The banking union and financial integration
Speech by Danièle Nouy, Chair of the Supervisory Board of the Single Supervisory Mechanism at the Joint conference of the European Commission and European Central Bank on “European Financial Integration and Stability”,
27 April 2015, Brussels
Ladies and gentlemen,
It is a pleasure to speak today at this conference on “European Financial Integration and Stability” jointly organised by the European Commission and the European Central Bank.
The introduction of the euro on 1 January 1999 marked a milestone in the history of European integration. The introduction of the single currency was expected to foster financial integration in the euro area. This did occur in the years that followed, as reflected mainly in the convergence of prices for many asset classes. However, the occurrence of the financial crisis partly reversed this process, causing financial fragmentation and prompting the emergence of a split between periphery and core countries in the monetary union.
The establishment of the banking union is another unprecedented milestone in the path towards the Single Market. And one that I believe will make a substantial contribution to restoring and further deepening financial integration among the euro area countries.
The financial integration process that has taken place since the inception of the euro has been remarkable. Funding and liquidity markets soon became largely integrated. In its 2007 report on financial integration in Europe, the ECB reported that the unsecured money market was fully integrated. In the run-up to Economic and Monetary Union (EMU), government bond markets also became largely integrated. Yield differentials were close to zero, reflecting – inter alia – a convergence in the evaluation of sovereign risk. As a consequence, liquidity in repo markets, which is mainly collateralised by sovereign securities, was offered at similar prices throughout the EU. Similarly, the euro area corporate bond market received a major boost, as the introduction of the euro greatly increased the pool of possible investors. Progress was also made on the integration of the euro area equity markets.
In addition to the convergence seen in most asset prices, increases in the quantities of cross-border financial activity were also recorded. This was particularly pronounced in cross-border bank activity, which was, however, mainly driven by interbank markets and only to a limited extent by cross-border corporate lending. Overall, the ECB’s financial integration indicators suggest that euro area banking markets, and in particular the retail banking markets, continued to be rather fragmented. Financial integration was thus not complete, but, most importantly, it lacked a robust financial stability framework and sound economic fundamentals.
The recent financial crisis has plainly shown how fragile that financial integration was. According to the price-based financial integration composite (FINTEC) indicator, which measures the overall convergence of prices in money, bond, equity and banking markets, at the beginning of 2012 the level of fragmentation was similar to that existing before the introduction of the common currency. The crisis revealed an inconvenient truth: the integration achieved in several markets was fragile and the high degree of integration for example in interbank and government bond markets turned under stress into powerful contagion channels, accelerating the transmission of shocks across national borders.  The crisis painfully demonstrated the clear need to remove the asymmetry between integrated financial markets and a financial stability architecture that was primarily organised along national lines. This was clearly a prerequisite to achieving long-term sustainable financial integration.
An incomplete construction of the EMU
The rapid fragmentation of financial markets can be traced back to the fact that the framework for financial governance in Europe was not equipped to address the financial imbalances stemming from cross-border banking activity.  Although there was a common monetary policy, responsibility for banking supervision, as well as resolution powers, remained at the national level. This “home bias” of national supervision created an environment which allowed jurisdictions to promote “national champions” and to support local banking models. In addition, it may have led them to take a less strict stance regarding the risk behaviour of banks.
One of the main ways in which the integration of banking markets ought to be beneficial is through improvements in the allocation of capital. Competition from foreign banks is likely to increase the distance between the shareholders and management of a bank, and the special interest of stakeholders located where the bank operates.  This should help to prevent lending to less efficient activities. However, because foreign banks had only a limited presence, these benefits did not materialise in the euro area. On the contrary, financial integration in interbank markets had destabilising effects, as it created distorted incentives for risk-taking, arising from lower financing costs. There was instead a consequent increase in the leveraged positions of domestic financial intermediaries, with increasing exposure, particularly to certain economic sectors, such as real estate.  Risk became even more concentrated rather than diversified.
As a result of the increase in cross-border interbank activity, banks in surplus – non-stressed – countries built up large exposures to deficit – now stressed – countries. These exposures were mainly short term and debt-based, so funding dried up quickly when the first signs of distress emerged. It became evident that, once shocks occur, integrated markets provide powerful routes to propagate them quickly. Thus, integrated financial markets call for stronger supervision ex-ante, at the area-wide level, to counter and mitigate these negative effects.
One important effect of the former system of national supervision was that it contributed to strengthening the bank-sovereign nexus, which ultimately resulted in a reduction in the provision of capital to support the real economy. When problems arose in national banking sectors, Member States came to their aid with capital injections and guarantees, underlining the fact that each State was responsible for the financial stability of its own financial system. These actions put more pressure on the already weak fiscal position of some sovereigns. This, in turn, led to further losses for the banks resulting from their holdings of sovereign bonds. Ultimately, this vicious circle had detrimental consequences for economic growth, by limiting the credit provided to households and non-financial corporations to finance consumption and investment. 
Another deficiency of EMU was that there was no circuit breaker to stop financial fragmentation. In fact, this type of integration (based on short-term flows), together with the perverse incentives created by the supervisory architecture, resulted in the propagation and acceleration of the process of fragmentation. We need mechanisms which enable contagion channels to be shut down once big shocks start to spread. I expect the banking union – the Single Supervisory Mechanism (SSM) and the new European resolution framework – to create a structure that will foster robust and durable financial integration. Let me now explain how and where we should expect improvements in financial integration arising from the banking union.
How do we expect the banking union to have beneficial effects on financial integration?
The first stage of the banking union, the SSM, comprises a uniform supervisory framework for financial institutions in the euro area. It is an independent institution which has the right incentives and the necessary tools to act. This set-up should break the bank-sovereign nexus that I have described. Within the euro area there are no longer any borders to supervision, therefore, the promotion of national policies is no longer a factor: the SSM safeguards the stability of the European banking system as a whole. This will bring several positive effects.
First, a single approach to supervision will be applied, with a homogeneous set of rules and methodologies. There will no longer be any distinction between home and host supervisors for banks operating across borders. Instead, there will be a single supervisory model and cross-border banking groups will be able to report at the consolidated level.
Second, the possibility of “national bias” playing a part in supervision will be eliminated. Under the old supervisory system, situations may have occurred in which supervisory agencies treated national and foreign institutions differently. This allowed for behaviours such as the promotion of national champions and the ring-fencing of capital, which clearly distorted the functioning of free financial markets and created de facto barriers to the single European market.
These two positive effects should enable banks to achieve their optimal size and thus reap all the benefits that can be extracted from economies of scale. In addition, the single supervisory model of the SSM and the single European rulebook should also lower compliance costs, as regulatory compliance functions no longer need to be duplicated in different euro area countries.
Third, on the demand side, we should expect households and non-financial corporations to overcome any mistrust that they might have had regarding the soundness of foreign institutions. Previously, a branch of a foreign credit institution was supervised by the supervisory agency of the institution’s home country, and the nationals of the branch’s host country would probably not have been aware of the supervisory practices and deposit protection arrangements of the home country. Now, if the head of consolidation of the bank is located within the SSM, this will no longer be the case for the activities of its branches and subsidiaries located within the SSM.
Finally, with the establishment of the SSM, the ECB also gained responsibilities for macro-prudential supervision. From now on, the ECB will coordinate with the relevant national authorities the implementation of these policies and it will have a wide variety of tools at its disposal to strengthen the resilience of the financial system and prevent the build-up of imbalances which could result in increased systemic risk. We will now be in a much better position to avoid episodes such as those we have witnessed in recent years.
Together with common banking supervision, the Single Resolution Mechanism (SRM) is another key pillar of the banking union. The SRM includes a Single Resolution Board and a Single Resolution Fund financed by the banking industry. It will become fully operational in 2016, at the same time as bail-in tool will be implemented and applicable alongside the other resolution tools and powers provided for in the Bank Recovery and Resolution Directive and the SRM Regulation. This will be a decisive step in the efforts to shift the burden of bank failures from the public to the shareholders and non-insured creditors of the failing banks. In doing this, the SRM will together with the SSM significantly aid to break the link between banks and sovereign risks.
Where should we expect improvements in financial integration?
In general, based on the points that I have set out, I expect the banking union to not only restore the level of financial integration observed before the start of the financial crisis, but to also result in a deeper integration of a higher quality. We can expect important changes in two main areas: the restructuring of the whole banking sector and the integration of retail banking services.
The banking union is likely to foster a period of restructuring in the European banking sector. Current measures of the capacity and profitability of the European banking sector suggest that there is some room for efficiency gains, which should have a positive effect on conditions offered to customers. It is difficult to judge precisely what path this restructuring will take. However, it should lead to benefits for consumers via lower prices, and should also result in a faster pass-through of monetary policy decisions. In a more competitive market, interest rates charged by banks tend to respond more strongly to changes in market interest rates.  This is a key element for the correct functioning of monetary policy in a monetary union.
There was very little integration in retail banking services before the crisis and the situation deteriorated even further subsequently. In particular, cross-border bank lending to non-financial sectors – firms and households – was very low. Lending conditions, particularly non-price conditions, differed substantially, especially for households. Conditions in the mortgage market remained heterogeneous to a degree which is hard to attribute to differences in consumer preferences. For example, the typical loan-to-value (LTV) ratio for a first-time homebuyer ranged from 63% in Malta to 101% in the Netherlands. In some countries, such as Spain, Portugal and Finland, adjustable rate loans were the norm, whereas banks in Belgium, Germany and France offered almost exclusively fixed rate loans. Loan conditions often differed in terms of the maturity, the conditions for early repayment and the existence of caps for variable interest rates.  In addition, in some countries, government-sponsored and private guarantee schemes were implemented, resulting in major differences in the conditions offered to customers across Europe.
Of course, some of these differences are related to the different legal and institutional frameworks, which can only be changed by legislative action. Others may arise in part from household demand, which is influenced also by the cultural background. On the banks’ side, differences in corporate governance structures and tax regimes could account for the somewhat different services offered to customers. Deeper financial integration will not change all these characteristics, but at least some of the differences should be reduced. Ideally, we would like to move towards a situation where two identical borrowers located in different countries are able to obtain a loan at the same price, maturity, LTV ratio and conditions for early repayment.
As I have already mentioned, this integration should also be reflected in an increase in cross-border lending to non-financial corporations and households. This will be key to establishing a more lasting and durable integration. These flows are more stable and would not be so quickly reversed if a crisis were to start. Moreover, they are likely to provide better risk sharing mechanisms across countries than the ones based primarily on interbank markets. 
Other aspects of the banking union relevant for financial integration
There are other aspects of the banking union that are relevant for financial integration and there is still room for improvements that would promote even greater financial integration. Examples include the scope of the SSM and the establishment of a backstop for the Single Resolution Fund.
With regard to the scope of the SSM, owing to the increasing amount of cross-border activity within the Internal Market, limiting the SSM to the supervision of euro area banks clearly leaves room for significant dangers of contagion effects. Therefore, it is important for the stability of the overall financial system that incentives are created for other Member States to join the SSM, which would ultimately also have beneficial effects on financial integration.
With regard to the establishment of a backstop for the Single Resolution Fund, the effective financing of the Single Resolution Fund is particularly important for the credibility of the banking union and its effect on financial integration. Appropriate steps need to be taken to enhance the borrowing capacity of the fund. In addition, a common public backstop should be developed and put in place before the end of the transitional period, which will further weaken the link between banks and sovereigns. This was the commitment made by European leaders and it is crucial that it is kept.
The period of structural changes in the banking sector that lies ahead has the potential to permanently affect the structure of intermediation. Banks will focus on consolidating their balance sheets and developing more secure and viable business models. On the demand side, firms will respond by exploring new options for funding their businesses. Overall, the role of banks as the main providers of funds is likely to diminish and there will be a movement towards more capital market-based intermediation. This brings me to briefly touch on the important topic of capital market integration and development, in conclusion.
Conclusion: Building a Capital Markets Union
The establishment of a capital markets union (CMU) is key to completing the Single Market for all 28 Member States and a welcome step towards developing and integrating the EU financial markets. This, in turn, should support growth and competitiveness in the long run.
If comprehensive and well-defined, CMU can contribute to enhancing financial integration in several ways. First, it can help to further reduce the bank-sovereign link and therefore improve the allocation of capital throughout the EU economy. Second, it can create deeper cross-border markets with increased risk-sharing across the EU, thereby enhancing capital markets’ ability to cushion shocks. Third, CMU can help to overcome market fragmentation along national lines, which would also facilitate cross-border supervision of banks. We would reach this goal via several channels: (i) more harmonised accounting standards and tax laws for banks would simplify supervisory tasks by improving comparability and reduce opportunities for arbitrage; (ii) harmonised national practices and rules (such as for credit registers, insolvency and tax law, accounting standards and SME scoring) would facilitate the development of cross-border bank lending business; and (iii) more generally, less fragmented markets would also be beneficial to banks for funding purposes.
Overall, CMU can increase the resilience of the financial system by generating alternative sources of funding for the economy and reducing the dependence of the non-financial sector on bank funding, which is particularly detrimental in periods of bank deleveraging.
In this context, it is important to stress that as the European financial structure evolves over time, the supervisory framework should be assessed and improved to match changing needs, including those arising from the development of CMU.
- See, for example, the speech by Gertrude Tumpel-Gugerell, entitled “The road less travelled: exploring the nexus of macro-prudential and monetary policy”, at the conference on “Learning from the financial crisis: financial stability, macroeconomic policy and international institutions”, Rome, 12 November 2009, or the research paper by Fecht, F., H.P. Grüner and P. Hartmann on “Financial integration, specialization and systemic risk”, Journal of International Economics, 88, pp. 150-161, 2012.
- See the speech by Vítor Constâncio, entitled “The European Crisis and the role of the financial system”, at the Bank of Greece conference on “The crisis in the euro area”, Athens, 23 May 2013.
- See Giannetti, M. and S. Ongena (2009), “Financial Integration and firm performance: Evidence from foreign bank entry in emerging markets”, Review of Finance, 13, pp. 181-223.
- See Maddaloni, A. and J.-L. Peydró (2011), “Bank risk-taking, securitization, supervision and low interest rates: evidence from US and Euro area lending standards”, Review of Financial Studies, 24: 2121-2165.
- See Popov, A. and N. van Horen (2014), “ Exporting Sovereign Stress: Evidence from Syndicated Bank Lending During the Euro Area Sovereign Debt Crisis”, Review of Finance, forthcoming.
- See van Leuvensteijn, M., C. Kok, J. Bikker and A. van Ritxel (2008), “Impact of Bank Competition on the Interest Rate Pass-Through in the Euro Area”, ECB Working Paper Series No 885, March.
- See “Housing Finance in the Euro Area”, ECB Occasional Paper Series No 101, March 2009.
- For a discussion of various risk-sharing mechanisms trading off efficiency gains and contagion risks, see, for example, Fecht, F., H.P. Grüner and P. Hartmann (2007), “Welfare effects of financial integration”, CEPR Discussion Paper No 6311.