The Need for Deepening Euro Area Integration
City Week 2019: The International Financial Services Forum
Pablo Hernández de Cos
Governor

Ladies and gentlemen,
Let me start by thanking Maurice Button and the Board of Patrons of City Week 2019 for
their invitation to participate in City Week 2019. It is a pleasure to be here together with
leading participants from the financial sector.
2019 marks the year in which we are celebrating the 20th anniversary of the launch of the
euro. However, this celebration is taking place at quite a challenging point in time. The
legacies of the crisis in terms of unemployment and debt, the rise of populism, the threat
posed by protectionism and uncertainties stemming from Brexit all make for a complex
situation.
But to the surprise of many, this background has not reduced European citizens' support
for the European integration process. Quite the opposite I would say. Euro area citizens
have declared the highest level of support for the euro ever recorded. The latest
Eurobarometer survey shows that 74% of citizens across the euro area countries favour the
Economic and Monetary Union (EMU), with a single currency, the euro. The survey also
reveals strong support for more coordination and economic reforms to improve the
performance of national economies.
These figures provide solid grounds for European governments and institutions to
combine efforts aimed at making the euro area architecture more robust and resilient
to shocks, and at increasing its ability to respond when shocks occur.
Admittedly, Europe has already taken bold steps to increase its capacity to detect and
handle crises. During the crisis years, two new intergovernmental treaties were introduced,
paving the way for strengthening economic and fiscal stability by creating the European
Stability Mechanism. This key instrument provides financial assistance to countries in
difficulties and, as recently agreed, may also act as a fiscal backstop in banking resolution
processes. New procedures for the surveillance of imbalances (the Macroeconomic
Imbalances Procedure) and the reform of the Stability and Growth Pact were also
agreed.
In the financial arena, important reforms, such as the creation of the Single Supervisory
Mechanism and the Single Resolution Mechanism for significant banks, were
implemented. On top of this, the impulse of monetary policy, with a substantial broadening
of the ECB's monetary policy toolkit, was also a crucial factor that helped cope with the
Euro crisis and its negative impact on price stability.
Attempts to draw comparisons between the governance framework in the United States
and the European Union should be mindful that the US currency union has had 150 years
to evolve, while the European currency union is still rather young. Nonetheless, it is precisely
with this long-term perspective that we have to judge EMU.
All in all, while acknowledging the relevance of the various institutional changes made, a
broad consensus points to the fact that additional reforms are needed in the EU's
architecture, and in particular in the architecture of the European Monetary Union.
Against this background, allow me to briefly sketch those reforms which, in my view,
deserve more attention in EU policy-makers' agendas during the next institutional period
following the European elections.
First, there is an urgent need for more progress to complete the single market for
services. For example, by addressing obstacles in the regulation of professional services
and other administrative barriers, and by enhancing cross-border cooperation in the energy
sector.
Second, there is also a pressing need to strengthen and simplify the fiscal framework.
The current fiscal rules have proven to be overly complex, hard to enforce, and unable to
prevent a procyclical fiscal policy. Moreover, steps in this direction might be essential for
promoting economic stability and a more favorable environment for investments ahead of
the challenge of digitalisation.
Third, more efforts need to be made to preserve the multilateral system of trade.
***
Focusing now more on specific euro area reforms, I would highlight in particular two
priorities which, in my view, should be at the center of the discussion.
Firstly, the need to increase financial integration and the development of European capital
markets by reinforcing the Banking Union and the Capital Markets Union initiatives.
Secondly, progress towards a more comprehensive fiscal stabilisation capacity at the
Eurozone level.
The need to increase financial integration
European citizens and firms still face several barriers to investing across European markets.
Pensioners and investors in different countries have access to different investment products
and their rights differ as a result of diverging local insolvency laws.
The banking sector still remains mainly national, and intertwined with the sovereign
of its host jurisdiction. For bank depositors and national authorities, the current situation
is such that the ultimate backstop for insuring deposits in a failed institution relies
completely on a national government which has a limited say on the on-going supervision
and resolution of the failed institution. This is so since decision-making processes on these
responsibilities are now adopted by the European single mechanisms.
Notwithstanding cultural, legal or historical reasons, these inconsistencies and obstacles
are broad-based, and stem from pure regulatory barriers, a lack of infrastructure or limited
political resolve. The results are pervasive. Investment portfolios are not well diversified
and investment opportunities are lost as these may not always be matched with savers'
funds. The financial system remains fragile and fragmented because of the doom-loop
between sovereigns and banks.
An important consequence of insufficient integration is the limited capacity of risk-sharing
mechanisms in the Euro Area countries, compared with those of the United States.
As you know, risk-sharing is the ability of countries to diversify country-specific shocks
among other member states through the cross-country savings and capital market channels
(i.e. the private risk-sharing mechanisms), as well as through fiscal transfers (the public
sector channel).
With regard to the private channels, the degree of risk-sharing through capital markets
is comparatively low in Europe. And although it moved on a rising trend during the
precrisis years as a result of the increase in wholesale financial integration, it subsequently fell,
remaining at levels well below those observed in the United States. Limited development of
equity markets in Europe, prevailing national investment bias in the Euro area relative to that
in the United States, and a greater concentration of cross-border investment in a small
number of Member States in Europe are some of the reasons explaining such divergent
reactions between these two financial areas.
The budgetary channel is practically non-existent in the euro area. By contrast, in the
United States, estimates show that the public channel helps soften between 10% and 20%
of adverse shocks in a particular State.
As a result, the credit channel is ultimately the sole means for cushioning shocks
across Euro Area countries. However, the credit channel is not enough to compensate for
the weakness of the other channels. This means that, on average, between 40% and
60% of an adverse shock impacting a Euro Area country translates directly into a
decline in that country's consumption. These figures are double the impact calculated for
the United States.
Besides the need to strength risk-sharing mechanisms to address macroeconomic shocks,
achieving key targets such as controlling the levels of public debt and reducing the
sovereign risk nexus (often cited as the most fundamental original flaws of the euro design)
do not only depend on introducing policies of pure fiscal discipline. They also require
soundly functioning and well-integrated financial markets capable of diversifying risks
across borders and correctly pricing concentration risks. This is why, in my view, the
most immediate and significant challenge facing EMU is to reinforce the integration of both
banking systems and capital markets.
Reinforcing the Banking Union
When the euro was launched, there was actually an expectation that many banks would
become truly European, providing retail services across the whole euro area. The reality is
quite different.
Cross-border consolidation remains very limited and most firms and households in the
euro area remain largely dependent on their domestic banking systems to maintain
investment and smooth consumption profiles.
Although no formal barriers to foreign banks exist, relevant distortions arise from
stillsignificant specificities in banking regulations across countries. Some of the existing
savings banks, government-owned banks or regional banks in the EU are protected by
national legislations hampering incentives to compete or effectively sheltering them
from competition. Moreover, regulation fails to fully acknowledge the benefits generally
arising from geographical diversification in a single market.
We also need to address the current deadlock on the third pillar of the Banking Union,
the European Deposit Insurance Scheme (EDIS). Some experts argue that this third
element may not be essential once we have in place a stringent resolution framework with
homogeneous bail-in requirements; but in my view, it remains crucial to make EDIS a reality.
Such a scheme would have a strong impact on trust and contribute to increased
risksharing, insofar as it is designed as a fully fledged mutualised EDIS. Contributions to EDIS
taking into account bank-specific risks could limit the risk of permanent
crosssubsidisation and would also help deal with the sovereign-bank nexus. This would
contribute to reducing the link between national governments and banks and preventing
destabilising cross-border flights to safety in the event of difficulties.
Moving towards a Capital Markets Union
The other key initiative to increase the integration of Europe's financial markets and to
facilitate risk-sharing capacity in EMU is the Capital Markets Union project. The project
aims at providing firms with the same funding opportunities, and households with the same
saving opportunities, irrespective of the member state in which they are located.
However, inconsistent regulations, as well as varying market practices and industry
standards across EU countries, prove to be key impediments in developing a truly
pan-European capital market.
As a result, country savings and investments are still highly correlated, a fact known as
the Feldstein-Horioka puzzle. This correlation has subsided over time in the case of the
European Union but is still sizable, which is more bewildering in the case of the currency
union. A departure from perfect capital mobility has important economic implications, as it
might be leading to lower aggregate investment, a higher home bias in investment decisions
and a lack of portfolio diversification.
The Capital Markets Union project has received a stronger push over the last few
months. Most of the work in terms of harmonising investment products across the EU has
already been agreed. Progress on savings products has also been achieved. In particular,
the development of the market for the Pan-European Pension Product is particularly
relevant considering the situation of public finances in many EU countries and the
challenges posed by population ageing. But, looking ahead, greater headway is needed
over the coming years. In particular, allow me to highlight three dimensions.
First, the legal framework: Insolvency regimes vary widely across jurisdictions for financial
and non-financial corporations, as a result of cultural traditions and legal frameworks. This
is a major obstacle for cross-country investments and, I would add, a very difficult one
indeed to overcome.
Second, the strengthening of European regulators. As European markets become more
integrated and technologically complex, this is becoming a more essential element that
policy-makers need to address. It will be even more important since, depending on the final
outcome of negotiations, Brexit might increase the risk of fragmentation, as some
companies and transactions may be reallocated to various possible destinations, while
others may remain in the UK.
Third, more needs to be done in terms of making capital taxation more consistent. The
debate has stalled in this regard. For example, the various regimes for withholding taxes,
with more than 90 types of forms in different languages, are often cited as a huge obstacle
for investment by market participants. Moreover, the favorable tax treatment of debt
compared to that of equity has significant economic implications.
A well-functioning Capital Markets Union will have major ramifications as it will attract
institutional investors, improving the allocation of resources and strengthening the
international role of the euro. Crucially, it will help reshape capital markets in Europe after
Brexit. I believe that this project is essential for the Single Market, for the Economic and
Monetary Union and a resilient euro, and, ultimately, for the EU's global competitiveness. I
am certain that these and other matters will be raised and discussed during the following
panel of this conference.
The case for a fiscal stabilisation capacity
But, even if developments in European financial markets were complete, private
risksharing would still be inefficiently low. This is because private investors do not yet
internalise the positive macroeconomic stabilisation externalities of their portfolio choices.
In this context, the other area that urgently needs addressing is enhancing the
stabilisation capacity of the euro area through fiscal instruments.
Moreover, the efficiency case for fiscal risk-sharing ultimately hinges on the relevance
of idiosyncratic shocks and the capacity of national fiscal policy to face these shocks.
The efficiency argument meets the responsibility argument in the case of fiscal liabilities
stemming from inadequate Euro-wide policies, as is now the case of financial supervision
and resolution.
True, some evidence suggests that national business cycles have now become more
synchronised. But it is clear from economic developments over the last decade that the
mere sum of national fiscal buffers may not be enough to accommodate severe
common shocks.
In addition, although in normal circumstances monetary policy should be able to deal with
aggregate shocks, it may not be the case in situations in which monetary policy is already
operating at the effective lower bound.
As the comparative analysis reveals, all other mature currency unions have centralized fiscal
tools allowing governments to take actions when difficulties arise in a particular state or in
situations of an aggregate recession. Despite several measures taken in response to the
crisis, the EU still lacks fiscal tools to cushion against asymmetric or large systemic
shocks that may arise in the Euro area.
At the latest European Summits, a consensus seems to be emerging for a small budget
within the EU's regular budget, earmarked for specific support for member states in the
form of loans seeking to promote competitiveness and convergence, in particular in
the areas of innovation and human capital. While such a budget may be a first step
towards more ambitious instruments, we should realise that its limited size would not make
it a suitable tool for smoothing the adjustment costs for countries experiencing a severe
shock. And nor would it contribute to improving the design of fiscal policy at the euro area
level in the event of a widespread recession.
By contrast, a centralised fiscal capacity could contribute to both aims through
temporary fiscal transfers for countries experiencing a particularly adverse shock. Several
proposals have been discussed. They include the need to designate a Euro area finance
minister with her own budget for macroeconomic stabilisation, a rainy-day fund with or
without the possibility of issuing debt, a European unemployment (re-)insurance scheme,
and so on. Views on these proposals, however, differ in terms of size, allocation of
competences, political feasibility and in many other respects.
According to Banco de España simulations, the effective design of any of the proposals
needs to be sizable enough to provide stabilizstion for an economy facing a recession,
even a large economy facing a deep recession. The trigger mechanism must be clear and
smooth to ensure a timely response. But it should also address legitimate concerns over
moral hazard and permanent transfers. The phasing-out should ensure that fiscal transfers
will not be permanent so as to avoid undue redistribution across member states.
To preserve sound incentives, in my view, countries with access to this instrument must
comply with fiscal rules and with the rules of the Macroeconomic imbalances procedure.
Even countries with a good fiscal record can fail to deal with sizable shocks, but ex ante
compliance with fiscal rules -and a transparent process- is necessary to dispel doubts
about the behaviour of the country under stress, while also providing flexibility for national
fiscal buffers.
The Banco de España simulations show that, with an annual contribution of 0.35% of GDP
per country, it is possible to design a fiscal capacity with a risk-sharing capacity similar to
that of the existing instruments in the US. If such an instrument had been in place since
the inception of the Euro, most countries (and not only the usual suspects) would have
benefited from the scheme at one point, without permanent redistribution across
countries.
Finally, the creation of a common safe asset for the euro area should be explored further.
The normal operations of markets and financial intermediaries require a broad spectrum of
assets with sufficient liquidity and minimum counterparty risk. This situation is amplified in
turbulent times, as investors react to increases in uncertainty by accumulating assets with
a low level of perceived risk. Within the EMU, the volume of such assets is insufficient, as
only the debt of a small group of countries is perceived as riskless, thereby giving rise to
scarcity and financial fragmentation. An improvement in the fiscal position of countries might
help expand the number of available safe assets. But a common safe asset will have
additional benefits, by contributing to reducing the link between national governments and
banks; preventing destabilising cross-border flights to safety in the event of difficulties; and,
more generally, promoting a more stable and equitable provision of safe assets for the EMU
as a whole.
In sum, there is a pressing need to improve the functioning of the EMU before the next crisis
hits. Increasing financial integration and introducing fiscal instruments to improve
macroeconomic stabilisation are of the utmost importance in achieving this goal.
Thank you for your attention.