3 Current State of Play

Jörg Decressin, Wim Fonteyne, and Hamid Faruqee
Published Date:
September 2007
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This chapter reviews the current state of financial integration in the European Union, with a particular focus on the interplay among integration policies, the architecture of financial markets, and actual progress toward integration.1 The next section reviews the state of integration across various markets, including the convergence of prices for similar financial products, the cross-border correlation of returns, and developments in cross-border financial flows. The following section outlines current financial integration policies, in particular the Financial Services Action Plan (FSAP), the Lamfalussy process, and the European Commission’s White Paper for 2005–10. The concluding section reviews some important remaining gaps.

Progress toward Financial Integration

Money Markets

The uncollateralized interbank money market is basically fully integrated, which is crucial to the conduct of a unified monetary policy in the euro area and to the integration of other financial markets. Domestic interbank money markets fully converged (Figure 3.1), merging into a unified euro interbank money market with the launch of the euro. This was the result of careful preparation, including the development both of areawide reference rates (EONIA and Euribor) and of large-value cash payment system infrastructures (TARGET and EURO1).2 According to ECB survey data, cross-border interbank transactions between euro area counterparties (measured by the number of counterparties) represented about 54 percent of all interbank transactions in 2004.3

Figure 3.1.Convergence of Euro Area: Interest Rates

(In percent)

Source: Bloomberg L.P.

Note: Three-month interbank borrowing rates. For euro area, the domestic borrowing rates are replaced by Euribor starting January 1, 1999.

Repo markets, however, remain largely segmented along domestic lines.4 This primarily reflects the fragmentation of clearing and settlement systems for cross-border securities transactions (discussed more here and in Chapter 5). To some extent, this fragmentation has been overcome by monetary authorities and their counterparts through the Eurosystem’s Correspondent Central Banking Model (CCBM)5 and by other market participants through tripartite repo transactions.6 Nevertheless, the existing fragmentation raises transaction costs, limits the pool of collateral that is effectively and readily available to market participants, and thus impairs the efficiency of the euro money market.

Fragmentation also affects the market for short-term securities, notably those issued by financial institutions and corporations. Key factors are the multiplicity of settlement circuits, differences in legal frameworks and disclosure requirements, and heterogeneous issuance practices and market conventions. As a result, well-established domestic markets operate alongside a newer euro commercial paper (CP) market in London, and there are few connections between them. The London market has proved to be very dynamic and innovative, growing significantly in size and reaching a stock of securities of about €420 billion by end-2005.

For a truly euro-area-wide money market to emerge, further changes are thus necessary. The Undertakings for Collective Investment in Transferable Securities (UCITS III) directive, which awaits implementation, is expected to harmonize the investment rules applying to money market funds and remove limitations on investment in CP and other short-term securities. Proposals such as the Short-Term European Paper (STEP) project have been put forward by market participants to achieve the integration of European short-term securities markets through progressive standardization of money market securities and convergence of issuance practices.7 Whether the short-term securities markets can be fully integrated without active support of European and national authorities remains an open question, however.8

Government Bond Markets

Monetary union has fostered a deeper, more liquid and complete, and increasingly integrated government bond market. The convergence of yields (Figure 3.2) shows the degree of integration of euro area government bond markets. The volatility of yields has also declined significantly and is increasingly driven by common factors. Of course, some yield differences should be expected to persist because government bonds in the euro area are not perfect substitutes: countries carry different credit risks and there is no areawide “bail out” mechanism (Artus, 2005).

Figure 3.2.European Union: Long-Term Government Bond Spreads

(In basis points)

Source: Bloomberg L.P

Note: Spread between yield on 10-year government bond and 10-year German government bond.

Monetary union undid the segmentation created in sovereign debt markets by the use of national currencies, introducing direct competition for an increasingly international pool of investors. The challenge for public debt managers is therefore to secure the attractiveness not only of their own debt but also, more generally, of the euro government bond market, combining competition and cooperation.9 The harmonization of secondary market conventions, new issuance policies (publication of auction calendars, promotion of fungible benchmark issues, and increased use of syndication), and active debt management on the secondary market have contributed to the increasing homogeneity, transparency, and liquidity of public debt markets. Simultaneously, competing government debt issuers have expanded the range of products offered to investors.10

The transformation of secondary market infrastructures, through the increased use of electronic trading, has facilitated the integration of government bond markets, including the narrowing of spreads. The MTS network has become the main cash trading platform for European government bonds. It provides both real-time quotations from selected market makers to a wide range of professional participants and automated electronic execution. Through market-making obligations imposed on the participating dealers, these platforms contribute to enhancing the liquidity and transparency of the secondary market. The characteristics of these electronic platforms, in particular liquidity arrangements and the organization of pre-trade transparency, may raise important issues regarding the resilience of the liquidity offered by these platforms, including somewhat “artificial” liquidity.11 Specifically, an important question in the context of the FSAP and the discussions surrounding the implementation of the Markets in Financial Instruments Directive (MiFID), is how pre-trade transparency affects the supply of liquidity, including the activities of large market participants.12

Corporate Bond Markets

Monetary union brought together markets that had been largely segmented by currency into an integrated and more diversified euro market (Pagano and von Thadden, 2004). Issuance of nongovernment bonds by euro area residents13 grew significantly in the years surrounding the introduction of the euro: volumes outstanding grew from about €2.1 trillion at end-1997, to about €3.1 trillion at end-2001, and about €6 trillion by the end of 2006. Financial institutions remain the dominant issuers in this market, accounting for close to 90 percent of volumes outstanding (46 percent including government bonds). Nonfinancial corporate bond issuance also started to boom around the time the euro was introduced, but slowed somewhat after peaking in 2003 (Figure 3.3). In stock terms, they represent a bit more than 10 percent of volumes outstanding (6 percent including government bonds). In a sign of increasing breadth, the market has developed not only in terms of the number of issuers but also in terms of the variety of their credit ratings (Table 3.1).

Figure 3.3.Euro Area: Euro-Denominated Nonfinancial Corporate Bond Issuance

(In billions of euros)

Source: Dealogic Bondware.

Table 3.1.Distribution of European Corporate Bond Issuers by Whole Letter Rating
Investment grade30179416772878889916960
Speculative grade2422118128141171195
All issuers321834388901,0061,0301,0871,155
Source: Moody’s Investors Service.
Source: Moody’s Investors Service.

Investment strategies of institutional investors underscore the area-wide nature of the corporate bond market. Euro adoption was associated with significant inflows by internationally investing bond funds and by pension funds and life insurance companies. By 2003, more than half of the assets of bond funds in the euro area countries were invested with an areawide strategy. As a result, country-specific factors have played a decreasing role in determining bond prices and spreads relative to international and industry-specific factors. In contrast, the share of bond funds with a Europe-wide strategy remained stable between 1998 and 2001 in Denmark, Sweden, and the United Kingdom, which have not adopted the euro (Lane, 2006).

Investment Banking and Asset Management

The integration of investment banking activities has mainly benefited Europe’s larger corporations. Investment banks face declining underwriting fees on corporate bond issues, with increased economies of scale and fewer barriers to entry in the underwriting businesses.14 Investment banks also face a high degree of competition, in large part because of the greater role played by U.S. investment banks, which have expanded their market share. This situation of growing integration and competition in the provision of investment banking services to large corporations contrasts significantly with the fragmented financial markets faced by Europe’s small and medium-size enterprises (Bris, Koskinen, and Nilsson, 2002).

The European asset management industry still operates in a largely fragmented environment. The European Union’s framework for investment funds needs further development, especially given Europe’s need for retirement savings ahead of the looming demographic shock. Despite a succession of regulatory steps, including the recent UCITS III directive, legal and tax barriers continue to hamper the development of cross-border investment products (Heinemann and others, 2003). In 2003, only 18 percent of investment funds, representing 31 percent of the industry’s estimated €10 trillion worth of assets under management, were considered “true” cross-border funds. Furthermore, the growing importance of non-harmonized/alternative investment funds such as hedge funds and private equity, real estate, and commodity funds15 has led to specific regulations being implemented in various European countries in recent years. This has been done in a rather uncoordinated and unharmonized way, adding to the fragmentation of the industry.

Markets for Securitization

Securitization, virtually nonexistent in the mid-1990s, has been expanding rapidly but remains underdeveloped (Figure 3.4).16 A key obstacle to a deeper market is the absence of a common legal framework for pan-European securitization programs. The securitization landscape in Europe largely remains an aggregation of local markets, using different techniques and instruments. The United Kingdom retains a dominant share of European securitization, at about 45 percent, whereas Ireland, Portugal, and France are marginal issuers. Issuance from Germany is progressively gathering momentum, supported by the “True Sale Initiative” that became operational in 2004. In the securitization market, maybe more than in other market segments in Europe, the need to overcome differences in legal frameworks and market fragmentation has spurred the development of “high-tech” products that are based on sophisticated financial engineering.

Figure 3.4.European Securitization

(Issuance in billions of euros)

Source: European Securitisation Forum, ESF Securitisation Data Report.

Covered bond markets, by contrast, have a stronger footing in Europe. Balance sheet securitization17 represents an important segment of European financial markets: the size of the EU covered bond market stood at close to €1.8 trillion at the end of 2005, representing around 20 percent of the total European bond market. From Germany, the covered bond model has spread in various forms across Europe, including to the United Kingdom. The recent UCITS III and the Capital Requirements Directive (CRD) are important steps toward the creation of a more homogeneous covered bond market. They provide, for the first time, a clear definition of covered bonds and a list of classes of eligible collateral. To allow covered bonds to benefit from a beneficial risk weighting, they also introduce new requirements for collateral, including with respect to type, credit quality, valuation, and loan monitoring (European Covered Bond Council, 2006).

Interest Rate Derivatives Markets

Interest rate derivatives developed significantly since monetary union (Figures 3.5 and 3.6).18 The growth of the over-the-counter (OTC) euro-denominated futures market has been especially significant at the short end, where the development of liquidity management tools went hand in hand with the integration of the euro interbank money market.19 For exchange-traded derivatives, a period of fierce competition between exchanges and products resulted in the concentration of liquidity and activity in two sets of contracts: the Euribor-based three-month Euronext-LIFFE (London International Financial Futures and Options Exchange) contract and the series of German government debt-backed contracts developed by Eurex-Deutsche Borse.

Figure 3.5.Three-Month Interest Rate Future Contracts: Evolution of Open Interest

Source: Datastream.

Note: In millions of Euribor equivalent contracts.

Figure 3.6.Open Interest: 10-Year Treasury and 10-Year Euro Bund

Source: Datastream.

Note: Prior to 1999 data refer to German bund; in millions of Euro bund equivalent contracts.

Equity Markets

Integration trends in equity markets are less clear-cut. Equities show an increased correlation of price movements across countries and a convergence of premiums.20 However, this could reflect increased synchronization of fundamentals among euro area countries and the globalization of companies, as suggested by the increased correlation of sector returns.21

Consolidation of trading infrastructures is proceeding, but significant fragmentation remains. The three main trading platforms—Euronext group,22 which ties markets of different sizes in a decentralized but technically uniform trading environment; Deutsche Börse Group; and the London Stock Exchange (LSE)—offer different organizational models. Most Nordic and Baltic exchanges have united in OMX (based in Stockholm), which has a similar decentralized structure as Euronext. While the established stock exchanges are seeking further consolidation,23 they face increasing competition from new trading platforms, such as multilateral trading facilities (MTFs) and the internalization of orders, which are being made possible by the MiFID.24 This increasing competition benefits issuers and investors by reducing trading costs, but competing platforms can also result in fragmentation of liquidity, a risk MiFID might amplify.

Postmarket Infrastructures

Inefficiencies in clearing and settlement of cross-border securities transactions constitute a major hurdle toward an integrated areawide financial market. Clearing and settlement remain organized around preexisting domestic structures that have proven difficult to integrate. The cross-border clearing and settlement channels include local/correspondent banks, which are members of the foreign central securities depositories (CSDs), operate through an international central securities depository (ICSD) or a global custodian, or use, when available, direct links between CSDs.25 Of these, global custodians and ICSDs are used most extensively, as they offer a single entry point, in particular for nonresident investors who have no “natural” base in any euro area country. However, this fragmentation of channels and the involvement of multiple intermediaries raises costs, magnifies credit and operational risks, fragments market liquidity, and contributes to delays for market participants.26

In 2001, the Giovannini Group identified 15 barriers to efficient cross-border clearing and settlement and cross-border consolidation in the industry, arising from differences in technical requirements, market practices, domestic tax procedures, and domestic laws and regulations. In 2003, the group proposed a strategy to remove these barriers that combines actions by market participants and public authorities (Giovannini Group, 2001, 2003). While progress has been made, in particular with regard to technical differences and market practices, much work remains to be done. The removal of remaining barriers will not necessarily dictate how the clearing and settlement industry will evolve, but can be expected to increase the pressure and opportunities for consolidation (see also Chapter 5).

MiFID is expected to contribute to improving cross-border clearing and settlement efficiency. MiFID extends the rights of market intermediaries (investment firms and banks) and regulated markets to access central counterparties and securities settlement systems located in other member states under nondiscriminatory conditions. Furthermore, investment services providers are now granted the right to choose the settlement location for their transactions (but not the right to choose their clearing location), thus eliminating the need to maintain multiple memberships in securities settlement systems.

Retail Finance

Retail financial services, for individuals and small and medium-size businesses, remain highly fragmented. Limited convergence of interest rates—to the extent measurable given the diversity of products—suggests that the market for consumer loans shows little integration.

Mortgage markets appear somewhat more integrated, possibly reflecting collateralization, which reduces the need for monitoring and enables securitization and competition. Nonetheless, cross-border activity remains marginal (only 1 percent of European mortgage borrowers are believed to have taken mortgage loans from another member state). While the costs of mortgages appear to be fairly uniform across countries, available mortgage products differ across national markets.27 Increased integration of European mortgage markets would be expected to have a positive impact on the EU economy—the integration of mortgage markets would raise GDP by 0.7 percent and private consumption by 0.5 percent over a 10-year period (European Commission, 2005b; London Economics, 2005). Yet the debate remains open as to how and how far integration should be promoted. A White Paper is expected on this issue from the European Commission in 2007.

Integration has begun in the market for time deposits, but heterogeneous regulatory and tax regimes impede integration in the market for savings deposits. The integration of markets for demand deposits is dependent on progress in the area of retail payments, and the infrastructure for retail payments remains fragmented along domestic lines. This situation is being addressed by the Payment System Directive (PSD). The PSD provides the legal background for the Single Euro Payments Area (SEPA) initiative, which seeks to enable economic agents in the euro area to make and receive payments in euros, whether between or within national boundaries, under the same basic conditions, regardless of their location (European Central Bank, 2006b).

Financial Integration Policies

Since the late 1990s, three major initiatives have been shaping financial integration policies: the FSAP, the Lamfalussy process, and the White Paper. The FSAP was the most important of these three initiatives, as it was aimed at creating a single financial market to complement monetary union. The Lamfalussy process seeks to facilitate decision making, harmonize supervisory practices, and address financial stability challenges. The White Paper, the most recent of the three initiatives, outlines the European Commission’s policies for the 2005–10, post-FSAP era.

The Financial Services Action Plan

The FSAP was a broad legislative and regulatory program launched in 1999 and aimed at removing barriers to the cross-border flow of financial services and capital within the European Union. The FSAP (European Commission, 1999) was based both on the realization that monetary union would not create a single financial market by itself and on earlier work that had identified remaining barriers to the creation of such a market (European Commission, 1998). While touching upon many things, the FSAP pursued three strategic objectives: a single wholesale market, open and secure retail markets, and state-of-the-art prudential rules and supervision (Table 3.2). In practice, it went further on the first and third of these objectives. Combined with additional measures that have been agreed in response to market developments, the FSAP built the backbone for Europe’s future financial markets. The supranational legislative phase of the FSAP was largely completed by the 2005 target date, but implementation of the different measures at the national level is expected to take several more years. Hence, the FSAP’s full impact will only become clear in the years ahead.

Table 3.2.FSAP: Main Issues in Wholesale Financial Markets and Prudential Supervision
Market abuseHarmonized rules on the prevention of insider dealing and market manipulation on regulated and unregulated markets
Markets in financial instrumentsRegulation of the authorization, behavior, and conduct of business of securities firms and exchanges
ProspectusSingle passport for issuers of equity and debt securities on the basis of the prospectus approved by the regulatory authorities of the issuer’s country
TransparencyFinancial reporting and dissemination of information by securities issuers; securities issuers required to provide detailed semiannual information and quarterly updates
AccountingImplementation of International Financial Reporting Standards (IFRS)
Regulation of UCITS depositoriesProgressive reduction in differences in national rules regarding the depositories of assets in UCITS, including depositories’ liability, the convergence of prudential requirements, transparency, and investor information
Implementation of UCITS directivesContent and presentation of the simplified prospectus; clarification on the use of derivatives instruments by UCITS and the need for adaptation of risk management standard and investor protection
Occupational pension fundsGuidance principles for asset allocation, in line with the “prudent person rule,” and call for the elimination of discriminatory tax provisions
Settlement finalityReduction of systemic risk in payment and securities settlement systems
Status of collateralIncreased legal certainty regarding the validity and enforceability of collateral arrangements backing cross-border transactions
Cross-border mergersRules governing takeover bids and the protection of minority shareholders
Statutory auditClarification of the duties and responsibilities of statutory auditors; independence and ethics; criteria for national public oversight of the audit profession
Capital framework for banks and investment firmsImplementation of Basel II
Financial conglomeratesIdentification of “significant financial groups” and designation of a supervisory co-coordinator for each conglomerate
Reinsurance supervisionHarmonization of supervisory methods, removal of the remaining barriers for intra-EU cross-border reinsurance activities, and increased protection of policy holders
Insurance solvencyCreation of a consistent risk-based insurance solvency system
Sources: EU commission; Bank of England, Quarterly Bulletin.Note: for more detailed information about the FSAP and the measures taken under each of the themes listed above, see
Sources: EU commission; Bank of England, Quarterly Bulletin.Note: for more detailed information about the FSAP and the measures taken under each of the themes listed above, see

MiFID is, to a large extent, the cornerstone of the FSAP. MiFID has the potential to reshape European financial markets, starting with equity markets. The directive will provide securities firms with an updated EU “passport,” allowing them to offer a range of financial services across member states on the basis of home-country control. Key features of the directive are the promotion of open market architecture, competition between regulated and unregulated markets, and the search for a balance between market efficiency and investor protection, in particular through complex order-execution and transparency rules. Following requests from member states and industry, the transposition and implementation deadlines for MiFID were extended by six months each, delaying full implementation to November 1, 2007.

Two further directives––the prospectus and transparency directives—are particularly important. These directives seek to unify the rules imposed on issuers regarding financial disclosure. Together with the introduction of the International Financial Reporting Standards (IFRS), which unifies the accounting framework for publicly listed firms, these directives will provide investors with better and more homogeneous information and will allow issuers to issue across EU markets on the basis of a single prospectus.28 Regarding bond issues, the disclosure requirements imposed on issuers vary depending on whether they are deemed to target wholesale or retail investors. There are fears that this new framework may prove excessively cumbersome and expensive, particularly for non-European companies. Some companies are already choosing to list their shares and eurobonds in venues that are not covered by the European directives.29 By offering investors and issuers additional choice, these developments should contribute to the completeness of European financial markets. A risk, however, is that they may foster creation of opaque, unlisted markets that would weaken the benefits of the new framework in the area of investor protection.

The FSAP is producing substantially modernized and harmonized prudential regulations, but because it does not touch the country-based institutional framework for supervision, the challenge remains of how to consistently implement harmonized prudential regulations in a decentralized supervisory system. The CRD implements Basel II in the European Union, but goes beyond it in many respects, including in that it is applied to all banks and investment firms. Solvency II is aimed at achieving a similar overhaul toward risk-based prudential regulation for insurance companies, while catching up with banking in terms of regulatory harmonization. In some ways, the latter is a more pioneering endeavor, in the sense that it is not linked to an international initiative. While the CRD came into force on January 1, 2007, a framework directive for Solvency II is only scheduled to be proposed in mid-2007 and full implementation is likely to take at least a couple more years.

The Lamfalussy Process

The Lamfalussy process was devised to address challenges related to the speed, quality, and adaptability of regulatory and legislative decision making and to harmonize implementation and supervisory practices across countries. Originally designed specifically for securities regulation, the process was a response to a growing consensus that the EU institutions’ slow decision-making procedures were at odds with their increasingly important role as regulators of rapidly changing financial markets and with the legislative burden produced by the FSAP (Committee of Wise Men, 2000, 2001). The goal is to speed up the legislative process and deliver more uniform and better technical regulation by limiting legislation to passage of “framework directives,” with implementation details being filled in by technical committees. The process also seeks to address the above-mentioned challenge of implementing a harmonized regulatory framework in a decentralized supervisory system by ensuring consistent implementation of EU rules and harmonization of supervisory practices. Initially limited to the securities markets, the Lamfalussy process was extended in November 2003 to the banking sector and the insurance and pensions sector. Within the securities sector, its coverage was extended to the mutual funds industry. All in all, the Lamfalussy structure now comprises three broad sectoral pillars.

As a legislative and regulatory tool, the Lamfalussy process has become a major vehicle for the design and implementation of the FSAP, particularly for securities markets (MiFID) and insurance (Solvency II). In banking, the implementation and harmonization dimension of the process has dominated thus far, as the CRD was not legislated through the Lamfalussy process. The process is organized in four layers, which exist in each of the sectoral pillars:

  • The core principles of legislation take the form of directives and regulations adopted by the political bodies, the European Council and the European Parliament (Level 1), on the basis of proposals prepared by the European Commission.
  • Technical implementation of framework directives and regulations is done by the European Commission, on the basis of recommendations made by high-level regulatory committees (Level 2), in consultation with Level 3 committees and users and experts from industry.30
  • The implementation of EU legislation at the national level is the task of expert committees composed of national regulators and central banks (Level 3).31 Level 3 committees are responsible for supporting a consistent day-to-day implementation of EU legislation, by issuing guidelines and reviewing national regulatory practices.
  • Compliance with and enforcement of legislation by member countries is mainly the responsibility of the European Commission (Level 4).

With most of the FSAP legislative work completed, the focus is now on implementation and harmonization. For developments on the ground, much depends on how Level 2 and Level 3 committees, particularly the latter, conduct their work. The role of these committees is especially important in areas where the principle of the single passport granted by the home country has yet to be implemented and where cross-border competition can be seriously undermined by host-country regulation. A significant further strengthening of cooperation between national authorities will be required to avoid risks of “renationalization” of regulation (Level 2) and to ensure the convergence of supervisory practices (Level 3). A review of the Lamfalussy process is due for completion by end-2007. The assessments of a group of experts, the Inter-Institutional Monitoring Group (IIMG), will serve as input for this review. In its second interim report (Inter-Institutional Monitoring Group, 2007), the group noted that the Lamfalussy process has achieved much progress, but often produced excessively detailed rules. Moreover, additional efforts were needed to enhance supervisory cooperation, including by finding a formal solution for (cross-sector) work on financial conglomerates.

The implementation of MiFID offers a major test. The directive is a compromise between significantly divergent domestic approaches to market regulation. The key to its success will be the ability of CESR to foster genuine cooperation by national authorities in the design of the implementing measures to achieve a convergence of supervisory practices, preserve the directive’s cohesion, and avoid its dilution. The postponement of MiFID to November 2007 illustrates the difficulties associated with designing these implementing measures, transpositioning the directive into national regulations, and fostering implementation by market participants.

The White Paper

The European Commission’s “White Paper on Financial Services Policy” seeks to build on and complete the FSAP’s achievements. The White Paper (European Commission, 2005c) outlines the Commission’s policy priorities for 2005–10,32 recognizing that the FSAP will continue to produce a significant implementation burden during this period and that both authorities and market participants suffer a certain degree of reform fatigue. The White Paper therefore focuses on finalizing, consolidating, and implementing past initiatives; promoting “better regulation” and increased transparency; addressing the global dimension of financial integration; and launching a select few new initiatives. In particular, policies will focus on the following areas:

  • Integration of clearing and settlement systems. While work on removing the Giovannini barriers continues, the European Commission has opted for a market-based approach to opening up the market for clearing and settlement services (European Commission, 2004a). At its insistence, the industry agreed on a “Code of Conduct” 33 on November 7, 2006, that seeks to achieve the Commission’s objectives in terms of price transparency, effective choice of settlement venue, and unbundling of services, thereby increasing competition. In parallel, the ECB announced in July 2006 that the Eurosystem was considering development of a common securities settlement platform for securities transactions in central bank money (“TARGET2-Securities”). The Governing Council of the ECB confirmed the feasibility of, and formally launched, the TARGET2-Securities project in March 2007.
  • Retail financial services. Ongoing work on mortgage credit, consumer credit, and retail payments (SEPA) will continue, while renewed attention will be given to credit intermediaries, customer mobility, and removal of restrictions and increased competition with respect to bank accounts. Competition policy is expected to play a major role in these efforts, as the European Commission’s Competition Directorate General is conducting a sector inquiry into retail financial services.34
  • Regulatory and supervisory structures. The White Paper opts not to undertake fundamental institutional changes. Instead, the focus of the European Commission’s policies will be on making the Lamfalussy process work, clarifying and optimizing home-host responsibilities in a consolidated supervision approach, developing cross-sectoral regulatory cooperation, and introducing common data and reporting requirements (for a more in-depth discussion, see Chapter 10). Work on Solvency II will continue.
  • Investment funds. The Commission published another White Paper, on Enhancing the Single Market Framework for Investment Funds, in November 2006.35 Increased efficiency in the framework for harmonized investment funds (UCITS) will be sought through a combination of legislative and nonlegislative actions, and will seek to simplify passporting mechanisms, harmonize prospectuses, and increase supervisory cooperation. Also on the agenda are clarifying the tax treatment of fund mergers, applying MiFID to investment funds, and using delegation in security custody activities. The Commission refrained from proposing any legislative initiatives in the area of alternative investment funds for the time being, but set up a work program to explore the associated issues further.
  • Mergers and acquisitions. The White Paper announced the European Commission’s intention to revise Article 16 of the Banking Directive and Article 15 of the Insurance Directive in order to increase clarity, transparency, and disclosure with respect to supervisory approval of mergers and acquisitions. To that effect, the Commission proposed a Directive in September 2006 that would introduce specific criteria against which supervisors should judge merger and acquisition proposals and would reduce the assessment time from three months to 30 days.

Challenges Ahead

Integrating retail markets is likely to remain a long-term and complex challenge. Language and legal systems, in particular consumer protection issues, are important factors in the fragmentation of retail markets. These factors complicate the integration process and render the outcome of regulatory initiatives uncertain. Considering the significant information asymmetries in retail credit markets and the limited impact of deregulation and technological progress on cross-border retail business to date, a local presence may well remain necessary for banks to access new retail markets. Ensuring that obstacles to cross-border consolidation in the financial sector are effectively removed will therefore have to remain a priority for EU authorities, alongside continued efforts to remove artificial barriers to the cross-border sale of retail financial products through media such as the Internet.

The European Union’s financial integration policies and financial stability framework must keep pace with these and other emerging challenges. Financial integration policies, in particular the Lamfalussy approach, rely heavily on consensus building and the willingness of different stakeholders to move forward. This puts the integration process at constant risk of being derailed by “national interests” and regulatory fatigue. Having a proactive European Commission is an essential, but by no means sufficient, condition to keep the process going, and will become all the more important in resolving taxation issues and differences in legal systems—notably between civil and common law approaches—which are among the main obstacles to further integration and will be harder to overcome than technical barriers. Meanwhile, progress toward financial integration itself along with rapid changes in financial markets present a constant challenge for financial stability arrangements. These challenges are explored in the following chapters.


The chapter draws extensively on Haas (2005).


TARGET (Trans-European Automated Real-time Gross settlement Express Transfer system) is run by the ECB and the national central banks. EURO1, a net settlement system, is run by the Euro Banking Association (


The percentage of cross-border interbank transactions has declined slightly in the last three to four years, possibly reflecting the redistribution role performed by large banks to the benefit of smaller banks within countries and, within large banking groups, the concentration of treasury activities in the home country. See European Central Bank (2005b).


A repurchase agreement (or repo) is an agreement between two parties whereby one party sells a security to the other with a commitment to buy it back, usually at an agreed date and price. In effect, a repo operation is a form of collateralized lending. According to the European Repo Council, the gross size of euro-denominated repo (and reverse repo) transactions amounted to €6 trillion as of June 2006, more than twice the estimated size in December 2001.


The CCBM is designed to allow Eurosystem counterparties to use securities issued in other euro area countries as collateral in operations with their national central bank (NCB), by transferring the collateral to an account maintained by the “issuing” country’s NCB, which acts as a correspondent central bank (CCB).


In tripartite repo transactions, securities and cash are delivered by the trading parties to an independent custodian bank or clearinghouse, which is responsible for ensuring the maintenance of adequate collateral value. In 2005, triparty repos represented about 11 percent of all repo transactions, up from about 7 percent a year before. See Chailloux (2005).


The STEP task force was set up by the ACI-Euribor. Its recommendations for establishing a European market for short-term securities include, in particular, use of a single set of market conventions and a standardized information memorandum for issuers. The STEP Market Convention was signed in June 2006.


While the ECB supported the launch of a “STEP label,” it did not offer the kind of catalytic role it played for the EONIA initiative in 1998–99.


While there is no formal coordination of issuance policy between countries, different venues, such as the EFC Sub-Committee on EU Government Bills and Bonds Markets, allow for technical discussions and exchanges of information.


New products include inflation-indexed bonds and, more recently, ultra-long-maturity bonds. Given the rapidly aging European population and ongoing pension system reforms, ultra-long fixed-income securities are expected to meet a growing demand, while also providing the necessary anchor for the development of new investment and hedging products.


The MTS system organizes quoted prices so that the best bid and offer prices are displayed, but layered behind these is a “depth of book” (this is, other market makers’ prices that will be used when larger trades come through). This approach has many advantages: market makers can quote prices that are, in effect, conditional on the strength of demand; and traders can rapidly execute large complex trades, confident that they are getting the best price for each trade.


Madhavan, Porter, and Weaver (2005) find that on the Toronto Stock Exchange, the increase in pre-trade transparency (public dissemination of the limit order book) had detrimental effects on liquidity and on the depth of the market.


The market for euro-denominated bonds issued by nonresidents is not considered here. Note, however, that international debt securities denominated in euro (i.e., issuance of debt securities in a currency other than the currency of the country in which the issuer resides) represented around 35 percent of the outstanding stock of international debt securities in the second quarter of 2005 (U.S. dollar–denominated issues accounted for about 39 percent), about 14 percentage points above its level at the start of EMU. See European Central Bank (2004c, 2005c). Of course, variations in these numbers in part reflect exchange rate movements.


Average gross fees in the euro-denominated corporate bond market halved in 1999 (from 1.7 to 0.8 percent) and have remained around 0.6 percent since then, a level similar to the United States (Santos and Tsatsaronis, 2003).


Nonharmonized retail-oriented funds in particular are estimated to represent about 20 percent of total assets under management.


Commercial mortgage-backed securities (CMBSs) and residential mortgage-backed securities (RMBSs) dominate securitization activities, accounting for, respectively, 45 and 12 percent of issues in 2005. Asset-backed securities (ABSs), including the fast-growing collateralized debt obligation (CDO) segment, account for the bulk of the rest. Despite fast growth, European securitization markets are dwarfed by those in the United States. Whereas total European securitization issuance amounted to €320 billion in 2005, U.S. issues of ABSs, MBSs, and collateralized mortgage obligations (CMOs) topped $3 trillion.


Covered bonds are backed by a priority claim on a subset of the assets (loans in particular) of the issuer, which remain on the issuer’s balance sheet. In contrast with securitization, the bonds remain liabilities of the issuer, rather than of a special-purpose vehicle (SPV).


In 2005, euro-denominated contracts represented 45 percent of global daily transactions in OTC interest rates derivatives (forwards, swaps, and options) and 38 percent of notional amounts outstanding, ahead of dollar-denominated contracts, which represented 34 and 25 percent, respectively.


Interest rate swaps indexed on the overnight euro reference rate are estimated to represent a daily average turnover of €40 billion.


Chapter 5 provides an in-depth analysis of this integration.


The Euronext group brings together the stock markets of Paris, Brussels, Amsterdam, and Lisbon, as well as the LIFFE derivatives exchange.


The European stock exchange landscape remains in flux and is becoming entangled in global developments. At the time of writing, Euronext and the New York Stock Exchange (NYSE) were completing a merger, whereas Nasdaq’s second bid for the LSE had been withdrawn.


Seven leading investment banks have announced their intention to create a pan-European MTF for equities when MiFID comes into force in November 2007.


Such direct links do not exist between all CSDs and, furthermore, often offer only “free-of-payment” securities transfer facilities, meaning that the cash component of the transaction has to be processed independently, through another system.


Differences in fee structures and services complicate comparisons, but estimates of the cost difference between domestic and cross-border transactions by Deutsche Borse and the Giovannini Group (2001) show the latter to be between 29 percent and 11 times more expensive, depending on the type of transaction and the estimation method. According to one study, direct clearing and settlement costs in Europe are between 3 and 300 times as expensive as in the United States, depending on market and settlement channel, with cross-border transactions being between 66 percent and up to 100 times as expensive as domestic ones (NERA Economic Consulting, 2004).


The Forum Group on Mortgage Credit (2004) offered a series of 48 recommendations to the European Commission on how to better integrate mortgage markets, addressing issues such as consumer confidence, legal and collateral framework, and distribution. Its work formed the basis for the Commission’s 2005 Green Paper (European Commission, 2005b).


Significant differences in corporate law remain, however.


The Alternative Investment Market, a component of the LSE, has relinquished its status as a regulated market to become an “exchange regulated market.” Similarly, Euronext and OMX have launched new “organized” but unregulated markets (Alternext and First North), which are accessible to equity issuers with limited requirements but also offer investors more guarantees than the so-called free markets. In the Eurobond market, similar initiatives have been launched in London, Luxembourg, and Switzerland.


Level 2 committees are the European Securities Committee (ESC), the European Banking Committee (EBC), and the European Insurance and Operational Pensions Committee (EIOPC).


The Committee of European Securities Regulators (CESR), the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), and the Committee of European Banking Supervisors (CEBS).


The White Paper was preceded by a Green Paper, which analyzed the policy challenges and was used for public consultation (European Commission, 2005a).


See “European Code of Conduct for Clearing and Settlement,” available on the website of the European Commission (, under the Internal Market and Services Directorate General.


On July 17, 2006, the Competition Directorate General published an interim report on current accounts and related services (available on the DG’s website). The report mainly contains factual findings and is meant to serve as a basis for consultation and further work.


See European Commission (2006a). This White Paper is based on the recommendations put forward in July 2006 by expert groups set up by the Commission.

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