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Financial Integration and Stability in Europe

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					                            Gertrude Tumpel-Gugerell
                           Member of the Executive Board

                   Financial Integration and Stability in Europe

                                 Concluding remarks

           Conference on “Financial Integration and Stability in Europe”
         organised by the Banco de España, the Center for Financial Studies
                           and the European Central Bank

                              Madrid, 1 December 2006




Ladies and gentleman,

I would like to thank the Banco de España and the ECB-CFS Research Network for
inviting me to participate in this conference which is, as you know, already the
network’s eighth conference. The interesting papers and the lively discussions of the
last two days have shown that the choice of topic, namely financial integration and
stability in Europe, was indeed a good one, and I think we will all return home with
new insights and suggestions for further research.
Allow me, however, to start with one critical remark: I think that Europe needs to be
careful not to weaken itself by questioning its own success too much. Financial
integration is an essential part of the wider process of political and economic
integration in Europe. The Single Market and Economic and Monetary Union (EMU)
are unthinkable without the clear objective of an integrated financial sector. The
question of what the consequences of financial integration are for financial stability in
Europe is a very relevant and legitimate one. However, this question should not, in
my view, put in doubt the great opportunities that financial integration has to offer.
Instead, we should try to understand better the institutional and political requirements
that need to be fulfilled in order to make Europe as stable and integrated as other
economies of a similar size and degree of development.
Against this background, I would like to make the following three points:
1) As financial integration is beneficial for Europe, it is important to continue to
remove legal and commercial barriers.
2) Stability concerns are not a reason to halt the integration process.
3) Further integration will be conducive to stability, especially when a high level of
financial integration is reached, when cooperation at the European level is further
enhanced and when a forward-looking approach is adopted.


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Let me now explain these three points in more detail.

1. Financial integration in Europe

Forty years ago, an expert group from the European Commission – that included
Alexandre Lamfalussy – presented a blueprint for “The Development of a European
Capital Market”1. The report clearly identified obstacles to further integration and
stressed the need for convergence and harmonisation in financial regulation and
supervisory practices.
Twenty years later, the Delors Report returned to the vision of a financially integrated
Europe and linked it closely to monetary union. Concerning the first stage of EMU,
the report says: “In the monetary field, the focus would be on removing all obstacles
to financial integration and on intensifying cooperation and the coordination of
monetary policies … Through the approval and enforcement of the necessary
Community Directives, the objective of a single financial area in which all monetary
and financial instruments circulate freely and banking, securities and insurance
services are offered uniformly throughout the area would be fully implemented”.
While the Delors Report envisioned a fully integrated financial area as a precondition
for the introduction of the single currency, in fact Stage One of EMU was far from
complete when Stage Three was implemented.
Why did financial integration lose some of its prominence in the run-up to EMU? I
think one of the major reasons was the expectation that it would follow automatically
from the abolishment of the restrictions on capital mobility. As it turned out this
expectation was too optimistic. The single currency has increased liquidity through an
integrated money market but financial integration has not come automatically.
Lamfalussy’s message from the 1960s remains valid. Financial integration only
succeeds when it is underpinned by a common legal and supervisory framework. The
European Commission’s Financial Services Action Plan illustrates that this message
has been now understood. However, I believe that further progress on the removal of
legal and supervisory barriers is needed.
Over the last few years, we have also realised the importance of a pan-European
market infrastructure for financial integration. Europe is fragmented not only because
of differences in regulation and supervision but also because market participants rely
on infrastructures that are still distinctly national. Removal of these barriers is a key
priority for the ECB. Building on the success of TARGET, the Eurosystem will next
year launch the more integrated TARGET2 system, which is based on a single shared
platform. In the securities field, it is currently evaluating the opportunities for
providing a common securities settlement service which would greatly facilitate the
cross-border use of securities.

2. Financial integration and financial stability

Are financial stability concerns a reason not to advance further with financial
integration in Europe? My answer would be no. In fact, I believe that further financial
integration can enhance European financial stability, but, for this to happen, we need
two things: first, a much more integrated European financial system and, second,
intensified cooperation at the European level and a more forward-looking approach.
From the theoretical papers presented at this conference – for example the paper
presented by Hans-Peter Gruener and his co-authors – and also from the seminal
papers in the literature – such as those by Allen and Gale or Freixas, Parigi and


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Rochet – the analysis of this matter is not fully conclusive.2 On the one hand,
increasing financial integration improves financial stability: it broadens and deepens
financial markets, increases liquidity and the possibilities for risk sharing and thus
strengthens the overall resilience of the European financial system. On the other hand,
greater financial integration may mean that national financial systems are increasingly
exposed to common risks, and financial disturbances may be transmitted more easily
across borders (i.e. there is greater potential for financial contagion and systemic
risk).
However, Allen and Gale show us in their 2000 paper in the Journal of Political
Economy that a very complete financial system (i.e. a financial system in which every
financial institution interacts with all other financial institutions) allows all the
liquidity in the system to be shared by all financial institutions and, at the same time,
makes the economy more robust in the face of shocks to financial institutions. Thus,
when the market is complete and, hence, financial integration is very high, financial
stability is enhanced. In my opinion, this is the benchmark we should aim at in
Europe.
At the same time, I take the stability concerns seriously. Over the last 15 years, the
financial sector has grown significantly faster than other parts of the economy. It is
thus now more important to the economy than it was in the past. Moreover, a wide
range of financial innovations and greater interdependence among financial
institutions have drastically changed the financial landscape. As a result, risks
stemming from the financial sector for the economy as a whole may indeed be higher,
new risks may arise and the magnitude of a possible financial crisis may now be
greater than before. However, this is clearly a world-wide phenomenon and certainly
not specific to the European context.

3. Cooperation at the European level and a forward-looking approach

What is the solution? First, we need convergence and harmonisation in the regulatory
framework and in supervisory practices. This is a precondition for financial
integration but also an important ingredient for a stable European financial sector.
Convergence and harmonisation are closely linked to cooperation among supervisors,
central banks and finance ministries. For crisis management, especially, common
procedures that are well established among the different authorities are of paramount
importance. Second, we should pursue a forward-looking approach that identifies new
risks and intervenes at an early stage.
Let me elaborate these points in turn.

Cooperation at the European level
As the integration of our capital markets deepens, it is of utmost importance, from a
financial stability viewpoint, that we be able to rely on an efficient financial and
banking supervision framework. The success of the “Lamfalussy process” in the
securities field prompted EU authorities and Member States to propose its extension
to, inter alia, the field of banking regulation and supervision. As a matter of principle,
these processes should lead to a more flexible regulatory process and a more
consistent implementation of EU legislation in Member States, and foster the
convergence of supervisory practices.
In this respect, I believe that coordination between supervisors and central banks is
key. An illustration of this can be found, for instance, in the Memorandum of
understanding on high-level principles of cooperation in crisis management situations


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that has been agreed between the EU banking supervisory authorities and central
banks. Although, day-to-day supervision remains at the national level, the Lamfalussy
Committees should strive towards both enhancing convergence of supervisory rules at
the EU level and improving cooperation between competent authorities in day-to-day
supervision. Again, memoranda of understanding can facilitate the bilateral exchange
of supervisory information, for instance covering the special information needs that
arise in the event of financial troubles.
Most recently, the Committee of European Banking Supervisors (CEBS) has launched
a new strand of work to support the establishment and functioning of the group-
specific colleges of home and host supervisors which will be set up under the Capital
Requirements Directive. While the operation of these networks of supervisors –
referred to by the CEBS as “operational networks” – is the responsibility of the
supervisors involved, the CEBS will offer assistance, notably with a view to ensuring
that the approaches taken are consistent within and across networks.
To be completely successful, however, the Lamfalussy approach needs to receive
active political support. The work of the Level 3 Committees is expected to promote
supervisory convergence and cooperation, thus providing an effective response to
challenges arising from financial integration in the EU. However, as noted in the First
Interim Report of the Inter-institutional Monitoring Group, the Lamfalussy process is
still a “learning-by-doing process”, and some issues may need further consideration.
For instance, the report notes that there is “a potential danger in the fact that the
results of the Level 3 Committees may be more “consensus” than “best practices”
driven”. Unfortunately, it would appear that national considerations might be slowing
down the legislative process.
It is even more important that the Lamfalussy approach is strong and efficient now
that it has been extended to banks. Everything should be done to explore as fully as
possible the opportunities that the Lamfalussy structure offers. Next year’s review of
the achievements of the Lamfalussy committees will allow us to take stock of the
progress made and reflect on possible improvements.
However, the Lamfalussy approach alone is not sufficient to bring about the adoption
of new legislation fostering integration. Integration and pan-European stability will
not be achieved without strong institutions and political will. We need commitment
and a specific plan (set by the EU Council) with clear dates and steps that set out how
the process is to progress. Next year’s review may show that the Lamfalussy
committees need a stronger legal basis to make measures to achieve supervisory
convergence more effective.

A forward-looking approach
One type of risk which is receiving attention in financial markets is liquidity risk. The
materialisation of this risk is more difficult to predict than for other risks, such as
credit risk, and therefore the nature and the level of coordination between supervisors,
researchers and central banks may be different.
In this conference, empirical papers have shown that large European banks now
interact much more than in the past and that they are also more and more exposed to
common risks. Large banks are key players to enhance liquidity in the system, both
funding liquidity (for example, through loans) and market liquidity (for example, by
facilitating the trading of a wide range of securities in different markets and across
national borders). Liquidity is a critical component of well-functioning financial
systems. Yet we have witnessed several liquidity strains in the past few decades, in
which investors have been unable to trade securities or access capital markets


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adequately. These include: the 1987 US stock market crash; the Russian default in
1998; the Long Term Capital Management (LTCM) episode in the same year; and,
most recently, the period following the credit downgrades of General Motors and
Ford in May 2005.
Market liquidity risk is highly non-linear: it arises primarily when asset prices fall
sufficiently to push intermediaries close to their funding limits. Lower market
liquidity further aggravates the funding position of intermediaries due to an increase
in hair-cuts and margin requirements, as well as the deterioration of collateral values.
When illiquidity is high, the correlation among assets rises significantly because all
share scarce liquidity; this, in turn, implies that there is a possibility of contagion
among different classes of assets and markets.3
The problem for regulators and central banks is that it is very difficult to predict when
there will be a liquidity crisis in financial markets. Research in this area is still at an
early stage. But I believe that research has a significant role to play. We need tools
that can assess, ex-ante, the liquidity risks and their impact on financial stability.
A forward-looking approach should also include the move towards prompt corrective
action via structured early intervention and resolution, as presented by Charles
Goodhart at this conference. I share Charles’s hope that these instruments can prevent
a crisis before it escalates. Supervisors should be given the legal support for a set of
sanctions, culminating in the ability to force a bank’s reorganisation by
recapitalisation, merger or closure once it becomes seriously undercapitalised but
before it becomes insolvent. Again, further cooperation between supervisors,
researchers and policy-makers would be desirable for the task of defining the
instruments and parameters on which such early interventions would be based.

4. Conclusions

Let me conclude saying that effective and efficient banking supervision is essential,
both to promote financial integration and to safeguard financial stability. The
introduction of the euro and the single monetary policy, the existence of a single
payment area and the growing process of financial and banking integration in Europe
are good reasons for an enhanced common European approach to prudential
supervision and financial stability. The main factors of relevance to financial stability
– risks, information, payments, liquidity, crisis, contagion – now have a European
dimension. Thus if we want to enhance financial stability in Europe, more financial
integration is needed, as well as strong and forward-looking coordination among
supervisors and central banks.
Thank you very much for your attention.

1
  European Economic Community Commission, “The Development of a European Capital Market –
Report of a Group of Experts appointed by the EEC Commission”, 1996.
2
  See Allen, Franklin and Douglas Gale, “Financial Contagion”, Journal of Political Economy, 2000;
Falko Fecht, Hans Peter Grüner and Philipp Hartmann, “Financial Integration, Specialization, and
Systemic Risk” Mimeo, 2006; and, Freixas, Xavier, Bruno Parigi, and Jean Charles Rochet, “Systemic
risk, interbank relations, and liquidity provision by the central bank”, Journal of Money, Credit, and
Banking, 2000.
3
  See e.g. Acharya, Viral and Stephen Schaefer, “Understanding and Managing Correlation Risk and
Liquidity Risk”, report prepared for International Financial Risk Institute (IFRI) Roundtable, 29-30
September 2005.




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