Jean-Claude Trichet: Financial integration in Europe and important
financial sector issues
Keynote speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the
Second Symposium of the ECB-CFS research network on "Capital Markets and Financial
Integration in Europe", Frankfurt am Main, 13 February 2008.
* * *
Ladies and Gentlemen,
It is a great pleasure for me to address such a distinguished audience of researchers, market
participants and policy makers here at the Second Symposium of the ECB-CFS research
network on "Capital Markets and Financial Integration in Europe". As you will probably all
appreciate, we are living in challenging times right now. And many, although not all, of the
main challenges relate to financial sectors. So, for my remarks today I have made a selection
of important financial sector issues, some more structural and others more related to recent
developments.
My presentation is divided into two broad parts. In the first part, I would like to broadly
address the importance of financial integration in Europe, review the current state of
integration and tell you about our activities in this area. In the second part I would like to look
at one specific part of the European regulatory set-up that has been less often discussed in
the past in relation to financial integration, namely the structure of deposit insurance
schemes. I will conclude by some remarks on the present very significant market corrections
and financial turbulences that we experienced in the international financial system since the
summer last year.
Financial integration
Financial integration is an important part of the Lisbon Agenda and the European Union's
Single Market Program. In particular, among industrial countries the free flow of capital
across borders unleashes competitive pressures that reduce the cost of capital and allows
for better sharing of risk for consumers and firms. It is therefore the long-standing view of the
Eurosystem that financial integration is an important process for the general well-functioning
of the European economy.
Since its creation in 2002, the ECB-CFS network has featured important pieces of research
that further substantiated our conviction in this regard. We have seen more of this since this
morning in the present Symposium. One paper adds that the benefits of financial openness
through the corporate sector arise particularly from improvements in total factor productivity,
rather than through capital accumulation.1 Another illustrates how cultural factors, such as
mutual trust and confidence, matter for the degree of risk sharing even among European
regions within the same country.2 While we have certainly made a lot of important progress
in European financial integration over the last decades, not the least through the introduction
of the euro, available research also suggests that a lot of benefits in terms of cross-country
risk sharing are still to be reaped and therefore further efforts are necessary.
Research presented this afternoon also threw a positive light on the role of financial
integration with respect to Central and Eastern European countries. In fact, this contrasts a
bit with some previous literature that argued that developing and emerging market countries
are less able to reap the benefits of financial integration. One paper argued that foreign
banks appear to allocate credit more efficiently than domestic banks in this region.3 And,
accordingly, another finds that financial integration has helped convergence and economic
growth in Central and Eastern European countries.4
Financial integration is also of key importance for the performance of the tasks of the
Eurosystem. First, a well-integrated financial system enhances the smooth and effective
transmission of monetary policy throughout the euro area. Second, financial integration is
relevant for our task of contributing to the safeguarding of financial stability. Integrated
markets reinforce the shock-absorption capacity of the system, as they are more liquid and
offer better opportunities for financing and risk distribution. Finally, without prejudice to the
main objective of price stability, we support the general economic policies of the European
Union.
What is the current state of European financial integration? Here I will be very brief today, as
I have characterised this already at various occasions in the past and as financial integration
is not a fast-moving process. The degree of integration in the euro area varies considerably
across different market segments. The euro money market is already highly integrated, as it
is closest to the single monetary policy and supported by area-wide large-value payment
systems, such as TARGET or EURO 1. An important exception is the market segment for
short-term debt securities, which shows some fragmentation owing to the prevailing
differences in market standards and practices. The bond markets are also relatively well
integrated. For instance, the cross-border holdings already constitute around 40% of the total
of the long-term debt securities held by monetary financial institutions. Equity markets are
less advanced than bond markets but show signs of increasing integration. For example, the
proportion of variance of equity returns explained by euro area shock is around 38% when
measured over the period of 1999-2007. Still relatively fragmented securities clearing and
settlement systems continue to constitute obstacles to the further integration of securities
markets in Europe.
In general, wholesale and capital market-related activities of banks show solid signs of
increasing integration, while retail banking and the underlying retail payment systems have
remained more fragmented, as has been the case for mortgage markets. Finally, as was
discussed in detail in an ECB staff presentation earlier during this Symposium, financial
markets in the member states that joined the European Union in 2004 are significantly less
integrated than those in the euro area.5 In sum, a lot has been achieved in the past, not the
least through the introduction of the euro, but more needs to be done in the future to reap the
full benefits of the Single Market for Financial Services.
Let me now mention some examples where we have focused our efforts to contribute -
within the realm of our competencies - to improving financial integration and where we plan
further work. We tend to group our efforts relating to financial integration in four types of
activities: (i) giving advice on the legislative and regulatory framework; (ii) acting as a catalyst
for collective private sector initiatives; (iii) enhancing knowledge and raising awareness; and
(iv) providing central bank services. I select examples from each group.
As regards legislative and regulatory advice, the Eurosystem was fully involved in the review
of the Lamfalussy framework that took place at the end of last year and published a
contribution to the assessment regarding the banking sector. We generally share the broad
agreement among EU bodies that the Lamfalussy framework has significantly increased the
efficiency and effectiveness of financial regulation and supervision in the EU.
At the same time, however, a number of further improvements seem warranted to reap all
the benefits. First, increased regulatory convergence is called for, in particular for reducing
national options and discretions in EU directives. Indeed, the inconsistent implementation as
well as the "gold plating" of EU rules at the national level give rise to significant compliance
costs for financial institutions operating across borders. Second, we need to strengthen the
basis and decision powers of the "level 3" committees of supervisory authorities pursuing
supervisory convergence and cooperation Third, further improvements in the arrangements
for the supervision of cross-border financial groups should be achieved. All authorities need
to be adequately informed to effectively perform the ongoing supervision of cross-border
institutions as well as to be fully prepared to address potential cross-border situations of
financial distress. Given the increased scope and intensity of the cross-border activities of
EU banking groups, the need for effective information-sharing and cooperation in their
supervision is now more important than ever. In this respect, the Eurosystem underscores in
particular the importance of strengthening information sharing also between supervisory
authorities and central banks without supervisory responsibilities with respect to the major
EU banking groups.
Next, I am turning to our role as catalyst for market activities fostering financial integration.
The example I choose here is the Single Euro Payments Area, in short SEPA initiative, led
by the European Payments Council, which has started officially last month. It is a market-led
initiative aiming at removing technical, legal and commercial barriers against smooth
cashless cross-border payments in euro. The objective is to make cashless paying with euro
as easy, efficient and safe as it is today within one country. This has genuine benefits for
consumers, firms and public administrations having to conduct cross-border payments. The
launch included both the roll-outs of the SEPA credit transfer system and the SEPA cards
framework. The SEPA direct debit system will follow before the end of 2009. The ECB has
supported the European Payments Council in a variety of ways. For example, the ECB
regularly organised meetings with stakeholders such as end-users, infrastructures providers
and card schemes. We have also published a study of SEPA's potential economic impact,
which highlighted, among other things, the room for cost reductions for banks.6
The ECB is also very active in enhancing knowledge about financial integration. Our
research network on "Capital Markets and Financial Integration in Europe" with the Center for
Financial Studies at the University of Frankfurt and whose Second Symposium you are
currently attending is one good example. A major task of the ECB in this area is also the
"Report on Financial Integration in Europe". This report was published for the first time last
year and it displays, among other things, our most important indicators to assess the degree
of financial integration in different parts of the financial system. The second report will come
out next month, and will again feature a number of interesting analyses and conclusions.
I would like to mention yet another example in this group of activities, namely our contribution
to the possible extension of the market transparency provisions in the Market in Financial
Instruments Directive, in short MiFID, to financial instruments other than equities. The
interest of the ECB in this issue follows in particular from the great importance of
wellfunctioning markets for the transmission of monetary policy impulses. We explained our view
at a public hearing held by the European Commission in September 2007. Focusing on post-
trade transparency in retail and wholesale bond markets, we proposed a market-led
controlled experiment about the trade-off between transparency and liquidity. In such an
experiment, post-trade transparency could be gradually introduced, starting for example with
the most liquid bond market segment, in order to assess its effects on market liquidity. The
ECB stands ready to support such an experiment. In the present time, the importance of
transparency in financial markets to allow for an efficient processing of information has of
course become particularly evident.
Finally, we provide central banking services that also foster financial integration. For
example, most recently we successfully launched TARGET2, the second generation of our
large-value payment system. By moving from a system composed of mutually interconnected
national real-time gross settlement systems to a common system with a single shared
platform for payments, we achieve further harmonisation for users in different countries and
realise considerable scale economies. We achieved a single price structure for both
domestic and cross-border transactions, the possibility of consolidated liquidity management
for cross-border financial institutions and a harmonised set of cash settlement services for a
variety of connected systems. The new system started in November last year with the first
wave of countries. More countries will join in a few days and the last wave will follow in May
this year.
With a view to maximising the benefits from TARGET2, the Eurosystem is currently also
exploring the possibility of providing settlement services in central bank money for
eurodenominated securities transactions. The objective of this project, called
TARGET2Securities, is to concentrate securities and cash settlements within Europe on an efficient,
single platform. The user requirements of the system are currently the subject of a public
consultation. The Governing Council will take into consideration the views of the
stakeholders as well as the relevant public authorities prior to making a decision, by
mid2008, on whether to launch the project.
Deposit insurance
Let me move to an area that has received relatively scarce attention in relation to financial
integration, which is the design of deposit insurance schemes. Although I look at it today
primarily from an integration perspective, we should keep in mind that deposit insurance
plays also an important role in crisis prevention and resolution. Deposit insurance serves two
different but interrelated purposes. Its consumer protection purpose is to protect small and
unsophisticated bank depositors against loosing a potentially important part of their wealth.
Its financial stability purpose is to avoid bank depositor runs.
While it is nowadays hardly challenged any more that deposit insurance is a necessary
element of the regulatory set-up, there is also awareness that an ill-designed deposit
insurance scheme can have important adverse effects. On the one hand, a too generous
coverage - protecting also large sophisticated depositors - could reduce market discipline
for banks and therefore create distortions in the allocation of risks, including potential
incentives for excessive risk taking by banks. This, in turn, could contribute to instability and
related costs. On the other hand, unclear arrangements or only partial coverage for retail
depositors could open the way again for bank runs.
In order to illustrate the relevance of deposit insurance schemes for financial integration, let
me recall the definition of financial integration we are using for our work. According to this
definition, a market for a given set of financial instruments or services is fully integrated when
all potential participants in that market (i) are subject to a single set of rules when they decide
to deal with those financial instruments or services, (ii) have equal access to this set of
financial instruments or services, and (iii) are treated equally when they operate in the
market. The instrument in question here is the basic bank deposit. Differences of rules and
regulations across countries about how deposits are guaranteed could therefore affect the
degree of integration achieved. Given that small depositors tend to be immobile, and
therefore cross-border retail deposit holdings are rather limited in the EU at present, the main
issues arise with respect to the compliance costs for cross-border banks and the competition
between banks that are subject to differing rules and regulations governing deposit insurance
schemes.
Let me compare some main features of deposit insurance schemes across European
countries, starting with coverage.7 In EU countries, the amount of fully insured deposits per
depositor varies between 20,000 euros, the minimum threshold prescribed by the Directive
on Deposit Guarantee Schemes, and about 103,000 euros. Everything else equal, depositors
that possess as much as 100,000 euro in a bank account are more likely to be sophisticated
and therefore less needing protection than small depositors. And without such insurance,
large and sophisticated depositors may exert some market discipline on banks. In other
words, banks with a large share of their deposits in a country with high coverage may have
different incentives and access to deposit finance compared to banks in lower coverage
countries. A related point could be made about the different types of deposits that are
covered by the respective schemes.
A second important parameter of a deposit insurance scheme is the funding structure. In the
EU some schemes are pre-funded, i.e. they collect the means for being able to pay out in
case of a bank failure beforehand, others are only funded ex post, i.e. in case of a bank
failure the necessary amounts are collected from other banks, and again other schemes use
a combination of the two. For the pre-funded schemes the premium structure is of relevance.
Some schemes use flat rates in proportion to banks' deposits and others take some aspects
of bank risk in the pricing into account. All this leads to greatly varying "coverage ratios"
across the EU, defined as the size of funds divided by the total amount of deposits covered.
The differences in funding structures can lead to differences in the costs of deposit insurance
for banks headquartered in different countries.
As the views of stakeholders tend to be divided, an important issue for further analysis and
research is whether differences in coverage and funding structures have a significant impact
on the competition among banks originating from different countries.
In addition, cross-border banks with subsidiary structures have to obey to the rules of the
deposit insurance scheme in each country where they are represented. This is complicated
and costly for them. Once they have become a member of a scheme and paid into it, it is
often impossible to recover the funds in case they would like to streamline the group by
moving to a branch structure, e.g. by becoming a Societas Europea. This might discourage
cross-border groups from streamlining their company structure, which could become a factor
limiting financial integration. In this area as well, I a missing a study providing answers that
take all benefits and costs of different options into account.
All these observations raise the issue as to whether the mechanisms for coordination at the
level of the EU should be used to achieve more convergence in the various aspects of
deposit insurance schemes in the context of the presently decentralised approach to financial
regulation and stability. This convergence could go in the following directions. First, in
addition to setting a lower bound, also the maximum amount covered could be limited and
the specification which deposits are included and which not better harmonised. Partial
insurance, or the so-called co-insurance, for smaller deposits could be removed where it still
exists, as recent experience seems to suggest that it may reintroduce incentives for retail
depositors to run a bank. Second, it may be advisable to move towards pre-funded schemes,
which are financed through risk-sensitive premia. This would bring bank incentives better in
line. Obviously, it would also mean significant transitional costs for the countries that
presently operate schemes funded ex post. Pre-funded schemes would also permit to
mobilise very rapidly the guarantee which might be a decisive advantage to avoid bank runs.
Such European convergence of deposit insurance practices would, however, not solve the
problem that at least as important differences exist between European and non-European
countries.
Deposit insurance is naturally not only relevant for financial integration but also, very much,
for the handling of financial crises. Clearly the cross-country differences I mentioned above
(and several others more) are at least as much an issue for crisis prevention, management
and resolution as they are for financial integration. Convergence in deposit insurance
arrangements across European countries should not advance in a way that neglects either
the financial stability or the financial integration aspect of it. Both need to be well aligned.
Overall, we agree with the Commission's "bifurcated" approach, according to which further
progress at a shorter time horizon should first be achieved using the available non-legislative
mechanisms and more fundamental reforms requiring legislation should be based on a
deeper analysis, particularly considering the results of the debates on the financial stability
set-up and burden sharing that are presently under way in Europe.8
Let me conclude with some remarks on the ongoing process of significant market correction
that global finance is experiencing since several months, with its episodes of high market
volatility and financial turbulences.
The last G7 meeting in Tokyo was a good occasion to exchange views on the underlying
causes of the recent turbulences and on the areas where significant improvements will have
to be brought about in global finance. The communiqué of the G7 that Ministers and
Governors signed captures pretty well the large consensus we have at present on both the
methodology and the six domains where we agree action will be necessary. This large
consensus is very important because the challenges that we have to cope with are global
and the solutions themselves can be nothing but global and very closely harmonised
between the economies that are making up the global economy. I think particularly of the two
vast continental economies that are on both sides of the Atlantic.
On top of stressing the absolute necessity to work very actively, and very united together, to
draw the right lessons from the present market correction - which, according to our agreed
methodology, we will do when receiving the definitive report of the Financial Stability Forum
on the occasion of the next spring meetings of the Bretton Woods Institutions in Washington
- I will make three remarks.
First, the international community is able to produce a right and pertinent diagnosis of the
global finance's situation. As chairman of the Global Economy Meeting which takes place
every two months in Basel, under the auspices of the BIS, I mentioned regularly in 2006 as
well as in the first months of 2007 that my colleagues and I were judging that there was a
significant underpricing of risks in global finance. This situation was substantiated by a very
low level of spreads, a very low level of risk premia, an abnormally low level of volatility in a
large number of markets. We had explicitly and publicly called for institutions and markets to
prepare themselves for a correction that was both unavoidable and necessary to pave the
way for more sustainable path of global finance. Such analysis and diagnosis were reflected
pretty well in most Financial Stability Reviews published by central banks, not the least in the
ECB publication a long time before the market correction. The BIS publications were
themselves equally clear in this respect.
Second, a good analysis and a pertinent diagnosis are a necessary condition for future
necessary market corrections to be as smooth and as orderly as possible. But it is not a
sufficient condition per se as is clearly demonstrated in the present episode of turbulence
and as was regularly observed in the previous periods of sharp and abrupt market
corrections. And that is the reason why it is so important, so decisive that we draw all the
lessons from the present episode, across the board, without any prejudices, without giving
any privilege of untouchability to any part and parcel of global finance. From that standpoint I
think the work of the Financial Stability Forum - scrutinizing liquidity risk management as well
as credit rating agencies, analysing without complacency the weakness in the structure of
incentives of the "originate to distribute" model as well as the monitoring of the off-balance
sheet vehicles, examining the implementation of the Basel II agreement as well as the
arrangement for dealing with in particular weak cross-border financial institutions - is of the
essence.
Third, even with a right and pertinent diagnosis, and appropriate significant improvements in
benchmark voluntary principles and codes of conduct for the private sector as well as
substantial progress in rules and regulations, in cooperation and coordination between
authorities where needed, my understanding is that we could not be ensured that the
"unavoidable and necessary market corrections" of the future will be reasonably "smooth and
orderly".
For a higher likelihood of that to happen we need probably simultaneously what I would call a
further significant change of culture at national as well as at global level. I would sum up this
change in our overall approach with these words: Transparency, Holism and Anti cyclicality.
Transparency because enhanced public information on institutions as well as on financial
instruments is the only way we have to avoid contagion and herd behaviour in times of
difficulty. Holism because, technology and globalisation helping, we have progressively built
global finance on the basis of the very close interconnections of all markets, all institutions,
all economies. We must continue to improve our full understanding of the functioning of the
financial system as a whole. The Financial Stability Forum gathering banking, insurance and
market surveillance authorities, central banks, international financial institutions, treasuries
etc., was the first major illustration of this necessity to address the global financial system as
a whole. We have to reinforce considerably this holistic approach. And Anticyclicality
because a number of rules and regulations, on the one hand, and of behaviours of public and
private institutions as well as of markets, on the other hand, have a tendency to be largely
procyclical, amplifying the booms as well as the busts in the cycle. We must look at all parts
and parcels of global finance with a view to diminishing progressively their procyclical
components which implies, in particular but certainly not exclusively, eliminating as much as
possible asymmetry in the treatment of booms and busts and extending as much as
possible, where needed, the time horizon adopted by all the institutions concerned.
Many thanks for your kind attention.