Lucas Papademos: Financial integration, development and stability -
lessons from the crisis
Speech by Mr Lucas Papademos, Vice President of the European Central Bank, at the
conference "Financial integration and stability: the legacy of the crisis" sponsored and
organised by the European Central Bank and the European Commission, Frankfurt am Main,
12 April 2010.
* * *
I. Introduction
Welcome to the European Central Bank! And welcome to this event which has been jointly
organised by the European Commission and the ECB. The topic that we have chosen for this
conference is the relationship between financial integration and financial stability. The
integration of financial markets is an important policy objective of the EU because it fosters
economic efficiency and growth. The Commission and the ECB have a common and keen
interest in pursuing this objective. The Commission pursues the goal of financial integration
in Europe, as part of its Single Market programme. The ECB promotes the integration of
financial markets in order to enhance the efficiency of the European economy but also
because it facilitates the smooth and balanced transmission of the single monetary policy
and increases its effectiveness. Cooperation between European institutions is not always
properly recognised or even known. Hence, organising this event jointly has a double aim:
first, to advance the European financial integration process by assessing the progress
achieved and the policies pursued; and, second, to highlight the extent of cooperation
between our two institutions in achieving common objectives.
In my remarks, I would like to address two issues: First, I will highlight the interacting links
between financial stability, on the one hand, and financial integration and development, on
the other. And I will provide an overview of the effects of the crisis on financial integration
and development, as well as of the role of the latter in the emergence of systemic risks. I will
consider the processes of financial development and integration together, because, although
conceptually they are distinct, they are related in practice and they have interacting links to
financial stability. Second, I will focus on a more specific, but important and topical, issue: the
impact of the still unfolding crisis on the integration and functioning of the sovereign and
corporate bond markets in the euro area.
II. The links between financial stability, integration and development
The crisis has revealed a rather complex set of interdependencies between financial stability,
integration and development. In general, an environment of financial stability and the
processes of financial integration and development are mutually reinforcing. The stability of
the financial system does contribute to its development and integration. This is evident from
the experience of the first eight years of EMU that were characterised by financial stability
which facilitated a steady and significant progress towards more financial integration and
development.
At the same time, and in the opposite direction, a more integrated and innovative financial
sector typically enhances competition, facilitates portfolio diversification and access to
funding, improves risk-sharing opportunities and increases market liquidity. As a result, the
shock-absorbing capacity of the financial system is improved, thereby enhancing financial
stability.
However, the crisis demonstrated that a highly integrated and developed financial system
does not always and necessarily strengthen financial stability. Under certain conditions,
financial integration and certain forms of financial innovation can contribute to the build-up of
vulnerabilities and the emergence of systemic risks. In the years preceding the crisis, as the
global financial system evolved at a rapid pace, the proliferation of complex and opaque
financial products, the development of innovative securitisation techniques, the emergence of
inappropriate incentive structures, the increased interconnectedness of markets and
institutions, in an environment of enhanced competitive pressures and excessive credit
growth, encouraged risk-creation and risk-taking; and increased the scope for contagion
across institutions, markets and borders.
The emergence of systemic risks and the eventual eruption of the crisis were also the
consequence of the fact that corporate governance, risk management, market infrastructures
for derivative products as well as supervisory practices and regulatory frameworks did not
keep up with the rapid transformation of the financial systems.
What has been the impact of the crisis on financial integration and development? The crisis
caused severe dysfunctionalities in several financial markets and had adverse effects on
development and integration in certain market segments. The issuance and trading in the
most complex variants of asset-backed securities - like the CDOs - came virtually to a halt
after the crisis broke out and the markets for such products have yet to revive. Even the
interbank money market - the most highly integrated one in the euro area - showed signs of
segmentation after August 2007, which intensified in September 2008. The ECB Report
assesses in detail the impact of the crisis on financial integration and development and it
examines, in particular, the extent to which cross-border integration has improved in various
markets as they are returning to more normal conditions.
Let me conclude by making two points regarding the policy implications of the crisis for the
advancement of financial integration and development. The crisis has provided a stressful
but valuable test for financial innovation and cross-border integration, indicating what needs
to be changed so as to reap the benefits of integration and development for efficiency and
growth, while safeguarding financial stability, by addressing potential systemic risks that
might stem from these processes. The recent experience, the ongoing policy debate and
economic research converge on the need for greater transparency, reduced financial product
complexity, improved corporate governance and more effective risk management. Moreover,
the crisis revealed the need for a strengthened regulatory framework, enhanced
macroprudential oversight, intensified micro-prudential supervision and better cross-border crisis
management and resolution regimes. The list is long, but it is vital that progress continues to
be made on all relevant fronts. A lot has been achieved so far, but much more remains to be
done.
In particular, the global regulatory reform underway and the new EU supervisory framework
will greatly contribute to both financial stability and increased financial integration. The
European System of Financial Supervisors will support financial integration by promoting a
single set of micro-prudential rules and the equal treatment of market participants. In parallel,
the European Systemic Risk Board will foster financial integration by safeguarding financial
stability that allows market participants to better exploit cross-border opportunities.
III. The impact of the crisis on the sovereign bond markets in the euro area
Let me now turn to the second issue, namely the impact of the crisis on the sovereign bond
markets in the euro area. This has been significant but heterogeneous, as demonstrated by
diverging yield spreads. Moreover, it has varied over time reflecting the effects of different
factors.
The major phases in the movements in intra-euro area government bond yield differentials
since the outbreak of the crisis are broadly familiar. (SLIDE 1) Therefore, I will abstain from a
chronological description of developments and will focus on three key factors that shaped
euro area sovereign bond spreads at different stages: First, the risk transfer from the
financial system to the government sector; second, the importance of market liquidity premia;
and third, the emergence of more country-specific sovereign credit risks.
III.1 Risk transfer from the financial system to the government sector
In March 2008, euro area government bond spreads showed the first discernible increases
since the beginning of the crisis in summer 2007. Thereafter, spreads abated somewhat but
did not return to pre-crisis levels. Intra-euro area sovereign bond spreads picked up
appreciably after the bankruptcy of Lehman, reflecting "flight to quality", but they widened
substantially in October 2008, when EU governments announced large fiscal stimulus
packages and comprehensive measures to support financial institutions. These measures
led to higher government bond yields as market participants perceived that they induced a
risk transfer from the banking system to the public sector. These perceptions were also
reflected in credit default swap (CDS) premia during this period.
There were marked increases in CDS for government securities, while those on contracts for
banks decreased. (SLIDE 2) Moreover, as the fiscal burden associated with the financial
system support measures was perceived to differ across countries, sovereign credit risk
premia increased to different degrees, leading to a widening of intra euro area government
bond yield spreads.
The bank rescue support packages also had a dynamic effect on sovereign credit spreads.
As analysed in a recent ECB study1, the financial system support measures apparently
brought about a stronger reaction of sovereign credit spreads to shocks, and
correspondingly, a more muted reaction of bank credit spreads to the same disturbances.
Hence, after October 2008, the general intensification of financial market pressures had
stronger effects on sovereign credit spreads, while the "crisis sensitivity" of banks' credit risk
premia decreased.
III.2 The relevance of market liquidity premia
Besides credit risk premia, market liquidity premia have constituted an additional important
determinant of the pricing of sovereign debt securities. Investors have been willing to accept
a lower yield for those debt securities, which are readily convertible into cash. While the
comovement between CDS premia and sovereign bond yield spreads suggests that a large
part of the fluctuations in the latter during the crisis was due to changes in the relative pricing
of credit risk, other factors also influenced the pricing of government securities. (SLIDE 3)
There is evidence that market liquidity conditions played a vital role in the widening of
sovereign bond spreads during the crisis.
This becomes apparent by taking a closer look at the French and German sovereign bond
yield spreads. (SLIDE 4) In March 2009 the difference between the ten-year bond yields
reached more than 50 basis points. Did this sizeable gap reflect different perceptions of the
credit risk of these two AAA-rated sovereign issuers or did it reflect the effects of differences
in market liquidity conditions?
An answer is provided in the ECB Financial Integration Report by examining the difference in
agency bond yield spreads in these two countries. Debt securities issued by the French
CADES and the German KfW would be expected to have the same risk characteristics as
French and German government debt, respectively, since the debt securities issued by these
two agencies are fully guaranteed by the respective governments. It turns out that, in
contrast to the government bond yield spreads, agency yield spreads remained remarkably
stable. This suggests that there were no significant changes in the perceived relative credit
quality of the sovereign issuers, but market liquidity factors influenced favourably the German
government bond yields.
III.3 The role of individual sovereign issuers' credit risk
Let me turn to the third factor that has shaped developments in the euro area government
bond markets, namely country-specific sovereign credit risk. After reaching new peaks at the
beginning of 2009, sovereign bond yield spreads have followed a downward trend, but with a
few exceptions. (SLIDE 5) For some euro area Member States, notably Greece, they have
widened again since mid-November 2009.
The large and persistent increase in the spreads in the case of Greece has been driven by
concerns regarding its long-term fiscal sustainability as well as worries about the country's
ability to refinance its maturing government debt this year. Following the announcement of
additional fiscal consolidation measures by the Greek authorities in March and the statement
by the Heads of State and Government of the Euro Area later in that month, Greek bond
spreads narrowed somewhat. But re-ignited market concerns on the macroeconomic outlook
and the government's refinancing requirements drove spreads substantially higher over the
past few days. Contagion effects to other countries via the government bond markets have
been limited so far. The statement on the support to Greece by Euro Area Member States
issued yesterday had a significant favourable impact on the Greek sovereign spreads today.
Overall, government bond yield spreads in some countries remain at relatively elevated
levels compared to their pre-crisis levels.
III.4 The relation between corporate and sovereign credit risk premia
Before concluding, I want to briefly focus on the relationship between sovereign and
corporate credit risk premia. Should we expect adverse spill-overs from developments in
sovereign credit spreads to the relative costs of corporate financing across euro area
countries? In particular, in the European monetary union is it still the case that sovereign
credit risk premia provide a lower bound for credit risk premia of corporations residing in the
respective country?
As there are no intra-euro area exchange rate risks and the cross-country money market
volatility is very small, these sources of cross-country differentials in risk premia are not
relevant. But there may be other channels of adverse spill-overs from the sovereign to the
corporate bond markets: A country with significantly higher sovereign financing costs would
need to reduce its fiscal deficit, and would be expected to take fiscal consolidation measures,
including increases in corporate taxes. This would potentially dent into firms' profits, worsen
their credit risk assessment and drive up their credit risk premia.
So what is the empirical evidence so far? During several phases of the crisis, bond yield
spreads for euro area non-financial corporations showed distinct co-movement with the
respective sovereign bond yield spreads. This may be explained by common factors which
affected both a country's fiscal position and its firms' profitability, or by changes in risk
perceptions that affected both types of credit spreads.
However, we have also observed episodes of decoupling between developments in
sovereign and corporate credit risk premia. Lately, it turned out that sovereign credit risk
premia (in terms of CDS spreads) did not always provide a floor for all corporations operating
in the respective country. A case in point is that CDS premia of several euro area
telecommunication companies ranged above the respective sovereign CDS spreads in 2008
and early 2009, but this relation has been reversed during various periods thereafter.
(SLIDE 6)
The crisis has also shown that there are several channels through which deteriorating public
finances and worsening sovereign credit risks can spread to the financial sector and affect
the credit risk of financial institutions. Spreads on CDS contracts for larger banks and the
sovereign CDS for government securities of the countries where these banks are domiciled
have moved together over the past six months. (SLIDE 7) Two snap-shots are shown on this
chart, one on 30 September 2009 and the other on 26 March 2010. Between these two
dates, as sovereign CDS spreads rose, so did bank CDS spreads, and in some cases
substantially so. This important pass-through of sovereign credit risk to bank funding costs is
in the opposite direction from the feedback observed in the fall of 2008, when bank credit
risks resulted in an increase of sovereign funding costs, when governments committed to
support their banking sectors. In assessing this evidence, we should keep in mind that the
limited market liquidity characterising some CDS markets suggests particular caution in
interpreting cross-country developments in CDS premia on government bonds.
These relationships clearly deserve further analysis and they underscore the important
interactions between the government and corporate sectors across the euro area countries
despite the high degree of financial integration in the euro area.
IV. Concluding remarks
In conclusion, I would like to stress three points. First, developments in sovereign yield
spreads and CDS premia on government bonds should be interpreted with great caution with
regard to their implications for market integration. The degree of integration of sovereign
bond markets is difficult to measure and assess. Most importantly, in a monetary union,
sizeable bond yield spreads may not indicate lack of market integration but market
participants' judgement on relative sovereign credit risks. It is a salient feature of an
integrated bond market that investors can easily change their positions among different
sovereign securities whenever the credit risk outlook changes. Hence, a widening of
sovereign bond yield spreads, reflecting changes in perceived credit risks, does not
necessarily signal a reduced degree of market integration. However, at the same time it
cannot be excluded that some fragmentation may indeed have taken place during the crisis,
reflecting different market liquidity conditions, as I previously explained.
Second, looking ahead, the cross-country dispersion of price-based indicators of financial
integration in various markets is likely to reflect a different appreciation of risks across the EU
compared with that prevailing before the crisis.
Finally, it is important to recognise that despite the adverse temporary effects of the crisis on
the integration of financial markets, the high degree of financial integration achieved in the
euro area before the eruption of the crisis helped contain its impact on the financial system
and the broader economy.
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BIS Review 47/2010