Lucas Papademos: Monetary stability and financial integration in Europe
Speech by Mr Lucas Papademos, Vice President of the European Central Bank, at the First Annual
Meeting of Greek and Turkish Bank Chief Executives, organised by the Institute of International
Finance, Alpha Bank and Işbank, Athens, 9 May 2005.
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Introduction
Thomas Jefferson, the third President of the United States of America, once said: "Banking
establishments are more dangerous than standing armies". If he was right, then I have certainly
ventured straight into the lion's den by accepting to speak at the first annual meeting of Greek and
Turkish Bank Chief Executives. But Jefferson's remark is clearly not relevant to this gathering. And it
is, indeed, a great pleasure for me to address the first such meeting, organised by the Institute of
International Finance, Alpha Bank and Işbank. The increasing cooperation and good, neighbourly
relations in this region can be further enhanced through this bankers' forum, which offers opportunities
to exchange views, establish contacts and foster closer ties in the economic and financial fields.
Moreover, such a forum can also contribute to a deeper understanding of the process of European
integration, which both Greece and Turkey support. A better understanding of the requirements and
implications of this evolving process is useful so that all participants can undertake appropriate action
in order to maximise the benefits expected from integration and minimise potential adjustment costs.
Being a central banker among commercial bankers, I have chosen my topic accordingly. I will address
two issues that are of fundamental importance to the banking sector and closely related to the
responsibilities and functions of a central bank: monetary stability and financial integration. More
specifically, I will first review past achievements of and future challenges for the single European
monetary policy in securing price stability in the euro area. Then, I will assess the current state of
financial integration and the outlook for the completion of the single market in financial and banking
services. In examining the latter issue, I will highlight the role of the ECB in fostering financial
integration and the importance and implications of an integrated financial sector for the conduct of the
single monetary policy and for the establishment of conditions conducive to economic growth in
Europe.
Securing monetary stability in Europe
Price stability is an essential condition for sustainable growth and entails many benefits for all sectors
of the economy. Monetary policy can effectively deliver price stability over the medium and longer
term, provided that it is supported by consistent economic policies. This is why the maintenance of
price stability in the euro area has been enshrined in the Treaty as the ECB's primary objective. With
an average euro area inflation rate of close to 2% since 1999, the ECB's record so far has been in line
with our quantitative definition of price stability. It is true that inflation has been somewhat higher than
2% for some fairly long periods of time as a result of several adverse shocks - such as repeated rises
in oil prices or indirect tax increases, to name but two. Nevertheless, the ECB has succeeded in
delivering a high degree of price stability over the medium term. In fact, by focusing on maintaining
price stability over the medium term rather than seeking to counteract unfavourable price shocks with
an overly aggressive monetary policy designed to restore price stability within a short period of time,
the ECB has avoided excessive volatility in economic activity and employment.
The ECB's commitment to its primary objective of price stability and its ability to achieve this goal over
the medium term are widely recognised by financial markets. A central bank's credibility in pursuing
policy objectives is vital to the preservation of monetary stability. The credibility of the ECB's monetary
policy has been established, and it is reflected in long-term inflation expectations, which have
remained low and stable. And this, in turn, has been a major factor in attaining the historically low level
of euro area bond yields that is giving considerable support to economic activity.
What is the outlook for price stability and what are the challenges ahead? Overall, there is no
significant evidence of underlying domestic inflationary pressures building up in the euro area. HICP
inflation, excluding its more volatile components of energy and unprocessed food, was 1.6% in March,
unchanged from February. Economic analysis suggests that domestically generated inflationary
pressures are likely to remain limited. In an environment of moderate economic growth and continuing
slack in labour markets, wages should continue to increase at a modest pace and the pricing power of
firms should be constrained.
Nevertheless, there are several upside risks to price stability, despite the presence of downside risks
to economic growth. At the present juncture, the persistently high oil prices and their potential
second-round effects on wage and price-setting pose a threat to price stability. At the end of April, oil
prices were around 30% higher than at the beginning of 2005 and around 50% higher than a year ago.
They have exerted upward pressure on inflation and are the main reason why, over the coming
months, HICP inflation is likely to remain around the level of 2.1% recorded in March and April.
Responsible behaviour on the part of social partners is essential if such second-round effects are to be
avoided. Further unanticipated increases in indirect taxes and administered prices could also have
adverse effects on price developments. Moreover, continued strong monetary and credit growth
stimulated by low interest rates in the euro area, together with the high level of excess liquidity, signal
risks to price stability over the medium to longer term, as economic activity gains momentum and
approaches its potential aggregate output level. We must therefore continue to be vigilant with regard
to the materialisation of these upside risks to price stability.
There are two other important and more general issues that I would like to address with regard to the
preservation of monetary stability. They concern the role of national fiscal policies and of the structure
and functioning of markets in determining the effectiveness of monetary policy in maintaining price
stability in the euro area and in individual Member States.
I do not have to explain to this audience that prudent fiscal policies foster growth and employment
directly, through various channels; for example, by allowing a reduction of distorting taxes and of the
inefficiencies and burdens resulting from excessive levels of government expenditure and deficits.
Sound fiscal policies are also key to the effective functioning and credibility of the macroeconomic
framework of Economic and Monetary Union. In particular, they can support monetary policy in
maintaining price stability with low interest rates. Over relatively short periods, fiscal policies that are
incompatible with a stability-oriented monetary policy may not give rise to tensions in credit markets,
depending also on the influence of other determinants of economic activity and inflation. Over the
longer term, however, persistently high budget deficits and rising debt-to-GDP ratios will come into
conflict with the ECB's monetary policy, which is committed to the objective of price stability.
Unfortunately, fiscal developments in the euro area continue to be, on average, far from satisfactory
and, in several Member States, disappointing. While some countries have succeeded in achieving and
maintaining sound budgetary positions, a significant number of others have not, including the larger
ones. The prospect of a determined return to balanced budgetary positions is rather bleak. In the
meantime, euro area governments' indebtedness as a percentage of GDP of has again increased. It is
therefore essential that the recently revised Stability and Growth Pact be implemented in a firm,
rigorous and credible manner in order to ensure a rapid return to sound budgetary positions. This will
not only facilitate the conduct of monetary policy over time, but is primarily in the interest of the
countries themselves.
The positive confidence effects of fiscal consolidation measures can be enhanced if such measures
are part of a comprehensive structural reform agenda. I cannot spell out here in detail which reform
measures would be appropriate. However, the main thrust of the necessary reforms is fairly obvious
and generally agreed upon. Besides, it has been clearly outlined in the recently revised Lisbon
agenda, which the ECB very much supports. What I would like to stress here is that the necessary
reforms for increasing the euro area's potential output growth and reducing the high rate of
unemployment will also contribute to enhancing the effectiveness of monetary policy in maintaining
price stability in the euro area and to minimising output volatility in response to adverse price shocks.
Reforms that foster productivity growth, improve the flexibility and adaptability of labour markets, and
increase competition in the markets for goods and, in particular, services, will produce multiple
benefits in terms of faster growth and lower output volatility in an environment of price stability.
Moreover, such reforms, together with prudent fiscal policies implemented at the national level, will
help bring the higher inflation rates recorded in some euro area countries down to the average for the
single currency area. The ECB's monetary policy can and will secure price stability for the euro area
as a whole. It is the responsibility of governments to ensure that the same high degree of monetary
stability is attained at the national level, so that the competitiveness of the respective economies will
not be eroded and faster growth can be sustained together with price stability.
Structural reforms are not only needed on the "real" side of the economy. Reform and integration in
financial markets are also crucial for economic welfare in Europe. Closer to home for me, they also
have direct implications for the transmission of monetary policy impulses. The degree of financial
integration is important in determining how effectively this transmission will work in practice. For
example, it cannot be ruled out that single monetary policy decisions may sometimes be channelled to
countries in a non-uniform manner on account of the fact that the financial system of the euro area -
that is, financial institutions, markets and the infrastructure - are not yet fully integrated in all aspects.
This brings me to the second part of my address: European financial integration.
The state of financial integration in Europe
First of all, what do we mean by financial integration? We at the ECB see it as an objective that is
achieved when potential market participants with the same relevant characteristics face a single set of
rules, have equal access to markets and are treated equally. If the opportunities thus created have
been exploited by market forces to a substantial degree, financial integration will have been attained.
Success in advancing towards that goal has varied across market segments. While the euro has
undoubtedly played a very important role as a catalyst for financial integration in general, it is a fact
that integration is more advanced in the market segments that are closer to the single monetary policy,
notably the money market. There we have achieved almost complete integration, thanks, inter alia, to
the establishment of the necessary pan-European payment infrastructure (the TARGET system). A
fully integrated interbank money market was, and is, a sine qua non for the implementation of the
single monetary policy, since it ensures an even distribution of central bank liquidity and a
homogeneous level of short-term interest rates across the euro area.
Integration in bond markets has also progressed significantly. Government bond yields have
converged considerably and they are now mainly driven by euro area-wide shocks and news, and only
a small fraction of yields can be explained by national risk factors. The convergence of government
bond yields has largely been due to the elimination of (intra-euro area) exchange rate risks and the
convergence of inflation expectations across countries as a result of the introduction of the euro. The
corporate bond market has witnessed exceptional growth since 1999 and is also fairly integrated, in
the sense that the country of issuance is only of marginal importance in explaining yield differentials.
From a central banking perspective, the development of an integrated corporate bond market is of
relevance, as a shift from intermediated financing to market financing implies a diminished role for the
bank-lending channel of monetary policy.
Looking at equity markets in Europe, I think an appropriate characterisation would be that their
integration is a slow and laborious process of overcoming fragmentation. That said, there are
encouraging signs of an increasing degree of integration, such as the substantial decrease in the
so-called "home bias" in the equity holdings of investment and pension funds, and a more
homogeneous reaction of equity prices across the euro area to monetary policy signals.
In all of this, the banking sector has of course played - and will continue to play - a crucial role. As
was discussed at various sessions during the morning, the European banking sector has undergone
considerable consolidation in recent times, and the banking markets in the different EU countries have
become fairly similar in terms of their market structures, not least because the euro has created more
transparency across national borders.
Thus far, however, the consolidation process has mainly involved mergers and acquisitions (M&As) of
relatively small credit institutions within national boundaries, and mostly in countries where the degree
of bank concentration was lowest. By contrast, there have been very few cross-border mergers.
Indeed, the presence in EU countries of large pan-European banking groups through branches and
subsidiaries is relatively limited. The average share of foreign branches and subsidiaries accounts for
only about 15% of the euro area banking market. From a euro area-wide perspective, the lack of
progress in creating pan-European banks is a reflection of significant impediments to cross-border
M&As, which are hindering the realisation of economies of scale and blocking the beneficial effects of
increased efficiency within the EU economy.
The pace of integration in the banking sector has been uneven. Integration is well advanced in
wholesale and capital-related activities, while it is lagging behind in the retail markets. This partly
reflects differences in the nature of competition in these segments of financial services. Proximity to
clients, bank-customer relationships and access to information play a key role in retail banking, while
they are less crucial for investment banking and for corporate banking aimed at large companies.
Overall, the rather modest progress in the integration of the banking sector translates into persistent
cross-country differences in bank lending rates, which are relatively large, as can be seen, for
instance, in the case of bank overdrafts to non-financial corporations and consumer loans to
households. These differences stem from differing national regulatory arrangements, practices and
product characteristics; and they result in different levels of collateralisation, average maturities and
periods of fixation. Especially in the retail sector, the low degree of integration causes different
pass-through of changes in monetary policy rates to retail bank interest rates - which is a key aspect
in demonstrating to the European citizens, in a tangible manner, the benefits of the euro and
integrated financial markets.
Fostering financial integration: the role of the ECB
Given the importance of financial integration, not only for the welfare of European citizens and the
competitiveness and dynamism of the financial sector in Europe, but also for the effective transmission
of our monetary policy, what can the ECB do to foster financial integration?
The ECB, as the central bank of the euro area, can first make a direct contribution in its fields of
competence, e.g. through the provision of the pertinent infrastructure. To be more concrete we are, as
I am sure you are aware, replacing the euro area's current decentralised payment system with a single
technical platform, TARGET2, which is due to go live in 2007. TARGET2 will further improve financial
integration. It will increase cost-effectiveness and allow for the provision of a harmonised level of
services across Europe, supported by the implementation of a single price structure for domestic and
cross-border payments. TARGET2 will also offer new functionalities in terms of banks' euro liquidity
management and consolidated information - which should make it one of the most sophisticated
payment systems in the world.
Beyond such a direct contribution, the ECB sees itself predominantly as a catalyst for change, seeking
to enrich the debate in the relevant EU-wide fora and through dialogue with market participants. In this
endeavour we wish to support and complement the activities of the private sector and public
authorities, notably the European Commission.
One such field of activity relates to retail payment systems, particularly the initiative to create a Single
European Payments Area (SEPA) as from 1 January 2008. The SEPA is important, not least because
it represents a very tangible benefit in the everyday lives of Europeans. European citizens and
enterprises will be able to make payments throughout the euro area from a single bank account using
a single set of payment instruments, as easily and safely as they do today in the national systems. In
addition, national infrastructures should migrate to a pan-European payments infrastructure by the end
of 2010, which means that investments in the next generation of national systems should be made
from a pan-European perspective in order to ensure compliance with the SEPA. Of course, all of this
concerns the investment decisions in individual banking establishments, but I am confident that banks
which can offer payment services of the quality envisaged by the SEPA will have competitive
advantages.
As outlined already, for the ECB, as a supranational institution, the cross-border dimension of the
banking sector in the EU, and the related regulatory and supervisory issues, are of particular interest.
At the ECB, we see the ongoing consolidation of the European banking sector as a predominantly
market-driven process. What public policy at the EU level can and should do is to remove potential
prudential and supervisory obstacles to cross-border M&As. For example, in 2004 the European
Commission launched work on possible obstacles to cross-border consolidation in the financial sector,
aiming to clarify, inter alia, the supervisory approval process for the acquisition of a qualifying
shareholding in a credit institution. The ECB, through its participation in the Committee of European
Banking Supervisors, is contributing to the shaping of the relevant rules. Similarly, the implementation
of the Financial Services Action Plan (FSAP) should help to reduce company law obstacles to
cross-border M&As. I believe that the introduction of the European Company Statute, the forthcoming
Directive on cross-border mergers, and the new EU Takeover Directive should all have an influence
on spreading cross-border bank M&As across EU Member States in the years to come.
Finally, as you might be aware, the European Commission recently issued, for public consultation, a
Green Paper with its strategy for the so-called "post-FSAP period". Indeed, this period consitutes a
"window of opportunity" to further enhance European financial integration. The ECB will contribute to
defining the priorities to be pursued in order to complete the Single Market for financial services. From
our perspective, the focus should now be on the consistent implementation and enforcement of
existing EU legislation at the national level. New legislative initiatives should be kept to a necessary
minimum. Furthermore, the policies relating to the regulatory and supervisory framework should be
complemented by and be closely coordinated with other relevant policies for financial services. I am
thinking, in particular, of competition policy, which is crucial for the development of a pan-European
market. And lastly, incentives should be provided for the private sector to play its role in exploiting the
opportunities offered by public action.
Concluding remarks
Obviously, I have managed to close the circle. My remarks have brought me from the realm of public
policy to the more concrete activities of the banking sector and back to public policy issues. I shall now
heed the advice that a speaker should always take care to stop talking before his audience has
stopped listening. Let me therefore conclude with two brief remarks:
The ECB is committed to, and will continue to support, the process of structural reform in financial
markets, as well as in labour and product markets. One of the most important contributions that the
ECB can make in this respect is to provide, as in the past, a strong and reliable anchor for
safeguarding monetary stability. That said, the relationship between a stability-oriented monetary
policy and structural reforms is not unidirectional. As the reform process gains momentum, it will
facilitate the conduct and enhance the effectiveness of monetary policy in maintaining monetary
stability at a higher rate of economic growth.
Thank you very much for your attention.