More, Not Less, Financial Integration Needed in Europe

IMF Blog, May 12, 2011

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Author: Antonio Borges
Date: May 12, 2011
Core claim: The crisis was not caused by too much financial integration; rather, Europe suffered from too little financial integration in key respects. Deeper financial integration and stronger pan-EU institutions are needed to prevent and better resolve future crises.

In the run-up to the global crisis, countries in the euro area periphery, and countries in emerging Europe that had fixed their currency to the euro, had very high current account deficits.
The introduction of the euro in 1999 likely facilitated these high current account deficits by:
- Eliminating foreign exchange risk within the euro area and reducing it in countries on the road to euro area membership.
- Causing interest rates in Europe to converge at low levels.
- Boosting investment and reducing saving in countries that previously had been living with high interest rates.
The IMF’s Regional Economic Outlook for Europe is cited as discussing that the problem was not the size of capital flows per se, but how those flows were used.

Financial integration was sufficient to foster large credit inflows, but insufficient to resolve crises quickly.
Cross-border mergers and acquisitions in the euro area remained limited, so banking flows to the euro area periphery largely took the form of debt rather than equity, exposing periphery banks to rollover risk.
The EU adopted a common currency in the euro area but did not put in place effective instruments to handle cross-border risks or mitigate the build-up of imbalances financed by cross-border financial flows.
Banking problems were addressed at the national rather than EU level, causing banking and sovereign problems in euro area periphery countries to exacerbate each other:
- Sovereign debt problems worsened because of the fiscal costs of banking problems.
- Concerns about the public sector increased problems for the banking sector.
Consolidation has often occurred slowly, if at all, and frequently within borders; restructuring has sometimes led to refocusing on the domestic market and sales of foreign operations, reducing financial integration further.

Bank fiscal consequences would be reduced if domestic markets had been more open to foreign bank ownership; national public sector policies for supporting and recapitalizing banks would not have been the only options.
Banks would suffer less spillover from sovereign debt problems if deposit guarantees and other implicit guarantees did not depend solely on underwriting by the state.
It would be easier to consolidate the financial sector across borders rather than within national confines.
A pan-EU supervisory regime might have spotted excessive exposures or expansions of banking systems and helped avoid ill-considered unilateral policy moves.

Financial integration alone is not enough; restoring growth in crisis-affected countries is essential.
Sustainable economic growth depends on productivity; some countries struggled to raise productivity over the past decade despite ample access to foreign capital.
To boost sustainable growth:
- Better policies are needed at the national level.
- Better governance at the EU level would help enforce such policies.
- Further European economic integration would unlock substantial efficiency gains, particularly if it removed obstacles to cross-border competition that still exist.

Promote deeper integration of Europe’s banks, including through cross-border merger and acquisitions.
Strengthen pan-European institutions (including supervisory frameworks) to handle cross-border risks.
Increase vigilance both nationally and across borders to prevent repeat build-ups of imbalances.
Combine deeper financial integration with national policy improvements and EU-level governance reforms.

Source: More, Not Less, Financial Integration Needed in Europe — Antonio Borges, May 12, 2011.