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1 63((&+ 3HGUR6ROEHV Member of the European Commission responsible for Economic and Monetary Affairs )LQDQFLDOLQWHJUDWLRQDQGJURZWK European Financial Market Convention %UXVVHOV0D\

2 ,QWURGXFWLRQ Ladies and gentlemen, Let me start by thanking the Federation of European Securities Exchanges for inviting me to speak at this convention. In recent years, there has been a visible acceleration in the development and integration of EU financial markets. There are three main, interrelated factors behind such an acceleration. The first factor is globalisation, which has been fostered by the liberalisation of international capital movements, financial deregulation and advances in technology. The second factor is the advances in creating a common regulatory framework across the EU, as part of the effort to complete the Internal Market in financial services. This effort at EU level has also been accompanied by financial reforms in the Member States. The third factor is the adoption of the euro. Before January 1999, the need to operate in many national currencies was the major obstacle to financial integration in the Union. The presence of a sizeable exchange risk limited the attractiveness of cross-border investment, reduced the incentive to proceed with regulatory harmonisation at the EU level, and dampened competitive pressures on the Member States home markets. The introduction of the euro as the single currency of twelve Member States has altered this situation dramatically. The euro has greatly reduced exchange risk as a source of fragmentation in the EU financial system. As a result, deeper integration is reflected in more homogenous markets, a wave of consolidation among intermediaries and exchanges and the emergence of new and innovative products and techniques. At the same time, however, the euro has highlighted the opportunity costs of the many remaining sources of fragmentation in the system. These opportunity costs, or in other words the benefits of financial integration, will be the focus of my intervention today. I will argue that the potential gains to be reaped are large, and that the reform of financial markets should be seen as a powerful economic instrument to raise the growth potential of the European economy. I will develop my argument in three steps. First, I will argue that financial market integration implies a more efficient EU financial system. Secondly, I will review the role of an efficient financial system in the growth process. Finally, I will assert that the current EU strategy is appropriate, provided that all policy actors are convinced of the rewards ahead and invest the necessary political capital to reach the ambitious objectives that the EU has set for itself. $PRUHHIILFLHQW(8ILQDQFLDOV\VWHP Despite recent progress, the EU financial system remains highly fragmented. Member-State financial structures have evolved over time under the influence of the specific national needs and specific national preferences concerning legal and regulatory frameworks. By and large, these national financial structures are efficient from Member States domestic perspective. However, the need to operate across so many different national-based structures creates major inefficiencies for the pan-european investor and consumer. As a result, cross-border financial activity in the EU is constrained and important gains in financial efficiency are foregone. 2

3 Integration, by fulfilling the potential for cross-border financial activity, will provide for a significantly more efficient EU financial system and help to deliver the full benefits of a single currency. These efficiency gains from integrating the EU financial system will derive, ILUVW RI DOO, from larger and more liquid financial markets. In an integrated market, financial market operators will be able to reduce costs by exploiting the economies of scale and scope implied by access to a larger pool of potential customers. Borrowers and investors will have access to a wider range of products. And there will be increased possibilities for efficient risk-sharing. 6HFRQGO\, integration implies a move to a more competitive environment. Competition is key, because it ensures that the efficiency gains are passed through to the investor as a higher rate of return, and to the borrower as a lower cost of capital. Moreover, competition stimulates financial innovation and the creation of new financial services and instruments that respond to the changing needs of the economy, such as the problem of ageing populations. 7KLUGO\, integration will further raise the efficiency of the financial system by promoting investor protection and systemic stability. Indeed, financial stability will probably be enhanced in an integrated and larger market, which will be better able to withstand external shocks. Of course, this is true only if an appropriate framework for regulation and prudential supervision will be in place, so that financial crises may be prevented to the extent possible, and properly managed whenever they happen. $PRUHSURGXFWLYH(8HFRQRP\ These efficiency gains from the integration of the EU financial system can be expected to influence economic performance via two main channels. The ILUVW channel is increased capital accumulation. The more efficient pricing of investment risk within an integrated EU financial system will offer wider opportunities to hedge against that risk. This will reduce uncertainty and contribute to an environment more conducive to investment. In addition, the intermediation of savings to investment within an integrated and competitive financial system will lower transactions costs, boost investor returns and lower the costs of borrowing. Finally, more liquid European financial markets would make euro-denominated assets more attractive as investment vehicles for international investors. Among the positive effects of this will be an increase in foreign capital inflows and the further development of the euro as an international currency. The VHFRQG channel is an increase in the productivity of capital. The availability of more specialised financial intermediaries within an integrated EU financial system will raise the average productivity of investment through improved project selection, evaluation and monitoring. Notably, the wider opportunity to share risks will allow the allocation of investment to prima facie riskier and more specialised projects, which on average tend to be more productive. Similarly, the availability of more liquid markets will allow a larger proportion of savings to be invested in projects of a longer-term duration, which are also typically more productive than those of a shorter-term duration. A growing body of theoretical and empirical research supports the existence of a robust and economically significant positive link between financial market development and growth. In this context it appears that the traditional distinction between bank-oriented and market-oriented financial systems is not so relevant. Other characteristics have come to be regarded as more relevant for the overall efficiency of a financial system - for instance, its completeness and adaptability. 3

4 A complete financial structure offers firms financing through markets and intermediaries with the best correspondence to their needs at the different stages of their life. An adaptive structure provides leeway for the evolution of new forms of financial intermediaries or contract forms, if the business environment changes. To contribute to the analysis, the Commission has recently contracted out two studies on the impact of financial market integration on economic performance. The two studies are complementary. The bottom-up study uses a cross-country database at the level of the firm. The study will assess how financial structures effect corporate financing and growth and how financial integration is likely to affect those financial structures. The results will then be aggregated at sectoral level. The top-down study inputs some parameters that are suitable proxy for financial integration into a macro-econometric model. The work is ongoing and the results of these studies should be available by the end of the year. 7KH(8VWUDWHJ\WRDFKLHYHILQDQFLDOLQWHJUDWLRQ If the economic case for financial market integration is accepted, the interesting question if how best to proceed towards the attainment of financial integration. More precisely, what is the respective role of public policy and market forces in overcoming the barriers to integration? The European Commission supports the view that the integration process should in general be driven by market forces. The ongoing consolidation amongst financial intermediaries and market infrastructures shows that financial institutions are ready to take advantage of the opportunities offered by the euro, globalisation and technological change. The future structure of the European financial industry should be determined by market forces. Yet, there is a clear need for public policy action in a range of areas. For instance, policy measures are needed to address national difference in legal, regulatory and taxation frameworks, to guarantee that market forces operate in a competitive environment, to make sure that the stability of the entire financial system and of individual institutions is preserved, and to protect consumers. This need for action has been recognised at the highest political level. Successive European Councils have declared the integration of EU financial markets as a priority of economic reform in the EU. This priority is reflected in a coherent policy strategy at EU level and in the urgency which has been attributed to its implementation. First, and most importantly, the EU is committed to implement the Financial Services Action Plan (FSAP) - a package of 42 policy initiatives aimed at improving the functioning of the EU financial system by An even tighter deadline, 2003, has been set for actions relating to securities markets and the Risk Capital Action Plan. The Barcelona European Council has set the objective of having eight FSAP measures adopted before the end of The adoption of these measures will add to the considerable progress that has been made in financial integration in recent years. Second, the implementation of the FSAP is to be consistent across all of the Member States so that there is effective rather than just nominal - integration of national financial markets. The new decision-making framework for securities legislation, adopted on the basis of the proposals by the Lamfalussy Committee, should contribute to this objective and ensure that legislation is more swiftly adapted to the evolution of financial markets. The Commission will be vigilant to ensure that legislation is enforced evenly across the EU. 4

5 Third, competition policy is to be pro-active as financial integration proceeds. Anti-competitive behaviour by providers of financial services or Member State should be swiftly addressed by national and EU competition authorities. Only an effective competition policy will allow the benefits of integration to be fully realised and to spread from the financial sector to the rest of the economy. Fourth, consumers and investors are to be adequately protected so that will they have the confidence to operate in, and so enjoy the full benefits of, a single market extending across the Union. Varying national regimes for consumer protection have been one important factor holding back integration in retail financial services. The FSAP proposes an approach based on the harmonisation of rules essential for consumer protection combined with a shift to the country-oforigin principle and mutual recognition of legal matters. &RQFOXVLRQ To sum up, I think that the economic case for financial integration is very strong. A more efficient and integrated EU financial system will increase the availability of capital and improve its use, with positive knock-on effects on output growth and employment creation. While there has been much progress in financial integration in recent years, we cannot overlook the fact that an integrated financial market has been a Community objective since the 1970s. Moreover, the 2005 deadline set by the Lisbon European Council for implementation of the FSAP looks increasingly tight. Much of the delay in achieving financial integration is due to the complexity of the process, which can sometimes obscure its ultimate economic objective. This is why it is vital that the FSAP is not perceived only as a collection of highly technical legislative measures but rather as a powerful instrument of economic policy. An integrated financial sector is an essential part of the dynamic and prosperous EU economy that we are trying to build. Thank you for your attention. 5