key economies, such as the United Kingdom. They are much less severe in Japan; and
major emerging market economies have weathered the global turmoil relatively well so far. In
the euro area, the spread between the market expectation of the overnight interest rate
during the next three months (the EONIA swap interest rate) and the rate at which
commercial banks can borrow from each other over the same period - the three-month Libor
rate - suddenly jumped in August and has stayed elevated since, while it is usually a few
basis points only. Indeed, this spread has been widening again since early November, to
around 75 bp today. Since the interbank credit markets are uncollateralised, this large
premium presumably reflects increased liquidity and credit risk concerns, even among the
largest banks.
Liquidity and credit risk
What are the main causes behind this unexpected upsurge in liquidity risk and credit risk? I
would stress two key factors: information failures in credit markets; and weaknesses in the
"originate-and-distribute" business model adopted in recent years by large internationally
active banks.
First, the opacity of certain parts of the global financial marketplace, particularly the markets
for structured financial products and the off-balance sheet vehicles designed to hold them
(the now famous "conduits" and SIVs), has led to a sudden collapse of confidence in asset
valuations and a generalised distrust of counterparties. As a result, market participants now
wonder about the size and character of banks' exposures - including those of large
European banks - because of the existence of explicit or implicit backup credit lines to a
wide variety of market players. Beginning last summer, this crisis of confidence triggered an
evaporation of market liquidity for the instruments concerned and a funding liquidity squeeze
for those institutions that were suspected of being vulnerable to them.
Second, weaknesses in the "originate-and-distribute" business model of the large banks,
primarily in the United States and Europe. There are some very positive aspects of this
model, since it helps to diversify banks' revenue streams and risks. But the operation of this
model in recent years has been associated with an excessive relaxation in standards of
credit origination and credit monitoring in the financial system as a whole. As a result of the
current turmoil, the originators and securitisers of complex financial instruments have
become - in many cases to their own surprise - the "holders of last resort" of the more exotic
credit products. This development has also underlined weaknesses in the risk management
practices of investors, who underpriced the risks concerned and relied excessively on
external ratings for monitoring risk. And it has demonstrated that the wider distribution of risk
across the financial system, if not supported by transparency and market discipline, makes it
difficult to gauge the risk exposures of market participants.
The combination of these two factors - inadequate public information in credit markets and
weaknesses in the way credit risk has been distributed in the market - helps to explain why
the current turbulence has primarily affected the interbank markets at the core of our modern
global financial system and why this weakness was not foreseen before last summer.
Because they were focusing on the balance sheets of the regulated banking institutions,
observers wrongly underestimated the actual degree of leverage in the financial system as a
whole - I mean all the leverage generated not only by the activities of commercial banks, but
also by highly leveraged institutions, SIVs, conduits, LBO-financed firms, etc; that is, the
leverage of all institutions that, implicitly or not, was predicated on backup credit lines being
provided by regulated institutions in times of stress.
Looking forward
I believe that the financial integration that has taken place in the euro zone since the advent
of the euro in 1999 has contributed importantly to a remarkable rise in living standards and
greater financial and economic stability. It follows that continued financial integration is
essential to further the remarkable progress of Europe. So the question is: what lessons
should we draw from the current financial turbulence that can help to make the future course
of European financial integration both stronger and more immune to financial disturbances at
its core?
I do not pretend to have an answer to this question - at least not yet. But in closing let me
offer just four thoughts that are relevant to it. First, firm euro zone monetary policy will
continue to play a key role in fostering further European financial integration. The European
Central Bank has shown great success in maintaining an appropriate monetary stance while
at the same time fine-tuning its liquidity operations in the interbank market so as to ensure
that its overnight rate remains broadly on target, and that monetary conditions continue to be
set effectively given prevailing macroeconomic conditions. And the ECB has also been a
leading central bank in taking action to address dislocations in the longer-term interbank
money markets, even though this has proven difficult to realise given that the term premium
comes from banks' own uncertainties about liquidity and counterparty risks.
My second thought is that there is clearly a need for greater transparency in financial
markets on both sides of the Atlantic. This can take many forms. One is to reduce product
complexity: I expect to see more emphasis on financial assets - including structured
products - that have simpler features to make them less illiquid in difficult market conditions.
Another is more refined rating scales for these assets, giving investors a better sense of their
risk characteristics. There are signs that this is already happening in the marketplace, as
rating agencies and market participants adjust their methodologies for assessing and rating
risk.
Third, there is a need for improvement in risk management practices - not least liquidity
management by financial firms; standards of credit origination; and monitoring of the debt
servicing performance of borrowers. Experience suggests that prior to the current turbulence
investors underestimated the tail risks to which they were exposed, including the
interdependencies between credit, market and liquidity risks. Improvements in stress testing
can play a key role here. Needless to say, such stress tests should consider the
crosscountry nature of the euro area financial system.
Finally, greater financial stability calls for closer communication and cooperation among
players in the financial system, not just within the official sector, but also between the official
and private sectors. This is especially true in the euro area given its multiplicity of
jurisdictions and layers of responsibility, which puts a premium on cooperation. Meetings like
this suggest that the lesson is well understood by all the parties involved. This can only augur
well for the future.