Comment: The Euro at Five: Ready for a Global Role?
Remarks made at "Euro at Five: Ready for a Global Role"
Institute for International Economics
© Peterson Institute for International Economics
I would like to thank Fred Bergsten and Adam Posen for inviting me to participate in this conference and the Institute for International Economics for sponsoring and organizing this important progress report on the euro. I would also like to note at the outset that I am providing my personal views today and not those of the IMF, although there is little that is controversial about what I will say and much of it is based on material published in IMF publications.1
The role of any currency in international finance reflects the confidence with which it is perceived as a reliably liquid instrument for financial transactions and as a store of value. This confidence must be earned and depends importantly, though not exclusively, on the depth, liquidity, and efficiency of the currency's home or domestic markets and on the array of liquid portfolio investment opportunities in those markets.
The euro area is still developing pan-European markets and is likewise in the process of earning confidence. The dollar already enjoys the confidence of international markets. In this regard, it is unreasonable to assume that the euro and the dollar are competing on equal terms: the dollar has the distinct advantage of being there first and having gained substantial credibility. It has also demonstrated the ability to sustain this credibility even through some fairly trying times. Overall, given the head start the dollar has had, I would judge the euro as performing remarkably well in international finance at the young age of five. It is also fair to say that it has a long way to go before it reaches its full potential, both domestically and internationally.
The euro's role as an international vehicle for finance will grow as Europe develops a full array of deep, liquid, and efficient financial markets, extending well beyond its integrated money markets. So what will it take to further develop the depth and liquidity of Europe's markets?
There are four aspects of financial architecture-the plumbing of financial markets-where there are important remaining challenges. The first two, namely financial infrastructure and regulation, have more to do with the effectiveness of markets; the second two have more to do with the financial-sector policy apparatus-namely, prevention of financial problems and resolution of them. Overcoming these challenges in a politically unified Europe would be difficult enough, but European policy makers do not have this convenience.
On the financial infrastructure, and given what has been observed by others on this panel, a simple example will suffice. Before the introduction of the euro, European markets had some 31 systems for clearing and settling securities transactions. It also had 25 derivatives exchanges, 20 derivative clearinghouses, and 15 stock exchanges. Markets were national, each one had a currency, and each nation needed its own system, either run by the government or sanctioned and regulated by it. Some five years after the introduction of the euro, progress has been made in reducing these redundancies, but the euro area still has too many such systems based on national needs rather than European needs. Having to deal with all of these systems for clearing and settling securities transactions-mostly involving safe government securities-is very costly, cumbersome, and fraught with differences in accounting and other conventions, and other differences in business practices. It also strains liquidity management. There has been progress, but not enough, and this is holding back market integration.
Let me now turn to the regulatory environment for markets. Regulations lay out the rules of the game of finance in markets. In the US, financial regulation is primarily, if not exclusively, the competency of the federal government. There is a uniformity of rules, standards, business practices, etc. for issuing and trading securities and the infrastructure to facilitate this activity that is so vital to the securitized form of finance that takes place in US markets.
The same cannot be said for Europe. Indeed, the opposite can be said. There is a lack of uniformity and in fact a largely national orientation to securities regulation. Baron Lamfalussy and his committee of wise men have established a process whereby Europe can achieve significant convergence in securities, banking, and even insurance within Europe. This is the Financial Sector Action Plan. But the committee was formed to come up with a procedure, and did this, albeit a very complicated and cumbersome one. But it did not have the mandate to examine the scope of each of these important areas requiring regulations. And not all agree on the procedures.
Crisis Prevention and Resolution
Let me now turn to prevention and resolution of problems.
Confidence in a financial system depends in part on perceptions about the ability of the system to withstand problems and resolve them quickly with minimum cost. Europe is still a bank-dominated financial system, so banking supervision is a vital component of prevention.
The present approach to banking supervision in Europe reflects three principles inherited from the pre-euro Europe: decentralization, segmentation, and cooperation. The first means that primary responsibility for supervision will remain at the national level, probably for both wholesale and retail institutions. The second means that there are likely to remain separate supervisors (or departments within a single authority) for different types of financial institutions such as banks, securities firms, and insurance companies (let's leave pension funds aside). The third means that cross-border and cross-sector gaps will be handled through closer cooperation.
Decentralization, segmentation, and cooperation may work well in Europe, but this still remains to be seen. After all, one can say that the US architecture for financial supervision is even more complicated, multi-institutional, multi-jurisdictional, and segmented than it is in Europe. And, it is at least a defensible statement that the United States has some of the most efficient and effective financial institutions in the world. I would even go further and say that US supervision of financial institutions has been effective overall.
But there are two fundamental differences between Europe's and the Untied States' architectures for financial supervision and how they work in practice.
First, while there is some risk in the US system that a state supervisor would focus on the state's needs rather than the nation's, this is unlikely. Push-come-to-shove, the disparate parts in the US architecture have tended to focus on the nation's interest if this is what is required, especially since there is a sharing of responsibilities between federal and state regulators. It is less obvious that national supervision in Europe would tend, as a first priority, to focus on European priorities. After all, there are still different national interests, treasuries, taxpayers, and even laws. And there is no sharing arrangements spelled out in the law or Maastricht Treaty. Cooperation may work well and smoothly in normal periods of financial activity. But when a large financial institution-with significant cross-border business and exposures-licensed in one European country is having difficulties, it is difficult to imagine the national supervisor pursuing European interests first and national interests second. In short, there is the strong risk that there will remain a national propensity to protect national institutions, just as there has tended to be interest in producing national champions before mergers and acquisitions involving foreign institutions.
Second, despite the fragmentation of US supervision, there is a strong and unambiguous supervisor for the banking parts of very large financial holding companies that make up the core of the U.S. financial system, both in terms of the payments mechanisms and in terms of providing market-making and liquidity services across the US financial system and economy and even the global payments mechanism. By payments mechanisms I mean to include the payments mechanisms outside of the official payments mechanism Fed Wire, such as CHIPs, and the less formal, but perhaps equally important OTC derivatives markets. This supervisor-the U.S. Federal Reserve System-has had its authority over the large institutions solidified if not bolstered by the Gramm Leach Bliley Act. There is as yet no such supervisor in the euro zone overseeing the European equivalent of the major European financial institutions.
Now let me turn to the last area, resolution of problems: Crisis management mechanisms are somewhat clearer in Europe today than they were five years ago. But they are still not clear enough to satisfy doubtful international market participants and other outsiders (me included). In particular, it is not clear how a crisis involving a pan-European bank or one occurring across pan-European markets would be handled.
Let me illustrate this ambiguity, which does not appear to be constructive to me.
The ESCB is entrusted with the "Smooth operation of the payments system." In the specific case of a gridlock in TARGET, the Maastricht Treaty, which includes the statute establishing the ESCB implies that the ECB has competence to act as lender of last resort.
What does the treaty imply if crisis does not originate in TARGET? It is not clear.
According to at least one legal scholar in Europe, the treaty is silent about whether the ECB has competence to act as LOLR.2 According to this scholar, some have interpreted this silence as an indication that there is scope to enhance the ECB's authority in this area. Opposing this view, others see silence as an indication that the authority remains where it was before the treaty, namely with national authorities. Still a third interpretation is that along with other ambiguities in the treaty, the subsidiary principle leaves open the possibility for a Community competence, which could be exercised directly by the ECB or by the NCBs in their capacity as operational arms of the ESCB. Or maybe it leaves open the door for some other European institution, it is just not clear.
Some see this ambiguity as constructive, which admittedly is desirable if it is confined to ambiguity about the conditions under which LOLR assistance would be appropriate. But this is not the kind of ambiguity in the treaty. But this ambiguity seems to be about who does what or who has the authority.
There probably are informal and maybe even formal, written arrangements about who does what. But unless the markets have confidence that these mechanisms exist and that responsibilities are well defined and can be carried out effectively, they may count for naught in terms of building confidence and establishing credibility in this important policy dimension.
In the case of a general drying up of liquidity related to market developments or an unanticipated shock, the treaty is probably sufficiently silent that the ECB could act through its "market operations approach" and supply liquidity to the markets. But how does it go about distinguishing liquidity from solvency problems when it does not have immediate, independent access to information about the creditworthiness of the major financial institutions, be they of German, Italian, or French nationality?3
Looking to the Future
These are some of the remaining but not insurmountable challenges.
There should be little doubt that the euro is a major currency and a major force in international finance, second only to the dollar.
However, it is difficult to see the euro progressing much further than it already has in this dimension without further progress in each of these areas. Progress would first and foremost improve the depth, liquidity, transparency, and integration of European financial markets, which is a necessary condition for further progress internationally. Improving markets would, in my view, also facilitate a more rapid rationalization and consolidation of financial institutions in Europe, which is also needed for capturing the remaining and sizable potential efficiency gains of the Union.
I would not expect progress to be very rapid. All of the challenges just outlined have been challenges since 1999 when the euro was introduced. Progress has been made in each of these areas. But it has not been rapid, and it has not been sufficient to reach the euro's full potential either in catalyzing the creation of deep, liquid, and efficient pan-European markets or as an international vehicle for finance.
1. See Alessandro Prati and Garry J. Schinasi, Financial Stability in European Economic and Monetary Union, Princeton Studies in International Finance, No. 86, August 1999; and Alessandro Prati and Garry J. Schinasi, "European Monetary Union and International Capital Markets: Structural Implications and Risks," IMF Working Paper WP/97/62, May 1997; and Chapter III in International Capital Markets: Developments, Prospects, and Key Policy Issues, World Economic and Financial Surveys, Washington, D.C., International Monetary Fund, 1997.
3. For two distinct but related discussions of the role of central banks in ensuring financial stability see Garry Schinasi, 2003, "Responsibility of Central Banks for Stability in Financial Markets," IMF Working Paper 03/121 (Washington: International Monetary Fund, June), and Tommaso Padoa-Schioppa, 2003, "Central Banks and Financial Stability: Exploring the Land in Between," in The Transformation of the European Financial System, eds. Vitor Gaspar, et al. (Frankfurt: European Central Bank), pp. 269-310.