The road to financial integration

A well-integrated financial system is vitally important to financial services, as it enhances the smooth and effective application and transmission of monetary policy throughout the euro area. The financial system is composed of financial markets and their related infrastructures, and the financial institutions that are active in those markets.

We can be very proud of the euro money market, in particular the unsecured inter-bank market, which has been almost perfectly integrated since shortly after the introduction of the euro in 1999. The TARGET system developed by the European Central Bank (ECB), a large-value payment system that operates as a platform for balancing liquidity surplus and deficits within the euro area, has been instrumental in this respect. A financial market also needs an integrated market infrastructure to achieve full integration. The Eurosystem helps in this respect by providing central banking services that are conducive to fostering financial integration. Our decision to move to TARGET2, with the launch of the single shared platform planned for November 2007, underlines this point. Financial integration also has implications for our task of safeguarding financial stability. Awareness of the links between financial integration and financial stability is therefore crucial. As we know, on the one hand, more integrated financial markets offer better opportunities for financing and risk diversification, and thus help to improve the capacity of economies to absorb shocks.

On the other hand, the structural transformation of the financial system through enhanced financial integration, including the creation of intensified cross-border financial links, necessitates that we closely follow the process of financial integration.

But we should also bear in mind that financial integration is relevant to all of us – financial market professionals and citizens of Europe alike – because of the economic benefits that arise from financial integration. Indeed, financial integration is a key factor in the development and modernization of the financial system, which in turn increases the potential for greater and more sustained non-inflationary economic growth. It is generally accepted that financial integration fosters financial development and, ultimately, economic growth.

Financial integration allows for economies of scale and increases the supply of funds for investment opportunities. It also encourages competition and the expansion of intermediation and markets. This in turn leads to a more efficient allocation of capital, and thus increases the potential for higher economic growth. We are also aware that the degree of integration differs between market segments, with integration more advanced in those segments that are closer to the single monetary policy, above all the money market. Integration could still be improved in other segments. In order to realise the existing potential of financial integration for
economic growth, one must ask where such potential is to be found, in which parts of the financial system is financial integration more advanced and where it is still lagging behind. In short, what is the state of play of financial integration in Europe?

One area where integration is generally lagging behind is banking markets, where the degree of integration is different for different types of banking activities. Cross border inter-bank loans and holdings of securities have, in relative terms, experienced substantial growth. While securities issued by non-monetary financial institutions of another euro area country accounted for only 16 per cent of the securities held by euro area monetary financial institutions (MFIs) at the end of 1997, this share has now reached almost 40 per cent, pointing to a higher degree of capital market integration in the euro area. And although loans granted between domestic MFIs still account for more than 50 per cent of total EU MFI loans, euro area cross-border activity has increased from only 15 per cent at the end of 1997 to around 23 per cent today. Integration in retail banking has, by contrast, not made much progress, judging by recent price and quantity based indicators.

Towards a Regulatory and Supervisory Framework

We see it as a basic task of public authorities to create a framework conducive to fostering financial integration. This framework should be such that, generally speaking, all potential market participants in a given financial instruments or services market are subject to a single set of rules when they decide to deal with those financial instruments or services, have equal access to those financial instruments or services and are treated equally when they operate in the market. If the opportunities created have been exploited by market forces, true financial integration will have been achieved. Above all, there is a need to proceed with the adoption of the remaining measures envisaged in the Financial Services Action Plan (FSAP), in order to complete the regulatory framework and progress the implementation and enforcement of such measures at national level. Securities clearing and settlement is an area in which further integration is needed to fully exploit the benefits arising from a pan-European securities market. The Eurosystem supports the Commission’s intention to put forward a proposal for a Directive on securities clearing and settlement to complement the market-led removal of the so-called Giovannini barriers.

We also agree with the Commission’s proposal for better regulation, based on open, transparent, evidence-based policy-making, including an ex ante evaluation of possible costs and benefits. In its Green Paper, the Commission put forward retail financial services and asset management as areas where such efforts could be beneficial. With regard to the supervisory framework, the policy objectives are twofold. First, in order to realise economies of scale and scope, the framework should facilitate the development of cross border consolidation of financial institutions and the cross-border exchange of services and products. The second objective is to maintain the effectiveness of supervisory standards and action in a more integrated financial system.

The current institutional set-up, and in  particular the Lamfalussy framework, provides the appropriate structure for achieving these broad policy objectives, if its potential is maximised. This entails pursuing two operational goals, the first of which is to achieve supervisory convergence by the Level 3 committees, which should deliver supervisory action that is consistent on a cross-border basis.

The experience thus far is encouraging. The second goal is to strengthenthe cooperation between home and host authorities for the supervision of financial groups operating across borders. This is essential for reconciling the interests of supervisory authorities and the financial sector. A lack of progress could fuel demands to revise the current institutional set-up, as the financial industry occasionally points out.

The work of the Level 3 committees is  expected to strongly promote supervisory convergence and cooperation. Further developments in financial integration, especially the increasing prominence of both complex cross-border institutions spanning several Member States and large foreign establishments in host countries, may pose a challenge to the current arrangements. Furthermore, financial integration calls for increased supervisory cooperation across financial sectors.

The Central Bank can also act as a catalyst for collective private-sector activities, with a
view to fostering financial integration. Since competition among private financial agents is a necessity, coordination of interests can be facilitated with the aid of a catalyst. We are a central bank, but we are also a market participant, with an enormous breadth of knowledge and numerous contacts with other market participants. The two most important catalyst activities that are going on at present are the Short-Term European Paper (STEP) initiative and the Single Euro Payments Area (SEPA) project. With the aid of initiatives such as these, by 2008 we expect European citizens to be able to make payments throughout the euro area from a single bank account, using a single set of payment  instruments, as easily and safely as in the national context today.