September 10, 2007
MS. LOTZE: Good morning here in Washington and good afternoon to those in Europe, and welcome to this conference call on the new IMF book entitled "Integrating Europe's Financial Market". I'm Conny Lotze of the External Relations Department.
On the call today, we are joined by Michael Deppler, Director of the European Department, and two of the editors, Jörg Decressin, Division Chief, and Wim Fonteyne, Senior Economist, both in the European Department. This briefing is on the record. You have and access to three of the chapters under embargo. Mr. Deppler will make some introductory remarks and then we will take your questions. Thank you. Mr. Deppler, please.
MR. DEPPLER: Good morning, ladies and gentlemen. Welcome to this conference call. As you know, the Fund has been increasing its focus on financial sector issues over the last few years and the book that we are discussing today is a reflection of that increased focus. Let me sort of go through briefly some of the main points.
First, financial integration is something that is quite critical in growth performance over the medium term in Europe. As you know, historically, the euro area in particular, but the EU more generally, has grown more slowly than the U.S. particularly over the last decade. And when you look at that you find that half of the three-quarter percent shortfall in growth over the 1996 through 2003 period, for instance, is accounted for by lower productivity growth in the financial sectors excluding insurance.
Policymakers are well aware of this and have been quite active in trying to institute an integrated financial sector in Europe. The book goes through many of the steps that have been taken and the progress that has been made in the various areas.
The progress has been uneven, however. Certainly in retail and in the financial markets there has not been all that much progress. The capital markets also relative to the U.S. have been quite fragmented. And we see the same sorts of problems when you look at equities.
Moreover, if you look within what is happening to these various segments of the financial sector you will see that as measured by competition, the degree of integration that has been achieved in Europe is less than what we observe in the United States. For instance when you look at equity portfolios in Europe, you see a clear home bias in those portfolios. That is, investors are not diversifying their portfolios across countries nearly as much as they could to minimize their risks or, for given risk, optimize their rate of return. To us this is another symptom of incomplete integration of markets. So overall there is still some way to go in terms of achieving financially integrated markets.
Going forward, much hinges on the implementation of the EU Financial Services Action Plan which contains many worthwhile and very promising initiatives. However, the impact of these directives hinge really on their implementation. And here there are challenges that need to be faced. The Lamfalussy process which is the main instrument to achieve integration and to implement these initiatives, does involve building consensus around 27 national prudential authorities whose interests are not fully aligned. Moreover, the authorities face tension between fostering integration on the one hand and giving up control of the financial sector players in their countries and being accountable for financial stability in their countries as well.
Moreover, these challenges of implementation are increasing because the fact is that a single market is developing and is making headway. We see this all the time with all the mergers of the stock exchanges and the expansion of cross-border banks. So there is progress.
That progress is a good thing, but it also means that the risks associated with integration are increasing and integration itself creates new risks. It is important that those risks be managed if the process is supposed to be a smooth one through time. And these risks are probably most prevalent in banking because the interactions in banking simply are much faster than they seem to be for instance in insurance. This is raising challenges for the supervisors because they are no longer in full control over the long run. In this regard there is the need to strengthen information sharing among the various groups and for them to get more on top of the interlinkages within various groups across countries, but also, and this is a more longer-term problem, between groups where there is also a need for oversight.
So the book is arguing that strengthening cross-border financial stability could help promote progress toward efficient and effective financial crisis prevention, reduce moral hazard, and avoid unnecessary risks for national taxpayers. Establishing the foundation for a decentralized but more integration-compatible financial stability framework requires measures targeted at fostering cooperation. This entails an increased emphasis on joint responsibility and accountability, including mandates that call for minimizing the collective costs facing EU countries from cross-border financial institutions failures. The focus on joint responsibility and accountability is key to internalizing the externalities and spillovers that are inherent in the present setup.
Those are the basic threads of the book and I will be glad to answer any questions you might have.
MS. LOTZE: Thank you. I think we can go to questions now, please.
QUESTIONER: The line was really bad. I couldn't really hear anything that you say. In any case, I read the document. I don't know if you can translate the findings of your document on the situation that we are seeing now in the markets. They are very turbulent. There are a lot of risks. There are a lot of fears. I don't know if you can establish any kind of line or we can learn something about what is happening now to avoid these risks in the future.
MR. DEPPLER: There are some linkages, there are some similarities, but one has to be careful not to overgeneralize some of those similarities. In a sense, part of the problem in the present situation is it seems that some supervisors were not fully aware of the risks that some of their institutions were taking on off balance sheet. So there is a need there, just simply from a national point of view, to revisit whether or not the information flow and the comprehensiveness of those flows is adequate. But that's a problem of supervision within an individual country. This is a rather separate kind of issue.
When you think about the freezing of the interbank market, this is a bit more akin to some of the concerns in the book because the freezing of the interbank market comes from the fact that banks no longer trust each other to lend overnight. They are worried about who is going to be the next bank to reveal these kinds of exposures and hence be the counterparties to avoid lending overnight. So you have this freezing up of the system in terms of information and transactions.
This kind of situation happens in any crisis whether it be national or international and in our view, good management of these kinds of risks, where a dearth of information is leading players to overreact possibly to certain situations, is the kind of situation that in this book we try to address by looking forward at the kinds of risks facing the EU; and we see those risks going on out there as integration proceeds. Therefore, there is a need to set up procedures and frameworks which essentially address these issues ahead of time. Basically this is why we think that the system needs more emphasis on joint accountability and responsibility, so that all the players-the supervisors in the context of the book--have an incentive to share information and act in a preventive manner. So there are analogies here, but we are talking about a private-sector problem here and what's happening now, not a problem within the official sector.
QUESTIONER: Director Deppler, good morning. I'm sorry, I also had some audio problems so I hope my question is coherent. I just wondered if you could articulate a bit more what are the measures that you would see important to lower the risk, especially I think you mentioned something about the banking system referring to the European market, so you talk about how to lower risk, and what I heard was about the importance of joint responsibility and accountability. Aside from that, is there any other piece of the recipe?
MR. DEPPLER: The first thing to understand is that this is a hugely complex subject with many dimensions and some of these are covered in the book in considerable detail. Not considerable detail, but at least addressed.
One can go into a lot of detail, but what really matters as a starting point is setting up a framework where those issues begin to get discussed and this is why we emphasize joint accountability and responsibility. It is only in such a framework where there is a buildup of trust among the various parties that you can expect them to meaningfully begin to address the kinds of issues that arise from increased risks associated with integration. If you don't have that attitude toward addressing the problem, you are going to find it a very uphill struggle to address those problems.
The other dimension of your question I would say is that we do not have a view on the institutional counterpart to these sorts of ideas. In particular, we are definitely not against the present decentralized approach to supervision in Europe. In our view, the present decentralized approach is quite a compatible setup provided there is also some mandated need to take account of the externalities associated with the system and the risks. And once you have that in place, then you are more likely to be dealing with those risks in a more forward-looking way than has been the case up to now in Europe.
QUESTIONER: You mentioned earlier that the crisis in the bank market was related in some way to the fact that banks don't trust each other, but this whole episode seems to have increased the distrust that Europeans generally have in the new and more complex ends of the international financial markets and you see some European politicians calling for increased transparency, and President Sarkozy today was talking about speculators which is always quite a loaded word to use about capital markets.
I'm wondering if you see a backlash on the way against integration, and I presume the argument you'd make would be something along the lines that there are some gains in terms of economic growth from this, but it seems to me at least that people are genuinely quite afraid of what can happen as a consequence of a breakdown in this very complex system that they don't understand. Do you see the events of recent weeks as possibly being a blockage to further development?
MR. DEPPLER: I suppose there is a risk of that, but there is also the question of not throwing out the baby with the bath water in these kinds of situations. I think if you look at securitization on the U.S., it has led to a tremendous amount of growth in the U.S. over the past decade. That doesn't mean that the Europeans ought to be imitating that kind of setup here that happened in the U.S. I think in the U.S. there is the recognition that there is a need for somewhat more careful scrutiny as to what is happening as the basis of these asset-backed securities and so forth.
If you look at the setup in Europe, you're talking about arrangements which are far more risk averse than anything that you see in the United States. There is simply no subprime mortgage market in Europe. I think there are lessons to be learned, but we have to be careful not to have an overreaction to these kinds of developments. We would see asset-backed securities as a way forward, but clearly there is a need to be prudent in how these are implemented and carried through.
QUESTIONER: Dr. Deppler, I was wondering if you could maybe draw out a little further on the subprime crisis and the European economy, particularly how much of a threat is it to growth in Europe and is that something that the IMF may have to revise down its forecasts for the region that it put up in July?
MR. DEPPLER: I think as you have heard from the Managing Director, we are in the process of revising the numbers down. I am talking now about Europe, I don't speak about things beyond my purview. We are revising the numbers down. The revisions are likely to be moderate. We are talking decimal points, and we are talking more 2008 than 2007. The basic source of the revision of course is partly the Q2 outturns which were on the downside, but also the slower prospects in the U.S., together with the fact that there clearly is and there has been an increase in the pricing of risk and an increase therefore in the cost of credit. This is modifying the outlook somewhat. But we're talking relatively small numbers in Europe which otherwise has really been growing quite strongly.
The uncertainty of course is whether these freezes in the interbank market are going to have more lasting effects or whether they will just dissipate, and that is something that we just don't know and we don't really have good handles on. In fact, nobody really does. And so I would view those as clearly unquantifiable at this juncture. Nonetheless, they amount to a downside risk in the forecast going forward. But at this point these are risks, they are not the sort of things that we can quantify or observe. so clearly the world has become somewhat less certain, but we're not talking about at this point a major shock to the system.
MS. LOTZE: If there are no more questions, then let us thank you all for participating, and we will conclude the conference call here. Thank you very much.
MR. DEPPLER: Thank you.
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