Lucas Papademos: Financial integration in Europe
Presentation by Mr Lucas Papademos, Vice President of the European Central Bank, at the
press briefing on the occasion of the publication of the second edition of the ECB Report on
financial integration in Europe, Frankfurt am Main, 29 April 2008.
* * *
I. Introduction
Ladies and Gentlemen,
On behalf of the Executive Board of the European Central Bank, I would like to welcome you
to this press briefing on the occasion of the publication of the second edition of the ECB's
report on "Financial Integration in Europe".
The first report on "Financial integration in Europe" was published last year and we intend to
release it annually. Its main purpose is to contribute towards the advancement of European
financial integration and to raise public awareness of the Eurosystem's role in supporting the
financial integration process.
Before I turn to the content of the report, let me briefly recall why we prepare and publish this
report. The Eurosystem has a strong interest in the integration and the efficient functioning of
the financial system in Europe, particularly in the euro area, because it facilitates the
performance of our core tasks.
Starting with monetary policy, a well-integrated financial system facilitates the transmission of
monetary policy throughout the euro area. Financial integration is also highly relevant to the
Eurosystem's role in safeguarding the stability of the financial system. More integrated
financial markets enhance the opportunities for sharing and diversifying risk and increase the
market liquidity. At the same time, a more closely integrated financial system also raises the
scope for spill-over effects and contagion across borders, as the recent financial market
turmoil has manifested. Financial integration is also fundamental to our task of promoting the
smooth operation of payment systems and of securities clearing and settlement systems.
Finally, without prejudice to our primary objective of price stability, we support the general
economic policies of the European Union. The completion of a single market for capital and
financial services is an important policy priority which should foster the efficiency and
development of the European financial system and help increase potential growth.
The ECB and the entire Eurosystem fully support the efforts of the private sector and the EU
institutions to enhance the integration and development of the European financial system. In
this respect, the ECB works very closely with the European Commission, which has a
primary responsibility in this field. The ECB report complements the work of the Commission
in this area. I now turn to the content of the report and will highlight some of the main
findings.
The report consists of three chapters [see slide 2]. The first chapter sets out the ECB's
assessment of the state of financial integration in the euro area. This assessment is based
on a set of quantitative indicators we have developed. The second chapter contains in-depth
analyses of selected issues relating to financial integration. The final chapter of the report
gives an overview of the activities of the Eurosystem in 2007 aimed at advancing the
integration and development of financial markets in Europe.
II. The state of financial integration in Europe
Let me start with the ECB's assessment of the state of financial integration in the euro area
which covers the money, bond, equity and banking markets, as well as the underlying market
infrastructures. The tables on this slide [see slide 3] and on the following one summarise our
assessment of the degree of integration in the various market segments. Two key facts
should be highlighted: first, financial integration is generally more advanced in those market
segments that are closer to the single monetary policy; and, second, it depends on the
degree of integration of the respective market infrastructures. These conclusions confirm the
findings of last year's report.
In particular, the unsecured money market has been fully integrated since the introduction of
the euro, and the repo market is also highly integrated. The full integration of the large-value
payment systems has been instrumental in achieving this result. Government bond markets
have also become considerably integrated. Similarly, the corporate bond market received a
major boost with the introduction of the euro and has subsequently achieved a high degree
of integration. Some progress has also been made in the integration of euro area equity
markets, although the euro area securities infrastructure that underpins both bond and equity
markets is not yet sufficiently integrated. However, efforts to reduce these barriers are
currently under way.
Turning to the banking markets [see slide 4], integration has advanced well in the fields of
wholesale banking and capital-market activities. The integration of the retail banking market
has, however, been slow and hampered by the fragmentation of the European payment
systems.
After this broad overview, allow me to illustrate some specific developments in particular
market segments, also with reference to the recent episode of financial turbulence. In this
context, a pertinent question is whether the financial market turmoil has had an impact on the
degree of integration in various market segments. First, with regard to the nearly fully
integrated money markets, the recent financial turmoil has undoubtedly left a mark on the
cross-country standard deviation of the unsecured interbank lending rates, as you can see
from this chart [see slide 5]. Looking at this graph, one may wonder whether the turmoil has
in fact led to a higher segmentation, and therefore, less integration, in the market.
In response, let me now show you a related indicator for the secured money market which
strongly suggests that this is not likely to be the case. As you see in the chart [see slide 6],
the cross-country standard deviation of the interbank repo rates does not seem to have been
similarly affected. As credit risk is an important element in the unsecured markets, but not so
in the secured markets, this may lead us to conclude that the increase in differences in credit
risk across institutions, rather than increased segmentation, is the likely explanation for the
observed small but noticeable increase in the cross-country standard deviation in interbank
lending rates. Of course, we continue to monitor the evolution of these and other indicators
very closely in the coming months in order to obtain more information on the possible effects
of the turmoil on the money markets as well as on other financial markets.
I already mentioned that retail banking markets continue to be less integrated than other
banking market segments. The dispersion of total assets of euro area bank branches and
subsidiaries across euro area countries illustrates the point [see slide 7]. The horizontal line
within the pillars shows the median share of assets for both types of establishments.
Whereas the median share of assets of foreign subsidiaries increased to 14.4% last year, the
median share of assets of foreign branches slightly decreased, reaching 2.0%.
III. Special features
The second chapter of the report contains four "Special Features". These are in-depth
assessments of policy issues relating to financial integration that are of particular relevance
to the Eurosystem's tasks [see slide 8]. This year, we selected the following topics: (1)
concepts and measures of financial development; (2) the STEP initiative; (3) the integration
and development of mortgage markets; and (4) the integration of large-value payment and
securities transactions. Out of these four, I should like to focus on two, namely on financial
development and on the integration of mortgage markets.
III.1. Financial development
The special feature on financial development goes beyond financial integration and looks into
other elements that affect the performance of the financial system [see slide 9]. The concept
of financial development is introduced and is related to other concepts such as financial
integration, efficiency and stability. More precisely, financial development refers to the
process of financial innovation, institutional and organisational improvements that reduce
asymmetric information, increase the completeness of markets and contracting possibilities,
lower transaction costs, and enhance competition. In particular, financial development is
complementary to financial integration in reducing market frictions and fostering financial
market efficiency.
This chart [see slide 10] presents a simple framework to summarise the determinants of the
performance of the financial system and its links to the performance of the broader economy.
There are three levels of analysis. The first level concerns the fundamentals of the financial
system that do not change very fast, such as legal and regulatory frameworks or features of
the economy's financial structure. The second level relates to the performance of the
financial system, that is, its efficiency and stability. The third level focuses on the
performance of the economy as a whole, that is, economic growth and price stability. As you
can see, financial integration and financial development are processes that influence the
relationship between the fundamentals of the financial system and its performance.
A selection of indicators is provided in this Special Feature to monitor financial development
and efficiency [see slide 11]. These indicators can be grouped into general and
marketspecific indicators. An example of general indicators is the size of capital markets, which
aggregates the sizes of stock, bond and loan markets, as a percentage of GDP. On average,
euro area capital markets tend to be smaller than those in the United Kingdom and the
United States.
Let me continue with some examples of market-specific indicators. This chart [see slide 12]
shows the notional amounts of nominal outstanding interest rate derivatives, that is, forward
rate agreements, options, and swaps, by currency. By using derivatives, market participants
can better manage risks, lock in the future price of the underlying assets and even alter the
terms of the underlying financial contract. As a consequence, the allocation of capital and
risk across time and space is improved. The chart clearly shows that the most active interest
rate derivative markets are those denominated in euro and in the US dollar, with outstanding
amounts in 2006 of 86 and 75 trillion euro, respectively.
Focusing on the evolution of the interest rate derivatives market over time, this chart [see
slide 13] shows that the US-dollar denominated interest rate derivatives grew the fastest,
with the amount outstanding increasing sixfold. The second fastest growing markets were the
interest rate derivatives denominated in euro and in pound sterling, which both quadrupled
from 1999 to 2006.
Securitisation of illiquid bank assets is a form of financial innovation that has expanded
substantially in recent years. This chart [see slide 14] shows the extent of off-balance sheet
securitisation via asset-backed and mortgage-backed securities relative to gross domestic
product (GDP), using the location of the underlying collateral to link this financial innovation
to countries. According to this indicator, the United States is by far the most active market for
securitising mortgages and receivables such as car loans or credit card loans: the volume of
issuance amounted to 25% of GDP. In the euro area, the average volume of issuance was
only 2% of the GDP, with Spain, the Netherlands, Luxemburg, Ireland and Portugal having
the highest levels. The lack of integration in European mortgage markets partly explains
these facts. It also suggests that the ease with which issuers of asset-backed securities in
one country can include illiquid assets from other European countries is an important factor
that will influence the evolution of securitisation in Europe.
Another example of a market-specific indicator of financial development is the total amount of
venture capital financing as a share of GDP [see slide 15]. Despite having grown
substantially over the past ten years, venture capital financing remains only a fraction of the
UK and US figures in most euro area countries, with the exception of Finland.
To sum up, on the basis of the indicators identified so far, it can be concluded that there still
exists a fair degree of heterogeneity in financial development across markets and countries
in the euro area. On average, the euro area financial system compares well to a group of
benchmark countries, except perhaps relative to the United Kingdom and the United States,
which perform better on the basis of most of the indicators presented in the report. There is
certainly room for further analysis and assessment of financial development by enhancing
the existing indicators and by identifying new ones. And there is room for structural reforms
that can foster financial market efficiency.
III.2. The Short-Term European Paper (STEP) initiative
The second Special Feature, entitled "The STEP initiative", describes how the ECB and the
Eurosystem can act as a catalyst for private sector activities and, in this way, promote
financial integration in the euro area [see slide 17]. The Short-Term European Paper (STEP)
initiative to develop a pan-European short-term paper market originated from the observation
that the short-term securities market had been the least integrated money market segment
since the introduction of the euro. The STEP label, given to issuance programmes that
comply with a core set of commonly agreed market standards and practices, provides market
participants across the euro area with a common framework. Since its launch in 2006, the
STEP initiative has already yielded significant progress in market integration and
transparency.
III.3. Mortgage markets in Europe
The third special feature of the Report on which I will elaborate, given its topicality, concerns
the integration and development of mortgage markets in Europe. Mortgage markets are an
important part of the euro area financial system: the provision of mortgage loans is a key
financial service for households; mortgages accounted for almost 30% of total bank loans
and about 60% of the household liabilities; and asset-backed securities - of which
mortgagebacked securities represent a large share - have become an important source of collateral,
accounting for approximately 16% of all collateral deposited with the Eurosystem, a slightly
larger fraction than central government bonds.
Mortgage markets are very important, yet they remain one of the least integrated financial
markets in Europe and progress towards further integration has been slow. This is partly due
to natural barriers, such as language, affinity and consumer preferences. However, other
factors such as domestic infrastructures and differing legal and consumer protection
frameworks create barriers that can, and should, be addressed by policy-makers and market
participants.
The chart on slide 19 on new housing loans in euro area countries, classified by the period of
interest rate fixation, illustrates the diversity in the mortgage lending markets. In general, not
only the use of fixed and variable rate mortgages, but also early repayment and prepayment
options and loan maturities vary considerably across the euro area.
Similarly, diversity prevails on the funding side of mortgage markets. The chart on slide 20
illustrates the relative importance of residential mortgage-backed securities (RMBSs) and
covered bonds in the national markets. The dominance of only one type of instrument in
most countries is related to the presence of long-established legal frameworks, or the
existence of certain legal or other obstacles. Consequently, there seems to be room to
improve the availability of different mortgage funding instruments in euro area countries as
well as in other EU countries.
This Special Feature examines in considerable detail the potential implications of further
integration in European mortgage markets for the monetary policy transmission mechanism
and for financial stability. Overall, the Eurosystem's assessment is that further integration of
mortgage markets is desirable because it is likely to bring about a more uniform transmission
of monetary impulses and a more stable financial system as a result of improved risk
diversification [see slide 21]. At the same time, the process of financial integration may entail
certain risks to monetary and financial stability, such as increased vulnerability of domestic
financial systems to external shocks and intense competition that may lead to an erosion of
credit standards. So while we strongly support further integration in mortgage markets, we
are also of the view that this process should be carefully monitored.
That said, full integration of mortgage markets is a process that is likely to take many years
and will largely be driven by market forces [see slide 22]. We believe that market participants'
actions will help achieve significant further progress. For example, they can increase market
transparency, improve statistics, promote standardised mortgage products and develop
market benchmarks. Within the scope of its competencies, the ECB stands ready to support
such market initiatives, as we have done in the area of short-term securities.
III.4. Integration of large-value payment and securities transactions: TARGET2,
T2S, CCBM2
The final Special Feature, entitled "Integration of large-value payment and securities
transactions: TARGET2, TARGET2-Securities and CCBM2", considers the advances
towards an integrated and well-functioning European market infrastructure, focusing on the
contribution of the Eurosystem [see slide 23]. During the run-up to the introduction of the
euro, the Eurosystem established the TARGET system and the Correspondent Central
Banking Model (CCBM) which enabled the area-wide settlement of large-value transactions
in central bank money and the cross-border delivery of collateral to the Eurosystem. While
these were undoubtedly already major steps towards the integration of crucial market
infrastructures, TARGET and CCBM did not yet allow market participants to manage their
cash, collateral and securities positions in an integrated way. The recent establishment of
TARGET2 as a centralised technical service addresses this shortcoming for
eurodenominated large-value and urgent payments. It also enables the move towards a fully
integrated infrastructure in the fields of securities settlement, liquidity and collateral
management. The envisaged TARGET2-Securities project and the Collateral Central Bank
Management (CCBM2) facilities, together with TARGET 2, are "second generation" services,
which represent a quantum leap forward in the integration and quality of the euro area core
infrastructure, with substantial benefits for financial market integration.
IV. Eurosystem activities to promote financial integration
I now turn to the report's third chapter, titled "Eurosystem activities for financial integration". It
provides an overview of the main Eurosystem activities in 2007. The ECB and the
Eurosystem contributed to financial integration and development in a number of ways,
building on their expertise and special nature as public institutions which are both active in
the market and have close interaction with market participants. We distinguish between four
types of activities [see slide 24].
First, we give advice on the legislative and regulatory framework for the financial system and
make rules. A good example is the Eurosystem's contribution to the first full review of the
Lamfalussy framework last year. The Eurosystem reiterated its support to the Lamfalussy
framework subject to some necessary functional enhancements within the current
institutional framework and in particular emphasised the need for intensification of
cooperation and information-sharing between supervisors and central banks.
Second, we seek to act as catalysts for private sector activities. In this regard, we have been
instrumental in the success of the short-term European paper, or STEP, initiative. This
initiative aims to promote the integration of short-term paper market through the voluntary
compliance of market players with a core set of standards. The outstanding amount of
eurodenominated STEP-labelled securities already accounts for about 30% of all
eurodenominated short-term paper placed by non-government issuers worldwide.
Third, we enhance knowledge, raise awareness and monitor the state of European financial
integration. This Report, and the indicators of financial integration that are presented here,
are an illustrative example of this type of activity.
Fourth, we provide central bank services that also foster European financial integration. As
an example, I choose our wholesale payment system, TARGET2. The successful launch of
this single technical platform in November last year marks a significant milestone in financial
integration. TARGET2, replacing TARGET, provides for a harmonised service level, a single
price structure, and a harmonised set of cash settlement services in central bank money for
all "ancillary" systems, such as retail payment systems, clearing houses and securities
settlement systems. All central banks and TARGET users will have migrated to TARGET2 by
19 May this year.
V. Concluding remarks
This brings me to the end of my presentation. Central banks are at the core of financial
systems and therefore closely follow developments which can foster integration [see slide
25]. The ECB and the entire Eurosystem devote a substantial amount of resources to this
task, because we are convinced that progress in this area is important for the European
economy, within the framework established by the Lisbon agenda.
Finally, I should also like to stress that, while financial integration is an important driver for
increasing the efficiency of a financial system, financial efficiency also depends on financial
development. Therefore, future reports are envisaged to encompass analysis and
assessment of the various factors determining the efficient functioning of the financial
system. The special feature on financial development that I presented is a first step in this
direction.
Thank you very much for your attention. I am now at your disposal for questions.
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