The report looks into the close links between stability and integration of the financial sector that have become apparent in this new phase of the crisis. It also takes a forward-looking approach in an attempt to cast a glimpse into the future shape of the European financial sector once the crisis is overcome.
The 2010 European Financial Stability and Integration Report looks into the close links between stability and integration of the financial sector that have become apparent in this new phase of the crisis. Chapters 1 and 2 provide an account of market developments in the financial sector and the EU policy response during 2010. In addition, the report takes a forward-looking approach in an attempt to cast a glimpse into the future shape of the European financial sector once the crisis is overcome.
Financial integration has been and remains a major policy objective of the European Union in order to enhance economic efficiency, stability and growth. A more integrated and innovative financial sector reduces financial intermediation costs and provides financial instruments that better meet the demands of investors and borrowers. By providing better opportunities for risk diversification and better access to funding, financial integration can also contribute to financial stability. However, while the expected efficiency gains have largely materialised, the process of financial integration of the past decade was also associated with an unprecedented accumulation of risks. Unsustainable credit growth ensued and part of it was quite clearly linked to better opportunities for cross-border activities and competitive pressure to seek higher yields in riskier market segments. At the same time, EU financial regulation and supervisory practices lagged behind the highly integrated, fast expanding and sophisticated financial sector. The report shows how the ensuing crisis has not only undermined economic and financial stability, but also led to cross-border financial disintermediation during the crisis and diverging trends unfolding in certain market segments.
The analysis of developments in the financial markets during 2010 reveals some reassuring facts alongside new issues for policy attention. Chapter 1 of the report shows that the resilience of the financial sector and market stability improved, although large parts of the necessary process of restructuring in the banking sector are yet to come. Also, while systemic risk affecting the entire EU financial sector receded over the past year, distinct vulnerabilities remain: credit risk has become more country- and institution-specific, the outlook for continued strong bank earnings remains uncertain, roll-over risk remains present in the sovereign debt market, and the risk of crowding-out of private debt by sovereign debt issuance will increase in the recovery.
Low interest rates and government support favoured bank profitability and recapitalisation, but limited lending to the non-financial sector and in particular to SMEs remains a concern, even if in 2010 this was mostly due to subdued demand for bank credit. Larger non-financial companies were able to reorientate themselves towards tapping domestic or crossborder corporate bond markets. This may signal a change in the structure of financial intermediation in Europe, which has so far been mostly reliant on the banking channel. At the same time, further reorganisation in the banking sector might occur in a number of countries when normal market conditions are restored.
The deleveraging process in the banking sector that accompanied the crisis has affected more prominently the cross-border flow of capital, not only in Europe but also on a global scale. The reassessment of risk led to a sudden deterioration in access to foreign finance for banks in some countries, followed by strong disintermediation across borders. A retrenchment of cross-border lending can be detected in terms of both flows and diverging prices in 2010. Nevertheless, the main cross-border market integration channels remain in place, as illustrated by the resilience of cross-border branches and subsidiaries, cross-border membership of trading and post-trading platforms, and further progress achieved in migrating to a Single Euro Payments Area. Therefore, financial integration is likely to deepen further at a more sustainable pace when financial stability is restored.
Disruptions in the functioning of the inter-bank and wholesale money markets also suggest that integration in these markets was not as solid and advanced as often assumed before the crisis. These markets receded along national lines as risk assessment became more country-specific. The trend was mainly driven by the perceived vulnerability of some banking sectors interlinked with the fiscal weaknesses of the respective sovereigns. This is an example of how financial stability problems can have a direct impact on the process of financial integration. It shows the importance of continuing policy measures at both EU and national level for ensuring stability and adequate interconnection of European financial market infrastructures. It also points to the need for full implementation of fiscal consolidation programmes in order to restore market confidence.
Thus, the financial turmoil has put the integration of EU financial markets to the test. The policy response has consequently relied on further measures fostering both stability and integration. Learning from the lessons of the crisis, the EU has embarked on an ambitious process of strengthening the regulatory and supervisory framework to prevent future crises. These policy developments are covered in Chapter 2.
In this policy process, the year 2010 marked decisive progress in moving from shortterm crisis responses to implementing a policy agenda oriented towards re-building a sounder financial sector able to foster sustainable growth.
The main building blocks of the regulatory reform aim to reinforce the bed-rock foundations of the financial system: appropriate levels of high quality capital in the banking sector and good supervision of financial institutions. Thus the EU policy agenda in 2010 primarily focused on developing a new institutional framework, while enhancing crisis prevention, resolution and efficiency.
• The crisis made apparent the mismatch between the highly integrated EU financial markets and predominantly national supervisory structures. The creation of a new architecture of financial supervision in Europe, consisting of three new European Supervisory Authorities for the banking, securities markets and insurance and occupational pensions sectors, is a key moment in the Commission's reforms. These agencies have started operating in January 2011. The European Systemic Risk Board, which started operating also in January 2011, is charged with monitoring and issuing recommendations regarding the potential threats to the stability of the European financial system.
• Enhanced capital requirements will contribute to crisis prevention as strengthening micro-prudential regulation is the first line of defence. The Commission contributed to the new Basel agreement on bank regulation (Basel III) in 2010, to be introduced in an upcoming amendment of the Capital Requirements Directive (CRD IV). The crisis has shown that crisis prevention is not enough. Hence work progressed towards ensuring an adequate framework for the orderly resolution of failing financial institutions, in particular in a cross-border setting.
• In addition, the European Financial Stabilisation Mechanism (EFSM) and the European Financial Stability Facility (EFSF) were established in 2010 to provide up to EUR 500 bn to Member State governments and reduce tensions in euro area sovereign debt markets. In December, the European Council agreed to establish the permanent European Stability Mechanism (ESM) that will come into existence in mid-2013. The ESM complements the new framework of reinforced economic governance which aims to ensure effective and rigorous economic surveillance in the EU.
While efforts are focused on reinforcing stability and furthering integration, more attention is paid now to improving the efficiency of the financial sector for the benefit of its users. A series of policy measures were advanced with the Single European Payments Area as the flagship. Policy developments are also benefiting from increased attention towards qualitative aspects. Enhanced focus on structural issues related to the organisation and corporate governance of financial institutions, more integrated and comprehensive impact assessments and greater emphasis on the benefits accruing to consumers are likely to improve the quality of policy making in this area.
Finally, in parallel to the EU policy response to the financial crisis, the financial sector has itself started to adjust to the recent crisis experiences and emerging regulatory requirements. Among many other issues, the crisis has reopened the discussions around the advantages and disadvantages of various bank business models for cross-border banks. The report’s special feature is based on the replies of eight large pan-European banks to a questionnaire on issues related to their funding functions and risk management. The crisis has challenged different arrangements and models adopted by EU cross-border banks and triggered internal restructuring. The various newly adjusted forms of funding, liquidity and risk management seem to be independent of the legal form selected for entry (i.e. branch or subsidiary). A clear conclusion emerges from this study: the risk management function has become more centralised, and most of the banks are moving in this direction, which is more compatible with safer and more integrated financial intermediation.
Full report
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