Vítor Constâncio: Reflections on financial integration and stability
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the Joint
ECB-EC Conference on "Financial Integration and Stability in a New Financial Architecture",
Frankfurt am Main, 28 April 2014.
* * *
Ladies and gentlemen,
Dear colleagues and friends,
It is indeed a pleasure to participate in this joint presentation of two important policy reports:
the European Commission's European financial stability and integration report 2013 and the
ECB's Financial integration in Europe 2014 report.
Both studies illustrate that some steady, albeit uneven, progress is being made towards
financial stabilisation. Banks are reducing their liquidity buffers, repaying our LTROs and
regaining confidence from the markets. Money market integration is slowly improving,
particularly in the secured segment. Quantity-based indicators confirm a stabilisation in bond
markets and improved integration in equity markets. Given where we stood barely two years
ago - on the edge of redenomination risks - such progress is encouraging. However, it does
not mean we are entirely out of the danger zone.
If we look at banking markets, there is still a large dispersion of borrowing costs for
nonfinancial corporations across euro area countries. Thus, significant financial fragmentation
still remains in the euro area. This is a concern for the recovery and also for monetary and
macro-prudential policy.
Under the pressure of the global financial crisis and the sovereign debt crisis in the euro
area, several solutions - both global and European - have indeed been adopted. Stronger
crisis prevention mechanisms are now in place and a new crisis management framework has
been developed. We have financial backstops. A Single Supervisory Mechanism and a
Single Resolution Framework have been decided. Most of the countries in IMF/EU/ECB
adjustment programmes are "graduating" successfully, and several other stressed countries
are implementing structural reforms and financial consolidation. These are important steps
forward, towards a more stable and equitable functioning economic and monetary union.
We have certainly turned a corner and stabilised the situation. It is an important achievement
but it is not the end of the road as it is too soon to declare that the crisis is over. The euro
area still faces large challenges in terms of lacklustre growth, excessive unemployment,
remaining fragmentation and a low inflation period that threatens to aggravate the burden of
the debt overhang still besetting governments and private economic agents. That the
stressed countries were able to restore fundamental equilibria, like their external accounts,
and to resume positive economic growth is of great importance. However, we face now
structural medium term challenges that impair the European potential growth rate.
In my remarks today I will concentrate on issues such as the changing financial integration
and financial stability nexus, on how to restore a sound and resilient financial system and
finally on the need to improve our analytical tools and policy instruments.
Banks mirror their environment but also contribute to shaping it in many respects
When the crisis struck, a significant part of the banking system in several countries had to be
kept alive by public capital injections and state guarantees; where strains on liquidity were
present, the ECB provided a backstop in its capacity as lender of last resort. At the height of
the crisis several banks found themselves with large vulnerabilities: they were
undercapitalised, had fragile funding structures and, in retrospect, many had engaged in
unsound lending practices. For years, banks in creditor and debtor nations had fuelled the
imbalances that so greatly contributed to the sovereign debt crisis. Several banks had thrived
on complex structured investments whose risks were not well-understood, and a small
number of banks had become immersed in dubious acquisitions. This is the "banking
narrative" of the crisis.1
It is true that in some countries banks were also victimised by their sovereign, especially after
2010 when the ratings and access to market suffered the contagion from what was
happening with the sovereign debt crisis. With the benefit of hindsight, banks generated
instability and are now recognised as having been part of the problem. With the completion
of the Single Supervisory Mechanism, the phasing-in of a sound banking regulatory and
supervisory framework and the strengthening of banks' governance and ethical standards,
banks can become active parts of the solution to the crisis.
Yet, these are necessary but insufficient conditions to ensure that the banking system will
again become a vibrant financial engine of growth. Why? Because, over long periods of time,
the soundness and resilience of banks also hinges on the dynamism of the economy and
society: hence the habitat of banks also has to draw itself out of the crisis. The sustainability
of public and private finances and the health of the broader financial system are also critical
components in securing a successful and resilient banking system.
The crisis has left a heavy, uneven structural legacy across the euro area
As the earlier stages of this multi-layered financial crisis unfolded, it became apparent that
several banks had grown far too large for their economies, making the fate of several
governments and banks ever more intertwined. Fears of debt unsustainability in Greece
sparked concerns also about the public finances and financial health of other euro area
countries. Some speak of a twin crisis of "two debt overhangs". Others speak of the
"sovereign-bank nexus": they are all referring to the same phenomenon.2
That was when the "doom loop" between weak sovereigns and weak banks took hold to full
effect and when the flaws in the design of Economic and Monetary Union (EMU) became
most damaging.3 While significant progress has been made towards rectifying governance
failings and design flaws, the burden of the crisis on sovereigns, households and banks is
considerable and unevenly distributed.
Today, growth is low in many countries that are also overwhelmed by high unemployment,
especially among the youth. The general situation of lack of internal demand when some
external markets start also to decelerate, explains that investment is still almost 20 per cent
below what it was in 2007 which affects our potential growth. A declining demography and
insufficient progress in total factor productivity, further limit Europe ́s growth capabilities and
make it more difficult the absorption of the existing high unemployment. Such dynamics
thwart the deleveraging process of sovereigns and households, and complicate the return of
bank balance sheets to financial health.4
In my view, the legacy of the crisis constitutes still a vulnerability for the transition process to
a more effective and robust EMU. It stokes scepticism, which itself impedes the solutions to
the crisis.5 The situation had long required bold institutional reforms to the design of
monetary union and we should praise the European Commission for having quickly prepared
proposals for a Banking Union in 2012.
The banking union must be instrumental in resolving the crisis
In my view, the banking union must be instrumental in resolving the crisis and unravelling its
legacy. It is the crucial node to secure both financial integration and stability. The reason is
clear. In the euro area, about 75% of the real economy's financing needs still originate from
the banking sector. What is more, banks are crucial counterparties in the broader system of
financial intermediation. Therefore, the importance of establishing the Single Supervisory
Mechanism and creating a level playing field for all banks across Europe cannot be
overemphasized.6
A relevant part of this endeavour is the Comprehensive Assessment of bank ́s
balancesheets that will precede the beginning of the supervisory tasks by the ECB/SSM. Aiming at
completing the balance-sheet repair of the banks subject to the SSM it will improve their
capital and solvency position. In spite of the recent credit negative behaviour being mostly
the result of lack of demand, the enhanced robustness of banks will overcome remaining
credit supply restrictions that could hamper the recovery.
This process of repairing the banking system is only one part of the challenge policymakers
face in Europe. The other, more fundamental part is to build a safer and more resilient
financial sector that serves the real economy. This is ultimately the objective of the next
phase of banking union: building a single European supervisor via the Single Supervisory
Mechanism (SSM).
There are four ways in particular I expect the SSM to make a difference to banking in
Europe: by improving the quality of supervision; by creating a more homogenous application
of rules and standards; by improving incentives for deeper banking integration; and by
strengthening the application of macro-prudential policies.
The SSM should create the conditions and incentives for deeper integration of the European
banking market, which should in turn make the euro area less vulnerable to fragmentation.
Barriers that existed in the past to deeper retail banking integration, for example opaque
supervisory approval procedures, will no longer be relevant with a single European
supervisor. The substantial compliance costs that came from having to observe different sets
of rules and interact with several different authorities should also be reduced.
At the same time, the benefits of cross-border integration should increase. Cross-border
banking groups will be able to optimise their internal management of capital and liquidity.
Further efforts to reduce fragmentation and a drive to achieve genuine banking integration
can help Europe exit the crisis in at least three ways. First, more integrated banking markets
intensify competition: banks, as well as other financial market participants, will have to
change their strategies. More competition means that capital is allocated more efficiently.
This promotes access to new funding opportunities for companies, encourages investment
and thus contributes to higher economic growth. Small and medium-sized enterprises without
direct access to capital markets, in particular, may benefit the most from defragmentation.
Second, for the ECB, a re-integrated banking sector will ease the transmission of monetary
policy impulses and thus enhance the effectiveness of monetary policy.
Third, in several monetary unions, genuine financial market integration helps smooth out the
effects of asymmetric shocks. This mechanism of risk sharing can operate through income
insurance, for example, when a country's residents hold claims to dividends, interest or rental
income from investments in other countries.7 In the US this form of risk-sharing has been
shown to be more important than federal budget transfers. In the euro area, such risk sharing
will need to assume an increasingly more important role, especially given the absence of a
more significant central budget.8
On the other hand, incomplete financial integration carries significant risks. As the crisis has
demonstrated, financial integration increased the risk of contagion, without in parallel
generating adequate risk-sharing arrangements to offset its adverse effects. For example,
increased cross-border interbank funding was not accompanied by a sufficient diversification
of investment risks. As a result, banks in some jurisdictions quickly accumulated significant
exposures to local assets (such as real estate), and when the crisis hit, cross-border funding
was quickly withdrawn and sizeable losses had to be absorbed within national borders.
Looking ahead, lack of genuine financial integration and low resilience will always expose us
to systemic risks.
The crisis has also exposed our lack of some fundamental analytical tools and policy
instruments
The complexity and sequencing of the crisis, as well as its morphing over time, have also
exposed our weak understanding of micro- and macro-fundamentals. Here, I am talking
about basic notions, not only more advanced concepts and elements.
Few economists saw the financial crisis coming, understood the serious risks generated by
persistent imbalances and recognised the deep changes in economic structures and financial
markets that were under way during the build-up to the global financial crisis and the
sovereign debt crisis in the euro area. With EMU, the nature of prevalent shocks has
changed to slow moving processes that are more difficult to tackle with the few adjustment
mechanisms at the disposal of stressed countries. Facing this crisis, we were armed with a
toolkit that was suited to a previous era: i.e., inadequate models and limited monitoring tools
to support EMU.
It is thus understandable that the crisis has also heralded a "renaissance of research", with
both positive and normative implications. One of the least acknowledged outcomes of the
crisis is the enrichment of our professional toolkit to conduct economic, monetary and
financial analyses. Existing databases, models, analytical tools and forecasting and
projection apparatuses have been overhauled and enhanced, and new ones have been
added.
Through our Department of Research we have invested in all areas of micro- and
macroresearch that are directly and indirectly beneficial to our economic and monetary analysis.
We have launched research initiatives across European countries to understand how
economies work and what drives innovation, productivity, competitiveness, growth,
employment, equality and so on. Let me mention just a few examples of such initiatives
undertaken by the ECB and the Eurosystem:
• There is the Competitiveness Research Network, known as CompNet. Its
objective is to identify what drives the dynamics of competitiveness and productivity
across EU countries and heterogeneous firms, and relate the findings to policy
outcomes. CompNet has already assembled millions of data points and
observations in order to capture "non-price competitiveness". This initiative is
already showing that we need to augment our analyses with a global value chains
dimension, as the internationalisation of production matters. Had we had anything
similar prior to the crisis we would have been in a better position to anticipate the
effects of the propagation of the crisis along the supply chain.
• There is the Household Finance & Consumption Network (HFCN). Its objective
is to conduct surveys to collect household-level data on households' income,
expenditure, assets, debt and collateral. The data can then be aggregated to gauge
a measure of distress of individual households and to calculate credit risk indicators,
such as the probability of default, exposure at default or loss given default. Such
indicators can then be subject to stress tests for which a scenario can combine an
unemployment shock with an interest rate shock and a house price shock. Had such
data been available prior to the crisis, it would have facilitated the identification of
household borrowing and spending exuberance in several countries at an earlier
stage.
• There is the Macro-prudential Research Network (MaRs). Its objective is to
develop core conceptual frameworks, models and tools that provide research
support in order to improve macro-prudential supervision in the European Union.
The work performed under MaRs can yield more complex economic, financial and
monetary indicators that can more adequately address the complexities inherent in
the euro area.
In the context of MaRs and also resulting from work in our own Department of
Macroprudential Policy and Financial Stability, we have developed analytical tools that
include, for instance, early warning systems that can go to the level of individual banks,
decision tree risk models, structural VARs and Global VARs , contagion network models and
top-down stress test models for banks. One of the least acknowledged outcomes of the crisis
is the wealth of tools and models now available for conducting in-depth economic, monetary
and financial stability analyses. Looking at on-going developments, we are better able to
interpret the current situation and assess the fiscal and monetary stances. A good example
of this improved understanding is the development of the SYNFINT, the Synthetic Financial
Integration Indicator, presented in our Report and that is based on measures of
crosscountry price dispersion in the money, bond, equity and banking markets in euro area
countries.
Looking ahead, we are also better equipped to warn about looming systemic risks or
adjustment failings, as well as to identify strengths.9
Macro-prudential policy will have an important role to play
One of the more important goals of the on-going research is the grounding and calibration of
macroprudential instruments. The need for a macro-prudential perspective is one of the main
lessons stemming from the crisis. In fact, the whole regulatory reform after the crisis was
internationally discussed in Basle or in the FSB and the G20, from the macro-prudential
perspective. Indeed improving the design of Financial Regulation to ensure a resilient system
is the first instrument of macro-prudential policy.
I see macro-prudential policy as particularly important for the single currency, as
macroprudential tools can in principle allow policymakers to address financial imbalances in
a more country-specific and granular way.
I acknowledge that we do not yet have a large body of evidence on the effectiveness of these
policies, especially in advanced economies. That said, the studies that do exist tentatively
support the conclusion that macro-prudential policy can be effective in the euro area.
Assetside measures like LTV, LTI and DTI in particular have been found to be effective in
dampening real estate booms.10 As this was the sector at the heart of the crisis in several
euro area countries, this is encouraging. Further research in this area is essential to help us
better understand the impact and transmission channels of macro-prudential policies.
Questions of effectiveness aside, where the SSM represents a major step forward in
macroprudential policy, is in creating some centralisation of macro-prudential decision-making. The
SSM Regulation gives the ECB the power to apply stricter macro-prudential measures than
national authorities if it deems necessary. This allows us to take an integrated view of
macroprudential policy - spillovers, arbitrage effects - and provides a safeguard against inaction
bias at the national level.
Moreover, the important role of the ECB Governing Council in macro-prudential
decisionmaking allows for interactions between monetary policy and macro-prudential policy to be
internalised and synergies to be exploited. To give just one example, several of the
nonstandard measures we have adopted during the crisis, such as changes in collateral haircuts
or reserve requirements, might in certain cases overlap with macro-prudential measures like
liquidity ratios and margin requirements. This suggests that macro-prudential policies can
support us in fulfilling our mandate.
Conclusion
Let me conclude. Since the launch of the euro, we have become more interconnected. Trade
and financial links have deepened further and most companies and many banks have
acquired a European perspective. We are, de facto, each other's stakeholders. During the
crisis we have seen how what happens in one euro area country, however big or small,
reverberates in all others.
The crisis has partly reversed some integration but, as shown in the two reports, we are now
witnessing a degree of financial market de-fragmentation and reintegration.
We are also waiting for more sound research and analysis to come on stream. A deeper
understanding of the issues involved is paramount to making further progress on any one of
the multitude of fronts that we still need to explore. So, to this end, it is with great pleasure
that I now give the floor to our panellists for what I anticipate will be an in-depth and fruitful
discussion on the state of financial integration after the experience of the financial crisis.