Mario Draghi: Financial integration and banking union
Speech by Mr Mario Draghi, President of the European Central Bank, at the conference for
the 20th anniversary of the establishment of the European Monetary Institute, Brussels,
12 February 2014.
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Summary
A banking union will contribute to more sustainable financial integration in the euro area,
says ECB President Mario Draghi. Speaking at a conference celebrating the 20th
anniversary of the European Monetary Institute in Brussels, Draghi explains how stronger
supervision, cross-border banking integration and resolution frameworks can reduce the risk
of financial fragmentation. It was that kind of fragmentation which contributed to the recent
financial crisis.
Draghi explains that financial integration is necessary for an effective monetary union. But
"the euro area did not succeed in achieving sustainable financial integration", the ECB's
President says. "And we can see the importance of financial integration all the more in its
absence."
According to Draghi, financial integration before the crisis was incomplete. While the
interbank market was fully integrated, retail banking remained fragmented. That led to a
situation where banks used short-term and debt-based funding to increase lending to
favoured domestic sectors such as real estate. "As banks' assets were not well allocated, nor
well diversified geographically, they were more vulnerable to domestic shocks. And as their
foreign liabilities were mainly interbank, they could not share the subsequent losses with
other jurisdictions." So when the crisis hit, the cost of repairing balance sheets fell largely on
their domestic fiscal authorities. "The result was the infamous bank sovereign nexus", Draghi
says.
A banking union will generate a higher quality of financial integration. The Single Supervisory
Mechanism will enable supervisors to mitigate the possible destabilising effects of financial
integration. It will also help to maximise the benefits of integration by creating a policy
framework more conducive to cross-border banking. If problems still occur, the planned
European resolution framework will help by improving private risk-sharing while insulating
sovereigns. To reach that aim, Draghi makes a case to improve the design of the Single
Resolution Mechanism and the Single Resolution Fund. The proposed ten-year period to
mutualise national compartments into a single fund "creates uncertainty", the President says.
"We would see merits in doubling the pace of mutualisation to have a genuine European fund
within five years."
* * *
Dear Members of the European Parliament,
Dear Alexandre,
Dear Jacques,
Dear Luc,
Dear Governors,
Ladies and Gentlemen,
It is a pleasure to speak today at this conference marking the 20th anniversary of the
European Monetary Institute (EMI), and in particular to be part of this session that recognises
and celebrates the contribution of Alexandre Lamfalussy.
The discussion today has naturally focused on the EMI, the euro and monetary policy, but I
would like to take this opportunity to reflect on another issue which is vital for the single
currency, and to which Alexandre has made an immense contribution - that is, financial
integration.
Financial integration and the single currency are in many ways two sides of the same coin.
One fundamental reason for the single currency was to maximise the benefits of the single
market for capital. And, conversely, it was understood when the euro was conceived that
integrated financial markets would be necessary for an effective single currency.1
Alexandre's experience in academia, the private sector and central banking put him in a
unique position to contribute to this process. He contributed intellectually, for example
through his leadership of the SUERF2 network set up to promote discussion of financial and
monetary issues among academics, central bankers and market participants. He contributed
practically, not least as chairman of Euro-MTS, the European electronic fixed income market,
late in his career. And he made significant policy contributions, from overseeing the creation
of the TARGET payment system at the EMI to launching what became known as the
"Lamfalussy process" for supervisory and regulatory convergence in Europe.
For this reason, the ECB recognised and honoured his role by establishing about ten years
ago a "Lamfalussy Fellowship" programme. It sponsors five young economists each year to
conduct research on the integration, structure and performance of the European financial
system.
However, we know - and to our cost - that ultimately the euro area did not succeed in
achieving sustainable financial integration. While financial integration deepened significantly
after the euro was introduced, the global financial crisis caused that process to go into
reverse. And we can see the importance of financial integration for the single currency all the
more in its absence.
In the periphery, financial fragmentation has led to high interest rates for firms and
households, and disrupted monetary policy transmission. In the core, it has led to
exceptionally low interest rates for savers and potentially distorted asset prices.
Consequently, the whole of the euro area would benefit from lasting financial reintegration -
and indeed, addressing financial fragmentation has been one of the key tasks of euro area
policy-makers, including the ECB, over the past years.
What I would like to focus on today is one aspect of reversing fragmentation that is perhaps
underplayed - that is, the importance of raising the quality of financial integration in the euro
area. My view is that the incomplete financial integration we achieved before the crisis made
it susceptible to fragmentation. But I am confident that with a banking union we can create
the pre-conditions for more sustainable financial integration in the future.
Financial integration before the crisis: what went wrong?
Let me start by outlining how financial integration evolved before the crisis.
It was always understood that financial integration could have both stabilising and
destabilising effects.3 Some of the main stabilising effects were expected to come from
increased portfolio diversification. As banks and other investors became more diversified
across borders within the euro area, they could reduce their exposure to domestic shocks,
and this would be reflected in greater income and consumption risk-sharing.4 Indeed, global
and European evidence suggested that financial openness and integration had reduced
consumption growth volatility.5
Another benefit of financial integration was thought to come from improved allocative
efficiency. Research suggested that large cross-border banks in Europe could improve
overall economic performance, by making sure that productive capital was channelled
towards the most efficient firms. This would in turn reduce the risk of crises stemming from
mispriced investment risk.6
Destabilising effects of financial integration, on the other hand, were expected particularly
through risk-taking and contagion. Asymmetric information problems associated with
crossborder lending could lead to misaligned incentives and increased risk-taking. Similarly,
savings imbalances abroad could compress risk premia and lower financing costs, allowing
an increase in leverage in the domestic financial sector.7 And if negative shocks were to
occur, contagion could quickly spread through the interbank market, and lending to the real
sector across borders could be affected, too.8
As financial integration deepened, it was anticipated that the stabilising effects would overall
be more important than the destabilising ones - that is, the welfare benefits of better
diversification and improved allocative efficiency would offset the welfare costs of
occasionally higher risk-taking and contagion effects.9 So why were the costs of the
European crisis so high?
There are many reasons for this, but in my view one important factor was the incomplete
nature of financial integration in the euro area. Price convergence in many asset classes
created an appearance of financial integration, but it was in fact relatively shallow, in
particular in the banking sector. According to the ECB's financial integration indicators, while
euro area interbank markets became almost completely integrated, retail banking integration
remained largely fragmented.10 This mismatch had at least three consequences.
The first was on the asset side of banks' balance sheets. A main channel through which retail
banking integration is expected to improve allocative efficiency is by increasing the distance
between the main shareholders and management of a bank and the vested interests in the
country where the bank operates, i.e. by reducing so-called "related lending". But without
meaningful foreign competition, these gains did not materialise in the euro area. In fact, the
ability to borrow freely in interbank markets allowed local banks to increase lending towards
favoured domestic sectors such as real estate. This is essentially what we saw in Spain and
Ireland. In the process, financial integration concentrated rather than diversified risk.11
4
Demyanyk, Y., C. Ostergaard, and Bent E. Sørensen, 2008. "Risk sharing and portfolio allocation in EMU",
Economic Papers 334, European Commission.
5
Bekaert, G., C. Harvey, and C. Lundblad, 2006. "Growth volatility and financial liberalization." Journal of
International Money and Finance 25, 370-403.
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
Caballero, R., and A. Krishnamurthy, 2009. "Global imbalances and financial fragility." American Economic
Review 99, 584-588.
8
Popov, A., and G. Udell, 2012. "Cross-border banking, credit access, and the financial crisis." Journal of
International Economics 87, 147-161.
9
Fecht, F., Grüner, H., and P. Hartmann, 2007. "Welfare effects of financial integration." CEPR Discussion
Paper 6331.
10
Financial Integration in Europe, European Central Bank, April 2008.
11
Fecht, F., H. Gruener and P. Hartmann, 2012. "Financial integration, specialization and systemic risk", Journal
of International Economics, vol. 88.
The second consequence was on the liability side of banks' balance sheets. As banks'
funding from abroad came mainly through the interbank market, the composition of their
foreign liabilities was short-term and debt-based. This meant that funding could quickly dry
up at the first sign of distress.12 With a more integrated banking sector, however, this effect
would have been less dramatic. As foreign banks would have equity stakes, they would have
an incentive to maintain cross-border funding within the group. This is what happened, for
example, in the Baltic countries where foreign ownership of the banking sector was high.13
These two consequences combined to create a third effect. As banks' assets were not well
allocated, nor well diversified geographically, they were more vulnerable to domestic shocks.
And as their foreign liabilities were mainly interbank, i.e. not equity-based and short-term,
they could not share the subsequent losses with other jurisdictions. This meant that when the
crisis hit, the cost of repairing their balance sheets fell largely on their domestic fiscal
authorities. The result was the infamous bank-sovereign nexus that has perpetuated financial
fragmentation in the euro area.14
My conclusion from this experience is as follows: the quality and comprehensiveness of
integration matters. There are costs which can arise from a type of financial integration that is
short-term and reversible; or from having perfect integration in one market and fragmentation
in another. A key question for the euro area is therefore: how can we generate a higher
quality of financial integration for the future?
Making financial integration sustainable: the role of a banking union
The pre-crisis experience suggests three changes are needed.
First, stronger ex ante supervision to mitigate the possible destabilising effects of financial
integration. Second, an improved policy framework to maximise the stability benefits, namely
by encouraging deeper cross-border banking integration. Third, better ex post risk-sharing
arrangements, such as resolution frameworks, so as to prevent shocks from spilling over to
sovereigns.
I see that a banking union - the Single Supervisory Mechanism (SSM) and the new
European resolution framework - can make a significant contribution to these objectives. Let
me address each in turn.
Strengthening supervision
To begin with, the SSM will enable supervisors to better identify emerging risks and to act
counter-cyclically. This is thanks to its independence, its incentives and its instruments.
The SSM has been designed with the necessary independence to lean against localised
booms, being not only legally independent, but also independent of any single government or
national financial system. And that independence is reflected throughout its organisational
structure, for example by having mixed-nationality joint supervisory teams to supervise each
significant bank.
By virtue of its accountability, the SSM also has incentives that are clearly aligned with its
European financial stability objective - it has to answer for the failure of any bank in the SSM
area. Compared with national supervisors, this gives it all the more reason to take account of
excessive risk-taking and the cross-border externalities associated with it, and therefore to
be proactive if local financial developments pose increasing systemic risk.
Finally, the SSM has not only micro-prudential powers but also new macro-prudential
instruments to counter financial imbalances. For all the instruments in the EU legislation, it
may apply stricter measures than national authorities if it observes emerging risks. This
further strengthens the capacity at the European level to prevent financial instability.
Deepening integration
The SSM can also help maximise the benefits of financial integration by providing a policy
framework that is more conducive to cross-border banking integration.
Before the crisis, supervisory coordination mainly took place through the Lamfalussy process
and committees, which were a major step forward and the best that could be achieved at the
time. However, they were unable to fully iron out supervisory differences between EU
jurisdictions.15 This presented cross-border banks with substantial compliance costs and
reduced the economic synergies of integration.
For example, a Commission survey in 2005 found that opaque supervisory approval
procedures were a major deterrent to cross-border banking M&As in Europe. The need to
comply with different sets of rules and interact with several different authorities was also
reported to be a barrier to cross-border activity.16
The lesson from this period was that, while financial integration is ultimately a market-driven
process, policy plays a key role in creating the conditions for it to progress. To quote the
Lamfalussy report, "the EU has no 'divine right' to the benefits of an integrated market - it
has to build one".17 This SSM should help us in this building process.
A single supervisor automatically removes some of the dividing lines between jurisdictions
that create compliance costs. For example, there will no longer be a distinction between
home and host supervisors for cross-border banks. Instead, there will be a single supervisory
model and eventually a single supervisory culture, rather than one per country. And
crossborder groups will be able to report at the consolidated level.
Another benefit of the SSM - and perhaps a more important one - will be the lack of "hidden
barriers" to cross-border activity linked to national preferences. With a European supervisor,
borders will not matter. Issues such as protecting national champions or supervisory
ringfencing of liquidity will not be relevant. This means that banks will be in a better position to
achieve the economies of scale that were promised by the single financial market - and that
they also need to be competitive at the global level.
It is of course for banks to decide whether such integration makes business sense. And
some obstacles to cross-border integration that lie outside the remit of supervision - like
company law and tax - still remain. However, the low profitability and excess capacity of the
European banking sector suggests that efficiency gains could be achieved, and without
exacerbating the "too big to fail" problem.
Improving risk-sharing
Even with a higher quality of financial integration, we know that shocks may still occur that
cannot be contained within the private sector. The US, for example, has a well-integrated
financial market, and the Federal Deposit Insurance Corporation (FDIC) still plays a
prominent role in managing crises. Our challenge in the euro area is to ensure that, when
banks fail and the public sector has to intervene, it does not result in a recurrence of the
bank-sovereign nexus. The new European resolution framework will be key to achieving this.
This framework can help insulate sovereigns by improving private risk-sharing within the euro
area. First, it will ensure that the costs of bank failure are borne first and foremost by the
private sector, with sovereigns providing funds only in exceptional circumstances. The key
innovation here is the Bank Recovery and Resolution Directive, which provides the legal
underpinning for the bail-in of shareholders and creditors and other resolution tools.
Second, the new framework will allow resolution costs to be more evenly spread across the
euro area banking sector, and less concentrated in the affected countries, thus enhancing
the potential for cross-border risk-sharing. Specifically, the Single Resolution Mechanism
(SRM) will introduce a single resolution fund that is funded by and available to all euro area
banks.
Will this help break the bank-sovereign nexus today? In my view, the impact will certainly be
positive. The fact that the costs of any bank rescue will fall less on sovereigns should lift
expectations of government debt sustainability, thus improving asset quality for banks
exposed to their governments. And the fact that bail-ins will precede bail-outs means banks'
funding costs should be better decoupled from the fiscal condition of their sovereigns.
That said, in terms of breaking this nexus, there are some elements in the Council
agreement on the SRM that I believe could be improved. The main problem is uncertainty
about resolution financing arrangements. This is important, because if markets cannot
ascertain ex ante how resolution will be financed, and in what quantities, they may find
themselves having to price-in a residual risk of national government involvement, thus
perpetuating the bank-sovereign nexus.
One issue that creates uncertainty is the protracted time period - currently 10 years - over
which national compartments are to be mutualised into a single resolution fund. As legacy
risks will be addressed by the ECB's comprehensive assessment, this seems an unduly long
period. We would see merits in doubling the pace of mutualisation to have a genuine
European fund within five years. To be clear, this would not imply that banks have to pay
higher fees. The fund would still only reach its target level after 10 years, yet it would be a
truly single fund after five years.
Another issue that needs clarifying is what backstop arrangements will be in place in this
transition period, and also in the steady state. What makes resolution authorities credible is
the knowledge that, when private sector solutions do not suffice, they can draw on temporary
public bridge financing. This steadies expectations and supports financial stability.
Indeed, the job of a resolution authority could become more complicated if there are doubts
about the adequacy of its resources in times of systemic stress. Even in the US, where such
a public backstop is in place, the FDIC felt that its job was complicated during the financial
crisis by media scepticism about its finances.
For this reason, we believe that a single resolution fund needs a solid public backstop - be it
an ability to temporarily borrow from the market backed by guarantees from participating
Member States, or access to a credit line, potentially from the European Stability Mechanism.
This would not be a transfer system between taxpayers: as in the US, such borrowing would
be recovered by additional levies on the banking sector in the future. Therefore, the only
transfer would be an intertemporal one among banks.
Conclusion
To conclude, financial integration is essential for a well-functioning single currency, but it is
not something we can take for granted. We have learned a painful lesson here. Incomplete
financial integration is an Achilles heel: it creates vulnerabilities and is liable to fragment.
With the banking union, I am confident we are laying the foundations for more complete
financial integration in the future.
There are two final points I would like to make.
First, while I have spoken mainly about banking sector integration, a single financial market
must also ultimately extend to capital market integration - a theme that was close to
Alexandre's heart. There are still several barriers to such integration, and these call for the
attention of policy-makers. One example is barriers to high-quality securitisation of bank
loans, whose removal may help to promote lending to households and SMEs, and reduce
fragmentation. In the spirit of Alexandre, we need to begin addressing these issues in a
pragmatic manner, while never losing sight of our goal.
Second, we should not forget that fragmentation also comes from the demand side. If less
competitive countries undertake structural reforms that promote higher economic growth,
their economies will converge towards more competitive ones, and finance will tend to
follow.18 This is why, in addition to the banking union, the re-establishment of country
competitiveness is essential to reintegrate financial markets. In other words, all participants
have to help achieve and sustain financial integration.
Thank you for your attention.