29 April 2015

ECB: Financial integration and macro-prudential policy

Vítor Constâncio: "Furthering financial integration, namely with an ambitiously implemented Capital Markets Union, would facilitate capital flows across sectors and countries, ultimately improving risk-sharing across countries."

Speech by Vítor Constâncio, Vice-President of the ECB, at the joint conference organised by the European Commission and the European Central Bank “European Financial Integration and Stability”, 27 April 2015

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The new ECB powers and financial integration 

The ultimate purpose of a consistent implementation is to ensure that a high level of financial integration in the monetary union does not pose a threat to financial stability. By taming the financial cycle and by curtailing excessive risk-taking we reduce the misallocation of capital and bring the financial system to perform its main function: the efficient and prudent intermediation from savers to investors - including cross-border intermediation. 

Evidence indicates that cross-border flows are highly pro-cyclical. They thus make an important contribution to the build-up of imbalances also in local markets, such as the real estate. By taming the financial cycle, macro-prudential policy reduces the short-term and volatile financing. It fosters instead sustainable financial integration in the monetary union in order to withstand common and asymmetric shocks. 

To be fully capable to influence the financial cycle, a robust regulatory and macro-prudential framework requires that national supervisors recognise or reciprocate the regulatory and policy measures of the other countries. If reciprocity is applied only selectively, the level playing field is at risk and regulatory arbitrage will generate unintended negative spillovers. I imagine that a wide range of macro-prudential measures would benefit from automatic and mandatory reciprocity. Within the euro area, we have up until now only seen a single reciprocity arrangement on a voluntary basis. This was the application of higher risk weights for Belgian mortgage lending by Dutch authorities. 

I understand that a framework for analysing cross-country spillovers and the application of reciprocity is currently also being developed in an Expert Group within the ESRB chaired by the European Commission. I am looking forward to specific recommendations that safeguard the Single Market and simultaneously provide for a lenient and transparent application of reciprocity to promote financial stability in Europe.

Capital Markets Union

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Let me make the following three points: first, the main benefits of CMU, entail the development of risk capital and the creation of a market based risk-sharing mechanism across countries as well as the promotion of access to new sources of financing. Both these goals require a truly integrated European equity market which is of crucial importance in the CMU project. Notably, an increased role for venture capital initiatives would depend on a mature equity market that could provide significant returns in successful IPOs, offsetting losses in failing risky projects.

Second, these benefits of CMU will only materialise if the Commission strives towards a high level of integration with its CMU agenda. This requires a high degree of ambition and decisive legislative action to create the conditions for capital markets to develop and integrate. These actions are often in politically controversial fields such as in the areas of financial product taxation and insolvency laws.

Third, despite positive effects on financial stability stemming from greater financial diversification and market-based finance, more integration can also entail financial stability risks. It can exacerbate the size and speed of contagion. In addition, the ‘push’ towards market-based financing may lead to the build-up of risks in this part of the economy, typically less regulated and lacking information. 

This brings me back to the importance of an effective macro-prudential supervision and regulation, i.e. one that considers all systemically important financial entities and activities.

Improving the macro-prudential framework 

In order to make CMU a success with stronger capital markets and deeper cross-border financial integration in bank- and market-based financing, we need to further strengthen the European macro-prudential framework. The current framework focuses on the banking sector. 

With regard to the bank-based tools, our experience at the Financial Stability Committee revealed that even the instruments in the CRR/CRDIV framework are not homogeneously implemented at the EU level. 

Some of the shortcomings can be addressed through the continuous exchange between national authorities and the ECB, but other aspects require legal changes in the SSM Regulation and in the CRR/CRDIV framework. These legal changes also involve complementing the toolkit available at the European level with additional instruments. Limits to the loan-to-value (LTV) or debt service-to-income (DTI) ratios – currently under national legislation – do have cross-border implications and their effectiveness would be strengthened if made available to the ECB. If applied incoherently, they can distort the Single Market, obstruct financial integration and weaken financial stability. 

Progress on these issues will be made once the European Commission Report on the revision of the macro-prudential regulatory framework for consultation is available.

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Financial markets play a crucial role in promoting risk-sharing in a monetary union with strict budgetary rules and with conventional monetary policy unable to address asymmetric shocks. Furthering financial integration, namely with an ambitiously implemented Capital Markets Union, would facilitate capital flows across sectors and countries, ultimately improving risk-sharing across countries. But reaping the benefits from integration without raising financial stability concerns requires adjustments to the macro-prudential toolkit. 

The current bank-centred framework has its limits. Improvements require a more harmonised legal framework involving the review of the CRR/CRDIV framework and an extension of the toolkit to the non-banking sector and to market-based instruments. This will be a gradual process, but we need to address it already now while designing the Capital Markets Union, in order to ensure a successful and sustainable financial integration in Europe.

Full speech

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