SUERF / UniCredit Congress

Governance and Structure of European Finance
after EU Enlargement

held on 9th March, 2005 at the Städel Museum in Frankfurt.

Report by Frank Lierman and Morten Balling,
Members of the SUERF Council of Management

• Will the current structures of the financial systems continue?
• Alternatively: Will there be a convergence of financial systems within the EU area?
• If there is to be a convergence, will it be on the so-called Anglo-Saxon market based model?
• Will the current mix of what might be termed Shareholder Value and Stakeholder Value institutions survive?

The speaker believed that we move towards a hybrid system. There will be a degree of convergence in some areas but not in others. There will be some erosion of the traditional universal banking model. It is likely that banks in the EU area will continue to adopt a variety of business models.

Carlo Salvatori, President of UniCredit expressed his belief in the positive effects of the enlargement. It testifies the openness of the EU and the possibility to growth. The multiplication effect will be higher than the sum of individual countries. International integration is a source of development and growth. A big opportunity is offered by cultural, political, economic and financial factors. Of course risk should not be neglected. How can banks use those opportunities? UniCredit is undoubtedly a leader due to its huge investments in Central and Eastern Europe. A more homogenous regulatory framework must be created. Europe must be competitive internationally.

Rolf-E. Breuer, President of Bundesverband deutscher Banken underlined the challenges of financial market integration. A lot of progress has been made in the European money, bond and equity markets. He observes that consumers are reluctant to do business cross-border due to legal, tax and other uncertainties. Banks being active European wide still face national supervision. The Kok report confirms that the Lisbon agenda will not be reached. Either we continue integration or we stop. There are two major tasks. The commitment of member states to implement on the national level the European directives must be reinforced. Nearly all elements of the FSAP are decided, but their implementation is lagging. The reasons are probably a combination of unrealistic timing, conflicting priorities and absence of political will. New candidates for EMU have to respect the basic rules. More flexibility is needed to realise efficient working of labour markets, public finances and retail financial markets. The second task is to change the approach in financial market harmonisation. There is no time for a pause in harmonisation and no time for European fatigue.

According to Maurizio Sella, President of Associazione Bancaria Italiana, the main challenge is to build a more dynamic, competitive EU. The Lisbon objectives are not met because the macroeconomic performance of the EU remains unsatisfactory. The critical problem to emerge is the slow growth of total factor productivity, which is intimately related to the ability to incorporate technological innovation into the productive process. Meanwhile public deficits reduce the capacity for growth. An integrated financial system with a single deep, liquid capital market is the cornerstone of a more dynamic and competitive EU. Sound banking and good finance is what makes the economy healthy.

The potential of EU financial integration is estimated at 1 % growth of GDP. The benefits derive from the increase in competition and efficiency. The key to success is the ability to re-interpret the relationship between bank and firm. Financial integration requires regulatory intervention. Over-regulation can be a problem. We should not sacrifice the quality of regulatory solutions in order to speed up drafting and adoption of new rules. A final theme is the convergence of supervisory practices. Banking supervision is conducted in a national legislative framework. For banks doing business cross-border the model of lead supervisor is gaining momentum. The introduction of this concept should reinforce cooperation, avoid duplication of supervisory activities and simplify procedures.

The keynote speech was given by Jean-Claude Trichet, President of the European Central Bank. The economic and financial integration in Europe is historically unique as it combines both supranational and intergovernmental elements between sovereign states in a way that challenges previous concepts and definitions. The speaker used the strong expression "We are making history."

The single currency and the Single Market in Europe are often discussed using the optimum currency area literature as the theoretical framework, based on work done by Mundell (1961), McKinnon (1963) and Kenen (1969). The greater the degree of similarity and integration in production and consumer structures, the lower the risks of asymmetric shocks that would necessitate a different monetary policy or changes in the exchange rate in order to avoid prolonged periods of unemployment. There have been specific concerns for Europe as regards cross-border labour mobility, labour and product market flexibility and a cross-border fiscal transfer mechanism. The speaker did not like the negative tone of the debate because the theory should be applied in a dynamic framework and because the achievements in terms of convergence and integration have been significant. The euro is an incentive to reforms.

Internal exchange rate volatility has been removed. Significant convergence has been achieved. Inflation rate differences have been reduced. Public finances have been consolidated until 1998 but weakened since then. Real convergence is on the way. Trade integration is well advanced. Financial integration is strong partly due to the FSAP, but not yet for the retail banking sector. Creation of a Single European Payment Area is essential.

Financial structures are becoming more homogeneous implying that the transmission channels of monetary policy to the real economy can work in a comparable and predictable way across countries. There are still significant differences for debt securities and shares in financing the private sector and the vehicles used to manage the long-term savings and pensions Business cycles are more synchronised. Insufficient progress has been made regarding wage and price flexibility and labour market mobility. There is a lack of fiscal transfer mechanism due to the absence of a European federal budget.

The dynamics that have been set in motion are likely to lead to further changes and challenges. Where might EMU be heading? Two economic theoretical schools exist. The first suggests that as trade barriers are reduced, opportunities for economies of scale and specialisation in production where countries have a comparative advantage would increase. The other school states that European integration would lead to greater intra-industry trade integration and more similar economic structures and business cycles through convergence of factor endowments and technology and reduced exchange rate variability, which tends to weaken intra-industry trade.

The most realistic model may be one of regional diversity, with comparative advantages determining the regional specialisation, rather than centralisation of capital and labour in only a few areas, which would put greater demands on labour mobility and possibly lead to greater polarisation across regions.

The implications for monetary policy are clear.The ECB's mandate to maintain price stability is crucial. The ECB does not ignore sectoral, regional or country-specific information. Disaggregated evidence is analysed. Persistent inflation differentials are also taken into account. The medium-term orientation of monetary policy is a response to the nature and persistence of economic shocks. The low level of interest rates reflects the market's belief in the credibility of ECB's monetary policy.

Fiscal policy must be based on the principles of the Stability and Growth Pact. Since EU does not have a federal budget, the excessive deficit procedure should be maintained. The search for cohesion between the economic and monetary element is crucial. Structural policies contain the most powerful policy tools for addressing and preventing problems that may arise in a currency area, as well as in individual countries. There is no alternative.

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The first Round Table focused on Banking and Financial Integration in Europe: The Evolving Rules was chaired by Tommaso Padoa-Schioppa, Member of the Executive Board of the ECB.

Marco Grande, ECB presented the views of Baron Alexandre Lamfalussy, Chairman of the Committee of Wise Men on the Regulation of European Securities Markets and former President of the European Monetary Institute, Belgium who could not attend the Congress. The headline of the presentation was: "The four-level approach to financial regulation in Europe: achievements, concerns and queries." The two main objectives of the approach were to increase the efficiency of the decision process (core principles via level 1, technical details in level 2) and of the implementation process (supervisory in level 3 and national in level 4). The FSAP is a big achievement. There is widespread agreement that the quality of the regulations has significantly improved.

The concerns are linked to the observation that still too many technical details are dealt with in level 1 and that the consultation period must be speeded up. There is an uneven balance between various groups of stakeholders (investment banks, retail investors, institutional investors). It is crucial to extend the Lamfalussy approach to other segments. For banking, preserving the health of the banking system is essential. For securities, the primary objective is to foster the development of a competitive, liquid, transparent and efficient market. Against this background, how should the micro and macro prudential responsibilities be defined? Which role should be given to the central bank? In crisis periods the bank's role is huge, but in current banking supervision its role is unclear. The differences between countries are important. May be the ECB should be entrusted with an operational responsibility for supervision of a limited number of banks in cooperation with national authorities.

José María Roldán, Chairman of the Committee of European Banking believed that the Lamfalussy approach provides for a range of solutions, which means that it is possible both to be flexible and to develop over time. In Europe, we should develop a common culture of regulation. The possibilities offered by level 2 must be exploited properly. The objectives of CEBS are twofold: regulation that can adapt quickly to new market developments and practices, support integration and enhance EU competitiveness and strengthened cross-border and cross-sector co-operation among supervisory authorities and greater convergence of day-to-day supervisory practices and implementation. What progress has been made? The level 2 committee has not yet been formally established although CEBS (level 3) started a year ago. The only piece of EU banking legislation currently going through the legislative process is not a true Lamfalussy directive. More use of level 2 is needed. An evaluation of the complete existing banking legislation in the light of the Lamfalussy approach is also needed. More respect for dialogue and transparency for the level 3 committees is welcome.

The European banking industry is not sufficiently homogeneous to apply one set of rules to cover all banks. Nor are the issues that the banks face so simple that every eventuality can be covered in regulation. There is a need to have a balance between rules and discretion. Supervision is about judgment, not mechanics. Respect of the subsidiarity principle is also crucial. All in all we need a framework which gives sufficient consistency of approach to ensure a level-playing field, to avoid unnecessary supervisory burdens, and to encourage banks to develop their risk management techniques.

Giandomenico Magliano, Director General for Multilateral Economic and Financial Cooperation of the Italian Ministry of Foreign Affairs stressed the advantages for the small- and medium-sized companies of new financial products due to financial integration. The FSAP needs complementary steps. First all legislation must be implemented in all countries. A special effort is needed for SEPA and for the "consolidating supervisor". Secondly a consolidation of financial markets services is welcome including banks, insurance companies, investment funds, asset management firms. Finally, Europe being not a fortress should contribute to developing global cooperation. The increasing application of accounting and audit standards are clear signals.

Franco Bruni, Professor at the University Luigi Bocconi in Milan and Member of the SUERF Council of Management took a quite pessimistic academic view by stressing that we have no common model of financial stability and optimal regulation. A good definition is missing. Monetary policy does have a clear theoretical background, financial stability has not. The speaker asked: "How can we avoid financial overregulation? How can we harmonise depository insurance schemes? Regulation and supervision are preventive policies. When they fail, crisis management emerges. As long as fiscal policy is national, the cost of crisis is often paid by the national taxpayers. Why not transfer some fiscal matters to the European level? Finally he expressed some dreams: a real implementation of the Lamfalussy approach, centralisation of responsibility for macro financial stability, a European FSA for those intermediaries that are Pan-European banks. May be banks should be allowed to choose if they wanted to be subject to European supervision.

Tommaso Padoa-Schioppa underlined the close link between the fiscal issue and the Lisbon process. UK and Sweden have demonstrated that the economic system can be changed via appropriate fiscal and financial policies. What should come next? The full free circulation of goods, persons and services is not yet fully implemented. The minimum harmonisation of banking rules was not a real breakthrough. The Lamfalussy approach will need many years for its implementation. A further liberalisation and appropriate regulation are needed. Integration does not only concern a few euro area wide active banks. Local banks have to adapt themselves also.

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Round Table II "Monetary and Financial Policies in the New Integrated Union" was chaired by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECB. The major challenge for central banks in the new member countries is to converge to macroeconomic stability and to prepare the introduction of the euro, which implies a major step for the monetary authorities, but also relates to the functioning of the fiscal policies. Some of the new EU-members are already ERM II members. The current strategies must contribute to price stability and must be compatible with sustainable real and nominal convergence. When examining and evaluating alternative strategies, two characteristics of convergence must be considered: the exposure to large capital flows and the trend appreciation of the real exchange rate.

Significant challenges lie in the area of fiscal policies. Budget balances have worsened since 2000. Debt ratios have deteriorated, but the levels are mostly lower than those of the old Member States. How to react? The expenditure-based adjustments tend to be more durable and friendly to growth. The expenditure ratios are already high. There is also the risk of further fiscal liabilities due to population ageing and traditional pay-as-you-go pension systems. Reforms that improve the targeting of social assistance and increase employment incentives are vital.

Economic convergence is taking place: sustainable lower inflation; decline of long-term interest rates; gradual increase of credit to the private sector; appreciation of the currencies, except Poland; but deterioration of current account balances.

Axel Weber, President of the Deutsche Bundesbank characterized the EMU as a unique experience. The new Member States have made substantial progress, but are not yet ready for full EMU participation. Three countries adhere to ERM2. Nominal convergence is on the way. The convergence dividend is not perpetual. The goal is a credible stability policy. For real convergence the way to go is still long. Stable money presupposes stable public finance. The problem of an increasing cost of the government debt is important. Fiscal consolidation is needed to realise macroeconomic stabilisation. A reform of the big public sector is necessary. There have already been remarkable reforms during the last 15 years. But a clear set of commitments to adjust to lower inflation rates and prepare for the EMU is needed.

Elena Kohůtikova, Deputy Governor of the National Bank of Slovakia, described the monetary and financial revolution that took place (complete liberalisation of capital markets, increased attractiveness for foreign investors) and the evolution which is still going on (integration of financial markets and globalisation). Two major effects have been observed: market efficiency and financial stability have improved, but the conduct of monetary policy has become more difficult. It is a challenge to monetary policy that a large part of the domestic economy is not responding to domestic but rather to euro zone monetary policy, that many firms borrow abroad, and that exports and imports are mostly in euro.

The new member countries follow different exchange rate policies in relation to the euro. Floating countries (Czech Republic, Poland, Hungary, Slovakia) are exposed to large exchange rate fluctuations. Most of these currencies have appreciated. Countries with a fixed rate policy (Estonia, Lithuania, Latvia, Slovenia) have seen a modest depreciation of their currencies. The inflation rate is much higher than in the euro zone, especially in Hungary and Slovakia. The current account deficits vary. Due to favourable financing conditions we observe a fast credit growth, especially in the household sector. Companies borrow increasingly in foreign currencies abroad. Monetary policies are hard to conduct systematically. Integration must be continued. Monetary union is the ultimate objective. According to the speaker, euro zone entry is an economic necessity, not only a political goal. The new member states want to enter the euro zone between 2007 and 2010.

Ludek Niedermayer, Vice-Governor of the Czech National Bank, started his introduction by underlining the fast development of the financial market and the industry since mid 90's. Weak legal systems and corporate governance contributed to instability and later crises. Many EU players are dominant in the Czech financial system. 96 % of the bank assets are controlled by foreign capital. In recent years, financial performance and stability have improved considerably.

The Czech's way to EU has been characterized by fast, liberal and extensive reforms, which started in 1991, the split of the country in 1993, the rapid growth in the mid nineties but recession in the late nineties, a large inflow of FDI, a rapid appreciation of CZK, a GDP growth of 3-4 % in recent years, a huge current account imbalance and a large fiscal deficit.

The CNB is responsible for monetary policy, payment system, banking sector regulation and supervision, FX regulation and operates with an inflation targeting and a weakly managed floating of the CZK. In the coming years there is a need of fiscal consolidation, government institution reform, higher economic growth, moderation of the real appreciation of CZK, price stability and flexibility of the economy.

The monetary policy issues imply the maintenance of stable economic conditions reflecting the proximity of the euro zone and the need of relative price adjustment, the fulfilment of all criteria before the entry in the euro zone, the inflation targeting with managed floating of CZK in the preparation period before the entry.

Jerzy Pruski, First Deputy President of the National Bank of Poland mentioned that there currently were 13 countries outside the EMU and 12 countries inside. So, there is scope for doubling the number of EMU participants. The Stability and Growth Pact represents a challenge to the new member countries since a majority of them have substantial budget deficits. Poland has a lot of work to do to adapt its economy and fiscal policy to bring them in line with the convergence programme. The adoption of the euro is only possible if we have a sustained economic growth. The participation in ERM2 must be short and with an as wide as acceptable fluctuation range. Poland wants to join the EMU as soon as possible.

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Round Table III, The Evolution of the Bank-Firm Relationship in the Enlarged Europe was chaired by Luigi Passamonti, Head of the Financial Sector Convergence Programme of the World Bank. He formulated four introductory questions to stimulate the debate: Does finance make entry possible? Is incrementalism the only way forward? Can a strong capital market emerge? Where are the sources of change?

Herbert Brücker, Head of Deutsches Institut für Wirtschaftsforschung in Berlin focused on the links between the economy, labour market mobility and the financial sector. Is there a special demand for finance? Productivity increases have been high since the beginning of the transition. Accumulation of capital has to increase in order to exploit the growth potential. Thousands of people have left the agricultural sector but the productivity increase has been higher in the agricultural and industrial sectors than in the services sector.

Does the financial sector match the requirements for finance? The saving rates are lower than in the EU 15 while the investment rates are higher. The banking sector is relatively small. The equity market is small and there is no corporate bond market.

What are the causes of the shortcomings? There are a lot of causes: the institutional infrastructure is not yet finished, there is weak integration into European financial markets, weak corporate governance, the enterprise reform is only on the way, and poor liquidity of SMEs. On the other hand, FDI has become a major source of financing, and the FDI potential is not exhausted.

Regina Prehofer, Member of the Managing Board of Bank Austria Creditanstalt AG, started with a short description of the initial (early 1990s) situation in Central and Eastern Europe characterized by large local banks, which acted as financiers of the large-scale state industries and greenfield establishments of foreign banks that provided basic settlement services. Local financing services played a very subordinate role. In recent years banks have discovered that the SMEs have a huge potential (98 % of CEE enterprises). They look for "simple" bank products and have high investment and financing needs. Banks expanded their range of services: payments, cash management, internet banking, working capital facilities etc. Customers have been quick to realise that fast competent decision making and moderate prices are crucial. BACA launched cross-selling across national borders and cross-bank servicing of corporate customers with cross-border operations.

The reasons why company financing via domestic bank lending is not developing as dynamically as household lending is the lesser degree of undersupply by comparison to private sector lending, the good liquidity position of corporates and the high volume of corporate financing from abroad. Corporate customers expect package solutions, network products, cross-border cooperation and communication, rapid harmonisation of service and product portfolios, approaches and decision-making in line with the overall bank-customer relationship. A bank that succeeds in optimising the three-pronged approach of sales orientation-product range-settlement efficiency in a way that meets customers' expectations will be able to secure itself a substantial market share in this ever more competitive market.

Silvio Scaglia, Chairman of Fastweb, described the needs of a fast growing company in its relationship with the financial sector. The large Italian company carried out a successful IPO in year 2000. They learned that a strong link to the international capital market is necessary. Internationally oriented credible banks are needed. The speaker said that keeping in touch with international investors was high on his personal agenda.

Jacek Siwicki, Managing Partner of Enterprise Investors in Poland, focused on the private equity business. He characterized himself as "picky and greedy." Enterprise Investors did only realise 1 % of proposed projects. The speaker gave an answer to Passamonti's first question: "Yes, finance makes entry possible." But it is more difficult to finance small start ups than big established companies. Government intervention is needed in seed-financing. The speaker was sceptical with regard to political initiatives for the "sake of the nation." He preferred initiatives by business people who did it for profit.

In his concluding remarks Alessandro Profumo, CEO of UniCredit remarked that the audience during a long day had listen to speakers with very different experiences. He thanked all the speakers for their contributions. Central bankers, bankers, corporate customers of financial institutions and academics had all provided useful input to the debate on Governance and Structure of European Finance after EU Enlargement. Many of the rules that provide a framework for financial markets are now in place at the EU level. Now we need national implementation in 25 member countries. We have all a significant responsibility for developing a truly integrated European financial system.

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This report is an extended version of the report which will appear in the SUERF Newsletter in Summer 2005