28 November 2007

Article Mario Draghi: Transformation in the European Financial Industry

Current developments in financial markets will probably lead to a divergence in banks’ performance and stimulate cross-border consolidation. However the consolidation process is not irreversible, nor does it take but one shape.

Two forces may soon reshape the European asset management industry. On the supply side, regulatory changes are opening up the field for competition. At the same time, demand is changing considerably in response to aging and pension reforms, which expose households to financial and longevity risk.

Changes may already be under way. Vertical integration is decreasing. Some leading US banking groups have recently sold their asset management divisions to independent investment managers, in order to concentrate on core activities and avoid the conflicts of interest inherent in the marketing of in-house products. These changes could set the stage for the emergence also in Europe of a few specialized asset managers operating on a truly continental and possibly global scale.

Consolidation and the increasing integration of exchanges present policy makers with new challenges. The first is that the benefits of integration can be reaped in full only to the extent that there is full integration. This leads naturally to the second issue: what regulatory framework is best suited to a rapidly integrating marketplace?

Post-trading infrastructure plays a key role in financial markets, since it affects the liquidity and integrity of trading, portfolio diversification and risk sharing. The optimal industry structure in Europe would most likely consist in a small number of providers in competition with each other. The regulatory framework should aim only at preserving the contestability of the business.

The Payment Services Directive establishes a new category of players – “payment institutions” – that can offer a wide range of commercial and financial products and services in all EU countries.

The effect of monetary policy on bank credit supply and transmission through the “bank lending channel” have become less powerful than in a fairly recent past, although possibly more dependent on cyclical factors.

Events since the summer have shown that this system is inherently prone to liquidity crisis. These crises are large and sudden, and affect both types of intermediary. Central banks face a twofold challenge: to achieve their institutional objectives – price stability, in the case of the ECB – and to maintain financial stability while ensuring that the liquidity they inject reaches the points of the financial system where it is most needed.

This last objective has proven more difficult than expected. Until the recent crisis, for central banks lending at penalty rates to illiquid but solvent institutions and the lists of acceptable collateral and counterparties were fairly uncontroversial. Now they are the object of a ranging reflection within the relevant committees, and the Financial Stability Forum will report on it in the course of 2008.

The financial turmoil of recent months has tested all our institutional arrangements, but central banks generally and the ECB in particular have maintained a monetary policy stance consistent with their target while doing everything in their power to preserve world financial stability. They have shown how important it is to keep a firm anchor for price expectations, especially in times of great market turbulence.

© Graham Bishop