malcolm d knight : european financial integration in the context of current financial market turbulence keynote remarks by mr malcolm d knight, general manager of the bank for international settlements, at the 2007 eurofi conference “ achieving the integration of european financial markets in a global context ”, brussels, 3 december 2007. * * * let me thank you for the opportunity to address this distinguished group of executives and policymakers. eurofi is playing a leading role in identifying key strategic issues that need to be addressed to advance further towards the fundamental goal of achieving comprehensive financial integration in europe, and of promoting a closer dialogue between market participants and policymakers and in particular financial regulators. in my brief remarks tonight i want first to underscore several important achievements of financial integration in europe thus far that are key to its further progress. then i will outline several features of the current international financial market turmoil that have implications for the future progress of european financial integration. finally, i will comment on how the preliminary lessons from the financial disturbances we are currently witnessing may be important in shaping the ongoing process of financial integration in coming years. european financial integration the achievements of european financial integration over the past two decades are truly impressive. prior to the advent of the euro in 1999, european authorities took deep and successful steps to stabilise cross - country exchange rates and eliminate controls on international capital movements within what is now the euro zone. the introduction of the single currency less than nine years ago has led to an acceleration of financial integration by eliminating intra - zone exchange rate risk and achieving low and stable inflation. indeed, the establishment of a common currency backed by a european central bank with a clear monetary policy mandate and underpinned by firm fiscal rules has helped to clarify policy responsibilities and make more transparent the structure of this huge multi - country economic region. this has had the expected positive effect on european economies and, indeed, on global markets. over the past two decades, inflation in what are now the euro area countries has come down substantially, nominal interest rates have fallen, and inflation expectations have become well anchored at low and stable levels. as a result of these achievements, the european central bank has rapidly established itself as a key and credible institution in global financial markets. in itself, this move towards greater macroeconomic stability has boosted european financial integration. from the earliest years of the euro, issuance of corporate debt securities surged, supported by the elimination of exchange rate risk within the currency zone and higher demand from a larger pool of investors. likewise, a deep

euro area - wide interbank money market developed rapidly. this is a key component – indeed, perhaps the key component – of the financial infrastructure of the euro zone. its rapid development owes much to the major efforts of the european central bank in elaborating its monetary policy procedures and its liquidity operations. to be sure, european financial integration has not proceeded at the same pace across all sectors and markets. integration of the retail banking markets, for instance, has remained limited, reflecting the persistence of legal, institutional and regulatory differences. but things are moving. even a cursory reading of the financial press shows that financial integration is making visible progress almost day by day. the current financial market turmoil but how does the current turmoil in global financial markets impact on the positive picture that i have just sketched for you? let me recall that this turmoil follows a prolonged period of broadly based and aggressive risk - taking that was reflected in unusually low risk premia and low volatility across many asset classes. thus, prior to last summer, many careful observers believed that the price of risk was too low – so an increase in risk premia was widely seen as healthy from a financial stability perspective. there was a large element of wisdom in this point of view. nevertheless, when risk aversion suddenly jumped last summer there were major surprises. a first surprise was that a shock in one specific segment of the mortgage sector in the united states led to severe adverse effects not only in that country, but also in the euro zone, the united kingdom and canada. the impact in the euro zone was a surprise to many observers because increasing financial integration had greatly strengthened the european financial system. a second surprise was the sudden evaporation of liquidity in the major interbank markets, which has persisted since the summer and which has transmitted the tensions in credit markets to the very heart of the international financial system. the distortions in the interbank money markets have occurred mainly in the united states, the euro zone and a few other key economies, such as the united kingdom. they are much less severe in japan ; and major emerging market economies have weathered the global turmoil relatively well so far. in the euro area, the spread between the market expectation of the overnight interest rate during the next three months ( the eonia swap interest rate ) and the rate at which commercial banks can borrow from each other over the same period – the three - month libor rate – suddenly jumped in august and has stayed elevated since, while