Keynote address by Philip R. Lane, Governor of the Central Bank of Ireland, to the European Financial Forum

‘The Future of the European Financial System: A Macro-Financial View’

Good morning. I welcome the opportunity to participate in the inaugural European Financial Forum and discuss today’s theme “Building the Future of European Financial Services”. The appropriate development of the European financial system is critically important for the prosperity and stability of the European and global economies and will have a broad impact on the wellbeing of all European citizens.

Of course, there are many two-way interactions between the structure of the financial system and the policies of central banks and financial regulators. In one direction, the regulatory and monetary environment influences the behaviour of financial institutions and financial markets; in the other direction, the effectiveness of the instruments available to policy officials in maintaining financial stability and protecting consumers depends on the structure and composition of the financial system.

The European financial system currently faces myriad cyclical and structural challenges. Some relate to global forces, such as demographic trends, the growing share of emerging economies in the international distribution of output and wealth and the thirst for so-called safe assets such as high-quality sovereign bonds. At a European level, the legacy effects of the financial crisis and the European sovereign debt crisis mean that many sectors are focused on the repair of over-leveraged balance sheets, while there is an open debate about the likely duration of the current environment in which both policy rates and long-term interest rates are at historically low levels. At the same time, financial institutions must adjust to the new post-crisis regulatory environment, which requires shifts in conduct in addition to a more restrictive approach to balance sheet management. Further challenges and opportunities are provided by technological innovations that may enable the introduction of new types of financial products and new delivery methods, while also influencing the relative attractiveness of different international financial centres.

From a policy perspective, there is a clear consensus about some basic requirements for the future structure of the European financial system. In relation to the banking system, the global trend is towards lower leverage, higher liquidity ratios and higher capital ratios that are backed up by a layer of bail-in funding instruments that can add to capital in distressed scenarios. If a financial institution is too far gone, an orderly resolution plan is required to limit contagion effects and avoid a publicly-funded bailout intervention. However, as was comprehensively documented in the 2014 report “Is Europe Overbanked?” by the Advisory Scientific Committee of the European Systemic Risk Board, it is also clear that Europe is overly dependent on the banking sector, such that the policy regime should support a greater role for non-bank providers of debt and equity financing.^[1] Such non-bank funding can be intermediated through deeper and more liquid financial markets and a range of non-bank financial intermediaries.

These structural reforms of the financial system can deliver significant benefits. All else equal, the risk of a systemic financial crisis will be lower if banks are better capitalised, hold a greater proportion of liquid assets and rely on more stable sources of funding. Furthermore, the macroeconomic and fiscal impact of a banking crisis will be lower if non-bank alternative funding channels are available to firms and households, since deeper financial markets can facilitate greater diversification and risk sharing across sectors and countries. Through these mechanisms, such reforms may enhance financial and macroeconomic stability.

The common EU regulatory framework provides significant benefits compared to the alternative of a decentralised approach to financial regulation. In particular, the harmonisation of regulations limits the scope for regulatory arbitrage and fosters cross-border financial integration. An integrated European financial system can foster deeper and more liquid financial markets, generate scale economies in the production of financial services and induce greater competition across financial institutions.

These potential gains provide strong motivation for the European Commission’s proposals for Capital Markets Union (CMU). The CMU Action Plan published in September 2015 contains 33 initiatives that can be delivered over a range of time horizons. Already, work is well advanced to enable a simpler regulatory treatment for “plain vanilla” securitisation activities. A revamped prospectus regime should make it easier for firms (including small and medium enterprises) to raise capital throughout the EU, while also catering for the information and protection needs of investors. The merits of a harmonised and coordinated European approach to lending by investment funds is also under consideration.

For the euro area, the construction of a banking union is critically important for several reasons. Most directly, competition and cross-border integration in the banking sector will be enhanced by common area-wide systems of banking supervision and resolution (through the Single Supervisory Mechanism and the Single Resolution Mechanism, respectively). The resilience of the banking union would be further strengthened by the European Deposit Insurance Scheme, which is currently under negotiation. At a macroeconomic level, a deep banking union would sever the national diabolic loop between distressed banks and distressed sovereigns that was so evident during the European sovereign debt crisis. Such a banking union has great potential to deliver enhanced financial, fiscal and macroeconomic stability in Europe.

While offering many benefits, deeper cross-border financial integration, in both bank and non-bank sectors, carries several risks which require monitoring, and maybe even some new policy tools. Asymmetric shocks across countries may trigger pro-cyclical international debt flows, with households and firms in faster-growing countries tempted to borrow more, funded by outflows from slower-growing countries. If such flows become excessive, these may act as a destabilising force, as experienced by Ireland and Spain in the mid-2000s. While some of the risks would be shared by foreign investors under conditions of banking and capital market union, macroprudential policy interventions can also be deployed to attenuate national credit cycles. Examples include loan-to-value and debt-to-income limits on mortgages (as introduced here in Ireland in early 2015) and the activation of the new system of countercyclical capital buffer charges on banks.

Larger roles for non-banks and securities markets in the provision of debt funding also give rise to concerns about the vulnerability of these sectors to banking-type risks that relate to the basic properties of maturity transformation. For instance, possible mis-matches between liquid, short-term liabilities and illiquid, long-term assets and the scope for vicious spirals between liquidity freezes in funding markets and fire sales in asset markets.

In a financial sector populated by many bank and non-bank entities that interact across a wide range of funding and asset markets, the risk of indirect contagion across institutions is significant (if hard to quantify). As suggested by a new occasional paper from the European Systemic Risk Board, new policy tools may help to improve systemic resilience to indirect contagion.^[2] These include macroprudential liquidity regulation; restrictions on margins and haircuts to limit destabilising procyclical dynamics; and targeted information disclosure by regulators to alleviate specific market concerns at times of stress. For instance, the information disclosure associated with the ECB’s comprehensive assessment exercise was a milestone in the stabilisation of the European banking system in 2014.

At a minimum, the effective macroprudential regulation of financial markets and non-bank entities will require the gathering of detailed, granular data on balance sheets and market positions. While the provision of data on derivatives trades under the European Market Infrastructure Regulation (EMIR) is a promising start, much more comprehensive regulatory datasets are required to gauge systemic risk and calibrate policy interventions.

Finally, many of the policy issues that I have discussed in relation to the European financial system are also relevant at the global level. Especially during a period of considerable turbulence in emerging economies and much discussion of cyclical divergence between the US and European economies, it would be remiss of me to ignore the importance of global coordination among regulators and policy officials if the gains from global financial integration are to be obtained without putting international financial stability at risk.

In addition, given the intertwined nature of the European and global financial systems, the European Union should also play an influential role in addressing the well-known fragilities in the international monetary system. Through such global initiatives, the exposure of the European financial system to external shocks can be mitigated.



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^[1] “Is Europe Overbanked?,” Report No. 4 of the Advisory Scientific Committee of the European Systemic Risk Board, June 2014. Available here

^[2] Laurent Clerc, Alberto Giovannini, Sam Langfield, Tuomas Peltonen, Richard Portes and Martin Scheicher, “Indirect Contagion: The Policy Problem,” ESRB Occasional Paper No. 9, January 2016. Available here