Director, European Department, International Monetary Fund
At the IMF – Bruegel – Belgian National Bank Conference
Brussels, March 24, 2009
When seeing the title of this conference, many of you may have thought that we are a bit optimistic. Indeed, “the storm” is certainly not yet behind us. However, the key word of this title is not “storm”, but “future”. We are here to discuss what kind of financial system Europe wants to have when this storm is over, and what public policies can do to establish such a system.
When facing a storm, a sailor’s immediate reflex is to focus on navigating the waves. Surviving wave by wave. This attention for the immediate danger is, of course, essential. But a sailor’s chances of survival are greatly enhanced when he can, at the same time, set course toward a safe harbor rather than allow the waves to determine his destiny. Amidst all the crisis headlines, this conference is intended to discuss a “safe harbor”, a post-crisis “destination” for the financial system.
It is urgent that we think about this destination. The financial system today is partially dysfunctional, not only because of losses, but also because of uncertainty. Business models, financial sector practices, and market segments have failed. In many respects, financial intermediation needs to be reinvented. At the same time, a global regulatory response is underway to address the perceived failures that have caused this crisis. Such a response is desirable and necessary, but it also adds to the uncertainty. The sooner public policymakers can lift the fog and clarify the future rules of the game, the sooner financial sector participants will be able to devise new practices and new business models, and return to a new sort of normalcy. We hope that this conference will contribute to accelerating this process of restoring visibility of the future of the financial system.
What kind of financial system should Europe aspire to? The 1957 Treaty of Rome put forward the objective of a single financial market. Despite the costs of the crisis, which will undeniably be large, the rationale for such a single financial market remains compelling. Financial integration allows investors to seek higher returns and lower risks through diversification, and it enables borrowers to finance themselves less expensively and more reliably in deeper and more complete financial markets. This provides immediate benefits to consumers and businesses and, through interaction with other economic developments such as technological innovation, allows faster productivity and economic growth. Moreover, for the EU, an integrated financial market is an essential complement of integrated markets for goods and services. The case for a single financial market is perhaps even more obvious when looking at the alternative: there is no rationale for having 27 separated and artificially isolated financial systems functioning in autarky. The achievements of the EU’s New Member States over the past ten years, realized with the help of capital and financial services provided by citizens and companies from the Old Member States, clearly illustrate the benefits and the potential of a single financial market, even if recent developments may also illustrate the accompanying transformation of risks.
This crisis was not caused by financial integration. It has long been understood that integrated financial markets can allow the transmission of shocks, which has happened in an unprecedented way. But these shocks themselves were caused not by financial integration, but by a combination of flawed financial innovations, incentive problems, inadequate and sometimes faulty regulations, and macroeconomic policies. Part of the reason why the crisis took on such a global scale is the fact that many of these causal factors had been mirrored in financial and prudential systems around the world. Beyond these specific causal factors, perhaps the main underlying problem is the inadequacy of existing financial stability frameworks in the face of the sophistication and cross-border integration of modern financial systems.
The solution is to reform and modernize these financial stability frameworks, rather than to abandon the quest for an integrated, dynamic, efficient, and innovative financial system for the EU. What Europe needs is financial stability arrangements that will enable the development and integration of its financial system, while containing its risks. Europe can only lose from a return to repressed financial systems, and if policymakers give in to the temptation to engage in financial protectionism, this could be as damaging as trade protectionism was during the Great Depression.
Informed by the Larosière Report, as well as the Turner review and other thoughtful documents, EU leaders will make important decisions on Europe’s financial stability arrangements in the months to come. In making those decisions, they will shape the future face of Europe’s financial system, because financial intermediation is shaped by regulation and supervision perhaps more so than any other economic activity. For all its costs, this crisis presents a historic opportunity to put in place a sound financial stability framework for Europe that will foster the kind of high-performing integrated financial system that Europe’s citizens and businesses deserve. Doing so will require brave and far-reaching decisions, and a willingness to abandon old red lines. However, if the ongoing crisis has demonstrated anything, it is the immense importance of getting financial stability arrangements right.
The Turner review puts the choice that policymakers now face very clearly and very accurately: either we opt for “more Europe” or we will end up with “less Europe”. Either we opt for more integrated European financial stability arrangements, or we will end up seeing the prospect of an integrated financial market slip away from us, just when we were getting so close. There is no doubt in my mind which of the two is the better choice for Europe’s citizens.
The Larosière group has delivered an impressive piece of work in a very short time. Its proposals are ambitious, far-reaching, and well thought-through, but also achievable in relatively short order. Notably, the recommendations to establish a European System of Financial Supervisors and a European Systemic Risk Council deserve strong support. The Turner review added complementary proposals and additional perspectives to the debate. Let me comment on some of the specific issues that have been put on the table by these two important documents.
Both reports recommend the establishment of one or more EU-level prudential agencies. However, whereas the Larosière report proposes an integrated system of financial supervisors, including three cross-border Authorities, the Turner review emphasizes the need for a single regulator. The reality is that Europe needs both. Some European supervisory and regulatory system combining features of both proposals would probably be the best solution. The Turner review also argues for a rapid cross-sectoral integration of the EU’s pan-European prudential agencies, whereas the Larosière report puts this forward as a desirable medium-term objective. Given how much cross-sectoral integration has taken place in European financial systems, both proposed approaches deserve careful consideration. Regardless of its design, in my view it is essential that an EU-level prudential agency be given adequate resources, independence, and binding powers over national supervisors. A toothless agency is not going to solve the frequent home-host conflicts and distrust that have been such obstacles to integration and coordinated crisis management. Finally, national prudential agencies will have to work closely and in tandem with the future EU-level agencies. To do so, giving these national agencies an explicit and strong European mandate would be very useful.
In view of the experience with the Icelandic banks, both the Larosière report and the Turner review put the “single passport” in question. Yet, branch-based cross-border banking has been an important driver of financial integration. More importantly, it is a driver whose potential only became clear in the last few years, as the European Company statute made it possible for financial institutions to organize branch-based cross-border operations much more efficiently. There are inherent problems with branch-based banking as currently organized under the single passport, as it involves citizens of one country becoming dependent on the deposit insurance and financial stability arrangements of another. However, these problems can and should be resolved without undermining the single passport itself.
Which brings me to my final point. The underlying reason why the Larosière report and the Turner review have little choice but to propose increased host country control over branches is that they opted against tackling the underlying problem of crisis resolution. They do not fundamentally question the fact that crisis resolution remains a purely national affair. In essence, their reasoning is that, given that crisis resolution is national, a real single financial market (including with a single passport) is beyond reach. I think that we need to reverse this logic. The rationale for having a single financial market is much stronger than the rationale for maintaining the status quo on crisis resolution. We need to find ways to organize EU-level systems of crisis resolution for Europe’s cross-border banks. This is not impossible. Technically, there are many available options. The challenges are to overcome the political resistance and to ensure that any cross-border crisis resolution framework is incentive-compatible. In October 2007, the ECOFIN adopted a set of crisis management principles. These principles are, in many ways, an important part of the solution. The problem is that the incentives are missing for decision-makers to adhere to these principles in the heat of a crisis. What we need is a framework that ensures the consistent implementation of these principles.
Europe finds itself at a juncture. There are genuine risks that the global financial crisis and the policy reactions to it will derail the 52-year old quest for a single financial market. This can and should be avoided. Much depends on what policymakers will decide in the next few months. An ambitious overhaul of the EU’s cross-border financial stability arrangements, opting deliberately for “more Europe”, gives us the perspective of a well-performing and stable financial system. The opportunity should not be missed.
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