Miguel Fernández Ordóñez: Financial integration and stability in Europe
Opening remarks by Mr Miguel Fernández Ordóñez, Governor of the Bank of Spain, at the Conference
on "Financial Integration and Stability in Europe", organised by the Bank of Spain, the European
Central Bank and the Center for Financial Studies, Madrid, 30 November 2006.
* * *
Good morning ladies and gentleman. First of all, allow me to welcome you. We are really delighted to
host this conference at the Banco de España in Madrid.
Some of you are perhaps too young to remember, but it was here in Madrid, in 1989, that the
European Council decided to embark on the first stage of Economic and Monetary Union, as
envisaged in the Delors Report which was the catalyst for the EMU process. I would like to start my
intervention today with a quote from the Delors Report; a quote that refers to financial integration.
Simplifying, it said the following:
The objective of a single financial area, in which all monetary and financial
instruments circulate freely, and banking, securities and insurance services are
offered uniformly throughout the area, would be fully implemented through the
approval and enforcement of the necessary Community directives.
You can appreciate the appealing simplicity of its definition of an integrated financial market: one
where all monetary and financial instruments circulate freely, and where banking, securities and
insurance services are offered uniformly.
Nevertheless, the word "uniform" might sound a little strange to us today, when we prefer to use softer
terms such as "convergence". But of course Mr Delors was not thinking about uniformity of the
services themselves, but rather about the need to ensure that they could be offered and accessed on
an equal basis across the EU.
But what it is remarkable is that Mr Delors was referring to the steps that should be taken in Stage
One of EMU. He expected the integrated financial market to be in place at the beginning of the EMU
process, before going to the subsequent stages. Almost seventeen years have passed since Stage
One was launched. And we entered Stage Three almost eight years ago. EMU has proved to be a
successful reality, but the single financial area as defined in the Delors Report has not yet been fully
achieved.
Of course, there has been impressive progress in some areas, for instance, the European money
markets. And there has been good progress in others, like corporate bond markets and Government
bond markets.
In some fields, however, we are a long way from Mr Delors' vision of integration.
Looking at stock exchanges, for instance, we have certainly witnessed a decrease in the home country
bias in investor portfolios. But the overall level of home country bias remains high, indicating that a
significant degree of fragmentation remains.
And progress has been very limited in the retail financial services sector, where the cross-border
provision of services is still almost symbolic.
Also, while we have continued to see domestic consolidation of financial intermediaries, merger and
acquisition activity across borders has not been as high as we might have expected, as the European
Commission has pointed out. There are exceptions, of course - a notable one being on our doorstep,
with Banco Santander's acquisition of Abbey in the UK.
But what is the interest of central banks in all this? Should we worry about the lack of progress?
Should we actively promote greater financial integration? My earlier quote from the Delors report
would seem to indicate that the answer should be yes. Indeed, from the perspective of EMU it is very
clear that greater integration is desirable.
Why is this? Because in general terms, the higher the degree of financial integration in EMU, the more
homogeneously monetary policy decisions will be transmitted across the Member Countries.
The integration of money markets is an important achievement in this respect. It is at this level of the
financial system that central bank liquidity is distributed and that monetary policy decisions are
transmitted to short-term interest rates.
By the same token, the lack of integration in retail markets is an important concern. This is because
the European financial structure is mainly bank-based. Therefore, retail banking plays a central role in
the transmission of the single monetary policy impulses in EMU to the interest rates which actually
influence the expenditure decisions of households and firms.
But apart from our interest in the effective transmission of monetary policy, there is a broader reason
why central banks wish to see greater integration.
At the end of the day, the ultimate objective of a central bank, as of any public policy maker, is to
enhance citizen welfare. A number of pieces of empirical evidence reveal that financial integration has
a positive effect on economic growth and, therefore, on welfare. The European Commission, London
Economics and several researchers have provided us with interesting studies which estimate that a
total removal of national barriers in European financial markets would imply a long-term increase in
GDP growth of up to one percentage point.
There is also evidence for the US, based on analysis of the effects of the removal of restrictions on
cross-state bank branching and ownership, which points in the same direction.
These two aspects - monetary policy transmission and promoting citizen welfare - explain the efforts
that central banks have made to contribute to the integration process, although the leading roles and
initiatives rightly correspond to the European Commission and to market forces.
Maybe the most telling example of the central bank contribution is the establishment of TARGET,
promoted by the Eurosystem and introduced at the beginning of Stage Three with the aim of
integrating the system of large value payments across the euro area. It is widely recognised that its
success has played a crucial role in the integration of interbank markets in Europe.
However, the mandates of most central banks, including indeed both the Eurosystem and the Banco
de España, also cover other objectives. There is, in particular, an area which deserves special
attention in this context. I am referring, of course, to the function of promoting financial stability.
It is precisely in this area where the impact of financial integration is less clear. Does financial
integration promote financial stability? Or does financial integration put financial stability in danger?
As a matter of fact, while the effects of higher integration on per-capita income and on the efficiency of
monetary policy transmission have received a lot of attention by researchers, the impact of financial
integration on financial stability is under-researched. That is why we are holding this conference.
Despite the lack of research, it seems clear that there are some areas where financial integration
favours financial stability.
Firstly, a more integrated financial system enlarges the opportunities available to investors, lenders
and borrowers to diversify the different risks associated with their financial decisions. Through such
diversification, they should become less exposed to idiosyncratic shocks, asset prices and financial
flows should behave in a smoother way and as a result, the risk of financial distress should be
reduced.
Secondly, in a more integrated system, financial intermediaries would find it easier to grow and at the
same time would find the incentive to do so in the enlargement of their potential markets. Larger
institutions would therefore be in a better position to reap the benefits of greater economies of scale,
and would also increase their financial muscle to withstand potential shocks.
Unfortunately, however, there are no free lunches in the economy and it seems that financial
integration can also have negative effects on financial stability.
Therefore, fully integrated financial markets pave the way for shocks to propagate more quickly among
market participants, thereby affecting a wider range and number of them. Contagion becomes more
likely.
In the same way, the larger an institution, the higher is the probability that it becomes systemically
relevant, which would clearly have implications for financial stability in the event that it runs into
problems.
And, the more institutions operate across borders, the more the risks associated with their business
extends across these borders.
Despite these challenges for financial stability of an increasingly integrated financial system, let me
stress that, so far, the experience both for Spain and the Global Economy seems reassuring, but these
aspects clearly need further investigation. And the immediate and obvious question that arises is the
following: can we mitigate the potentially negative effects of integration on financial stability in order to
take full benefit of the advantages that I mentioned earlier in my intervention?
It is the supervisory authorities who are responsible for dealing with the risks I have identified. But this
is not an easy task. Despite the existence of common EU legislation in many key areas, supervision is
still organised on a national basis. This raises two key challenges.
First, it means that it is not easy for supervisors to capture all the relevant risks - within and across
borders - faced by the financial institutions for which they are responsible.
Secondly, institutions operating on a cross-border basis face duplications and inconsistencies in the
supervision applied to them by the different national authorities with which they are required to deal.
This increases their costs of doing business, and can therefore act as a barrier to integration.
In summary, supervisors face a double challenge in the face of increased EU integration: how to
ensure that their actions are effective, and thereby contribute to preserving financial stability; and how
to ensure that their actions are efficient. Their response has been to enhance cooperation. Indeed,
cooperation between supervisors has increased exponentially over the years.
More recently, the Lamfalussy approach has been implemented, and has set this cooperation in a new
structure that aims to promote a more efficient and effective approach to both supervision and
regulation in the EU financial services sector. The supervisory committees that form part of the
Lamfalussy structure have a major role to play in this respect.
And I think everyone would agree that the efforts being made by these committees are extremely
impressive. But we need to give these efforts time to bear fruit - the Lamfalussy approach is still rather
new, especially in the banking and insurance sectors. In addition, there are a number of initiatives
currently underway to exploit more fully the possibilities of cooperation and convergence provided by
this approach, and I think the results will be positive.
Now it may be that over the longer term, the current structure is judged to be insufficient to meet the
needs of a more integrated market, and that a more fundamental re-think of the organisation of EU
supervisory responsibilities is necessary. I personally think that this debate will intensify in the next
decade. But we would certainly need to proceed with great caution in this debate. I am a firm
supporter of the idea that changes should only be made if clear problems are identified.
But whatever happens, I think the solutions we have to look for should be cooperative in nature,
embracing the needs of all EU member states. This would, in my view, be preferable to an approach
which would tend to concentrate responsibilities in the hands of a few Member States while the
implications of their actions would extend far beyond their borders. Taking a more inclusive approach
is the way that we have found solutions in the past to European challenges, and I think it is the best
way forward. EU-wide financial stability is of interest to all of us.
Against the background that I have portrayed in my previous comments, it is clear that central banks
have a genuine interest in improving their understanding of how the objectives of financial integration
and financial stability, or even macroeconomic stability, interact with each other.
I already mentioned that this is an area which is under-researched. Two years ago, the Network on
Capital Markets and Financial Integration in Europe identified this gap and decided to include the
relationship between financial integration and financial stability in a list of the network's priority areas,
posing a series of stimulating questions aimed at providing some guidance for researchers' efforts.
I think it is useful to recall the five questions posed by the Network:
- First, how can financial regulations be designed so as to be conducive to integration while
still ensuring financial stability?
- Secondly, what are the main links between financial integration and contagion?
- Thirdly, what are the mechanisms that can trigger contagion and financial fragility?
- Fourth, how does competition in the financial services industry affect the ability of the
financial system to withstand shocks?
- And finally, how and to what extent do financial crises affect economic activity?
As you will have realised, there is an almost perfect correlation between these questions and the main
topics of the different papers that make up the excellent and well-balanced programme that the
organisers have put together for this Conference.
This is important because it shows that there is another less-explored way in which central banks can
effectively contribute to fostering financial integration: identifying the policy issues where the input from
research is welcome and providing researchers with a forum where they can debate their ideas among
themselves and with policy makers who, if convinced, will be in charge of carrying them forward.
I am sure that the presentations and discussions during the course of this conference will provide
central bankers with fresh and high-quality material which will be useful to us in finding the most
efficient way to foster financial integration without jeopardising our objective of promoting financial
stability.
I sincerely hope too that this conference will encourage researchers to go on working on these and
other related areas in the coming years, thereby rapidly filling the current gap between the policy
relevance of the questions posed and the availability of profound analytical and empirical research to
substantiate the possible answers.
I would like to end my intervention by thanking the organisers for gathering together such an
impressive group of researchers and policy makers, thanking the audience for their attention and
wishing you all a fruitful exchange of ideas and a pleasant stay in Madrid.
Thank you very much.