1. Tuning the Financial Systems of Advanced Economies

International Monetary Fund. European Dept.
Published Date:
November 2007
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Though Europe has made great strides in financial innovation and integration, many advanced European economies still need to level the playing field for the various forms of financial intermediation. Competitive and more diversified financial systems are better at distributing risk and identifying and supporting industries with high growth potential. These systems allow the complementarities of bank- and market-based financing to be fully exploited. At the same time, as the recent financial market turbulence underscores, both private and public prudential frameworks need to keep up with financial innovation if the benefits are to be reaped without incurring excessive risks. To secure the resilience of financial systems in advanced economies, it will be important to improve the management of market and liquidity risk, implement more advanced risk assessment models, and increase transparency of underwriting standards and counterparty risk exposures.


Financial systems in advanced European economies have been undergoing an unmistakable transformation. No longer is the European financial landscape dominated by a handful of large banks wielding considerable monopolistic power. Instead, competition among banks has been intensifying, and banks have been engaging in a wider variety of business than only traditional lending. Meanwhile, capital markets have been gaining importance, both as a source of funding and as a distributor of risks. And nonbank financial institutions have been rapidly emerging as another key intermediary of financial resources. As another sign of growing sophistication, the various forms of intermediation have also become less segmented, and—through an increasing use of innovative financial instruments—complementary relationships among them have been strengthening.

But, as the financial turbulence triggered by the meltdown of the U.S. subprime mortgage market has brought home, financial innovation comes with risks. Specifically, financial innovation often exploits interstices in existing prudential arrangements that can prove problematic. Moreover, in the context of financial globalization, turbulence spreads swiftly around the globe, sparing few countries from its adverse effects on confidence and real economic activity.

While it may be tempting for policymakers to try to slow financial innovation in view of such risks, a more productive policy approach would be to adopt reforms that simultaneously boost the efficiency of the financial system and tackle its vulnerabilities. Therefore, it will be important to clearly identify the benefits and causes of risks associated with a more sophisticated financial system before rushing to tighten regulation. In this respect, the initial reaction to the recent turbulence is encouraging, indicating a willingness by policymakers to preserve the benefits of financial innovation while confronting the prudential vulnerabilities.

The benefits of stronger competition, greater diversity, and closer integration among different intermediaries in the European financial systems are becoming increasingly evident. Households and firms enjoy a greatly expanded set of investment and borrowing options at a significantly lower cost, thanks to stronger competition and better risk distribution. Empirical analyses suggest that the considerable financial depth of advanced European economies is more effectively transformed into economic gains when the financial systems are more sophisticated.

However, despite much progress made to date, European financial systems can still become far more efficient. The substantial remaining obstacles are restricting the full play of competitive forces and stunting the development of financing channels. Hence, the directly measured economic contribution of the financial sector to growth in advanced Europe has been lagging, and there is considerable scope to further strengthen this sector’s role in mobilizing resources to productive use. Lower productivity growth of the financial sector accounted for about half of the economy-wide productivity growth gap between the euro area and the United States during 1996–2003.

At the same time, the recent financial market turbulence has helped pinpoint weaknesses and provide some preliminary lessons to help buttress the prudential foundation of the more market-based financial systems. In general, the increasing sophistication and complexity of financial transactions should be accompanied by an upgrading of private and public prudential frameworks. Recent events further highlight the need for better management of market and liquidity risk, upgrading of risk assessment models and due diligence, and greater transparency regarding the loan origination process and counterparty risk. Supervisory capacity may need to be boosted and the effectiveness of crisis management reviewed.8

Evolution of Financial Systems

While starting points and speed of evolution differ, financial systems in advanced European economies have generally been moving toward stronger competition, greater diversity of financial activities, and closer integration among different intermediaries.

The financial index developed in the September 2006 WEO9 provides one useful summary look at the composition of the financial systems in advanced Europe and their recent changes (Figure 16). In the remainder of this chapter, a higher score on the financial index will be described as a higher degree of sophistication of financial systems. The index quantitatively captures (1) the reliance of the system on traditional bank lending and the degree of competition among banks, (2) the extent of development of capital markets, and (3) the degree of new financial intermediation—including the prevalence of nonbank financial institutions and use of financial innovations. Nearly all advanced economies have made progress on all three fronts covered by the index. But the landscape remains uneven across Europe.

Figure 16.Financial Index by Subindices, 1995 and 2004

Source: IMF, World Economic Outlook.

Notes: traditional bank intermediation: a higher score indicates less reliance of the financial system on traditional bank lending and a greater degree of competition among banks; capital market development: a higher score indicates more developed stock and private bond markets; new financial intermediation: a higher score indicates a stronger presence of nonbank financial institutions and more prevalent use of financial innovations.

Competition and diversity of intermediation have increased. Competition in bank lending has strengthened, as illustrated by narrowing interest spreads (lending minus money market rates) (Figure 17). The amount of funds under management by various nonbank financial institutions (e.g., insurance companies, pension funds, and investment funds) has risen substantially (Figure 18). Partly reflecting this rise, stock markets have gained in liquidity (Figure 19), and debt securities have increasingly become a potent funding source (Figure 20).

Figure 17.Interest Spread, 1995 and 2004

(Lending rate less money market rate, percent)

Source: IMF, World Economic Outlook.

Figure 18.Assets of Nonbank Financial Institutions, 1995 and 2006

(Percent of GDP)

Source: Eurostat.

1/ Data for Denmark, Germany, and the Netherlands extend through 2005.

Figure 19.Stock Market Turnover, 1995 and 2005

(Percent of market capitalization)

Source: World Bank, A New Database on Financial Development and Structure.

Figure 20.Outstanding Amount of Domestic Debt Securities Issued by Nonfinancial Corporations, 1995 and 2006

(Percent of GDP)

Source: Bank for International Settlements.

At the same time, banks have become more integrated with markets and continue to play a prominent role in the financial system. While competition for household savings from nonbank financial institutions has increased, the banks’ practice of more intensely sourcing funds from other intermediaries through the wholesale markets allows them to expand without being constrained by the amount of deposits they attract. Various off-balance-sheet activities, such as sales of securitized bank loans to the market and trading of derivatives, have also been increasingly pursued by banks. In general, such activities have decreased the segmentation of banks, markets, and nonbank financial intermediaries, enabling funds and risks to be more flexibly transferred.10

Traditional relationship-based lending continues to be highly relevant even though the changing nature of intermediation and widening range of lenders and financing options have reduced its dominance. The main advantage of relationship-based lending—facilitating flows of finance in cases where there is serious information asymmetry—appears to remain a key dimension in the evolving financial systems. In particular, a study of Italian firms shows that the financing of small enterprises, which tends to be opaque and heavily reliant on relationship-based loans for funds, has not been significantly affected by the rapid increase in sophistication of the Italian financial system (Box 3).

Box 3.Continued Relevance of Relationship-Based Lending in an Evolving Financial System

As financial systems evolve, competition among banks and the diversity of financial intermediation increase, leading to a decline in the dominance of relationship-based lending. The expansion of borrowing alternatives benefits relatively transparent firms, as they get access to more competitively priced finance and become less vulnerable to the supply of funds from any one single lender.

However, an examination of the financing of Italian firms indicates that relationship-based bank lending appears to remain important where its main advantage counts most. Long-term interactions underlying relationship-based lending allow the lender to more effectively gather information about the borrower and thus facilitate flows of finance even in cases in which the borrower generates little publicly available information. Such mitigation of information asymmetry associated with opaque firms represents the main advantage of relationship-based lending. The study presented here, focusing on small enterprises—which tend to be opaque and rely heavily on loans from local banks—in Italy shows that their access to funds has not been significantly affected over the past 10 years, suggesting that the main advantage of relationship-based lending remains relevant even as the financial system is becoming increasingly sophisticated.

Italy is chosen for the case study for two main reasons. First, the transformation of its financial system has been one of the most rapid among the advanced economies (according to the September 2006 WEO’s financial index). Therefore, any effect of the change in the financial system on the financing of the major beneficiaries of relationship-based lending should be most readily detectable in Italy’s data. Second, small enterprises make up a large part of the corporate universe in Italy. Their significant representation should provide more confidence in the precision of the empirical results.

The empirical analysis examines the level of leverage of small enterprises (relative to larger enterprises) as a function of the financial system’s sophistication—of which a measure is constructed for each year of the sample period using the methodology for the September 2006 WEO’s financial index—controlling for fundamental factors found in the literature to be important determinants of the equilibrium leverage.1 In addition to the countrywide measure of the financial system, regional variation in the breadth of choice of lenders is measured as the number of lenders per firm in the region. Firm-level data used in the analysis cover more than 44,000 firms between 1995 and 2004.2 The sample includes small firms (with fewer than 50 employees), but excludes micro firms.3

Regression results suggest that the increase in financial sophistication during the sample period—measured either for the country as a whole or across regions—does not significantly affect the financing of small firms (table). Although the positive effect of increasing financial sophistication on the equilibrium level of leverage seems to be lower for small firms (negative coefficient estimate on the interaction term), the differential effect is far from statistically significant. The results for all firms indicate that the increase in financial sophistication has a small positive effect on the equilibrium level of leverage.

Small-Firm Financing in a Transforming Financial System
Dependent variable: Leverage level
coeff estz-statcoeff estz-stat
Small firm dummy* Financial index−0.22−0.50
Financial index0.
Dummy: small firms (<50 employees)−0.59−0.510.650.24
Regional financial index: No. of bank relationships per firm1.920.711.940.71
Notes: Estimation method: Generalized least squares random firm effect for all regressions. Number of observations: 400,000+ for each regression. Control variables included in the regressions but not reported: profitability, tangibility, lagged research and development (R&D) expenditure, lagged growth of exports, lagged growth of revenue, and constant. No reported coefficient estimates are statistically significant at the 10 percent level.
Notes: Estimation method: Generalized least squares random firm effect for all regressions. Number of observations: 400,000+ for each regression. Control variables included in the regressions but not reported: profitability, tangibility, lagged research and development (R&D) expenditure, lagged growth of exports, lagged growth of revenue, and constant. No reported coefficient estimates are statistically significant at the 10 percent level.
Note: The main author of this box is Iryna Ivaschenko.1 Control variables include profits, tangibility (see Campello, 2006, for a definition), past growth, and past business strategies aimed at improving performance (e.g., marketing and research and development expenditures).2 Data were graciously provided by the Bank of Italy. See Ivaschenko (2007) for details.3 Micro firms are those that do not produce even simplified balance sheet data.

Drivers of Change

The evolution of Europe’s financial systems has been driven in good part by domestic financial sector reforms. Large-scale privatization and deregulation of the banking sector in the 1980s and 1990s have increased competition and efficiency. Similarly, the substantial tightening of stock-listing requirements and corporate governance regulations has raised corporate disclosure standards and increased protection of investors from frauds, thus rendering equity more attractive.

Advances in information and communication technology have also contributed to this evolution. For instance, more timely availability and easier processing of borrower credit records encourage open competition among banks for potential borrowers (Petersen and Rajan, 2000), while increased access to the Internet and the proliferation of web-based trading channels promote wider and deeper investor participation in the stock markets (Choi, Laibson, and Metrick, 2002).

Financial integration—hastened by the harmonization of financial sector regulations and the adoption of a single currency among the euro area countries—may have been the most important factor underlying the transformation of the financial system (Decressin, Faruqee, and Fonteyne, 2007):

  • The lowering of barriers to integration of European banking has encouraged foreign entry and strengthened the contestability of the domestic banking sectors, prompting banks to expand into various off-balance-sheet activities (e.g., securitization, derivatives trading, and sale of risk management services). Moreover, the broadening of the client base across borders encourages banks to grow and benefit from economies of scale. The ensuing consolidations have further fostered banks’ capacities to engage in market transactions.
  • Integration across stock exchanges has promoted capital market development. In particular, the mergers and joint ventures of several European stock exchanges, most notably Euronext,11 have standardized the trading platforms and lowered market fragmentation, thereby reducing cross-border stock trading costs and improving market liquidity (McAndrews and Stefanadis, 2002).

Quality of the Financial System Matters

As discussed, the evolution of the European financial systems has led to significant changes in the way finance is intermediated. Why are such changes important to the wider economy?


Financial systems featuring stronger competition, greater diversity, and closer integration among intermediaries are more likely to direct finance to its most productive use. In such systems, flows of finance are more closely guided by market signals, and financial resources are more competitively priced. The strong presence of a multitude of different intermediaries and financing options also expands the opportunities for both borrowers and lenders to meet their specific needs. Moreover, an intermediary’s capacity to originate claims is less constrained by its ability to bear the risks involved in these claims by the increased tradability of risks via various innovative financial instruments—e.g., asset-backed securities (ABSs), collateralized debt obligations (CDOs), and credit default swaps. Consequently, each intermediary’s natural advantages are better exploited, the costs of risks are lowered, and the dispersion of risks becomes more optimal.12

This efficiency benefit is likely to be especially noticeable for advanced economies. These economies already have in place many elements of the fundamental infrastructure—e.g., strong tradition of rule of law, well-defined judicial systems, and good availability of information to the public—that are crucial for the effectiveness of sophisticated financial transactions. Furthermore, positioned at the technological frontier where opportunities can be fast-changing and uncertainties are high, advanced economies would certainly benefit more than less developed economies from a system where finance flows flexibly and risks are widely distributed.


The presence of such an efficiency benefit is supported by empirical work. For instance, cross-country macroeconomic analyses13 find that more sophisticated financial systems are associated with faster reorientation of the corporate sector to global growth opportunities, and more voluminous cross-border portfolio investment inflows and outflows.14

New research based on cross-country industry-level information confirms that the economic value of finance is enhanced in more sophisticated financial systems, that is, systems with a wider array of financial activities.15 The evidence suggests that two channels through which finance benefits the economy—the general reduction in costs of external finance and improvement in resource allocation in the corporate sector—work more effectively in such financial systems. Specifically, the positive effect of a greater availability of finance on the value-added growth of industries that are likely to be subject to the tighter financial constraints is larger in more sophisticated systems. Likewise, increased financial depth seems to strengthen the relative development (both value-added growth and productivity growth) of rising industries more in financial systems that are more sophisticated. In other words, more sophisticated financial systems appear able to derive larger efficiency gains from finance. Analyzing an even more detailed data set for Denmark suggests that the efficiency benefit applies also at the firm level (Box 4).

Box 4.Financial Intermediation at Work in Denmark

Cross-country industry-level analysis in Tang (2007) suggests that under the right conditions (i.e., a high degree of sophistication in the financial system and a flexible labor market), finance would tend to flow to firms with tighter financial constraints and greater growth potential. Denmark ranks high on financial sophistication (as measured by the September 2006 WEO’s financial index) and has one of the most flexible labor markets in Europe. Moreover, its corporate sector has considerably expanded its recourse to external finance in recent years. Zooming in on a panel of firm-level data of Denmark provides an ideal test to see whether finance indeed flows as hypothesized.

The test consists of verifying how a firm’s growth potential and the natural tightness of its financial constraint affect the amount of finance it attracts. Growth potential is measured by lagged sales growth, and the financing constraint is proxied by lagged cash flows and whether the industry it operates in has a high dependence on external finance. Reverse causality is dealt with by lagging the independent variables. Growth of debt finance is regressed on these variables of interest, along with current sales growth and total assets as controls. The panel data run from 2001 to 2006 and include roughly 1,000 Danish firms in each year (see the table).

Two main points emerge. First, the results confirm that more finance tends to flow to rising firms and firms in industries with high dependence on external finance. While the coefficient estimate on lagged cash flow is not statistically significant, it is of the expected sign.

Second, the regressions show that the information content embedded in the flows of finance seems in fact greater than suggested by the cross-country results. Finance not only flows to high-growth industries, it also seeks out the high-growth firms within each industry.

Determinants of Flows of Finance

Dependent variable: Growth of debt

Estimation Method
Fixed industry effectFixed industry effectGLS Random industry effectGLS Random industry effect
coeff estz-statcoeff estz-statcoeff estz-statcoeff estz-stat
Dummy: industry w/ high dependence on external finance0.022.52**0.022.51**
Lagged cash flows0.00−0.790.00−0.850.00−1.300.00−1.35
Lagged growth of revenue0.062.84***0.052.28**0.042.07**
Growth of revenue0.125.44***0.115.30***
Total asset0.001.96**0.001.98**0.002.44**0.002.47**
Notes: Year fixed effects are included in all regressions. Number of observations: 5,500+ for each regression. ** and *** denote statistical significance at 5 percent and 1 percent level, respectively.
Notes: Year fixed effects are included in all regressions. Number of observations: 5,500+ for each regression. ** and *** denote statistical significance at 5 percent and 1 percent level, respectively.

Garnering Benefits without Incurring Excessive Risks

Financial innovation is an important source of strengthened economic and financial performance over the medium term, but it is bound to pose challenges to private and public prudential arrangements, as highlighted by recent events. It is important that these challenges be met without undue costs to the greater availability of finance that innovation brings. Thus, a productive policy approach would be to implement measures that facilitate the move toward greater financial sophistication, while ensuring that prudential frameworks keep up with these developments to minimize the risks of financial crises. What does moving forward entail and how should risks be guarded against?

Moving toward Greater Sophistication

Competitive forces are likely to intensify financial integration and continue to push the European financial systems toward greater sophistication. While there have been major advances in integrating wholesale banking, there is still much room for further integration on the retail front. In addition, the delivery of numerous EU directives in the pipeline (notably the Markets in Financial Instruments Directive, or MiFID) will further facilitate capital flows and development of integrated financial services.

Nevertheless, the transformation of the financial systems is certainly not guaranteed and in fact does not appear to converge across countries. Specific domestic policy reforms are likely to be the main factor determining the ultimate extent and speed of the transformation, as illustrated by the experience of Italy (Box 5).

Box 5.Upgrading a Financial System: Italy’s Experience

The financial index of Italy’s financial system rose considerably between 1995 and 2004, showing great improvement in all three main components: the traditional banking intermediation, the new financial intermediation, and the financial markets.1 In part, this development reflects Italy’s lower starting base, as its financial markets still remain undersized and dominated by banks.2 Domestic reforms specifically geared at the banking sector, firms’ corporate governance, and the securities markets have, however, prominently contributed to the transformation of the financial system during the period.

Organizational Reforms: Privatizing the Major Financial Intermediaries

A large-scale privatization program was carried out in the banking sector in the 1990s, leading to more intense competition among Italian banks and a more efficient and less concentrated banking sector. In addition, many of the privatized banks became listed on the stock exchange, making it possible for them to raise funds from a diverse spectrum of investors and becoming subject to market discipline. Incidentally, the public trading of banks’ equity also benefited the development of the stock market by increasing the market’s liquidity.

The organization of the equity market has also been revamped. Following the stock exchange’s privatization in 1998, Borsa Italiana was created and charged with the responsibility to manage and develop the exchange. To complement the mandatory frameworks imposed by the state regulators, Borsa Italiana introduced a voluntary code of conduct (Preda Code) in 1999 to flexibly address some corporate governance issues that the formal requirements could not adequately deal with. Hoping to attract the listing of firms of various sizes and funding needs—especially salient given the predominance of small firms in Italy—Borsa Italiana introduced three separate exchange segments with different listing requirements. It is important that the segmentation allows smaller firms to access equity financing on the public market without incurring prohibitively high listing and compliance costs.

Upgrading the Legal and Regulatory Frameworks: Bolstering Investor Protection and Facilitating Financial Innovations

At the heart of greater nonbank intermediation lies investor confidence in the system’s ability to protect their investment, which was significantly boosted by the implementation of the Consolidated Law (Draghi Law) in 1998 and the Savings Law in 2005, the latter in response to corporate scandals. Along with the regulations introduced by Consob (a supervisory body of the stock exchange), the new law went a long way toward transforming corporate governance practices in Italy, particularly through a series of requirements aimed at improving the balance of power between the biggest shareholders and minority investors. Furthermore, self-dealing was made less attractive to the biggest shareholders by requiring mandatory bids and disclosure of material related-party transactions.

To make it easier for banks to securitize and sell their loans into capital markets, the Securitization Law was enacted in 1999. The increased ease of securitization expanded banks’ funding sources and enhanced their risk management capabilities. Last, but not least, the groundwork has been laid out for the implementation of many EU banking and financial market directives—notably the Capital Requirement Directive (Basel II provisions) and MiFID (Markets in Financial Instruments Directive).

Strengthening Enforcement: Empowering Regulators

Modalities of cooperation between the two supervisory authorities (Consob and Bank of Italy) charged with securities regulation have been clearly established, so as to facilitate exchanges of information and expertise while reducing the possible confusion of responsibilities. Moreover, regulators have been endowed with greater investigative and sanctioning authorities, thus ensuring stricter adherence to the regulations.

Unfinished Business

Although much effort has been made to modernize the financial system, the road ahead to catch up with the most advanced financial systems is still long. Notwithstanding low concentration, there is further scope to strengthen competition among banks, as the average price of basic banking services in Italy appears to be one of the highest in Europe (EFMA, Capgemini, and Ing, 2005). Similarly, there is room to reduce stock market listing costs; strengthen and streamline corporate governance, accounting, and disclosure requirements for all corporations, especially groups; and further enhance minority shareholder protection, mainly by permitting class action lawsuits and enhancing the effectiveness of the civil judicial system. Development of the private pension pillar and further public divestment might also help.

1 Italy’s ranking among the 18 sample countries improved in all three components between 1995 and 2004. It rose from 7 to 4 in traditional banking intermediation, from 17 to 11 in new financial intermediation, and from 18 to 14 in capital market development.2 See International Monetary Fund (2006a; 2007b).

In certain cases, reducing involvement—whether direct or indirect—of the public sector in banks will be desirable. State intervention in bank management undermines the sector’s efficiency by distorting the bank’s decisions and jeopardizing the growth of other competitive banks.16 Public sector divestment would remove such distortions and clear the way to list the banks publicly and subject them to greater market scrutiny and discipline.

Improving the corporate governance of many large nonlisted private banks by stepping up disclosure requirements would yield efficiency gains. A particular risk of insufficient disclosure is that managers of these banks might engage in channeling finance to where it produces personal gains but perhaps little economic value. Stronger oversight of the nonlisted banks’ corporate governance would strengthen the role of price signals as a basis of their lending decisions.

Similarly, there is still much room for further reforming the banking regulations to foster efficiency. For instance, loosening the restrictions on bank consolidation would facilitate greater economies of scale and improve the contestability of the overall banking sector. Imposing stricter limits on banks’ industrial participation, meanwhile, would weaken banks’ vested interest in the borrowing firms and give them more incentives to finance product market entrants.

Beyond bank lending, a level playing field should be established for all types of financial activities, to encourage diversity and integration among intermediaries. In this regard, abolition of state-administered preferential deposit schemes and relaxation of the ceilings on interest rates and fees charged on financial services would induce creation of a wider range of investment vehicles. In a similar vein, modification of the legal and regulatory frameworks facilitating the issuance of financial innovations such as ABSs and CDOs—which has been lagging in many advanced European economies17—as well as of complex corporate securities (e.g., convertible bonds) would be helpful.

Finally, removal of impediments to financial integration—including by expediting harmonization of the regulatory regimes and tax treatment, standardizing the clearing and settlement systems, and relaxing national authorities’ restrictions on cross-border mergers of financial intermediaries—would certainly make the environment more competitive and conducive to efficient financial transactions.18

Guarding against the Risks

The increasing sophistication and complexity of the financial system need to be accompanied by an upgrading of regulatory and supervisory frameworks to promote risk assessment and management capabilities, and transparency, while the threat to financial stability stemming from any inadequacies should be minimized. The recent financial market turbulence triggered by the meltdown of the U.S. subprime mortgage market highlights the need for prudential frameworks—whether adopted by market participants or enforced by regulators—to keep up with the financial innovations. Indeed, insufficient risk assessment and risk management capabilities, and lack of transparency regarding the counterparties’ risk exposures and the origination process, constitute interrelated vulnerabilities that culminated in the recent turbulence.

Managing liquidity and market risks by financial institutions deserves heightened attention. To the extent that these institutions become more reliant on highly procyclical and volatile wholesale funding, their liquidity should be closely regulated (e.g., with respect to the concentration of funding sources) and monitored. In general, as market transactions become more widely used for both liquidity provision and profit generation, prudential risk assessment should focus on not only default risks, but also market risks that can undermine the liquidity and solvency positions of financial institutions. One clear lesson from the recent events is that liquidity risks had not been fully taken into account and had been poorly managed by many market participants.19

Financial institutions, especially nonbanks, need to be encouraged to upgrade their risk assessment models as financial systems grow in complexity and to perform more rigorous due diligence. The tendency of many financial institutions to rely on ratings by external agencies for risk assessment could prove to be risky itself. Ratings by such agencies typically reflect only their assessment of the financial products’ default risks, and not market or valuation risks. Even then, their models on default risk assessment tend to be highly sensitive to certain assumptions grounded in limited historical information (e.g., regarding correlation of defaults on the various underlying assets). Combined with lack of information on underwriting standards, excessive reliance on rating agencies could give rise to systemic and persistent mispricing of risks, as illustrated by recent events.20 While rating agencies should improve and add to their tool kit in light of recent experience,21 financial institutions need to build up their own due diligence capacity as well.

Risk assessment would be facilitated by improving transparency concerning the underwriting standard in the loan origination process. Extending prudential oversight to encompass the loan originators not currently regulated could be considered. Alternatively, the underwriting standard could be verified by a truly independent third party.

Raising the information standard governing the counterparties’ risk disclosure would also be beneficial. Inadequate information about market participants’ risk exposures—especially through their contingent and off-balance-sheet activities—increases uncertainty faced by potential lenders and can cause funding channels to seize up in times of strain. More comprehensive and uniform accounting and regulatory treatment of illiquid financial instruments and contingent and off-balance-sheet items may be necessary.

Finally, authorities’ supervisory capacity may need further boosting. There is scope for greater cooperation among supervisors across sectors and borders. Insurance companies and pension funds have been increasingly assuming the risks transferred from banks via complex financial instruments. Hence, where still insufficient, more sharing of expertise by the prudential supervisors of the insurance and pension industries and their bank colleagues would be highly desirable. The effectiveness of crisis management by the regulators and central banks may need to be reviewed, in particular in dealing with individual problem institutions and system-wide liquidity strains. Overall, central bank responses have been effective, but European authorities may need to strengthen their capacity to enforce early remedial action and to intervene rapidly in troubled institutions in order to preserve overall confidence.

Note: The main author of this chapter is Athanasios Vamvakidis.


In what follows, the group of emerging European economies comprises Albania, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Macedonia, FYR, Malta, Moldova, Montenegro, Poland, Romania, Russia, Serbia, the Slovak Republic, Slovenia, Turkey, and Ukraine. All other European economies are included in the group of advanced economies.


The Services Directive aims at creating a free market for services within the European Union.


For recent empirical evidence, see Vamvakidis (2007).


The EU acquis, or acquis communautaire, refers to the total body of EU law.


Commonwealth of Independent States (CIS) countries covered by the IMF’s European Department are Belarus, Moldova, Russia, and Ukraine.


A recent IMF Working Paper has estimated that such reforms could increase potential growth substantially in Croatia (see Moore and Vamvakidis, 2007).

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