Strong fundamentals should allow Europe to weather financial turbulence relatively well. Nonetheless, growth is set to ease in 2008 in nearly all countries. Policymakers will need to deal up front with the financial market turmoil, while implementing fiscal consolidation and structural reforms, including in the financial sector, to address vulnerabilities, raise medium-term growth prospects, and deliver on the promise of convergence for emerging Europe. Three analytical chapters discuss reforms to strengthen Europe's financial systems to allow advanced economies to benefit from innovation without incurring excessive risk and, in emerging economies, to manage rapid financial deepening and develop financial systems further.
Note: The main author of this chapter is Man-Keung Tang. The underpinning analytical work is presented in Tang (2007).
8For further details see International Monetary Fund (2007a).
9“How Do Financial Systems Affect Economic Cycles?” Chapter 4 in IMF (2006b).
10In other words, the number of times savings are intermediated (“change hands”) on their way to the end borrowers has increased, and the possibility of slicing and bundling risks in ways that better cater to different intermediaries and investors has expanded.
11OMX Nordic Exchange, which consolidates exchanges in Denmark, Sweden, Finland, and Iceland, and Virt-X, which offers trading in pan-European blue-chip stocks, are two other notable examples.
14A more sophisticated financial system here refers to one that has a higher score on the financial index developed in the September 2006 WEO.
15To explicitly address possible endogeneity, rather than studying the simple correlation between finance and macroeconomic performance, the analysis exploits cross-country industry-level data to examine the mechanisms underlying finance’s contribution to the economy. For details of the analysis, see Tang (2007).
16Germany’s Landesbanken, for instance, significantly underperform their EU peers, and their high ratings, bolstered by the public sector ownership, give them an artificial advantage on the wholesale market over their privately owned counterparts (Brunner and others, 2004).
17Europe’s covered bond market, though, is very well developed. However, as the underlying assets of covered bonds remain on banks’ balance sheets (and hence have to be supported by a corresponding amount of regulatory capital), securitization represents a more effective way for banks to raise funds and manage risks.
19In particular, legal factors and concerns about reputational risks may force banks to reintegrate off-balance-sheet vehicles and fulfill contingent funding commitments.
20The lack of transparency on the origination process may, in turn, encourage the originators to adopt a laxer underwriting standard.
21For instance, there have been recent discussions on creating measures of valuation risks in the rating agencies’ assessments.
Note: The main authors of this chapter are Rudolfs Bems and Philip Schellekens. The analytical underpinnings of this chapter and the details of the simulations are presented in Bems and Schellekens (2007).
22Financial deepening will be interpreted here narrowly as the expansion of credit to resident nonfinancial corporations and households.
Note: The main author of this chapter is Edda Zoli. The underpinning analytical work is presented in Zoli (2007).
23The turnover ratio is defined as the value of trading relative to market capitalization.
24Croatia, the Czech Republic, Hungary, Poland, and Slovenia.
29For emerging Europe, explaining the development of segments of the financial sector other than bank credit is challenging. Econometric studies on the determinants of development of debt securities markets in the region are hampered by data limitations. For the equity market, while earlier empirical work underscored the role of the privatization process, single-digit inflation, rising income, shareholder protection, and institutional investor assets in fostering market capitalization during the 1990s, our recent study could not confirm these findings.
30Major steps in this direction were taken with the Financial Services Action Plan (FSAP), the Lamfalussy process, and the Commission White Paper on Financial Services Policy. The FSAP was launched in 1999 with the objective of removing barriers to the cross-border flow of financial services and capital within the European Union. The Lamfalussy process was established in 2001 to facilitate the implementation of the FSAP regulatory framework. The Commission White Paper on Financial Services Policy sets the priorities for EU-level financial sector reforms over 2005–10 (Haas, 2007a).
31For example, enforcing a debt contract costs on average 50 percent more in non-EU than in EU emerging economies. Furthermore, in several non-EU countries. firms tend to distrust courts (See EBRD–World Bank Business Environment and Enterprise Performance Survey, 2005; and Anderson and Gray, 2006).
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