The report's key recommendations on financial services include making sure that the structure of financial supervision is such as not to lead to fragmentation of the single market and to explore the possibility of reinforcing financial integration through the issuance of E-bonds.
The single market for capital and financial services
Supervision for a single market, not fragmentation of the market through supervision
The single market for capital and the closely interrelated single market for financial services are critical for the efficient allocation of resources - a key driver of growth and employment - and for the stability of the economy. In the Seventies and Eighties, particularly in Europe, a tight system of restrictions to competition and constraints on allocation in the financial services industry, often designed to favour the financing of public sector deficits, had negative implications for investments and growth. The subsequent phase of financial liberalization since the Nineties, not accompanied – particularly in the United States - by corresponding improvements in prudential regulation and supervision, was a key determinant of the financial crisis.
The European Union, also in the context of the G20, is currently engaged in an ambitious programme with the objective of putting in place an adequate supervisory system. The programme was triggered by the De Larosière Report, commissioned by the European Commission.
In this area, the policy process is being pursued as a matter of priority by the EU institutions. It does not appear necessary for the present report to review such ongoing work.
What does appear necessary, however, is to stress the critical importance that, in the forthcoming legislative decisions to be made by Parliament and Council, the implications on the single market for financial services be given central consideration. The supervisory structures that will be put in place following those decisions are likely to mark the EU’s financial landscape for a long time.
It would be a serious strategic mistake if the Council, under the pressure of Member States giving priority to a natural tendency to protect national supervisory competences, were to favour timid solutions. These would present the risk of leading to a fragmented and more vulnerable single market.
Supporting the single market and financial integration, through the issuance of E-bonds
The EU needs a modern and developed financial system, built around a liquid risk-free asset class, which - being the benchmark for pricing other assets - would provide the basis for efficiently performing the essential functions of allocating resources, intermediating savings to investment, supporting better risk sharing and ensuring a more uniform transmission of the single monetary policy across the euro area. This would reinforce the strengths of the Single Market, underpin the euro as a global currency and support the smooth functioning of the EU economies, during normal times but also in the face of external shocks and financial crises, ultimately amplifying the growth and jobs dividend for Member States.
The government bond market has acted as a catalyst in fostering the integration of European financial markets since the creation of the euro, supported by the emergence of a larger and diversified investor base, reducing transaction and financing costs for governments, and in turn spurring the development of markets for other related asset classes (such as corporate bonds, covered bonds, asset-backed securities and a range of derivative instruments).
Nevertheless, the government bond market is still fragmented, as debt issuance remains at the national level and no step has been taken to date – besides some more transparency and coordination of issuances - to achieve the economies of scale allowed by the euro. Fragmentation means that the European bond market is less liquid than the corresponding US and Japanese markets,8 resulting in costs for investors, issuers, other debtors and, ultimately, European citizens. For example, households are unnecessarily paying higher interest rates for their mortgages, which are priced using government bonds as a benchmark.
Companies, in particular smaller ones, can hardly get bond financing, which exposes them to risks in terms of corporate governance associated to equity financing. Major public infrastructure in Europe, such as the TENs, is transnational, unfit for the currently fragmented national schemes, and their funding suffers from the absence of a liquid bond market for very long maturities, while long-term investors such as Pension funds cannot find a supply of bonds matching their investment needs. Financial operations carried out by EU institutions are also probably more expensive than it could be. The current fragmentation deters foreign capital from coming to Europe – for example, sovereign wealth funds are not attracted by small-size issuances – and if it comes, it asks for a premium to compensate for the illiquidity of the European bond market, implying a net transfer of wealth to the rest of the world. Finally, non-functioning financial markets can hamper reforms in other areas. Overall, the potential of the euro is inevitably constrained without the underpinning of adequate financial instruments for portfolio investment within a single financial market, making the euro area a less attractive location for financial investment, particularly in times of financial crisis, which reduces the capital available to Europe and hence its potential growth and employment.
In Europe, there is a government bond which is perceived as a liquid and safe asset: the German Bund. Its strength reflects the relative preference of investors compared to other government bonds within Europe. But, seen from a global viewpoint, the Bund is a relatively small entity. The recent fall of the euro during the Greek crisis reflects a capital outflow from Europe towards US Treasuries, which even the quality of the Bund was not able to contain. Europe clearly loses from its lack of a global asset. Addressing the fragmentation of the government bond market requires creating a new, European-wide market, with a global dimension. At the same time, legitimate concerns need to be taken care of: any solution must ensure that fiscally-responsible countries cannot be forced to bail-out undisciplined member states, in one form or another. The simple fear of this would affect their current favourable market standing, thereby making any proposal immediately unattractive. Prudent changes in issuance practices need therefore to be pursued, so that they could at the same time improve the functioning of the single market and ensure the respect of the no-bail out rule of the Treaty. On top of a more effective multilateral surveillance, tackling moral hazard would benefit from stronger market discipline on profligate governments. This could be achieved by increasing the sensitivity of markets to national budgetary developments, and by making the possibility of a default of national debt more manageable by other EU countries, hence more likely and easier to price by markets.
Against this background, borrowing at large scale through a European body, and then on-lending to Member States, may represent a balanced solution. On lending to Member States should not exceed a given level of a country's GDP (the same for all Member states) so that, for their financing needs not covered through this mechanism, governments would continue to issue their own, national debt for which they would remain individually responsible.
Given that Member States would get access to cheaper funding through this mechanism, they would consider the European body a preferred creditor, compared to holders of their debt floating on the market, theoretically increasing the possibility of a default only on the latter. In turn, this should increase market pressure (and yields) on the floating debt, creating a stronger incentive for Member States to quickly reduce such debt through sound fiscal policies.
Such mechanism could include all EU countries, with the non-euro area countries also getting loans denominated in euro. This would reinforce their incentives to ensure stability vis-à-vis the euro, consistently with the ERM-II requirements, supporting the euro area enlargement process. In turn, the larger the number of EU countries participating in the mechanism, the larger the issuances by the European body, and the greater the benefits in terms of liquidity and depth of the European bond market, and ultimately for the EU Single Market.
Starting with a smaller set of countries would be interesting, provided it creates an issuer which is relevant on the global scene. Hence, the mechanism would already be attractive if EU Member States with smaller and medium size debts would join it, and the more so with large debt countries taking part. However, the real benefits for the EU would be reaped in full only if Germany would willingly participate in this process.
For Europe, this would mean a significant step towards a more efficient financial market and a stronger Single Market, underpinning the euro as an international currency and the overall European economy. To Germany, it would provide the possibility to guide a process which is highly relevant for Europe both politically and economically, and to influence the design of the mechanism in a way which deals with its concerns of securing stronger fiscal discipline in the EU and maintaining its favourable financing conditions.
Key recommendations:
· Make sure that the structure of financial supervision is such as not to lead to fragmentation of the single market;
· Explore the possibility of reinforcing financial integration through the issuance of E-bonds.
© European Commission
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