Frankfurt am Main, 25 April 2016
Risk Sharing and Macroprudential Policy in an Ambitious Capital Markets Union
Speech by Vítor Constâncio, Vice-President of the ECB,
at the Joint conference of the European Commission and European Central Bank on European Financial Integration and Stability
Ladies and gentlemen,
An integrated and developed capital market is of key relevance to the European financial system and the economy as a whole. In my speech today, I would like to provide a foundation for this statement from two interlinked perspectives. First of all, well-functioning capital markets are particularly beneficial for an area like the euro area if they lead to what economists call “financial risk-sharing”. At the same time, however, the process of financial integration and capital market development that can enhance such risk-sharing may be accompanied by the emergence of new financial stability risks that could undermine the envisaged benefits. Therefore, in order to reap the benefits of a true Capital Markets Union (CMU), we need to provide the conditions under which capital markets can flourish, whilst at the same time making sure that regulatory and supervisory measures keep financial stability risks in check.
In order to make progress on how this balance can be struck, I shall first review the case for cross-country risk-sharing via capital markets, review the evidence for the euro and consider how it can be enhanced. Next, I shall discuss the threats to financial stability that can be associated with complementing a more bank-based financial system, like the European one, with strengthening capital markets. Third, I shall let you know my views on which macroprudential policy reforms should be considered.
The benefits of financial risk-sharing for the euro area
One of the main reasons why financial integration is beneficial is that integrated financial markets help support constant consumption growth “in good and in bad states” of the world.[1] Consumption smoothing between countries, also known as risk-sharing, can increase welfare by hedging consumption against country-specific risks. In theory, in a perfectly integrated world, full risk-sharing can be achieved where consumption in regions or countries grows at a constant pace and is insensitive to local fluctuations in income and wealth.
Normally, high levels of risk-sharing are achieved across jurisdictions within a country, or within a federation that represents a functioning political, economic, and monetary union. For example, evidence suggests that three quarters of shocks to per capita gross product of individual states in the United States are smoothed, with about 40 percent smoothed by insurance or cross-ownership of assets, a quarter smoothed by borrowing or lending, and one-eighth smoothed by the federal transfers and grants. In other words, the contribution of markets is five times higher than the contribution of fiscal tools.[2] Regions within federations in Europe exhibit high levels of risk-sharing, too. For example, in pre-unification Germany, virtually all shocks to per capita state gross product were smoothed. However, due to less developed capital markets than in the United States, the largest portion – 50 percent – was smoothed through the federal tax transfer and grant system, and 36 percent were smoothed through financial markets.[3]
For countries in a monetary union such as the euro area, risk-sharing is particularly important because the single monetary policy is unable to address asymmetric shocks. With disjoint business cycles across countries, idiosyncratic shocks to EMU member states need to be insured through robust market or fiscal mechanisms. Reducing the volatility of aggregate consumption through various risk-sharing mechanisms can provide significant welfare gains for countries hit by specific shocks. And, by reducing internal divergences and facilitating macroeconomic adjustment, risk-sharing can be beneficial for the monetary union as a whole.
At this point it is quite clear that, in the foreseeable future, a number of mechanisms that have the potential to improve risk-sharing across countries will not progress quickly in Europe. For example, labour mobility will likely remain below levels achieved in common-language federations such as the United States or Germany. Similarly, building a European supra-national system of taxes and transfers to mimic the United States or the situation within some European countries is, at present, not a realistic prospect. Finally, the rules on fiscal deficits imposed by the Stability and Growth Pact will continue to set limits on national governments for smoothing large shocks.
For these reasons, it is more pressing than ever to boost Europe’s risk-sharing potential through financial market mechanisms. First, cross-border holdings of productive or financial assets can provide members of a currency union with insurance against idiosyncratic shocks. Second, well-functioning credit markets can contribute to smoothing consumption against relative income fluctuations, especially if most cross-border lending takes the form of direct lending to households and firms rather than of wholesale lending and borrowing in interbank markets.[4] The conclusion is that greater progress in risk-sharing in the euro area would require significantly more developed and integrated capital markets, as well as more banks operating at a pan-European level.
Quantitatively, the risk-sharing benefits of integrated financial markets can be large. By far the most important source of risk sharing are cross-regional and cross-border asset holdings, that is, various forms of equity holdings and firm ownership claims. Financial integration in Europe was expected to be greatly facilitated by the introduction of the common currency. However, in the years since the introduction of the euro, progress in capital markets and credit markets integration has been uneven. At present, the cross-border ownership of assets in the EU is still limited, despite the fact that the single currency in the euro area reduced some of the information barriers and transaction costs. Corporate financing through bond and equity markets is much more limited in Europe too, with banks being the undisputed primary source of funding for firms.
For all these reasons, the overall contribution of markets to risk-sharing has, on average, been somewhat limited.[5] Chart 1 demonstrates the contribution of various factors to risk-sharing over time. It shows that after the adoption of the euro, smoothing through factor income flows resulting from cross-border ownership of assets increased substantially, yet it remained on average below US levels. The notable exception is a brief period in the early-to-mid 2000s when capital markets smoothed between 30 and 40 percent of country-specific shocks to GDP. The contribution of capital markets declined substantially during the financial crisis and especially during the sovereign debt crisis. The contribution of credit markets has been lower, and it became even negative during the financial crisis when the European banking sector was particularly heavily hit. At present, almost 80 percent of the idiosyncratic shocks to a country’s economy remain unsmoothed, and changes in relative prices contribute the most to risk-sharing.
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