14 June 2013

ECB/Asmussen: Reintegrating financial markets

Speaking at the General Assembly of the ESBG, Asmussen referred to the problem of financial fragmentation as being "a key issue in all parts of the euro area". His approach to the problem came from three angles: the roles of governments, the ECB and the future banking union.

I begin with the role of governments because it is important to stress that they have the first responsibility for dealing for financial fragmentation. While there is much media focus on ECB actions and banking union, it is only really governments that can deal with the root causes of the current situation.

There are three channels where this is particularly relevant. First, one cause of financial fragmentation is the high public debt levels in some euro area countries, which, as domestic banks are heavily exposed to their own governments, harms banks’ asset quality. In Italy, for instance, 65 per cent of bonds were held domestically in early 2012, and in Spain 70 per cent. Clearly, governments have a central role in dealing with this problem by ensuring that their debt is safe and sustainable. This requires credible fiscal consolidation.  Second, another cause of fragmentation is low growth, which deters banks from taking risks, especially lending to SMEs. Interest rate spreads on SME loans compared with those for large non-financial companies have widened by an average of 40 basis points since 2010. A key part of the solution here has to be structural reforms that improve the medium-term growth outlook and hence support risk appetite. Only governments can introduce them. Third, fragmentation is also caused by weak bank balance sheets. Lack of capital, weak profitability or rising non-performing loans lead to lower credit provision or higher interest rates being charged on new loans to offset losses elsewhere. But it is governments that have to deal with this problem through recapitalisation and restructuring.

What is then the role of the ECB in addressing financial fragmentation?

The ECB necessarily operates within certain constraints. We are the European Central Bank, and so our focus is the euro area as a whole, not the concerns of any particular country. And we can only address issues that fall within our mandate to maintain price stability.

Within these constraints, we have acted to reduce financial fragmentation in two key ways. First, we have taken measures to reduce divergence between countries caused by bank funding risk. We have provided unlimited liquidity to banks in need at fixed interest rates, extending the maturity of our operations up to three years. We have allowed national central banks to tailor collateral rules to national conditions. And we have narrowed the interest rate corridor between the deposit rate and our main policy rate to 50 basis points, which reduces cross-country heterogeneity in funding costs. All this was designed to support the transmission of our low interest rates more evenly across the euro area.

Second, we have taken measures to remove fragmentation caused by redenomination risk. This risk was affecting some countries more than others as markets feared that, if one country were to leave the euro area, a domino effect would force certain others to leave as well. According to calculations, the redenomination premium being paid by Spain and Italy in July 2012 was up to 2 per cent. And the threat this posed for future price stability was evident in the cost of deflation protection in the euro area: this rose from 198 bps in January 2012 to a peak of 270 bps in July that year.

Our answer to this was the Outright Monetary Transactions (OMT) programme. Its effects have so far been powerful, not only in reducing sovereign spreads, but also in improving funding conditions for corporations, banks and individuals across the euro area. Financial fragmentation has been reduced, as shown by the best summary indicator, the level of Target2 balances. They have declined by €285 billion, or 25 per cent, since the peak last year. It is important to stress, however, that the benefits of lower financial fragmentation are not only being felt in struggling countries. I am aware that some of you here are concerned by the current low interest rate environment, as it reduces income for savers and squeezes returns for pension funds and insurance companies. Moreover, some are rightly worried that interest rates that are too low for too long could lead to misallocation of resources and reduce incentives for governments, banks, and corporates to adjust.

The creation of a common supervisory approach is essential to ensure that the overall system plays by a single set of rules. But it will not greatly affect day-to-day supervision for savings banks such as most of yours. This will still be carried out by local supervisors who understand the specificities and needs of smaller institutions. The SSM is not being created to interfere where local supervision functions well, but to ensure that there are no “blind spots” from which financial instability could emerge – as the crisis has shown, we cannot afford for even smaller banks to be completely off the radar.

The comprehensive assessment of banks under direct ECB supervision will involve an Asset Quality Review and Balance Sheet Assessment to be conducted by the ECB in the first quarter of 2014. This will then feed into the overall stress test to be conducted by EBA, in cooperation with the ECB, in the second quarter of 2014. This assessment is essential to ensure that the SSM starts with a clean slate and gain credibility in the market – we therefore want it to be as rigorous as possible.

How will these developments help financial fragmentation? First, the creation of a common supervisory approach, together with uniform data reporting requirements, should reduce compliance costs for banks and encourage greater cross-border banking activity. Second, the comprehensive assessment, if conducted to a high standard, should increase confidence in the overall health of the euro area banking sector. This is important to begin reintegrating the interbank and other bank funding markets.

But for these effects to be realised, it is essential that the SSM is accompanied by a credible SRM. Markets will only fully trust in SSM supervision if it is clear that banks can be safely wound down without damaging financial stability – otherwise they will expect supervisors to practice forbearance. Moreover, without a strong SRM bank funding costs will continue to be tied to the fiscal situation of the sovereign, which will perpetuate financial fragmentation.

The challenge is now to build consensus behind such action, particularly banking union. And the case is clearly a strong one. For countries in difficulty, financial reintegration is essential to reduce interest rates for borrowers and restart growth. For those doing well, it is essential to raise interest rates for savers and prevent future distortions.

Full speech

© ECB - European Central Bank