Keynote luncheon remarks at the conference 'Transatlantic Roundtable on Finance and Monetary Affairs'

Financial integration is of key importance for the European Central Bank (ECB), given its relevance for the conduct of the single monetary policy: a well-integrated financial system enhances the smooth and effective transmission of monetary policy impulses throughout the euro area. Today, I would like to highlight a further implication of financial integration, namely that it raises the economy’s potential for stronger non-inflationary economic growth.

Generally speaking, financial systems serve to channel funds from those economic agents that have a surplus of savings to those with a shortage; and to trade, hedge, diversify and pool risks. These functions are facilitated by financial integration. As a result, there is a better sharing and diversification of risk and a greater potential for stronger non-inflationary economic growth.

Regarding risk sharing, it is interesting to note that in the US, according to a particularly interesting research, capital markets would smooth out 39 % of the asymmetric shocks to gross state product (the equivalent of our GDP), the credit channel would smooth out 23 % of such shocks and the federal government, through the fiscal channel, 13 %. 25 % of the shocks would not be smoothed out. ^[1] Hence in the United States financial markets and financial institutions would contribute 62 % to the absorption of state idiosyncratic shocks. The effect is very substantially higher than the effect of the federal budget. We see from the US example that the financial channel can be much more important than the fiscal channel and that is a particularly important additional reason to speed up financial integration in Europe.

Financial integration is also very important for stimulating economic growth in Europe via its impact on the development of the European financial system. Financial development refers to the process of financial innovation, and to the institutional and organisational improvements in a financial system that reduce asymmetric information, increase the completeness of markets, add possibilities for agents to engage in financial transaction through (explicit or implicit) contracts, reduce transaction costs and increase competition. Progress in financial development can obviously also occur in perfectly integrated markets.

Therefore, by speeding up the reallocation of capital from declining to evolving and promising industries – the Schumpeterian process of “creative destruction” – both financial integration and financial development positively influence the efficiency of a financial system, ultimately leading to a higher potential for economic growth.

The introduction of the euro has already brought about important benefits resulting from increased financial integration. And the process of European financial integration and development is still ongoing: a research study by London Economics estimates the benefits of the full integration of European bonds and equity markets to be around 1% of GDP growth over a ten-year period, or approximately €100 billion. ^[2]

This brings me to the next point I would like to make, namely the identification of major achievements and challenges of European financial integration.

Let me first draw your attention to a new report entitled “Financial integration in Europe”, which the ECB published for the first time just three weeks ago. ^[3] The main purpose of this report, which will become an annual publication, is to contribute towards the advancement of European financial integration and to raise public awareness of the role of the ECB and the Eurosystem in supporting this process. My remarks will also draw on some of the findings of this report.

In order to better assess the state of European financial integration, the ECB has developed 42 quantitative indicators which are described in our report. ^[4] In a nutshell, the evidence confirms that the degree of integration varies according to the market segment, and that integration is generally more advanced in those market segments that are closer to the single monetary policy.

With respect to the euro area money market, the unsecured money market reached a stage of “near-perfect” integration almost immediately after the introduction of the euro, with the cross-country standard deviation of the average overnight lending rates among euro area countries as low as one to two basis points. This success has been sustained by the high degree of integration of the large-value payment systems. The launch of the single technical platform, TARGET2, in November this year will promote further financial integration, in particular through a harmonised service level, a single price structure, and a harmonised set of cash settlement services.

It is, however, also a fact that the euro area short-term debt securities market has witnessed only a limited degree of cross-border activity. This may partly be due to the fact that short-term debt securities issued in the euro area have very similar risk characteristics and therefore offer little scope for international diversification. Our indicator, which gives the share of short-term debt securities issued by euro area residents and held by other euro area residents, shows a rising trend – from 7% in 2001 to over 12% in 2005 – but the absolute numbers are small when compared to the corresponding indicators for the bond and equity market. In this respect, I would like to emphasise the Short-Term European Paper (STEP) initiative. The STEP initiative promotes the development of a European short-term paper market through market players’ voluntary compliance with a set of standards encompassed in the STEP Market Convention. By the end of March this year, 35 STEP-compliant programmes, amounting to €201 billion, had been launched under the STEP label. ^[5]

With respect to bond markets, euro area cross-border holdings of long-term debt securities have increased strongly – from about 10% at the end of the 1990s to nearly 60% in 2005 – suggesting that investors are increasingly diversifying their portfolios across the euro area and, therefore, that the euro area government bond market has reached a very advanced stage of integration.

Finally, the quantity-based measure of euro area equity market integration also indicates a rising degree of integration in the equity markets. Between 1997 and 2005, euro area residents doubled their holdings of equity issued in another euro area country to reach nearly 30%. This implies that, following the introduction of the euro, euro area investors have significantly reallocated their equity portfolio from domestic holdings to holdings elsewhere within the euro area.

As a remaining challenge to the integration of euro area securities markets, I note that the euro area securities clearing and settlement infrastructure is not yet sufficiently integrated, although several initiatives are underway. Last November, for example, at the European Commission’s request, the relevant European industry associations and their members signed a “European Code of Conduct for Clearing and Settlement”, which aims to foster competition and efficiency of clearing and settlement in the EU. The ECB welcomes this initiative and acknowledges the commitment by the industry.

In this respect, let me also mention that the Eurosystem considers developing a single platform for the settlement of securities in central bank money – the so-called TARGET2-Securities. The scope of this project is restricted to the settlement layer of the post-trading activity regarding securities settled in central bank money. The next step will be the definition of user requirements which will benefit from a public consultation.

Last but not least, I would like to mention the retail banking markets, which are less integrated than the other euro area financial market segments. However, we also see progress in some fields.

For example, the current fragmentation of the European retail payment infrastructures is being addressed by the so-called SEPA project that has been initiated by the European banking industry with a view to creating a single euro payments area. The Eurosystem supports this project in a catalyst role, by providing guidance to banks and the payments industry in setting objectives and defining high-level requirements. The self-regulatory approach chosen for SEPA is working well and we expect the European banking industry to launch the first SEPA instruments on 1 January 2008.

Furthermore, a number of indicators point to increasing cross-border banking activities in the euro area, such as the growing cross-border share in the financial holdings of banks and cross-border mergers and acquisitions. I would like to emphasise the fact that cross-border banking is first and foremost a market-driven process. Still, the public sector can play a significant role in providing an adequate policy framework. According to our assessment, which we also explain in the new ECB report, the EU supervisory arrangements have been substantially enhanced by two significant measures: the extension of the Lamfalussy approach to the banking sector and the adoption of the Capital Requirements Directive (CRD), which sets up the new regulatory framework in the EU for banks’ capital adequacy as agreed by the Basel Committee on Banking Supervision. Both measures contribute to increasing cooperation and coordination between supervisors on a cross-border basis. The CRD provides for better home-host supervisory cooperation, among other things, by enhancing the role of the authority responsible for the consolidated supervision.

I would also like to mention that regulatory convergence is important not only within the EU but also in a global context. The ECB supports the EU-US Financial Markets Regulatory Dialogue and believes it can serve as a forum where solutions to important regulatory issues on both sides of the Atlantic can be sought, such as accounting standards, the revised proposal for de-registration of foreign firms from US markets, and the recent announcement regarding the cooperation between the United States and the EU in audit oversight. Furthermore, the ECB supports the European Commission’s objective to deepen the financial dialogue with other countries, such as China and Japan.