Euro Area Policies: Selected Issues

International Monetary Fund

doi:10.5089/9781451813029.002.A005

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Euro Area Policies: Selected Issues

Author: International Monetary Fund

Publication Date:: 03 Aug 2005

eISBN:: 9781451813029

Language:: English

Keywords:: ISCR; CR; EU bank; market; bank; risk profile; financial system; EU member country; EU banking supervisor; EU-candidate country; Financial integration; Crisis management; Commercial banks; Personal income

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This Selected Issues paper for euro area policies analyzes the product market regulation and benefits of wage moderation. The paper identifies structural shifts in the relationship between wages and unemployment rates—a “wage curve”—in 20 industrial countries. It reviews euro area and cross-country developments in labor costs and their bivariate relationship with unemployment rates and business GDP. The paper also examines aspects of the European Central Bank’s monetary analysis, within the context of their overall two-pillar policy framework, and issues surrounding its use.

Abstract

V. European Financial Integration, Stability and Supervision ¹⁰³

A. Introduction

129. Technological advances, deregulation and the establishment of the Economic and Monetary Union (EMU) have contributed to European financial integration, although progress has been uneven. Most studies conclude that integration of money, bond and equity markets has proceeded apace, while integration of bank credit markets has been slower, and bank retail markets remain highly segmented.¹⁰⁴ Estimates of the “growth dividend” from European financial integration would appear large, as a wider variety of sources of finance for firms and households becomes available (Guiso and others, 2004). To date, the implications of integration for financial stability remain largely unexplored.

130. This paper explores the impact of financial integration for system-wide risk profiles of publicly-traded European financial institutions and assesses the implications for supervision and regulation. It begins with an overview of indicators of banking market penetration (Section B), which point to increasing cross-border exposures and ties in banking. Section C then asks 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. Section D reviews recent developments in the European regulatory and supervisory framework and identifies the challenges posed by the evolving risk profiles in the context of increasing financial integration. Conclusions are summarized in Section E.

131. 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. Increased links stemming from integration of European capital markets may have played a role, as increased exposures have occurred despite the still lagging integration of the relevant retail markets. The lack of improvement in risk profiles suggests that diversification benefits have been offset by higher risk-taking. The convergence of risk profiles across institutions potentially adds a new element of systemic risk that supervisors will need to be attuned to—a challenge that is not unique to Europe.

132. The regulatory and supervisory framework will need to continue adapting to the evolution of cross-border business and risk in the EU banking system. At this point, coherent structures that rely heavily on information exchange have evolved in the EU and appear to work well in normal times. But their fitness for more troubled times in an increasingly integrated EU can be less comfortably asserted. Given the complexities, the ongoing centralization of authority may need to be accelerated and carried further to deal with the supervision of cross-border financial institutions and to ensure speedy and efficient crisis management.

B. Aspects of Integration of Bank Credit Markets

133. National barriers to cross-border banking appear to be only slowly breaking down in the European Union. Foreign bank penetration has proceeded most rapidly in Central and Eastern Europe (CEE), as the less-developed financial systems of transition countries offered significant growth opportunities and a high return on direct investment (Focarelli and Pozzolo (2003), European Central Bank (2004b)). As a result, western European banks expanded rapidly into CEE well before the recent enlargement of the EU eastward and are now important players in the new member states (Box V.1). But cross-border banking penetration has been less visible within the original EU-15 countries.¹⁰⁵ It has been comparatively intense in some countries where language and cultural factors hastened cross-border ties as banks expanded and consolidated to take advantage of economies of scale. And as large European multinational corporations ignore borders, they bank where they can get the most favorable credit terms and the services they need—including outside of Europe. However, as noted in Degryse and Ongena (2004), small- and medium-sized enterprises and households still tend to bank with their local bank, which typically has home-country origin.

134. Nonetheless, indicators of cross-border banking activity point to a steady increase in banking integration in the EU-15 in recent years(Table V.1). Volume-type proxies for integration can be constructed from data on cross-border holdings of credit institutions and foreign exposures from the European Central Bank (ECB) and the Bank for International Settlements (BIS).¹⁰⁶ They show:

Cross-border activity of euro-area banks progressed unevenly across different types of activities. It progressed most rapidly in the area of securities holdings, less in the interbank loan market, and least in loans to non-banks (ECB (2004b)).
Assets of branches and subsidiaries of credit institutions from other European Economic Area (EEA) countries have increased significantly in the banking systems of most EU-15 countries since 1997.¹⁰⁷ The average amount of nonhost EEA banking sector assets has risen from the equivalent of less than 30 percent of GDP in 1997 to over 41 percent of GDP in 2003, with most of the expansion occurring through the increase of activities of subsidiaries.¹⁰⁸ An increase took place in all countries, with the exception of Belgium and Luxembourg—although in both these cases, banks from other European countries were already well established. For most of the smaller countries and the United Kingdom, the assets of other EU banks and subsidiaries are now a sizable share of their domestic GDP but the asset base of other EEA banks remains relatively small in the large continental countries.
Foreign branches and subsidiaries are increasingly likely to come—in some cases almost exclusively—from other EU-15 countries. The share of total foreign branches’ and subsidiaries’ assets that are European has risen on average from about 75 percent to close to 90 percent. The main exception is the United Kingdom, where the rapid expansion of EEA bank branches and subsidiaries has been matched by expansion from other localities, keeping the United Kingdom a large, geographically diverse international center.
Cross-border exposure of EU-15 banks to euro area countries has risen sharply. This rise is driven in large part by banks in London, which is a major financial center, increasing their exposure to euro-area countries. As a result, exposure from the United Kingdom drove total euro-area exposure of banks in the three non-euro EU-15 countries up by over 240 percent in nominal terms from 1999 to 2004. This raised the share of euro-area country exposure in total foreign exposure of the three non-euro countries from 22 percent to 29 percent (Figure V.1). Within the euro area, growth of cross-border exposure of banks to other euro area countries was also rapid, rising some 90 percent in nominal terms in this period. However, this was only sufficient to raise the share of total foreign exposure to other euro-area countries modestly.
European banks, especially those outside the euro area, have increased their share of euro-denominated assets. For many continental countries, the share of euro-denominated banking sector assets has inched up since the introduction of the euro and is at a high level—80–90 percent, for example, in Germany, France and the Netherlands (Figure V.2). For the United Kingdom, the percentage of euro-denominated assets in total assets remains much lower at around 40 percent. However, this percentage increased from just over 30 percent in 1999–2001. Taken together with the data on foreign exposures, it seems that the euro outsiders’ banks have been diversifying into the euro area whereas euro-area banks have primarily been expanding domestically or within the region.

Table V.1.

Assets of Branches and Subsidiaries from EEA Countries

Source: ECB (2004b)

^{^1/}Unweighted average.

Table V.1.

Assets of Branches and Subsidiaries from EEA Countries

	1997	1998	1999	2000	2001	2002	2003	1997	1998	1999	2000	2001	2002	2003
	(In percent of GDP)							(In percent of total foreign assets)
France	14.6	15.4	21.7	29.3	28.4	27.5	24.9	57.5	65.3	76.2	79.1	81.3	86.0	87.0
Germany	6.0	7.3	7.2	7.6	9.7	14.3	13.9	54.7	62.0	62.7	61.4	67.9	78.3	77.6
Italy	8.5	10.3	10.1	8.8	7.4	8.3	8.7	78.2	89.1	92.4	89.8	89.1	89.3	92.1
Spain	15.4	15.0	12.8	13.3	15.1	16.5	20.2	72.0	75.4	78.6	80.4	84.5	86.2	89.9
Large EMU ^1/	11.1	12.0	13.0	14.8	15.2	16.6	16.9	65.6	72.9	77.5	77.7	80.7	84.9	86.6
Belgium	69.5	63.3	62.0	62.5	69.4	65.0	63.6	74.6	78.9	86.3	89.1	91.3	90.7	89.9
Greece	11.9	12.4	15.7	23.5	21.7	25.4	26.5	59.4	63.8	70.3	74.1	76.1	82.2	86.4
Ireland	121.6	146.8	166.5	170.8	178.0	127.8	145.1	87.1	86.9	86.2	85.4	81.5	73.6	75.8
Luxembourg	2798.7	2810.0	2822.6	2617.6	2902.5	2617.4	2495.4	90.3	92.9	93.5	93.3	93.5	94.6	95.1
Netherlands	11.4	12.0	9.3	26.9	28.9	27.2	33.2	68.1	72.2	67.8	84.0	86.8	86.9	88.0
Austria	5.0	3.9	4.2	4.2	50.5	52.9	49.5	65.5	60.9	62.8	58.2	96.3	97.1	96.4
Portugal	31.0	53.9	34.6	57.9	67.7	65.8	68.8	88.4	89.8	84.3	95.3	95.8	96.2	97.2
Finland	8.2	7.7	9.5	7.9	8.2	10.8	9.6	100.0	100.0	100.0	100.0	100.0	100.0	100.0
Small EMU ^1/	382.2	388.7	390.6	371.4	415.9	374.0	361.5	79.2	80.7	81.4	84.9	90.2	90.2	91.1
EMU-11 (ex LX) ^1/	26.2	30.0	30.6	35.6	41.7	38.2	40.1	72.6	76.4	78.8	81.2	86.0	87.6	88.9
Total EMU-12	21.3	23.1	24.8	28.3	31.9	31.6	31.7	74.0	79.3	82.5	83.3	85.6	87.2	87.8
Denmark	9.6	14.4	10.0	13.2	44.0	48.8	48.3	100.0	100.0	100.0	99.4	99.7	99.8	99.7
Sweden	4.2	6.7	5.7	8.4	10.2	11.7	13.8	93.3	95.7	94.6	92.4	93.4	93.6	93.9
U.K.	77.7	82.0	81.6	85.4	89.8	81.2	88.5	45.2	50.9	49.6	48.5	48.8	48.6	45.7
Total non-EMU-3	60.6	65.5	64.9	69.1	76.1	69.9	75.0	45.8	51.8	50.3	49.3	50.5	50.7	47.8
Total EU-15	29.6	32.2	33.7	37.8	42.0	40.4	41.2	58.5	64.4	64.8	64.4	66.4	67.9	65.8

Source: ECB (2004b)

^{^1/}Unweighted average.

Table V.1.

Assets of Branches and Subsidiaries from EEA Countries

	1997	1998	1999	2000	2001	2002	2003	1997	1998	1999	2000	2001	2002	2003
	(In percent of GDP)							(In percent of total foreign assets)
France	14.6	15.4	21.7	29.3	28.4	27.5	24.9	57.5	65.3	76.2	79.1	81.3	86.0	87.0
Germany	6.0	7.3	7.2	7.6	9.7	14.3	13.9	54.7	62.0	62.7	61.4	67.9	78.3	77.6
Italy	8.5	10.3	10.1	8.8	7.4	8.3	8.7	78.2	89.1	92.4	89.8	89.1	89.3	92.1
Spain	15.4	15.0	12.8	13.3	15.1	16.5	20.2	72.0	75.4	78.6	80.4	84.5	86.2	89.9
Large EMU ^1/	11.1	12.0	13.0	14.8	15.2	16.6	16.9	65.6	72.9	77.5	77.7	80.7	84.9	86.6
Belgium	69.5	63.3	62.0	62.5	69.4	65.0	63.6	74.6	78.9	86.3	89.1	91.3	90.7	89.9
Greece	11.9	12.4	15.7	23.5	21.7	25.4	26.5	59.4	63.8	70.3	74.1	76.1	82.2	86.4
Ireland	121.6	146.8	166.5	170.8	178.0	127.8	145.1	87.1	86.9	86.2	85.4	81.5	73.6	75.8
Luxembourg	2798.7	2810.0	2822.6	2617.6	2902.5	2617.4	2495.4	90.3	92.9	93.5	93.3	93.5	94.6	95.1
Netherlands	11.4	12.0	9.3	26.9	28.9	27.2	33.2	68.1	72.2	67.8	84.0	86.8	86.9	88.0
Austria	5.0	3.9	4.2	4.2	50.5	52.9	49.5	65.5	60.9	62.8	58.2	96.3	97.1	96.4
Portugal	31.0	53.9	34.6	57.9	67.7	65.8	68.8	88.4	89.8	84.3	95.3	95.8	96.2	97.2
Finland	8.2	7.7	9.5	7.9	8.2	10.8	9.6	100.0	100.0	100.0	100.0	100.0	100.0	100.0
Small EMU ^1/	382.2	388.7	390.6	371.4	415.9	374.0	361.5	79.2	80.7	81.4	84.9	90.2	90.2	91.1
EMU-11 (ex LX) ^1/	26.2	30.0	30.6	35.6	41.7	38.2	40.1	72.6	76.4	78.8	81.2	86.0	87.6	88.9
Total EMU-12	21.3	23.1	24.8	28.3	31.9	31.6	31.7	74.0	79.3	82.5	83.3	85.6	87.2	87.8
Denmark	9.6	14.4	10.0	13.2	44.0	48.8	48.3	100.0	100.0	100.0	99.4	99.7	99.8	99.7
Sweden	4.2	6.7	5.7	8.4	10.2	11.7	13.8	93.3	95.7	94.6	92.4	93.4	93.6	93.9
U.K.	77.7	82.0	81.6	85.4	89.8	81.2	88.5	45.2	50.9	49.6	48.5	48.8	48.6	45.7
Total non-EMU-3	60.6	65.5	64.9	69.1	76.1	69.9	75.0	45.8	51.8	50.3	49.3	50.5	50.7	47.8
Total EU-15	29.6	32.2	33.7	37.8	42.0	40.4	41.2	58.5	64.4	64.8	64.4	66.4	67.9	65.8

Source: ECB (2004b)

^{^1/}Unweighted average.

Box V.1.

Foreign Bank Penetration in Central and Eastern Europe

Foreign bank penetration in Central and Eastern Europe developed in a markedly different way from cross-border penetration in the EU-15 countries. When the markets for financial services in the 8 CEE countries that joined the EU in 2004, and the three CEE accession candidates Bulgaria, Croatia, and Romania, opened up in the 1990s, western European banks grasped the opportunities for expansion.

This resulted in substantial foreign ownership of well over half of (and in some cases practically all) banking sector assets in almost all of the CEE countries. German, Dutch, and Austrian banks were especially quick to enter the CEE markets, with each having 10 percent or more of total EU-15 exposure to the CEE markets by 1999. Swedish and Finnish banks were also quick to enter the Baltic markets. During 2000-2004, further expansion followed, as Italian banks built up substantial exposure to the markets in Hungary, Poland, the Slovak Republic, and the EU-candidate countries. Most western European banks make substantial profits in their CEE markets. In Austria, for example, CEE activities account for roughly 10 percent of total assets but about one fourth of total Austrian bank profits. However, for most EU-15 countries, the exposure to the CEE countries remains a limited share of their total foreign exposure. Only Austrian and Italian banks currently have more than 10 percent of their foreign exposure in these countries.

135. Large banks in particular have increased their balance sheet, in part through cross-border activities, and expanded their links to financial markets(Table V.2). In recent years, similarities in business strategies can be detected for large banks in all the major EU-15 countries. Most have pursued rapid growth, either organically or through mergers and acquisitions, and have significantly raised their share of noninterest income. Through this process, banks’ incomes have increasingly relied on income generated through financial markets activity. However, whereas the direction of change has been consistent, substantial differences in the structure of balance sheets, as well as in profitability, remain across countries. For example, the average share of noninterest income ranges from 38 percent in France and Germany, to over 50 percent in the United Kingdom and returns on equity in 2003 varied from -6 percent in Germany to over 18 percent in the Netherlands.

Table V.2.

Balance Sheet Data from Individual Banks

Source: FitchIBCA database.

^{^1/}Excluding Credit Agricole because of missing data.

^{^2/}Excluding Deutche Bank for the comparison between 1999 and 2001 and between 1997 and 1999, because of missing data.

^{^3/}Excluding Banca Intensa and UniCredito because of missing data.

^{^4/}Excluding ING because of missing data.

^{^5/}Excluding BBVA (1997 and 1999) and Santander (1997) because of missing data.

^{^6/}Excluding HBOS because of missing data.

Table V.2.

Balance Sheet Data from Individual Banks

		1997	1999	2001	2003	1997	1999	2001	2003	1997	1999	2001	2003
		France				Germany				Italy
Income
	Interest (percentage of total)	75.3	70.4	68.9	61.3	75.1	74.5	72.6	62.0	68.7	59.2	60.4	52.4
	Operating (percentage of total)	24.7	29.6	31.1	38.7	24.9	25.5	27.4	38.0	31.3	40.8	39.6	47.6
Asset growth in 2 years (percentage)			27.5	5.8	64.8		3.9	18.1	11.7 ^2/		8.0	0.7	36.8
Liabilities growth in 2 years (percentage)			27.2	5.6	64.2		3.7	18.0	11.7 ^2/		7.9	0.0	36.0
Return on Equity		9.5	10.4	13.2	10.2	7.0	6.0	1.5	-6.2	-2.9	13.3	10.4	8.0
Total Capital Ratio		10.5	10.9	10.9	12.4 ^1/	9.3	9.9	10.9	12.3	10.0	8.9	8.8	10.3 ^3/

		1997	1999	2001	2003	1997	1999	2001	2003	1997	1999	2001	2003
		Netherlands				Spain				United Kingdom
Income
	Interest (percentage of total)	66.4	65.4	65.8	57.6 ^4/	64.7	61.9	62.2	55.0	58.8	56.4	54.9	47.8 ^6/
	Operating (percentage of total)	33.6	34.6	34.2	42.4 ^4/	35.3	38.1	37.8	45.0	41.2	43.6	45.1	52.2 ^6/
Asset growth in 2 years (percentage)			25.5	19.4	51.6		0.7	17.1	42.5		13.5	74.2	53.5 ^6/
Liabilities growth in 2 years (percentage)			25.4	22.3	51.9		0.5	15.8	42.9		13.0	72.9	54.2 ^6/
Return on Equity		12.8	16.2	17.7	18.5	13.0	16.2	14.3	15.1	22.7	20.8	13.3	16.8
Total Capital Ratio		10.7	10.9	11.0	11.8 ^4/	11.9	10.1	11.2	10.5 ^5/	12.0	13.0	11.9	12.0

Source: FitchIBCA database.

^{^1/}Excluding Credit Agricole because of missing data.

^{^2/}Excluding Deutche Bank for the comparison between 1999 and 2001 and between 1997 and 1999, because of missing data.

^{^3/}Excluding Banca Intensa and UniCredito because of missing data.

^{^4/}Excluding ING because of missing data.

^{^5/}Excluding BBVA (1997 and 1999) and Santander (1997) because of missing data.

^{^6/}Excluding HBOS because of missing data.

Table V.2.

Balance Sheet Data from Individual Banks

		1997	1999	2001	2003	1997	1999	2001	2003	1997	1999	2001	2003
		France				Germany				Italy
Income
	Interest (percentage of total)	75.3	70.4	68.9	61.3	75.1	74.5	72.6	62.0	68.7	59.2	60.4	52.4
	Operating (percentage of total)	24.7	29.6	31.1	38.7	24.9	25.5	27.4	38.0	31.3	40.8	39.6	47.6
Asset growth in 2 years (percentage)			27.5	5.8	64.8		3.9	18.1	11.7 ^2/		8.0	0.7	36.8
Liabilities growth in 2 years (percentage)			27.2	5.6	64.2		3.7	18.0	11.7 ^2/		7.9	0.0	36.0
Return on Equity		9.5	10.4	13.2	10.2	7.0	6.0	1.5	-6.2	-2.9	13.3	10.4	8.0
Total Capital Ratio		10.5	10.9	10.9	12.4 ^1/	9.3	9.9	10.9	12.3	10.0	8.9	8.8	10.3 ^3/

		1997	1999	2001	2003	1997	1999	2001	2003	1997	1999	2001	2003
		Netherlands				Spain				United Kingdom
Income
	Interest (percentage of total)	66.4	65.4	65.8	57.6 ^4/	64.7	61.9	62.2	55.0	58.8	56.4	54.9	47.8 ^6/
	Operating (percentage of total)	33.6	34.6	34.2	42.4 ^4/	35.3	38.1	37.8	45.0	41.2	43.6	45.1	52.2 ^6/
Asset growth in 2 years (percentage)			25.5	19.4	51.6		0.7	17.1	42.5		13.5	74.2	53.5 ^6/
Liabilities growth in 2 years (percentage)			25.4	22.3	51.9		0.5	15.8	42.9		13.0	72.9	54.2 ^6/
Return on Equity		12.8	16.2	17.7	18.5	13.0	16.2	14.3	15.1	22.7	20.8	13.3	16.8
Total Capital Ratio		10.7	10.9	11.0	11.8 ^4/	11.9	10.1	11.2	10.5 ^5/	12.0	13.0	11.9	12.0

Source: FitchIBCA database.

^{^1/}Excluding Credit Agricole because of missing data.

^{^2/}Excluding Deutche Bank for the comparison between 1999 and 2001 and between 1997 and 1999, because of missing data.

^{^3/}Excluding Banca Intensa and UniCredito because of missing data.

^{^4/}Excluding ING because of missing data.

^{^5/}Excluding BBVA (1997 and 1999) and Santander (1997) because of missing data.

^{^6/}Excluding HBOS because of missing data.

136. In summary, the data support a picture of increased cross-border penetration indicative of increasing integration of European banking. Branches and subsidiaries from other EU-15 countries are a rising presence. Cross-border exposures are continuing to grow rapidly. Driven in large part by the banks in London, outsiders are diversifying into euro assets and raising their exposure to euro area countries. That said, the picture remains far from one in which the banks found on High Streets across Europe typically come from a kaleidoscope of countries. Rather, banks from other countries are more likely to be found in a country’s financial center.

C. Evolution and Convergence of Risk Profiles

137. Financial integration may affect individual and system-wide risk profiles of financial intermediaries differentially as it expands their investment opportunities. On the one hand, financial integration may enhance diversification opportunities relative to specialization for individual intermediaries, which may rely on an enlarged set of investments across activities and borders to enhance expected returns for the same amount of risk. On the other hand, a system of intermediaries can become less diversified as a whole if intermediaries either choose greater exposure to the same risks, or the risks they are exposed to become more similar. As such, the probability increases that a large number of financial institutions would adjust in a similar way to an adverse shock, thereby amplifying the overall impact on the economy or financial markets.

138. The extent to which financial institutions’ business strategies tilt toward specialization or diversification has different implications for the evolution and convergence of their risk profiles. If specialization strategies dominate on net, then intermediaries’ risk profiles should exhibit heterogeneity and a lack of convergence. Conversely, if diversification strategies dominate on net, then their risk profiles should become more similar and exhibit convergence. Whether convergence is toward lower or higher risk profiles will be determined by the desired risk-return combination embedded in their business strategies.

139. The dynamics of system-wide risk profiles and their convergence are explored here through the construction of distance-to-default measures for a set of publicly traded European financial institutions during 1991–2003. The distance-to-default (DD) measure is constructed for a “portfolio” of banks and insurance companies belonging to each of the available Datastream stock indices of 13 of the EU-15 countries.¹⁰⁹ The DD varies positively with market-determined returns on assets and capitalization and negatively with the volatility of assets (Box V.2). Thus, an increase (decrease) in DD indicates a lower (higher) risk profile, which can result from higher expected profitability, better capitalization, lower asset volatility, or a combination of these factors. Cross-country convergence (or divergence) in system-wide risk profiles is measured by a decrease (or increase) in the cross-sectional standard deviation of DDs.¹¹⁰

Box V.2.

The “Portfolio” Distance-to-Default Measure

The basic structural valuation model by Black and Scholes (1973) and Merton (1974)—hereafter BSM—underpins the “portfolio” distance-to-default (DD) measure used in this paper. In the BSM model, the portfolio’s equity is viewed as a call option on the portfolio’s assets, with strike price equal to the current book value of total liabilities. When the value of the portfolio’s assets is less than the strike price, its equity value is zero. The market value of assets is not observable, but can be estimated using equity values and accounting measures of liabilities. The monthly DD measures used here are estimated with the methodology described in Vassalou and Xing (2004) using daily equity data and annual accounting data.

Under BSM assumptions, the distance-to-default of a portfolio ofN firms is given by:

D D_{t} = \frac{L n ({V_{t}}^{p} / {L_{t}}^{p}) + (μ_{p} - 0.5 {σ_{p}}^{2})}{σ_{p}}

where $V^{P} = Σ_{i} {V_{t}}^{i}$ and $\begin{matrix} L_{t}^{p} = & Σ_{i} L_{t}^{i} \end{matrix}$ are the total value of assets and liabilities respectively. The mean and variance of the portfolio are respectively given by $\begin{matrix} μ_{p} = & Σ_{i} w_{t}^{i} μ^{i} \end{matrix}$ and $\begin{matrix} σ_{p} = & Σ_{i} \end{matrix} Σ_{j} w_{t}^{i} w_{t}^{j} σ_{i j},$ where $\begin{matrix} w_{t}^{i} = & V_{t}^{i} / Σ_{i} v_{t}^{i} \end{matrix}$ and σ_ij is the asset return covariance of firm i and j. Thus, the “portfolio” DD embeds the structure of risk interdependencies among firms. “Default” at date t + 1 occurs when $V_{t}^{p} < L_{t}^{p} .$ Thus, the DD indicates how many standard deviations $L n (V_{t}^{p} / L_{t}^{p})$ has to deviate from its mean in order for default to occur. Since $\begin{matrix} V_{t}^{p} = & L_{t}^{p} + E_{t}^{p}, \end{matrix}$ where $E_{t}^{P}$ is the value of equity, declines in $V_{t}^{p} / L_{t}^{p}$ are equivalent to declines in capitalization $(E_{t}^{p} / L_{t}^{p}) .$

The “portfolio” DD can be viewed as a risk profile measure tracking the evolution of the joint risks of failure of the firms composing a portfolio. Lower (higher) levels of the DD imply a higher (lower) probability of firms’ joint failure. Since positive and negative variations in the individual firms’ DD are allowed to offset each other owing to firms’ return correlation, the DD of a portfolio is always higher than the (weighted) sum of the DDs of the individual firms. As a result, the probability of “failure” associated with the “portfolio” DD is always lower than that associated with the actual probability of joint failures of sets of firms in the portfolio. Thus, the “portfolio” DD can be viewed as tracking the evolution of a lower bound to the joint probabilities of failure.

Despite the strong underlying assumptions, the dynamics of the “portfolio” DD provide useful information regarding the market valuation of systemic risk potential. The basic DD measures are constructed assuming that asset values follow a lognormal process, which does not capture extreme events adequately, and that the liability structure is composed of only equity and debt with fixed maturity for all firms, and no rollover of debt. As a result, the implied estimates of probability of failure at a point in time may be imprecise. Moreover, without additional assumptions, the measures do not allow an identification of supply and demand factors that may drive their components. However, their dynamics have high informational content in signaling (forward-looking) market valuations of financial distress, as their predictive content for financial distress has been found significant. They have been shown to predict supervisory ratings, bond spreads, and rating agencies’ downgrades in both developed and developing economies (see Krainer and Lopez (2001), Gropp, Vesala, and Vulpes (2004), and Chan-Lau, Jobert, and Kong (2004)). Importantly, they have been found to have significant predictive power for actual defaults, even superior to measures based on “reduced form” statistical models of default intensities (see Arora, Bohn and Zhu (2005)). As a result, they have become a standard tool of surveillance kits for financial as well as nonfinancial sectors.

140. The risk profiles for the sample of banks considered do not in general appear to have improved over the past 15 years. In none of the countries do bank DDs exhibit a systematic or significant upward trend (Figures V.3a -b). Indeed, in 11 out of the 13 countries analyzed, distance-to-default has tended to narrow—although such narrowing is statistically significant only for Belgian, Dutch, and German banks. This suggests that, in most countries, risk reductions achieved through diversification have likely been offset by higher risk-taking. This finding does not appear to be unusual, as similar patterns can be detected for large US banks in this period (see De Nicoló et al. (2004)).

141. Reflecting their wide differences in size, business focus and market penetration, the evolving risk profiles of publicly traded European banks over time are far from homogeneous. In Belgium, Germany, and the Netherlands, and to some extent Spain and the United Kingdom, the DDs exhibit a downward trend since 1991. In most other countries the trend has typically been downward since the mid 1990s, often reversing a preceding upswing.¹¹¹

142. However, the largest banks exhibit more similar patterns, as increases in asset return volatility have not necessarily been offset by increases in capitalization and improvements in asset returns(Figure V.4). With the exception of German banks, large banks in France, Italy, Spain, the Netherlands, and the United Kingdom have experienced significant increases in asset return volatility since the beginning of the 1990s. Substantial increases in capitalization and improvements in returns have occurred as well, but they have not been sufficient to offset increases in risk-taking captured by the rise in asset return volatility. Put differently, large European banks may have supported higher risk/higher return investments with larger capital buffers. Yet, risk-adjusted asset returns and overall risk profiles have not improved.

143. Qualitatively, the dynamics of system-wide risk profiles for insurance companies in most European countries present a similar picture to that of banks(Figure V.5). The distance-to-default has also, if anything, tended to decline rather than increase. Compared to banks, the dynamics of the DD for insurance companies are more heterogeneous across countries. However, the dynamics of risk profiles for banks and insurance companies have become more similar both within countries, and, as documented below, between countries, in part as a result of on-going or increased conglomeration.¹¹²

144. Real business cycle developments do not appear to provide a systematic explanation of risk profile dynamics of bank or insurance companies across countries. The correlation of the cyclical component of the bank DD with the cyclical component of GDP growth varies widely in magnitude. It is significantly negative in 7 countries (Belgium, Germany, Greece, Ireland, the Netherlands, Portugal, and the United Kingdom), while it is positive in Austria, and not significantly different from zero in the remaining countries.¹¹³ This correlation also varies widely for the insurance sectors.

145. Notwithstanding cross-country heterogeneity, the risk profiles of banks and insurance companies converged markedly during 1991–2003(Figure V.6). Convergence of banks’ risk profiles has occurred steadily, with the standard deviation of DDs dropping by over 40 percent (from 3 in 1991 to 1.8 in 2003). Insurance sectors exhibit a similar pattern, with the standard deviation of DDs dropping by 38 percent (from 4.5 in 1991 to 2.8 in 2003). Moreover, the bulk of convergence in the overall DD measures has reflected a decline of the standard deviation of trend, as opposed to cyclical, components. Together with the lack of a systematic correlation across countries between DDs and the business cycle, this suggests that convergence in risk profiles across countries is unlikely to have been driven to an important extent by increased synchronicity in real business cycles.¹¹⁴

146. Increased exposure to financial cycles would appear a significant, although by no means unique, driver of convergence in risk profiles at large listed banks. Integration of money, bond and equity markets may have played a role, as it has likely favored the diversification of institutions’ securities portfolios, which in turn may have increased their exposures to common financial shocks.¹¹⁵ European banks have exhibited a substantial increase in noninterest income (ECB (2004a)). This increase has been accompanied by a volatility of noninterest income growth significantly higher than that of interest income growth at large banks since 1997 (Table V.3). Moreover, the correlation between interest and noninterest income growth has been high (0.79 for the EU-15), indicating decreasing diversification benefits across traditional and nontraditional business lines. These facts, as well as the dominance of convergence of the trend components of DDs, suggest that intermediaries’ business strategies, albeit different in many dimensions, may have produced the same outcome: a heightened exposure to common financial shocks.¹¹⁶ Again, similar results are found for US banks (see Stiroh (2004)). The much less pronounced convergence of the cyclical component suggests that exposures of European banks to common sources of real shocks do not appear to have played a critical role yet, consistent with the current segmentation of the European bank retail markets. Thus, common exposure to financial shocks, as opposed to real shocks, seems to be an important factor explaining the convergence of risk profiles.

Table V.3.

Volatility of Income Growth for Large Listed Banks, 1997-2004^*

^{^*}Source: Bankscope. Volatility is measured by the sample standard deviation.

Table V.3.

Volatility of Income Growth for Large Listed Banks, 1997-2004^*


	# of	Net Interest	NIR minus	Non-Interest	Net Income	Correlation
	banks	Income (NII)	Loan Loss Provisions	Income (NONII)		NII with NONII
France	13	17.4	19.1	18.1	27.7	-0.30
Germany	8	8.2	17.4	12.3	103.6	0.66
Italy	20	6.8	7.4	16.1	254.9	0.15
Spain	9	9.1	8.4	10.7	13.1	0.49
The Netherlands	4	18.8	17.1	26.6	31.8	0.68
U.K.	15	9.2	9.2	11.8	17.8	0.79
EU 15	101	8.3	7.2	12.1	17.7	0.79

^{^*}Source: Bankscope. Volatility is measured by the sample standard deviation.

Table V.3.

Volatility of Income Growth for Large Listed Banks, 1997-2004^*


	# of	Net Interest	NIR minus	Non-Interest	Net Income	Correlation
	banks	Income (NII)	Loan Loss Provisions	Income (NONII)		NII with NONII
France	13	17.4	19.1	18.1	27.7	-0.30
Germany	8	8.2	17.4	12.3	103.6	0.66
Italy	20	6.8	7.4	16.1	254.9	0.15
Spain	9	9.1	8.4	10.7	13.1	0.49
The Netherlands	4	18.8	17.1	26.6	31.8	0.68
U.K.	15	9.2	9.2	11.8	17.8	0.79
EU 15	101	8.3	7.2	12.1	17.7	0.79

^{^*}Source: Bankscope. Volatility is measured by the sample standard deviation.

147. Nevertheless, European banks have undertaken a strengthening of their capital positions and improvements in risk management in the past few years. For instance, the ECB (2004c) reports recent improvements in distance-to-default measures for 37 large EU banks, particularly since end-2003 (chart S43). Such strengthening may have supported increased risk-taking in many instances, but it also helped them to weather a sequence of adverse financial shocks during 2000–03 (ECB (2004a) and ECB (2005)).

148. In sum, convergence of risk profiles of listed banks and insurance companies has occurred despite the still lagging integration of the relevant retail markets. Convergence appears to be the result not of more synchronized business cycles but of increased similarity in income sources and exposures to financial shocks, as financial institutions have pursued common growth strategies. In turn, such strategies may have been favored by integration of money, bond and equity markets and the ensuing diversification of securities portfolios. The similarity of the U.S. and European trends suggest that other drivers not necessarily related to integration per se, such as developments in technologies, may have had an important role.

D. Implications for Regulation and Supervision

149. It is essential that the financial sector regulatory and supervisory system—still largely nation-based—keep pace with the evolving nature of cross-border financial institutions and changing risk profiles. Large firms are increasingly organized along business lines, irrespective of national boundaries and legal corporate structures. Banking regulation and supervision must take account of these structures. Furthermore, the prudential infrastructure must also be designed to accommodate different levels of financial intermediation—and the associated process of catch-up—across different member states, most notably between the EU-15, the new member states, and the accession countries. The priority areas continue to be: (a) coordinated supervision of cross-EU financial institutions, and especially of conglomerates; (b) development of crisis management mechanisms; and (c) convergence of regulatory and supervisory practices. Moreover, progress in the integration of financial markets will benefit from the lower regulatory burdens that will result from greater regulatory and supervisory convergence. The recent Green Paper issued by the European Commission raises a number of these issues and seeks input from the industry and other practitioners on its suggestions how to move forward.¹¹⁷

Supervision of cross-EU financial institutions

150. Financial institutions operating across borders add a degree of complexity to a nation-based system of supervisory bodies.¹¹⁸ In the case of a conglomerate with tri-sector activities in many of the 25 member states, for example, potentially dozens of agencies across the EU could have a supervisory interest. Key questions include: (i) who should take prime responsibility for supervising any particular financial institution with cross-border activities? (ii) is coordination among supervisory bodies both within and across member states satisfactory? (iii) are supervisors’ powers to intervene in problem cases clear? and (iv) are incentives across different supervisory bodies sufficiently compatible?

151. The fundamental principle enshrined in the Codified Banking Directive (2000/12/EC) is that home countries supervise their banks’ foreign branches while host countries supervise foreign subsidiaries, notwithstanding the existing obligation of home country supervisors to also exercise supervision on a consolidated basis. The approach encourages financial integration by essentially permitting a bank to open branches in other member countries under a single license of the head office of the branch. However, supervisory responsibilities are not entirely black and white. A host-country supervisor is responsible for enforcing local liquidity requirements on foreign branches and can take measures to protect depositors in an emergency situation. At the same time, the home-country supervisor is responsible for supervising a parent bank as well as its foreign subsidiaries, on a consolidated basis, while the host supervisor retains responsibility over EU as well as non-EU foreign subsidiaries in its own jurisdiction.

152. For conglomerates, the coordination of supervision has been further clarified in the Financial Conglomerates Directive (2002/87/EC) of December 2002.¹¹⁹ Under the Directive, solvency requirements are imposed upon each conglomerate as a whole, in order to avoid “double gearing.”¹²⁰ All significant intra-group transactions must be reported at least once per year. Each conglomerate has to have adequate risk management processes and internal control mechanisms. The member state that provided the license to the top regulated entity in the conglomerate is responsible for coordination and overall supervision. When requested, the coordinating supervisor and the supervisors of regulated entities within a financial conglomerate shall exchange information essential or relevant to the exercise of supervision. Essential information shall even be volunteered. The coordinating supervisor also gathers and disseminates information in emergency situations.¹²¹ Application of sanctions should also be coordinated. With regard to issues related to the implementation of the Directive, the Commission is assisted by the Financial Conglomerates Committee and the Mixed Technical Group (MTG), chaired by the Commission.

153. In practical terms, however, management of the supervisory process by the coordinating supervisor can be a forbidding task. The appointed agency needs to continually coordinate information gathering and dissemination across all countries and financial sectors in which the conglomerate is active. The range of information to be gathered is broad, as described in Article 12 (1), (a) through (h) of the Financial Conglomerates Directive, which covers identification of the group structure, strategic policies, risk management, adverse developments with regard to the group, and supervisory measures undertaken against the group. The reporting burden of the conglomerate also potentially increases above what is needed to satisfy its national sector reporting requirements, notwithstanding the principle that the coordinating supervisor first take recourse to national sector supervisors when obtaining information (Article 11 (1), final paragraph).

154. Furthermore, lines of responsibility might not always be fully clear. While Article 11 (1) (e) provides the coordinating supervisor with the authority to plan and coordinate supervisory activities with regard to a conglomerate, Article 12 (2) confirms the authority of national sector supervisors to take certain actions with regard to their supervised entities, although consultation with the other involved supervisors is required unless the situation is considered urgent.

155. While the procedures envisaged in the Financial Conglomerates Directive work under routine conditions, their effectiveness could be challenged in a crisis. The procedures rely on good, collegial cooperation and the responsibilities of the coordinating supervisor involve a very considerable up-front investment in supervisory capacity, which will require time and effort to build. Moreover, crisis management is not explicitly covered by the Directive, except possibly in cases of “adverse developments which could seriously affect regulated entities” (Article 12 (1) (g)). Even then, the authority of the coordinating supervisor will not go beyond collecting and disseminating information. The question also arises as to whether, in a crisis situation, the coordinator is best placed to do this, rather than the supervisor closest to the crisis. Crisis management will in any case place cooperation and coordination processes under a considerable amount of stress.

156. As a positive response to potential supervisory coordination problems, various member states have negotiated bilateral or multilateral memoranda of understanding (MoUs). Some examples are provided in Box V.3. The MoUs go beyond the requirements in the Directives. They further clarify responsibilities and actions in the supervision of large financial institutions whose activities could have stability implications for either country. Obviously, any form of cross-border supervision, and in particular intervention, raises issues of responsibility and accountability at a national level.

157. Nonetheless, a remaining fundamental challenge is to better align the incentives of supervisors in different countries. For example, the home supervisor of a large conglomerate may be less concerned than the host supervisor about the activities of a small branch or subsidiary in a small member state, even though the branch or subsidiary may have systemic importance in the host market. Moreover, a home supervisor could be influenced by national interests that could deter timely intervention in a bank operating in another country: reputational issues could be at stake for a marquee financial institution or tax payer funds could be at risk if solvency became a problem.¹²²

158. Given the complexity of the coordination exercise and given that the incentive compatibility problem cannot be entirely eliminated, a case may exist for centralizing elements of supervisory authority at the EU level. It may be that further MoUs, in concert with growing acceptance of a lead supervisor approach, can tie down the key stability concerns where the most important financial conglomerates are involved. However, the potential number of bilateral MoUs is vast and each MoU would in principle need to be continually revised to reflect changes in the financial landscape. And there would remain a risk that reporting lines and obligations would be both unclear and onerous on financial institutions. Thus, some form of centralization of authority may be desirable. Or, as a minimum, the role of national supervisors, as for instance laid down in the Financial Conglomerates Directive and the MoU among supervisors and central banks, may need to be expanded with a mandate to implement actions across the EU, bypassing in certain cases the role of other national authorities.¹²³

Box V.3.

Bilateral Cooperation on Prudential Supervision and Crisis Management

The EU features many MoUs between supervisors. First, an extensive network of some 80 bilateral MoUs exists between supervisors on the exchange of supervisory information relating to home-host issues. Second, a multilateral MoU was concluded on information exchange during times of crisis. This MoU sets out broad modalities of cooperation, and information sharing, and enumerates the types of information to be shared. It also provides for coordination of media communications. Third, the ECB and country authorities recently concluded an MoU on cross-border and systemic issues, involving both supervisors and the ministries of finance of the member states.

In addition, there are various examples of cooperation between European supervisors going well beyond the minimum standards described above. These include:

In the Nordic countries, cooperation goes furthest. The Nordea Group, whose parent company is Swedish and which is in the process of adopting European company status,¹ has subsidiaries in all the Nordic countries. In terms of lending, Nordea bank is the largest bank in Finland, the second-largest in Denmark, the third-largest in Norway and the fourth-largest in Sweden (Swedish Riksbank 2003). Supervisory cooperation between the Nordic supervisors is extensive, with a multilateral memorandum of understanding on crisis management in place (Nordic Central Banks, 2003).

Going forward, Nordea’s planned simplification of its legal structure into a European company would mean that Nordea’s present subsidiaries would become branches of the Swedish parent bank. By the home country principle, this would mean that the Swedish Finansinspektionen would be supervising major parts of the Danish, Finnish, and Norwegian banking sectors. Supervisory authorities from these countries argue that in this case, it would be justifiable that the role and power of the host country authority are broader than what they presently are. Against this background, the Nordic supervisory authorities have launched investigations concerning the impact of the restructuring on cooperation between supervisors (Bank of Finland, 2004).

In the Benelux countries, the formation of the Belgian-Dutch Fortis bancassurance conglomerate in 1990 drove the need for consolidated supervision at the conglomerate level. Against this background, the Belgian and Dutch banking and insurance supervisors concluded specific MoUs covering reporting requirements, the location of activities within the conglomerate, and the modalities of information exchange and consultation between supervisors (Banking, Finance, and Insurance Commission, 1995). Going beyond the specifics of the MoUs, information exchange and cooperation on a practical level are considered to be smooth and effective.

The merger in 2000 between the Austrian Bank, Austria-Creditanstalt, and Germany’s HypoVereinsbank spurred closer cooperation between Austrian and German supervisors. Supervisors from the two countries concluded MoUs in the areas of banking and securities supervision (BaFin, 2004) and work closely together in practice.

1 The European company statute enables the setup of a European public limited-liability company (Societas Europaea or SE). SE status is designed to greatly facilitate cross-border presence of multinationals, or even the movement of the SE’s head office between member states (Council of the European Union (2001)).

159. More centralization does not necessarily mean the creation of an omnibus EU-wide supervisory agency. Various options could be considered that would fall well short of an “EU FSA,” not least because the case for bundling supervision of the different financial sectors under the same roof even within a single country is not clear-cut. And the merits of centralizing supervision of specific sectors, e.g., EU banking, would need careful consideration and in the end would have to rely on some form of local information gathering and supervision.

160. An intermediate option would be to have a two-tiered structure in which the supervision of only the largest European financial institutions is placed in the hands of a centralized body. Such a body would be charged with monitoring the activities of a handful of large banks/conglomerates from a perspective of ensuring EU-wide stability, along the lines of the US Federal Reserve’s Large Complex Business Organization program; the supervision of by far the majority of EU financial institutions would remain with national authorities.¹²⁴ As a first step, the main supervisory authorities involved in monitoring large financial groups could set up more regular sharing of information on strategies, risk profiles and the potential for contagion risks. The EU supervisory committees could also have access to a basic set of information on major EU financial groups in order to be more aware of the conditions and risks of the institutions that are most relevant for the EU as a whole.¹²⁵

161. To be fully effective, however, any centralized supervisory body would need to have clearly defined powers and responsibilities. Thought might also have to be given to whether some other relevant powers, such as lender of last resort (LOLR) function, solvency support, and winding up rules should remain within the competence of national authorities.

Crisis management mechanisms

162. Crisis management mechanisms are currently being revamped in response to the second Brouwer Report of 2001.¹²⁶ The report concluded that the framework of MoUs on supervisory cooperation in Europe was functional but did not adequately address crisis management. It laid down arrangements for supervisory cooperation (lists of contact persons, conduct of on-site inspections and information exchange, etc). On March 1, 2003, the ECB, banking supervisors and EU national central banks agreed on a non-legally binding MoU that sets out high-level principles on dealing with cross-border financial crises in the EU.¹²⁷ The MoU is based on the principle of home country responsibility to inform other involved supervisors and to take most of the crisis management decisions. Host authorities, however, also remain authorized to use their own crisis management tools. In general terms, the MoU sets out the broad modalities of cooperation and information sharing, enumerates the types of information to be shared, and provides for coordination of media communications.

163. The March 2003 MoU, while a positive beginning, is unlikely to be the last word. The framework does not go far beyond information sharing. Individual member states in principle retain their own freedom of action and will be compelled by different national interests and incentives, as discussed above. At the level of the individual member states, the division of responsibilities remains at the discretion of each member state. The MoU does, however, leave the option to conclude “ex-ante agreements” on crisis management between the authorities of the member countries involved in supervising a specific cross-border institution. The MoU does not address the implications of a systemic crisis.

164. A recent additional MoU among Ministries of Finance, national central banks, the ECB, and EU banking supervisors addresses crisis management issues. The focus of the MoU, which was concluded at the ECOFIN meeting of May 14, 2005 and entered into effect on July 1, 2005, remains on information sharing, although it also promotes the development of crisis management tools. Reaching agreement on modalities is a difficult process and the nomination of a lead crisis manager for systemic crises can be expected to be even more difficult than for individual institutions. Member states are likely to want to retain their individual intervention authority, which could hinder effective resolution at the EU level.

165. LOLR issues in a systemic crisis also need to be clarified. The EU member countries are served by the European System of Central Banks (ESCB), consisting of the ECB, and the national central banks. The central banks of the countries participating in the euro area are clearly the largest group, covering roughly half of the countries. National central banks would generally have sufficient resources to cover liquidity problems that individual institutions might face in many cases. In a systemic crisis, however, coordination of LOLR functions would be essential. The present system relies on good communication and understandings between central banks and supervisory agencies.¹²⁸ At the EU level, no formal crisis management committee or similar type of institutional structure has been announced—unlike in some regions, e.g. the Nordics. Operational modalities are, however, tested periodically in “war games” in which failures of systemically important financial institutions are simulated. The war games provide important lessons to central bankers about potential weaknesses in the coordination of responses to a crisis, and provide pointers on how to manage systemic liquidity and avoid breakdowns in payments systems.

166. In order to ensure appropriately prompt resolution of insolvent financial institutions, greater ex ante clarity about the apportionment of fiscal costs would also be helpful. A failure of a large financial institution could exhaust a local deposit insurance system, prompting questions as to “who pays what” and “who receives what.” The cost of cross-border systemic crises can be widely different from country to country, certainly when knock-on effects such as credit access and impact on labor markets are taken into account. Crises with EU-wide systemic importance can cause serious disruption in one country, and much less in another. Deciding fiscal responsibilities is not easy: (i) Should the costs somehow be pro-rated? (ii) Should the home country of a large conglomerate—even if the crisis did not originate in that country—be compelled to contribute more than others? (iii) Should there be provisions to protect smaller markets, where a conglomerate may have systemic dimensions, or to ring-fence assets of the conglomerate in that country? (iv) What should the relationship be between supervisory responsibility and responsibility for bearing the resolution costs in case of problems? It will not be easy to build consensus on answers to such questions.

Regulatory and supervisory convergence

167. Further convergence of laws, regulations, and supervisory practices across EU countries would level the playing field, minimize the regulatory burden on the industry and help lessen some of the conflicting incentives that might arise in a crisis situation. As such, regulatory convergence can contribute to the integration of financial markets, facilitate more effective supervision, and create greater clarity. Such a process will need to be subject to appropriate accountability and transparency arrangements.

168. The streamlining of rulemaking is taking place under the so-called Lamfalussy process. The Lamfalussy process was initially designed to streamline the regulatory process of the securities sector within the EU. However, in response to pressures to integrate EU financial markets, the Council of Ministers of Finance of the EU invited the European Commission to extend the Lamfalussy process to banking, insurance and investment funds in order to establish a new financial services committee organizational structure.¹²⁹ The key concept of the Lamfalussy process is to move much of the discussion on technical aspects and supervisory practices “downstream” to technical committees, thereby avoiding lengthy discussions at the political level. It distinguishes four levels in the EU financial rulemaking architecture: Level 1 (legislative)—adoption of principle-based directives by the EU Council of Ministers and the European Parliament in “co-decision” procedures; Level 2 (technical implementation)—secondary legislation based on the directives, proposed by the European Banking Committee (EBC),¹³⁰ with technical advice from the Committee of European Bank Supervisors (CEBS), to the Commission for enactment by the latter; Level 3 (exchange of information, cooperation and convergence of supervisory practices)—CEBS¹³¹ with a mandate to promote consistent implementation of level 1 and 2 rules by member states; Level 4 (strengthened enforcement)—enhanced enforcement of EU financial rules by the European Commission, member states, regulatory bodies and the private sector. Although a preliminary assessment by the Commission suggests the Lamfalussy process is having a positive impact on securities markets regulation, it is too soon to assess whether it is achieving its objective of greater rulemaking flexibility and efficiency in banking.

169. Even so, the rulemaking process remains populated by numerous committees and advisory bodies, which detracts from its efficiency. In the banking area, for example, eight different agencies and bodies are involved in maintaining banking sector soundness and stability (Box V.4). The structure ensures inputs from most relevant parties. However, inclusiveness and multiple layers of decision-making may become a liability when too many conflicting interests need to be reconciled—a problem that has increased with the accession of ten new member states. Therefore, a new round of restructuring may be worth considering, possibly in the context of the second evaluation of the Lamfalussy process in 2007, as envisaged in the Commission’s Green Paper.

170. Convergence of regulatory and supervisory practices and standards has proceeded on a number of fronts. Some of the most important initiatives undertaken, with CEBS carrying much of the agenda, include the introduction of International Financial Reporting Standards (IFRS) in the EU per January 1, 2005 and reinforcement of rules on statutory audits. These measures will provide an important contribution to the elimination of differences in accounting systems across the EU. Furthermore, in the context of the debate on IAS 39, CEBS has drafted a proposal to IFRS for the development of prudential adjustments (“prudential filters”) in order to avoid any unintended changes in prudential computations under IAS 39 which could be counterproductive from a supervisory point of view. The Commission’s “Green Paper” on post-FSAP financial services policy suggests a number of measures to further level the playing field for financial services, including a “Financial Services Rulebook” to simplify and consolidate all relevant (national as well as EU) financial services rules.

Box V.4.

Key Bodies in the EU Banking Sector Supervision and Stability Architecture

European Banking Committee(EBC): high-level representatives of the Ministers of Finance of member states, chaired by the Commission; the ECB, the chair of CEBS, and (optionally) national central banks may participate as observers. The EBC advises the Commission on policy issues related to banking activities and on Commission proposals in the banking area. The EBC is a “Level 2” Lamfalussy Committee.

Committee of European Banking Supervisors (CEBS): representatives of supervisory authorities and central banks of the EU member states and the European Central Bank (ECB) as a non-voting member; only supervisory authorities have voting rights. CEBS’ main focus is regulatory and supervisory convergence. Tasks include promoting supervisory cooperation, exchange of information on individual institutions including in distress situations, issuance of nonbinding interpretative guidelines and recommendations on regulations, setting standards in areas not covered by Level 1 or 2 legislation. Supporting working groups comprise: the former Groupe de Contact of European supervisors;¹ technical working groups on capital requirements, accounting and auditing; a Task Force on Supervisory Disclosure; and a temporary committee on bank reporting. A Consultative Panel of market participants has been formed to secure input from market practitioners. CEBS is a “Level 3” Lamfalussy committee.

European Central Bank (ECB): Financial stability monitoring in cooperation with national central banks and supervisory agencies (annual report on “EU Banking Sector Stability”); publication of the Financial Stability Review; advice on financial rulemaking within the “Lamfalussy” structure; participation in the Basel Committee on Banking Supervision, the EBC and CEBS (observer status). For a central role of the ECB in banking supervision in the EU, the EU Council must activate Article 105 (6) of the Treaty. This is politically unlikely at this time.

ESCB Banking Supervision Committee (BSC): National central banks, banking supervisory authorities and the ECB; BSC plays a key role in the preparation of supervisory MoUs between EU supervisors. It also performs macro-prudential and structural monitoring of the EU financial system, and analyzes the impact of regulatory and supervisory requirements on financial stability. Preparatory work is performed in four working groups: macro-prudential analysis; structural developments in the EU banking sector; crisis management, and credit registers.

Economic and Financial Committee (EFC): Deputy-Ministers of Finance, the European Commission, the ECB and the national central banks; it provides high-level assessments of developments in financial markets and services, and advises the ECOFIN and the Commission.

Financial Stability Table (FST): twice per year (April-September), the EFC meets in a special composition, including CEBS, the other level-3 Committees for securities and insurance (CESR and CEIOPS), as well as the BSC, under the heading “Financial Stability Table,” to discuss financial stability issues. The discussion of banking issues is based mainly on ECB reports and the ECB Financial Stability Review, and on ad-hoc input from CEBS. The FST has recently prepared, with the assistance of the FSC, an MoU on systemic crisis management among Ministers of Finance, banking supervisors, national central banks and the ECB, which was adopted at the ECOFIN on May 14, 2005.

Financial Services Committee (FSC): previously the Financial Services Policy Group, the FSC is composed of representatives of the Ministries of Finance, the Commission, the ECB and the chairpersons of the Level 2 and 3 Committees of the three sectors (ECB and Committee chairs have nonvoting observer status). It discusses and provides guidance on cross-sector strategic and policy issues, especially technical and political aspects, and assists the EFC in preparing ECOFIN meetings.

Financial Conglomerates Committee (FCC): created by Directive 2002/87, the FCC provides guidance to EU supervisory authorities on the implementation of conglomerate supervision.

1 The Groupe de Contact was initially created in 1972 and recognized by the First EU Banking Directive of 1977.

171. The EU also envisages a synchronized and largely harmonized adoption of Basel II. This would encompass common guidance on the supervisory review process (Pillar 2 of the new Basel Capital Adequacy Framework; consultation draft forthcoming), as well as guidance for validation of internal ratings-based credit risk and operational risk approaches. The risk of an unlevel playing field under Basel II has been further reduced by a limitation of the number of items of national discretion. The adoption of the concept of the “consolidating supervisor” will facilitate dealing with home-host issues, as will the issuance of common guidelines on home-host issues (consultation draft forthcoming). Common implementation of Pillar 3 of Basel II will be further facilitated by the issuance of a common framework for supervisory disclosure. Building on the common introduction of IFRS and Basel II, CEBS is also developing a common framework for bank balance sheet and income statement data and common reporting of the solvency ratio; reporting is to take place using XBRL (Extensible Business Reporting Language), facilitating consistent compilation of capital data across the EU.

172. Further convergence in deposit insurance and legal frameworks for bank resolution remains necessary. Although consistent with the Deposit Insurance Directive (94/19/EC), deposit insurance schemes vary widely on important issues such as amount of coverage—even within countries, between domestic banks and branches of banks from other EU countries—co-insurance, risk-based premiums, and funding (see Garcia and Nieto (2005)). In about a fourth of member countries, institutions can offset claims on depositors, providing a disincentive to depositors from abroad. These essential differences are not only a source of uncertainty for depositors, and hence a barrier to more integration of retail banking, but also complicate the “who pays what” problem described in the preceding section. Likewise, the need to further develop common legal frameworks for resolving problem banks adds to the complexity of managing failed institutions operating in more than one European country. These issues are partially dealt with in Directive 2001/24/EC on the Reorganization and Winding–up of Credit Institutions.

E. Conclusions

173. Supervision and regulation will need to continue to evolve to keep up with the changing shape of the financial system, changing corporate structures and management practices, as well as evolving risk profiles. Although the EU is far from a single market in banking and insurance services, internal borders are increasingly porous. Financial institutions have grown rapidly in size and their cross-border ties are becoming increasingly complex, as they follow the transnational development of their large corporate clients. At the same time, market-based indicators suggest that aggregate risk among large banks in the system has not necessarily declined while the convergence of risk profiles across institutions and countries is a potential new source of systemic risk. Against this background, the EU is adapting the supervision of cross-border financial conglomerates, strengthening crisis management, and rationalizing the legislative and regulatory process through the Lamfalussy process.

174. Under the current system of nation-based supervision, the challenge will be to align the incentives of different supervisory bodies and continue to improve coordination. However, while the specter of “too many cooks” retains its relevance, the EU has already taken a number of steps in this direction. Aside from the regulatory convergence already undertaken within the regulatory committees such as CEBS, the Maastricht Treaty itself—subject to activation of the relevant provision by the European Council—potentially envisages a more important role of the ECB in financial supervision. Moreover, individual member countries and regional groups are responding to the challenge through closer cooperation and the use of bilateral MoUs. An EU-wide MoU on crisis management has been concluded in 2003, and an MoU on how to deal with systemic crises was recently concluded. The ECB and other central banks also conduct war games to test crisis readiness. Nonetheless, further steps toward some form of more centralized supervision, perhaps at least of the largest financial conglomerates, should be considered. Meanwhile, efforts should continue to promote convergence of laws and regulations across EU countries, including the harmonization of deposit insurance schemes and bank resolution frameworks.

175. The trend towards a more integrated prudential system is driven by the financial sector integration process itself, which in turn follows integration developments in the real sector. The markets demand a regulatory and supervisory system that avoids unnecessary regulatory burdens, complexity, and constraints. At the same time, the gradual transition of the nation-based supervisory system in the EU to a more integrated system, while advancing, is encountering more resistance.

176. Clearly, the current debate is not about “national versus central” regulation and supervision, but about (i) how far and (ii) how fast to move in the direction of centralization. An “organic” approach to further centralization may be attractive from some perspectives but leaving supervision to catch up with business practices may in the end prove not only more costly, but also leaving supervisors without the necessary tools in time of need.

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103

Prepared by Gianni De Nicoló (RES), Robert Corker, Alexander Tieman, and Jan-Willem van der Vossen, with research assistance from Marianne El-Khoury (all MFD).

104

See Barros and others (2005), Baele and others (2004), Adjaouté and Danthine (2004), and Adam and others (2002) for definition of indicators of financial integration and relevant evidence. See also Chapter IV.

105

The EU-15 comprise: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom.

106

For a discussion of quantity-type measures of integration, see Manna (2004). Annual data from the ECB on assets of EU branches and subsidiaries of foreign credit institutions from countries inside the European Economic Area is available from 1997 to 2003. Quarterly data from the BIS on foreign exposures is available from 1999:Q2 to 2004:Q3 for most countries in the euro zone and the United Kingdom

107

EEA countries are selected for consistency with the relevant statistics produced by the ECB for earlier years.

108

This despite the fact that for branches the European ‘single passport’ applies. The single passport enables a bank to branch into other EU member states’ markets based on its home country banking license, without requiring additional licensing by the host country authority.

109

Distance-to-default type measures are routinely used in leading financial stability reports, such as the ECB and the Bank of England Financial Stability Reviews. The number of banks in the available index of each country is: Austria (8), Belgium (7), Denmark (9), France (8), Germany (16), Greece (9), Ireland (3), Italy (29), the Netherlands (4), Portugal (7), Spain (15), Sweden (5), and the United Kingdom (11). The number of insurance companies in the available index of each country is: Austria (3), Denmark (3), France (6), Germany (15), Greece (1), Ireland (1), Italy (10), the Netherlands (2), Spain (2), and the United Kingdom (15).

110

As illustrated in Solnik and Roulet (2000), the evolution of the cross-sectional standard deviation for a set of variables captures the degree to which correlation among these variables changes through time.

111

The initial upward trend in Sweden is essentially the outcome of the banking crisis of the early 1990s, when financial institutions experienced a large drop in the DD measure.

112

See Deutsche Bundesbank (2005). On the relationship and evidence between conglomeration and risk in an international context, see De Nicoló et al. (2004).

113

Trend and cyclical components are constructed by applying the Hodrick-Prescott filter to monthly frequency data, adopting the value of the smoothing parameter used in Ravn and Uhlig (2002). The filter is applied to interpolated quarterly GDP growth data for the 1985.1-2003.4 period.

114

Other factors potentially at work may be a clustering of traders’ strategies increasing co-movements in volatility, as well as converging market valuations of risk management practices.

115

Potential increases in direct risk interdependencies in the form of heightened exposures to potential contagion have been documented in ECB (2004d).

116

Some caution about generalizing the conclusions to the entire European banking sector is warranted. Whereas the Bankscope data cover the largest banks in the EU, in some countries (e.g., Germany) with low banking concentration a large share of banking assets is not represented. That said, ECB (2000) documented the similarity in volatility of interest and noninterest income with data up to 1998 for all banks and highlighted the possibility that bank operational, reputation and strategic risks associated with the increased importance of activities generating noninterest income may have heightened at that time.

117

See European Commission(2005).

118

For an overview of the supervisory framework for conglomerates, see Dierick (2004).

119

The Directive has yet to be fully implemented in all countries.

120

Also see Directive 2002/87/EC, Annex I.

121

In this connection, questions have been raised whether national regulatory and supervisory authorities provide sufficient information on individual institutions and groups to the ECB. In an article in the April 29, 2005 Wall Street Journal, for example, G. Thomas Sims remarks that many national central banks “refuse to regularly share [with the ECB] information about the banking sector [sic] because they say it would break confidentiality agreements with banks in those countries.” The article quotes Mr. Padoa-Schioppa as saying that, as a result, the ECB “lacks a full view” of the financial system.

122

See also Walkner and Raes (2005) for further discussion of incentive issues.

123

For an interesting discussion of this and other options for the institutional setting for financial supervision in the EU, see Schoenmaker and Oosterloo (2005).

124

For example, in 2004, the 13 most internationally active banks in the EU accounted for about one fourth of total EU banking assets. In the EU-15, there are more than 7,000 other credit institutions.

125

These ideas for information sharing were advocated by ECB Executive Board Member Padoa Schioppa in a speech in March 2004 (http://www.ecb.int/press/key/date/2004/html/sp040322.en.html).

126

Report on Financial Crisis Management, Brussels, April 17, 2001, EFC/ECOFIN/251/01-en-Final.

127

Cooperation with non-EU authorities is outside the scope of the MoU, the full content of which has not been disclosed to the public.

128

In principle, the ECB has not made a commitment to provide LOLR facilities beyond the euro area so as not to engender moral hazard problems.

129

Directive of the European Parliament and of the Council of Ministers amending Council Directives 73/239/EEC, 85/611/EEC, 91/675/EEC, 93/6/EEC and 94/19/EC; 2002/83/EC and 2002/87/EC.

130

Commission Decision of November 5, 2003, 2004/10/EC.

131

Commission Decision of November 5, 2004, 2004/5/EC.

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Euro Area Policies: Selected Issues

Author: International Monetary Fund

Volume/Issue:: Volume 2005: Issue 266

Publisher:: International Monetary Fund

ISBN:: 9781451813029

ISSN:: 1934-7685

Pages:: 180

DOI:: https://doi.org/10.5089/9781451813029.002

Keywords
V. European Financial Integration, Stability and Supervision 103
E. Conclusions
References

View raw image

Consolidated Foreign Exposure

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Euro-Denominated Assets of the Banking System

(In percent of total assets)

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Bank Distance to Default and Trend Component

(Large EMUs)

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Bank Distance to Default and Trend Component

(Small EMUs and Others)

View raw image

Large Banks: Market-based Returns, Volatility and Capitalization

(January 1991=100)

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Insurance Distance to Default and Trend Component

View raw image

Convergence of Bank and Insurance Distant to Default

Table V.3.

Volatility of Income Growth for Large Listed Banks, 1997-2004^*


	# of	Net Interest	NIR minus	Non-Interest	Net Income	Correlation
	banks	Income (NII)	Loan Loss Provisions	Income (NONII)		NII with NONII
France	13	17.4	19.1	18.1	27.7	-0.30
Germany	8	8.2	17.4	12.3	103.6	0.66
Italy	20	6.8	7.4	16.1	254.9	0.15
Spain	9	9.1	8.4	10.7	13.1	0.49
The Netherlands	4	18.8	17.1	26.6	31.8	0.68
U.K.	15	9.2	9.2	11.8	17.8	0.79
EU 15	101	8.3	7.2	12.1	17.7	0.79

^{^*}Source: Bankscope. Volatility is measured by the sample standard deviation.

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Abstract

V. European Financial Integration, Stability and Supervision 103

A. Introduction

B. Aspects of Integration of Bank Credit Markets

C. Evolution and Convergence of Risk Profiles

D. Implications for Regulation and Supervision

Supervision of cross-EU financial institutions

Crisis management mechanisms

Regulatory and supervisory convergence

E. Conclusions

References

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