Financial (Dis)Integration in Europe

On 3 May, the meeting of the European Central Bank (ECB) in Barcelona prompted the deployment of more than 8,000 policemen to contain protests from Spanish citizens angered by the economic crisis — including unprecedentedly high unemployment rates that skyrocketed to 24.1 percent in March and drastic austerity measures.

A couple of days before, the ECB had published its annual report on Financial Integration in Europe. The report shows that the financial crisis raging for more than four years now has had a significant impact on the “Single Market” as envisioned by Europe‘s intellectual fathers. This is the first setback of the financial integration ofEurope, which accelerated in the 1990s and got an additional boost from the introduction of a single currency in 1999.

With the crisis, though, differences in yields of sovereign bonds have dramatically increased, with Greece, Ireland, Portugal, and now Spain and Italy watching their funding conditions worsen, and yields on German bonds — once seen as a safe haven for investors — plummeting. In parallel, banks located in the weakest countries find it more and more difficult to access liquidity. This translates to segmented funding conditions across the EU for the private sector. Tightening credit conditions for companies and individuals in southern EU countries have further contributed to the economic crisis and deterioration of the job market.

More findings from the ECB report:

Euro-area sovereign bond markets continued to experience severe tensions in 2011, giving rise to concerns of the systemic nature. Sovereign yields diverged further, reflecting growing fiscal sustainability concerns in some countries and higher risk aversion of investors. Bond yields of larger countries also occasionally came under intense pressure. Cross-border holdings of government bonds by euro-area banks as a ratio to total holdings also was steadily declining, returning to pre-euro-area levels. 

For money markets, the intensification of the financial crisis led to a decline of the unsecured money market and a growth in the secured market, with the collateralized nature of repo transactions making them relatively more resilient to heightened credit risk concerns. Still, both the secured and unsecured money markets are increasingly impaired. Volatility of unsecured interbank overnight lending rates across euro-area countries sharply increased, as the tensions in sovereign bond prices generated concerns over the impact on banks’ balance sheets in some countries. As a result, many banks saw their access to the unsecured money market severely curtailed. The pricing of risk in the repo market has become more dependent on the geographic origin of both the counterparty and the collateral, in particular when these were from the same country; this has contributed to additional money market segmentation and fuelled country and financial risks. Also, the share of transactions via central counterparties (CCPs), which minimize counterparty risk, increased markedly. 

Corporate bond markets have also experienced significant tensions, in both the financial and non-financial sector. Indicators suggest that country-level effects have become more important in driving yield developments, reflecting the differences in the fiscal situation and economic outlook of euro-area sovereigns.

Relative to other markets, equity markets, even though affected by the prevailing market tensions, have been less impacted by the deterioration of euro-area financial integration.

In the banking markets, the crisis gave rise to substantially more heterogeneous bank financing conditions for non-financial corporations and households across euro-area countries. This seems mostly due to cross-country differences in bank financing conditions related to the relative strength of individual sovereigns and their economies, including credit risk. The supply of bank loans as well as credit standards also have been affected by varying degrees from one country to another, depending on domestic economic outlooks and differences in banks’ access to, and costs of, funding.

These elements demonstrate how the crisis has hampered financial integration, which suffered from deficiencies in the pre-crisis financial and institutional framework of the euro area. Indeed, there is a paradox in having, on one side, a common currency (the euro) and central bank and, on the other, fiscal policies and regulatory arrangements fragmented along national lines combined with a weak common governance and supervisory framework.

With the financial crisis, EU institutions have taken steps on various fronts to strengthen financial and institutional frameworks. This resulted in a wave of new legislation over the last couple of years, including:

• Reform of the financial supervision framework: creation of the European Systemic Risk Board and the three European Supervisory Authorities (ESMA, EBA, EIOPA)
• New financial regulations: Basel 3 and CRD 4, MiFID (Markets in Financial Instruments Directive), EMIR (European Market Infrastructure Regulation), credit rating agencies, etc.
• Upcoming legislative proposal for bank recovery and resolution
• Strengthened fiscal and economic governance at the EU level, with the so-called “six-pack” and “fiscal compact”, aimed at preventing unsustainable fiscal developments and macro-economic imbalances, notably through stricter public deficit rules, mutual budgetary surveillance of EU Member States, and sanctions in cases of non-compliance
• Creation of two crisis resolution instruments (the European Financial Stability Facility for 440 billion euros and the European Stability Mechanism for 500 billion euros to provide liquidity to euro-area countries under severe market pressure.

Yet that does not seem sufficient to reverse the current trend of “financial disintegration” of EU markets, as evidenced by the recently increasing yields of sovereign bonds of some southern EU Member States. In this context, one of the tools that EU leaders may still consider to enhance financial integration in the eurozone is eurobonds — or sovereign bonds commonly issued by member states of the eurozone.

Last January, CFA Institute conducted a poll of European members on eurobonds. While only a slight majority of respondents thought that resolution of the euro-area sovereign debt crisis should require common issuance of sovereign bonds, a large majority believed strict preconditions should be met for common issuance to be effective, most notably: significant enhancement of economic, financial, and political integration, and increased surveillance and intrusiveness in the design and implementation of national fiscal policies.

As you can see, major challenges stand in the way of an improvement in EU financial integration.