EUROPEAN
CENTRAL
BANK
WO R K I N G PA P E R S E R I E S
WORKING PAPER NO. 230
THE EURO AREA FINANCIAL
SYSTEM: STRUCTURE,
INTEGRATION AND POLICY
INITIATIVES
BY PHILIPP HARTMANN,
ANGELA MADDALONI AND
SIMONE MANGANELLI
May 2003
EUROPEAN
CENTRAL
BANK
WO R K I N G PA P E R S E R I E S
WORKING PAPER NO. 230
THE EURO AREA FINANCIAL
SYSTEM: STRUCTURE,
INTEGRATION AND POLICY
INITIATIVES1
BY PHILIPP HARTMANN2,
ANGELA MADDALONI2 AND
SIMONE MANGANELLI2
May 2003
1 We appreciated Marco Pagano’s comments on an outline of this paper and also early comments by Vítor Gaspar. Research assistance
by Anna Maria Agresti, Sandrine Corvoisier and Fabio Moneta is gratefully acknowledged.We thank participants to the Oxford Review
of Economic Policy editorial meeting at the European University Institute in Florence, in particular Christopher Allsopp, Mike Artis (the
editors) and our discussant Eric Fisher. The points made by an anonymous referee helped us to improve the paper. The opinions
expressed herein are those of the author(s) and do not necessarily represent those of the European Central Bank or the Eurosystem..
This paper can be downloaded without charge from http://www.ecb. int or from the Social Science Research Network electronic library
at: http://ssrn.com/abstract_id=xxxxxx
2 European Central Bank. E-mail: simone.manganelli@ecb.int; philipp.hartmann@ecb.int; angela.maddaloni@ecb.int.
© European Central Bank, 2003
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ISSN 1561-0810 (print)
ISSN 1725-2806 (online)
Contents
Abstract
4
Non-technical summary
5
Introduction
7
2.
Financial structures of G-3 economies
2.1 International comparison
2.2 Recent changes in the financial structure of the euro area
8
9
13
3.
Financial integration in the euro area
3.1 Money markets
3.2 Bond markets
3.3 Equity markets
3.4 Banking
17
17
20
24
28
4.
Main policy initiatives to improve financial integration in Europe
4.1 The financial services action plan of the European Commission
4.2 The Lamfalussy report on the regulation of European securities markets
4.3 The application of the Lamfalussy framework to the banking sector and the
reform of the financial services policy group
4.4 The work of the Giovannini Group
33
34
35
Conclusion
41
5.
37
39
References
43
European Central Bank working paper series
48
ECB Working Paper No 230 May 2003
3
Abstract: Four years after the introduction of the euro, this paper provides an overview of the current structure and
integration of the euro area financial systems and related policy initiatives. We first compare the euro area financial
structure with that of the United States and Japan. Using new and comprehensive financial account data, we also
describe how the euro area financial structure evolved since 1995. We document the progress towards integration of
the major euro area financial segments, namely money markets, bond markets, equity markets and banking. Finally,
we discuss recent policy initiatives aimed at further improving European financial integration.
Key words: financial system design, financial structure, financial integration, euro area, financial policy
JEL Codes: G00, F36
4
ECB Working Paper No 230 May 2003
NON-TECHNICAL SUMMARY
This paper describes the main developments in the euro area financial markets before and after the
introduction of the single currency. It first compares the financial structure of the euro area with that of
the United States and Japan. It documents how the euro area financial structure is placed somewhat in
between those of these two countries, with financial institutions playing an important role, but with
market based instruments developing further. It then looks at the evolution of the euro area financial
structure in the last few years. It shows how the importance of government financing has gradually
diminished in the period under review, while one of the most dynamic financial market developments
was the expansion of the market for corporate bonds. The increased bond issuance, however, has not yet
led to a regime shift in which market-based instruments have to a significant extent substituted loans and
private equities as the primary means of corporate financing in continental Europe. Interestingly, in
various dimensions the financial structure of euro-area countries seems to become more diverse over
time.
We assess the progress towards financial integration in the most important euro-area financial
segments, namely money, bond, and equity markets, as well as banking. The available data suggest that
the unsecured money market strongly integrated with the introduction of the euro, as the single currency
and related euro-area-wide large-value payment systems link the different countries well. The same
cannot be said, however, about the repo market. Government bond markets also integrated considerably
with the EMU convergence process, but they still exhibit some small (but non-negligible) cross-country
yield differentials since January 1999, that cannot be explained with credit risk. Moreover, as different
sovereigns focus their issuance on different maturities, there is no single homogeneous benchmark yield
curve, which hinders arbitrage and derivatives pricing. As the euro made primary corporate bond markets
more contestable, in particular regarding foreign competition, one important factor in the development of
this market was a considerable reduction of underwriting fees. Also, some progress occurred in the
integration of euro-area equity markets, as stock exchanges in a few countries merged to form Euronext
and professional asset managers replaced country allocation by sector allocation strategies. Powerful
obstacles to the further integration of repo, bond and equity markets remain the still fragmented
securities settlement industry in Europe, which charges much higher fees for cross-border transactions
than for domestic transactions, and differences in legal systems. Overall, while asset holdings have
become more international in the euro area since the introduction of the single currency, securities
markets are still much less integrated than in the US. In the area of retail banking the increased
homogeneity of interest rates seems to be driven more by macroeconomic convergence than by market
integration. For example, cross-border loans to non-banks have somewhat increased, but remain a very
small fraction of total lending. This is quite different in wholesale activities, as inter-bank lending
jumped up with the introduction of the euro and banks’ cross-border securities holdings also expanded
considerably. While the strongly domestic bias in the consolidation strategies of European banks has
ECB Working Paper No 230 May 2003
5
only changed very mildly recently and while the single European passport to create foreign bank
branches seems not to be used very much, it is interesting to report that also in the US cross-state
penetration by banks still remains quite limited.
Finally, the paper discusses in detail the most important high-level policy initiatives to foster
financial integration in Europe: the Commission’s Financial Services Action Plan, the Lamfalussy
Committee of Wise Men and the application of its work to all financial sectors, as well as the work of the
Giovannini Group. We review the main microeconomic and legal reforms identified in and tackled after
these initiatives, and we document the institutional changes to which they led. For example, recent
institutional changes for cross-border supervisory co-operation seem to have laid out the path through
which a more centralised European supervisory structure may emerge in the future.
6
ECB Working Paper No 230 May 2003
INTRODUCTION
In the last two decades the financial systems of industrialised countries have gone through profound
changes. The importance of traditional banking intermediation from deposits to loans has diminished.
Capital markets have considerably developed. Many financial innovations have emerged and at the same
time we have witnessed a substantial shift toward institutionalised management of savings. National and
international boundaries that limited the geographic scope of trade in financial services have been
eroded. The activities performed by banks have changed to keep pace with this transformation.
The main driving forces behind these developments were the significant demographic changes, the
wave of financial liberalisation, the information technology revolution that characterised the past two
decades, as well as the launch of the European Economic and Monetary Union (EMU).
It is essential to document and monitor this transformation, because it might have important
economic and political implications. For instance, it is now widely accepted that the size of the financial
system is strongly correlated with the level of economic development (King and Levine 1993, Levine,
1997). Different financial system structures (sometimes also called architectures) have different welfare
implications. Bank-based systems provide better inter-temporal and worse cross-sectional risk sharing
than market-based systems (Allen and Gale 1995 and 2000). They also influence borrowers’ choices of
financing source, ultimately affecting the rate of financial innovation and the likelihood of investing in
new/riskier technologies (Thakor 1996, Boot and Thakor 1997, Rajan and Zingales 2003). Moreover,
increased financial integration can reduce the cost of capital and thereby spur economic growth. Two
recent reports estimate the effect of substantial further integration in Europe at about 1 percent increase
in GDP growth (Giannetti et al. 2002 and London Economics 2002). Similarly, developed and integrated
capital markets can improve the welfare of countries joining a monetary union, by achieving better
income insurance and consumption smoothing through cross-ownership of productive assets and access
to outside credit markets (Sorenson and Yosha 1998, Yosha, Kalemnli-Ozcan and Sorenson 2001).
Monitoring and understanding financial system transformation is of major importance for the core
functions of central banks as well. Changes in the banking sector and in financial markets may affect the
monetary transmission mechanism (see e.g. Ehrmann et al. 2003 and Chatelain et al. 2003). Financial
development may change the choice and quality of financial market indicators of underlying economic
variables that central banks employ in their conjunctural analysis to take monetary policy decisions
(Issing 2002). Central banks use modern financial contracts to provide the liquidity the banking system
needs to fulfil its function. As the financial system evolves and as this evolution affects the money
market, these operational procedures may have to be adjusted as well, including the selection of assets
accepted by central banks as collateral against the provision of liquidity. Financial transformation can
also have implications for the design, efficiency and safety of large-value payment systems. Although
less well known to the general public, this is another major task of central banks. The Eurosystem, for
ECB Working Paper No 230 May 2003
7
example, is responsible for TARGET, a real-time gross settlement system that allows for intra-day
overdrafts against adequate collateral.1 Again, changes in the relative importance of different assets
accompanying the development of the financial system may require, inter alia, adjustment of central
banks’ collateral policies. Finally, structural change in financial systems can be associated with the
emergence of instability. As central banks play an important role in maintaining financial system
stability, they need to follow such structural change carefully (Padoa-Schioppa 2003).
In the light of these arguments, it should not be surprising that European political and monetary
authorities put great emphasis on financial reforms and the integration process in euro area financial
markets. Four years after the introduction of the euro this paper provides a broad but concise overview of
the current structure and integration of the euro area financial system and related policy initiatives. The
paper contains three main sections. In the next section, we describe how the euro area financial structure
changed since 1995, and compare it with the United States and Japan, using new and comprehensive
financial account data. Moreover, it is examined whether financial structures across European countries
have become more similar after the introduction of the single currency. Section 3 assesses the progress
toward financial integration in the major euro-area financial segments, namely money markets, bond
markets, equity markets and banking. This section also describes some of the most interesting financial
developments that occurred alongside with the integration process, partly spurred by the euro. Finally, in
section 4 we briefly present some main policy initiatives aimed at further advancing the process of
European financial integration. We will describe in some detail the Financial Services Action Plan of the
European Commission, the Lamfalussy approach to reform the process of securities market regulations
and its application to other financial sectors, as well as the work of the Financial Services Policy Group
and of the Giovannini Group. Section 5 concludes.
2. FINANCIAL STRUCTURES OF “G-3” ECONOMIES
A financial system is defined by the set of institutions (markets and intermediaries) through which
households, corporations and governments obtain funding for their activities and invest their savings. In
a given financial system, the mixture of financial markets and intermediaries operating in the economy
defines the financial structure of that system. As discussed in the introduction, different financial
structures might have different economic and welfare implications for a given financial system.
Therefore, it is important to understand the current structure of the European financial system and how it
is transforming. In sub-section 2.1, we first compare the financial structures of the three main economic
areas of the world: the euro area, the United States and Japan. In sub-section 2.2, we then focus our
attention on the euro area, describing how its financial structure has evolved over the past six years. We
1
8
TARGET stands for Trans-European Automated Real-time Gross settlement Express Transfer system.
ECB Working Paper No 230 May 2003
will not enter the debate on whether one structure is better than another one. We will limit ourselves to
describe the current developments, pointing out the most important changes.2
2.1 International comparison
Table 1 offers a broad overview of the financial structures of the three main economic areas of the world.
In terms of overall size, expressed in percentage of GDP, the euro area financial system is similar to the
one of the United States, and smaller than Japan. The greater size of the Japanese financial system is
related to the much greater weight of Japanese banks.3
Euro area
Households
Non-financial corporations
Financial corporations
Government
Total
Assets
202
147
371
28
748
Liabilities
57
240
369
80
746
Net Position
145
-93
2
-52
2
United
States
Households
Non-financial corporations
Financial corporations
Government
Total
322
112
334
20
788
80
132
332
62
606
242
-20
3
-42
182
Japan
Table 1 – Overall picture of the financial structure in the euro area, United States and Japan at the end
of 2001, with breakdown by sector. All the values are expressed in percentage of GDP.
Households
Non-financial corporations
Financial corporations
Government
Total
281
140
596
86
1,104
78
250
598
146
1,072
203
-110
-2
-60
32
Source: ECB, Federal Reserve System and Bank of Japan
Two common features emerge from table 1. First, households have a large positive net position in
financial asset holdings. Second, financial corporations, given their role as financial intermediaries, have
a net position close to zero. Therefore, households can be regarded as the ultimate providers of funds for
non-financial corporations and governments.
2
This exercise is largely based on euro area financial account data – compiled according to the European System of
Accounts (ESA 95) – which provide a detailed and complete overview of the financial relationships between
economic sectors in a country (see European Central Bank 2002a). However, the best available data are in general
not consolidated, which means that double counting occurs and it may not be homogeneous across sectors.
3
The financial accounts data for the euro area, the United States and Japan are not fully comparable. In particular,
we should note that in the US financial accounts statistics, sole proprietorships and partnerships without
independent legal status that are market producers belong to the “non-financial corporations” sector, while in the
euro area and Japanese financial accounts these belong to the “households” sector. Marketable assets and liabilities
are generally valued according to their market value. However, in the US financial accounts, except when the
market value of equities is reported as a separate item, almost all the series are shown at book, or historical values.
The importance of the Japanese financial sector, as shown in table 1, reflects in part the non consolidation of the
interbank business.
ECB Working Paper No 230 May 2003
9
The overall picture displaying households as financing the other two domestic, non-financial
sectors and the position of the euro area vis-à-vis the rest of the world (see the total net position in Table
1) has been broadly stable since the mid 1990’s. All gross financial positions have been increasing
relative to GDP, except the government sector. For this sector, the ratio of financial assets relative to
GDP has been stable, while liabilities have fallen, leading to a slight improvement of the financial
position of governments over the period. In the euro area, this development has been accompanied by an
increased indebtedness of corporations, which changed from about 59% of GDP in 1995 to around 74%
in 2000.4 This ratio is comparable to the one in the U.S. (66%), but lower than the Japanese one (127%)
(See European Central Bank 2002a). However, there were marked differences across euro area countries.
Firms in countries like France, Germany, Italy and Spain were generally less indebted than companies in
the Netherlands, Portugal and Finland.
Tables 2 and 3 present the breakdown by asset of the investment and source of funding for the
different sectors. In terms of debt financing, non-financial corporations in the euro area and in Japan
resort to a much larger extent than US corporations to loans (see table 2). Bonds represent a significant
source of funding for U.S. and Japanese non-financial corporations, while they are still relatively
unimportant in the euro area. However, as we will see in sub-section 2.2, a boom in corporate bond
issuance for non-financial corporations in the euro area has been one of the most striking developments
happening contemporaneously with the introduction of the single currency.
Table 2 – Source of financing in the euro area, United States and Japan at the end of 2001, with
breakdown by sector. All the values are expressed in percentage of GDP. Shares of non financial
corporations for the United States are estimated with the market value of shares of “Non Farm
Nonfinancial Corporate Business” as reported in Table L.102 of the flow of funds accounts.
Japan
United
States
Euro area
Loans
Households
Non-financial corporations
Financial corporations
Government
Total
52
68
12
15
95
Debt
Securities
0
8
50
57
115
Shares
0
132
75
0
207
Currency &
Deposits
0
0
170
4
174
Households
Non-financial corporations
Financial corporations
Government
Total
75
40
32
0
72
2
29
87
47
163
0
108
73
0
181
0
0
59
0
59
Households
Non-financial corporations
Financial corporations
Government
Total
67
99
107
36
242
0
25
57
103
186
0
75
19
2
96
0
0
241
0
241
Source: ECB, Federal Reserve System and Bank of Japan
4
The degree of indebtedness of the non financial corporations is calculated as the sum of all liabilities excluding
shares, technical reserves and other accounts payable.
10
ECB Working Paper No 230 May 2003
The importance of private equity (unquoted shares) seems to be a peculiar characteristic of the
euro area financial system, due to the fact that euro area economies have a relatively large proportion of
small and medium-sized enterprises (SMEs).5 Indeed, 66% of all employees in Europe are employed in
SMEs, compared with 46% in the United States and 33% in Japan (European Commission 2002b). Partly
as a consequence of this, many euro area companies either resort to banks to finance their activities, or
use extensively unquoted shares.
On the investment side, households in the U.S. have a much stronger preference for equities
(representing 147% of GDP) than in the other two economies (67% for the euro area and 21% for Japan),
where they hold higher amounts of currency and deposits (see table 3). There are several hypotheses that
can explain such differences in households’ behaviour. For example, social security benefits differ
significantly across countries and are likely to affect the investment choices of households. Indeed, the
large diffusion of company retirement accounts in the United States (the 401K) might imply that US
households hold indirectly more shares than their euro area counterparts. Moreover, in the euro area,
where social security benefits are more generous, people have a lower incentive to invest in securities to
support their retirement (see, for example, Poterba 2001 and Ang and Maddaloni 2003). Differences in
taxation of capital gains and in the treatment of bequests might play a role as well (Poterba 2003).
Shares
Euro area
Households
Non-financial corporations
Financial corporations
Government
Total
19
9
80
2
110
67
77
69
9
222
Currency &
Deposits
61
15
77
6
159
Households
Non-financial corporations
Financial corporations
Government
Total
23
2
111
7
142
147
2
85
2
235
48
14
16
3
80
17
9
140
21
21
29
153
36
39
J
a
p
Debt Securities
United
States
Table 3 – Investments in the euro area, United States and Japan at the end of 2001, with breakdown by
sector. All the values are expressed in percentage of GDP. The investment in shares of non-financial
corporations in US represent only “investment in finance companies subsidiaries” and it does not
include investments in foreign companies as reported in tables L.102 and L.103 of the flow of funds
accounts.
Households
Non-financial corporations
Financial corporations
5
Good and comprehensive data on private equity are not readily available. However, one can deduce its importance
from juxtaposing the figures in the column “equities” of tables 2 and 3 (which include both private and public
equity financing or holding) with data on stock market capitalisation, which is available from the Federation
Internationale des Bourses de Valeur (http://www.fibv.org). However, data shortcomings also require a word of
caution. Full coverage of private shares is not available in all euro area countries, and significant differences in the
valuation methods applied to these instruments across countries persist.
ECB Working Paper No 230 May 2003
11
Government
Total
10
175
14
85
9
237
Source: ECB, Federal Reserve System and Bank of Japan
Equity investment tends to be more popular among euro area non-financial corporations (they hold
77% of GDP in shares) than in Japan and the United States, where shareholdings by the corporate sector
are limited to 21% and 2% of GDP, respectively. The fact that euro area non financial corporations have
a significantly higher propensity to hold shares than to hold other securities compared to their US and
Japanese counterparts might reflect that corporate cross-shareholdings are an important (albeit not much
studied) phenomenon in the euro area.6
The data reported so far confirm also that financial institutions play a bigger role in the euro area
and Japan than in the US. These findings are consistent with the traditional distinction that characterise
continental European and Japanese financial systems as “bank-based”, and the U.S. system as more
“market-based” (see, for example, Allen and Gale 2000). However, the continental European system is
no longer “bank-based” in the same way as it was in the past. While credit institutions are still the
preferred source of intermediation for financial investments in the euro area, their “traditional” business
is on a relative decline compared to other intermediaries, such as investment funds, pension funds and
insurance companies. This trend can be observed throughout the euro area, although with particular
strength in Belgium, France and Italy. More permissive regulations of investment and pension funds, as
well as tax advantages for investors in life insurance products, played some role in these developments.
The introduction of the euro might have further strengthened the movement away from traditional bank
deposits, given that the disappearance of currency risk has facilitated cross-border diversification of
portfolios, thus increasing the demand for securities (see also section 3). The increase in demand for
longer term high-yielding securities also reflects the ageing population in the euro area, which enhances
long term savings and hence the channelling of funds into mutual funds, pension funds and insurance
companies. At first sight, it might seem that the importance of banks has been diminishing relative to
other types of intermediaries. However, the fact that mutual funds to a wide extent are managed and
marketed by banks, as well as the fact that banks are increasingly involved in insurance and pension fund
businesses (“bancassurance”), indicate that the role of banks in the intermediation process is changing
rather than diminishing.
In summary, we notice that financial institutions have a great weight in the Japanese financial
system, where loans remain by far the most relevant source of funding for corporations. Market based
instruments are much more developed in the United States, as shown by the importance of equities and
6
Data refers to both domestic and foreign shares. For a discussion of the use of cross shareholdings in euro area
countries, both in the financial and in the non-financial sectors, see also Morin (2000), Gorton and Schmid (2000)
and Focarelli and Pozzolo (2001).
12
ECB Working Paper No 230 May 2003
bonds as sources of financing for non-financial corporations and as investment devices for households.
The euro area financial system is placed somewhat in between, with financial institutions playing an
important role, but with market based instruments developing further.
2.2 Recent changes in the financial structure of the euro area
We now look at the evolution of the euro area financial structure in the last few years. Figure 1 shows
how assets and liabilities were allocated among the four main sectors from 1995 to 2001. Two main
features emerge. First, non-financial corporations have increased their share of total assets at the expense
of the household and government shares, especially after 1999. Second, on the liability side, fiscal
consolidation and the constraints imposed by the Stability and Growth Pact have led governments to
reduce their budget deficits and debt exposures. Arguably, this reduction of government financing
created room for more financing of non-financial corporations, as shown by the substantial increase in
their share of liabilities. This may have been prompted, on the one hand, by a general decrease of interest
rates, which fostered investments by the corporate sectors. On the other hand, investors looking for longterm, fixed income instruments had to turn more to non-government assets.
Figure 1 – Composition of assets and liabilities as percentage of total, with breakdown by sector.
(Source: ECB)
Financing - Debt securities (% GDP)
Financing - Loans (% GDP)
80
70
70
60
Financing - Shares (% GDP)
180
160
140
60
50
50
120
40
100
30
80
40
30
20
20
10
10
60
40
0
20
0
0
1995
1996
1997
Households
Financial corporations
1998
1999
2000
2001
Non-financial corporations
Government
1995
1996
1997
Households
Financial corporations
1998
1999
2000
Non-financial corporations
Government
2001
1995
1996
1997
Households
Financial corporations
1998
1999
2000
2001
Non-financial corporations
Government
Figures 2 and 3 report the breakdown by sector of the different sources of financing and
investment. Equity financing shows a clear upward trend, with a peak in 1999, partly reflecting the high
stock market valuation of the last years of the 1990s. In 1999 non-financial corporations show a
significantly higher increase in the importance of equities, than financial corporations. Financial
corporations have increasingly financed themselves through bonds, while loans have become more
important for households, partly reflecting developments in the housing markets of several euro area
countries (see European Central Bank 2003a), and for non-financial corporations. (At the same time
financial corporations have also constantly increased their investment in bonds, which stabilised after
1998.) While, overall, non-financial corporations have made more use of market financing, in absolute
terms the available data do not allow to draw the conclusion that, in relative terms, their growth
happened in excess of the contemporaneous growth observed for loan financing. In other words, in terms
ECB Working Paper No 230 May 2003
13
of non-financial corporate financing, we are not able to identify any significant structural change from
the traditional bank-loan-based financial system in continental Europe to a more securities-market-based
system similar to the United States. This finding is consistent with earlier empirical findings by Schmidt
et al. (1999) and European Central Bank (2001c), but contrasts with the view of Rajan and Zingales
(2003).
Figure 2 – Breakdown by sector of the sources of financing in the euro area (%GDP). (Source: ECB)
Financing - Debt securities (% GDP)
Financing - Loans (% GDP)
80
70
70
60
Financing - Shares (% GDP)
180
160
140
60
50
50
120
40
100
30
80
40
30
60
20
20
40
10
10
0
0
1995
1996
1997
1998
Households
Financial corporations
1999
2000
20
0
1995
2001
Non-financial corporations
Government
1996
1997
1998
1999
2000
Households
Non-financial corporations
Financial corporations
Government
2001
1995
1996
1997
1998
Households
Financial corporations
1999
2000
2001
Non-financial corporations
Government
Figure 3 – Breakdown by sector of the investment of funds in the euro area (%GDP). (Source: ECB)
Investment - Debt securities (% GDP)
Investment - Currency & Deposits (% GDP)
Investment - Shares (% GDP)
90
90
90
80
80
80
70
70
70
60
60
60
50
50
50
40
40
40
30
30
30
20
20
20
10
10
10
0
0
0
1995
1996
1997
1998
1999
2000
Households
Non-financial corporations
Financial corporations
Government
2001
1995
1996
1997
Households
Financial corporations
1998
1999
2000
2001
Non-financial corporations
Government
1995
1996
1997
Households
Financial corporations
1998
1999
2000
2001
Non-financial corporations
Government
It is worthwhile to explore in more detail the evolution of the corporate bond market, as some
researchers regard this as the most striking development after the introduction of the single currency (see,
for instance, Galati and Tsatsaronis 2001 or Peree and Steinherr 2001). In figure 4 we report the net
issues of corporate bonds by banks and other corporations. We note two things. First, the introduction of
the euro in 1999 coincides with a significant jump in the issuance of corporate bonds. Second, in the year
2001, corporate bond net issues by non-bank institutions (the sum of non-monetary financial
corporations and non-financial corporations) surpasses issuance by banks. This second development is
even more striking in view of the fact that before 1998 such a market was practically not existent. Since
the period 1999-2001 coincided also with significant corporate restructuring, with large IPO’s7 and with
the UMTS license auctions in the telecommunication sector, it is not obvious that this development can
7
The biggest IPOs in terms of volume during this period were the privatisation of ENEL (the Italian energy
provider) and Deutsche Post and the public offers of Infineon Technologies (German chip producer), Orange
(French mobile phone) and Alstom (French manufacturing).
14
ECB Working Paper No 230 May 2003
be attributed to the euro. For example, Carnegie-Brown and King (2003) point out that the euro corporate
bond issuance was proportional to M&A activity in the euro area and that bond financing was similarly
pronounced in non-euro area European countries, like the United Kingdom.
Figure 4 – Net issues of corporate bonds in the euro area (in ELOOLRQ Source: ECB)
400
350
300
250
200
150
100
50
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
-50
Monetary financial institutions
Non-monetary financial corporations
Non-financial corporations
Total corporate sector
If M&As, UMTS licenses and IPOs were the only driving forces, we should observe a significant
drop in the amount of issues in 2002, a year during which the importance of these factors subsided
considerably. Despite a significant decline for non financial corporations, Figure 4shows that the net
issuance for non-monetary financial corporations has remained at sustained levels. This suggests that the
introduction of the common currency, by enlarging the pool of potential investors and reducing
underwriting costs, did have a significant effect on this market (see also the discussion in sub-section
3.2). Further evidence about the impact of the euro on the importance of corporate bond financing is
provided by Rajan and Zingales (2003). Using panel data on domestic corporate debt outstanding in
several countries since 1989, they regress the amounts of national debt issues on country and year
dummies as well as on an indicator variable for countries that adopted the euro. They find that the euro
had an independent positive and statistically significant effect on the amount of net debt issues. However,
despite the significant growth of corporate bond issuance in the euro area, we should recall from Table 2
that total bond financing by non-financial corporations did not exceed 8% of FDP by 2001, compared to
29% and 25% for the US and Japan, respectively.
To evaluate how the financial structures of the individual euro area countries evolved over time,
we plot in figure 5 weighted cross-country standard deviations between 1995 and 2001. All the figures
ECB Working Paper No 230 May 2003
15
are expressed in percent of GDP and weighted according to the relative GDP contribution of each
country to the euro area total.8 This measure, called σ-convergence, is borrowed from the growth
literature. For example, Adam et al. (2002) applied it to asset prices, describing their evolution across
locations over time. We apply it to asset and liability components, to see if euro area financial structures
are becoming more uniform over time. Figure 5 shows that the importance of currency and deposits and
of loans in euro area countries has become more heterogeneous over time. Bond investment and
financing, on the other hand, seem to become more uniform. To our knowledge, there is no theory that
explains how the different financial structures of the euro area countries should evolve over time.
Moreover, it is important to stress that convergence in individual countries’ financial structures is neither
necessary nor sufficient for European financial integration. Nevertheless, from the perspective of central
banks developments in financial structures should be carefully monitored, as they might have important
implications for the transmission mechanism of the single monetary policy.
Figure 5 – Weighted standard deviations of euro area assets and liabilities with breakdown by asset
(%GDP). (Source: ECB)
Sigma-convergence - Liabilities
Sigma-convergence - Assets
45
40
40
35
35
30
30
25
25
20
20
15
1995
1996
1997
Currency & deposits
1998
1999
Debt securities
2000
Loans
2001
1995
1996
1997
1998
Currency & deposits
1999
Debt securities
2000
2001
Loans
In sum, we found that an unprecedented boom of corporate bond issuance in Europe constituted
one, maybe the major financial market development on the continent in recent years. The origins of this
boom range from the forces unleashed by the euro – including also the constraints imposed by the
Stability and Growth Pact on government finances –, to corporate restructuring and the liberalisation of
telecommunication business. This bond market boom, however, and also some growth of equity
financing in the euro area, has not yet led to a significant shift of corporate financing from the traditional
bank-based structure to a more market-based structure, as known for the US financial system, because
loan financing grew as well. At the same time, non-bank financial intermediaries have grown in
importance in Europe, although part of them tend to be managed, or part of their services marketed, by
8
The weighted standard deviations were computed as follows. Let wi be the GDP weight of country i and xi country
i’s asset or liability, expressed in percent of its GDP. Then σ =
16
12
∑
i =1
wi ( xi −
12
∑
i =1
wi xi ) 2 .
ECB Working Paper No 230 May 2003
banks. Interestingly, we further document that financial structures across euro area countries have been
diverging during the second half of the 1990s, with the notable exception of the bond sector.
3.
FINANCIAL INTEGRATION IN THE EURO AREA
Financial integration is different from financial structure in that it refers to the ease with which financial
instruments can be traded across regions, across national borders or even globally. Formally, one can say
that an economic area is financially integrated if there are no barriers that discriminate economic agents
in their access to and investment of funds within that area, on the basis of their location. As a
consequence of this definition, i) financial instruments with identical cash flows should command the
same price, ii) there should be no systematic differences in the portfolio allocation and sources of
funding of economic agents within the area, after controlling for their individual characteristics. This
provides the rationale to look at both price-based and quantity-based indicators. In this section we
discuss the degree of integration of different financial markets (money, bond, stock and banking
markets), looking both at price and quantity measures of integration. We also describe a number of recent
developments relevant for the further integration of European financial markets, such as the emergence
of common bond market trading platforms or the status of stock market consolidation.
3.1 Money markets
A single currency can be expected to have the strongest effect on the integration of the money market. A
single monetary policy is characterised by a unique short-term policy interest rate (such as the ECB main
refinancing rate or the Fed federal funds target rate) and an area-wide wholesale payment system (such as
TARGET in the euro area and Fedwire in the US). In such conditions interbank deposits (of healthy
banks) in different locations of the area are extremely close substitutes and there are little obstacles to
arbitrage away any short-term interest rate differentials.
Some descriptive evidence confirms that the euro area interbank deposit market became extremely
integrated very shortly after the introduction of the euro in January 1999. Hartmann, Manna and
Manzanares (2001, figure 4) plot 5 months of intra-day overnight deposit rates from brokers located in
different euro area countries and the UK, arguing that apart from the special year 2000 changeover week,
cross-border rate differentials were very small. In figure 6 we plot 3-month deposit rates from January
1995 to January 2003. Of course, the massive convergence of these rates is undisputable.9 The law of one
9
Adam et al. (2002, table 5.1) calculate average cross-sectional 3-month interest rate spreads vis-à-vis Germany
and find them to be 0 for euro area countries (after January 1999) and very different from 0 for Denmark and the
UK.
ECB Working Paper No 230 May 2003
17
price has established itself even without the emergence of a common cross-border trading platform for
interbank deposits.
Figure 6 – Convergence of 3-month money market rates. (Source: ECB)
euro area
Greece
Austria
Ireland
Belgium
Italy
Finland
Netherlands
France
Portugal
Germany
Spain
25
20
15
10
5
Adam et al. (2002) calculate
Jan.2003
Nov.2002
Jul.2002
Sep.2002
Jan.2002
Mar.2002
May.2002
Nov.2001
Jul.2001
Sep.2001
Jan.2001
Mar.2001
May.2001
Nov.2000
Jul.2000
Sep.2000
May.2000
Jan.2000
Mar.2000
Jul.1999
Nov.1999
Sep.1999
May.1999
Jan.1999
Mar.1999
Jul.1998
Nov.1998
Sep.1998
May.1998
Jan.1998
Mar.1998
Nov.1997
Jul.1997
Sep.1997
Jan.1997
Mar.1997
May.1997
Nov.1996
Jul.1996
Sep.1996
Jan.1996
Mar.1996
May.1996
Nov.1995
Jul.1995
Sep.1995
May.1995
Jan.1995
Mar.1995
0
-convergence measures of 3-month interest rate differentials
between euro area countries and Germany by regressing the change in these differentials on their level in
the previous period. A negative regression parameter
indicates that convergence towards a common
steady-state level is taking place and the absolute size of the parameter measures the speed with which
that is taking place. The results show negative
coefficients throughout, which however more than
double in size with the introduction of the euro. In other words, convergence of 3-month money market
rates or the integration of this market has increased markedly after EMU.
The same authors also calculate the cross-sectional dispersion of 3-month deposit rates at any
point in time and regress it on a time trend, the -convergence measure. A negative regression parameter
indicates a trend towards greater market integration, since it implies that the law of one price tends to
hold with greater accuracy over time. The results suggest that money market integration already
increased somewhat before January 1999. However, with the introduction of the euro the standard
deviation of cross-country rates basically collapses to zero, consistent with full money market integration
(see Adam et al., 2002, figure 5.9).
Additional evidence on increasing money market integration in the euro area after the start of stage
3 can be provided with quantity based indicators. Following Galati and Tsatsaronis (2001), Gaspar,
Hartmann and Sleijpen (2003) plot the share of euro area banks’ cross-border claims on other euro area
banks as a percentage of total cross-border interbank claims between 1990 and 2002. It is very visible
from their figure, reproduced here as figure 7, that cross-border lending in the euro area interbank market
increased significantly during 1998 and 1999 and clearly in excess of cross-border interbank lending
18
ECB Working Paper No 230 May 2003
outside the euro area. It seems that the impact of the euro amounted to a 10 percentage point level effect
in the size of the euro area interbank market relative to non-euro area interbank markets. Adam et al.
(2002, figure 5.17) present data from the Fédération Européenne des Fonds et Sociétés d’Investissement
(FEFSI) between December 1997 and June 2001. They show that the share of assets invested in money
market funds with an area-wide investment strategy (as opposed to a national investment strategy)
increased dramatically during 1999 for most countries.
Figure 7 – Euro area cross-border interbank lending, 1990-2002(amounts outstanding at end-of-quarter,
in billion euros and % of total). Data cover information for 19 industrial countries (EU countries
excluding Portugal, Canada, Japan, Norway, Switzerland and the United States) and 6 other countries,
hosting major offshore banking centres (Bahamas, Bahrain, the Cayman Islands, the Dutch Antilles,
Hong Kong and Singapore). (Source: Bank for International Settlements)
E u ro a re a b a n k s ' c ro s s -b o rd e r c la im s o n b a n k s
%
in EU R b illio n s
50
i n s i d e th e e u r o a r e a ( l h s )
1200
i n s i d e th e e u r o a r e a a s a p e r c e n ta g e o f to ta l c r o s s - b o r d e r c l a i m s
b y a l l r e p o r ti n g b a n k s ( r h s )
45
40
1000
35
800
30
25
600
20
400
15
10
200
5
0
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Whereas all indicators for uncollateralised money market instruments point in the same direction,
a significant increase in integration at the start of stage 3 and presently a very high degree of integration,
it is important to caution that this does not apply to all money market instruments. Notably the market for
repurchase agreements (repos) is considerably less integrated than the market for deposits (see in
particular the second Giovannini Report discussed in sub-section 4.4, European Commission 1999b and
CEPS 2000). Solid evidence on the European repo market is relatively scarce however, in particular
regarding measures of price differentials. Ciampolini and Rohde (2000) report some market survey
evidence on interest rate spreads between German and Italian (general collateral) repurchase agreements.
It turns out that monthly or 3-month Italian repos usually trade 4-5 basis points higher than German
repos. Similarly, Canoy et al. (2001, table 7.2) show general collateral repo rates of a large Dutch bank,
differentiated according to whether the collateral was German, Dutch, Italian or Belgian government
bonds. Depending on the maturity and the country pair chosen those rates could differ up to 7 basis
points on the same day, with the largest differential occurring between German and Belgian collateral for
the longest maturity of 6 months.
ECB Working Paper No 230 May 2003
19
As regards quantity measures, euro repo market turnover is smaller than euro cash market turnover
and displays a smaller share of cross-border trading. However, the year 2000 ECB money market report
(see European Central Bank 2001a) also showed an increase of intra-euro area cross-border trading
between 1999 and 2000 (see the chart “Activity in the euro area deposit, repo and foreign currency swap
market” in the annex). The year 2001 ECB money market report (see European Central Bank 2002c)
confirmed that the share of trading with national counterparts is still higher in the repo market (slightly
above 40%) than in the unsecured market (around 30%). And more than half of euro repo trading is still
in instruments secured by home country collateral.
In sum, the euro area money market is characterised by a very large, very liquid and highly
integrated unsecured deposit market and by a smaller and less integrated repo market. The main reasons
for the former are certainly the single currency and related area-wide wholesale payment systems. The
main reasons for the lagging repo market are (i) a fragmented securities settlement infrastructure that
hampers the flow of collateral across borders (see also sub-section 4.4), (ii) contractual heterogeneity
related to a multiplicity of Master Agreements and some legal uncertainty, and (iii) the imperfect
substitutability of government debt used as collateral and related price differentials (see also sub-section
3.2, notably figure 8/right panel).
3.2 Bond markets
The integration of government and corporate bond markets has also been significantly affected by the
introduction of the euro. The euro has created a more homogeneous market, considerably expanding the
base of investors. This contributed to making both government and corporate bond markets more
competitive, ultimately leading to profound changes. In the following, we first describe developments
regarding the integration of corporate bonds and then we turn to government bonds.
We have already talked about the corporate bond market in sub-section 2.2. There we saw that
Europe witnessed an unprecedented boom of corporate bond issuance. Related to this, another interesting
development happened in corporate euro bond underwriting. Before the introduction of the euro, firms
wishing to issue bonds in a foreign market would usually have to select an investment bank with
marketing and sales expertise in the currency of that country. Afterwards, however, underwriting became
a much more contestable business. This is confirmed in a study by Santos and Tsatsaronis (2002), where
it is shown that the arrival of the euro had an important negative impact on the underwriting fees of
international corporate bonds issued in the new currency. Fees went even down to the levels observed in
the US corporate bond market. This finding is particularly striking, as in 1994 the average fee for bonds
denominated in European currencies was twice the corresponding figure in the US. An important feature
in this development is that most of the underwriting business was taken over by the largest international
investment banks, suggesting also that vis-à-vis the large euro-oriented investor base borrowers privilege
20
ECB Working Paper No 230 May 2003
capacity over business relationships in the choice of an underwriter. Clearly, the greater contestability of
the international euro market acted as a powerful substitute for foreign entry into national underwriting.
The government bond market was also very much affected by the introduction of the euro. From a
structural perspective, the significant reduction in the importance of government debt related to the
budget constraints imposed by the Stability and Growth Pact was already discussed in sub-section 2.2.
By eliminating exchange rate risk, increasing the homogeneity of different sovereign issues, and
therefore increasing their degree of substitutability, the euro has also intensified the competition in the
Treasury bond market. As a consequence, government debt underwent a significant restructuring process.
Most Treasuries decided to specialise on certain points of the yield curve, in order to increase the
liquidity of the outstanding issues and to minimise borrowing costs. A general strategy has been to buy
back or exchange the less liquid bonds with a smaller number of more liquid maturities, specialising on
particular segments.10 These developments lead to the absence of a single homogenous sovereign-based
yield curve in Europe, which constitutes an obstacle to full financial integration, as it hinders arbitrage
activity and the pricing of derivatives. (See Dunne et al. 2000 for an in-depth discussion of this
benchmark question.)
In fact, price-based indicators show that the integration of the government bond market has
advanced less than is the case for money market. Figure 8 displays the plots of 10-year government bond
benchmark yields and spreads over the German bond, for the countries that joined the euro. On the one
hand, the left panel shows that convergence has clearly taken place in this market. The indicators
proposed by Adam et al. (2002) confirm this, as the speed of convergence increased after the adoption of
the single currency, while the standard deviation (which measures the σ-convergence) in 1999 decreased
substantially with respect to the levels of 1995. On the other hand, the right panel of figure 8, which plots
the euro area government bond spreads over the German bond for the more recent period, shows that the
10-years bond yield spreads are still significantly different from zero, mostly ranging between 10 and 30
basis points. This is evidence that the government bond markets of the euro-area are still somewhat
segmented, in the sense that the pricing of government bonds (with identical credit risk rating) has not
fully converged. One possible explanation may be the existence of multiple equilibria (see Danthine et al.
2001): the difference in yields between similar government bonds generates a liquidity risk in the smaller
markets, which in turn justifies the difference in yield. Adjaouté and Danthine (2003) argue that the costs
associated with the persistence of such market segmentation are non-negligible. They estimate that if the
market could be co-ordinated to the optimal equilibrium, e.g. through public policy, at the current debt
levels euro area Treasuries could save at least ELOOLRQ
10
For instance, German bonds represent the benchmark for the 10 year maturity, while French bonds have a
dominant position in the 5 to 7 year maturity. The French government has started to issue inflation-linked and
constant maturity bonds (known as “TEC 10”, Taux de l'Échéance Constante à 10 ans). The Italian government has
a dominant position in the segment of floating rate issues (see European Central Bank 2001b).
ECB Working Paper No 230 May 2003
21
Austria
Greece
Portugal
Belgium
Ireland
Spain
Finland
Italy
France
Luxembourg
Austria
Belgium
Finland
France
Ireland
Italy
Mar.2001
euro area
Germany
Netherlands
Nov.2000
Figure 8 – Convergence of 10-year government bond yields and spreads over the German rate. (Source:
ECB)
Luxembourg
Netherlands
Portugal
Spain
0.6
20
0.4
18
16
0.2
14
0
12
10
-0.2
8
-0.4
6
4
-0.6
2
Jan.2003
Nov.2002
Jul.2002
Sep.2002
May.2002
Jan.2002
Mar.2002
Jul.2001
Nov.2001
Sep.2001
May.2001
Jan.2001
Jul.2000
Sep.2000
May.2000
Jan.2000
Mar.2000
Nov.1999
Jul.1999
Sep.1999
May.1999
Jan.1999
Jul.2002
Jan.2003
Nov.2002
Mar.2002
Sep.2002
May.2002
Jul.2001
Jan.2002
Nov.2001
Mar.2001
Sep.2001
May.2001
Jul.2000
Jan.2001
Nov.2000
Mar.2000
Sep.2000
May.2000
Jul.1999
Jan.2000
Nov.1999
Mar.1999
Sep.1999
May.1999
Jul.1998
Jan.1999
Nov.1998
Mar.1998
Sep.1998
May.1998
Jul.1997
Jan.1998
Nov.1997
Mar.1997
Sep.1997
May.1997
Jul.1996
Jan.1997
Nov.1996
Sep.1996
Mar.1996
May.1996
Jul.1995
Jan.1996
Nov.1995
Sep.1995
Jan.1995
Mar.1995
May.1995
Mar.1999
-0.8
0
Quantity-based indicators paint a similar picture, with government bond markets increasingly
integrating, but significant home biases remaining. Table 4 displays the amount of euro area government
debt by geographical residence of holders as a percentage of GDP. While, as already mentioned, the total
amount of government debt decreased over the period 1995-2001, the percentage of debt held by nonresident increased. Although this trend towards international diversification started well before the
introduction of the euro, it increased more substantially only after 1999. As the holdings of euro area
government bonds outside the euro area did not change very much (see Detken and Hartmann 2000,
figure 8, and 2002, figure 4 and table 5), it is likely that most of the cross-border diversification reflects
intra-euro area investments. Therefore, one can argue that the introduction of the common currency has
contributed to reducing the “home bias” in the sovereign euro-denominated bond market.
Table 4 – Euro area government debt by holder.
% GDP
Domestic
Non resident
Total
Source: ECB
1995
58.3
15.9
74.2
1996
58.9
16.5
75.5
1997
56.9
17.9
74.9
1998
53.3
19.8
73.1
1999
49.7
22.3
72.0
2000
46.0
23.6
69.5
2001
45.0
24.1
69.1
Blanco (2001, table 4) reports data on trading activity in the 10 year government bond futures
markets. It emerges that the futures based on German bonds and traded in Eurex have absorbed most of
the liquidity of the Italian, Spanish and French markets in 1998 and 1999. Only in 2000 Euronext (see
the box on “Consolidation of Stock Exchanges” in the next sub-section) managed to restore the liquidity
of the French bond futures traded on MATIF to pre-EMU levels, although this remains low when
compared to the German market.
Competition has also fostered changes in the market structures and practices of the euro area.
Market transparency has been increased with the pre-announcement of auction calendars, and with the
concentration of the issuance activity on a smaller number of benchmark securities.
22
ECB Working Paper No 230 May 2003
Some electronic trading platforms have expanded to cover trading in most euro area government
bonds. The most successful of these platforms was MTS.11 MTS is an electronic quote-driven market,
where primary dealers quote continuously bid-ask prices for agreed securities. The MTS market model is
based on a two-tiered structure: a central “super-wholesale” market for European government bond
benchmarks (EuroMTS) and a combination of domestic markets for national issuers. Liquidity is
guaranteed by the presence of market-makers and by the use of a common electronic trading platform
(known as Telematico), that allows to exploit the economies of scale of a European network of operators.
Corporate governance decisions (e.g. conditions of access, obligations of market-makers, list of traded
securities) and market supervision remain at the national level. The popularity of these platforms has
been generally higher in countries with a relatively smaller outstanding amount of public debt securities.
This might reflect substantial differences in the entry costs among national markets. Many investors may
find smaller government debt markets not attractive enough to incur the fixed and operational costs of
entering them. The access to all these markets through a common, cross-border platform has apparently
been an attractive alternative for them. It seems that these trading platforms have had a quite significant,
positive impact on the integration of government debt markets in the euro area, and on the liquidity of
some of the smaller markets.
An area where progress in the integration of market infrastructure has proven to be more difficult
is the settlement of securities, including bonds. Whereas the number of large-value payment systems in
the euro area has declined from 18 in 1997 to 5 in 2001, inter alia through the creation of TARGET by
the Eurosystem, the number of securities settlement systems has only come down from 23 to 14. (For
comparison, in the US the relevant number of systems for payments is two, and there are also two
systems for securities settlement.) It has been estimated that, partly as a consequence of this
fragmentation, the costs of settling cross-border debt securities transactions are 10-20 times higher than
for national transactions (see Adjaoute’ et al. 2000, and European Commission 2001). Clearly, this is a
significant obstacle to further European bond market integration.
In summary, the government bond market has converged rapidly in the period before the
introduction of the euro, although to a lesser extent than the money market. Yield differentials remaining
by the time of the introduction of the euro in January 1999 still persist. Although they are relatively
small, significant benefits might be gained from a further integration of these markets. As discussed in
11
MTS stands for Mercato Telematico dei titoli di Stato. It was founded in 1988 in Italy to improve the
management of the Italian government debt. Since then it expanded to cover a broader range of securities and other
countries of the euro area. As of today, the MTS Group includes EuroMTS (based in London), EuroCreditMTS,
MTS Amsterdam, MTS Belgium, MTS Espana, MTS Finland, MTS France, MTS German Market, MTS Ireland,
MTS S.p.A. (MTS Italy), MTS Japan and MTS Portugal. Although it is not easy to characterise the developments
in the trading activity of the spot market, due to the lack of detailed and comprehensive data, MTS seems to emerge
as the dominant platform for bond trading in Europe. Galati and Tsatsaronis (2001) report that in 2000 an estimate
of about 40% of all bond transactions took place through the EuroMTS electronic platform. The shift from OTC
towards trading on these electronic, cross-border platforms has been different across countries.
ECB Working Paper No 230 May 2003
23
sub-section 2.2, the corporate bond market has witnessed an unprecedented boom, partly related to the
euro. The greater contestability of the primary markets in the common currency area resulted in a
significant reduction in the underwriting fees of corporate bond issues in euro. Cross-border trading of
government bond has been facilitated through international electronic platforms, but cross-border trading
of all bond is still very much hampered by the fragmentation of the European securities settlement
industry.
3.3 Equity markets
In a financially integrated equity market, there are no effective barriers that prevent agents to invest in
their preferred assets, independently of their location. This implies on the one hand that expected returns
are decreasing in their covariance with global returns (as opposite to a segmented world, where only the
behaviour of local returns matter, see, for instance, Bekaert and Harvey 1995 and Stulz 1999). On the
other hand, optimally diversified global portfolios should display no particular preference for domestic
equities. Therefore as equity markets become increasingly integrated, one should expect the share of
domestic stocks in household portfolios to decline relative to the share of foreign stocks (as described,
for example, in Ayuso and Blanco 2001).
Adjaouté and Danthine (2003) provide a comprehensive review of the recent developments in
European equity returns. First, they verify a necessary condition under which financial integration would
result in a lower risk premium, compared to segmented markets. This condition simply states that the
variances of the national equity indices must be higher than the variance of the global portfolio. The
empirical evidence is unambiguous for the euro area: the standard deviation of the local markets
(measured by Morgan Stanley Capital International (MSCI) indices) is always greater than the
corresponding EMU index. In other words, integration of equity markets should lead to a lower cost of
capital and therefore stimulate economic growth. Second, they use a multi-factor model that allows for
equity returns to be affected not only by the global market portfolio, but also by country and industry
factors. Their finding supports anecdotal evidence12 of a shift in the portfolio allocation paradigm: the
first step of the top-down approach to portfolio selection has shifted towards deciding on a sector (rather
than country) allocation. Third, they confirm these results using standard mean-variance models. Since
1995, Sharpe ratios of optimal portfolios constructed from sector indices have been constantly higher
than those constructed from country indices.
Fratzscher (2001), instead, proposes a multivariate GARCH model to study changes in the
integration of European stock markets since the mid-1980’s. The processes entering the GARCH model
24
ECB Working Paper No 230 May 2003
are individual countries’ returns, euro area returns and US returns. This allows him to evaluate the
relative importance of regional shocks originating in the euro area with respect to global shocks coming
from the rest of the world (proxied by the US). He finds that European equity markets have become more
highly integrated with each other and have gained importance in world financial markets since 1996. He
also finds that reduced exchange rate variability and convergence of interest rates were the driving forces
behind this integration process.
These results should in general be taken with some caution, as they are usually sensitive to model
specification, data sources and time periods. Moreover, the estimated relationships are highly timevarying, so that it is very difficult to tell whether they are driven by the integration process or by some
other common shocks (such as supply/demand or monetary policy shocks).
Microeconomic data concerning agents’ portfolio composition are becoming increasingly available
and can be usefully employed to complement the evidence provided by price-based indicators. Guiso,
Haliassos and Jappelli (2003) study the current state of stockownership among households in major
European countries. Their main finding, in the light of the present discussion, is that, although euro area
households’ participation in stock markets has increased significantly in the last decade, country
dummies still explain participation, after controlling for age, education, income and wealth. This can be
interpreted as evidence that euro area countries’ equity investors are characterised by different
participation costs and therefore that significant barriers to complete integration remain.
Adam et al. (2002) report data on international portfolio diversification for investments funds,
pension funds and insurance companies. The share of equities invested in funds with European-wide
scope has increased for most countries between December 1997 and June 2001. Similar results hold for
portfolio compositions of pension funds and insurance companies. By contrast, Sweden and United
Kingdom did not show analogous signs of international diversification. This points towards an increased
financial integration of the euro area equity markets, although considerable differences within euro area
countries persist.
Regarding market capitalisation of euro area stock exchanges, it increased remarkably in the last
few years, but still remains significantly lower than in the United States. However, correcting for price
increases and using the total market indices provided by Datastream, the annual growth rate of market
capitalisation in the euro area from 1998 to 2001 was higher than in the U.S. and in Japan. Specifically,
from 1998 to 2001, “corrected” market capitalisation in the euro area increased by 24%, compared to
15% in the U.S. and 9% in Japan (see figure 9, right panel).
12
Brookes (1999), for example, reports the result of a survey by Goldman Sachs, in which asset managers said they
would change the allocation of their portfolio after the introduction of the euro and base their decisions on sectors
ECB Working Paper No 230 May 2003
25
Figure 9 – Stock market capitalisation in EUR billions (Source: FIBV) and annual growth of market
capitalisation calculated as the growth in the units of a total market index in the euro area, U.S. and Japan
(Source: Datastream).
Market Capitalisation (EUR billion)
Market Capitalisation "Real" Annual Growth
Rate
16000
14000
12
12000
10
10000
8
8000
6000
6
4000
4
2000
2
euro area
US
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0
0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Japan
euro
US
Japan
This result can be in part explained by the privatisation policy implemented by several euro area
governments, which was one of the main drivers of equity issuance activity during this period. The
largest telecommunications companies as well as companies providing services such as water, power,
transportation and mail were privatised, generating a high number of initial public offers (IPOs). The
total number of IPOs and their volume surpassed those in the U.S. for the first time in 1999 and remained
substantially higher than in the U.S. and in Japan in 2000. Although the trend partly reversed in 2001 and
2002 in the midst of a global decrease both in volume and number of IPOs, the number of IPOs in the
euro area remained higher than in the US. The high number of IPOs caused a net increase in the number
of publicly listed companies in euro area exchanges, despite a large number of de-listings, due to
consolidation in various industries. As a side effect of this consolidation process, the resulting larger size
of the companies contributed to a slight increase in the average concentration index on the different euro
area stock exchanges. The telecommunication sector, for instance, constitutes an important share of the
market capitalisation of all euro area stock exchanges together.
Regarding the market infrastructure, stock trading in the euro area has historically taken place on
the national stock exchanges. Consolidation among these national markets has remained quite moderate,
despite the relatively successful merger of the exchanges in Amsterdam, Brussels and Paris, creating
Euronext (see Box 1). However, from 1998 to 2000, the share of foreign companies listed on euro area
exchanges increased from 14% to 26%, as reported in European Central Bank (2002a). This seems to
indicate that some integration is achieved through at least cross-border participation in euro area stock
markets. At the same time, though, as for bonds, the costs of settling cross-border equity transactions
remain – by the time of writing – still considerably higher than for domestic transactions. This significant
obstacle to further equity market integration in Europe is the subject of work by the Giovannini Group
(see section 4.4).
rather than on countries. Other investment banks and asset funds explicitly professed this change in attitude as well.
26
ECB Working Paper No 230 May 2003
Summing up, analyses of equity returns and risk premia in the euro area provides weak evidence
that some integration in equity markets took place over the past few years. At the same time, there has
been a shift in the asset allocation paradigm, which is now based on sector (rather than country)
diversification. Quantity-based indicators show increasing stockownership among households and
greater international portfolio diversification among investment funds, pension funds and insurance
companies. Market capitalisation in the euro area increased significantly, compared to the United States
and Japan, reflecting the relatively higher number of IPOs in the last few years. Overall, however,
European equity markets still remain significantly less integrated than US or Japanese equity markets.
The large number of separate markets and the fragmented structure of systems to settle cross-border trade
remain important factors in this situation.
Consolidation of stock exchanges
While at first the introduction of the euro seemed to have given an impulse to consolidation of trading
structures, more recent developments support the idea that “true” consolidation may give way to
specialisation of markets. On the one hand, if the so-called “parallel markets” are taken into account, the
total number of exchanges in the euro area has actually increased. These new exchanges are separately
incorporated segments organised by existing exchanges, targeting specific economic sectors, like for
example technology firms.13 These markets offer alternative trading systems, with cheap and easy access
to trading in the shares of a limited number of companies. On the other hand, some consolidation is
taking place for traditional stock exchanges. The most noticeable example has been the creation of
Euronext in September 2000, by the merger of the stock exchanges of Amsterdam, Brussels and Paris.
Euronext is subject to Dutch legislation and it has a subsidiary in each of the participating countries.
Each subsidiary holds a local stock market licence that gives access to trading in all the participating
countries. Euronext achieved consistency in some, but not all the institutional characteristics of its
predecessor markets. Single quotation and a common order book are guaranteed as well as price
dissemination systems, a unified trading platform and one clearing and settlement system, Euroclear.14
Nevertheless, the local markets are not legally merged, which implies e.g. that the regulatory body in
each of the participating countries retains its prerogatives. From the beginning, Euronext was not
intended to be a closed structure and was eager to finalise agreements with other stock exchanges. In
13
We refer in particular to the Euro.NM, a pan-European network of regulated stock exchanges created between
1996 and 2000: the Euro.NM Amsterdam (Netherlands), the Euro.NM Brussels (Belgium, the Euro.NM Helsinki
(Finland), the Neuer Markt (Germany), the Nouveau Marche’ (France), the Nuovo Mercato (Italy) and the Nuevo
Mercado (Spain).
14
Notably, at the end of September 2002, the merger between Euroclear and CRESTCo was officially completed.
CRESTCo owns and operates the real-time settlement system used to settle UK, Irish and international securities as
well as money market instruments. The Euroclear Group now covers five major European markets: UK, Ireland and
the Euronext markets of France, the Netherlands and Belgium.
ECB Working Paper No 230 May 2003
27
2001, this resulted in the acquisition of Liffe, the London derivatives trading platform, and the agreement
to integrate also the Portuguese exchanges of Lisbon and Porto.15
Before Euronext, another even larger merger between stock exchanges was tried. Already in 1998, the
Deutsche Börse (DB) and the London Stock Exchange (LSE) were planning to merge in an attempt to
gain the leadership position in Europe. The creation of iX (“international Exchange”) was officially
announced on May 2000. The DB and the LSE planned to participate in equal measure as shareholders of
the new exchange, which would be subject to British legislation. It was envisaged to quote the ‘blue
chips’ of both exchanges in London and the technology stocks in Frankfurt. The trading system would
have been the German one (Xetra), considered more modern and more reliable. While the negotiations
between the two stock exchanges were still in process, the OM Gruppen, owner of the Stockholm stock
exchange, made an unexpected public offer and tried to take over the LSE. This event critically affected
the projected merger between DB and LSE, which was subsequently rejected by the LSE Board.
Several reasons led to the failure of the merger.16 In general, there were some doubts that the merger
would create value added and would consistently exploit economies of scale. First, contrary to Euronext,
where companies belonging to the same sector retained the freedom to chose the location of their listing,
iX required the ‘blue chips’ to be traded in London and the technology stocks in Frankfurt. This solution
would have implied costs for both exchanges. Second, some of the companies would have had to move
from one exchange to the other and deal with the change in regulations and supervisory authorities.
Finally, the new entity did not include the creation of a common clearing and settlement system, hence it
would have failed to provide lower settlement costs.
3.4 Banking
As banking is a multi-product business, it is quite complex to describe its process of integration. In
principle, the absence of barriers to entry would ensure a perfectly integrated banking market, as the
threat of new entries deters incumbents from charging prices in excess of their marginal costs. In
practice, such an ideal condition is very rarely met. Several studies show that even in the United States
the distance between borrower and lender does affect the lending conditions (see, for example, Petersen
and Rajan 2002, and Berger et al. 2001). Degryse and Ongena (2002), using a data set containing more
than 17,000 loans made by an important Belgian bank to individual firms, find that loan rates decrease in
the distance between the firm and the lending bank. Similarly, loan rates increase in the distance between
the firm and competing banks.
15
It should be noted, however, that the settlement of transactions on the Portuguese exchange, as a member of
Euronext, is not conducted by Euroclear.
16
For additional insights, see Moneta (2000).
28
ECB Working Paper No 230 May 2003
Berger et al. (2003) take an even more extreme position and claim that the banking industry may
never become fully globalised – or integrated for that matter. They argue that some banking services –
such as relationship lending to small businesses – will be always provided by small local institutions
operating in the nation in which the services are demanded. Their econometric analysis uncovers that
foreign affiliates of multinational corporations prefer to use host nation banks for cash management
purposes. This is consistent with the view that a host nation bank may best know the local market,
culture, language and regulatory conditions in the host nation. In addition, it may have superior
information about local non-financial suppliers and customers.
Although complete integration may never be achieved, one way to describe the progress of
integration in the banking market is to show how existing barriers to entry have been progressively
reduced. A different, but complementary strategy is to look at how price and quantity indicators – related
to both wholesale and retail banking activities – have evolved. In the rest of this section we will tackle
both points.
Deregulation, technological innovation, growth in cross-border activities of non-financial
companies, as well as the introduction of the euro, were all factors that contributed to the reduction of
global and European barriers to competition in the financial services industry. Financial institutions
mainly responded to these pressures by cutting costs and by consolidating their activities, either through
mergers and acquisitions or through cross-shareholdings.
Since the launch of the euro, the number of (euro area) monetary and financial institutions (MFIs)
has steadily declined at a monthly average rate of 0.3%. Between January 1999 and June 2002, the
number of MFIs decreased by 11.1%.17 Merger and acquisition activities involving credit institutions in
at least one of the euro area countries peaked in 1999 after the introduction of the common currency, but
at the end of 2001 this number was comparable to the 1998 level. While the majority of deals was still
domestic, i.e. they involved credit institutions located in the same country, the percentage of domestic
M&As over the total has been diminishing constantly from 1995 on. Conversely, the number of deals
involving foreign credit institutions, located in the euro area and outside, increased over the same period
(see figure 10).
The empirical literature has found evidence that “efficiency barriers”, such as geographical
distance or differences in language, culture and regulations, do inhibit cross-border bank mergers.18
Recent empirical results support the view that the incentive for cross-border mergers relies more on
economies of scale than on economies of scope (see, for instance, Buch and DeLong 2002).
17
Similar patterns were observed in other non-EMU European countries.
There exists a large body of literature, both theoretical and empirical, addressing issues of banking consolidation.
The main theoretical arguments include scale, scope and X-efficiency effects (see, for instance, Berger et al. 1999
and Berger et al. 2000).
18
ECB Working Paper No 230 May 2003
29
Figure 10 – Number of M&A deals involving credit institutions in the euro area countries and
Geographical distribution of the M&A deals involving credit institutions in the euro area. The domestic
deals involve institutions in the same country, while the euro area ones concerns to banks situated in two
different countries of the euro area. The “world M&A” involve one institution located in the euro area
and another located outside. (Source: SDC Thomson Financial)
Geographic Location of M&A deals among credit institutions
M&A between Credit Institutions
120%
160
140
100%
Total M&A
120
29%
27%
33%
32%
33%
80%
37%
42%
100
6%
11%
Domestic M&A
4%
10%
60%
80
18%
13%
11%
60
40%
Outside euro
area M&A
67%
61%
63%
57%
40
50%
51%
1999
2000
47%
20%
Euro area M&A
20
0%
0
1995
1995
1996
1997
1998
1999
2000
2001
1996
1997
domestic
1998
euro area
2001
world (outside EU)
As far as regulatory barriers are concerned, the most important developments in the euro area have
been the Second Banking Directive and the Financial Services Action Plan.19 The main principles
incorporated in the Second Banking Directive were the single banking license and supervisory home
country control. Under the single license, all credit institutions authorised in an EU country would be
able to establish branches or supply cross-border financial services in all other countries of the EU
without further authorisation. Dermine (2003), however, finds that cross-border mergers involving
European banks of significant size have all resulted in holding company structures with subsidiaries,
rather than branches. Similarly, the overall number of foreign bank subsidiaries in Europe is high relative
to the number of foreign branches. So, he concludes that the single banking license is more an illusion
than a reality. The reasons he sees for the surprisingly high importance of corporate subsidiary structures
range from management considerations (such as the greater acceptability of consolidation for local
managers and shareholders) to different corporate taxation and deposit insurance systems. (See also the
detailed discussion of Huizinga 2003 of possible explanations for this phenomenon.) Moreover, the
supervisory home country principle implies a discrepancy with more area-wide arrangements for
competition policy. Carletti and Hartmann (2003) discuss the division of labour between supervisory and
competition reviews of bank mergers in EU countries. It turns out that in various countries home country
supervisory authorities have a stronger (or even exclusive) role in these reviews than competition
authorities. This feature may also play a role in the still subdued cross-border consolidation in the euro
area. Finally, some observers feel that a euro area wide supervisory authority could lower further any
remaining obstacles to banking integration. However, others argue that given existing banking structures
19
We postpone the discussion of the Financial Services Action Plan until section 4.1.
30
ECB Working Paper No 230 May 2003
this step would be premature at the present time (see e.g. Belaisch et al. 2001 and Economic and
Financial Committee 2000).
Rosengren (2003) provides a comparison between the European and the US banking system. He
finds that there are still significant limits to the geographic expansion of banking activities within the
United States, which surprisingly resemble very much the ones observed by Dermine within Europe. For
example, none of the five largest US banks has major operations in the New England area (the Federal
Reserve Bank of Boston district), despite its proximity to New York, the state with the strongest
concentration of large and complex banks. Similar observations can be made for other regions of the
United States. More generally, only 6 % of all US banks operate in more than one state and no bank has
major retail operations in all regions of the US. However, despite these similarities to Europe, Rosengren
still regards US banking markets as more integrated, because first – in contrast to European banks – US
banks have significantly reduced the number of their subsidiaries over the last decade, and second
subsidiaries are organised on a functional basis rather than a geographical basis.
Let us now look at how price-based and quantity-based indicators have evolved. In wholesale
banking,20 we have already seen in section 3.1 that the relevant short term deposit rates quickly
converged after the introduction of the single currency. For retail banking, Cabral et al. (2002) report
average monthly retail interest rates data on household lending, corporate lending and deposit accounts
between 1998-1999 and 2001-2002. They also report banks’ margins over market interest rates, on the
ground that these margins, unlike market interest rate levels, are not affected by macroeconomic factors.
They find that between 1998-1999 and 2001-2002 differences across countries in household and
corporate lending rates and deposit rates declined in the euro area (cfr. tables 17 and 18). However, the
reduction in the standard deviation of banks’ margins was much lower, signalling that the developments
were mainly driven by convergence in the macroeconomic monetary conditions.
Indicators based on the costs associated with retail cross-border payments show weak evidence of
convergence in bank charges across Europe (see Adam et al. 2002). Although there is some evidence of a
reduction of the average duration for such transfers, the average cost of cross-country transfers has not
converged at all. Transferring DFURVVERUGHUFRVW RQDYHUDJHLQDQG LQ
Given the evidence that market-led convergence had failed to materialise, a regulation, submitted by the
European Commission and recently approved by the European Parliament, will impose that bank charges
for cross border payments in euro must be the same as for similar transactions within a single Member
State as of 1 July 2003.
Regarding quantity-based indicators, increases in cross-border banking business were observed
between 1997 and 2002 at the euro area level. The upper panels of figure 11 shows data on cross-border
ECB Working Paper No 230 May 2003
31
loans to banks and non-banks respectively, broken down by the residence of the borrower (euro area, EU
and non-EU countries).21 The amounts of loans are expressed as a percent of total domestic loans. We
notice an upward trend in euro area cross border loans, but the absolute amount of loans to non-banks
remains very small compared to interbank loans. Therefore, strong home biases both in lending and in
borrowing seem to persist, as confirmed also by Buch et al. (2003). The increase in euro area interbank
loans, instead, has been particularly significant, especially in consideration of the fact that the opposite
trend is observed for non-EU countries. This is consistent with the data shown in figure 7 of section 3.1.
Figure 11 – Euro area cross-border loans and bank holding securities, as a percentage of the respective
domestic amounts. (Source: ECB. Note: the ECB will start the regular publication of these data in
summer 2003)
Cross-border interbank loans
Euro area
Rest of EU
Cross-border loans to non-banks
Rest of the world
Euro area
35
Rest of EU
Rest of the world
5
4.5
30
4
3.5
25
3
20
2.5
2
15
Cross-border securities holdings issued by banks
Euro area
Rest of EU
2002Q3
2002Q2
2002Q1
2001Q4
2001Q3
2001Q2
2001Q1
2000Q4
2000Q3
2000Q2
2000Q1
1999Q4
1999Q3
1999Q2
1999Q1
1998Q4
1998Q3
1998Q2
1998Q1
Cross-border securities holdings issued by non-banks
Rest of the world
Euro area
35
70
30
60
25
50
20
40
15
30
10
20
5
10
0
1997Q4
1
1997Q3
2002Q3
2002Q2
2002Q1
2001Q4
2001Q3
2001Q2
2001Q1
2000Q4
2000Q3
2000Q2
2000Q1
1999Q4
1999Q3
1999Q2
1999Q1
1998Q4
1998Q3
1998Q2
1998Q1
1997Q4
10
1997Q3
1.5
Rest of EU
Rest of the world
0
1997Q3 1997Q4 1998Q1 1998Q2 1998Q3 1998Q4 1999Q1 1999Q2 1999Q3 1999Q4 2000Q1 2000Q2 2000Q3 2000Q4 2001Q1 2001Q2
1997Q3 1997Q4 1998Q1 1998Q2 1998Q3 1998Q4 1999Q1 1999Q2 1999Q3 1999Q4 2000Q1 2000Q2 2000Q3 2000Q4 2001Q1 2001Q2
In the lower panels of figure 11, we report bank holdings of securities issued by banks and nonbanks, again as a percentage of the respective domestic holdings. Cross-border securities holdings issued
by banks increased from 15% to about 35%, while cross-border securities holdings issued by non-banks
boomed from little more than 20% in 1997 to about 60% in the second quarter of 2001. This signals that
banks have increasingly diversified their portfolio investments in securities, especially across the euro
20
Wholesale banking refers here to activities in which the two sides of the transaction are banks or other financial
institutions.
21
See Angeloni and Ehrmann (2003) for individual country data on Germany, France and Italy.
32
ECB Working Paper No 230 May 2003
area. Again, this is consistent with the home bias reduction documented for government bonds in subsection 3.2.
Finally, anecdotal evidence indicates that when banks operate across borders, they generally tend
to focus on specific product segments. Few institutions have activities throughout the euro area, but they
serve mainly corporate customers, while cross-border activities in the field of retail banking remain
limited. The most effective way to gain access to the retail sector of a foreign country seems to remain
the merger with or acquisition of an existing local bank.
In summary, there has been a significant and progressive erosion of barriers to foreign entry in the
banking industry, although significant barriers such as different corporate taxation and some regulatory
factors remain. Convergence in short term deposit rates for wholesale banking has taken place, while the
increased homogeneity of retail interest rates across the euro area seems to be driven more by
macroeconomic convergence than by the actual integration of the retail banking industry. Similar
conclusions can be drawn from quantity indicators of banking integration. They show a significant
increase in euro area interbank loans, but still subdued (while nevertheless increasing) cross-border
consolidation, as well as persistence of home biases in lending and borrowing to non-financial
corporations.
4. MAIN POLICY INITIATIVES TO IMPROVE FINANCIAL INTEGRATION IN EUROPE
It is long recognised that the creation of the European single market for goods and services also requires
the removal of any barriers to an integrated market for financial services. For example, only under the
right balance between competitive forces and financial regulation financial structures will emerge that
lead to an efficient fulfilment of the functions of the financial system in Europe. Moreover, the euro can
only fully develop its catalytic role for the further development and integration of the European financial
system, if it is supported by policies conducive to the free flow of financial services in the euro area and
by an adequate legal, regulatory and supervisory framework.
However, the EMU was a process mainly driven by macroeconomic considerations: a single
monetary policy and price stability across the continent. Already shortly after the introduction of the
euro, policy makers realised that a single currency was not a sufficient condition for full financial
integration. (The most important evidence to reach this conclusion was discussed in the previous
section.) Therefore, several high-level policy initiatives were launched to implement the necessary
microeconomic and legal reforms. This section of our paper discusses in greater detail two of the most
important initiatives, the European Commission’s Financial Services Action Plan in general and the
Lamfalussy Committee’s proposals for the reform of securities market regulations specifically. Another
ECB Working Paper No 230 May 2003
33
sub-section describes the recent application of a variant of the Lamfalussy approach to the banking
sector. At the end we touch on the work of the Giovannini group.
4.1 The Financial Services Action Plan of the European Commission
The European Council held in Cardiff on 15-16 June 1998 concluded that in order “to enable the single
market to make its full contribution to competitiveness, growth and employment, still more needs to be
done”. It singled out financial services as one of the areas where additional efforts were needed, inviting
“the Commission to table a framework for action … to improve the single market in financial services, in
particular examining the effectiveness of implementation of current legislation and identifying
weaknesses which may require amending legislation” (European Council, 1998, point 17.). In response
to this mandate, the Commission established on 28 January 1999 a high-level Financial Services Policy
Group (chaired by the competition commissioner Mario Monti and composed of personal representatives
of EU Finance Ministers as well as the ECB) and published on 11 May 1999 an action plan to improve
the single market for financial services (European Commission, 1999a).
This Financial Services Action Plan formulates three “strategic objectives”: Ensuring 1) a single
EU market for wholesale financial services, 2) open and secure retail markets and 3) state-of-the-art
prudential rules and supervision. Overall 43 legislative measures were proposed. 19 under the first
objective concern the “raising of capital on an EU-wide basis”, the establishment of a “common legal
framework for integrated securities and derivatives markets”, steps “towards a single set of financial
statements for listed companies” (accounting), measures to contain “systemic risk in securities
settlement”, steps “towards a secure and transparent environment for cross-border restructuring”
(corporate governance) and efforts to ensure a “single market which works for investors” (investment
fund regulations). 9 measures under the second objective address the elimination of price differentials
across the EU and consumer protection issues. 10 measures under the third objective deal with the
elimination of gaps in the EU supervisory framework, notably the adoption of new capital adequacy
regimes, money laundering and e-money regulations, winding-up provisions for financial institutions and
the regulation of financial conglomerates. The plan also includes a fourth, “general objective” regarding
the “wider conditions for an optimal single financial market”. The 5 remaining measures fall under this
objective and mainly deal with tax issues, notably tax harmonisation.
Each of the measures received a priority ranking between 1 (calling for immediate action) and 3
(requiring new work), and an “optimal timeframe” was attached. All measures are envisaged to be
adopted at the EU level by mid 2004, so that they can be transposed into national laws by 2005. The
latest progress report published by the Commission stated that 31 had been achieved by December 2002
(European Commission, 2002a, 2003), including e.g. directives on financial collateral arrangements,
UCITS (which stands for Undertakings for Collective Investment of Transferable Securities, covering
34
ECB Working Paper No 230 May 2003
various forms of investment funds), insurance intermediaries, financial conglomerates, distance
marketing of financial services, winding-up of banks and insurance companies, money laundering and emoney as well as the creation of the two securities committees foreseen by the Lamfalussy report (see
next sub-section). Measures included in the action plan where progress has proven to be more difficult
include e.g. the European takeover directive.
4.2 The Lamfalussy report on the regulation of European securities markets
On 17 July 2000 the Economics and Finance Ministers of the European Union appointed an independent
Committee of Wise Men (2001) under the chairman Alexandre Lamfalussy to discuss “the practical
arrangements for implementation of the Community rules concerning the areas identified by the
[Financial Services] Action Plan and … propose various approaches to adjusting the practice of
regulation and cooperation between regulators…”.22 For example, it requested the committee “to
consider how to achieve a more effective approach towards transposition and implementation, in
particular in the following areas of regulation: the listing of enterprises, the public offer of securities and
requirements relating to reporting by issuers, the conduct of cross-border financial operations, the day-today operation of the regulated markets, the protection of consumers and investors in the provision of
investment services, and the integrity of the market”. However, ministers explicitly excluded the
prudential supervision of banks from the mandate of the committee (see the next sub-section).
Based on the responses it received on a questionnaire made available on the Internet and sent to a
wide range of institutions and experts in the field of securities market regulation, the committee affirmed
that “there are significant gains from building an integrated financial market in the European Union”. If
the EU would not capture those benefits, then economic growth, employment and prosperity will be
lower and the weaker European performance will lead savings to be diverted to foreign market places. It
identified the existing EU legislative process, which is described as “too slow, too rigid, complex and illadapted to the pace of global financial market change”, as a major source of regulatory obstacles to
achieving the full integration of European financial markets.23 The committee also noted that due to
ambiguity “existing rules and regulations are implemented differently” (in different countries),
threatening the “competitive neutrality” of supervision (p. 7).
22
Apart from Lamfalussy, the committee was composed of Cornelius Herkströter (Director of BHP Billiton and
former President of Royal Dutch/Shell), Luis Angel Rojo (former Governor of the Bank of Spain), Bengt Ryden
(President of the Stockholm Stock Exchange and former President of the International Federation of Stock
Exchanges, FIBV), Luigi Spaventa (President of the Italian securities market regulator CONSOB), Norbert Walter
(Chief Economist of Deutsche Bank) and Nigel Wicks (Chairman of the British securities settlement company
CRESTCo).
23
Under the legislative process in force at the time the European Commission proposed full directives to the
Council of Ministers and the European Parliament. Both had to decide on the legislation, including the technical
details. After this agreement on the EU level, it had to be implemented by all member states.
ECB Working Paper No 230 May 2003
35
To heal these shortcomings the Lamfalussy Report proposes a new regulatory approach for the
EU, which distinguishes four “levels” of work in the regulatory process. Level 1 concerns the
development of broad regulatory “framework principles”, the core political principles essential for the
respective legislation. These principles would be developed within the current institutional set-up, i.e. the
adoption of directives and regulations through joint decisions of the Council and the Parliament upon a
recommendation by the Commission. A key novelty of the proposals is that the development of the
technical details of level 1 directives and regulations (level 2 implementation measures) would be
delegated to a fast-track procedure involving two new committees, the European Securities Committee
(ESC) and the Committee of European Securities Regulators (CESR).24 Regulatory proposals would be
put forward by the European Commission to the ESC, based on the advice of the CESR. The CESR
would be composed of the heads of national securities market regulators and undertake market and
consumer consultations. The ESC would be composed of very highly ranked ministry officials (usually
state secretaries in finance ministries), chaired by a commissioner and decide by qualified majority. It
would basically act like an area-wide regulatory body. The European Central Bank would participate in it
as an observer.
An important feature of these arrangements is that while the Parliament preserves its role
regarding the broad “framework principles” (level 1), it would be very little involved in the elaboration
of the technical details (level 2). However, the level 2 committees would be obliged to keep the
Parliament fully informed on the technical work and the Parliament would have the right to send a level
2 legislative proposal back to the Commission for re-examination in case it goes beyond the ambit of
technical details of level 1 legislation. Overall, keeping the role of the Parliament and the Council of
Ministers mainly at the top level of broad principles is expected to lead to a speedier procedure for
passing new regulatory legislation or subsequent amendments.
The CESR would also have an independent role on the third level of the regulatory process, the
homogenous implementation of level 1 and level 2 legislation at the national level. Representatives of
national regulators would cooperate in the committee to reach consensual agreements on this. Finally, the
European Commission would be in charge of strengthening the enforcement of regulatory legislation on
the national level, cooperating with other relevant parties (level 4).
Apart from the legislative process in the area of securities market regulation, the report also makes
three further recommendations: 1) Regulatory and supervisory structures should converge more among
member countries; 2) an EU regulatory framework for clearing and securities settlement should be
established and issues of competition policy and systemic stability in this sector addressed; and 3)
24
Of course, clarity about the distinction between level 1 and level 2 decisions is crucial. The Lamfalussy report
therefore presents several examples (Committee of Wise Men, 2001, pp. 22-24).
36
ECB Working Paper No 230 May 2003
cooperation between financial regulators and institutions in charge of micro and macro prudential
supervision should be strengthened.
On the basis of the report, the European Council (2001) approved at its Stockholm meeting in
March 2001 a resolution on more effective securities market regulation in the European Union. This
resolution welcomed the Lamfalussy report and approved the implementation of its four-level approach
(framework principles, implementing measures, cooperation and enforcement). However, it also
formulated a number of additional points, some of which apparently aim at clarifying the institutional
balance between Commission, Council and Parliament. In particular, the split between framework
principles (level 1) and implementing measures (level 2) should be decided on a case-by-case basis by
the European Parliament and the Council based on a proposal by the Commission. The resolution
generally calls for clarity and transparency, which allows all parties to know in advance the precise scope
and purpose of the provisions pertaining to each of those levels. For example, the Commission should
indicate in advance what kind of implementing measures are foreseen.
The Council resolution further requests the frequent use of the level 2 implementation measures
that are faster to adopt. However, in doing this the Commission should avoid measures that go against
“predominant views” in the Council. Since the Council endorsed them as well the European Securities
Committee and the Committee of European Securities Regulators were created in June 2001. Both
committees began to operate in the planned composition in 2002, addressing as their first tasks the
market abuse (insider dealing and market manipulations) and prospectus directives.
4.3 The application of the Lamfalussy framework to the banking sector and the reform of the
Financial Services Policy Group
Another field of policy work that will have an important impact on financial structures and integration in
Europe is the reform of institutional structures for bank regulation and supervision. The Brouwer Report
(Economic and Financial Committee, 2000) had still concluded that the “existing institutional
arrangements provide a coherent and flexible basis for safeguarding financial stability in Europe” (italics
by the authors) and that “no institutional changes are deemed necessary.” It rather called for
strengthening international co-operation and exchange of information between supervisory authorities
and central banks within the current institutional set-up.
During the preparation of this paper, however, the situation changed in that both the German and
the UK government supported in the informal ECOFIN meeting in Oviedo in April 2002 the view that
new arrangements may be necessary to better deal with threats to financial stability at the EU level. A
good deal of the subsequent discussion revolved around the issue whether and how the four-level
Lamfalussy framework (including related committees) could be applied to other financial sectors,
ECB Working Paper No 230 May 2003
37
notably banking and insurance. At its meeting in July 2002 the ECOFIN Council asked the Economic
and Financial Committee to report on the implementation modalities of this approach for other financial
sectors by September 2002.
The Economic and Financial Committee (EFC) responded to this request with a report on financial
regulation, supervision and stability (Economic and Financial Committee, 2002). To take into account
sector specificities, the report advances the establishment of three different level-2 committees for
banking insurance and financial conglomerates. The level of their members, the origin of their chair
persons and their function within each sector follow closely the example of the European Securities
Committee. The previously existent Banking Advisory Committee and the Insurance Committee will be
reformed to become the level-2 committees in their respective sectors. The ECB would be an observer in
the banking and conglomerate committees.
Similarly, the level-3 committees for banking and insurance follow closely the example of the
Committee of European Securities Regulators. There would be no extra level-3 committee for financial
conglomerates. However, to benefit from synergies between banking supervision and central banking
both national supervisory authorities and central banks without supervisory responsibility would be
represented in the banking committee, with supervisors holding the vote. Moreover, the ECB, the
Banking Supervision Committee (BSC) of the European System of Central Banks and the Groupe de
Contact would participate as observers. The Groupe de Contact also becomes the main working group of
the banking committee and would deal – inter alia – with the exchange of sensitive supervisory
information, including in crisis management situations. In relation to this and as a follow-up to the
recommendations of the Brouwer Report the Banking Supervision Committee of the European System of
Central Banks worked on the development of co-operation principles and procedures between central
banks and supervisors in the European Union. Very recently, they have been formalised in a
“Memorandum of understanding on high-level principles of co-operation between the banking
supervisors and central banks of the European Union in crisis management situations” (see European
Central Bank 2003b).
At the same time when the ECOFIN Council adopted the Lamfalussy approach for all financial
sectors, it also requested a reform of the Financial Services Policy Group (FSPG). As mentioned above,
this group had been established under the chairmanship of the Internal Market Commissioner,
comprising personal representatives of ECOFIN Ministers and the ECB. In the context of the
establishment of the single market for financial services, it had been asked to examine the need for new
legal initiatives, for changes in existing provisions, for simplifications and for making existing provisions
more coherent. Subsequently, it was asked by the Council to continue addressing questions of strategy,
discuss cross-sector developments and monitor progress with the FSAP.
38
ECB Working Paper No 230 May 2003
The reform reconfigured the FSPG under member state chairmanship and gave it a partly new role
to provide political advice and oversight on financial market issues to the ECOFIN Council. In doing
this, it is intended to “fill the currently existing gap between the political and the technical regulatory
level and provide for cross-sectoral strategic reflection, separate from the legislative process” (Economic
and Financial Committee, 2002, p. 20). Apart from defining strategic areas and monitoring the
implementation of the FSAP, it will also consider “hot” short-term issues. Pragmatic co-operation with
the level-2 committees is expected. Particularly important may become in the future that the new FSPG
should “in a special format contribute, via the EFC, to discussions in the ECOFIN (or particularly,
informal meetings of Ministers of Economy and Finance and Central Bank Governors) on issues related
to financial stability”. For this purpose it should consider stability issues across banking, insurance and
capital markets, discuss vulnerabilities in the EU financial system and build networks with supervisors,
level-3 committee chairs and the ECB.
Overall, it emerges that the introduction of the Lamfalussy Committees and the reform of the
FSPG have the potential to foster the multilateral mode of financial services sector and financial stability
policies in Europe. As a consequence these institutional reforms may have prepared the ground for
further progress with European financial integration. So far, European policy makers have regarded the
step to European supervisory authorities as premature. However, when the time comes it seems likely
that the new Lamfalussy Committees will constitute the nucleus of such new authorities.
4.4 The work of the Giovannini group
In 1996 the European Commission established a group of financial market participants and experts,
chaired by former MIT professor Alberto Giovannini. The initial task of this “Giovannini Group” was to
advise the Commission on how to prepare the capital markets for stage 3 of EMU. In this capacity the
group produced its first report on “The impact of the introduction of the euro on capital markets”
(European Commission, 1997). The main objectives of this document were to identify technical solutions
for bond, equity and derivative markets how to manage the changeover and to provide guidance for both
public authorities and market participants. It drew together the market view at the time how harmonised
the future euro markets should ideally be. The most important recommendations were derived on bond
markets. For example, the report had an important impact on how public debt was re-denominated into
euro. It also gave advice on which market conventions should be harmonised and how (e.g. regarding
day counts, coupon frequency and business day definitions).
After the euro changeover the group continued to provide the Commission with economic analyses
and market-based perspectives on capital market issues in the EU, in particular regarding market
efficiency and improvements in market integration. So far, it delivered three more reports and a fourth
has been expected since the fall of 2002. The second report on “The EU repo markets: opportunities for
ECB Working Paper No 230 May 2003
39
change”, issued in October 1999 (European Commission, 1999b), stated that the markets for repurchase
agreements (repos) in the European Union were fragmented through infrastructures, market practices,
and fiscal and legal differences (see also the discussion in sub-section 3.1). It made one general and
several specific recommendations how to improve this situation. Generally, the report recommended
actions that would enable counterparties located in different EU countries to trade better securities
originating from different countries, adopting a single, cost-efficient approach and infrastructure
platform.
The specific recommendations were addressed to market operators, infrastructure providers and
public authorities. Market operators are asked to review self-imposed rules and practices that limit repo
activity of institutional investors, adopt sound risk management techniques (such as standardised
documentation, daily marking-to-market, prudent hair-cuts etc.) and introduce timely margin payments
that are identified separately from income payments. Infrastructure providers should reduce transaction
costs, which originate in multiple trading, netting and settlement systems each using different
communication systems and operation procedures, through the standardisation of systems. Finally, public
authorities should encourage the adoption of sound risk management, remove remaining tax
disincentives to repo activity and introduce legislative reforms. The latter concern particularly the
recognition of netting, the reliability of collateralisation techniques and the extension of “finality”
recognition to repo trading and related settlement procedures.
The third, somewhat shorter report by the Giovannini Group addressed the issue of “Co-ordinated
public debt issuance in the euro area” (European Commission 2000). It argues that while considerable
harmonisation of national market conventions had already been achieved, important remaining
differences are a source of market fragmentation. In this regard the report refers to premia greater than
what seem to be justified by credit risk (see Figure 8 in sub-section 3.2) and points out that the current
decentralised approach to public debt issuance is an obstacle to full market integration. However, market
participants in the group were divided about how severe such problems are. Some agreed with the
inefficiency view, pointing to different liquidity premia across issuers and problems of deliverability into
futures contracts. Others argued that spreads are not sufficiently large or volatile to cause any great
concern and that, in any case, the market was still too young to allow for strong conclusions.
Four options (or “hypotheses”) for greater co-ordination are discussed: 1) Co-ordination on
technical aspects of debt issuance; 2) creation of a joint debt instrument with several country-specific
tranches; 3) creation of a single euro-area debt instrument backed by joint guarantees; and 4) borrowing
by an EU institution for on-lending to member states. The Giovannini Group did not reach a consensus
on proposing any of these options, but it stated that a joint debt instrument does not seem to be practical
for the euro area as a whole. However, it was agreed that such an instrument could be beneficial for a
sub-group of smaller member states, currently paying higher liquidity premia. It is also clear that the
40
ECB Working Paper No 230 May 2003
options implying reciprocal guarantees on debts by different member states would require changes of the
Maastricht Treaty and have other legal and institutional consequences that are outside the remit of this
group.
The present work of the Giovannini Group focuses on clearing and settlement infrastructures in the
EU. A first report “Cross-border clearing and settlement arrangements in the European Union”
(European Commission 2001) describes “clearing and settlement as an essential feature of a smoothly
functioning securities market, providing for the efficient and safe transfer of ownership from the seller to
the buyer” (p. i). However, despite some recent consolidation the EU infrastructure for clearing and
settlement remains highly fragmented (19 national central securities depositories (CSDs) and 2
international CSDs (ICSDs)). The group affirms that “the additional cost that is associated with this
fragmented infrastructure represents a major limitation on the scope for cross-border securities trading in
the Union”. For example, participants estimate that the per-transaction income of ICSDs (a proxy of their
fees) is about 11 times higher than the case for national CSDs. (See also the discussions is sections 3.1,
3.2 and 3.3.)
The report identifies 15 barriers to efficient cross-border clearing and settlement, 10 regarding
national differences in technical requirements/market practices, 2 concerning national differences in tax
procedures and 3 originating in legal uncertainty. It calls for market-led convergence in technical
requirements/market practices and public efforts in the area of taxes and legal harmonisation. However, it
recognises that legal uncertainties due to the concepts of underlying national laws would be difficult to
change. The second report in this field is expected since the fall of 2002 and will deal with future
prospects of this industry and potential models for restructuring.
5. CONCLUSION
This paper described the main developments in the euro area financial markets before and after the
introduction of the single currency. We first compared the financial structure of the euro area with that of
the United States and Japan. We documented how the euro area financial structure is placed somewhat in
between those of these two countries, with financial institutions playing an important role, but with
market based instruments developing further. We then looked at the evolution of the euro area financial
structure in the last few years. We found that the importance of government financing has gradually
diminished in the period under review, while one of the most dynamic financial market developments
was the expansion of the market for corporate bonds. The increased bond issuance, however, has not yet
led to a regime shift in which market-based instruments have to a significant extent substituted loans and
private equities as the primary means of corporate financing in continental Europe. Interestingly, in
various dimensions the financial structure of euro-area countries seem to become more diverse over time.
ECB Working Paper No 230 May 2003
41
We assessed the progress towards financial integration in the most important euro-area financial
segments, namely money, bond, and equity markets, as well as banking. The available data suggest that
the unsecured money market strongly integrated with the introduction of the euro, as the single currency
and related euro-area-wide large-value payment systems link the different countries well. The same
cannot be said, however, about the repo market. Government bond markets also integrated considerably
with the EMU convergence process, but they still exhibit some small but non-negligible cross-country
yield differentials since January 1999, that cannot be explained with credit risk. Moreover, as different
sovereigns focus their issuance on different maturities, there is no single homogeneous benchmark yield
curve, which hinders arbitrage and derivatives pricing. As the euro made primary corporate bond markets
more contestable, in particular regarding foreign competition, one important factor in the development of
this market was a considerable reduction of underwriting fees. Also, some progress occurred in the
integration of euro-area equity markets, as stock exchanges in a few countries merged to form Euronext
and professional asset managers replaced country allocation by sector allocation strategies. Powerful
obstacles to the further integration of repo, bond and equity markets remain the still fragmented
securities settlement industry in Europe, which charges much higher fees for cross-border transactions
than for domestic transactions, and differences in legal systems. While asset holdings have become more
international in the euro area since the introduction of the euro, securities markets are still much less
integrated than in the US, for example. In the area of retail banking the increased homogeneity of interest
rates seems to be driven more by macroeconomic convergence than by market integration. For example,
cross-border loans to non-banks have somewhat increased, but remain a very small fraction of total
lending. This is quite different in wholesale activities, as inter-bank lending jumped up with the
introduction of the euro and banks’ cross-border securities holdings also expanded considerably. While
the strongly domestic bias in the consolidation strategies of European banks has only changed very
mildly recently and while the single European passport to create foreign bank branches seems not to be
used very much, it is interesting to report the observation that also in the US cross-state penetration by
banks still remains quite limited.
Finally, we discussed in detail the most important high-level policy initiatives to foster financial
integration in Europe: the Commission’s Financial Services Action Plan, the Lamfalussy Committee of
Wise Men and the application of its work to all financial sectors, as well as the work of the Giovannini
Group. We reviewed the main microeconomic and legal reforms identified in and tackled after these
initiatives, and we documented the institutional changes to which they led. For example, recent
institutional changes for cross-border supervisory co-operation seem to have laid out the path through
which a more centralised European supervisory structure may emerge in the future.
42
ECB Working Paper No 230 May 2003
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