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A quarterly magazine of the IMF
June 2006, Volume 43, Number 2

EU: From Monetary to Financial Union
Wim Fonteyne

Overcoming the remaining hurdles to financial integration in Europe

In the 1957 Treaty of Rome, the founding fathers of the European Union (EU) set out to create a common market where goods, services, people, and capital could move freely. The push for financial integration got under way in earnest in the 1980s, when capital accounts were opened and a single banking license was introduced. But even though the single market was formally completed at the end of 1992, significant obstacles to cross-border activity remained, including in financial services. Financial integration picked up renewed momentum when the euro was introduced in 1999, eliminating exchange rate–related costs and risks of cross-border financial operations. But since then, progress has proved to be more difficult than expected.

The European authorities have followed a pragmatic approach toward integration, identifying and eliminating specific obstacles, while leaving it up to market participants to turn integration into reality. This pragmatism is motivated by the complexity of the challenges and by the fact that radical solutions—such as a single EU legal, regulatory, and supervisory system—are not considered politically feasible. The approach has worked well insofar as many of the purely technical obstacles to integration have been tackled, delivering major benefits in terms of cheaper capital and better service for businesses and consumers. But remaining barriers to full financial integration are formidable, and their removal will require strong political commitment.

Why does financial integration matter?

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, should allow faster productivity and economic growth. However, these dynamic effects are hard to disentangle, model, and quantify. Most studies of the benefits of financial integration are therefore limited to quantifying static effects. London Economics (2002, 2005), for example, estimates that the reduction in firms' financing costs resulting from the integration of bond, equity, and bank markets would increase the EU's real GDP level by 1.1 percent and employment by 0.5 percent (that is, about one million new jobs) and that an accelerated integration of European mortgage markets could yield a net gain of 0.9 percent of GDP during the first 10 years. Attempting to quantify dynamic effects, Giannetti and others (2002) estimate that integration that brings the EU level of financial development to that of the United States would raise the growth rate of the EU manufacturing industry by close to 1 percentage point a year. Although all EU members are likely to gain from integration, the biggest winners will be those countries with previously underdeveloped financial systems, in particular new member states.

Financial integration not only brings benefits, though; it also allows shocks to be transmitted more easily between countries. An effective and integrated financial stability framework is therefore an indispensable complement to an integrated financial market.

The current state of play

Overall, Europe has made major progress in creating a single market for wholesale financial services—which range from capital markets to the provision of financial services to large corporate and public sector clients. Financial services providers, their large clients, and institutional investors now essentially operate on a European (if not global) scale. European wholesale financial activities are increasingly concentrated in a few financial centers, of which London has become the most important. In several markets, integration has caused rapid development in terms of the quality and quantity of services offered. Investment banking, for example, is now almost completely integrated, very competitive, and highly sophisticated, partly because of the know-how and competitive pressure brought by U.S. institutions. Corporate and government bond markets have become much deeper and more liquid since monetary union, contributing to the current historically low spreads between the yields on bonds issued by different governments. At the global level, the issuance of euro-denominated bonds has now reached about the same level as that of dollar-denominated bonds. Finally, equity market returns are increasingly correlated, reflecting growing cross-border portfolio flows and investment strategies, as well as advancing real economic integration.

But even at the wholesale level, some financial markets are less integrated than others. Differences in legislation have held back the integration of markets in collateral-based instruments such as asset-backed securities, and the continued fragmentation of Europe's clearing and settlement systems (which ensure payment and transfer of ownership after a trade has been agreed on) has hampered the integration of equity markets. Although several stock markets have merged—forming transnational entities such as Euronext and OMX (in the Nordic and Baltic countries)—or increased their level of cooperation (for instance, the derivatives exchange Eurex is a joint venture between the German and Swiss stock exchanges), national markets continue to prevail, and cross-border trading remains more expensive and less common than domestic transactions.

However, the EU's retail financial markets—which provide financial services to its nearly 460 million consumers—remain fragmented and lag behind wholesale financial services, although they benefit from the integration of wholesale markets. Positive developments include the rapid expansion of Western European banks into Central and Eastern Europe, and the formation of large international financial conglomerates by institutions from smaller countries. The pace of consolidation in the banking sector also appears to be picking up: several large cross-border mergers and acquisitions have succeeded recently, improving the climate for such operations. But overall, national barriers to cross-border banking are breaking down only slowly. Some member countries still favor "national champions" or maintain a significant degree of state ownership of financial institutions. And those banks that are active across borders must still spend considerable resources adapting their retail products to national markets because of differences in consumer protection arrangements, contract law, and taxation. These difficulties have led banks to rely more on foreign subsidiaries than on branches to organize their cross-border activities, thus forgoing important efficiencies.

Remaining obstacles

Two of the main prerequisites for achieving full financial integration are deeper EU capital markets and a prudential regime that is adapted to an integrated market with increasingly complex financial transactions.

Capital market challenges. Capital market development would have important spillover effects for financial integration in other markets. Relative to the size of their respective economies, EU capital markets are much smaller and bank balance sheets much larger than those of the United States (see table). As a consequence, the EU financial system is often thought of as being bank-based and that of the United States as market-based. In reality, however, this distinction is not clear-cut. Apart from balance sheet size and, to a lesser extent, number of branches, the two banking systems are of similar importance. U.S. banks also do not lend less than EU banks, but they securitize a much higher share of their loans, thus taking them off their balance sheets. Europe's larger bank balance sheets and smaller capital markets are therefore directly related phenomena.

Alike, yet different
European and U.S. financial markets share many similarities, but U.S. banks are much more aggressive about securitizing risk, resulting in higher profits and deeper capital markets.

Euro area and U.S. banking system structural indicators, 2004
Euro area
Number of banks, per million people
Number of bank branches, per million people
Number of bank employees, per million people
Return on assets, percent
Euro area and U.S. market indicators, in percent of GDP, 2004
Euro area
Bond market capitalization
Equity market capitalization
Bank assets
Bank loans to nonfinancial private sector1
Asset-backed securities, stock outstanding
Asset-backed securities, new issuance

Sources: European Central Bank, U.S. Federal Reserve, U.S. Federal Deposit Insurance Corp., European Securitization Forum, IMF World Economic Outlook database, and IMF staff calculations.
Note: ... denotes data not available.
1Including securitized bank loans.

EU banks are also less profitable than their U.S. counterparts. IMF (2005) research indicates that this lower profitability does not result from more competition. Instead, it is probably due to the fact that EU banks are less specialized in high-value-added activities. Whereas U.S. banks pass standardized risks on to the markets through securitization and manage more profitable nonstandardized risks themselves, European banks keep the bulk of their assets on their books. They do so in part because capital markets are less developed, incomplete, or fragmented. Mortgage loans in the United States, for example, are mostly securitized (in mortgage-backed securities) and placed in a highly liquid market that attracts global investors. But in the EU, legal frameworks (and hence markets) for the securitization of mortgage loans are country-specific, if they exist at all. These capital market constraints in turn hinder the integration of the retail-
oriented banking markets and, more fundamentally, national economies.

All in all, the evidence suggests considerable scope for an improved symbiosis between banks and capital markets through further development of the latter. Doing so will require overcoming substantial hurdles, though. Key ones are differences in the legal and judicial treatment of collateral and the need for a better and more integrated financial market infrastructure—notably payments and securities clearing and settlement systems.

Prudential challenges. As markets and economic policies integrate, financial institutions link up across borders, grow in size and complexity, and become increasingly sensitive to common shocks. IMF (2005) research indicates that, despite increased opportunities for diversification, the risk profiles of large European banks and insurance companies have not improved. This suggests that the beneficial effect of diversification has been offset by higher risk taking. There has also been a convergence in risk profiles across countries, with available evidence suggesting that this is primarily due to increasing exposure to common financial shocks.

These developments raise the question of how to manage cross-border risks to financial stability in an integrated financial market. A natural solution would be to institute a single supervisor, supported by a decentralized network to monitor the activities of large institutions on the ground and supervise local and regional institutions. Some market participants have proposed bringing existing national supervisors together in such a two-tiered structure, much as central banks were brought together with the European Central Bank (ECB) in the European System of Central Banks. However, policymakers and national supervisors have been reluctant to transfer any supervisory authority to the European level. Although partly driven by a desire to preserve existing institutions, this reluctance is also based on fundamental questions about residual national responsibilities for financial stability and the organization of lender-of-last-resort support, deposit insurance, and taxpayer liability within a supranational setting.

Supervision of cross-border financial institutions and crisis management rely on cooperation and information exchange between national agencies. The basic principle is that home countries supervise their banks' foreign branches and perform consolidated supervision of cross-border banking groups, whereas host countries supervise subsidiaries of foreign banks. For example, a German bank's activities in London are supervised by Bafin, the German supervisory agency, if carried out by a branch, and by the U.K. Financial Services Authority if done by a subsidiary. In either case, Bafin would supervise group-level consolidated risk taking. Convergence of regulatory and supervisory practices is being sought through the Lamfalussy process (see box) and will also be boosted by the harmonized adoption across the European Union of Basel II, the new capital adequacy framework adopted in 2004 by the Basel Committee of Banking Supervisors.

Policies to achieve a single market

In 1999, the European Commission launched the Financial Services Action Plan (FSAP), a legislative and regulatory program aimed at removing barriers to the cross-border flow of financial services. The FSAP's main focus was on bond and equity markets, the prudential framework, and financial infrastructure. The supranational legislative phase of the FSAP was largely completed by 2005, but implementation at the national level is expected to take several more years. Alongside the FSAP, the "Lamfalussy process" was introduced as a framework to achieve convergence of supervisory practices, consistent implementation of FSAP legislation, and streamlined rule-making.

The EU Commission (2005) recently presented its financial sector policy objectives for 2005–10 in a White Paper. Recognizing the implementation burden the FSAP will continue to represent, the Commission's main focus will be on implementing, consolidating, and improving existing legislation. New legislative initiatives will be considered only in a few critical areas, such as retail financial services.

This decentralized approach remains untested in terms of real-life financial stress and may suffer from increasing tension between rapidly evolving markets and the desire to preserve existing institutions. It also faces specific challenges: the incentives of the different supervisory agencies are not always aligned, lines of responsibility sometimes lack clarity, and no centralized repository of information on large cross-border financial conglomerates exists. Effective management of risks without impeding integration requires a prudential system that evolves in sync with the financial sector for which it is responsible. Therefore, the case that already exists in favor of further centralizing elements of prudential authority at the EU level is likely only to strengthen with time. Meanwhile, increased cooperation and information sharing among all prudential authorities and the ECB is crucial and could be facilitated by the centralization of up-to-date information on key financial groups in a shared areawide database.

Political commitment will be key

Completing the financial integration process will require addressing some fundamental policy questions, which will, in turn, require political commitment. Perhaps the most urgent challenge is the integration of payments and clearing and settlement systems. Tax and legal obstacles will also have to be overcome to allow full integration of retail markets and an optimal symbiosis between capital markets and banking systems. Finally, the question of what constitutes an optimal financial stability framework for an integrated EU market must remain on the table. The choice is not between a centralized and a decentralized framework, but about the degree of centralization that will give Europe the best tools to manage risks to its financial stability without impeding the integration process itself.


European Commission, 2005, "White Paper—Financial Services Policy 2005–2010" (Brussels).

Giannetti, Mariassunta, Luigi Guiso, Tullio Jappelli, Mario Padula, and Marco Pagano, 2002, "Financial Market Integration, Corporate Financing and Economic Growth," Economic Paper No. 179 (Brussels: European Commission Directorate-General for Economic and Financial Affairs).

International Monetary Fund, 2005, Euro Area Policies—Selected Issues (Washington).

London Economics, 2002, "Quantification of the Macro-Economic Impact of Integration of EU Financial Markets."

———, 2005, "The Costs and Benefits of Integration of EU Mortgage Markets," available at

Wim Fonteyne is a Senior Economist in the IMF's European Department.