Jean-Claude Trichet: The process of European financial integration
Text of the 24th Mais Lecture by Mr Jean-Claude Trichet, President of the European Central Bank, at
Cass Business School, London, 11 May 2006.
* * *
Introduction
Ladies and gentlemen,
First of all, let me thank very warmly the Cass Business School for inviting me to give this year's Mais
Lecture. Held in honour of Lord Mais, it is the 24th lecture of its kind, which is in itself an impressive
achievement. Keeping with the School's practice of exploring major economic policy issues, I have
decided for today's Mais Lecture to address "The process of European financial integration".
It is certainly a topic that is of interest to many: market participants, policy-makers and academics
alike. In this respect, it is my hope that this lecture will attract attention of the audience under these
multiple angles of vision.
Let me stress from the very beginning that the ECB has the utmost interest in furthering European
financial integration. In this respect, I should like to draw your attention to the May edition of our
Monthly Bulletin, which was published this morning, and which contains an article on European
financial integration and the ECB's role in fostering this process.1
I will structure my remarks as follows, covering three main parts.
First, I will give an overview of the ECB's basic conceptual framework that underlies our work on this
matter. Second, I will explain why we are very deeply interested in making progress with European
financial integration. And third, I will elaborate on the current state of financial integration in the euro
area, based on the measurement via quantitative indicators that the ECB published for the first time
last year. I will also mention specific ECB and Eurosystem activities that aim to foster financial
integration.
Conceptual elements of the ECB's monitoring framework for financial integration
To start with, let me explain how the ECB defines the concept of European financial integration. An
obvious measure of financial integration is to check the validity of the law of one price within the euro
area. The law of one price states that assets with identical risks and returns characteristics should be
priced identically regardless of where in the euro area they are transacted. If all agents face the same
rules, have equal access and are treated equally, any price difference between two identical assets
will be immediately arbitraged away.
This brings me to the definition of financial integration that the ECB has adopted: the ECB considers a
market for a given set of financial instruments or services to be fully integrated when all potential
market 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.
Let me now explain our definition of financial integration in more detail.
One can say that a financial system consists of three principal components, namely the financial
markets, the related financial infrastructure and the financial institutions.
The ECB's definition of financial integration uses the term "market" in a broad sense, covering all
possible exchanges of financial instruments or services, be it on an organised market, such as a stock
exchange, or an over-the-counter market created by a financial institution's supply of a financial
instrument or service. Furthermore, a financial market can never be fully integrated without the
integration of the related market infrastructure, in particular the payment and securities clearing and
settlement systems. In this sense, you should also note that the term "rules" as contained in the ECB's
definition is used in a broad sense, and includes features such as laws and regulations, supervisory
arrangements, market conventions and self-regulation, and standards and practices related to
financial infrastructures. Finally, financial integration can also be fostered by financial institutions
establishing branches and subsidiaries in other euro area countries or by two institutions merging
across borders.
The wide coverage of the ECB's definition of financial integration is attributable to the fact that if only
the first condition is fulfilled, i.e. the existence of a single set of rules for a given market, potential
participants might still be discriminated against in terms of access to the market. Consequently, the
ECB's definition includes a second condition whereby participants should not be discriminated against
in their access to a market. The third condition for full financial integration is that once all potential
market participants have accessed the market, they should be treated equally in their operations within
that market.
These latter two conditions in particular should also be seen within the general Treaty provision that
the Eurosystem acts "in accordance with the principle of an open market economy with free
competition, favouring an efficient allocation of resources".2 This general provision was also one of the
guiding principles applied when we established our definition.
To conclude these conceptual remarks, I would like to point out that we are facing a complex process
of progressive financial integration whilst the ECB's definition describes a final state of full, or perfect,
integration. By providing a benchmark against which we can assess the state of financial integration,
this definition underpins our analytical, empirical and policy analysis. Let me now explain the various
reasons that motivate our interest in making progress with European financial integration and
consequently also our analytical and empirical work on this matter.
The reasons for the ECB's interest in progress towards financial integration in Europe
The ECB's interest arises from four main reasons:
First, the integration of the financial system plays an important role in the transmission and
implementation of the single monetary policy for the euro area.
Second, in more general terms, the Treaty establishing the European Community requires us to
support the general economic policies in the European Community, among which European financial
integration is a priority policy objective.
Third, financial integration is important for the Eurosystem's task under the Treaty to monitor and
safeguard financial stability.
Fourth, finally financial integration is important for our tasks in the area of payments and securities
settlement infrastructures.
Accordingly, the ECB's Governing Council included the promotion of European financial integration as
one aim in the Eurosystem's mission statement, which reads: "[...] We in the Eurosystem have as our
primary objective the maintenance of price stability for the common good. Acting also as a leading
financial authority, we aim to safeguard financial stability and promote European financial
integration."3
Let me elaborate in more detail on two of the reasons just mentioned, namely the general implications
of financial integration to increase the potential for stronger non-inflationary economic growth and the
implications of financial integration for the conduct of the single monetary policy in the euro area,
which is of utmost interest to the ECB.
Financial integration is a key factor in the development and modernisation of the financial system,
which, in turn, increases the potential for greater and more sustainable non-inflationary economic
growth. By making markets deeper and more liquid, financial integration creates economies of scale
and increases the supply of funds for investment opportunities. The integration process fosters
competition, the expansion of markets and intermediation, thereby leading to further financial
development. Financial development, in turn, leads to lower intermediation costs and a more efficient
allocation of capital. Allocating resources to the most productive investment opportunities will
ultimately increase the potential economic growth.
Let me mention in this respect a research study by London Economics that estimates the benefits of
the integration of European bonds and equity markets to be around 1% of GDP growth over a ten-year
period, or approximately €100 billion.4
While such figures can always be subject to estimation error, economic reasoning suggests that the
overall benefits of financial integration will remain significant.
So, to sum up: a financial system that is not yet fully integrated in all of its components implies a cost
in terms of foregone economic growth. As we are well aware, Europe urgently needs to strengthen
growth and increase employment, which are the two main goals of the renewed Lisbon programme. In
this respect the full completion of the single market of financial services is a key element in the
achievement of the single market in the service sector which is absolutely of the essence: it is in this
domain that we are very significantly lagging behind the US.
This leads me to the second reason for the ECB's interest in financial integration that I would like to
explain in more detail. Monetary policy in the euro area has proved very successful in maintaining
price stability and building economic agents and market participants' confidence in its ability to
continue to do so. As a consequence, the anchoring of inflation expectations has been remarkably
solid. Interest rates are still at very low levels in both nominal and real terms: short-term real interest
rates remain close to the lowest levels we have seen in decades. And medium and long term rates are
incorporating a low level of inflation expectations. Through this last achievement in particular the single
monetary policy makes the best possible contribution to pave the conditions for sustainable growth in
economic activity and job creation.
In this respect, one could also illustrate the relationship between monetary policy and financial
integration with the help of the Tinbergen rule, which states that there should be at least the same
number of instruments as there are targets. Since the ECB's single monetary policy's aim is to
maintain price stability - for which we have, via the steering of short-term interest rates, only one
instrument at hand - it follows that financial integration, which itself increases the potential for higher
economic growth, thereby also facilitates the conduct of monetary policy, as, all other things being
equal, price stability will be ensured through appropriate monetary policy at a higher level of
sustainable growth.
There is a second major reason why financial integration is beneficial to the single monetary policy in
the euro area. A well-integrated financial system is essential for the implementation of the single
monetary policy, as it enhances the smooth and effective transmission of monetary policy impulses
throughout the euro area.
While the single monetary policy is capable of ensuring price stability - and, as I mentioned, has done
so very successfully over the past seven years - even if financial integration is less than complete in
certain areas, the transmission of monetary policy could be even more homogeneous with perfect
financial integration. The degree of financial integration is therefore important in determining the
effectiveness of the monetary policy transmission throughout the euro area: the higher the degree of
financial integration, the more effectively the transmission will work in practice.
This leads me to give you my assessment of the current state of financial integration in the euro area.
In doing so, I will also mention specific ECB and Eurosystem activities that aim to foster financial
integration. Although financial integration is first and foremost a market-driven process, the ECB and
the Eurosystem have certainly a part to play. At the same time, I will also highlight some important
areas where financial integration is still lagging behind and where more action from market participants
is required.
The state of financial integration in the euro area, ECB and Eurosystem activities to foster the
process, and future challenges
I would now like to illustrate some results provided by the monitoring framework that we have built up
for assessing the process of financial integration in the euro area.
Our monitoring framework draws on quantitative indicators of financial integration that the ECB has
developed. You will remember my earlier reference to the ECB's definition of financial integration that
an obvious measure of financial integration is to check the validity of the law of one price within the
euro area. In particular, our price-based indicators that measure discrepancies in asset prices based
on their geographic origin are directly relevant in this respect. Such quantitative measures offer the
advantage of being able to assess both the current level of financial integration and its evolution over
time, i.e. whether integration is progressing, stable, or even regressing in respective parts.
The first set of indicators, covering the state of integration of euro area financial and banking markets,
was published last year, along with an explanatory report.5 This first publication covers the money
market, the government and corporate bond market, the equity market and the banking markets. In the
next publication, due in September, we will expand the set of indicators by adding indicators related to
the integration of financial institutions and financial infrastructures. In the following, I will also touch
upon such possible new indicators that we are at present compiling.
To start with, let me give you my assessment of the integration of the euro area financial and banking
markets. While the euro generally acted as a major catalyst for the integration of all these markets, the
degree of integration differs between market segments, with integration being more advanced in those
market segments that are closer to the single monetary policy, above all the money market. I would
summarise the situation as follows: in general, financial integration is very strong in the money market;
it has progressed significantly in government bond markets; it has improved for the corporate bond
market; it is slow but progressing in the case of the equity market; and financial integration is
unfortunately much less advanced in a range of banking market segments.
I would now like to give the results of some selected indicators, whereby I will restrict myself to the two
"extremes": the satisfactory level of integration is represented by the money market and the
government bond market; and an unsatisfactory level of integration prevails in retail banking markets. I
will also look at the degree of integration of financial infrastructures and financial institutions.
Let me start with the money market. The unsecured interbank deposit market was almost perfectly
integrated right at the start of Monetary Union. Our indicator, the cross-country standard deviation of
the average overnight lending rates among euro area countries, was as low as three basis points in
early 1999 and has since decreased to just one basis point. By way of comparison, in January 1998,
i.e. one year before the start of Monetary Union, the cross-country standard deviation was higher than
130 basis points. Our indicators for one-month and 12-month maturities also consistently show a
highly integrated unsecured money market, with the respective cross-country standard deviation of
EURIBOR lending rates among euro area countries standing, since early 1999, at values not higher
than, and normally below, one basis point. Finally, a similar picture of a relatively high degree of
integration prevails for the repo market, where we measure the degree of integration since the launch
of the EUREPO index in March 2002 on the basis of EUREPO rates: the euro area cross-country
standard deviation of the one-month EUREPO rates has normally been below one basis point, and the
one for the 12-month maturity normally below two basis points.
The decisive role of the euro in enhancing financial market integration is furthermore visible in the
interest rate derivatives markets. For example, the euro interest rate swap market has become the
largest interest rate swap market in the world, the euro segment's daily turnover of €250 billion being
about one and a half times larger than the equivalent US dollar segment figure of €160 billion.6 An
important segment of the euro interest rate swap market is the euro overnight index swap market,
where the launch of the EONIA Swap Index in June 2005 is evidence of both its importance and its
further potential. Indeed, this market segment is almost perfectly integrated, with a cross-country
standard deviation for EONIA Swap Index quotations of 0.1-0.2 basis point.
The integration of the money market is of course a prerequisite for monetary policy implementation,
since only an integrated interbank market can ensure an even distribution of central bank liquidity and
a homogeneous level of short-term interest rates across the euro area. This has been mostly
supported by the establishment of the related large-value payment system infrastructure, our TARGET
system. This is an obvious example where the Eurosystem contributes to fostering financial
integration. The launch of the single shared platform, TARGET2, planned for November 2007, will
enhance financial integration even further, as it will provide a harmonised level of service and a single
price structure.
I should also like to mention that the short-term securities market is the least integrated segment of the
money market. The European commercial paper and certificates of deposit markets are segmented in
several market places. But I expect that the market-led Short-Term European Paper initiative, the
STEP initiative, will advance integration. This initiative aims at the convergence of standards and
practices through market participants' compliance with the STEP Market Convention. In the coming
days, Euribor ACI and Euribor FBE will formally adopt the STEP Market Convention. Issuers will then
be able to apply for the STEP label. The Eurosystem has supported this private-sector initiative since
its inception by acting as a catalyst. It provides technical support for the labelling process for the first
two years, and the ECB produces statistics on yields and volumes for this market.
Let me now turn to the euro government bond market, which is another market that has achieved a
very high degree of integration, as revealed by the ECB's published indicators. In the run-up to
Monetary Union, euro area government bond yield spreads converged, and since then, government
bond yields in different euro area countries have been driven mainly by euro area-wide factors and
news. But let me take the opportunity here to explain the relationship between financial integration and
market discipline, given that this has at times given rise to misunderstandings.
It is sometimes argued that the convergence in euro area government bond spreads which was seen
in the run-up to Monetary Union is evidence that the process of financial integration may be
detrimental to the functioning of market discipline, the latter being the influence exerted by markets on
governments by pricing different risks of default.
This reasoning, however, neglects the fact that the observed convergence in government bond yield
spreads mainly reflected the closer coordination of monetary policies across euro area countries - an
overall compression of risk premia also observable in other markets and outside the euro area - and
the ensuing convergence of inflation expectations across countries, as well as the progressive
elimination of uncertainty regarding exchange rate movements and, finally, the disappearance of
intraeuro area exchange rate risk by the time the euro was introduced. Since 1999, government bond yield
spreads have mainly reflected differences in liquidity and in perceived credit risks, which in turn reflect
the sustainability of the countries' fiscal positions. I will highlight two implications.
First, such "local factors" continue to have an impact on bond yields in various euro area countries.
Yest, pricing differences related to credit risk perceptions do not signal a lack of integration. I refer to
my earlier discussion of the conceptual elements of our framework for assessing financial integration,
where I stated that the law of one price - one obvious measure of financial integration - holds for
assets with identical risks and returns characteristics to be priced identically regardless of where they
are transacted. The integration of euro area government bond markets means that yields converge
across countries to the extent that the underlying bonds have identical risk-return characteristics. A
government bond of a country with a very poor fiscal policy is riskier than a government bond of a
country with a sound fiscal position. Consequently, the market will demand higher yields in the first
case, even with perfect integration of government bond markets.
Second, the ongoing process of integration of the euro area government bond market may in principle
reinforce the market-driven disciplinary effects. Market discipline is most effective in efficient,
competitive and well-functioning markets. A necessary condition for financial markets to correctly price
sovereign bonds is that governments have access to the capital markets on the same terms as other
borrowers, and in particular that each country will ultimately bear the full costs of the credit risk implied
in its government debt.7 If these conditions are satisfied (and there are no market failures), perfectly
competitive markets will provide an accurate assessment of the risk/return profile of each bond. Under
these circumstances, market forces ultimately lead to funds being allocated efficiently in the most
productive manner, with proper account being taken of risk.
There is little doubt that the progress in financial integration witnessed in euro area government bond
markets over the last few years has helped to improve the efficiency of financial markets in general
and of government bond markets in particular. By eliminating barriers to trade and creating a truly level
playing field, financial integration increases the level of competition in the financial markets, thus
enhancing their capacity to accurately price assets. Financial integration therefore may foster market
discipline. Available evidence indeed suggests that market discipline is at work in the euro area
government bond market. For example, credit default swaps data indicate that countries with poorer
fiscal positions pay a higher premium and that markets therefore exert disciplinary pressure on
governments.
Having dealt with the government bond market, let me now briefly discuss the state of integration of
the financial infrastructure related to securities markets in general, namely the securities clearing and
settlement systems. Only if financial infrastructures are adequately integrated can the financial
markets, like bond and equity markets, function smoothly. And this is one area where financial
integration is still lagging behind and where action from market participants is required.
Let me first give some figures for the present situation. Just by looking at the development of the
number of systems in the euro area over time, we note that the number of central securities
depositories declined from 22 in 1998 to 19 in 2005, and the number of securities central clearing
counterparties declined from 14 to 7. This leads us to conclude that the number of securities clearing
and settlement systems that are often not efficiently connected to each other is still rather high, in
particular if we compare it to the significant progress that has been made in the integration of
largevalue payment systems, with the overall number standing at 4, down from the 23 that existed before
the introduction of the euro and the TARGET system.
The Eurosystem strongly supports further integration in the securities clearing and settlement
infrastructure. To this end, it also acts as a catalyst for private-sector activities and holds meetings with
the banking and securities settlement industry of the euro area to discuss the further integration of the
euro securities settlement infrastructures. I would also like to highlight the work that the European
Commission is investigating whether to propose a framework directive on clearing and settlement. I
can tell you, the ECB would indeed welcome a legislative initiative in this field.
Having mentioned securities clearing and settlement as one major area where further progress in
integration is required, I will now turn to the banking markets where, as I stated earlier, the degree of
integration in the retail segment can be deemed to be unsatisfactory.
Let me first briefly present some facts concerning banking consolidation. The decrease in the number
of institutions has been a common trend in EU Member States' banking sectors. The number of credit
institutions in the euro area declined from around 12,000 in 1985 to 6,400 in 2004. Consolidation has
been attributed mainly to mergers and acquisitions (M&As) between institutions, and much less to
failures or voluntary liquidations. The data also show that consolidation has so far been a primarily
domestic development. Between 1985 and 2005, cross-border mergers accounted for only about 20%
of the number and value of all M&A deals in the euro area and the EU. Cross-border banking
consolidation is quite limited not only when compared to domestic consolidation, but also in
comparison to other financial sectors in the EU (on average 45% of total transactions).
Nevertheless, a relative increase of cross-border M&A transactions has been observed in the last
years, as the number and value of cross-border M&As increased to around 30% of total M&A
transactions in the EU banking sector. Moreover, I expect that a number of EU initiatives that have
been already adopted or are underway should significantly reduce the policy-related obstacles to
cross-border banking consolidation: I would just mention the European Commission's review of the
regulatory provisions8 underpinning the supervisory approval process for qualifying shareholdings, the
ongoing work by the level 3 Lamfalussy committees to enhance supervisory convergence and
cooperation, and the recent adoption of the cross-border mergers directive.
Cross-border consolidation of banks is one way of looking at the integration of euro area banking
markets, i.e. one looks at the financial institutions themselves. Another way is to look at the price for
financial products. Our published price-based indicators relate to the euro area cross-country standard
deviation of interest rates for different financial products. For example, it is revealed that the
crosscountry standard deviation of interest rates on consumer credit has been rather high and constant, on
average 0.9% over the past three years. Similarly, the cross-country dispersion of interest rates on
lending for house purchase amounts to, on average, 0.5% over the past three years, with no clear
declining trend visible as yet. The indicators therefore support the conclusion that the integration of
retail banking markets is lagging behind.
I have earlier mentioned the implication of financial integration for the monetary policy transmission
mechanism, which is the pass-through from changes in official monetary policy rates over market rate
changes to bank interest rates. So, whilst the euro area money market is highly integrated, permitting
the first part of the pass-through chain to function in an homogeneous way, in contrast the link
between market rates and banks' retail interest rates, i.e. the second part of the pass-through chain
continues to show a significant degree of heterogeneity within the euro area.
The integration of retail banking markets is therefore a further challenge that has to be addressed. In
this respect, I recall the European Commission's White Paper on Financial Services Policy 2005-2010,
which targets, among other things, the further integration of retail markets in Europe. The Eurosystem,
in its role of providing advice on the legislative and regulatory framework for the financial system, also
made its contribution to the European Commission's consultation, expressing its support for the key
policy orientations of the financial services policy over the next few years.9
As regards mortgage markets, I would like to highlight the European Commission's launch of a broad
discussion about the possible benefits and ways of further integrating European mortgage markets.
The Eurosystem also made its contribution to the respective Green Paper.10
Let me now, after having discussed financial markets, banking markets, financial institutions and
wholesale financial infrastructure, address the issue of the retail payment system infrastructure.
By contrast with the developments in large-scale payment systems, the situation for retail payment
services today is nearly unchanged as compared with that prevailing before Monetary Union: in 2005
there were still 15 different retail payment systems within the euro area, compared with 20 in 1998.
This fragmentation of retail payment services implies sizeable costs in terms of foregone financial
benefits that could result from the integration of retail payments, as a result of standardisation and the
opening-up of payment services markets to more competition. The European banking industry has,
however, launched an initiative to create a Single Euro Payments Area (SEPA).
SEPA can be described as an integrated market for payment services which is subject to effective
competition and where there is no distinction between cross-border and national payments within the
euro area. The introduction of the euro as the single currency of the euro area will only be completed
with the SEPA, i.e. when consumers, businesses and governments are able to make cashless
payments throughout the euro area from a single payment account anywhere in the euro area using a
single set of payment instruments as easily, efficiently and safely as they can make payments today in
the domestic context. Improved payment service levels will benefit the end-users with transparent
prices and cost-efficient services. SEPA will allow the payments industry to become more efficient,
thereby providing significant savings and benefits to the wider European economy.
Acting as a catalyst for private-sector activities fostering financial integration, the ECB actively
supports the SEPA project and offers coordination with the banking industry and end-users. I would
also like to draw your attention to the joint statement from the European Commission and the ECB on
SEPA that was issued just last week, on 4 May. In this statement, we outlined our common vision for
the SEPA and the process leading to its realisation, encouraging the European banking industry and
the other relevant stakeholders to create the necessary technical conditions. The realisation of SEPA
calls for the removal of all technical, legal and commercial barriers between the current national
payment markets. To achieve this, two milestones have been set.
First, the European Payments Council has set objectives for January 2008, namely that is should be
possible by that date to use the SEPA credit transfer and direct debit payment instruments; that the
technical barriers be removed and the provisions and standards to ensure interoperability be defined;
and that the necessary conditions for infrastructures to become SEPA-scheme compliant be
established.
Second, a critical mass of national credit transfers, direct debits and card payments should have
migrated to SEPA payment instruments by the end of 2010. Further steps will be necessary to ensure
the widespread adoption of new and efficient SEPA instruments. The Commission and the ECB also
stress that it is important that all relevant stakeholders, in particular the public sector, contribute to
achieving SEPA. By showing political support and by becoming early adopters of the SEPA products,
the public sector can effectively contribute to the SEPA's success.
With respect to the integration of payment services markets, I also would like to recall that the
Eurosystem is working together with the European Commission on the development of a new legal
framework for payment services in the internal market. Currently, there is a wide variety of national
legislation related to payments, which makes the