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Mr. Jörg Decressin, Mr. Wim Fonteyne, and Mr. Hamid Faruqee

Abstract

Europe has made considerable progress in integrating its financial markets.1 In the 1957 Treaty of Rome, the founding fathers of the European Union (EU) set out to create a common market where goods, services, people, and capital could move freely. They thus put Europe on a course toward a single financial market,2 one characterized by a free flow of capital and the free provision of financial services across borders. Fifty years later, European financial integration has made significant headway, with monetary union perhaps the most visible marker.

Mr. Jörg Decressin, Mr. Wim Fonteyne, and Mr. Hamid Faruqee

Abstract

The integration of financial markets in the European Union poses evolving risks to financial stability and challenges to existing financial stability arrangements. Chapter 2 points out that financial integration carries risks of contagion and fundamental spillovers, as well as transition risks. Chapters 6–8 show that increasing integration has not diminished banking system risks because diversification gains have been offset by higher risk taking. Moreover, integration has increased banks’ exposure to EU-wide or euro-area-wide financial cycles and has increased the role of large, complex cross-border and cross-sector financial institutions, which can be an added source of systemic risk. As experience has shown, including in the European Union, financial crises can be extremely costly both fiscally and in terms of economic growth. Although full-blown crises may be unlikely, the costs of preventing or containing crises can be very substantial. Two key questions therefore are: How should cross-border risks be managed to ensure financial stability in an integrating financial market? And how should the EU financial stability framework be adapted to do so?

Mr. Jörg Decressin, Mr. Wim Fonteyne, and Mr. Hamid Faruqee

Abstract

This chapter provides a bird’s-eye view of financial integration from a conceptual standpoint and also outlines its potential risks and benefits. At a very broad level, the integration of financial markets is a complex and multifaceted process, involving the behavior and interaction of agents, institutions, and markets operating in the context of different national policies and legal and prudential frameworks. In Europe, a layer of complexity is added at the supranational level through EU and euro area institutions—including the European Parliament, the European Commission, and the European Central Bank—and through policy initiatives—in particular, EU treaties and directives. To help make sense of all this, the conceptual framework developed here offers a lens through which to view many of the central policy challenges and issues facing the “European experiment,” upon which subsequent chapters elaborate. The following main questions are posed in this chapter: (1) What is financial integration? (2) What are the potential benefits? (3) What are the risks? Answers to these basic questions help define the key issues, the stakes, and the priorities for financial market policies.

Mr. Jörg Decressin, Mr. Wim Fonteyne, and Mr. Hamid Faruqee

Abstract

This chapter reviews the current state of financial integration in the European Union, with a particular focus on the interplay among integration policies, the architecture of financial markets, and actual progress toward integration.1 The next section reviews the state of integration across various markets, including the convergence of prices for similar financial products, the cross-border correlation of returns, and developments in cross-border financial flows. The following section outlines current financial integration policies, in particular the Financial Services Action Plan (FSAP), the Lamfalussy process, and the European Commission’s White Paper for 2005–10. The concluding section reviews some important remaining gaps.

Mr. Jörg Decressin, Mr. Wim Fonteyne, and Mr. Hamid Faruqee

Abstract

This chapter analyzes differences in efficiency and competition between EU and U.S. banks and puts these differences in the context of historical developments and market structures.1 Financial markets in the United States offer a natural benchmark because they are the only markets that match or exceed those of the European Union in both size and level of development and because banking markets were highly fragmented in both areas until the late 1980s. By contrast, money and capital markets, as well as regulation and supervision, have always been highly integrated in the United States but not in the European Union. Specifically, the chapter examines the causes of banking market fragmentation and the role of policies in addressing it; explores the structural differences between banks and markets in the European Union and the United States; presents evidence suggesting that EU banks are less efficient in raising revenue than their U.S. counterparts and that there is less competition among banks in the European Union than in the United States; and reflects on the reasons for the lower revenue efficiency of EU banks.

Mr. Jörg Decressin, Mr. Wim Fonteyne, and Mr. Hamid Faruqee

Abstract

This chapter reviews the progress made in integrating Europe’s equity markets. As noted in Chapter 3, it is more difficult to discern trends in the integration of equity markets than in other markets, in part due to measurement issues. Given this limitation, this chapter addresses the following key questions. How should financial integration in equity markets be measured? Is there something approaching a “European reflex” with respect to investment decisions that leads agents to look beyond national borders? What are the differences among euro area and EU member states with respect to equity market integration? What are the impediments to further and faster integration of national stock markets?

Mr. Jörg Decressin, Mr. Wim Fonteyne, and Mr. Hamid Faruqee

Abstract

This chapter1 explores the impact of financial integration on system-wide risk profiles of publicly traded European financial institutions. The chapter provides an overview of indicators of banking market penetration, and then assesses whether the benefits of risk diversification arising from integration are reflected in convergence of financial institutions’ risk profiles to lower risk levels. It documents the evolution and convergence of risk profiles of publicly traded banks and insurance companies, offering insights into the role of financial integration as a driver of risk profile dynamics. A key finding is that the risk profiles of financial institutions have indeed converged, but not to lower risk levels. Convergence has likely been driven by increased exposures to common financial shocks. Enhanced links stemming from integration of European capital markets may have played a role, as increased exposures have occurred despite the lagging integration of the relevant retail markets. The lack of clear improvement in risk profiles suggests that diversification benefits have been offset by higher risk taking.

Mr. Jörg Decressin, Mr. Wim Fonteyne, and Mr. Hamid Faruqee

Abstract

This chapter1 focuses on the international diversification of and associated risks for the 12 most internationally active large banking groups (ILBGs) in the European Union. The chapter relates general trends among these ILBGs to accounting-data-based and market-based measures of risk, both at the level of individual institutions and as a group. The chapter finds that diversification has proceeded and generally benefits individual ILBGs, but that risks to the group of ILBGs as a whole have not necessarily declined.

Mr. Jörg Decressin, Mr. Wim Fonteyne, and Mr. Hamid Faruqee

Abstract

This chapter1 investigates bank business correlations within individual countries and across countries in Europe. In doing so, it seeks to disentangle the relative importance of EU-wide versus country-specific drivers of bank soundness and profitability in order to gain insights into the state of banking system integration and to aid in the design of financial stability arrangements. A growing literature measures comovements between EU banks, typically finding that EU-wide macroeconomic and banking-specific shocks are significant and that some risks have increased since EMU.2 These results are generally derived from market-based indicators, notably DD measures.3 The contribution here is the following:

Mr. Jörg Decressin, Mr. Wim Fonteyne, and Mr. Hamid Faruqee

Abstract

This chapter analyzes regulatory and supervisory frameworks in the European Union, building on assessments carried out under the IMF-World Bank Financial Sector Assessment Program(FSAP).1 The FSAP has so far covered about two-thirds of the IMF membership, including virtually the whole European Union (Table 9.1), and is therefore an important source of comparable information on the quality of supervisory frameworks.2 This chapter analyzes the information from the FSAP assessments in a comprehensive way, relying on a combination of quantitative and qualitative approaches, focusing on the EU countries, and paying particular attention to cross-border issues.