Recent turmoil in the world’s financial markets, sparked by concerns about subprime mortgage lending in the United States, seems to have hit Europe particularly hard. European banks are also less profitable than their counterparts in the United States and less sophisticated in terms of their ability to pass on risk to other financial players.
Would pushing ahead with financial integration help Europe address these problems? What can policymakers do to reduce the risk of financial crises? And who should be responsible for supervising financial institutions in a unified European market?
These are some of the questions discussed in a new book published by the IMF, entitled Integrating Europe’s Financial Markets. In a recent interview, Michael Deppler, head of the IMF’s European Department, and Wim Fonteyne, a Senior Economist in the same department and one of the book’s three editors, discussed the findings of the book with the IMF Survey Magazine.
IMF Survey Magazine: The book talks about the need to rethink Europe’s framework for ensuring financial stability. Does the recent volatility in the financial markets hold any lessons for policymakers?
Deppler: It’s a bit early to be drawing lessons from the latest developments. However, to the extent that the problems reflect an imbalance between supervisors’ understanding of what was happening and what markets were in fact up to, then, yes, the book does speak to the recent market turmoil. Basically, there is a risk that Europe’s supervisory arrangements are not keeping up with the explosion in cross-border financial flows within Europe.
Europe is torn when it comes to financial integration. On the one hand, there is a strong impulse toward achieving integrated financial markets, with new legislation being enacted to that end. On the other hand, oversight of financial markets remains fundamentally national rather than integrated.
In our view, this has resulted in insufficient oversight of new risks that have emerged in the wake of the explosion in cross-border transactions. Europe needs to work out stronger arrangements to oversee these risks. This raises a whole range of issues.
But, ultimately, what is needed is to make supervisors responsible not only for what is happening in each individual country, but for what happens in Europe as a whole. That is the core message of the book.
IMF Survey Magazine: The book argues that financial integration would boost economic growth in Europe. Why would more integrated markets make a difference?
Fonteyne: The financial sector plays a key role in the economy and also in our lives. It makes economic growth possible by ensuring that good ideas and investment projects can be funded. It also provides people with the means to manage discrepancies between their incomes and their needs—for example, credit allows us to finance a house early in life, and savings and investment products make it possible for us to be financially secure in retirement.
By making all of this possible, the financial sector boosts people’s lifetime incomes and helps them spend their money in ways that are more advantageous to them.
Financial integration reproduces these benefits on a European scale. As a result, the benefits are bigger and go to more people. For example, financial integration makes it possible for the pension savings of an elderly German couple to find their way to a young entrepreneur in Bulgaria, benefiting both parties in the transaction.
Financial integration also boosts financial development. Currently, there are still big differences in financial development across the European Union (EU), but integration helps the less financially developed countries catch up with the more developed ones.
This is particularly important for the new EU member states in central and eastern Europe. But not only laggards benefit—financial integration can accelerate the pace of financial development everywhere, including in more developed countries. This, in turn, provides a boost to the whole economy.
IMF Survey Magazine: Many banks based in western Europe have already established branches in central and eastern Europe, helping spark a credit boom in those countries. How has that affected financial stability?
Deppler: First, let me underscore what Wim said about the benefits of financial integration. There is no question that the huge inflows of capital channeled through the banking system have fostered economic growth and strengthened prospects in central and eastern Europe. At the same time, however, those inflows have also created risks to financial stability—risks that must now be managed by the authorities.
For most of the host authorities in central and eastern Europe, the inflows pose both macroeconomic risks and prudential risks. The immediate macroeconomic risk is that an unsustainable credit boom will develop.
But the rapid expansion of credit also creates prudential risks, partly because the screening of credit applications might suffer as their numbers rise, and partly because credit booms typically lead to increased balance sheet mismatches for the borrowers and, at one level removed, additional credit risks for the banks.
This interview is an edited version of the audiofile, “Integrating Europe’s financial markets.” It is not a transcript of the podcast interview. For exact quotes, listen to the audiofile on the Podcasts and Videos page at http://www.imf.org/imfsurvey
But supervisors have uneven access to relevant information. The home supervisors in western Europe are responsible for supervising the consolidated banks, but they have access only to partial information about what is going on in the foreign subsidiaries.
Correspondingly, the supervisors in the host countries have, at best, an incomplete view of the position of the parent bank. All in all, this means that supervisors in Europe have become interdependent.
Yet decision making remains decentralized, which means that valuable information may not be immediately available to those who need it most. This setup is a recipe for mishandling shocks and makes it difficult to prevent crises or to manage them when they happen.
So coming back to the main theme of the book, integration is creating new risks and increasing the challenges confronting supervisors. The fragmented, country-based orientation of the supervisory arrangements does not fit well with the cross-border character of the operations of the new financial institutions.
There is, in other words, a mismatch between the actual degree of financial integration and the way supervisory accountability is currently structured. There is a need to strengthen information sharing among supervisors and for supervisors to get on top of the linkages within various banking groups across countries.
IMF Survey Magazine: So it sounds like there is a good case for more integration. Yet it seems like an impossible feat to try to reconcile the legal systems of 27 different countries. Is it really realistic to aim for fully integrated financial markets?
Fonteyne: Throughout the history of the EU, people have questioned whether it was realistic to seek economic integration or, indeed, integration in other areas. But if we look back at the past 50 years, many of these self-proclaimed realists have been proved wrong. How realistic something is depends on the time frame one considers, as well as on other factors, such as political will.
It is clear that we will not have fully integrated financial markets tomorrow or next year. But, even though a fully integrated market might not be achieved in the foreseeable future, making progress toward that objective is beneficial in itself.
Deppler: Europe needs to balance its commendable—and growth-enhancing—impulse toward integrated financial markets with the impulse to retain a national approach to controlling the risks associated with such integration. In our view, this basically requires more integrated—integrated, not centralized—approaches to supervision. I have little doubt that Europe will eventually get there. But how and how fast they get there and how many risks they run along the way are open questions.
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Integrating Europe’s Financial Markets
Edited by Jörg Decressin, Hamid Faruqee, and Wim Fonteyne
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